# Petition — Chestnutt Corp. v. Fogel > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385003_2377%3A1 ## Record - **Collection:** Supreme Court brief - **Document type:** Petition - **Published:** January 1, 1976 - **Citation:** 429 U.S. 824 ## Text Ocroser TERM, 1975 N#5- 1665 CuHEstNuTT Corporation, Georce A. CHESTNUTT, JR., ARNOLD JOHN CuRRIER, WaRREN K. GREENE and Sranuey L. Saset, Petitioners, v. 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 2 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 iv 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, v. 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. 3 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 4 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 5 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. 6 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 7 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!”. 8 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 9 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 Se 10 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. 11 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 12 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 13 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. 14 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 15 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 16 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 17 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). 18 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 19 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- 20 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 21 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 22 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 23 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 24 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. 25 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- 26 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 27 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 28 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: 29 “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). 30 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) 31 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. 32 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. 33 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 34 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 ee 35 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 —— 36 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 ee ee EIT ee rt es ea Be te core « tale eek hn te Re < & cea ODA rae > iw at: 0 APPENDIX la 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, v. | 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 2a 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 3a 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, v. 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. 4a 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 5a 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- 6a 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 7a 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 8a 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. 9a 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) 1. 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) 2. 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) 3. 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 ee ee ee ee eg ee an Et eo er ee ee wee a oe ~~ 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. aes tescat's a ae ee ee ee ee eee ee eS ee ee ge eee ee ee ee wees. Cae ee 23a Decision of District Court (383 F.Supp. 914) A. {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. 5. [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. 6. 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, or (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 +o Rosauinp Foger and Geratp Fogezt, Plaintiff s-A ppellants, v. 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, promot [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385003_2377%3A1. Public record. Not legal advice.