Petition — Chestnutt Corp. v. Fogel

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Ocroser TERM, 1975

N#5- 1665

CuHEstNuTT Corporation, Georce A. CHESTNUTT, JR.,

ARNOLD JOHN CuRRIER, WaRREN K. GREENE

and Sranuey L. Saset,

Petitioners,

Rosatinp Focet and Geratp Foce.,

and

Americas Investors Funp, Inc.,

Respondents.

PETITION FOR WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS FOR THE

SECOND CIRCUIT

Cienpon H. Lee

90 Park Avenue

New York, New York 10016

(212) 953-9200

Counsel for Petitioners

Of Counsel

Rocers Hoce & Hits

90 Park Avenue

New York, New York 10016

TABLE OF CONTENTS

PAGE

ID FD wacenrtissccscterseotieintisindinitinatiabpnritencidiiniitiabatpaiiseas 2

I sicccciveccasaticeciiiilicaintiiaidaedsiiccaineicigtiaidatiaaaaiinasiasiaiaia 2

Questions Presented for Review ...................-.-s:--:-see-e---+ 2

FE ID aiiicsiicteitthidiaceaeliaiitliceabataleniidilaindiedis chide 3

IS Ge Te TO csisishenienpsichtiviicteniineimecimailins 3

oe gt eee 4

TN ID ciciinisens iceirscdnsinndieiinniiennsinnies 9

Small Shareholdings, Effect of “Load”, Re-

I HIE cacisinchsniscanncssabsibigeicocbiniasanatebcaniestiaitioee 9

Required Brokerage at Fixed Commission

STII. iiehissihceseieiescabiindisc tildnigaelaipiceieaiueiiaaealincialanaliaiin 11

Concerning the “Unaffiliated” and “Disinterested”

IT wdceatsaicibleibichias ecicriaasatinadicia Siidimcindemmenidente 15

A. Director Richard Radcliffe ....................... 16

B. Director Eugene Ulrich ............................. 19

C. Director William F. May ............................. 20

D. Director Frank Fowler ...........................-.. 20

E. Director Frank Veeder ............................---- 21

PF. Director Jolm Currier .............0.c.-c.02..-20.0 21

The Position of the “Affiliated Directors” and

SIE MTIIIIIIIT ciissnstccscciscesbstibesesteamsiannenaiininesepibabietinasies 21

A. Director George A. Chestnutt, Jr. ......... 21

B. Director Warren K. Greene ...................... 22

C. Director Stanley Law Sabel ...........0.......... 24

rm iii

PAGE Statutory AUTHORITIES

Defendants as Innocent Bystanders in Three- " Investment Company Act of 1940 PAGE

nee | eceidenemnamiananaliisucuidianauaieass 25

OD} PS SE in ee ee 31

Reasons for Granting the Writ ................-.-csscsecseeeseeees 30 la 3, 30

RE ccsctiscnnctnsttemnsscccnrenssinsnicccnsntatenss coececccecseeeeesces weonvee SO DGD sxesinasneeninisiteichainiesoascndnesettinnsenseinetineeceeeuseetiibtconnsennite 3

EEE A Se ee oe ee ee 33

APPENDIX

Denial of Petition for Rehearing ............................ la BIT ceceeeecreeeceneeetnenenenernenenennenenenaanenennneanen te '

o . UU aieatassisceetieinidladihdehialeahiesitinatinttda aca athe 3

(rr EE ee ee cocece e a

IE» ccctiictnsnvereticcsinemrses ee ee 3

Decision of District Court (383 F.Supp. 914) ........ oa a 3

Opinion of United States Court of Appeals ........ 33a Section 19 of the Securities Exchange Act of 1934 ... 33

RRETEOS ..n.22220:2002-. neosanetersenerssecsnencanesvenanesamevencncenece SUM Securities Acts Amendments of 1975 (Pub. L. 94-29) .. 3

i - Securities Acts Amendments of 1975 §6 ..000000000........ 3, 31

TABLE OF AUTHORITIES

Cases: Securities Exchange Act of 1934 00000 eee 3

CE Ge ee kik ieee ae ge REST Er ee aS Er 4,10

Ernst at Ernst Vv. Hochfelder,. a U.S. es . eae 30 15 US.C. . 10(d) (1) ee ee 19

; - Rg | ae 34

Gordon v. New York Stock Exchange, 422 U.S. 659 ....30, 32

I rn I 34

Moses v. Burgin, 445 F.2d 369, 375 ............ seecceeeesseeeeees 30 oa Oe we OO Paes 34

SEC vy. Capital Gains Research Bureau Inc., 375 U.S. | | | ee 34

i Ie aa ceeeenaries .-B, 26, 30, 31 15 U.B.C. § BOa-20(B) (1) acca cecceceecccccececcseceeecee-o--..---. 34

Tannenbaum v. Zeller (75-7503) ..................ccccceeseeeeecseeee 35 15 U.S.C. § 80a-17(e)(1) and (2) 200. 34

(Argued and pending, Second Circuit) 15 U.S.C. § 80a-2(a) (40) ooccccccccceecccceeeeeeceeeceoeeceeeceeee 34

United States v. NASD, 422 U.S. 694 .....0000000.. 30, 32, 33

PAGE

15 U.S.C. § 80a-22(c) and () .....-.....---.c.-cc-cercseseesees 34

15 U.S.C. § 80a-1(1) (2) -............-a-cecccccccssecenescesensees 34

15 U.S.C. § 80a-9(a)(1) amd (2) -...222.....--ecceeeeceeeee 34

15 UBC. © BORGO) oncceececceceecesenceececessscerssersconmnmnnnens 34

15 U.S.C. § 80a-22(b)(1) amd (2) -..2..22....-2c.ececeeeeeee 34

OTHER AUTHORITIES

SEC, Public Policy Implications of Investment Com-

pany Growth, H.R. No. 2337, 89th Cong. 2nd Session

(1966) [Ex. 4 in Evidence] ................ aieimiedaanaieea passim

SEC, Institutional Investor Study (House Document

No. 92-64, 92nd Congr., Ist Sess., Part 4 (1971), pp.

> keene 27, 28

Rule 10b-13 (17 C.F.R. § 240.10b-13 (1975) ...................- 29

Release No. 9920 (December 27, 1972, CCH Fed. SEC

Fe” SS il! ) 29

Release No. 10,102, CCH SEC L. Rep. 79,327 (1973) .... 29

In THE

Supreme Court of the United States

Ocroser Term, 1975

No.——

CuestNutr Corporation, Georce A. CuestNnutt, JR.,

Arno_p Jonn Currier, Warren K. Greene

and Stanutey L. Saset,

Petitioners,

Rosatinp Focet and GeraLp Fooet,

and

AMERICAN Investors Funp, Inc.,

Respondents.

PETITION FOR WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS FOR THE

SECOND CIRCUIT

CuestNutr Corporation (a Connecticut corporation),

George A. Chestnutt, Jr., Arnold John Currier, Warren

K. Greene, and Stanley L. Sabel, defendants in this ac-

tion, pray that a Writ of Certiorari issue to review the

decision of the United States Court of Appeals for the

Second Circuit which reversed the decision of the Dis-

trict Court for the Southern District of New York and

remanded the case for determination of damages.

Opinions Below

The decision of the District Court is reported in 383

F. Supp. 914. The opinion of the Court of Appeals is

unofficially reported in { 95,393 CCH, Fed. Sec. L. Rep.

and has not yet been officially reported. Such opinions are

set forth in the appendix (A. 5, A. 33).°

Jurisdiction

Judgment of the Court of Appeals was dated and en-

tered December 30, 1975, and petitioners’ timely Peti-

tion for Rehearing (with Suggestion of En Banc) was

denied March 17, 1976 (A. 1-4). Jurisdiction of this Court

is invoked under 28 U.S.C. 1254(1).

Questions Presented for Review

Where full compliance is admitted with all applicable

statutes and regulations and it was found after trial

that there had been full disclosure of stock brokerage prac-

tices of a no-load mutual fund (A. 21)—

Whether retroactive, implied liability for money damage

can be imposed on a registered investment counsel and

adviser by displacing and substituting for this Covurt’s

high standard for investment counselors and advisers of

not engaging in conflicting “brokerage” (SEC v. Capital

Gains Research Bureau Inc., 375 U.S. 180, 190 (1963))

conjectural “remarks” (A. 35) voicing a contrary and

transient administrative whim, for which the Court of

Appeals imposed “harsh” (A. 82) liability for failure to en-

gage in conflicts of interest including joining a regional

*“A. —” is appendix hereto; “Tr. —” means trial transcript;

“a” means appendix below.

stock exchange. This question necessarily embraces and

includes :

(1) Whether a victim of cartels was required to at-

tempt to join them, and if so, could have joined with-

out deceit?

(2) Whether federal common law “waste” will lie for

failure to enter a new and conflicting business, or

whether defendants could rely upon existing statute

law and regulation as provided in §38(c) of the In-

vestment Company Act of 1940?

(3) Whether investment advice and counselling is es-

sentially equivalent to brokerage as held by the Court

of Appeals?

(4) Whether old or supervening law prevents plain-

tiffs from showing either fact of damage or liability

under §36 of the Investment Company Act of 1940

and §6 of the Securities Acts Amendments of 1975?

Statutes Involved

Set forth in the Appendix are applicable provisions of

investment Company Act of 1940 4417, 36(a), 36(b),

38(c) (15 U.S.C. 80a, et seq.; 54 Stat. 815 et seq.,

as amended)

Securities Acts Amendments of 1975 (Pub. L. 94-29)

(Section 6)

Statement of the Case

The Court of Appeals, reversing the trial court, held

defendants liable for money damages for failure to join

a regional stock exchange (“PBW”) ; for failure to join the

National Association of Securities Dealers; and for failure

through self-dealing with a captive account to generate

hypothetical profits, — of which might spill over to the

ee ne a Sem ee ee ere em

captive customer, which would thereby receive a prefer-

ence over the general public through a rake-off called “‘re-

capture”.

A “No-Load” Fund

Defendant George A. Chestnutt, Jr. (“Chestnutt”) has

been in the investment counselling business since 1946,

both managing hundreds of individual accounts and publish-

ing an advisory service to subscribers called “American

Investors Service” (Tr. 108-116). His entities have al-

ways been registered investment counsel and «advisers

under the Investment Advisers Act of 1940 (15 U.S.C.

80b, et seq.).

In 1957 American Investors Fund, Inc. (the Fund), a

New York corporation, was formed and issued its first

prospectus in 1958. The Fund’s first million dollars of

shares were sold to subscribers to “American Investors

Service” (Tr. 114) published by a partnership, American

Investors Company, later becoming American Investors

Corporation, then reincorporated in Connecticut as Chest-

nutt Corporation (“the Adviser’) in 1966.

The Fund is a “no-load” fund under §10(d) of The

Investment Company Act of 1940 (the Act).* It initially

*15 U.S.C. 80a-10(d), including the amendment effective De-

cember 15, 1971 substituting words “interested persons” for “affil-

iated persons” provides:

“10(d) Notwithstanding subsections (a) and (b) (2) of this

section, a registered investment company may have a board of

directors all the members of which, except one, are interested

persons of the investment adviser of such company, or are

officers or employees of such company, if—

(1) such investment company is an open-end company ;

(2) such investment adviser is registered under title IT

of this Act and is engaged principally in the business of

rendering investment supervisory services as defined in

title II;

_ (3) no sales load is charged on securities issued by such

Investment company ;

(4) any premium over net asset value charged by such

company upon the issuance of any such security, plus any

paid a flat 1% advisory fee to the Adviser, which was the

rate in effect at the time plaintiffs made their first pur-

chases in January 1963, and which rate was voluntarily

reduced below the statutory level for no-load funds in

1964 (Stip., 27-28a), after the fund had reached about the

$12 million level. That year, 1963, this Court decided SEC

v. Capital Gains Research Bureau, Inc., supra.

The Fund is sold by direct mail and advertising (Tr.

137-139). The Adviser used mailing lists and advertise-

ments in financial papers and certain New York and Los

Angeles newspapers (Tr. 139). The Adviser “keyed” its

advertising in order to determine its effectiveness and

knew from correspondence that the Fund’s reputation

spread by word of mouth, which the Adviser referred to as

“radiation” in its contemporaneous sales records, abbrevi-

ated “rad.” (Tr. 140).

About 40% of the Fund’s sales were attributed directly

to advertising, “known ads that we put in.. .”, “keyed” for

advertising response and about 45% to 50% to “radiation”.

Chestnutt attributed some of the “radiation” to advertis-

discount from net asset value charged on redemption

thereof, shall not in the aggregate exceed 2 per centum;

(5) no sales or promotion expenses are incurred by such

registered company; but expenses incurred in complying

with laws regulating the issue or sale of securities shall not

be deemed sales or promotion expenses;

(6) sheh investment adviser is the only investment ad-

viser to such investment company, and such investment

adviser does not receive a management fee exceeding 1 per

centum per annum of the value of such company’s net

assets averaged over the year or taken as of a definite date

or dates within the year;

(7) all executive salaries and executive expenses and

office rent of such investment company are paid by such in-

vestment adviser; and

(8) such investment company has only one class of secu-

rities outstanding, each unit of which has equal voting

rights with every other unit.

ing, although it is not measurable. In a falling market,

advertisements were predictable failures (Tr. 141).

It took about 5 years for the Fund to attain total assets

of $5 million (Ex. E, the 1973 Semiannual Report contain-

ing a chart), at which level newspapers first published daily

quotations,

The Securities and Exchange Commission has taken note

of the special niche of “no-load” funds in “Public Policy

Implications of Investment Company Growth” (H.R. No.

2337, 89th Cong. 2nd Sess. 1966, Ex. 4, p. 53; Tr. 126)

stating: |

“From the small investors point of view the sales load

is by far the principal cost of a mutual fund ine*t-

ment. Most mutual fund investors are small investors,

and the 8.5% sales load they normally pay is—assum-

ing that the net asset value of the Fund’s shares does

not change—almost 19 times the prorated share of the

customary annual advisory fee of % of 1%.”

Plaintiff Rosalind Fogel attended college (Ex. R, p. 5).

Her husband had four years of accounting education (Ex.

R, p. 16), and they carefully reviewed the records of in-

vestment companies’ performance and deliberately com-

menced buying Fund shares (Ex. R, pp. 9, 11) in 1963

because it was a no-load fund and she would not have to

pay a 9.3% load or commission, as she had ‘in her prior

purchase of a different fund. She testified:

“We were shopping for something thet would save us

a commission fee. It was a no-load fund and appealed

to us because of the performance record.” *

(Ex. R, p. 7, see also pp. 15-16).

*The Fund’s investment record for its entire history 1958

through 1974 appreciated exactly three times as much as the

Notwithstanding the Fund’s “performance record”, when

plaintiffs commenced buying in January 1963 (Ans. { 2,

15a) the Fund’s total net assets were only $6.6 million

(Ex. E). Plaintiffs made a number of cash investments

including one of $200 on January 1%, 1969, six months af-

ter commencing this suit and two years after commencing

a first suit (67 Civ. 60), now dismissed.

The SEC noted (Ex. 4, p. 52) that approximately 60

no-load funds were only a littie over one-twentieth, or

about 5%, of the mutual fund industry (Ex. 4, p. 52, 59),

and described the distinctive industry pattern which ob-

tained with the no-load funds under Section 10 (d) of the

Act (at p. 59):

“No-load shares are sold by the fund itself with the aid

of its investment adviser. The absence of a sales load

precludes the development of the complex distribution

systems and the exertion of the vigorous direct selling

efforts characteristic of the load funds. No-load funds

employ no salesmen. However, they and their advisers

stimulate share sales by advertisements in newspapers

and periodicals, stating that the fund is a no-loaa fund

and inviting requests for copies of its prospectus. And

some no-load funds encourage brokers to recommend

their shares to prospective investors by directing their

portfolio brokerage business to those brokers who pro-

mote[*] the sale of their shares. Other significant

sources of business are the advisers general nonfund

advisory clientele, recommendations by lawyers, bank-

ers and others on whom people rely for investment ad-

vice; articles in the financial press; the reputation of a

Dow Jones Industrial Average, or by 116.5% versus 38.4%

(including reinvestment of capital gains but excluding income

distribution ).

*N.B.: “promote”, rather than “sel!”.

particular fund for investment expertise; and new

investment by existing shareholders.

“These methods of obtaining business have been con-

siderably less effective than the load funds’ far more

vigorous, personalized selling drives. Hence the no-

load funds have only a small share of total mutual

fund assets and shareholder accounts.”

Since the Fund is a no-load fund, there was never any

legal or economic function to be performed by an “under-

writer” or “dealer” in what the SEC ealls a “complex

distribution system”.

By contrast, an underwriter (or “dealer-distributor”)

is an integral, functioning link in the sale of load funds.

The underwriter has both legal and economie functions in

that the underwriter “buys” shares from a fund at whole-

sale and “sells” shares to other dealers, or else sells to the

public directly through the underwriter’s captive sales

force, thereby avoiding having to split the “load” or com-

mission with retail dealers or brokers.

These methods of doing business, amply described in

the numerous prospectuses of “load” funds introduced by

plaintiffs’ need no elaboration. Many load funds are parts

of huge conglomerates (for example, the $6 billion dollar

“TDS” complex, Stip. 29a). Many have been formed by

New York Stock Exchange brokerage houses, at least in

part to stimulate commission business on the Exchange as

well as to obtain up to 9.3% of the small investors’ funds

as a load or commission.

The SEC (Ex. 4, also at p. 53) further stated:

“The $85 sales load on a $1,000 purchase of mutual

fund shares from which an 8.5 percent load is deducted

is 9.3 percent of the $915 that actually goes to the

fund and would be described as a 9.3 percent charge,

if mutual fund sales loads were computed in the way

in which selling commissions and discounts are usually

computed in the exchange and _ over-the-counter

markets.” (footnotes omitted)

Technical Analysis

The Adviser’s advice is based on “technical analysis”

(Tr. 110-115). About 95% of the selection and timing of

the transactions is derived by in-house technical research

(Tr. 116-123). Nothing is derived from brokerage firms

(Tr. 121), but brokers are on the phone with suggestions,

and every day’s mail contains studies which the brokers

submit to stimulate business.

The technical analysis is minutely described in all the

prospectuses (Ex. 5-15) of the Fund. It is sufficient here

merely to note that the Adviser keeps daily statistical

records on approximately 1300 stocks, divided into 70

industry groups, and that the data are fed into the pre-

determined program of a computer, which ranks such

stocks in percentile groupings which shows their “relative”

market strength, both by individual stocks and by industry

groups. The Adviser publishes weekly information with

respect to 1,000 stocks of these 1,300, and with respect to

the 70 industry groups therein.

An example of the weekly report is Ex. D. Chestnutt’s

pamphlet “Stock Market Analysis Facts and Principles”

is Ex. N. Chestnutt described technical analysis, Tr. 110-

123.

Small Shareholdings, Effect of “Load”, Redemptions, Sales

As the SEC pointed out (supra, p. 6) “most mutual fund

investors are small investors .. .”. That is true of this

Fund,* where the average shareholding of the Fund is

about $2,000 (Tr. 126).

Reference to financial statements in the funds prospec-

tuses (Ex. 5-15), shows for each year under “Statement Of

Changes in Net Assets” both the proceeds from sales of

Fund shares and the pay-out on redemption of Fund

shares. At the end of 1962, and immediately prior to the

plaintiffs’ first purchase, the total net assets of the Fund

were only $6.6 million. Nevertheless, for the 10 years 1962

through 1972 the Fund paid redemptions aggregating $363

million, or 55 times the Fund’s total net assets at the begin-

ning of the period.**

Thus, plaintiffs would have had no opportunity to invest,

or continue investments, in a no-load fund, which would

have been 55 times its 1962 height under water after 10

years, were it not for total sales of additional shares of

$650 million in that 1963 through 1972 period.

Accordingly, new sales are imperative if the Fund, or its

industry, are to survive as a medium for small investors.

Sales to accounts averaging $2,000 in size, at the

customary “load” of 9.3% of invested capital, would have

amounted to approximately $60 million paid to under-

writers and distributors (and divided by them among

salesmen and other dealers). However, since this Fund is

a no-load fund, its shareholders saved that $60 million

which was put to work as their investment.

*In i970 the Fund for the first time established a $400 mini-

mum initial subseription, with subsequent investments of $10.

(Ex. 12)

** Redemptions of $27.7 million and $14.4 million in 1973 and

1974 resulted in net redemptions, after sales of new shares, of

$17.3 million and $4.4 million for such periods, respectively.

Required Brokerage at Fixed Commission Rates

The SEC stated (Ex. 4, p. 53):

“Injections of new capital into and withdrawal of

old capital from a mutual fund lead to purchases and

sales of portfolio securities that entail brokerage

costs”.

This truism was followed on page 54 with:

“Since the cost of purchasing a round lot of a listed

security, which is usually around 1 percent of the

purchase price, must be paid by sellers as well as by

buyers, the total cost of the purchase and subsequent

sales of a listed security, assuming no change in the

security’s market price, is normally about 2 percent

(1 percent when buying and a second 1 percent when

selling) of the security’s price”.

Thus, a billion dollars in-and-out, turned over only once

in a decade, would result at old (fixed) rates in brokerage

commissions of $20 million on portfolio transactions of that

billion dollars, sanctified by the SEC and now called

“excess commissions”.

The Fund could not save any money at the fixed rates.

Its brokerage practices were described in its proxy state-

ments and prospectuses (Ex. 5-15), and, as an example, the

material information on brokerage from the 1969 proxy

statement (Ex. 19) for approval of the advisory agreement

and election of directors, is set forth in full:

“Brokerage Commissions

“The Fund’s investment policies have resulted in a

higher than average rate of portfolio turnover, 39.5%

in 1966, 64.0% in 1967, and 81.9% in 1968, exclusive of

all U. S. Government securities and all other securities

whose maturities at the time of acquisition were one

year or less. The Fund places orders for transactions

in portfolio securities with brokers or dealers provid-

ing the most favorable prices and executions available.

Speed and accuracy in obtaining market quotations,

promptness in execution of orders at minimum com-

mission rates, and prompt reporting of executions are

absolutely essential. Among such brokers and dealers,

those who have provided helpful information to tne

Fund, or have assisted in the sale of Fund shares, are

given preference (without agreement so to do) in al-

locating brokerage business, but not at any sacrifice

in price or execution. Whether or not such preference

were given, the Fund would have to pay the same

amount of commissions.

“Helpful information obtained from brokerage

sources involves quick, accurate quotations and data

as to the size of the market; data on money statistics,

earnings projections, dividend prospects; probable

sellouts, mergers, consolidations, and liquidations; gen-

eral tape action, with volume of shares, blocks re-

cently traded or to be traded, who the huyers and

sellers are believed to be, and other information as to

the state of the market at a particular moment.

“Brokerage commissions of $551,668 were charged

to the Fund on purchases and sales of the Fund’s port-

folio securities in 1966, $1,995,087 in 1967, and $3,122,-

160 in 1968. Of such amounts the Fund allocated ap-

proximately $261,913 in 1966, $935,966 in 1967, and

$2,022,457 in 1968, to brokers who provided helpful

information, and approximately $289,755 in 1966,

$1,059,121 in 1967, and $1,099,703 in 1968, in connection

with the sale of Fund shares. Ineluded in the above

amounts allocated for helpful information and sale of

Fund shares are brokerage commissions of $33,435 in

1966, $23,936 in 1967, and $44,537 in 1968, to Vilas &

Hickey (the wife of a registered representative of

which firm owned 6.3% of the voting and other securi-

ties of the adviser). Prior to December 5, 1968, when

the practice was discontinued in the industry, the Fund

in some instances directed the broker who executed

orders to give up to another broker a portion of his

commission in accordance with stock exchange rules

and regulations. The total amount of such give-nps

during the last two fiscal years was $326,120 iu 1967

and $633,095 in 1968. Since December 5, 1968, the Fund

has discontinued directing give-ups but has continued

giving preference in the ailocation of brokerage busi-

ness to such brokers and dealers who have provided

helpful information or who have assisted in the sale

of Fund shares. Following are tabulations showing

for 1967 and 1968 the ten brokers who received the

greatest amount of brokerage commissions by virtue

of direct or indirect participation in the purchase or

sale of portfolio securities for the Fund.

1967

Gross Give-ups (Give-ups

Broker Commissions — reccived paid

“Hayden Stone & Co. .............. niicdeaa $232,128 $ 3,560 $ 22,885

ee 193,652 = 50,742

Clark, Dodge & Co., Ine. ................... olla 122,829 115 15,394

C. E. Unterberg Towbin ........................... 88,586 —_ om

Tucker, Anthony & R. L. Day .............. . 83,645 350 _-

E. F. Hatton Company, Ine. .............. 79,098 635 1,457

Bateman Eichler, Hill Richards ............ 19,018 57,915 —

Bear Stearns .................... secenveiineeatenmemdtaitin 111,697 224 36,245

McDonnell & Co. ............. seventeen 64,772 1,125 om

a 85,658 — 23,560

1968

Gross (ive-ups (Five-ups

Broker Commissions received paid

“Jesup & Lamont ..... sashestniian $311,067 — $110,210

nee . 188,295 -- 123,060

Merrill Lynch Pierce Fenner &

Smith Ine. ............ snaiesniine sscshtignimapaaeaaaa 178,506 $ 1,495 —

Bemaretn TRU, BID. xncccsresssicesnsssncncennan 174,763 14,985 28,598

G6. 4. Gaston @ GA, Gt sccennneee 170,356 = 78,892

Renee GRIN ccccecceescssntnnceeee . 140,949 1,000 35,405

Thomson & McKinnon, Ine. .................... 126,833 — 31,905

Clark, Dodge & Co., Ine. ...................... 103,968 — 7,985

Sidney A. Siegel & Co., Ine. ....... ............ 99,949 — —

Model Roland .............. RS ARE 98,624 -—— 17,445

“Without knowing what the results would have been

absent the helpful information, the Fund knows of no

way to determine the approximate value of helpful

information obtained. Helpful economie information

relating to particular investment situations, received

hy the Fund, is generally unsolicited and offered by a

broker to stimulate business. It is the practice of the

Fund upon receiving such helpful information from

brokerage sources to refer such information to its in-

vestment adviser, for verification and opinion as to

validity, accuracy, and for further research and rece-

ommendation as to the desirability of acting upon such

information. This involves work by the adviser with

related costs, and to the extent such information can

be utilized, such information can aid the Adviser in

achieving better investment performance for the Fund.

The information itself, for which the Fund allocated

approximately $546 in 1966, $7,664 in 1967, and $7,615

in 1968, aided the adviser in performing its obligations

under its advisory contract with the Fund as well as

benefiting the Fund.”

The trial Court found:

“The use of reciprocals and give-ups was fully disclosed

in the prospectuses of the Fund” (A. 21).

This decade of full disclosure bore in each year the in-

dividual signatures of all directors, whose oral testimony

included the following.

Concerning the “Unaffiliated” and

“Disinterested” Directors

At the time this action was commenced, 4 of the 7 Fund

Directors were “unaffiliated.” (Ex. 11).

While under Section 10(d) of the Act, the Fund could

have had only one director who was not an “affiliated per-

son” (and later after December 15, 1971 an “interested per-

son”)—since this no-load fund did not charge an advisory

fee in excess of one per cent—the trial Court found that

at all times there had been either three or four independent

directors (A. 10). Director Currier who joined the Board in

1962 was an “unaffiliated director”, both before and after

joining the Board, but later acquired privately from an

individual about 2% of the Adviser’s stock. Under the 1970

amendments (effective December 15, 1971), creating a new

definition of “interested person”, Currier became an “in-

terested person” thereafter, although remaining an “un-

affiliated” director.

A. Director Richard Radcliffe

Radcliffe joined the Board in 1958 when the Fund was

about $1 million in size.

His entire deposition, although taken by plaintiffs, was

introduced in evidence by defendants as Exhibit Q. He also

testified in person (Tr. 367-388). Plaintiff’s counsel called

him the “most sophisticated” of the unaffiliated directors

(Ex. Q, pp. 1-11) for the good reason that following

Radcliffe’s graduation from Yale, he was from 1948 to 1950

at the American Institute of Economie Research in Great

Barrington, Massachusetts; from 1950 through 1953 with

White, Weld & Co. in the investment advisory department ;

from 1953 to 1965 was a managing partner of A. W. Jones

& Co., the well publicized and highly suecessful partnership

hedge fund; and from 1965 to the present a managing

partner of Fairfield Partners, another hedge fund. Years

of most esoteric and broad experience—25 of them—never

led Radcliffe to recommend that either A. W. Jones & Co.

or Fairfield Partners or American Investors Fund, Ine.

have any affiliation with a broker. He was familiar with the

efforts commencing in 1965 of certain load funds, having

a functioning “underwriter-distributor”’, to participate

through NASD membership in recapture, the hypothetical

profits of which might be used to reduce advisory fees

(Ex. Q, pp. 23-28).*

*It is stipulated in the pretrial order (29-30a) that Waddell

& Reed, Ine., a $2.6 billion conglomerate, in 1965 apparently

agreed to reduce the advisory fees by 50% of a brokerage sub-

sidiary’s profits, hopefully to be derived from running brokerage

through different markets of regional exchanges for the purpose

of “recapture”. This self-dealing program resulted in a death

Radcliffe did not believe that this experiment in self-

dealing was applicable to the Fund

“Because they are a no-load fund. They have no NASD

member, broker-dealer, selling the Fund’s shares and

for that reason would not qualify for membership on

any exchange that I know of ” (Ex. Q, pp. 30-31).

At pp. 33-34 of Ex. Q, plaintiffs’ counsel made it entirely

clear that he was talking about a “paper company”; a

“shell” that was not in the brokerage business; a “dummy”

that would not be in the brokerage business and would be

operating “solely for the purpose of receiving give-ups”,

doing no business for the public and would not have sold

investment company shares to the public.

At pp. 44-46 of Ex. Q Radcliffe made his views clear

that he would have been “opposed” to any such course, that

“would have led the management company into a field

on which they had no expertise and it would have been

a diversion of their efforts and would have required

that they set up some kind of a brokerage business”

(p. 44).

And again, and going to the heart of the matter,

“T think it would have caused them to make some dif-

ferent type of decisions than they were making, in

the manner that first of all, there would be a question

of the very conflict of whether you allocate commis-

sions to yourself or whether you allocate commissions

to brokers for executing orders and providing you with

information and assisting in the sale of funds” (p. 46).

sentence and consent order of extermination of Kansas City

Securities Corp., which Waddell & Reed had formed. (SEC Re-

leases Nos. 40-8556, 34-11072 and 428 under The Investment Ad-

visers Act of 1940, all da.ed October 24, 1974).

Racliffe and all directors were, of course, completely

familiar with the prospectuses and proxy statements, re-

ceiving proofs prior to directors’ meetings and discussing

the references therein to the Fund’s brokerage practices

(pp. 47-49). Radcliffe repeated his opinion that Chestnutt

Corporation should stick to managing the Fund and not

get into the brokerage business; that American Investors

differed from other types of funds; that there was a “con-

flict of interests” leading to poor execution if there were an

inducement to trade on the thin Pacific Coast Exchange

and his own view that

“T think there is a real risk that a Fund recaptures com-

missions is going to generate commissions, simply for

the purpose of recapturing them, which means the in-

vestment decision is tainted by the desire to earn some

money out of commissions” (pp. 57-58).

Radcliffe made it absolutely erystal clear and in the light

of his experience:

“T have always been opposed to the combination of

brokerage and investment managers, and I think the

two areas should be separated, that brokers should not

be in the investment management business and invest-

ment managers shouldn’t be in the brokerage business”

(p. 59).

While Radcliffe had investigated becoming a broker, he

had never sought it (p. 59).

Radcliffe’s trial testimony (Tr. 367-387) is equally to

the point. His background, personal placing of brokerage

orders, both on the long and the short side for hedge funds

and his failure to recommend brokerage activity for A. W.

Jones & Co., Fairfield Partners or the Fund are repeated

(Tr. 367-372). With respect to the prospectus language

of two other no-load funds, T. Rowe Price Growth Stock

Fund and T. Rowe Price New Era Fund (Exhibits T and

T-1), he was asked specifically whether the language in

such prospectuses with respect to conflict of interest and

diversion of energies of that adviser accorded with his

views both presently and when he was a member of the

Fund’s Board. He was in emphatic agreement that those

exhibits, disclosing management of well over a billion dol-

lars and several times the size of American Investors

Fund, Inc., that it would be improvident to participate in

the brokerage business (Tr. 375-376).

Radcliffe noted the difference between load funds hav-

ing an underwriter and no-load funds and in his judgment

as a director, it was necessary for the Fund and its Ad-

viser to promote the sale of Fund shares (Tr. 380-381).

And he did know what Waddell & Reed was up to, and said

“ .. it’s not what I think American Investors should have

been doing” (Tr. 378).

One such “unaffiliated” and “disinterested” director, all

that is required of a no-load fund under § 10(d)(1) of the

Act, “sophisticated”, specialized, and experienced in the

very field of portfolio transactions and who had served for

11 vears while the Fund grew from $1 million to over $300

million, is quite sufficient to defeat plaintiffs’ claim. The

insiders could not have fooled him if they tried.

B. Director Eugene Ulrich

But the newest “disinterested” director, as well as the

other directors, was to say the least well informed, and

indeed was as peculiarly well qualified as Radcliffe.

Ulrich, with a Masters Degree from the Tuck School,

in 13 years with Arthur Andersen & Co. audited other

investment companies and investment advisers and com-

mon trust funds of Bankers Trust and Morgan Guaranty.

He had been internal auditor of Sinclair Oil, Controller of

B. P. Oil Corporation and was Assistant Controller of

American Airlines (Tr. 331-334).

Coming on the Board in 1971, Ulrich never recommended

that the adviser engage in brokerage; considered it a

“conflict of interest” for the adviser even to be “connected

with” brokerage or “doing brokerage business” (Tr. 336).

Moreover, on cross-examination and apart from policy

judgments, this director of varied experience in the invest-

ment company field concluded “... I think the cost of

maintaining a brokerage business would probably exceed

the benefits” (Tr. 337).

C. Director William F. May

Unaffiliated director May, who left the Board in 1965

after a coupie of years because of a conflict (Tr. 358) upon

joining the Bankers Trust Board, is a chemical engineer,

holder of an Advanced Management degree from Harvard

Business School, Chairman and Chief Executive of

American Can Company, director of Johns-Mansville and

the New York Times, and Trustee of Lincoln Center, Uni-

versity of Rochester, Dartmouth and Brooklyn Polytechnic

Institute. He never recommended the formation of a

brokerage firm (Tr. 361), just as he never sought to have

his own corporation perform all types of services. Mr.

May’s service coincided with the growth of the Fund from

$6.6 million at the end of 1962 to about $50 million, and

with the reduction in the advisory fee from the flat 1% to

the decreasing sliding seale described in the stipulation

(27-28a) and prospectuses, Exs. 6, 7, and 8.

D. Director Frank Fowler

Plaintiffs took the deposition (Ex. P) of “disinterested”

director Fowler, but did not offer it in evidence, and

insisted that this “defendant” be produced, while neglect-

ing to advise the Court the “defendant” was never served

(Tr. 345). When Fowler was produced at the next session

of the trial some days later, plaintiffs declined to examine

in open Court, presumably as a device to sidetrack oral

examination of Radcliffe. Fowler, an independent business-

man and engineer and director since 1962 was opposed to

any involvement in brokerage (Ex. P, especially pp. 35-37).

E. Director Frank Veeder

Named but unserved defendant director Veeder died

several months before trial and was never deposed.

F. Director John Currier

Currier, likewise having a Masters Degree from Harvard

Business School, and president of a major division of

Genesco, became a director in 1962 and thereafter ac-

quired a less than 2% stock interest in the adviser. He

continues to be an “unaffiliated” director, and during the

period until December 1968, when “give-ups” were abol-

ished, qualified to be the sole “unaffiliated” director, under

Section 10(d) of the Act, becoming an “interested person”

only after the 1970 amendments effective 1971 (Tr. 317-

319).

He was opposed even to the “possibility” of having the

adviser participate in brokerage (Tr. 322), and recognized

the inherent conflicts and diversion of effort.

The Position of the “Affiliated Directors” and

“Interested Persons”

A. Director George A. Chestnutt, Jr.

Chestnutt had always been an investment counsellor and

an investment adviser. He had never been a broker or

dealer. His opposition to being in the brokerage husiness

is expressed throughout his testimony but can be noted

especially at Tr. 229 to 230 on cross examination, as

follows:

“Q. Did counsel advise you that it was illegal? A.

They have advised me against it because it was

fraught with self-dealing, with temptations of various

sorts, and as I have said before, the expression Mr.

Sabel used, shoemaker stick to your last.

“It is an old expression and Mr. Sabel has used it

repeatedly in telling me to stay out of the brokerage

business and stick to the thing I know best, which is

analyzing the market.”

“Q. If you form an affiliate that merely receives

commissions and pays them back to the fund, where is

the self-dealing? A. I didn’t know that it was possible

to do that and it never occurred to me until you

brought it up.”

“Q. Did you ever make any inquiry of the NASD

or of the Philadelphia Exchange which it was possible?

A. NASD stands for National Association of Securi-

ties Dealers. That means that the members are securi-

ties dealers; not just holding out a place for a mail

drop for checks to fall into. It didn’t occur to me that

it was a national association of check drop artists.”

B. Director Warren K. Greene

Greene, who had spent some five years with First Boston

Corporation and had received a Masters Degree in finance

(Tr. 238) and had had intensive training and experience in

the various departments of that firm (Tr. 239-241), was

opposed to any entry into the brokerage or underwriting

business by the adviser (Tr. 295-299). On the basis of his

experience, and the fact that the Fund was a “no-load

fund”, he was asked on cross examination whether the

adviser was eligible to be a member of the NASD, and he

repeated what he had said on deposition, namely that since

there was no dealer organization or underwriting affiliation —

there was no need to be either a broker or a broker-dealer

(Tr. 300). Then the Court stated:

“T am not questioning the wisdom or the prudence, I

am just questioning your eligibility, and you testified,

just read, that you weren’t eligible, and I take it from

what you just this moment told me you weren’t eligible

because you didn’t meet the definition of broker or

broker-dealer; is that it?”

The Witness: “That’s right, sir.”

The foolhardiness and the conflict of interest in creating

any functioning brokerage affiliate for dealing on regional

exchanges (as distinguished from a shell or a sham) was

made crystal clear by the uncontradicted testimony (Tr.

311-313) that a proper allocation of expenses, including

space, salaries of officers, salaries of traders and other

overhead matters should be about $150,000 to $200,000 per

year. Thus, if the Adviser had formed a_ brokerage

affiliate to funnel and increase brokerage on the thin

markets of regional exchanges, the amount of business done

on such regional exchanges would have had to be vastly

increased before there could have been any “net profits” to

share with the Fund upon some formula, and in the mean-

time tne Adviser could have unburdened itself of sub-

stantial annual expenses, to be paid for by Fund brokerage

business placed on regional exchanges, for the sole purpose

of ultimately creating a hypothetical profit of which the

Fund would get some share. Indeed, if a brokerage affiliate

for purposes of regional membership were formed, and it

exactly broke even, the Fund would get nothing whereas the

Adviser would have saved between $150,000 to $200,000 in

overhead.

C. Director Stanley Law Sabel

Sabel had suffered strokes and was deposed by plaintiffs

(Ex. 23, p. 4, Ex. O) both in this action and the prior action

(67 Civ. 70). Practising since 1932 in New York, member

of Massachusetts and Connecticut bars,* a specialist in

securities law, author of law review notes, holder of both

LLB and LLM in corporation finance from Harvard, Sabel

has continued as director of the Fund since inception.

His opposition to brokerage involvement was deliberate

and principled, as well as soundly grounded on the judg-

ment “Shoemaker stick to your last” (Ex. 23, p. 38). He

clearly recognized that suggestions in the 1966 SEC report

(Ex. 4) as to recapture were not applicable to a no-load

fund. Copies were furnished all directors (Ex. 23, pp. 20-

24). He pointed precisely to the language in Ex. 4 relating

to “.. . dealer distributed funds” which shows the distinc-

tion in the SEC’s own mind with respect to “recapture”

availability (Ex. 23, pp. 54-55).

Sabel recognized the inherent conflicts in self-dealing

brokerage for the Fund (Ex. 23, pp. 32, 36-38, 50 81-83),

and the opposition of disinterested directors, particularly

Radcliffe and Fowler to any such conflict or sham and

deceit.

Sabel was entirely familiar with the NASD rules for

eligibility, and indeed it was those rules which had occa-

sioned correspondence with the NASD (Ex. A) in March

1967.

* Mr. Sabel has since passed and been admitted to the Georgia

bar, where he resides at Saint Simons Island.

He would not advise a “deceitful” (Ex. 23, p. 43) “letter

drop”.

At pp. 41-49 (Ex. 23) Sabel carefully analyzed the

NASD eligilibitly requirements, especially at p. 46, where

he quoted “. . . whose regular course of business consists

in actually transacting any portion of the brokerage or

investment banking business.” (Also Ex. 23, p. 88)

With respect to the Pacific Coast Stock Exchange, where

plaintiffs contend there could have been some gross dollars

“recaptured” before expenses. Sabel noted with precision

the prerequisite of NASD membership to participate in

that regional exchange, under whatever umbrella (Ex. 23,

pp. 52-54). All of this had been his, as general counsel’s,

advice to the directors (Ex. 23, pp. 66-67). All prospectuses

and proxy statements fully disclosing the Fund’s brokerage

practices—as the trial Court found (A. 21)—had been

provided to directors before their meetings (Ex. 23, pp.

78-79).

Defendants as Innocent Bystanders in

Three-Cornered War

An early, wild shot in the three-cornered war between

the SEC, Congress and the New York Stock Exchange was

a single sentence appearing on page 173 of the 346 page

PPI December 5, 1966 report. Without reference to direct

mail, or no-load funds, the Commission conjectured that

since four huge complexes (having captive sales forces)

had become members of the Pacific Coast Exchange, and

shirking its duty to press for reasonable rates, and launch-

ing a suggestion for a preferential advantage arising out

of self-dealing stated that:

“Tt would not be inconsistent with those rules for dealer-

distributed funds to direct give-ups to the adviser-

underwriters, all of whom are NASD members, for

the purpose of applying these give-ups to reduce the

advisory fees payable by the funds.” * (emphasis

added)

“82 Alternatively, the fund itself could form a broker-

affiliate to which it could direct give-ups. If this course were

followed—and no fund now does so—the give-ups would inure

to the direct benefit of the funds’ shareholders.”

That staff report totally ignored the standards of SEC v.

Capital Gains Research Bureau, supra, enunciated three

years before and, the very year, 1963, these plaintiffs first

bought their shares.

The report carefully defined execution as “the actual work

of making a trade on the exchange floor” (p. 168, n. 59).

It stated that the four mutual fund affiliates which had

recently joined the Pacific Exchange “execute” orders—

not only for their respective funds on that exchange floor—

but also “obtain a considerable amount of non-fund busi-

ness” from firms which are members of the New York

Stock Exchange, in return for fund brokerage business

on the New York Exchange, and that a part of the “profits”

from that tied-business was applied to reduce the advisers

fees (pp. 172, 173). (emphasis added)

This devious trial balloon was predicated upon exploiting

captive customers to attract “profits” (to the adviser), plus

swap and tie business on various floors, in a back-scratch-

ing, churn inducing charade.

Six weeks later, February 9 and 10, 1967, the General

Counsel of the SEC spoke at the University of Pennsy]-

vania, at a forum attended by Fund general counsel, defen-

dant Sabel. Mr. Loomis stated (115 U.P.L. Rev. 835):

“Mr. Loomis: Herb Anderson’s remarks seemed to

indicate at least part of the confusion that has surrounded

this problem. He appears to feel that our objection to

customer directed give-ups is a criticism of the funds and

of the fund managers, and that the fund managers, or the

NASD, or the L.C.L., should do something about it. We don’t

look at it that way—at least, I don’t. So long as the stock

exchange rules permit this way of doing things, I don’t

particularly blame the funds for doing it, and the NASD

and the I.C.I. have no power to change the rules of the stock

exchanges anyhow.

“So long as the stock exchange rules permit this practice,

it is to be expected that the funds will do something with

these commissions, rather than not do anything with them.

Thus, we view this as a problem of exchange rules, not as

a practice in which the funds or their managers or the

NASD or the I.C.1. are in any way delinquent. Of course,

this system does create, as the report points out, and as

Bob and I have mentioned, an incentive for funds, and

perhaps for fund salesmen, to do things which :aise ques-

tions. But by and large this is not a problem of any mis-

conduct on the part of funds or fund managements, but, in

our view, a defect in the exchange commission rate struc-

ture.” (Emphasis added)

The opportunities for palming off overhead, allocations

of expenses and consolidated tax, temptations to churn,

and the fact that only “net profits” from brokerage would

he considered were belatedly stated by the SEC in its

Institutional Investor Study which in 1971 recognized.

“Even if a fund adviser offsets the management fee by

the total net income earned by an affiliated broker on

the funds’ transaction, it may still receive financial

benefits from the arrangements. For instance, one such

arrangement provides for the deduction of an allowance

for income taxes of the brokerage affiliate in determin-

ing the brokerage affiliate’s net income. Since the

adviser and the brokerage affiliate filed a consolidated

tax return the after-tax income of the adviser ts m-

creased.” (House Document No. 92-64, 92d Cong., Ist

Sess., part 4, pp. 2298-99 (1971).) (emphasis added)

In a footnote the Study explains the process in more

detail:

“For example, a mutual fund manager with a scheduled

fee of $2 million and a brokerage subsidiary with

pre-tax income of $1 million would offset the manage-

ment fee by $500,000 (assuming a 50 percent tax rate).

On consolidated pre-tax income of $2.5 million ($15

million management fee and $1 million in brokerage

net income) the adviser would net $1.29 million after

taxes. Without the subsidiary the adviser would have

received a $2 million fee on which it would have netted

only $1 million after taxes.” (Jd. at 2299 n. 91.)

But even earlier, upon the proclamation of proposed

Rule 10b-10 in January 1968, never adopted and —_

drawn, suggesting “recapture” by “dealer-distributed

funds, Commissioner Smith in dissent stated the proposal :

« . . would only exacerbate the sometime byzantine

arrangements among brokers with respect to give-ups

without meeting directly the basic problem, which is

a reasonable level of commission rates.”

Yet, on January 29, 1972, the SEC answered the request

of the Sears Roebuck empire, whose mutual fund affiliate

had obtained PBW membership, that it be permitted to

reduce management fees paid by the fund by the entire

amount of the PBW members net income attributable to

both direct and tied-in fund brokerage business. The Staff

refused to issue a no-action letter stating:

“As you know, the Commission is considering the

problem of institutional access to National Security

Exchanges. The resolution of this problem may affect

the proposed arrangement among Fund, Manager and

ATC. Because of this factor, in addition to the prob-

lems under Sections 17(e) and 17(d) of the Act and

Rule 17d-1 thereunder, the Manager, ATC, and the

Fund will be acting at their own risk if they proceed

with the proposed arrangement.” Allstate Enterprises

Stock Fund, Inc. (emphasis added).

The Commission has likewise blown hot and cold on the

question of obtaining preferences for tender offer “solicita-

tion fees”, Following passage of the “Williams Act”,* ex-

pressly designed to prevent preferences and payments on

the side, the Commission issued its Rule 10b-13 (17 C.F.R.

§240.10b-13 1975). Thereafter the Commission in its

Release No. 9920 (December 27, 1972, CCH Fed. Sec. L.

Rep. §79156) stated that it viewed “the payment by a

‘ender offerer of a soliciting dealer’s fee, directly or in-

directly, in part or in whole, to a tendering shareholder, as

compensation otherwise than pursuant to such tender or

exchange offer.” And it went on to state, with particular

reference to mutual funds, that the proposed amendment

was intended to assure that no soliciting fee be paid back

directly or indirectly to any “tendering shareholder or its

affiliate” which was described as “any investment adviser

to any investment company”.

The Commission’s Release No. 10,102, CCH Fed. See. L.

Rep. { 79,327, issued in 1973 was a complete flipflop, indi-

eating that a Fund manager may have “an obligation to

name an affiliated broker” to receive solicitation fees, there-

by accomplishing the very preference and discrimination

which the Williams Act was designed to outlaw.

* 82 Stat. 455 (1968), 15 U.S.C. § 78n(d) (7).

Reasons for Granting the Writ

The decision below cannot be reconciled with Ernst €

Ernst v. Hochfelder, U.S. : Gordon v. New York

Stock Exchange, 422 U.S. 659; United States v. NASD,

422 U.S. 694; Cort v. Ash, 422 U.S. 66, and SEC vy. Capital

Gains Research Bureau, supra.

It is of utmost public importance that any “implied”

remedy under the 1940 Act be fully considered in the light

of the express remedy in §36(b) added in 1970, which in

subdivision §36(b)(1) shifted to the plaintiff the burden

of proof of violation of fiduciary obligation, and in §36(b)

(3) limited recovery to the amount of “compensation or

payments received from such investment company, or the

security holders thereof, by such recipient.”

Indeed, counsel for plaintiffs has himself attested to

the public importance, being quoted the day after the

decision (Wall Street Journal, December 31, 1975, p. 5)

“Mr. Pomerantz predicted a ‘chain reaction’ of suits im

New York against other advisers of mutual funds that

er arate

haven’t tried to recapture commissions.

Further, this case conflicts directly with the First Cir-

euit’s decision in Moses v. Burgin, 445 F.2d, 369, 375, in-

volving a “load” fund having a functioning underwriter,

holding:

‘the directors had no duty to pursue plaintiffs sug-

vested course of action, and without their doing so,

recapture was not freely available. Plaintiff knew of

Fund’s practice when she bought her shares; she

could have chosen a fund that did have an affiliated

broker.” (Emphasis added)

While it is admitted that defendants were ineligible to

join the major cartel, the NYSE, had they in fact created

a bona fide brokerage business, under §17(e) of the Act

defendants could have kept in their own pocket the gross

amount of “the usual and customary broker’s commission”

for transactions on regional cartels, 2% on secondary dis-

tributions and 1% on over-the-counter transactions.

Supervening statutory amendments in 1970 and 1975

now require all investment companies and their advisers

to conform to the actual practice of defendants in the past,

including, specifically, the requirements under the Adviser’s

Act that all mutual fund advisers now register as advisers

(§203(b))* and section € of the Securities Act Amendments

of 1975 which finally divorces investment management

from the brokerage with which defendants had no link,

legal or meretricious.

In Capital Gains Research this Court was especially con-

cerned with impairment of investment judgment (375 U.S.

at 190) stating:

“... not engaged in any activity such as security sell-

ing or brokerage, which might directly or indirectly

bias an investment judgment... ”.

And the Court stated earlier

“The report stressed that affiliations by investment ad-

visers with investment bankers, or corporations might

be ‘an impediment to a disinterested, objective, or criti-

cal attitude toward an investment by clients. . ”” (at

187-188),

and further:

“The report incorporated the Code of Ethies and Stan-

dards of Practice of one of the leading investment

* 15 U.S.C. 80b-3(b) (2) and (3), as amended 1970, P.L. 91-547.

counsel associations, which contained the following

canon:

“(An investment adviser] should continuously occupy

an impartial and disinterested position, as free as

humanly possible from the subtle influence of pre)-

udice, conscious or unconscious; he should scrupu-

lously avoid any affiliation, or any act, which subjects

his position to challenge in this respect.” (at 188,

emphasis the Court’s)

The conflict with the Gordon and the NASD cases is

equally apparent. The SEC at all times had the power

under the Securities Exchange Act of 1934 and under the

Advisors Act and under the Investment Company Act of

1940 to make all needful rules and regulations applicable

to the exchanges themselves, or to investment companies

alone, to have raised its ephemeral views and transient no-

tions (or “remarks”) into rule or regulation.

In the NASD ease this Court quoted in Note 45 the Com-

mission Chairman’s report to Congress including:

“No issuer of securities is subject to more detailed

4 ”9

regulations than a mutual fund.

In the next to the last paragraph of “IV A” this Court

stated:

“The SEC’s election not to initiate restrictive rules or

regulations is precisely the kind of administrative

oversight of private practices that Congress contem-

plated when it enacted §22(f).”

In Gordon, the SEC’s active concern for competition did

not mandate competition until formal action by the SEC.

The SEC’s thinking out loud for more than 10 years did

not change its regulations having the force of law.

That portion of its thinking out loud directed to invest-

ment companies did not change the regulations or rules

relating to mutual funds, any more than it did the regula-

tions under §19 of the Securities Exchange Act of 1934.

Leviathan acts by thrashing its tail—not by vapor spouts.

“Thar’ she blows” is not an adequate ratio decidendi for

determining official action.

Collateral attack, both public and private, “. . . where

[the SEC] has not deemed it appropriate to prohibit the

conduct,” has been precluded. J” 8. v. NASD, note 41 and

accompanying text including Cou: t’s statement “We agree.”

In the NASD case we invite special attention to notes 3,

13, 21, 22 and 45, together with the accompanying text.

Here there is no showing of violation or failure to ad-

here to any rule or regulation of the SEC, or of any ex-

change, or of the NASD.

The administrative oversight by electing “not to initiate

restrictive rules or regulations” would further appear to

require full consideration of the provisions of Section 38(c)

of the Act which provides “no provision of this title impos-

ing any liability shall apply to any act done or omitted in

good faith conformity with any rule, regulation, or order

of the Commission. . .” (Emphasis added).

The public importance of this case is further emphasized

by its unique characterization of brokerage :*

“The adviser in the present case originates transac-

tions for many investors in addition to the Fund; if

that were not enough, something might be said for

piercing the corporate vail and regarding the adviser

as acting ‘for the account of’ for the Fund’s share-

holders” (A71) (emphasis added).

* Without regard to capacity.

a La Ne

and the suggestion on the following page

“the term ‘broker’ . . . could well include an adviser

placing buy and sell orders for the portfolio of a

mutual fund...” (A72)

This Court’s opinion in U.S. v. NASD, in Note 3° stated

the law to the contrary with respect to the Exchange Act of

1934 and in Notes 21** and 22*** gave the definitions from

the 1940 Act of dealers and brokers in the margin.

*“3 In this opinion we will use the term “broker-dealer” to

refer generally to persons registered under the Securities Ex-

change Act of 1934, 15 USC §§ 780 et seq. [15 USCS §§ 780

et seq.}, and authorized to effect transactions or induce the pur-

chase or sale of securities pursuant to the authorization of that

Act. We also will refer separately to “brokers” and “dealers”

as defined by the Investment Company Act, see 15 USC §§ 80a-

9(a)(6) and (11) [15 USCS §§ 80a-2(a) (6) and (11)], to de-

seribe the capacity in which a broker-dealer acts in a particular

transaction.

**“9] The Investment C . -iny Act defines a “dealer” to be:

“fA]ny person regulu:., gaged in the business of buying

and selling securities for his own account, through a broker

or otherwise, but does not include a bank, insurance com-

pany, or investment company, or any person insofar as he

is engaged in investing, reinvesting, or trading in securities,

or in owning or holding securities, for his own account, either

individually or in some fiduciary capacity, but not as a part

of a regular business.” 15 USC § 80a-2(a)(11) [15 USC

§ 80a-2(a) (11)].

A “broker,” by contrast, is defined to be:

“fA]ny person engaged in the business of effecting trans-

actions in securities for the account of others, but does not

include a bank or any person solely by reason of th. fact that

such person is an underwriter for one or more investment

companies.” Id., § 80a-2(a) (6).

#** “99 Congress employed the term “broker” without reference

to “dealer” in various sections of the Act. See id., §§ 80a-8(¢) (2) ;

80a-10(b) (1) ; 80a-17(e) (1) and (2). In other instances, the Act

refers to “dealer” without reference to “broker,” see id., §§ 80a-

2(a) (40); 80a-22(c) and (d). And in some cases, ineluding the

very definition of the term “dealer” itself, see n. 21, supra, the

rene see 8

The exhaustive discussion of implied liability in Ernst

& Ernst v. Hochfelder need not be repeated, but we may

refer to :

“The logic of this effect-oriented approach would im-

pose liability for wholly faultless conduct where such

conduct results in harm to investors, a result the

Commission would be unlikely to support.”

In the present case there is no victim.* There is no loss

There is no unjust enrichment. There is nothing to be

restored. No defendant ever received a red cent with which

to pay a judgment of liability. There is neither violation

of law, nor failure to abide by regulation or any rule of an

exchange. There is no negligence, J

There was full disclosure.

. The SEC could not have obtained a mandatory injune-

tion to compel vertical integration into the brokerage busi-

ness which was not required by statute.

As a matter of statute law there is not one word to sunp-

port either the complaint or the decision below.

As a matter of fact and as a matter of law, no one could

> “a . , .

have “relied” on anything other than the full disclosure in

the prospectuses and proxy statements,

The remedial provisions of the Act are ripe and im-

portant for determination.

On February 9, 1976 a different panel of this Cireuit

heard argument in Tannenbaum vy. Zeller (75-7503) wherein

Act refers to both “broker” and “dealer” i

! r’ in the sa isi

- id., §§ 80a-1(b) (2) ; 80a-9(a)(1) and (2); and 80a.30(a).

F inally, the Act In some cases refers to the more general term

broker-dealer,” see id., §§ 80a-22(b)(1) and (2).

*The reeurrent term “exces _ :

*,* cess comm issions” is ‘ .

competitive own proper progeny. the SEC’s non-

ee ——

the SEC has filed the first week in May a 50 page brief in

support of affirmance of a decision of no liability where a

fund did no business with its affiliated NYSE member

firm.

It would be anomalous indeed if liability were fastened

for failure to enter a new business, while abjuring an ex-

isting vehicle would exculpate.

CONCLUSION

This Court does not sit to right wrongs nor to trim

excrescences; but, nevertheless, obedience to unskewed

shape of statutes must remain its constant concern.

It is respectfully submitted that this Court should grant

the Petition and issue the Writ prayed.

Respectfully submitted,

Cienpon H. Lee

90 Park Avenue

New York, New York 10016

(212) 953-9200

Counsel for Petitioners

Of Counsel

Rocers Hoce & His

90 Park Avenue

New York, New York 10016

EIT ee rt es ea Be te

core

« tale eek hn te Re < & cea

ODA rae > iw at: 0

APPENDIX

Denial of Petition for Rehearing

UNITED STATES COURT OF APPEALS

For THE Seconp Circvit

Docket No. 74-2582

At a Stated Term of the United States Court of

Appeals, in and for the Second Circuit, held

at the United States Court House, in the

City of New York, on the seventeenth day

of February, one thousand nine hundred

and seventy-six.

Present:

Hon. Henry J. Frrenpwy,

How. Paut R. Hays,

Hon. Wicrrep FEINBERG,

Circuit Judges.

RosaLtinp Focet and Geratp Focen,

Plaintiffs-A ppellants,

| Georce A. CHEstTNuTT?, JR., Joun Currier, Frank G. Fow rer,

Jr., Warren K. Greene, Ricnarp W. Rapcuirre, Stran-

LEY L. Sapet, Francis L. Veeper, AMERICAN INVESTORS

Corp., AMERICAN INVEsTORS Funp, INc., and Cuestnutt

Corp.,

Defendants-A ppellees.

ee ee ot ne

Denial of Petition for Rehearing

A petition for a rehearing having been filed herein by

counsel for the defendants-appellees (other than American

Investors) bs

Upon consideration thereof, it 1s . .

Ordered that said petition be and hereby 1s denied.

A. Dante, Fusaro

Clerk

Judgment

UNITED STATES COURT OF APPEALS

For tHE Seconp Circurr

Docket No. 74-2582

At a stated Term of the United States Court of

Appeal for the Second Circuit, held at the

United States Courthouse in the City of

New York, on the thirtieth day of December,

one thousand nine hundred and seventy-five.

Present:

Hon. Henry J. Frrenp.y,

Hon. Paut R. Hays,

Hon. Witrrep Fernsera,

Circuit Judges.

Rosatinp Focer and Geratp Focet,

Plaintiffs-Appellants,

Georce A. Cuestnutt, JR., Joun Currier, Frank G. Fow er,

Jr., Warren K. Greene, Ricnarp W. Rapcurre, Stan-

LEY L. Saver, Francis L. Veeper, AMERICAN INVESTORS

Corp., AMERICAN INvesTors Funp, Inc., and CuestNuttT

Corp.,

Defendants-A ppellees.

Appeal from the United States District Court for the

Southern District of New York.

Judgment

This cause came on to be heard on the transcript of record

from the United States District Court for the Southern

District of New York, and was argued by counsel.

On Consiperation WHEREOF, it is now hereby peo

adjudged, and decreed that the judgment of said yams

Court be and it hereby is reversed and the action be —

it hereby is remanded to the District Court Bag -

proceedings in accordance with the opinion of this cour

with costs tv be taxed against the appellees.

A. Dante, Fusare

Clerk

By Vincent A. CaRrLin

Chief Deputy Clerk

at aes ioe me a ae

a — ane ee ey

Decision of District Court (383 F.Supp. 914)

WYATT, District Judge.

This is the decision after trial with-

out a jury on the issue of liability alone.

There will be judgment for defendants

on this issue.

Plaintiffs are and have been since

January 11, 1963 holders of record of

shares of capital stock of American In-

vestors Fund, Inc. (Fund), a New York

corporation. Fund is a diversified open-

end management investment company

registered as such under the Investment

Company Act of 1940 (15 U.S.C. § 8Ma-

1 and following (“the 1940 Act”); see

§§ 80a-3, 80a-4, 80a-5, 80a-8). Fund

is one of the many companies usually

called a “mutual fund”. Fund does not

charge a “sales load” (commission) on

its shares sold (15 U.S.C. §§ 80a-2(a)

(35), 80a-10(d).

Fund was organized in 1957 and had

for some time as its investment adviser,

American Investors Corporation. Since

July 19, 1966, the investment adviser

of Fund has been Chestnutt Corporation

(Adviser), a Connecticut corporation

which acquired all the assets of Ameri-

Decision of District Court (383 F.Supp. 914)

can Investors Corporation. | For ae

ity the term “Adviser will usua Bass

meant to include American ee on

Corporation. The Adviser ee

Fund and acts under an pogpersge baw

visory contract between it an

George A Chestnutt, Jr. iGesvae?.

for whom the Adviser is named, 1s . af

ident and principal stockholder ss a

of the Adviser and president and 4

rector of Fund. He has been hens chie

figure in Fund and in the Adviser.

The action was commenced on J uly -

1968, and is a derivative one on behal

of Fund (a nominal defendant). The

action is also said to be brought repre-

sentatively” for all other “shareholders

of tne Fund similarly situated’; what

this means is not clear.

The named defendants are the Ad-

visor, its predecessor (American In-

vestors Corporation) and the seven di-

rectors of Fund when the on

commenced. Four of these individua!

defendants were served and er

George, Currier, Greene, and Sabel.

Currier is a director of Fund and owns

Ae tek 8 eee OO emeeiaeio

acetate heruisi its

Decision of District Court (383 F Supp. 914)

voting common stock (2%) of the Ad-

viser; he is a corporate executive in the

women's wear field. Greene is vice

president and a director of Fund and

vice president and a smal] stockholder

(0.4%) of the Adviser. Sabel is a law-

yer and a director of Fund; before his

retirement in 1971, Sabel was senior vice

president and secretary of Fund and

was also vice president, secretary, di-

rector, and = substantial stockholder

(16°c) of the Adviser (he may still be

a substantial stockholder of the Ad-

viser).

The complaint named three other di-

rectors of Fund who were not served

and did not appear: Fowler, Radcliffe,

and Veeder.

Jury trial was demanded by plain-

tiffs.

The complaint in one count avers a

claim that the Adviser and the individ-

ual defendants enriched themselves at

the expense of Fund by the use of

“reciprocal brokerage” and “give-ups”.

Specifically, the charge is that defend-

ants violated the 1940 Act “by failing

Decision of District Court (383 F.Supp. 914)

to recapture brokerage commissions tor

the Fund” ‘(Post-Trial memo for plain-

tiffs, p. 2).

The complaint avers that this Court

has jurisdiction under the 1940 Act and

also under the Investment Advisers Act

of 1940 (15 U.S.C. § 80b--1 and follow-

ing) and the Securities Exchange Act of

19384 (15 U.S.C. § 78a and following;

“the 1934 Act”). Plaintaffs appear to

rely solely on the 1940 Act.

By order filed June 29, 1973, it was

directed that “the issue of liability will

be tried separately and before the issue

of damages”. The Court was advised

at that time that the action would be

tried without a jury.

A pretrial order signed September 4,

1973 (but for some reason not filed un-

til October 4, 1973) noted that the right

to a jury trial had been waived by “‘both

parties”.

Without opposition by defendants, the

plaintiffs were permitted to serve and

file a supplemental complaint, the prin-

cipal (if not only) function of which was

to bring the complaint down to date.

Decision of District Court (383 F.Supp. 914)

The supplemental complaint was filed on

August 24, 1973 (a copy with verifica-

tion added was filed on August 30, 1973).

No order was made that defendants plead

to the supplemental complaint (Fed.R.

Civ.P. 15(d)); note was taken of this

situation at trial and new paragraphs

of the supplemental complaint were

“deemed denied” (SM 6; SM refer-

ences are to pages of the stenographic

minutes).

It is difficult to tell the time period

for which this action is brought. Based

on the averments in paragraphs 21(a)

and 23(a) of the supplemental complaint,

it would appear to be from January 1,

1965 down to date. For reasons which

will appear, however, the claim as to

give-ups must end on December 5, 1968,

and the claim as to reciprocal brokerage

must end on July 15, 1973. Counsel for

plaintiffs insist (SM 65) that member-

ship on two regional exchanges would

have yielded preferences thereafter, but,

as will appear, SEC Rule 19b-2 pro-

hibited this, effective March 15, 1973.

10a

Decision of District Court (383 F.Supp. 914)

Since 1964, Fund hes had either eight

or seven directors.

With respect to directors, the parties

have used the terms “affiliated’’ and

“unaffiliated” but have not defined these

terms. The 1940 Act uses the expression

“interested persons” in referring to di-

rectors (15 U.S.C. § 80a-10(a)) which

is elsewhere defined to include an “affil-

iated person” (15 U.S.C. § 80a-2(a)

(19)(A)(i)) which latter term is else-

where defined (15 U.S.C. § 80a-2(a)

(3)). For purposes of this action, an

affiliated director may be considered

as one connected with or having an in-

terest in Advisor, as opposed to an in-

dependent director, having no connection

with or interest in Adviser.

Since 1964, Fund has had either three

independent directors out of seven or

four independent directors out of eight.

Fund has had four affiliated directors.

Currier is counted as an affiliated di-

rector because, while not employed by

Advisor, he has owned 2% of the voting

common stock of Adviser.

on wormed

lla

Decision of District Court (383 F.Supp. 914)

Fund and Adviser had the same coun-

sel. Sabel and his firm were counsel

to both until 1971 or 1972. Clendon H.

Lee, whose wife has been for a long

time the owner of a small amount ( 1%)

of the voting common stock of Adviser

became special counsel to Fund in 1965

and his law firm has acted as counsel

to Fund since at least April 28, 1972.

Under the investment advisory con-

tract, Adviser manages and advises

Fund, furnishes all offices to Fund, pays

all officers and employees of Fund. and

in short does everything for Fund.

Fund pays nothing for expenses ex-

cept fees to directors.

Under the investment advisory con-

tract, Fund pays the Adviser for its

services on an annual rate of a percent-

age of the net asset value of Fund.

These payments have been substantial,

ranging from $187,000 in 1964 to $1,557,-

000 in 1969. 3

12a

Decision of District Court (383 F.Supp. 914)

The charges in this action had their

origin in the size of the transactions

made on stock exchanges by mutual

funds and other institutions. As these

transactions developed, they involved

buying and selling large blocks of shares

and at the rates fixed by the exchanges

(no quantity discounts) the brokerage

commissions became so great that mem-

bers of the exchanges could execute fund

transactions at a cost of only a small

part of the commissions which had to

be charged. Naturally, exchange mem-

bers were eager for mutual fund busi-

ness and would have been willing to

rebate part of their commissions to the

customer mutual funds but were pre-

vented by exchange rules from doing so.

In this climate, brokers had a strong

motive to give help to managers of mu-

tual funds by (a) selling shares of the

fund or (b) supplying the manager with

investment research and advice, or (¢)

doing both. The manager of the mutual

+t of its bro-

fund would then allocate part o is br

kerage business to such helpful brokers,

13a

Decision of District Court (383 F.Supp. 914)

and could sce that the commissions

earned by such helpful brokers bore a

relation to the value of the sales efforts

and of the research and advice. Those

allocated orders were known as “recip-

rocals”’.

For some funds, especially big funds,

it became undesirable to allocate broker-

age orders on the basis of the value of

non-brokerage services rendered. This

was principally because sales of the mu-

tual fund shares were made by many

independent brokers or dealers; to send

brokerage transactions through so many

brokers would not be prudent from a

management standpoint, this for many

good reasons.

To meet this situation, the brokers

and mutual fund managers worked out

the technique of the “give-up”.

The give-up technique was that the

broker who executed the fund transac-

tion surrendered a part of his commis-

sion to other brokers designated by the

customer fund, acting of necessity

through the fund manager. In this way,

l4a

Decision of District Court (383 F.Supp. 914)

the fund manager could spread the com-

missions on fund executions among a

number of brokers, who, although they

had nothing to do with execution of

the transaction, had been otherwise help-

ful in selling fund shares or in giving

investment advice or both.

Brokers executing transactions for

mutual funds were willing to give up

as much as 75% or more of their com-

missions. . at

As might be expected, the Securnnen

and Exchange Commission - (SEC)

came concerned with the infuenes 0

fund and other institutional —.

tions on the structure of the mal .

for securities, as well as with the a

rates (without quantity discoun os

charged under exchange rules. It bys

this last feature which had resulte | in

the development of reciprocals and give-

ups. :

en give-up technique was not el

out its limits. Because of a rule of e

New York Stock Exchange (NYS -

commissions on transactions there cou

Re A ETNA ABH Nt ct a MITE at NN Re iat MASI ANS i sete iy Mis

BS ever

s ee ee ee ee OT ae

ee See te ee

l5da

Decision of District Court (383 F.Supp. 914)

only be given up to other members of

that exchange. The regional exchanges,

as a way of competing with NYSE, were

less strict. Nearly all the regional ex-

changes permitted commissions to be

given up to non-members provided they

were members of National Association

of Securities Dealers, Inc. (NASD).

NASD is the only “national securities

association” registered with the SEC

under Section 15A of the 1934 Act (15

U.S.C. § 780-3: the Maloney Act (added

in 1938)), the purpose of which was to

establish supervised self-regulation of

over-the-counter brokers and dealers.

NASD has rule-making power.

The availability of give-ups posed a

dilemma for fund managers. The busi-

ness was that of the funds; the fund

was the customer. But exchange rules

prevented any rebate on the fixed com-

missions to the customer. Rather than

leave all the commissions with the exe-

cuting brokers, the fund manager di-

rected give-ups to those brokers who sold

fund shares. True, as plaintiffs argue,

l6a

Decision of District Court (383 F.Supp. 914)

this benefited the fund manager be-

cause it rewarded brokers who sold fund

shares, who thus increased the assets of

the fund, and who thus enabled advisory

fees to increase. But it did no harm to

the fund because (by definition) the fund

could in no event secure a rebate. In

point of fact, there was some bencfit

to the fund stockholders from the in-

crease in fund assets by sale of more

shares; advisory fees usually, if not

always, go down on a sliding scale of

ascending assct value (such was the

case with Fund here).

Some fund managers, however, sought

to secure a benefit to their funds by

recapturing for them a part of the ex-

cess commissions available as give-ups.

This was done beginning in 1965 by use

of a broker-dealer affiliate who was a

member of NASD, as, for example, the

underwriter who sold shares of a “load”

fund on a commission basis and whose

qualification to be a member of NASD

was clear. In at least a few instanees,

the fund managers created a broxer-

dealer subsidiary which became a mem-

ber of a regional exchange. By these

sks pl LAI ie ental: 5 bese SE Annee et hills tat ea fi Rat 0 AED I APE

17a

Decision of District Court (383 F.Supp. 914)

means, some of the commissions on

portfolio transactions were used to re-

duce the advisory fees of the fund man-

agers. 8

The concern of the SEC with fixed

commission rates (without quantity dis-

counts on large transactions) included

a concern with the give-up technique.

These concerns in 1968 led to discussions

between the SEC and NYSE; asa result

of pressure from the SEC, give-ups on

NYSE were prohibited by its rules after

December 5, 1968. In response to the

same pressure, all the regional exchanges

prohibited give-ups at the same time.

~Reciprocals could not be used after

July 15, 1973, because a Rule of NASD

effective that date prohibited them.

(The Rule was adopted by NASD after

the SEC had publicly stated that “recip-

rocal practices must be terminated” for

a number of reasons given in the state-

ment; see SEC Policy Statement, Feb-

ruary 4. 1972.)

In its continuing study of the secu-

rities business, the SEC took note of

the use by some fund managers of mem-

bership in regional exchanges as a means

a eee

18a

Decision of District Court (383 F.Supp. 914)

of securing give-ups or otherwise to

recapture commissions. The SEC found

this to be against the public interest and

on this account and for other reasons,

effective March 15, 1973, the SEC adopt-

ed Rule 19b—-2 under the 1934 Act. This

Rule required that each member of a

national securities exchange must have

“as the principal purpose of its member-

ship the conduct of a public securities

business” (emphasis supplied), which

was defined to mean that 80° in value

of its exchange transactions had to be

for persons not affiliated. The effect

of this Rule was to make it impossible

for investment companies to recapture

any part of their commissions through

the use of broker affiliates (unless such

affiliate did 80% of its business with

persons independent of the investment

company, that is, was truly a “public”

broker).

The SEC took note at the time (Re-

lease No. 9950, January 16, 1973, section

VII(A)):

“On the regional exchanges many

subsidiaries of investment managers

and insurance companies have pur-

chased seats to trade for the account

Oe eee

Se i ees te Oa

a oa rye

19a

Decision of District Court (383 F.Supp. 914)

of the affiliated ‘parent’ or to be used

for ‘recapture’ of commission dollars

for that parent.”

One of the principal reasons given for

the adoption of Rule 19b-2 was a finding

by the SEC that “membership [in an

exchange] utilized primarily

for the purpose of recapturing

commissions charged on exchange secu-

rities transactions, directly or indirectly,

is inimical to the protection of investors,

fair dealing in securities traded in upon

such exchanges, the fair administration

of such exchanges and the interests of

the public investors we are mandated

to protect in the development of a cen-

tral market system for listed securities.”

SEC Release No. 9950, January 16, 1973,

Introduction.

It may be mentioned that Rule 19b-2

has been’ attacked by a regional ex-

change; its appeal to a court was dis-

missed for lack of jurisdiction, without

reaching the merits. PBW Stock Ex-

change, Inc. v. SEC, 4835 F.2d 718 (3d

Cir. 1973), cert. denied 416 U.S. 969, 94

S.Ct. 1992, 40 L.led.2d 558 (1974).

20a

Decision of District Court (383 F.Supp. 914)

The Adviser and those interested in

it—chiefly George— managed and con-

trolled the Fund. If there were a con-

flict in interest between the Fund and

the Adviser, the economic interest of the

chief personalitics would be with Ad-

viser. Ina general sense, however, what

was good for the Fund was good for

the Adviser, that is, the more successful

and the larger the Fund became, the

greater would be the advisory fee to

Adviser.

In the matter of reciprocals and give-

ups, there is no question but that the

Adviser, acting for Fund, directed re-

ciprocals and give-ups to brokers who

sold Fund shares or who gave research

material to the Adviser or both. To

what extent this was done is difficult

to say. According to the records, all

brokerage commissions were so treated.

For example, in the prospectus of Fund

dated May 1, 1968 (Ex. 11) it was stated

that all brokerage commissions were

paid either to “brokers who provided

helpful information” or to brokers “in

connection with the sale of Fund shares”.

hie ae

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~~ a a oe tit ASEM Bite Sa AA DONS Hed Fie ABD wee >

21a

Decision of District Court (383 F.Supp. 914)

In his testimony, George suggested that

records for the SEC required such allo-

cation to be made. In any event, it is

clear that the Adviser directed substan-

tial amounts of reciprocals and give-ups.

The Adviser used give-ups to reward

brokers who sold Fund shares, seeing

to it that they got in earned commis-

Sions or give-ups at least 267 and usually

more of the amount of Fund shares sold

by them. Discovery into the specific

amounts of give-ups was not permitted

(because related to liability) but it is

known that there were $326,120 in give-

ups In 1967 and $633,095 in 1968. Near-

ly all the transactions for Fund were on

NYSE but a “small percentage” was on

regional exchanges (SM 286). It is

known that there were $205,000 in grive-

ups on regional exchanges’ between

October 1966 and November 1968.

The use of reciprocals and give-ups

— fully disclosed in the prospectuses of

“und,

. Mutual funds may sell their shares

a number of different ways. Some

use an underwriter who buys at whole-

Sale from the fund and sells at retail

22a

Decision of District Court (383 F.Supp. 914)

cither through an internal sales force

or through independent broker-dealers

who are paid a commission. Others,

the no-load funds—-such as Fund here—

sell direct to investors or through inde-

pendent broker-dealers who are not paid

a commission. The use of give-ups sup-

plied a motive to brokers for selling

Fund shares; since no commission was

paid on such sales, give-ups (or recip-

rocals) were the only reward to the

brokers.

The use of give-ups and reciprocals

did benefit the Adviser. Their use also

benefited the Fund and its stockholders

because the larger the Fund, the smaller

the expenses of Fund would be per dollar

of invested assets.

[1] The use of reciprocals and give-

ups did not cause any damage to Fund

unless plaintiffs can establish that they,

or a part of them, could have been re-

covered for the benefit of Fund.

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23a

Decision of District Court (383 F.Supp. 914)

{2} Under the theory of the case for

plaintiffs, it is necessary for them to

show that Fund or Adviser could have

formed a subsidiary which could have

properly become a member of NASD.

While this is a hypothetical matter, it

can be determined because the qualifica-

tions for NASD membership are in

evidence (Ex. 21).

Counsel for plaintiffs insist that a

subsidiary of Fund or Adviser could be

a “broker” and be eligible for NASD

membership; that obtaining member-

ship would be “routine”. Counsel for

plaintiffs do not argue that such a sub-

sidiary should do business with the pub-

lic in competition with other brokers

nor that the subsidiary should execute

any transactions for Fund. The argu-

ment is that the subsidiary could secure

NASD membership solely to qualify for

give-ups and other preferences on re-

gional exchanges. See Post-Trial Mem-

orandum for plaintiffs pp. 19-41

Counsel for defendants ignore = this

issue and offer no help to the Court.

It remains a responsibility of the Court

24a

Decision of District Court (383 F.Supp. 914)

to reach a just determination of the 1s-

sue.

It is concluded that such a specially

created subsidiary of Fund or Adviser

would not be eligible for membership

in NASD.

The qualifications for NASD mem-

bership are in relevant part as follows

(Ex. 21, p. 1049):

“Any broker or dealcr authorized

to transact and whose regular course

of business consists in actually trans-

acting any branch of the investment

banking or securities business in the

United States, under the laws of any

State and/or the laws of the United

States, shall be eligible to member-

ship in the Corporation a

The definition of a “broker” is as fol-

lows (Ex. 21, p. 1059):

“The term ‘broker’ means any indi-

vidual, corporation, partnership, asso-

ciation, joint stock company, business

trust, unincorporated organization or

other legal entity engaged in the busi-

ness of effecting transactions in se-

curities for the account of others, but

does not include a bank.”

ee ee ke ee eee eee ee eee ee Ere

25a

Decision of District Court (383 F.Supp. 914)

This definition is in substance that con-

tained in the 1934 Act (15 U.S.C. § 78c

(a)(4)).

A subsidiary such as plaintiffs suggest

would not be “transacting any branch of

the . . . securities business”. It

would not be “transacting” any “busi-

ness”; it would simply be a device for

securing a preference in commission

rates for one investor over other inves-

tors. Nor would it be a “broker” since

it would not be “effecting transactions

in securities for the account of others”.

It would not be “effecting transactions

in securities’; it would simply be re-

ceiving preferences. Nor would it be

acting for the account of “others” (plu-

ral); the suggestion is that it act. for

Fund alone to qualify for preferences.

Neither the 1934 Act nor the NASD

qualifications contemplate that such a

device could be considered a “broker”.

Counsel for the plaintiffs understand-

ably rely on the testimony by deposition

of general counsel to NASD (Ex. 20).

This testimony is puzzling; it is not

clear. At one point, the witness states

26a

Decision of District Court (383 F.Supp. 914)

that there is a “free entry policy” be-

cause “Anyone can become a_broker-|

dealer under the 1934 Act who meets the

statutory requirements”. This Court

agrees. If the witness means that such

a subsidiary as plaintiffs suggest would

be eligible for NASD, I disagree. True,

had there been an application, NASD

might have accepted the application.

This would not have established eligi-

bility but would have been an admini-

strative failure of NASD. In any event,

civil liability cannot be imposed for fail-

ure of defendants to do what it would

have been deceptive and improper for

them to do.

[3] The principle is accepted that

defendants were under a duty by all

proper means to secure for Fund the re-

turn of excess brokerage commissions.

It is not shown that defendants could

have properly secured any return for

Fund.

Counsel for plaintiffs ably argue that

there were three ways of doing this:

(a) give-ups through the PBW Stock

27a

Decision of District Court (383 F.Supp. 914)

Exchange, (b) give-ups and discounts

through the Pacific Coast Stock Ex-

change, and (c) tender offer fees. Sec

Post-Trial Memorandum, pp. 24-30 All

three depended, however, on member-

ship in NASD and, as explained above.

the suggested subsidiary would not be

eligible for NASD membership,

In addition, counsel for plaintiffs ar-

gue (Post-Trial Memorandum, pp. 30-

39) that there were advantages to mem-

bership by a new subsidiary in the PBW

Stock Exchange. It is accepted that

membership in PBW did not require

membership in NASD (SM 57-58).

These advantages, if any, were obtain-

able only for the period prior to March

15, 1973, when Rule 19b-2 beeame ef fee-

live. But to secure such advantages (as-

suming that there were some) would re-

quire defendants to pretend that the new

subsidiary was a broker, when in fact

it wus not, for the purpose of securing a

preference over other investors by re-

capturing a part of the fixed commis-

sions. While it may have been theoreti-

cally possible for PBW and the defend-

28a

Decision of District Court (383 F.Supp. 914)

ants, in collusion and for the selfish pur-

poses of cach, to accomplish such a re-

sult, it would have been contrary to pub-

lic policy. The SEC found, as already

noted, that to use membership in an ex-

change “for the purpose of

recapturing commissions . . . 38

inimical to fair dealing in se-

curities traded in upon such exchanges

Civil liability can scarcely be imposed

for failing to do what it would have been

contrary to public policy for the defend-

ants to do.

Counsel! for plaintiffs, with some rea-

son, rely on Moses v. Burgin, 445 F.2d

869 (ist Cir. 1971), cert. denied 404 U.S.

994, 92 S.Ct. 532, 30 L.Ed.2d 547 (1971),

and argue (Post-Trial Memorandum, p.

2) that “the issues and facts” in the case

at bar are “virtually identical to the is-

sues and facts” in Moses. The argument

cannot be accepted.

Ts —

29a

Decision of District Court (383 F.Supp. 914)

Whether Moses was rightly decided is

subject to some doubt and such doubt

is permissible since the decision is not

binding in this Cireuit. It should be

noted that Moses was decided in June,

1971, some time before the finding by

the SEC that use of exchange member-

ships to recapture commissions was

against public policy and before the adop-

tion of Rule 19b-2. The Moses decision

has not been applied in any action in this

Circuit but has been discussed by Judge

Gurfein in Weiss v. Chalker, 55 F.R.D.

168 (S.D.N.Y.1972) and 59 F.R.D. 533

(S.D.N.Y.1973). There is nothing in

Judge Gurfein’s discussion which would

Sugvest liability in the case at bar.

For present purposes, it is assumed

that Moses reached the right result. 1t

is not. applicable here, however, because,

While the situation in Moses is super-

ficially similar to that in the ease at bar,

the two situations on study are seen to

be clearly distinguishable.

The fund in Moses was not (as here)

«a no—load fund. On the contrary it sold

its shares to an underwriter (Crosby)

30a

Decision of District Court (383 F.Supp. 914)

which was a subsidiary of the adviser

and which resold the shares through in-

dependent brokers and dealers who in

turn resold to investor customers who

paid a commission on the purchase.

Crosby was a member of NASD.

Crosby was not only a member of

NASD before the Moses litigation began

but Crosby appears properly to have

qualified for such membership. Crosby’s

qualification for NASD membership was

accepted without question by all parties

in Moses and by the Court of Appeals

(see 445 F.2d at 375). While Crosby

was not a “broker” and did not deal with

the general public, it was a “dealer”

because it bought the fund shares for its

own account and resold them “to inde-

pendent broker-dealers” (445 F.2d at

371). This fits the definition of “deal-

er’ used by NASD (Ex, 21, p. 1059).

Counsel for plaintiffs in Moses are

counsel for plaintiffs here. In Moses

they argued that the fund could have

recovered (“recaptured”) part of the

commissions paid on fund portfolio trans-

actions,

3la

Decision of District Court (383 F.Supp. 914)

(a) by creation of a broker affiliate,

(b) by channeling give-ups to Crosby

(a member of NASD) and having Crosby

credit the fund on its advisory fee.

The District Court ruled (316 F.Supp.

31) that neither method of recapture

Was available.

The Court of Appeals ruled that there

was no duty to recapture by creating a

broker affiliate but that there was a

duty to channel give-ups to Crosby.

The holding in Moses was that if re-

covery (“recapture”) of give-ups was

“freely available” to the fund there, its

directors had a duty to recover them for

the fund (445 F.2d at 874). The Court

of Appeals found that some of the re-

sional exchanges “permitted members of

the National Association .of Securities

32a

Decision of District Court (383 F.Supp. 914)

Dealers (NASD) who were not eachange

members... to receive caenemner-

directed give-ups. Crosby was a membe)

of NASD.” (445 F.2d at 375)

It is not clear on what basis the Court

in Moses held liable the adviser and a

affiliated directors. At some points,

it appears to be because there le

“failure to disclose” to the unaffilia ed

directors “the possibility of a Aa

through Crosby’s NASD vega “1

(445 F.2d at 377, 383-84). But Ww vA

ever the basis of liability may be, it mus

rest on a conclusion by the Court of 4

peals that recapture was “freely avasl-

able” in Moses. The conclusion is —

expressly stated but it is implicit in re

reasoning (sec, for example, 445 F.

at 384-85). |

For the reasons already given, recap-

ture was not “freely available’ in the

case at bar. Thus, the decision in Moses

vy. Burgin has no application. |

The clerk is directed to enter judg-

ment in favor of defendants, dismissing

the action on the merits.

So Ordered.

33a

Opinion of United States Court of Appeals

UNITED STATES COURT OF APPEALS

For tHe Seconp Cracurr

—o>—

No. 39—September Term, 1975.

(Argued September 22,1975 Decided December 30, 1975.)

Docket No. 74-2589

Rosauinp Foger and Geratp Fogezt,

Plaintiff s-A ppellants,

Grorce A. Cuestyurr, Jr. Joun

Fowzer, Jr, Warren K. GREEN

CLIFFE, Stanury L. Saper, Francis I. Veeper, Amenrt-

CAN Investors Corporation, CHEstNuTT Corporation

and American Investors Funp, Inc.,

Curnira, Frank G.

BE, Ricnarp W. Rap-

Defendants-A ppellees,

Before:

Frrenpiy, Hays and Fernsera,

Circuit Judges.

te.

Appeal by plaintiffs, stockholders in a no-load mutual

fund, in a derivative action against the investment adviser

and several of its directors, from a judgment of the Dis-

trict Court for the Southern District of New York, Inzer

B. Wyatt, Judge, 383 F. Supp. 914 (1974), dismissing the

action on the merits.

Reversed for computation of damages.

—+-o->—

34a

Opinion of United States Court of Appeals

Asranuam L, Pomerantz, Esq., New York, N.Y.

(Richard M. Meyer, Esq., William E. Hau-

dek, Esq., Daniel W. Krasner, Esq., and

Pomerantz Levy Haudek & Block, Esqs.,

of Counsel), for Plaintiffs-Appellants.

CLenpon H. Ler, Esq., New York, N.Y. (Rogers

Hoge & Hills, Esqs., of Counsel), for

Defendants-Appellees (other than Ameri-

can Investors Fund, Inc. Nominal Defen-

dant ).

Dewey, BaLuantine, Busnpy, Parmer & Woop

(Edward N. Sherry, Judson A. Parsons,

Jr., and Martin A. Schwartz), for Lord,

Abbett & Co., as Amicus Curiae.

—>—

Frrenviy, Circuit Judge:

More than four years after the First Circuit decided

Moses v. Burgin, 445 F.2d 369 (1971), reversing 316 F.

Supp. 31 (D. Mass. 1970), concerning the duty of the man-

agers of a mutual fund to recapture brokerage commis-

sions for the benefit of the fund, this court is confronted

with the problem for the first time. In reviewing Judge

Wyatt’s dismissal on the merits of a recapture action in

the District Court for the Southern District of New York,

383 F. Supp. 914 (1974), we must determine whether we

agree with the First Circnit’s decision and, if so, whether

it applies to the somewhat different facts here at issue.

With some qualifications our answers to both questions are

in the affirmative. We therefore reverse and remand for

the determination of damages.

. 35a

Opinion of United States Court of Appeals

I. The Root of the Problem.

The present is one of what we understand to be a large

number of derivative stockholders actions brought on be-

half of mutual funds against investment advisers, distribu-

tors, and directors of both,’ primarily in consequence of

remarks in the SEC’s Report on the Public Policy Implica-

tions of Investment Company Growth (PPI) 16,172-73

(1966), House Report No. 2337, 39th Cong. 2d Sess.

The basic factual situation giving rise to the recapture

problem is well described in Judge Wyatt’s opinion, 383

F. Supp. at 916-18, in the opinion of Judge Wyzanski, 316

F. Supp. 31 (D. Mass. 1970), and the reversing opinion

of the First Circuit in Moses v. Burgin, supra, in PPI, and

in countless law review notes and articles both before and

after Moses.? Accordingly we shall endeavor to be brief

in our statement of the problem and will assume familiarity

with the typical structure of the externally managed open-

end mutual fund, a mere shell whose investment and man-

1 A 1971 article stated there had been fifty. Butowsky, Fiduciary

Standards of Conduct Revisited—Moses v. Burgin and Rosenfeld v.

Black, 17 New York Law Forum 735, 736 (1971), see also Comment,

Mutual Funds and Independent Directors: Can Moses Lead to Better

Business Judgment, 1972 Duke Law Journal, 429, 430 n.8. Some such

suits have been settled, ¢.g., Weiss v. Chalker, 55 F.R.D. 168 (8.D.N.Y.

1972), 59 F.R.D. 533 (8.D.N.Y. 1973). Another action has recently

been dismissed on the merits, although on grounds differing, at least

in considerable part, from those adopted by the district court in the

instant case. Tannenbaum v. Zeller, CCH Federal Securities Law

Reports 7 95,257 (Carter, D.J. 1975).

2 In addition to the articles cited in n. 1, see The Use of Brokerage

Commissions to Promote Mutual Fund Sales, 68 Colum. L. Rev. 334

(1968); Conflict of Interest in the Allocation of Mutual Fund

Brokerage Business, 80 Yale L.J. 372 (1970); Miller and Carlson,

Reeapture of Brokerage Commissions by Mutual Funds, 46 N.Y.U.L.

Rev. 35 (1971); Fiduciary Obligations of Mutual Fund Managers

in Portfolio Transactions, 22 Syracuse L. Rev. 1107 (1971); Note,

60 Georgetown L.J. 1594 (1972); Note, 13 Wm. & Mary L. Rev. 530

(1971).

36a

Opinion of United States Court of Appeals

agement functions are performed by an adviser and whose

sales are handled either by the adviser (or the fund itself)

in the case of no-load funds or by a distributor (which may

or may not be identical with the adviser) in the case of

load funds.

At the root of the recapture problem was the historic

practice of the New York Stock Exchange (NYSE) and

other exchanges of charging a fixed rate of commission on

each share traded regardless of the size of the transaction

(except for the odd-lot differential). Since the costs of

executing an order do not vary in accordance with size,

the large sales and purchases at the command of invest-

ment advisers of mutual funds were particularly attractive

orders. At first fund managers allocated their brokerage

business to reward brokers who had been helpful in selling

the fund’s shares, in furnishing advice, or in doing both;’

orders allocated as rewards were known as “reciprocals.”

However, as the business grew, the practice of reciprocals

resulted, especially for the large funds, in using too many

brokers, some of whom were not the best qualified tc exe-

cute the particular order placed with them. Hence there

developed the practice of relying on a few executing brok-

ers who were then instructed to “give-up” a portion of

their commissions, sometimes as much as 75%, to another

broker whom the fund manager wished to reward. On

NYSE this was permitted only in favor of another mem-

ber, but six of the seven regional exchanges permitted

“give-ups” in favor of non-members as well, provided they

were members of the National Association of Securities

Dealers, Inc. (NASD).

There was an obvious tension between the give-up and

those representations made by the investment company in

3 Some brokers rendered other services, such as making the required

daily computation of the fund's net asset value, see PPI at 164.

37a

Opinion of United States Court of Appeals

its prospectuses which investors would be likely to under-

stand as meaning that the amounts paid to the investment

adviser constituted the fund’s cost for management and

investment advice and, in the case of “load” funds, that

the amounts retained by the distributor constituted the cost

of sales. In fact, the management-directed “give-ups” to

non-executing brokers represented additional amounts that

were being paid for advising, selling or both, and the true

costs of these services were thus higher than the advisory

fee or the sales load. To the extent that a management

company restricted its own research because of what was

being furnished by brokers who were rewarded with give-

ups or that a distributor retained for itself a larger part

of the sales load than would have been competitively feas-

ible in the absence of give-ups, the stipulated management

fees yielded greater profits than they otherwise would

have. The practice entailed other evils unnecessary here

to detail. Still, if there was no way for a fund to “recap-

ture” the excess of the fixed and unvarying commissions

over what the executing broker would willingly accept,

something was to be said for using the excess to reward

brokers who had served the fund in some fashion rather

than simply overpaying the executing broker. The SEC

put its finger on the problem as early as 1963 when it said

in its Report of the Special Study of Securities Markets,

House Doc. No. 95, 88th Cong. Ist Sess. p, 234:

The Special Study concludes and recommends:

1. The pattern of reciprocal business in the mutual

fund industry is unique. The economies of the volume

of securities transactions generated by the mass pur-

chasing power of the funds for the most part are of

minor benefit to the funds themselves. The primary

beneficiaries are their investment advisers and their

frequently related principal underwriters, who to a

a ee

38a

Opinion of United States Court of Appeals

large extent use reciprocity to reward the sales efforts

of fund retailers, thereby increasing their own re-

wards. The use by fund advisers of investment ad-

vice and research provided by brokerage firms in

return for fund brokerage, without diminution of

their investment advisory fees, is another indication

of the manner in which they are the primary benefi-

ciaries of reciprocal business. This unbalanced recip-

roeal structure is a direct outgrowth of a minimum

commission rate structure which prohibits volume dis-

counts and rebates. In the broad study of the com-

mission rate structure recommended to the Commis-

sion in chapter VI-I, appropriate consideration should

he given to the desirability and appropriate form of

a volume discount from the viewpoint of mutual funds.

As developed by Mr. Justice Blackmun in Gordon v, New

York Stock Exchange, Inc., —— US. . (1975),

43 U.S.L.W. 4958, 4961-62, reform of the commission rate

structure had a long gestation period. Meanwhile a few

adviser-underwriters decided to recapture for their funds

some of the spread between the fixed and unvarying com-

missions payable to executing brokers and the lesser

amounts the latter were willing to accept on large orders.

In a discussion of this development, at 172-73, PPI echoed

the Special Study’s criticisms of mutual fund reciprocal

and give-up practices and continued in a passage meriting

full quotation, pp. 172-73:

(a) Use of brokerage commissions to benefit

the funds

(i) Reducing advisory fees.——As has been noted,

subsidiaries of four adviser-underwriters that main-

tain their own retail sales forees—among them three

of the largest, Investors Diversified Services, Inc.,

39a

Opinion of United States Court of Appeals

Waddell & Reed, Inc., and Channing Financial Corp.,

as well as the smaller Imperial Financia! Services,

Inc.—are now members of the Pacific Coast Stock

Exchange. These subsidiaries execute orders for the

funds on the Pacifie Coast Stock Exchange. More im-

portant, however, they obtain a considerable amount

of nonfund business from broker-dealers who are dual

members of the Pacific Coast Stock Exchange and

other exchanges in return for fund brokerage busi-

ness on other exchanges, primarily the NYSE. All

the net profits of IDS’s subsidiary and about 40 to

90 percent of the net profits of Waddell & Reed’s and

of Imperial Financial Services’ subsidiaries have been

applied to reduce advisory fees payable by the funds

in those complexes.

Widespread emulation by institutional investors of

the precedent set by these four complexes could have

a marked effect on the economics of the securities in-

dustry. Within the framework of the existing com-

mission rate structure it is a method whereby mutual

fund shareholders can derive greater benefits than

they have heretofore received from fund brokerage

commissions. However, among dealer-distributed

funds the important role that portfolio brokerage

plays in the competition for dealer favor has kept

fund managers, with few exceptions, from using ex-

change memberships to reduce costs of the funds.

Similar competitive factors have also operated

against the use, for the benefit of the funds and their

shareholders, of regional exchange rules permitting

give-ups to any member of the NASD on transactions

executed on those exchanges. It would not be incon-

sistent with those rules for dealer-distributed funds to

direct give-ups to their adviser-underwriters, all of

whom are NASD members, for the purpose of apply-

40a

Opinion of United States Court of Appeals

ing these give-ups to reduce the advisory fees payable

by the funds. Unless and until such procedures be-

come widespread, any adviser-underwriter to a dealer-

distributed fund who chose to utilize fund brokerage

in this manner would place itself at a disadvantage

in competing for the interest of nonmember dealers in

selling the fund shares which it distributes. (Footnotes

omitted. )

This passage followed an earlier summary in which PPI

had written, beneath the heading “(c) Impact of mutual

fund reciprocal and give-up practices,” p. 16:

Under existing commission rate structures, mutual

fund shareholders could derive greater benefits from

their brokerage commissions if the give-up portions

of the commissions were transmitted to the funds them-

selves or their adviser-underwriters for the purpose of

reducing management costs. However, in the face of

competitive pressures managers of the dealer-distrib-

uted funds have not used brokerage for this purpose.

(Footnote omitted.)

Postponing further developments on the SEC front for

discussion in Part III of this opinion, we turn with this

background to the case at hand.

II. The Proceedings in the District Court.

This action was brought in July, 1968 by two stockholders

of American Investors Fund, Inc. (the Fund) on behalf

of the Fund. The Fund is a diversified open-end, no-load

management investment company registered under the In-

vestment Company Act. From the date of its organization

in 1957 until July, 1966, its investment adviser and man-

ager was American Investors Corporation; since that date

4la

Opinion of United States Court of Appeals

the adviser and manager has been Chestnutt Corporation.

We shall refer to the two collectively as the Adviser. The

chief figure both in the Fund and the Adviser has been

George A. Chestnutt, Jr. The amended complaint al-

leged that as a result of the growth of the Fund, fees paid

to the Adviser rose from such modest amounts as $93,347

in 1963 and $187,083 in 1964 to figures exceeding $1 million

in the period 1967-70, the highest being $1,557,000 in 1969.

The supplemental complaint continued with allegations

concerning the Fund’s brokerage fees and the “allocations”

of these, as shown in the following table :*

Allocated to Allocated to

brokers who had brokers who had

Brokerage provided helpful assisted in the saic

fess information of Fund Sha: es

1964 $ 275,000 $ 162,000 $ 113,000

1965 387,000 247,000 140,000

1966 551,668 261,913 289,755

1967 1,995,087 935,966 1,059,121

1968 3,122,160 2,022,457 1,099,703

1969 2,489,281 1,196,059 1,293,222

1970 2,059,234 . 1,108,667 950,000

The supplemental complaint® continued that, by awarding

reciprocal brokerage, sales of Fund shares are stimulated

(with attendant increases in the advisory fee), and brok-

4 Since the sum of the second and third columns approximately equals

the first, they substantially overstate the amount of commissions that

would have been recaptured on any view.

5 A separate action, Fogel v. Chestnutt, 67 Civ. 60 (8.D.N.Y.), was

brought in January, 1967, charging that 1.0.8. Ltd. there a defen-

dant, had caused a corporation which it dominated to cause the

Fund to use a particular broker when that broker's research anil

advisory services were channeled to 1.0.8. and not to the Fund. See

Fogel v. Chestnutt, 296 F. Supp. 530 (1969). This case was “statis-

tically closed” on April 25, 1975.

42a

Opinion of United States Court of Appeals

ers are used to furnish advisory services the Adviser is

obligated to provide. Thus the Adviser has in effect re-

ceived compensation exceeding the amounts provided in

the investment advisory contract. Although an affiliate of

the Fund or the Adviser could have been empowered to

act as the Fund’s broker and save a portion of the broker-

age commission, this was not done because the Adviser

“prefers to profit from such brokerage transactions used

to pay its obligations by awarding the Fund’s brokerage

commissions to others.” In what is probably its crucial

paragraph the supplemental complaint alleged:

The Fund or the Investment Adviser could have or-

ganized an affiliate for the purpose of reducing the

net brokerage commissions paid by the Fund. This

affiliate could have recaptured the Fund’s brokerage

commissions on various regional exchanges since at

least January, 1965. Defendants Chestnutt, Sabel, and

Greene intentionally misled and misinformed the

Fund’s unaffiliated directors by telling them that such

recapture was not available to the Fund.

The adviser and four of its directors—Chestnutt, Sabel,

Currier and Greene—who had been served filed an answer

denying most of the non-formal allegations of the com-

plaint and pleading various affirmative defenses. The only

one of importance was:

27. The Fund has received the benefit of brokerage

services equal in value to the brokerage commissions

paid by it at the regular, customary and required

minimum rates for transactions on national securities

exchanges, and the Fund has received the benefit of

brokerage services equal in value to brokerage com-

missions paid by it in accordance with regular and

customary rates obtaining in other markets, all in

a ee

43a

Opinion of United States Court of Appeals

accordance with rules and regulations of national se-

curities exchanges and associations authorized and

empowered by law to determine brokerage practices,

rates and procedures, and this action may not be

maintained.

Although the parties had initially demanded a jury trial,

this was waived. A pretrial order directed that the issue

of liability be tried separately. Various facts were stipu-

lated. These included that until 1971 defendant Stanley L.

Sabel was senior vice president, secretary and a director

of the Fund, and vice president, secretary, general coun-

sel and a director of the Adviser; that his law firm of

Sutton, Sabel & Schupp became counsel to the Fund about

1966, and that Sabel owned 16% of the stock of the Ad-

viser; that Clendon H. Lee, whose wife owned 1% of the

stock of the Adviser, was special counsel to and a director

of the Adviser, became special counsel to the Fund in 1965,

and had acted since 1967 as counsel for the Adviser and

the served defendants in this action; and that defendant

Currier owned 2% of the stock of the Adviser. The stipu-

lation included facts as to the acquisition of membership

in the Pacific Coast Exchange and the reduction of ad-

visory fees through the recapture of commissions by Wad-

dell & Reed, Inc., Investors Diversified Services, Inc., the

Channing Complex, and Imperial Financial Services, sub-

stantially as stated in PPI, pp. 1314-1316 supra. There was

also a stipulation concerning the degree of consideration

given to recapture by the directors of the Fund and the ad-

vice on that subject by Sabel and Lee, of which more here-

after. There was some narrowing of plaintiffs’ contentions

and a 17-paragraph statement of defendants’ answers.

After trial Judge Wyatt rendered an opinion dismissing

the action on the merits, 383 F. Supp. 914. Accepting the

principle “that defendants were under a duty by all proper

44a

Opinion of United States Court of Appeals

means to secure for Fund the return of excess brokerage

commissions,” he concluded it had not been shown “that

defendants could have properly secured any return for

Fund,” 383 F. Supp. at 920. Assuming arguendo that

Moses v. Burgin had been correctly decided, he viewed it

as distinguishable on the ground that the fund there con-

cerned was a load fund whose shares were sold by an

affliated underwriter, who was qualified as a “dealer”

within the NASD definition of that term and who was in

fact a member of the NASD entitled to receive customer-

directed give-ups on certain regional exchanges until the

abolition of such give-ups on December 5, 1968. Recogniz-

ing that NASD membership was not required for mem-

hership on the Philadelphia-Baltimore- Washington Ex-

change, Judge Wyatt ruled that such membership" “would

require defendants to pretend that the new subsidiary was

a broker, when in fact it was not, for the purpose of se-

curing a preference over other investors by recapturing a

part of the fixed commissions” and that this would have

run counter to public policy, 383 F. Supp. 920-21. The

plaintiffs have appealed.’

ituti i i tions, were prohibited

6 Institutional memberships, with some excep ;

following the adoption of Rule 19b-2 which ultimately became so

tive March 29, 1973, under the Securities Exchange Act of ,

see 17 C.F.R. § 240, 19b-2 (1973).

7 We decline to yield to defendants’ urging that we make a fy

disposition without reaching the merits, on the ground of lagen

failure to allege with sufficient “particularity” their efforts to o

action from the directors or their reasons for failing to do #0, >

required by F.R.C.P. 23.1; ef. Brody v. Chemical Benk, 482 F.

1111 (2 Cir. 1973). Defendants refer to our decision in Papilsky v.

Berndt, 503 F.2d 554 (2 Cir. 1974), as having “carefully reserved

the right after trial to obtain judgment of dismissa) for failure to

comply with Rule 23.1" (emphasis in original), Defendants-A ppellees’

Brief at 31. Whe most casual reading of Papilsky would show that

what was said on the subject of reservation was addressed to a situa-

tion in which objection had been made before trial and overruled

by the trial judge. While the answer in this case made a formal

45a

Opinion of United States Court of Appeals

Il.

Before analyzing the legal issues it will be convenient

to update the discussion of administrative developments

in Part I of this opinion, which we left with the publica-

tion of PPI at the end of 1966. A year later the SEC

announced in Release No. 8239 that it had under consider-

ation proposed Rule 10b-10, an effort to implement the

suggestion put forward in PPI, which we have quoted,

that “it would not be inconsistent with [the] rules [of

certain regional stock exchanges] for dealer-distributed

funds to direct give-ups to their adviser-underwriters, all

of whom are NASD members, for the purpose of applying

these give-ups to reduce the advisory fees payable by the

fund.” Having identified “its antecedents” in PPI, Release

No. 8239 went on to explain that

the reasoning on which the proposed rule is based is

that if, as pointed out [in PPI] a mutual fund manager

has various means at his disposal to recapture for

the benefit of the fund a portion of the commissions

paid by the fund, he is under a fiduciary duty to do so.

Furthermore, diversion of such commissions to benefit

an investment company manager may be viewed as

additional compensation to the manager for handling

the portfolio transactions of the fund within the mean-

ing of, and in violation of, Section 17(e)(1) of the In-

vestment Company Act. The proposed rule therefore

reflects a duty on the part of mutual fund managers

as fiduciaries not to use commissions paid by their

beneficiaries for the benefit of the fiduciary when prac-

tices, procedures, and rules of the markets in which

denial of the paragraph of the complaint which sought to show com-

pliance with F.R.C.P. 23.1, no issue of non-compliance was included

in defendants’ 17 contentions listed in the pre-trial order. We regard

the point as having been abandoned. .

46a

Opinion of United States Court of Appeals

such fiduciaries act permit their beneficiaries to re-

ceive tangible benefits in the form of reduction of the

charges now borne by them.

The proposed Rule was as follows:

Rule 10b-10

(1) It shall be unlawful for any registered investment

company or affiliated person of such registered

investment company*® to directly or indirectly, to

order or request any broker or dealer:

(a) to pay or arrange for the payment, directly

or indirectly, of all or any portion of a com-

mission on any securities transaction to any

broker, dealer or any other person unless

pursuant to a written contract the full

amount of such remittance is required to be

paid over to such registered investment

company, or fees owed by or charged to

such registered investment company are re-

quired to be reduced in an amount equal to

the remittance ;

(b) to designate or employ any broker or dealer

on any transaction to transmit, execute or

clear a transaction or to perform any other

function for which compensation is required

or made unless pursuant to a written con-

tract the full amount of such compensation

is required to be paid over to such registered

investment company or fees owed by or

charged to such registered investment com-

pany are required to be reduced in an

amount equal to such compensation.

47a

Opinion of United States Court of Appeals

(2) For the purposes of this rule a person is affiliated

with a registered investment company if such per-

son:

(a) is an officer, director, trustee, employee, in-

vestment adviser, member of an advisory

board, depositor, promoter of or principal

underwriter for the registered investment

company, or

(b) directly or indirectly, through one or more

intermediaries, controls, or is controlled by,

or is under common control with the regis-

tered investment company, its investment

adviser or principal underwriter, or

holds with the power to vote, five per centum

or more of the outstanding votir.z securities

of the registered company.

The Release added a highly significant footnote keyed to

the initial reference to a “registered investment company” :

“Although the proposed rule is couched only in terms of

persons who are afliliates of and fiduciaries to invest-

ment companies, the principles which are set forth

above may be equally applicable to other managers of

pooled funds who act in a fiduciary capacity and who

are able to reduce the portfolio commissions of their

beneficiaries. To the extent that such managers direct

give-ups for their benefit, when they are in a position

to utilize them for the benefit of beneficiaries, it would

appear that under the Federal Securities Laws or

otherwise, this use of give-ups other than for the bene-

fit of these beneficiaries would also constitute an im-

proper practice by such fiduciaries. Accordingly, the

48a

Opinion of United States Court of Appeals

Commission believes that it is appropriate to solicit

comment on this issue and will consider whether the

proposed Rule 10b-10 should be applicable to other

fiduciaries who manage pooled funds.

In the same release the SEC called for comment on a pro-

posal by NYSE directed to its members dated January 2,

1968. The NYSE proposal, although extremely vague,

contemplated a volume discount, “continuation of the prac-

tice of customer directed give-ups on their own transactions

with a limitation on the percentage amouut which may be

so given-up,” and the taking of “steps to prohibit reciprocal

practices which result in de facto rebates of NYSE com-

missions even where those arrangements involve other

markets than the NYSE floor, provided that the SEC will

aid in prohibiting such practices in other markets.” Ap-

parently cheered by NYSE’s first indication of willingness

to consider a volume discount, the SEC characterized the

NYSE proposal as “to a significant extent an alternative

approach” to the proposed Rule 10b-10, saying:

While the New York Stock Exchange proposal and

proposed Rule 10b-10 are not mutually exclusive on

all points, the New York Stock Exchange proposal is,

to a significant extent, an alternative approach. Inso-

far as the New York Stock Exchange proposal would

provide institutional investors with a volume discount

while at the same time closing, insofar as possible, the

various avenues by which an institutional manager can

recoup, commissions for the benefit of the fund, it

could, depending upon the nature and extent of the

volume discount, provide a direct rather than an in-

direct means by which institutional investors may ob-

tain the benefit of lower charges.

49a

Opinion of United States Court of Appeals

During 1968 there were various communications between

the SEC and NYSE, recounted in Gordon v. New York

Stock Exchange, supra, U.S. at ——, 43 U.S.L.W. at

4961, which culminated in the establishment of a volume

discount for orders exceeding 1,000 shares and other altera-

tions in rates. In a letter proposing the volume discount,

NYSE also stated that it would be impossible to deter-

mine the impact of the interim schedule so long as give-ups

continued. Accepting the NYSE proposals in a letter of

August 30, 1968, released as « formal decision “Approving

Interim Commission Rate Measures,” SEC Chairman

Cohen replied:

Your letter .. . states that [the various exchanges

would] “prohibit customer-directed give-ups of work

or money in consideration of listed business .. .” We

understand that this eiange is intended to prohibit

all forms of customer-directed give-ups, but is not

meant to preclude or interfere with non-customer

directed interdealer reciprocal business on regional

exchanges nor is it designed to prevent the procedures

whereby broker-dealer affiliates of institutions may

credit or return commissions to institutions with which

they are affiliates.

Not predisposed to endure both volume discounts in fixed

commissions and the system of give-ups by which fixed

rate commissions had been evaded, NYSE abolished give-

ups effective December 5, 1968 and the regional exchanges

followed suit. In anticipation of this the SEC had issued

an order on December 3, 1968 directing future mutual fund

prospectuses to reflect changed stock exchange rules pro-

hibiting “customer-directed give-ups” but nothing was said

about the proposed Rule 10b-10, which presumably had

50a

‘Opinion of United States Court of Appeals

become unnecessary, or about the qualification mentioned

in Chairman Cohen’s letter.

The next item is a letter of November 10, 1969 from SEC

General Counsel (now Commissioner) Loomis in response

to an inquiry about the duties of funds to recapture. Mr.

Loomis replied, in pertinent part, as follows, Securities

and Exchange Act Release No. 8746, CCH Federal Securi-

ties Law Reports { 77,761:

You first ask whether mutual fund management has

a fiduciary duty to acquire a stock-exchange seat di-

rectly or through an affiliate, in order to utilize this

means to recapture brokerage which in turn will be

offset against management charges. We do not believe

that management has this duty if in the exercise of its

best business judgment management determines that

it is not in the best interests of the fund to create such

an affiliate. Proposed Rule 10b-10, as published for

comment on January 26, 1968, to which you refer, has

been withdrawn.

As you suggest, the statements in letters from the

Commission to stock exchanges in connection with their

adoption of rules abolishing the customer-directed give-

ups, that the Commission understood that these rules

were not designed to terminate procedures whereby

institutions may obtain returns of commissions merely

reflected, in our view, that the exchange rules with

respect to customer-directed give-ups did not, and were

not intended to, terminate the existing arrangements

which a few mutual fund organizations have made for

the indirect recapture of a portion of their commis-

sions. It is my understanding that this is not presently

accomplished by means of customer-directed give-ups,

which have been abolished but in other ways, primarily

by reciprocal practices. If these reciprocal practices

5la

Opinion of United States Court of Appeals

are available to fund managements, it did not seem

appropriate to foreclose their use to benefit the fund

itself.

It should be understood, however, that if mutual fund

management does acquire a seat on a regional stock

exchange whose rules permit the recapture of commis-

sions paid by the fund through the use of that seat,

there may be circumstances under which such recap-

ture could be required and that the management may

not be free to simply retain for itself revenues derived

from this source. This is particularly likely to be true

where the affiliate on the exchange does not execute or

clear transactions for the account of the fund, but

merely receives revenue from other ‘brokers, which

revenue is attributable to transactions executed for

the account of the fund by such other brokers. . . .

In your letters you suggest various courses of action

which the Commission might take with respect to the

question of so-called “institutional membership” and

other aspects of the commission rate structure. Deci-

sions on these matters will have to await further devel-

opments in the inquiries concerning the commission

rate structure to which I referred earlier.

Having achieved establishment of the volume discount,

the SEC then turned to another objective, bringing about

competitive rates on large orders. The history of this

endeavor is also recounted in the Gordon opinion, —— U.S.

at , 43 U.S.L.W. at 4962. On February 4, 1972, the

SEC issued a Policy Statement on the Future Structure

of the Securities Markets, CCH Federal Securities Law Re-

ports No. 409. This wide-rang* + statement included sev-

eral passages bearing on the problems here presented. One

was this, pp. 42-43:

52a

Opinion of United States Court of Appeals

[Wle believe that the cost of selling and purchasing

mutual fund shares should be borne by the investors

who purchase them and thus presumably receive the

benefits of the investment, and not, even in part, by the

existing shareholders of the fund who often derive lit-

tle or no benefit from the sale of new shares. To im-

pose a portion of the selling cost upon the existing

shareholders of the fund may violate principles of fair-

ness which are at least implicit in the Investment Com-

pany Act.

Finally, the practice of compensating broker-dealers

for mutual fund sales by assigning them commission

business violates the long accepted precept in invest-

ment company regulation that an investor is entitled

to know how much was paid to those who sell him an

investment. This practice puts the investment company

in the position of issuing a prospectus which purports

to specify the sales compensation but fails to quantify

the additional compensation paid to the customer’s

broker-dealer in the form of commission business

awarded on the basis of success in selling investment

company shares.

The Commission believes it should be made clear

now that these reciprocal practices must be terminated.

When the NASD completes its study of what it con-

siders to be a fair load for the sale of investment com-

pany shares, as required by the Investment Company

Amendment Act of 1970, it will be in a position to

recommend a sales charge which reflects the full in-

centive appropriate to such sales and which can be fully

and explicitly disclosed to the buyers of such shares.

To accomplish this the Commission is sending a letter

to the NASD setting forth the Commission’s views and

requesting the NASD to direct its members to discon-

53a

Opinion of United States Court of Appeals

tinue the use of reciprocal portfolio brokerage for the

sale of investment company shares. If such a response

is not forthcoming, the Commission will then consider

rule-making to accomplish the desired result.

Another was this, p. 44, 46-49:

Institutional Membership

The question of institutional membership on national

securities exchanges is an exceedingly difficult one, and

in dealing with it we have painstakingly reviewed the

alternatives presented to us. It is the Commission’s

firm view that, as a central market system develops,

it should have at its heart a corps of professional

brokers and market makers serving investors. More.

over, in light of the strain which the magnitude and

tempo of the transactions of financial institutions cur-

rently place on the securities markets, it is our view

that institutions should not be permitted to deal

through brokerage firms established principally to

handle their own transactions but should be required

to deal through brokers dedicated primarily to serv-

ing and having fiduciary obligations to a broad in-

vesting public. Thus, as a general rule, the Commis-

sion believes that membership in the central market

system should be open only to those who meet quali-

fying standards and who have the primary purpose

of serving the public as brokers or market-makers .. .

Certain regulatory problems arise out of the rela-

tionships created by institutional membership. The

first stems from the existence of a structure of fixed

minimum commissions. So long as such a structure

exists, large investors should not, by virtue of their

economic power and size, be entitled to obtain rebates

of commissions not available to other investors. While

Sda

Opinion of United States Court of Appeals

fixed minimum commissions exist, they should apply

to all investors, and an exception should not be given

to a particular person, Institutional membership, how-

ever, provides a vehicle for obtaining rebates, either

directly or indirectly.

Second, institutional membership may result, to a

greater or lesser degree depending on the eircum-

stances, in the use of exchange membership for pri-

vate purposes rather than for the purpose of serving

the public in an agency capacity or otherwise per-

forming a useful market function, In part, this prob-

lem is similar to that discussed in the preceding para-

graph: the problem of using exchange membership

as a means of obtaining a reduced commission rate.

But the problem of using exchange facilities for pri-

vate purposes is broader in seope than the rate ques-

tion. For we believe that membership in the market

system should be confined to firms whose primary pur-

pose is to serve the public as brokers or market

makers. Stock exchanges are affected with an over-

riding national interest which demands that they act

to maintain and improve the publie’s confidence that

the exchange markets are operated fairly and openly.

The public should have the assurance that a member

of an exchange is dedicated to serving the public, and

membership by institutions not predominantly serving

non-affiliated customers should not be permitted to

cloud this objective. ,

Our authority to deal with these problems derives

from the stated purposes of the Securities Exchange

Act and is most specifically expressed in Section 19(b)

of such Act which deals with “sueh matters as...

the fixing of reasonable rates of commission, interest,

listing, and other charges... and... similar matters”,

Opinion of United States Court of Appeals

Insofar as institutional membership is employed pri.

marily as a vehicle for obtaining recapture of commis.

sions, as in the first situation described above, it

should not be allowed to exist, Membership under

those cireumstances is plainly in conflict with the con-

cept of fixed minimum commissions and results in ex-

change membership solely for private purposes, We

believe that such membership and practices which per

mit the rebate or recapture of commissions, directly or

indirectly, should be eliminated. The Commission in-

tends to act promptly to terminate this type of mem-

bership. The regional exchanges, as vital elements of

the central market system, should compete on their

merits as market components and should not need this

special competitive tool.*

In response to this Report, see | 78,906 Fed, See. L. Rep.

(1972), NASD proposed a rule to abolish reciprocals ;

this rule became effective July 15, 1973, see $79,414 Fed.

See, L. Rep, (1973), By contrast, the validity of the SEC's

conclusions on the evil of institutional memberships, which

were quite at variance with the earlier pronouncements we

have quoted, was vigorously challenged, notably by Elkine

Wetherill, president of the PBW Stock Exchange, see

Wetherill and Hendon, Institutional Membership and

the Experience of the Philadelphia-Baltimore- Washington

Stock Exchange, 13 Boston College Ind. & Com. Rev. 959

(1972). Senator Williams introduced a bill, 8S. 3169, 92d

Cong. 2d Sess, (1972), which would remove the SEC's

power to restrict institutional membership until one year

Commissioner Owen dissented from so much of the report as would

allow an institution to establish or acquire a broker-dealer if the

latter did business “predominantly with public investors,” He thought

doing business for the parent should be prohibited since any such

relationship “permit(s] of a rebate situation, either directly or in

directly,” at 61-62

56a

Opinion of United States Court of Appeals

after the effectiveness of a rule requiring negotiated rates

on all transactions exceeding $100,000, Nevertheless, the

SEC promulgated Rule 19b-2, effective March 29, 1973,

forcing every exchange to “require every member of such

exchange to have as the principal purpose of its member-

ship the conduct of public business,” *

The story finds its end in the Securities Act Amendments

of 1975,'° 89 Stat. 97, whieh, of course, were not available

to Judge Wyatt, Section 11 of the Securities xchange Act

was amended so that, subject to certain exemptive powers

of the SEC, and exceptions not here material, exchange

transactions for one’s own account or that of an associate,

would be unlawful, subject to a three-year phasing out

provision for persons who were exchange members on

May 1, 1975, 89 Stat, 110. Section 6 was also amended to

provide that “no national securities exchange may impose

any .chedule or fix rates of commissions, allowances, dis-

counts, or other fees to be charged by its members,” sub-

ject to a one year extension for floor brokers and odd-lot

dealers and a “fail-safe” provision for the reinstitution of

such schedules if the SEC approved, 89 Stat, 107,

IV. The Basis of Liability,

Plaintiffs assert two different theories of liability for

defendants’ failure to make efforts to recapture. One is

” A member was to be deemed to have such a purpose only if 80%

of ita securities business was “effected for or with persona other

than affiliated persona’ or waa one of eight deseribed categories.

PRW challenged the validity of the rule, but this challenge was

diemissed on juriadietional grounds, PRW v, SEC, 486 F.2d 718

(4 Clr, 1078), cert. denied, 416 U.S, 060 (1074),

10 8.470, the predecessor of the Amendments ultimately enacted, would

have continued inatitutional memberships so long as fixed rates were

being phased out, and would have required the SEC to withdraw Rule

192 during this period, Sen, Rep, No, 03-187, 93 Cong, lat Bena,

(1973),

57a

Opinion of United States Court of Appeals

that such efforts were required by Fund's certificate of in-

corporation; the other is that they were required as a mat-

ter of fiduciary duty—or perhaps more accurately that

management was obliged as a matter of fiduciary duty to

put the problem fairly before the independent" directors,

While both theories demand some further showing of the

possibility and legality of recapture, we observe that the

obligations entailed by the contract theory might well be

more severe than those entailed by the theory of breach of

fiduciary duty.

The contract argument is as follows: The Certifieate of

Incorporation of the Fund provided in 3(¢)(iv) that;

1 Section 5 of the Investment Company Amendments Act of 10970

strengthened the requirement that at least 40% of the directors of

an investment company not be “affiliated persona’ by substituting the

term “interested persons,’ 15 U.8.C, (6 80a-10(a), “Interested per

sone” includes, in addition to “affiliated persons,’ “members of the

immediate family of such persons and persons who have beneficial

or legal interests as fiduciaries in securities issued by the investment

adviser,” “any broker-dealer’ “and affiliated persons of any such

broker dealer,” and legal counsel for the Fund or the adviser, Sen,

Rep. No, 01.184, 3 U.S, Code Cong, & Adm, News 4928 (1970), An

“affiliated person” in:

(A) any person directly or indirectly owning, controlling, or

holding with power to vote, 5 per centum or more of the out

standing voting securities of auch other person; (B) any person

5 per centum or more of whose outstanding voting securities are

directly or indirectly owned, controlled, or held with power to

controlling, controlled by, or under common control with, such

other person; (D) any officer, director, partner, eopartner, or

employee of such other person; (EB) if such other person ia an

investment company, any investment adviser thereof or any mem.

ber of an advisory hoard thereof; and (F) if such other person

is an unincorporated investment company not having a board of

directors, the depositor thereof,

15 U.B.C, §80a-2(0)(5), Sinee the expanded requirement, although

it does affect a present defendant, does not decisively tip the in

terested /disinterested balance, we shall use the term “independent”

throughout to indicate persons either not “affiliated” prior to the

1970 amendments or not “interested” thereafter.

Opinion of United States Court of Appeals

The public offering price of each share of capital stock

shall be the net asset value then in effect plus the

load or commission charged adjusted to the nearest

full cent. Any load or commission for the distribution

of shares of the Corporation by a distributor may be

fixed from time to time by the By-Laws of the Corpora.

tion, but shall in no event exceed 842% of the public

offering price, nor shall the consideration per shere

to be received by the Corporation after deduction of

such load or commission be less than the net asset

’

value, ...’

The by-laws made no provision for a sales load or com-

mission. A direct payment of commissions from the Fund's

treasury to brokers selling shares of the Fund would thus

have violated the charter. There is no significant difference

when the Fund allows selling brokers to receive commis-

sions which it could have “recaptured.” A similar argu-

ment, made by the same counsel, was accepted in Moses v.

Burgin, supra, 445 F.2d at 374."

Although the argument is not without force, we think

it presses too far. The term “net asset value” is one of

art in the mutual fund industry and is elaborately defined

in the certifieate of incorporation. The objective of the

charter provision was to prevent dilution of per share

net asset value by the issuance of new shares at a discount;

defendants’ failure to recapture part of the commissions

on portfolio transactions does not result in such dilution.

Plaintiffs’ real complaint is not that new shareholders did

not pay net asset value but that the Adviser, for selfish

12 A comment on Moace raises the question why, if this theory were

sound, the court went on with an extensive discussion, 445 F.2d at

477, et weq., of management's duty to make full disclosure to the

unafiliated directors and the apparent resting of liability upon that

ground, Butowasky, supra n.1, 740-50 (1971),

59a

Opinion of United States Court of Appeals

motives, refrained from handling portfolio transactions in

a manner that would have diverted a portion of the com-

missions to itself, with an attendant decrease in the ad-

visory fee—in substance a charge of breach of a fiduciary

duty resulting in corporate waste,

When we pass to the theory of breach of fiduciary duty,

we are confronted initially with the question of the appli-

cable standard. The Moses court predicated federal juris-

diction on § 36 of the Investment Company Act prohibiting

“gross misconduct or gross abuse of trust,” 445 F.2d at

373, and seemingly also held, 445 F.2d at 384, that defen.

dante’ conduct violated that standard as the First Cirvait

had interpreted it in Aldred Investment Trust v. SEC, 151

F.2d 254, cert. denied, 326 U.S, 795 (1946). Taking a less

expansive view of § 36 as originally enacted, we have held

that the Act implicitly established « federal standard of

fiduciary duty in respect of dealings between a mutual fund

and its adviser, Brown v. Bullock, 204 F.2d 415, 421 (2 Cir.

1961) ; Rosenfeld v, Black, 445 F.2d 1337, 1345 (2 Cir, 1971),

a duty which the 1970 amendment makes explicit “with

respect to the receipt of compensation for services, or of

payments of a material nature, paid by such registered

investment company, or by the security holders thereof, to

such investment adviser or any affiliated person of such

investment adviser”—the situation presented here.

We agree with the First Circuit, 445 F.2d at 376, that

under the scheme of the Investment Company Act an in-

vestment adviser is “under a duty of full disclosure of

information to . . . unaffiliated directors in every area

where there was even a possible conflict of interest between

their interests and the interests of the fund”—a situation

which occurs much more frequently in the relations between

a mutual fund and its investment adviser than in ordinary

business corporations, see id.; Comment, Duties of the Inde.

60a

Opinion of United States Court of Appeals

pendent Director in Open-End Mutual Funds, 70 Mich.

L. Rev, 696, 698-99 (1972); Mundheim, Some Thoughts on

the Duties and Responsibilities of Unaffiliated Directors

of Mutual Funds, 115 U. of Pa. L. Rev, 1058, 1060-61 (1967).

Chief Judge Aldrich went on to quote from the SEC's

decision in Imperial Financial Services, Inc, CCH Fed,

Sec. L, Rep. {| 77,287 at 82,464 (1965), as we do in the mar.

gin.” He emphasized that the communication of informa-

tion must be “effective,” bearing in mind that the indepen-

dent directors are not full-time employees and that “neither

their activities nor their experience’ may be “primarily

connected with the special and often technical problems of

fund operation.” He concluded:

If management does not keep these directors in-

formed they will not be in a position to exercise the

independent judgment that Congress clearly intended,

The only question can be whether the matter is one

that could be thought to be of possible significance,

Although the Fund apparently would have qualified for

the single unaffiliated director exception of §10(¢) it had

Richard Radcliffe, who served from 1958 until Dev ber,

1969, was highly sophisticated in investment company mat.

ee sn

15 The Investment Company Act's requirement as to unaMliated

directors, if its purposes are not to be subverted, carries with it

the obligation on the part of the affiliated directors, and the in-

vewtment adviser itself, to insure that unaffiliated directors are

furnished with sufficient information so as to enable them to par

ticipate effectively in the management of the investment company,

i) We reject the suggestion implicit at some parte of defendante’

| brief on adequate knowledge hy one unaffiliated direetor would suMfee

even when a fund has opted to have several; shareholders rely on

what the fund bas done rather than on a lesser requirement, of whieh

the Fund did not avail itself,

6la

Opinion of United States Court of Appeals

ters. None of the others appear to have been, although

they had experience in other forms of business."

The data yielded by the record on the subject of dis-

closure is as follows:

The pre-trial order states:

Subsequent to the filing of an action by these iden-

tical plaintiffs in this Court, against these defendants

and others in January, 1967, (67 Civ. 60) which claimed,

among other things, impropriety in connection with

brokerage commissions charged on Fund _ portfolio

transactions, Messrs. Sabel and Lee advised all of the

directors of the Fund and the Adviser on numerous

occasions, including meetings of such Boards, that no

impropriety had been found in connection therewith.

On or about February, 1968, upon the issuance by the

Securities and Exchange Commission of its 1934 Act

Release No. 8239 dated January 26, 1968 proposing a

new Rule 10b-10 (which proposal the Commission later

withdrew), Messrs. Sabel and Lee specifically advised

all of the directors of the Fund and the Adviser that

the suggested form of “recapture” contained in such

15 The following chart represents the composition of the Fund's board

of directors during the relevant period:

1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973

George A. Chestnutt, Jr.* (affiliated) (interested )

Stanley Satel* (affiliated) (interested )

John Currier* (unaffiliated) (interested )

Eliz. Sullivan (affiliated) | Warren K. Greene® (affiliated) (interested )

Hichard Radcliffe (unaffiliated) | Wm. Semmes (disinterested)

Frank G. Fowler (unaffiliated) (disinterested )

Francis L. Veeder (unaffiliated) (disinterested )

P. Murtaugh | Wm. May | vacant | Eugene Ulrich

(unaffiliated) | (unaffil.) | | (disinterested )

* Defendants who were served

62a

Opinion of United States Court of Appeals

proposed, but never adopted, new Rule 10b-10 by its

express terms applied only to “dealer-distributed

funds”, rather than a no-load fund such as the Fund

which has no “distributor” or “underwriter”, and

Messrs. Sabel and Lee advised that the question of

possibility of recapture of brokerage commissions

which the Fund is compelled to pay upon execution of

portfolio transactions does not arise.

There are no writings reflecting any discussions or

deliberations by any of the Fund’s directors with re-

spect to recapture.

63a

Opinion of Unite? States Court of Appeals

minutes or other records referring to such discus-

sions.

7. (a) Identify and describe, by time, place and per-

sons present, all meetings of the boards of directors

of the Fund or the investment adviser from 1963 to

the present at which the possibility of recapturing

brokerage commissions was discussed.

(b) State whether there is any existing record of

such discussions, including but not limited to memo-

randa, minutes, correspondence or tape recordings.

Plaintiffs also offered defendants’ answer to their Inter-

The answer, omitting one paragraph whi

rogatories Nos. 5, 6 and 7, which read as follows: ; ip nln penae

differ in substance from the first paragraph quoted from

5. (a) State whether at any time from January 1, the pre-trial order, was as follows:

1963 to the present any of the defendants discussed

with or otherwise informed any unaffiliated directors

of the Fund of the possibility of recapturing the Fund’s

brokerage commissions in any manner whatsoever, in-

cluding but not limited to membership on regional ex-

changes, or N.A.S.D. affiliation by Chestnutt Corp. (the

“investment adviser”).

(b) If the answer to (a) above is in the affirmative,

identify and describe each such discussion and all

memoranda, minutes and other writings referring to

such discussions.

6. State whether at any time from January, 1963

to the present any discussion of the possibility of Ex-

change membership for the Fund, the investment ad-

viser or any affiliate of the Fund or the investment

adviser was discussed between or among any directors

of the Fund or the investment adviser, and if so iden-

tify and describe each such discuss'on, including the

time, place and persons present, and all memoranda,

All directors of the Fund knew and have always

known since becoming directors that the Fund was a

“no-load” Fund and sells its shares directly by mail,

and to some extent upon receipt of telephone orders,

to subscribers who become Fund shareholders by such

direct purchases without the intervention of, or any

commission payable to, any broker or dealer, or under-

writer. Accordingly, the Fund differs from most other

mutual funds in that it is not “dealer-distributed”,

nor is there any “underwriter”, nor is there any broker

or dealer affiliated with the Fund or affiliated with the

Adviser or affiliated with any officer or director of

either and all directors of the Fund have known these

facts at all times.

No director has suggested that the Adviser divert

its resources, efforts and talent from advice and man-

agement of investments to enter the new, untried and

risky business of public brokerage or underwriting as

one of many prerequisites to becoming a member of

an exchange or of the N.A.S.D. The management of

64a

Opinion of United States Court of Appeals

the Adviser understands that unaffiliated directors

of the Fund are and have been categorically opposed

to any brokerage or underwriting activity by the Ad-

viser or such activity by any new brokerage or under-

writing entity which might be created by or at the

instance of the Adviser, because of the inherent con-

flict of interest and the diversion of attention and

resources from investment advice and management.

All Fund directors have had brought to their atten-

tion the February 1972 statement by the Securities

and Exchange Commission relating to the future

65a

Opinion of United States Court of Appeals

practical considerations in the future, and the unaffili-

ated directors have been so informed...

Defendants do not believe that there are any papers

or writings referring to any such discussion but de-

fendants are continuing to search for any. Such ad-

vice from counsel has been on a continuing basis

including conferences with defendants in connection

with the defense of both actions brought by these

plaintiffs and in connection with periodic review of

the Fund’s Prospectus.

structure of securities markets, including the separate

statement by its senior member, Commissioner Owens,

The testimony of the independent directors indicated

nothing more in the way of disclosure. Director Radcliffe

expressly disapproving any brokerage functioning endorsed the language in prospectuses of two T. Rowe

whatever by an affiliate of a mutual fund on its be- Price funds"* and said that it would be improvident to

half, as constituting a clear conflict of interest, as well sas

as the majority text suggesting the propriety of stock

exchange membership and brokerage functioning

where the brokerage activity was preponderantly for

the public, together with informal Commission state-

ments indicating that any brokerage whatever for an

affiliated mutual fund should be permitted only where

80% of the brokerage business was with the general

public as distinguished from any affiliated mutual

fund. The Adviser, upon advice of counsel, and in

view of widely varying contentions advanced in legis-

lative committees, conflicting views within the Securi-

ties and Exchange Commission, and widely varying

views within the securities industry with respect to

market structure, commission rate structure, applica-

bility of antitrust laws, access to markets, and a vari-

ety of other matters, has in 1972 caused incorporation

papers to be drawn for a possible brokerage subsidi-

ary of the Adviser, which incorporation papers have

not been filed pending clarification of legislative and

The passage from the Rowe Price New Era

Fund, Ine.

dated May 1, 1973, Radcliffe endorsed read: re

The Securities and Exchange Commission has recently adopted

a rule which requires national securities exchanges to grant mem-

bership access to institutions, which for this purpose would in-

clude the Fund and [the Adviser], provided that the primary

purpose of membership is to transact publie business. [The

Adviser], which has since its inception taken the position that

the business of rendering investment supervisory services should

be separated from the brokerage business, has informed the Fund

that, in its opinion, the possible advantages of exchange member-

ship are insufficient to overcome the disadvantages. Exchange mem-

bership would have the effect of reducing brokerage costs of the

Fund, either directly (if the Fund were the member), or through

a “recapture” arrangement (if [the Adviser] were the member) ;

however, it would also divert the energies and financial resources of

[the Adviser] from the business of rendering investment super.

visory services to the conduct of a public brokerage business <i

would create a potential conflict between the desire to reduce com.

mission costs and the possibility that better price and execution

could be obtained elsewhere. In addition. the savings which might

result from exchange membership would not necessarily exceed ra

savings to be attained through negotiated commissions on trans.

actions through unaffiliated brokers. After cousidering the :

sible advantages and disadvantages of exchange membershi ‘"

light of the views of [the Adviser], the Fund's Board of Diree.

66a

Opinion of United States Court of Appeals

participate in the brokerage business. Director Ulrich,

who joined the board only in 1971, considered it a “con-

flict of interest” for the adviser “even to be connected

with brokerage.” Director May, who left the board in 1966,

never recommended the formation of a brokerage firm—

something plaintiffs likewise have not suggested. Director

Currier, whose status changed from “unaffiliated” to “in-

terested” on December 14, 1970, by virtue of §5 of the

Investment Company Act Amendments Act of 1970, see

fn. 11, also professed to be opposed even to the possibility

of having the adviser participate in brokerage. With the

possible exception of Director Radcliffe (as to whom see

note 16), it is not clear at all that any of these witnesses

thoroughly understood the forms of recapture which the

plaintiffs propose.

The testimony of the other directors was as follows: In

answer to a question whether counsel had advised that

forming an NASD affiliate or securing an “introducing

membership” on a regional exchange was illegal, Chest-

nutt said they had advised against it “because it was

fraught with self-dealing, with temptations of various

sorts.” Mr. Sabel had “repeatedly” used the hortatory

expression “shoemaker stick to your last,” instructing

Chestnutt to stay out of the brokerage business and stick

to the thing he knew best, namely, analyzing the market.

When asked where the self-dealing would be if he formed

an affiliate that merely received commissions and paid

tors, including all of the directors who are not affiliated with [the

Adviser] has determined that exchange membership would not be

in the best interests of the Fund or its stockholders.

As applied to this case, this passage was m

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