Petition — Burks v. Lasker

—_— K

7: od “WAEL PODAK, rR. CLER

IN THE

Supreme Court of the United States

October Term, 1977

HARRY G. BURKS, Jr., erai.,

Petitioners,

Vv.

HOWARD M. LASKER, et ano.,

Respondents.

PETITION FOR WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

DANIEL A. POLLACK

MARTIN I. KAMINSKY

61 Broadway

New York, New York 10006

Counsel for Petitioners Burr,

Chalker, Haire, Hutchison and

Anchor Corporation

LEONARD JOSEPH

JOHN M. FRIEDMAN, Jr.

140 Broadway

New York, New York 10005

Counsel for Petitioners Burks,

'Topkins, Kemmerer, Monroney,

Phillips and Wade

EUGENE P. SOUTHER

ANTHONY R. MANSFIELD

63 Wall Street

New York, New York 10005

Counsel for Petitioner

Fundamental Investors, Inc.

June 2, 1978

INDEX

PAGE

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ee ae De ce ech esnedan eeen 2

EE cnc adouasns ee eendeesacwes 2

ae ee ec aecbabedans : 3

i dg cnc osetnesdeccevece 3

Reasons for Granting the Writ .................. 8

eM ee ee cv bede'ce cows 22

Citations

CASES:

Corbus v. Alaska Treadwell Gold Mining Co.,

ST eee re ae 11, 12

Cort Vv. Ash, 422 U.S. 78 (1975) .............. 13,14

Fogel v. Chestnutt, 553 F.2d 731 (2d Cir.), cert.

denied, 429 US. o 4 ee a hee 17

In re Kauffman Mutual Fund Actions, 475 F.2d

257 (ist Cir.), cert. denied, 414 U.S. 857

te ar ee a ae 15, 16, 17

Santa Fe Industries, inc. v. Green, 430 U.S. 462

CS. ea es ee | 13,14

Tannenbaum v. Zeller, 552 F.2d 402 (2d Cir.

EE Sa SE ap ee Se a Ae ee a 17

United Copper Securities Co. v. Amalgamated

Copper Co., 244 U.S. 261 (1917) ............ 11,12

STATUTES:

Investment Company Act of 1940, §§ 36(a),

36(b), 1S U.S.C. §$§ 80a-35(a), 35(b) (1970)

3, 17, 18, 19, 20, 21

Delaware General Corporation Law, 8 Del. Code

S§ 141(a), 141(b) (1974) ...............3,13,14

Federal Rules of Civil Procedure. Rule 23.1 .... 15

a

te

—— ee

a a a

IN THE

Supreme Court of the United States

October Term, 1977

No. 78-

Harry G. Burks, Jr., er. al.,

Petitioners,

HowarD M. LASKER, ef ano.,

Respondents.

PETITION FOR WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

Petitioners, Harry G. Burks, Jr.. Edward B. Burr,

Thomas F. Chalker, John R. Haire, Harvey C. Hopkins,*

S. P. Hutchison, Donald L. Kemmerer, A. S. Mike Mon-

roney, Charles F. Phillips, Jeptha H. Wade, Anchor Cor-

poration and Fundamental Investors, Inc., respectfully

pray that a writ of certiorari issue to review the judgment

of the United States Court of Appeals for the Second

Circuit entered in this proceeding on January 11, 1978.

* Deceased.

Opinions Below

The opinions of the District Court (Hon. Henry F.

Werker) are reported at 404 F. Supp. 1172 (S.D.N.Y.

1975) and at 426 F. Supp. 855 (S.D.N.Y. 1977). The Dis-

trict Court also filed an unreported opinion and order

denying a motion for reargument on January 7, 1976. The

opinion of the Court of Appeals is reported at 567 F.2d

1208 (2d Cir. 1978). All four opinions below are repro-

duced in the appendix to this petition.

Jurisdiction

The judgment of the Court of Appeals was entered on

January 11, 1978, and a timely petition for rehearing was

denied on March 9, 1978. This Court’s jurisdiction is in-

voked under 28 U.S.C. § 1254(1).

Question Presented

Plaintiffs*, two out of 90,000 shareholders of a mutual

fund, seek to maintain a derivative action, purportedly on

behalf of the fund, against the investment adviser and

various directors of the fund for an investment loss sus-

tained by the fund. The disinterested directors of the

fund, who are not defendants in the lawsuit, exercising

their business judgment and acting with the advice of

independent special counsel, concluded that maintenance

of the derivative action was contrary to the best interests

of the fund and its shareholders, and instructed the fund’s

litigation counsel to move to dismiss the derivative action.

The District Court held, in its first opinion, that the

disinterested directors had the power, as a matter of busi-

ness judgment, to determine on behalf of the fund, not to

prosecute the possible claim. After permitting extensive

* In this petition respondents are referred to as “plaintiffs”

~ as “plaintiffs” and

petitioners as “defendants.” PI

3

discovery on the issue of the independence of the dis-

interested directors, the District Court held, in its second

opinion, that the disinterested directors were truly inde-

pendent and had acted in good faith in making this deter-

mination. Accordingly, the District Court granted the

motion to dismiss. The Court of Appeals, while agreeing

that the disinterested directors had acted in good faith,

held that the Investment Company Act of 1940 impliedly

precluded the disinterested directors from exercising their

business judgment to forego prosecution of the possible

claim against the investment adviser and the other di-

rectors. On this basis, the Court of Appeals reversed and

remanded the case.

Question: Are the independent and statutorily disin-

terested directors of a mutual fund incapacitated, as a

matter of law, from exercising their business judgment to

determine whether the maintenance of a stockholder’s deri-

vative action against the investment adviser and various

directors of the fund for an investment loss is in the best

interests of the fund and its shareholders: i.e., does the

Investment Company Act of 1940 require that a stock-

holder’s derivative action be permitted to proceed, in any

and all events, even though the independent and statu-

torily disinterested directors have concluded, in the good

faith exercise of their business judgment, that mainte-

nance of the derivative action is contrary to the best

interests of the fund and its shareholders?

Statutes Involved

The statutes involved in this case are the Investment

Company Act of 1940, 15 U.S.C. §§ 80a-35(a), 35(b),

(1970) and the Delaware General Corporation Law, 8 Del.

Code §§ 141(a), 141(b) (1974).

Statement of the Case

This case arises out of the purchase in 1969 by Funda-

mental Investors, Inc. (“Fundamental”), a mutual fund,

4

of $20 million of the commercial paper of Penn Central

Transportation Company (“Penn Central”) from Gold-

man, Sachs & Co., a leading commercial paper dealer.

At the time of the purchase, Penn Central commercial

paper was rated “prime” (the highest rating) by the Na-

tional Credit Office, a subsidiary of Dun & Bradstreet, Inc.,

the most widely utilized commercial paper rating agency

in the country. Fundamental had a portfolio composed

largely of equity securities and worth approximately $1

billion. The Penn Central commercial paper was pur-

chased by Fundamental as a short-term investment of un-

employed cash, i.e., a temporary utilization of funds until

they were needed for purchases of equity securities in the

stock market. Commercial paper of major national cor-

porations has traditionally been considered by the finan-

cial community to be a cash equivalent.

On June 21, 1970, Penn Central, the sixth largest

corporation in the country, filed a Petition for Reorganiza-

tion, and the notes purchased by Fundamental (and many

other financial institutions, universities, charitable organiza-

tions, etc.) were not paid at maturity.

On November 4, 1970, Fundamental initiated an ac-

tion, with three other plaintiffs, against Goldman, Sachs

& Co. (“the Welch action”) under the federal securities

laws for rescission of their purchases of the notes. The Com-

plaint charged that Goldman, Sachs & Co., the exclusive

dealer in Penn Central commercial paper, had withheld

material, adverse non-public information on the financial

condition of Penn Central.

On February 5, 1973, more than three years after the

purchase by Fundamental, two stockholders of Fundamen-

tal commenced the instant derivative action (“the Lasker

action”) purportedly on behalf of Fundamental. The

Complaint charged Anchor Corporation (the investment

adviser to Fundamenial) and all of the directors of Funda-

5

mental at the time of the purchase (i.e. 1969), with viola-

tions of statutory and common law duties in making and

retaining the investment for Fundamental in Penn Central

commercial paper.

On July 30, 1973, on motion of all defendants, and

prior to joinder of issue, then District Judge Murray I.

Gurfein stayed the Lasker action pending the resolution

of the claims of Fundamental against Goldman, Sachs &

Co. in the Welch action.

On July 9, 1974, Fundamental settled the Welch action

as follows: Goldman, Sachs & Co. took back the notes,

paid Fundamental $5.25 million in cash and assigned to

Fundamental a 73.75 per cent interest in the proceeds of

the $20 million of notes in the Penn Central reorganiza-

tion proceedings.

On July 24, 1974, at their next regular meeting, the

Board of Directors of Fundamental reviewed the status of

the Lasker action, and determined that the five directors

who (a) were not affiliated in any way with the investment

adviser (Anchor), and (b) were not directors at the time

of the events complained of in the Lasker action, and (c)

were not defendants in the Lasker action, would, acting as

a quorum pursuant to the by-laws and Delaware law, con-

stitute the Board of Directors to decide what position Fun-

damental should take regarding the Lasker action.* The

* Plaintiffs argued below that the five disinterested directors could

not be inde »endent because they had been nominated for their posi-

tions on the Board by defendants in the Lasker action. The District

Court, after reviewing the extensive discovery on the issue of inde-

pendence, held that there was no evidence whatsoever that any of

the five disinterested directors was influenced in any way by any

defendant in the Lasker action. See 426 F.Supp. at 846. The testi-

mony clearly shows that no defendant ever mentioned the Lasker

action to any one of the five directors prior to, at the time of, or in

connection with, his or her nomination to the Board. Indeed, the

first time that any of the five disinterested directors focused, at all, on

the Lasker action was at the July 24, 1974 meeting when they were

designated a quorum to decide what position should be taken by

Fundamental—this meeting occurred several years after most of them

became directors, Each of the five disinterested directors was a

person of high repute and achievement in business or government,

and each was selected by the Directors Qualification Committee

which, at all times, consisted of a majority of disinterested directors.

- .

an EA ceca ccc aaa Laas ccc

6

six other directors, i.e. the four who were affiliated with

Anchor and the two who were not affiliated with Anchor

but who were named as defendants in the Lasker action,

determined to take no part in the decision.

To assist them in their deliberations, the disinter-

ested directors retained independent special counsel, Hon.

Stanley H. Fuld, former Chief Judge of the State of New

York. Judge Fuld had no previous connection with any

of the parties.

On December 5, 1974, after several months of investi-

gation, Judge Fuld reported the results of his analysis in

a comprehensive legal and factual memovandum, and

advised: .

“As a result of my analysis of the facts and the

law, it is my Opinion that there was no violation by

Anchor or by the Fund directors of any provisions

of statute or of any common law or contractual

obligation to the fund, in connection withthe acqui-

sition and retention of the Penn Central commercial

”

paper. ¢

Judge Fuld also identified and analyzed the alternative

courses of action available to the directors, and concluded

his memorandum as follows:

“It is for the Board of Directors of the Fund to

determine, in the exercise of its discretion and busi-

ness judgment, which alternative to adopt.”

After receiving Judge Fuld’s December 5, 1974 memo-

randum, the disinterested directors carefully reviewed it

and raised several questions regarding the subjects covered

in the memorandum and the alternatives available to them.

In response to these questions raised by the disinter-

ested directors, on December 18, 1974, Judge Fuld deliv-

ered a brief supplemental memorandum in which he advised,

among other things, that whether or not a corporation seeks

to enforce in the courts a cause of action for damages is, like

other business questions, a matter of internal management,

and is left to the discretion of the directors.

On December 18, 1974, the disinterested directors held

a special meeting devoted exclusively to this subject. At the

meeting they discussed the entire matter with Judge Fuld

at length, and questioned management about the details of

the underlying transaction. After several hours of discus-

sion, they adjourned the meeting and decided to give the

matter further thought before reaching a decision.

On January 6, 1975, having conferred further with

Judge Fuld in the interim, the disinterested directors held

another special meeting of the Board. After several hours of

review and deliberation, they voted unanimously to instruct

the fund’s litigation counsel to move to dismiss the Lasker

action as contrary to the best interests of Fundamental.

Their reasoning is set forth at length in the record and is

quoted in the first opinion of the District Court.* (404

F. Supp. at 1176-77).

The District Court, in its first opinion, endorsed the

basic theory of the motion to dismiss (i.e. that the disinter-

ested directors had the power, in the exercise of their

business judgment, to determine that the corporate claim

asserted in the derivative action should not be prosecuted),

but denied the motion with leave to renew following dis-

covery on the sole issue of the independence of the

* Among the factors considered by the directors were the follow-

ing: (a) Judge Fuld’s opinion that Anchor had not violated any law

or contractual obligation, (b) the directors’ own determination that

Anchor had acted in good faith in recommending the Penn Central

investment, (c) the potential business disruption to Fundamental and

its investment adviser if the action were to proceed, (d) the fact that

numerous other respected institutional investors (including banks,

hospitals, universities etc.) had made the same investment at the

same time.

8

disinterested directors. The District Court wrote (404 F.

Supp. at 1180):

“If the minority directors were truly disinter-

ested and independent the Court will not substitute

its judgment for that of the Board.”

At the conclusion of extensive discovery proceedings

Fundamental renewed its motion to dismiss. The District

Court granted the renewed motion and wrote (426 F.

Supp. at 849):

“Plaintiffs have not adduced any factual support

for their conclusion that the members of the disin-

terested quorum acted other than independently.”

[emphasis supplied].

On January 11, 1978, in an opinion devoid of support-

ing legal authority and contrary to all relevant precedents,

the Court of Appeals reversed and remanded, concluding

that, as a matter of law, the Investment Company Act of

1940 impliedly deprived the independent and statutorily

disinterested directors of the fund of their power to deter-

mine not to assert a possible corporate claim against the

investment adviser and other fund directors for an invest-

ment loss sustained by the fund.

A timely petition for rehearing in banc was denied on

March 9, 1978.

Reasons for Granting the Writ

The decision of the Court of Appeals—holding that,

as a matter of law, disinterested directors of a mutual fund,

acting in good faith and with the advice of independent

counsel, lack the power to exercise their business judgment

to terminate a stockholder’s derivative action against the

invest nent adviser and various directors of the fund, main-

tenance of which the disinterested directors have concluded

to be contrary to the best interests of the fund and its share-

9

holders—raises an important question involving the extent,

if any, to which the Investment Company Act of 1940 dis-

places settled state law concerning corporate governance.

This question has not been, but should be, settled by this

Court.* The decision of the Court of Appeals for the

Second Circuit is in conflict with principles enunciated by

this Court, is in conflict with applicable precedent in the

Court of Appeals for the First Circuit (as well as its own

prior precedents), and raises issues of substantial public

importance.

The decision of the Court of Appeals, if allowed to

stand, will undermine basic principles of corporate gov-

ernance in the mutual fund industry.** Under this decision,

mutual funds can be held hostage, ir compulsory litiga-

tion, to the whims of a single stockholder. Such persons

will be empowered to compel large public mutual funds,

like Fundamental, to assert claims in litigation which dis-

interested directors, who are the legally elected representa-

* The importance of the case was expressly recognized by the

Court of Appeals in the opening sentence of its opinion:

“This appeal by two mutual fund shareholders raises an

important question of first impression...” [emphasis supplied].

(567 F.2d at 1208).

The importance of the case to the entire mutual fund industry,

and to the ratione! utilization of the federal court system, is indicated

by the amicus briefs filed in this case by Investors Diversified Services,

Inc., the ~~ mutual fund complex in the country, and by the

Investment pany Institute, the national association of mutual

funds, investment advisers and underwriters.

** Although the Court of Appeals purported to confine its decision

to the mutual fund industry, the central basis for its decision was a

legal presumption that the independent directors could not pass

fairly on plaintiffs’ proposed corporate claims against the investment

adviser and their fellow directors. See fn.*, p. 15 below and 567

F.2d at 1212. However, this presumption cannot readily be confined

to mutual fund corporations—the pessimistic view of human nature

which underlies the presumption applies, if at all, to all directors of

all corporations, not just to directors of mutual fund corporations.

Thus, if the opinion below is permitted to stand, it may well have a

serious impact on corporate governance beyond the mutual fund

industry.

10

tives of all stockholders, have determined to be contrary

to the best interests of those mutual funds and their many

shareholders.

The potentially harmful effects of the decision on mu-

tual funds, their investment advisers and the federal courts

are manifest. Invariably, some investments made by mu-

tual funds will result in losses and others in profits. If the

investment adviser and directors of mutual funds can be

called to account in stockholder’s derivative actions on

every investment that results in a loss, without the disinter-

ested directors being able to deflect such suits, where ap-

propriate, in the exercise of their good faith business

judgment, there would be unlimited potential for litigation

which could cripple the mutual fund industry. Every in-

vestment decision (i.e. to buy, sell or hold) would become a

potential subject for time consuming and expensive litiga-

tion in the federal courts; management of mutual funds

would become an impossibly hazardous business, and the

federal courts would be thrust into the role of arbiters of

the propriety of every unsuccessful investment decision.

Thus, the effects of the decision below are extraordinarily

severe, since each fund makes literally thousands of invest-

ment decisions each year.

In short, this case raises the fundamental question of

whether the legally elected representatives of all stockhold-

ers, or a single stockholder, who may well not have the

broader interests of all stockholders in mind, will have the

right to determine whether or not the mutual fund should

assert a possible claim in litigation.

sv oe

MD om

ll

The decision of the Court of Appeals in this case is in

conflict with principles enunciated by this Court.

In a line of cases going back 75 years, this Court has

held that the decision whether or not to prosecute litigation

on behalf of a corporation rests solely with the board of

directors. Absent fraud, corruption, or similar invalidating

factors, the board’s exercise of business judgment is final

and a stockholder’s derivative action does not lie. See, e.g.,

Corbus v. Alaska Treadwell Gold Mining Co., 187 U.S.

455 (1903); United Copper Securities Co. v. Amalgamated

Copper Co., 244 U.S. 261 (1917).

In Corbus, supra, this Court set forth the business

judgment rule in the context of a litigation decision as

follows:

“The directors represent all the stockholders

and are presumed to act honestly and according to

their best judgment for the interests of all. Their

judgment as to any matter lawfully confided to their

discretion may not lightly be challenged by any

stockholder or at his instance submitted for review

to a court of equity. The directors may sometimes

properly waive a legal right vested in the corporation

in the belief that its best interests will be promoted

by not insisting on such right. They may regard the

expense of enforcing the right or the furtherance of

the general business of the corporation in determin-

ing whether to waive or insist upon the right. And

a court of equity may not be called upon at the

appeal of any single stockholder to compel the di-

rectors of the corporation to enforce every right

which it may possess, irrespective of other consider-

ations. It is not a trifling thing for a stockholder

to attempt to coerce the directors of a corporation

12

to an act which their judgment does not approve,

or to substitute his judgment for theirs.” 187 U.S.

at 463.

This doctrine was subsequently reaffirmed by this

Court in United Copper, supra. In that case, the plaintiff

stockholder claimed that his corporation had been dam-

aged by the defendants’ acuons in violation of the anti-

trust laws. The board considered suing the defendants and

refused to do so. This Court ruled that the stockholder

could not then maintain a derivative action on behalf of

the corporation. Justice Brandeis wrote:

“Whether or not a corporation shall seek to

enforce in the courts a cause of action for damages

is, like other business questions, ordinarily a matter

of internal management, and is left to the discretion

of the directors, in the absence of instruction by

vote of the stockholders. 244 U.S. at 263.

The Court of Appeals in the case at bar legislated an

exception to the business judgment rule inconsistent with

the cases cited above and inconsistent with the structure

of the Investment Company Act of 1940—the statute relied

on by the Court of Appeals. If there is to be an exception

to this rule, for mutual funds, that exception should be

legislated by Congress and not by the courts. Neither the

provisions of the Investment Company Act of 1940 nor

the legislative history suggests that Congress ever intended

any such exception. *

* Indeed, the legislative history, which was not cited by the Court

of Appeals, contradicts the result reached by the Court of Appeals in

this case. See Point IV below.

eee

at ee ee ee

wo

ie

13

The decision of the Court of Appeals in this case is in

conflict with applicable and controlling state law of cor-

porate governance and the pronouncements of this Court

on the deference to be given state law in such matters.

This Court has specifically held that in the absence of

any express federal statutory provision to the contrary,

state law governs the powers of directors. Thus, in Santa

Fe Industries, Inc. v. Green, 430 U.S. 462, 479 (1977), this

Court last year wrote:

“Corporations are creatures of state law, and

investors commit their funds to corporate directors

on the understanding that, except where federal

law expressly requires certain responsibilities of

directors with respect to stockholders, state law

will govern the internal affairs of the corporation.”

[quoting from Cort v. Ash, 422 U.S. 78, 84 (1975)]

{emphasis in original].

Fundamental, the mutual fund involved in this case, is

a Delaware corporation.* Delaware General Corpora-

tion Law, Section 141(a), empowers the board of directors

of a corporation to manage the affairs of the corporation.

No distinction is made under that law for mutual fund

corporations. Management of the affairs of a corporation

has long been held to include the power to decide whether

or not to pursue a possible claim of the corporation in

litigation. The District Court so held at bar, and the Court

of Appeals did not take issue with this principle.

The Court of Appeals, however, erroneously differen-

tiated between mutual fund directors and directors of

* Congress, when it enacted the Investment Company Act of

1940, left the organization of mutual funds to state law. Mutual

funds are creatures of state law, not (like national banks, for example )

creatures of federal law.

14

other types of business corporations with respect to their

business judgment power to maintain or not maintain

litigation on behalf of the corporation.* In so doing, the

Court of Appeals engrafted onto the Investment Company

Act of 1940 new limitations on the powers of mutual fund

directors not placed there by Congress and in conflict with

the plan of corporate governance intended by the law of

Delaware.

The Court of Appeals did not and could not cite any

provision of federal law which expressly overrides or

abrogates the power of the directors under state law. The

fact is that there is no such provision in the Investment

Company Act of 1940 or in any other federal statute.

Thus, the decision of the Court of Appeals is in conflict

with the principles clearly enunciated by this Court in

Santa Fe and Cort, supra. The Court of Appeals simply

created a rule of federal law where none exists. In this

case, the Delaware law must be given effect since there

is no federal law expressly (or, as shown in Point IV, im-

pliedly) overriding Delaware law.

The decision of the Court of Appeals for the Second

Circuit in this case is in conflict with the decision of the

Court of Appeals for the First Circuit in Jn re Kauffman

Mutual Fund Actions, 479 F.2d 257 (1st Cir.). cert.

denied, 414 U.S. 857 (1973).

The Court of Appeals in this case singled out mutual

fund directors and, without warrant, distinguished them

* The Court of Appeals also erroneously stressed the fact that

the decision at bar was reached by a “minority” of the board, disre-

garding the fact that the “minority” of five disinterested directors

indisputably constituted a lawful quorum under Delaware General

Corporation Law Section 141(b) and under Fundamental’s certificate

of incorporation.

15

from directors of all other types of corporations. Thus,

the Court of Appeals wrote (567 F.2d at 1212 n.14):

“We base our decision on the unique nature of

the investment company and its symbiotic relation-

ship with its investment adviser; we need not reach

questions of the exercise of a similar power by

directors of other types of corporations.”*

The notion that mutual fund directors—especially the

disinterested directors—are under a special disability vis-a-

vis directors of other types of corporations in exercising

business judgment concerning the maintenance of litiga-

tion, has been firmly rejected by the Court of Appeals for

the First Circuit in the leading case of Jn re Kauffman

Mutual Fund Actions, 479 F. 2d 257 (lst Cir.) , cert. denied,

414 U.S. 857 (1973), a case not even cited by the Court of

Appeals below.** The Court of Appeals for the First Cir-

cuit there wrote (479 F.2d at 266-267):

“ _. the underlying business judgment may be suf-

ficiently unsound to call for correction. But it does

not follow that it is to be conclusively presumed in

such a case that an unaffiliated, or disinterested

director, if demand were made upon him, would be

* As noted above at p. 9, this attempt by the Court of Appeals

to limit the scope of its ruling is illusory. The central basis for the

decision of the Court of Appeals was the | presumption that, be-

cause the independent directors had to work and interact with their

fellow directors, “[i]t is asking too much of human nature to expect

that the disinterested directors will view with the necessary objectivity

the actions of their colleagues in a situation where an adverse deci-

sion would be likely to result in considerable expense and liability

for the individuals concerned.” 567 F.2d at 1212. How the “unique

nature” of the mutual fund industry supports application of such a

presumption is not explained, nor can it be. In any event, applica-

tion of such a presumption in the context of mutual funds conflicts

with settled law in another circuit, as shown in Point III.

** The result reached by the Court of Appeals at bar also renders

meaningless Rule 23.1 Fed. R. Civ. P. Why have a rule requiring

demand on directors if the directors have no power to act?

16

unable to exercise an independent judgment in con-

sidering what new course to take.” [footnote and

citation omitted].

“Nor do we think that an exception is to be

made in the case of unaffiliated directors of a mu-

tual fund on the ground that since they are expected

to be sensitive to misconduct of this variety they are

automatically incapacitated from performing their

duties—their approval or acquiescence making

them ‘wrongdoers’—once a stockholder alleges a

corporate injury stemming from the adviser-fund

relationship. Apart from the fact that this, again,

would enable a plaintiff to try his case on the merits

in order to determine whether he had a right to

bring it, it would be a misconception of the nature

of unaffiliated directors. Normally self-dealing by

any corporate directors is suspect. Congress rec-

ognized, however, that a certain type of self-dealing

is endemic in a mutual fund, and must be permitted.

In order to make sure that the directorate not be

top-heavy, it [Congress] provided for a minimum

number of directors who would not be so interested.

We do not believe it should follow from this that,

as directors required to be disinterested in a par-

ticular transaction, they differ in their fiduciary

obligations from a disinterested director in any

other corporate venture. All disinterested directors

must ‘act honestly and according to their best judg-

ment for the interests of all.’ [citation omitted].

When corporate action, or inaction, is subsequently

challenged, their duty is not extinguished, but

rather, refocused. After a demand provides them

with ‘full knowledge of the basis for the claim,

[citation omitted], it is for the directors, who have

‘the advantage of familiarity with the enterprise,

with those who have conducted it and with the rec-

ord of success or failure’ [i.e., the disinterested

17 =

directors] to decide on the appropriate corporate

response. {citation omitted]. To the extent that they

are ‘watchdogs’ they should be given the oppor-

tunity, not deprived of it.” (emphasis supplied).

At bar, under the per se rule of disqualification adopted

by the Court of Appeals, the disinterested directors were

improperly deprived of their opportunity to serve as

“watchdogs” of the fund’s best interests because they were

presumed to be legally incapable of deciding on the appro-

priate corporate response.

IV.

The reasoning of the Court of Appeals, insofar as it

purports to find a basis for its holding in the Investment

Company Act of 1940, does not withstand analysis.*

This action is brought under Section 36(a) of the In-

vestment Company Act of 1940. The Court of Appeals

* The decision below also conflicts with two earlier decisions by

the Court of Appeals for the Second Circuit under the Investment

y Act of 1940: Fogel v. Chestnutt, 533 F.2d 731 (2d Cir.

1975), cert. denied, 429 U.S. 824 and Tannenbaum vy. Zeller, 552

F.2d 402 (2d Cir. 1977). In Fogel supra, Judge Friendly wrote (553

F.2d at 749-50):

had mandated ieentens directors in order ‘to

supply an independent check on management and to provide

a means for the ntation of shareholder interests in invest-

ment company * [citation omitted). The minimum re-

quirement to cette | the Fund's independent directors to dis-

charge these duties with respect to recapture was a careful

investigation of the possibilities performed with an eye eager ?

discern them rather than shut against them, and, if these

bilities were found to be real, a —s of their legal difficul-

ties and their economic pros and cons. It would have been still

better to have the investigation or recapture methods and their

legal consequences performed by disinterested counsel furnished

to the independent directors.

‘If this had been done and the in ndent directors had

concluded that, because of legal doubts, business considerations

or both, the Fund should make no effort at recapture, we would

have a different case

18

erroneously equated Section 36(a) of the Investment

Company Act of 1940 with Section 36(b).* The Court

of Appeals reasoned that since Congress, in the 1970

amendments to the Investment Company Act of 1940,

“specifically provided in Section 36(b) that shareholders

may sue derivatively to recover excessive fees paid to the

adviser,” it “would surely be anomalous” not to imply the

same power for the alleged violations of Section 36(a) of

the Investment Company Act of 1940 sued upon here. (567

F.2d at 1212). Why it “would surely be anomalous” is not

explained, nor is any authority offered for the proposition.

Section 36(b) was enacted into law by Congress in 1970

as an amendment to the Investment Company Act of 1940

—it is a unique and highly specific section dealing solely

with the compensation of investment advisers. Section

36(b) expressly created a right of action by a shareholder

of a mutual fund against the investment adviser for breach

of fiduciary duty with respect to investment advisory fees,

irrespective of whether the disinterested directors have, in

the exercise of their business judgment, approved those

fees.

If Congress had intended to provide in Section 36(a), a

far broader section than Section 36(b), the unique mecha-

nisms of Section 36(b), it could and would have done so in

the 1970 amendments—it did not do so. The Court of

Appeals improperly added such a provision to Section

36(a) where Congress saw fit not to do so.

The legislative history, which was not cited by the

Court of Appeals, supports defendants’ view. Thus, Sen-

ate Report No. 91-184, which accompanied the 1970

amendments, states:

“Although section 36(b) provides for an equit-

able action for breach of fiduicary duty as does sec-

tion 36(a), the fact that subsection (b) specifically

* Section 36(a) deals with breaches of fiduciary duty; Section

36(b) deals solely with compensation of investment advisers.

19

provides for a private right of action should not be

read by implication to affect subsection (a).” {em-

phasis supplied]. 3 U.S. Code Cong. & Ad News,

9ist Congress, at p. 4911 (1970).

The foregoing passage, although focusing on the ex-

istence of a private right of action, a subject not at issue in

this case, indicates that Congress did not intend that the new

Section 36(b) be read to affect, in any way, Section 36(a),

i.c., Old Section 36. In short, the subject of investment ad-

viser compensation, covered by Section 36(b), is sui

generis.

Moreover, the Report expressly reaffirmed Congress’

intent not to disturb the authority of disinterested directors

to manage the affairs of a mutual fund in the exercise of

their business judgment, consistent with settled state law

concerning corporate governance:

“These provisions highlight the fact that the

section is not designed to ignore concepts de-

veloped by the courts as to the authority and respon-

sibility of the directors. Indeed, this section is de-

signed to strengthen the ability of the unaffiliated

directors to deal with these matters and to provide a

means by which the Federal courts can effectively

enforce the federally-created fiduciary duty with re-

spect to management compensation. The section is

not intended to shift the responsibility for managing

an investment company in the best interest of its

shareholders from the directors of such company to

the judiciary.” (Emphasis supplied] /d., at p. 4903.

A fortiori, if Congress in Section 36(b), which contains

an express right of action, did not intend to shift the re-

sponsibility for managing an investment company from the

directors to the judiciary, it necessarily follows that Con-

gress, in Section 36(a), where there is no such express

right, did not intend to shift the responsibility for manag-

ing an investment company from the directors to the

judiciary.

20

At bar, the District Court correctly analyzed and

rejected the plaintiffs’ argument based on the public policy

of the Investment Company Act of 1940 and held (404

F.Supp. at 1179-80):

“This Court cannot accept plaintiffs’ argument

that because the allegations of the complaint con-

cern violations of the Investment Company Act

and the Investment Advisers Act, the Board has no

power to exercise its business judgment because of

the strong public policies behind those Acts. Un-

like § 16(b) of the Securities Exchange Act which

allows shareholders to bring suit if the directors

decline a demand, Congress has made no such

statutory provision with respect to suits brought

under the Investment Company and Investment

Advisers Act. It is true that causes of action under

those Acts are implied rights of action. [Citations

omitted]. It does not necessarily follow that

because the right is implied a derivative suit should

always be allowed despite the good faith exercise of

business judgment by the directors not to sue. This

court is of the opinion that absent a statutory excep-

tion, whether a cause of action is expressly author-

ized or is ‘implied’ the directors of a corporation

should be given the chance to perform their duties

in running the business of the corporation including

whether to prosecute a cause of action. If they

have exercised their business judgment in good

faith then a decision not to sue should be final.”

On a motion by plaintiffs for reargument, the District

Court specifically addressed and rejected the Section 36(b)

argument, and held, in an unreported opinion and order

(see appendix):

“That section [36(b)] specifically gives a security

holder a cause of action against the investment

21

adviser or an affiliated person on behalf of the

investment company with respect to the receipt of

compensation. The question of who should deter-

mine whether or not the corporation is to sue is dif-

ferent under section 36(a) . . . where the basis for

suit is the more general claim of violation of fiduci-

ary duty and where no cause of action is given in

the statute to a security holder on such a claim.”

The District Court correctly perceived the distinction

between Sections 36(a) and 36(b); the Court of Appeals

either misperceived or ignored the distinction.

* * *

In sum, in this case the disinterested directors of the

mutual fund, after the fund had received a substantial

settlement of its investment loss, and based on the advice

of eminent, independent counsel, made a good faith deter-

mination, in the exercise of their business judgment, that

maintenance of this derivative action was contrary to the

best interests of the fund and its shareholders. In so doing

the directors exercised managerial power granted under

state law. The Court of Appeals concluded that such

state law power could not be exercised because of a sup-

posed congressional intent. However, that intent is nowhere

expressed in the Investment Company Act of 1940 and is

in fact negated by the legislative history of the Investment

Company Act of 1940.

The decision below does violence to prior decisions

of this Court and conflicts with a decision in another cir-

cuit. It presents an important question of federal law

which should be decided by this Court concerning the

construction of the Investment Company Act of 1940 and

the deference to be given by federal courts to state law

powers concerning corporate management.

For the foregoing reasons, a writ of certiorari should

issue to the United States Court of Appeals for the

Second Circuit.

June 2, 1978

22

CONCLUSION

Respectfully submitted,

DANIEL A. POLLACK

MARTIN I. KAMINSKY

61 Broadway

New York, New York 10006

Counsel for Petitioners Burr,

Chalker, Haire, Hutchison and

Anchor Corporation

LEONARD JOSEPH

JOHN M. FRIEDMAN, JR.

140 Broadway

New York, New York 10005

Counsel for Petitioners Burks,

Hopkins, Kemmerer, Monroney,

Phillips and Wade

EUGENE P. SOUTHER

ANTHONY R. MANSFIELD

63 Wall Street

New York, New York 10005

Counsel for Petitioner

Fundamental Investors, Inc.

APPENDIX

Opinion of the District Court, September 24. 1975

1172

States v. Bettenhausen, 499 F.2d 1223

(CA10 1974). As stated in United

States v. Fancutt, 491 F.2d 312, 314 (CA

10 1954):

“Jury verdicts in criminal cases are

to be rendered on the facts as dis-

closed by evidence and the law as

pronounced by the court. That which

the prosecutor thinks, believes or

knows are not to be given considera-

tion. Such argument is improper.”

The issue in this type of proceeding,

however, is not whether the actions of

the district attorney were error but

whether the conviction of the petition-

er was the result of an unfair trial in

violation of the Fourteenth Amendment.

Sampsell v. People of the State of Cal-

tifornia, 191 F.2d 721 (CA9 1951). it

is only where criminal trials in state

courts are conducted in such a manner a3

amounts to a disregard of that funda-

mental fairness essential to the very con-

cept of justice that due process is of-

fended and federal court interference is

warranted. Chavez v. Dickson, 230 F.2d

727 (CAS 1960). After careful con-

sideration of the record, it cannot be said

that the efforts of the prosecutor re-

sulted in a denial of the fundamen:zal

fairness essential to the concept of jus-

tice. As pointed out in United States v-.

Fay, 350 F.2d 400, 401 (CA2 1965):

“(For] whatever error the state

court may have committed in failing

to grant a new trial, the defect in the

trial did not attain constitutional pro-

portions. The prosecutor’s conduct did

not create a situation so prejudicial to

the appellant that he was denied a fair

trial within the meaning of the due

process clause of the Fourteenth

Amendment.

“Conduct of state prosecutors which

it was contended was unfair and pre)-

udicial has consistently been held on

collateral attack in the federal courts

to fall short of constituting a lack of

due process. [Citations omitted.)"

This is not a case where the comment

of the prosecutor infringed upon any

1a

404 FEDERAL SUPPLEMENT

specific guarantees of the Bill of Rights.

It is not a case where the prosecutor

consistently and repeatedly misrepre-

sented the evidence before the jury. Cf.

Miller v. Pate, 386 U.S. 1, 87 S.Ct. 785,

17 L.Ed.2d 690 (1967). It is not a case

where there was non-disclosure by the

prosecution of specific evidence favora-

ble to the accused. Cf. Brady v. Mary-

land, 373 U.S. 83, 83 S.Ct. 1194, 10 L.

Ed.2d 215 (1963). There was otherwise

no unfair manipulation of the evidence

so as to have an effect on the jury’s de-

termination. The evidence of guilt was

strong. In fact, the petitioner admitted

guilt but relied upon the defense of en-

trapment. The actions of the prosecu-

tor constituted only the ordinary trial

errors of a prosecutor, not that sort of

flagrant misconduct necessary to estab-

lish a denial of constitutional due proc-

ess for relief on collateral attack. See

Donnelly v. De Christoforo, 415 U.S. 637,

94 S.Ct. 1868, 40 L.Ed.2d 421 (1974).

Accordingly for the foregoing reasons

the Petition for Writ of Habeas Corpus

will be denied.

It is so ordered.

2

(2 [eer sewete trart=>

>

Howard M. LASKER and Irving

Goldberg, Plaintiffs.

v.

Harry G. BURKS, Jr., et al.

Defendants.

No. 73 Civ. 552 (HFW.)

United States District Court,

S. D New York.

Sept. 24, 1975.

As Amended Oct. 17, 1975.

Two stockholders of registered in-

vestment company brought shareholders’

derivative action against company’s in-

LASKER v. BURKS

za

1173

Cite as #04 F Supp. 1172 (1975)

,estment advisor and several former and

present members of the company’s board

of directors. On the company’s motion

to dismiss, the District Court, Werker,

J., held that an independent minority of

the company’s board of directors, who

constituted a quorum, had the power to

decide what position the company should

take in the suit; that the strong public

policies behind the Investment Company

Act and the Investment Advisers Act did

not bar the board of directors from ex-

ercising its business judgment on the

suit; that the board's decision not to

sue was not tantamount to an illegal

ratification; and that a question of

fact existed as to whether the minority

directors were truly disinterested and

independent.

Motion denied without prejudice.

1. Corporations ©310(1)

In stockholders’ derivative suit

against, inter alia, several company di-

rectors, disinterested directors, who were

minority of board, constituted quorum,

and were designated by full board to

make decision as to company’s position

in the suit, had power to exercise their

business judgment as to what position

company should take. Fed.Rules Civ.

Proc. rule 23.1, 28 U-.S.C.A.

2. Corporations C310(1)

Absent fraud or corruption or other

factors, stockholders cannot force corpo-

ration to sue. Fed.Rules Civ.Proc. rule

23.1, 28 U.S.C.A.

3. Corporations =310(1)

Strong public policies behind Invest-

ment Company Act and Investment Ad-

visers Act did not deprive corporate

board of directors of its power to ex-

ercise business judgment over stockhold-

ers’ derivative action. Investment Com-

pany Act of 1940, § 1 et seq., 15 U.S.C.A.

$ 80a-1 et seq.; Investment Advisers

Act of 1940, § 201 et seq.. 15 U.S.C.A.

§ 80b-1 et seq.; Fed.Rules Civ.Proc. rule

23.1, 28 U.S.C.A.

4. Securities Regulation 218, 223

Causes of action under Investment

Company Act and Investment Advisers

Act are implied rights of action. Invest-

ment Company Act of 1940, § 1 et seq.,

15 U.S.C.A. § 80a-1 et seq.; Investment

Advisers Act of 1940, § 201 et seq., 15

U.S.C.A. § 80b-1 et seq.

5. Corporations <=310(1)

Board of directors’ decision to op-

pose stockholders’ derivative suit in ex-

ercise of its business judgment did not

amount to illegal ratification. Fed.Rules

Civ.Proc. rule 23.1, 28 U.S.C.A.

6& Federal Civil Procedure 1741

In investment company’s stockhoid-

ers’ derivative action against company’s

investment adviser and several former

and present members of company’s board

of directors, question of fact existed as

to whether minority directors were truly

disinterested or independent, precluding

granting motion to dismiss on ground

that disinterested minority of board of

directors had determined that, in their

business judgment, action was contrary

to best interests of company sharehold-

ers. Fed.Rules Civ.Proc. rules 12(b),

23.1, 28 U.S.C.A.

ee

Aranow, Brodsky, Bohlinger, Benetar

& Einhorn, New York City, for plain-

tiffs.

Dewey, Ballantine, Bushby, Palmer &

Wood, New York City, for defendants

Burks, Hopkins, Kemmerer, Monroney,

Phillips & Wade.

Seward & Kissel, New York City, for

defendant Fundamental Investors, Inc.

Pollack & Singer, New York City, for

defendants Burr, Chalker, Hutchinson,

Haire & Anchor Corp.

MEMORANDUM DECISION AND

ORDER

WERKER, District Judge.

This is a shareholders’ derivative ac-

tion brought by two stockholders on

behalf of Fundamental Investors, Inc.

1174

(“Fundamental” or the “Fund”), a reg-

istered investment company under the

Investment Company Act of 1940, 15

U.S.C. § 80a-1 et seq. The defendants

are the Fund’s investment adviser, An-

chor Corporation (“Anchor”), a regis-

tered investment adviser under the In-

vestment Advisers Act of 1940, 15 U.S.C.

3 30b-1 et seqg., and several former and

present members of the Board of Direc-

tors of the Fund. The dispute between

the parties centers around the Fund's

purchase, on Anchor’s recommendation,

of $20 million in commercial paper of

the now bankrupt Penn Central Trans-

portation Company. As described in de-

tail below the complaint charges that

in connection with the purchase of the

Penn Central paper the defendants vio-

lated various sections of the Investment

Company Act, the Investment Advisors

Act and the common law. The Fund,

joined by all defendants, has now moved

under Rule 12(b) of the Federal Rules

f Civil Procedure to dismiss this ac-

ion on the ground that the independ-

t members of the Board of Directors

of the Fund have unanimously deter-

mined that, in their business judgment,

is action is contrary to the best in-

terests of the sharehoiders of the Fund.

BACKGROUND

The Fund made its purchases of Penn

entral 279-day notes from Goldman.

Sachs & Co., in lots of $35 million each

November 25, December 2, 4 and 8,

363. Unfortunately for the Fund and

her holders of Penn Central commer-

tai paper, Penn Central, on June 21.

970, filed a petition for reorganization

naer section 77 of the Bankruptcy Act

th the result that the notes were not

id at maturity or at any time to date.

aced with the possibility of a substan-

lal loss, the Fund and other plaintiffs

instituted suit in the Southern District

New York on November 4, 1970

ainst Goldman, Sachs & Co., for re-

ission of their purchases of the Penn

entral Notes. That action was entitled

elch Foods, inc. v. Goidman, Sachs &

“e., D.C., 398 F.Supp. 1393 (the “Welch”

*on).

404 FEDERAL SUPPLEMENT

32

The instant derivative suit was filed

on February 5, 1973. Jurisdiction was

predicated on section 44 of the Invest-

ment Company Act of 1940 (15 U.S.C.

§ 892-43), section 214 of the Investment

Advisers Act of 1940 (15 U.S.C. § 80b-

14) and pendent jurisdiction. The com-

plaint alleges that in making the pur-

chases of Penn Central commercial paper

the Fund and Anchor relied solely and

exclusively on Goldman, Sachs & Co..

and made no independent investigation

of the financial condition of Penn Cen-

tral or the quality of its commercial

paper. By failing to make an indepen-

dent investigation it is alleged that

Anchor failed to meet its responsibility

as the Fund's investment adviser and

that the Fund’s directors knew or should

have known of, and acquiesced in, the

failure of Anchor to meet its responsi-

bilities and thus failed to meet their re-

sponsibilities as members of the Fund’s

Board of Directors. Had an independent

investigation been made it is alleged that

a number of material adverse facts con-

cerning the financial condition of the

Penn Central and the quality of its com-

mercial paper would have been learned.

A3 a result of their actions, or inactions,

the defendants are charged with engag-

ing in acts and practices constituting

gross misconduct and a gross abuse of

trust in respect of the Fund in violation

of section 36 of the Investment Company

Act. Anchor is also alleged to have vio-

lated section 206, the antifraud section

of the Investment Advisors Act of 1940.

Plaintiffs also claim that the defendants

violated their common law fiduciary du-

ty to the Fund and that Ancor, aided

and abetted by the directors, breached

its Investment advisory contract with the

Fund.

The complaint goes on to allege that

from November 28, 1959 to June 21.

1970, the date Penn Central fiied for

reorganization, the financial condition

of the Penn Centrai deteriorated. Dur-

ing this period it is alleged chat Anchor

and the Fund directors failed to com-

mence a thorough and adequate investi-

gation of, and keep under continuous re-

view, the financial condition af Penn

LASKER v. BURKS

4a

1175

Cite as 404 F.Supp. 1172 (1975)

Central and the quality and safety of its

commercial papers. It is also alleged

that during this period the Fund's direct-

ors failed in their obligations to make

adequate attempts to resell the Penn

Central commercial paper it held and

that Anchor failed to advise the Fund of

the advisability of selling the commercial

paper. Plaintiffs again claim that these

acts by the defendants violate section

36 of the Investment Company Act;

that Anchor violated section 206 of the

Investment Advisers Act; that all de

fendants breached their common law

fiduciary duty; and that Anchor, aided

and abetted, by the Fund’s directors

breached its investment advisory con-

tract. Finally, the complaint alleges

that the defendants violated section 13

‘a)(3) of the Investment Company Act

by allowing the Fund to hold more than

10% of the securities of any one issuer

Penn Central) in contravention of the

Fund's registration statement filed pur-

suant to section 8(b) of the Investment

Company Act.

Subsequent to the filing of this deriva-

tive action, all defendants moved to stay

this action pending the resolution of the

claims of Fundamental in the Welch ac-

tion. The stay was granted by Judge

Gurfein on November 12, 1973. Funda-

mental’s claims against Goldman, Sachs

& Co., in the Welch action were settled

on July 9, 1974. The terms of the set-

tlement provided that Goldman, Sachs &

Co. would take back the Penn Central

notes, pay Fundamental! $5,250,000.00 in

cash and assign to Fundamental a 73.-

75% interest in the proceeds of the notes

in the reorganization proceedings.

!. Seetion 1 of Article Eight of the Certifi-

cate of Incorporation of Fundamental pro-

vires that:

“The number of direetor« which shall con-

-titute the whole board of directors shall he

~weh as from time to time shall be fixed by

et in the manoer provided in the by-laws

whieh shall also provide the number of di-

treetors which shall constitute a quorum;

provided. that in so case shall a quurym

be less than one-third of the total oumber of

“iteetors sor lexs than two dire-tors.”

With the settlement of the Welch ac-

tion, Fundamental had to determine what

position to take in this suit. It is ne-

cessary to set forth in detai] the actions

taken by the Fund’s Board of Directors

since it forms the basis of the defend-

ants’ motion to dismiss.

Fundamental’s Board of Directors met

on July 24, 1974 to review the settlement

of the Welch action and to decide what

position to take in this derivative ac-

tion. Since five of the directors are de-

fendants in this action and one is a di-

rector of Anchor, the Board determined

that the remaining five directors who

they considered disinterested would, act-

ing as a quorum pursuant to the by-

laws,' decide what position the Fund

should take in this action. The five

disinterested directors then decided to

retain the Honorable Stanley H. Fuld,

former Chief Judge of the New York

Court of Appeals, to review the entire

Penn Central matter and to report to the

Board.

After reviewing the complaint in this

derivative action, the proceedings in the

Welch action, the files of Anchor and

the Fund relating to the purchase of

Penn Central paper and after interview-

ing officers and employees of the Fund

and analyzing the facts and the law,

Judge Fuld sent a memorandum to the

disinterested directors on December 5,

1974 in which he stated his opinion that

there was “no violation by Anchor or

by the Fund directors of any provision

of statute or of any common law or con-

tractual obligation to the Fund, in con-

nection with the aecvisition and reten-

tion of the Penn Central commercial

Section 4 of Article Six of the By-Laws

of Fundamental provides that-

“Quorum: Except as otherwise provided

br law, the Certificate of Lacorporatica,

or these By-Laws, ut all meetings of the

Bourd of Directors one-third of the dire-

tors then in office. but nor less than three

directors shall be necessary for the trans

action of businex.”

92a

1176 404 FEDERAL SUPPLEMENT

paper.” (Dec. 5, 1974 Memorandum at

2). Judge Fuld went on to discuss in

detail each of the claims asserted in this

suit. Finally, Judge Fuld defined and

discussed three alternative courses of

action which the disinterested directors

might pursue, i. ¢., (1) seek realign-

ment so as to a plaintiff for the

purpose of exercising control over and

prosecuting the action; (2) conclude

that the action is sufficiently lacking in

merit and move to have the suit dis-

missed; and (3) take a neutral position

and permit the action to proceed for the

Furd’s benefit under the auspices of the

present plaintiffs.

After the disinterested directors re-

viewed his report and submitted ques-

tions to him, Judge Fuld sent a supple-

mental memorandum to the disinterested

directors on December 18, 1974. In his

memorandum Judge Fuld discussed in

more detail the possibility that the

Board should move to dismiss this suit

as not being in the best interests of the

Fund and the possible scope of judicial

review of such a decision.

The disinterested directors then met

in a series of special meetings to con-

sider Judge Fuld's memoranda. The

directors met with Judge Fuld: John R.

Haire, Chairman and Chief Executive of

Anchor; Donald L. Kemmerer and

Charlies F. Phillips, unaffiliated direc-

tors of Fundamental: and Eugene

Souther, litigation counsel to Fundamen-

tal in this action. Questions were posed

by the directors to all of these in attend-

ance concerning the merits of the deriva-

tive action and the alternatives open to

the Fund’s Board. The disinterested di-

rectors again met in private and decided

to give additional consideration to the

problem and convey any questions to the

designated Chairman of the disinterest-

ed directors, Leon T. Kendall.

A second special meeting of the dis-

interested directors was held on Janu-

2. One director, Mary S. O'Conner, was sot

present at the meeting. She had previously

tohi Me. Kendall what her derision was,

That vore wes reaffirmei by Mew. OC ouner

ary 6, 1975. Upon review of the alter-

natives available, the directors present

unanimously determined? that the pros-

ecution of this action was contrary to

the best interests of the shareholders

of Fundamental and that counsel should

be directed to seek dismissal of the ac-

tion. The factors considered by the di-

rectors in reaching their conclusion are

summarized in the Kendall affidavit %

22, and are as follows:

“(a) Chief Judge Fuld’s opinion that

there is no merit to the action and

little likelihood of its success;

(b) The business interruption to An-

chor, distraction of its personnel and

the likely inability for it to attract and

maintain personnel during pendency

of the action neccssarily would be

harmful to the sharehoiders of Fund-

amental ;

(ec) If the action were to proceed

against Anchor with the acquiescence

or under the control of Fundamental,

the adversary relationship that would

be created between Fundamental and

Anchor and the attendant serious

distraction of Anchor’s personnel from

their efforts on behaif of the share.

holders of Fundamental would leave

us no practical alternative but to re-

remove Anchor as investment adviser

and to seek to retain a new invest-

ment adviser: this would necessarily

result in delay, uncertainty and an in-

evitabie lapse in the management of

Fundamental’s affairs to the serious

detriment of its shareholders;

(d) Anchor had acted in good faith

and in what it believed was in the best

interests of Fundamental's sharehold-

ers in purchasing the Penn Central

commercial paper;

(e) Anchor had acted reasonably and

had followed procedures prudent at

the time in light of the then generally

at a special meeting of the disinterested di-

reetom hekl on Jaonary 2. 1975. Even

without heer presence, four direetors would

comstiture & quer,

ae

LASKER v. BURKS

6a

1177

Cite as 404 F Supp. 1172 (1975)

held belief that commercial paper was

equivalent to cash;

(f) A vast number of other institu-

tional investors, including many major

banks in New York City and through-

out the country and certain major mu-

tual funds, had also believed that

Penn Central was a sound business

enterprise and had purchased Penn

Central commercial paper at the time,

and many such investors still held that

paper when Penn Central petitioned

fe’ reorganization;

(g) To take no position at all and

thereby to allow two of the more than

90,000 shareholders to determine the

course of this action would not be a

decision at all, but an avoidance of our

obligation to all the shareholders;

(h) Chief Judge Fuld’s advice that an

investment adviser is not a guarantor

of the investments it makes and can

only be charged for breaches of con-

tract or of the standards applied by

the pertinent statutes and regulations.

Chief Judge Fuld had analysed the

facts and law and had concluded that

Anchor was not at fault and that there

was little likelihood that Anchor would

be held to have violated any statute

or regulation or to have breached any

agreement or duty;

(i) Given Chief Judge Fuld’s opinion,

if the action were to proceed, there

could be unnecessary costs to the

shareholders of Fundamental for legal

fees, both for its own counsel and for

the director defendants, who would

be entitled to reimbursement of coun-

sel fees if they were found to be liable

to Fundamental; and

(j) Even if there were a recovery of

the theoretical maximum amount of

damages, the net result to the share-

holders of Fundamental would be little

more than a net recovery of 10 cents

per share, or approximately 2°% of

Fundamental’s net asset value. The

remote chance of recovering that small

amount was not worth the risk of the

serious damage to Fundamental’s

fe # & os ... Ate

shareholders which proceeding with

this action might produce.”

DISCUSSION

The Fund now argues that the exten-

sive consideration given to the alterna-

tives available to the independent di-

rectors culminating in their decision to

seek dismissal of this suit was a good

faith exercise of business judgment

which cannot be upset by the two share-

holder plaintiffs who would force Fund-

amental to maintain this action. The

plaintiffs, of course, dispute this posi-

tion. After emphasizing, the merits

of the claims they have assserted and

criticizing the conclusions reached by

Judge Fuld, plaintiffs make the follow-

ing arguments in opposition to the de-

fendants’ motion to dismiss: (1) be-

cause of the broad regulatory legisla-

tion embodied in the Investment Com-

pany and Investment Advisers Act, the

decision whether to prosecute violations

of that Act is not a matter of “business

judgment” to be decided by directors of a

regulated fund; (2) to seek dismissal

of the action would be tantamount to an

unlawtul ratification of defendants’ con-

duct; (3) if a majority of the board’s

directors are disqualified, the existence

of a “disinterested” minority is irrele-

vant; (4) as a matter of law the miror-

ity directors are not “disinterested ;”

(5) the minority directors gave undue

deference to Anchor in making their

decisions; and (6) the motion is pre-

mature and defective under Rule 23.1.

These arguments will now be considered

At the outset, the obvious should be

stated—a shareholder’s derivative suit

is an action brought on behalf of a cor-

poration in which any recovery runs in

favor of the corporation. Ordinarily,

it is the corporation which would seex

the right to enforce any cause of action

it might have. Rule 23.1 of the Federal

Rules of Civil Procedure requires that a

complaining shareholder demand action

from the board of directors before

1178

bringing suit’ The Purpose of that

“demand” rule “is to give the derivative

corporation itself the spportunity to take

over 4 suit which was brought on its be-

half in the first place, and thus to allow

the directors the chance to occupy their

normal status as conductors of the cor-

poration’s affairs.” Brody v. Chemical

Bank, 517 F.2d 932 at 934 (2 Cir. 1957),

citing in re Kauffman Mutual Fund

Actions, 479 F.2d 257, 263 (ist Cir.),

cert. denied, 414 U.S. 857, 94 S.Ct. 161

38 L.Ed.2d 107 (1973).

No demand was made on the Fund's

Board of Directors in this case because

plaintiffs alleged (and it is not disputed)

that the majority of the Fund’s directors

are defendants charged with wrong-

doing and as such a demand would be

futile.* While no set formula has been

developed for determining what facts

must be plead in order to excuse a de-

mand on the Board of Directors—see

generally, TA Wright & Miller Federal

Practice & Procedure § 1831 (1972)—

that issue is not presented in this case.

Instead, this case presents the rather

unique Situation where a designated in-

dependent minority of a Board has taken

unilateral action with respect to a suit

brought on behalf of the corporation.

The decision of the independent direc-

tors was made after the settlement of

the Welch action whicn put an end to the

3. Rule 23.1 provides:

“In a derivative action broughe by one or

more shareholders or members te enforre

a right of a corporation or of an unincarpe-

rated association, the corporation or us-

sociation having failed to enforce 4 righe

which may properly be asserted by it, the

complaint shail be verified and shall allege

(1) that the plaintiff was a shareholder or

member at the time of the transartion of

Which he complains or that his share or

membership thereafter devolved on him hy

operation of law, and (2) that the action

is not a coilusive one to confer jurtadic-

tion on a court of the T’niredd States whieh

it woul not otherwise hinve. The com-

plaint shall alxo alleze with pertionlarity

the efforts, if any. made by the plainritft

to obtain the action he desires from the di-

reetorms of comparable authority amd. if

necessary, from the shurehellem of mem-

404 FEDERAL SUPPLEMENT

4.

7a

Stay in this suit. Plaintiffs argue that

even if Suit were instituted at the pres-

ent time (i. e., after settlement of the

Welch action) no prior demand on the

Fund’s Board would have been neces-

Sary because the majority of directors

would be disqualified. To allow a minor-

ity of the Board to seek dismissal of the

Suit would, it is argued, destroy the role

of “presumptive disqualification.”

While no case is directly in point,

this circuit has recently considered an

analogous issue in Brody v. Chemical

Bank, supra. There, the district court

had dismissed the derivativs causes of

action in plaintiff's comriaint because

the allegations in the complaint were in-

sufficient to excuse a demand on the

Board of Directors. Plaintiff had ai-

leged futility of demand because the

majority of directors were controlled by

the defendant corporation. However,

since institution of the suit, a new Board

had been installed but no demand was

made on it. The Second Circuit agreed

that a demand should have been made

but remanded because of the gravity of

the alleged wrongdoing. 482 F.2d i111

at ills (2 Cir.). After remand, the

plaintiffs filed a second amended com-

plaint but made no demand on the Board

of Directors because they alleged that a

Gemand on the Board of Directors at

the time the action was originally com-

ree ane rhe reasons for his failure to obrain

re wtion ot for not making the effort.

The (derivative action may not he main-

tained if it appears that the plaineiffg does

not fairly and adequately represent the in-

terests of the shareholders or members sim-

ilariy situated in enforcing the right of

the corperttion of association. The action

shall not he dismissed or compromised with-

out che approval of the court. and Botice of

the proposed dismissal or compromise shail

he given to shareholders or Member in such

manner as the court direers,”

No issue has heen raised coneerning wherl-

er a demand on the sharehoklers was Nees.

sary. Plaintiffs’ complaint alleges thar un-

der applicable law and the Certificate of

Theorperation vod By-Laws of the Fund, the

‘lireetors aml officers are vested with che

management of the Fund. Compiaine * T(b).

8a

LASKER v. BURKS 1179

Cite as 404 F.Supp. 1172 (1975)

menced would have been futile. The

district court again dismissed the de-

rivative counts and the Second Circuit af-

firmed on the reasoning that a demand

should have been made on the new di-

rectors. Brody, supra at 934.

{1} In this case, within a short pe-

riod after settlement of the Welch ac-

tion and the dissolution of the stay, the

Board of Directors met and designated

the independent directors to make a de-

cision as to the Fund's position in this

suit. In the Court’s view, the independ-

ent minority of directors had the power

to decide what position the Fund should

take. This is consistent with the policy

that a corporation be given the opportu-

nity to control a lawsuit brought on its

behalf, that the Board be allowed to

exercise its normal functions in running

the corporation, and that a derivative

suit should be resorted to as a last al-

ternative. See 3B J. Moore, Federal

Practice 7 23.1.19, at 23.1-252-53 (2d

ed. 1974) quoted in Brody, supra at 934.

Although the independent directors

could properly move for dismissal of

this action it is now necessary to de-

termine whether good faith business

judgment of the directors can be used

as a ground for dismissal. Defendants

rely on a line of cases which hold that

absent fraud or corruption or other dis-

qualifying factor, the good faith busi-

ness judgment of the directors not to

oring suit is final. See, e. g.. Hawes v.

Oukland, 104 U.S. 450, 26 L.Ed. 827

1881); Corbus v. Alaska Treadweil

Gold Mining Co., 187 U.S. 455, 23 S.Ct.

157, 47 L.Ed. 256 . 1903); United Cop-

ner Securities Co. v. Amalgamated Cop-

per Co., 244 U.S. 261, 37 S.Ct. 509, 61

L.Ed. 1119 (1917); Swanson v. Traer,

249 F.2d 854 (7th Cir. 1957); Ash v.

‘BM, 353 F.2d 491 (3d Cir. 1965), cert.

ds nied, 384 U.S. 927, 86 S.Ct. 1446, 16

L.Ed.2d 531 (1966); In re Kauffman

Mutual Fund Actions, 479 F.2d 257 (ist

Cir.), cert. denied, 414 U.S. 857, 94 S.Ct.

i681, 38 L.Ed.2d 107 (1973). Cf. Alle-

uheny Corp. v. Kirby, 244 F.2d 571 (2d

(tr. 1965), cert. dismissed, 384 U.S. 28,

6 S.Ct. 1250, 16 L.Ed.2d 335 (1966).

[2] As the Supreme Court recog-

nized in United Copper, supra, the de-

cision whether or not to sue is a matter

of internal management. 244 U.S. at

263, 37 S.Ct. 509. Absent fraud or cor-

ruption or other factors, the stockholders

cannot force the corporation to sue.

“ Stockholders} cannot secure the aid

of a court to correct what appear to

them to be mistakes of judgment on

the part of the officers . . . This

rule applies whether the mistake is due

to error of fact or of law, or merely

to bad business judgment. It applies

. where the mistake alleged is

the refusal to assert a seemingly clear

cause of action .....”

Ashwander v. Valley Authority, 297 U.

S. 288, 343, 56 S.Ct. 466, 481, 80 L.Ed.

688 (1936).

The reasoning behind the “business

judgment rule” and its application to

derivative suits was recently discussed

in this district in Bernstein v. Medio-

banca, Docket =73 Civ. 3549, (S.D.N.Y.

Dec. 24, 1974) (Connor, J.). There the

Court .eaffirmed the business judgment

rule aithough summary judgment was

denied, with leave to renew, because pos-

sible evidence of bad faith on the part

of the Board of Directors in deciding not

to sue was in the possession of the de-

fendants and plaintiff was given an op-

portunity to discover it.

[3,4] This court cannot accept plain-

tiffs’ argument that because the allega-

tions of the complaint concern violations

of the Investment Company Act and the

Investment Advisers Act, the Board has

no power to exercise its business judg-

ment because of the strong public poli-

cies behind those Acts. Unlike § 16/6)

of the Securities Exchange Act which

allows shareholders to bring suit if the

directors decline a demand, Congress ha3

made no such statutory provision with

respect to suits brought under the In-

vestment Company and Investment Ac-

visers Act. It is true that causes of a°-

tion under those Acts are implied righ‘s

of action. Brown v. Bullock, 194 F.Supp.

207 (S.D.N.Y., aff'd 204 F.2d 415 (2d

1178 404 FEDERAL SUPPLEMENT 9a

bringing suit.2 The purpose of that

“demand” rule “is to give the derivative

corporation itself the opportunity to take

over a suit which was brought on its be-

half in the first place, and thus to allow

the directors the chance to occupy their

normal status as conductors of the cor-

poration’s affairs.” Brody v. Chemical

Bank, 517 F.2d 932 at 934 (2 Cir. 1957),

citing In re Kauffman Mutual Fund

Actions, 479 F.2d 257, 263 (lst Cir.),

cert. denied, 414 U.S. 857, 94 S.Ct. 161,

38 L.Ed.2d 107 (1973).

No demand was made on the Fund's

Board of Directors in this case because

plaintiffs alleged (and it is not disputed)

that the majority of the Fund’s directors

are defendants charged with wrong-

doing and as such a demand would be

futile.* While no set formula has been

developed for determining what facts

must be plead in order to excuse a de-

mand on the Board of Directors—see

generally, 7A Wright & Miller Federal

Practice & Procedure § 1831 (1972)—

that issue is not presented in this case.

Instead, this case presents the rather

unique situation where a designated in-

dependent minority of a Board has taken

unilateral action with respect to a suit

brought on behalf of the corporation.

The decision of the independent direc-

tors was made after the settlement of

the Weich action which put an end to the

3. Rule 23.1 provires:

“In a derivative action brought by one or

more shareholders or members to enforre

a right of a corporation or of an unincorpe-

rated association. the corporation or as-

sociation having failed to enforce a rmght

which may properly be asserted by ir. rhe

complaint shail he verified and shail allege

(1) that the plaintiff was « shareholder or

member at the time of the transaction of

which he complains or that his siare or

membership thereafter devolved on him br

operation of law. and (2) that the action

is not a collusive one to confer jurisdlic-

tion on a court of the Unitei Srates which

it would not orherwixe have. The com-

plaint shall alse allege with particularity

the efforts, if any. made hy the piainrift

to obtain the action he «lesires from the «di-

rectom or comparable authority andl, if

necessary. from the shareholder or mem-

Stay in this suit. Plaintiffs argue that

even if suit were instituted at the pres-

ent time (i. e., after settlement of the

Welch action) no prior demand on the

Fund's Board would have been neces-

Sary because the majority of directors

would be disqualified. To allow a minor-

ity of the Board to seek dismissal of the

suit would, it is argued, destroy the role

of “presumptive disqualification.”

While no case is directly in point,

this circuit has recently considered an

analogous issue in Brody v. Chemica

Bank, supra. There, the district court

had dismissed the derivative causes of

action in plaintiff's complaint because

the allegations in the complaint were in-

sufficient to excuse a demand on the

Board of Directors. Plaintiff had al-

leged futility of demand because the

majority of directors were controlled by

the defendant corporation. However,

since institution of the suit, a new Board

had been installed but no demand was

made on it. The Second Circuit agreed

that a demand should have been made

but remanded because of the gravity of

the alleged wrongdoing. 482 F.2d 1111

at 1114 (2 Cir.). After remand, the

plaintiffs filed a second amended com-

plaint but made no demand on the Board

of Directors because they alleged that a

demand on the Board of Directors at

the. time the action was originally com-

bers anid the reasons for hix failure to obrain

the action of for not making the effort.

The derivative action may sot he main-

tained if it appears that the plaintiff does

not fairly and alequutely represent the in-

terests of rhe shareholders or members sim-

ilarly situated im enforcing the right of

the corperation or association. The action

shail not he dismissel or compromised with-

out the approval of the court, and notice of

the proposed dismisynl of compromise shall

be given [to simrehoklers or members in such

manner as the court directs.”

4. No issue has been raised concerning wheth-

er a demand on the shareholders was neces-

sary. Plootitfs’ complaint alleges that un-

der appleable law and the Certificate of

Incerporation and By-Laws of the Fund, the

directors and officers are vested with the

management of the Fund. Cumpiaiat * 7(b).

LASKER vy. BURKS

103 i179

Cite as 404 F Supp. 1172 (1975)

menced would have been futile. The

district court again dismissed the de-

rivative counts and the Second Circuit af-

firmed on the reasoning that a demand

should have been made on the new di-

rectors. Brody, supra at 934.

[1] In this case, within a short pe-

riod after settlement of the Welch ac-

tion and the dissolution of the stay, the

Board of Directors met and designated

the independent directors to make a de-

cision as to the Fund's position in this

suit. In the Court’s view, the independ-

ent minority of directors had the power

to decide what position the Fund should

take. This is consistent with the policy

that a corporation be given the opportu-

nity to control a lawsuit brought on its

behalf, that the Board be allowed to

exercise its normal functions in running

the corporation, and that a derivative

suit should be resorted to as a last al-

ternative. See 3B J. Moore, Federal

Practice 7 23.1.19, at 23.1-252-53 (2d

ed. 1974) quoted in Brody, supra at 934.

Although the independent directors

ould properly move for dismissal of

“ris action it is now necessary to de-

termine whether good faith business

‘udgment of the directors can be used

«s a ground for dismissal. Defendants

-ely on a line of cases which hold that

aosent fraud or corruption or other dis-

sualifying factor, the good faith busi-

ness judgment of the directors not to

wring suit is final. See, e. g., Hawes v.

Oukland, 104 U.S. 450, 26 L.Ed. 327

1881): Corbus v. Alaska Treadwell

Gold Mining Co., 187 U.S. 455, 23 S.Ct.

157, 47 L.Ed. 256 (1903); United Cop-

ver Securities Co. v. Amalgamated Cop-

yer Co., 244 U.S. 261, 37 S.Ct. 509, 61

L.Ed. 1119 (1917); Swanson v. Traer,

249 F.2d 854 (7th Cir. 1957); Ash v.

IBM, 353 F.2d 491 (3d Cir. 1965), cert.

denied, 284 U.S. 927, 86 S.Ct. 1446, 16

L.Ed.2d 531 (1966); In re Kauffman

‘Mutual Fund Actions, 479 F.2d 257 ‘1st

Cir.), cert. denied, 414 U.S. 857, 94 5.Ct.

161, 38 L.Ed.2d 107 (1973).

theny Corp. v. Kirby, 344 F.2d 571 (2d

(ir. 1965), cert. dismissed, 384 U.S. 28.

“6 S.Ct. 1250, 16 L.Ed.2d 335 (1966).

Cf. Alle-

[2] As the Supreme Court recog-

nized in United Copper, supra, the de-

cision whether or not to sue is a matter

of internal management. 244 U.S. at

263. 37 S.Ct. 509. Absent fraud or cor-

ruption or other factors, the stockholders

cannot force the corporation to sue.

“( Stockholders] cannot secure the aid

of a court to correct what appear to

them to be mistakes of judgment on

the part of the officers . This

rule applies whether the mistake is due

to error of fact or of law, or merely

to bad business judgment. It applies

, where the mistake alleged is

the refusal to assert a seemingly clear

cause of action oF

Ashwander v. Valley Authority, 297 U.

S. 288, 343, 56 S.Ct. 466, 481, 80 L.Ed.

688 (1936).

The reasoning behind the “business

judgment rvle” and its application to

derivative suits was recently discussed

in this district in Bernstein v. Medio-

banca. Docket #73 Civ. 3549, (S.D.N.Y.

Dec. 24, 1974) (Connor, J.). There the

Court reaffirmed the business judgment

rule although summary judgment was

denied, with leave to renew, because pos-

sible evidence of bad faith on the part

of the Board of Directors in deciding not

to sue was in the possession of the de-

fendants and plaintiff was given an op-

portunity to discover it.

(3, 4]

tiffs’ argument that because the allega-

tions of the complaint concern violations

of the Investment Company Act and the

Investment Advisers Act, the Board has

no power to exercise its business judg-

ment because of the strong public poli-

cies behind those Acts. Unlike § 16(b)

of the Securities Exchange Act which

allows shareholders to bring suit if the

directors decline a demand, Congress has

made no such statutory provision with

respect to suits brought under the In-

vestment Company and Investment Ad-

visers Act. It is true that causes of uc-

tion under those Acts are implied rights

of action. Brown v. Bullock, 194 F.Supp.

This court cannot accept plain-

207 (S.D.N.Y., aff'd 204 F.2d 415 (2d

1180

Cir. 1961); Bolger v. Laventiol, Krek-

stein, Horwath & Horwath, 381 F.Supp.

260 (S.D.N.Y.1974). It does not neces-

sarily follow that because the right is

implied a derivative suit should always

be allowed despite the good faith exer-

cise of business judgment by the di-

rectors not to sue. This court is of the

opinion that absent a statutory excep-

tion, whether a cause of action is ex-

pressly authorized or is “implied” the di-

rectors of a corporation should be given

the chance to perform their duties in

running the business of the corporation

including whether to prosecute a cause

of action. If they have exercised their

business judgment in good faith then a

decision not to sue should be final.

(5] The court must also reject plain-

tiffs’ argument that the decision not to

sue was tantamount to an illegal ratifi-

cation. Although it can be argued that

derivative suits should be allowed when

the Board has refused to sue on a non-

ratifiable wrong—see Note, Demand on

Directors and Shareholders as a Pre-

requisite To a Derivative Suit, 73 Harv.

L.Rev. 746, 762 (1960); Rogers v. Amer-

tcan Can Co., 305 F.2d 297 (3d Cir.

1962), the question of business judgment

is separate from the question of ratifica-

tion. S$. Solomont & Sons Trvst v.

New England Theatres Operating Corp.,

326 Mass. 99, 93 N.E.2d 241, 247 (1950).

Many of the cases which established the

business judgment rule and its relation

to derivative suits have involved claims

which were arguably non-ratifiable. See,

e. g., United Copper, supra; Ash v.

IBM, supra (antitrust violations).

{6] Another question which has been

considered is whether the merits of the

Plaintiffs’ claim should be considered in

deciding whether the directors decision

shou id be upheld. To do so would place

the Court in the position of substituting

its judgment for that of the directors

11a

404 FEDERAL SUPPLEMENT

which if made in good faith should not

be disturbed. The court has carefully

reviewed the many factors which the

Board considered before making its de-

cision not to sue. Although plaintiffs

argue that there is more merit to their

claims than Judge Fuld gave them, there

were many other factors considered by

the directors, as outlined in the Ken-

dall Affidavit 1 22—which led the di-

rectors to their decision.

It the minority directors were truly

disinterested and independent the court

will not substitute its judgment for

that of the Board. Plaintiffs have not

argued that the minority directors have

acted fraudulently or corruptly. They

have argued that they are not disinter-

ested or independent because they oc-

cupy similar positions with other funds

in the Anchor group and that Anchor

controls the selection and nomination

of the Fund’s directors. This asser-

tion has been denied and it is alleged by

the movant that these directors were

nominated by a three man Directors

Qualification Committee of which two

members were unaffiliated with Anchor.

Interest or lack of independence would

go toward the issue of good faith. I

am constrained therefore to permit the

plaintiffs to pursue discovery with re-

spect to the relationships of the minority

directors ana the Qualifications Com-

mittee to determine whether the mi-

nority directors were disinterested or

independent. It would appear that all

of the other questions resolved herein

are dependent upon a resolution of this

issue. The plaintiffs are to conduct

their discovery within 90 days from the

date hereof.

~The motion is denied without preju-

dice to renew the same upon the comple-

tion of discovery.

So ordered.

Opinion of the District Court. January 6. 1976

——— a eee

- -- O26? °6<a- « «e+ 6 @

UNITED STATES CISTRICT COURT

SOUTHERN DISTRICT OF NEW YORK

HOWARD M. LASKER and IRVING

GOLDBERG,

Plaintiffs,

, ~ against - ORDER

Be HARRY G. BURKS, JR., 73 Civ. 552 (HFW)

EDWARD B. BURR,

THOMAS F. CHALKER,

JOHN R. HAIRE,

HARVEY C. HOPKINS,

S. P. HUTCHINSON,

DONALD L. KEMMERER,

A. S. MIKE MONRONEY,

\ CHARLES F. PHILLIPS,

prgsonee - JEPTHA WADE,

ANCHOR CORP., and

iin FUNDAMENTAL INVESTORS, INC.,

* . . Defendants.

( 1. % HENRY F. WERKER, D. J.

5 tt hy Lye te ae Plaintiffs’ motion for reargument based on Judge Gagliardi's decision

a rs. Py. | | 4 fin Boyko v. The Reserve Fund, Inc., 74 Civ. 3419 (S. D. N. Y. Sept. 31» 1975) Is

i / | _ Bdenied. This court finds that Boyko is distinguishable from the case at hand due to

| the fact that Boyko concerns Section 36(b) of the Investment Company Act, 15

U.S.C. § 80a-35(b). That section specifically gives a security holder a cause of

action against the investment adviser or an affiliated person on behalf of the

investment company with respect to the receipt of compensation. The question of

who should determine whether or not the corporation is to sue is different under

Section 36(a), 15 U.S.C. § 80a-35(a), where the basis for suit is the more genera!

\ a claim of violation of fiduciary duty and where no cause of action is given in the

eh,

Statute tc a security holder on such a claiin.

SO ORDERED.

DATED: New York, New York

January 6, 1976

13a

Kf. Lhew 4

U/YS. D. J.

Opinion of the District Court. January 7. 1977

14a

426 FEDERAL SUPPLEMENT

torney had represented to the court, or, if

he did consent, lacked authority to do sw.

In effect, the Vorhauers seek to recover

against the United States either for (1) the

misrepresentations of an assistant United

States Attorney, (2) the presumably unjust-

ified reliance by an assistant United States

Attorney on the authority of Mr. Scandone

to consent to the destruction of plaintiffs’

property, or (3) the presumably unjustified

reliance by a District Judge on the repre-

sentations of an assistant United States At-

torney. Even if the plaintiffs were able to

prove that the actions of the Assistant

United States Attorney or Chief Judge

Lord were in some way culpable*® they

would not be able to recover against the

United States because these actions were

certainly not authorized by it. See Region-

al Rail Reorganization Act Cases, supra, 419

U.S. at 127, 95 S.Ct. at 350 n. 16; Yearsiey

v. Ross Construction Co., 309 U.S. 18, 21-22,

60 S.Ct. 413, 414-415, 84 L.Ed. 554 (1940);

Hooe v. United States, 218 U.S. 322, 336, 31

S.Ct. 85, 89, 54 L.Ed. 1055 (1910).

{10,11} Since this case does not fall

within the rubric of the Rail Cases, “it

follows that the asserted entitlement to

money damages depends upon whether any

federal statute ‘can fairly be interpreted as

mandating compensation by the Federal

Government for the damage sustained.’”

Testan, supra, 424 U.S. at 400, 96 S.Ct. at

954, quoting Eastport-Steamship Corp. v.

United States, 372 F.2d 100%, 1009, 178

Ct.Cl. 599, 607 (1967). Plaint.ffs have

pointed to no such statute. Indeed the only

arguably * applicable statute is the Federal

Tort Claims Act, 28 U.S.C. § 2671 et seq.,

but it provides plaintiffs no foundation for

recovery since they have failed to exhaust

their administrative remedies. See 28

U.S.C. § 2675; Bialowas v. United States,

443 F.2d 1047, 1049 (3d Cir. 1971).

5. It will be noted that a suit against Judge Lord

individually would be barred by the doctnne of

judicial immunity, see Pierson v. Ray, 386 U.S.

547, 87 S.Ct. 1213, 18 L.Ed.2d 288 (1967), anda

suit against the assistant United States Attor-

ney would present difficult issues of prosecuto-

rial immunity under Imbier v. Patchman, 424

U.S. 409, 96 S.Ct. 984. 47 L.Ed. 2d 128 (1976).

Accordingly, the complaint against the

United States must also be dismissed. |

Howard M. LASKER and Irving

Goldberg, Plaintiffs,

v. :

Harry G. BURKS, Jr. et al, Defendants.

No. 73 Civ. 552 (HFW).

United States District Court,

S. 0. New York.

Jan. 7, 1977.

Two stockholders of registered invest-

ment company brought stockholders’ deriv-

ative action against company’s investment

advisor and severa! and present members of

the company’s board of directors to recover

damages for purchase of 270-day notes of

issuer which subsequently became bank-

rupt. Following denial of defendants’ mo-

tion to dismiss without prejudice, 404

F.Supp. 1172, the defendants renewed their

motion to dismiss. The District Court,

Werker, J., held that since nondefendant

minority directors sought dismissal of ac-

tion, plaintiffs had burden to establish that

minority directors’ actions lacked independ-

ence; and that unsupported contentions of

plaintiffs failed to meet burden of estab-

lishing that minority directors’ actions

lacked independence precluding decision to

abandon derivative claims raised in suit,

and thus both corporate and individual de-

fendants could not be required to proceed to

a trial.

6. The Tort Claims Act would not afford a basis

for relief against the United Staies on account

of the actions taken by Judge Lord since the

Act does not cover members of the judicial

branch of government. See Cromein v Unued

States, 177 F.2d 275 (Sth Cir. 1949). cert. de-

nied, 339 U.S. 944, 76 S.Ct. 790 94 L.Ed. 1359

(1950).

j

}

|

LASKER v. BURKS

15a

Cite as 426 F Supp. 844 (1977)

Defendants granted summary judg-

ment.

1. Federal Civil Procedure 22533

Since parties had each submitted affi-

davits and excerpts from extensive deposi-

tion testimony to assist in disposition of

motion to dismiss, court was required to

treat motion as one for summary judgment

under rule 56. Fed.Rules Civ.Proc. rules

12(b), 56, 28 U.S.C.A.

2. Corporations @=310(1)

Fact that each of minority directors

knew someone on board at time that he or

she was nominated did not require preclu-

sion of business judgment rule permitting

minority of board to determine what posi-

tion company should take in stockholders’

derivative suit, where relationships which

existed between minority directors and de-

fendant directors were de minimis.

3. Banks and Banking 314

Business judgment rule, permitting dis-

interested directors who were minority of

board to determine decision to be taken in

stockholders’ derivative suit against, inter

alia, investment advisor was not inapplica-

ble merely because each minority director

had received remuneration for service on

boards of other mutual funds advised by

investment advisor.

4. Banks and Banking 314

Application of business judgment rule

permitting disinterested directors who were

minority of board to determine what posi-

tion company should take in stockholders’

derivative suit was not rendered inapplica-

bie on theory that a minority director of a

mutual fund can never act independently

given the relationship between mutual

funds and their advisors.

5. Securities Regulation <= 214

It was not inappropriate for attorney,

who advised investment company, to partic-

ipate in deliberations of disinterested di-

rectors, who were minority of board, prior

to determination as to what position invest-

ment company should ta). in stockholders’

derivative suit, since designating attorney

as an interested person only served to limit

his participation on board as a director and

did not mean that minority directors were

interested in suit or that their deliberations

were somehow subject to improper influ-

ence or that they lacked the necessary de-

gree of independence. Investment Compa-

ny Act of 1940, §§ 2(aX19WA)iv), 10, 15

U.S.C.A. §§ 80a-2(a) 19) AMiv), 80a—10.

6. Banks and Banking 314

Presence of several defendant directors

during initial presentations at meeting of

disinterested quorum did not demonstrate

minority directors’ lack of independence

thus precluding determination of position

company should take in stockholders’ deriv-

ative suit on behalf of investment company,

since minority directors had invited such

defendants to join meeting and such de-

fendants and counsel were excused before

disinterested quorum made its determina-

tion.

7. Securities Regulation 214

Even if minority directors erred in de-

termnination made during deliberations as to

what position investment company should

take in stockholders’ derivative suit, court

could not upset their reasoned judgment

without some showing chat independence of

disinterested quorum was impermissibly

curtailed. Investment Company Act of

1940, §§ 2aX19NANiv), 10, 15 US.C.A.

§§ 80a-2(ay 19 A\iv), 80a—10.

8. Securities Regulation 220

In investment company’s stockholders’

derivative action against company's invest-

ment advisor and several former and

present members of company board of di-

rectors, since nondefendant minority di-

rectors sought dismissal of action, plaintiffs

had burdca to establish that minority di-

rectors’ actions lacked independence. I[n-

vestment Company Act of 1940,

§§ 2a 19NAMiv), 10, 15 U.S.C.A. §§ 80a-

2a 19K Aiv), 80a—10.

9. Securities Regulation 219

In investment company's stockholders’

derivative action against company’s invest-

ment advisor and several former and

845

846

present members of company’s board of di-

rectors, unsupported contentions of plain-

tiffs failed to meet burden of establishing

that minority directors’ actions lacked inde-

pendence preciuding decision to abandon

derivative claims raised in suit, and thus

both corporate and individual defendants

could not be required to proceed to a trial.

Investment Company Act of 1940, §§ 1 et

seq., 2(aX1$,AXiv), 10, 15 U.S.C.A. §§ 80a-

1 et seq., 80a-2(aX 19 AXiv), 80a—10.

10. Corporations *310(1)

The existence of a casual relationship

among directors, without more, cannot be

taken as an indication that minority di-

rectors were unable to reach an indepen-

dent business decision and make determina-

tion to abandon derivative claims.

ll. Securities Regulation 214

Fact that Investment Company Act

terms an attorney whose advice is sought to

be an “interested person” could not suggest

that minority directors had an interest in

contested transaction which went beyond a

generalized concern for the security of the

investment company thus precluding exer-

cise of business judgment in determination

to abandon derivative claims in investment

company’s stockholders’ derivative action.

Investment Company Act of 1940, $§ 1 et

seq., 2a)19MAiv), 10, 15 USCA.

§§ 80a-1 et seq., 80a-2ay19WANiv), 80a-

10.

12. Federal Civil Procedure = 2470.1

Summary judgment may not be grant-

ed unless, drawing al! reasonable inferences

in favor of the nonmovant, no material

factual issue is shown. Fed.Rules Civ.Proc.

rule 56, 28 U.S.C.A.

13. Federal Civil Procedure = 2544

Party opposing summary judgment mo-

tion must adduce something beyond conclu-

1. Under the rule,

Questions of policy of manage-

ment. expediency of contracts or action, ade-

quacy of consideration, lawful appropriation of

corporate funds to advance corporate interests,

are left solely to their honest and unselfish

decision. for their powers therein are without

426 FEDERAL SUPPLEMENT

16a

sory allegations. Fed.Rules Civ.Proc. rule

56, 28 U.S.C.A.

Aranow, Brodsky, Bohlinger, Benetar &

Einhorn, New York City, by Anthony

L.Tersigni, Herbert A. Einhorn, David J.

Sweet, Steven Mallis, New York City, of

counsel, for plaintiffs.

Seward & Kissel, New York City, for

defendant Fundamenta! Investors, Inc.

Pollack & Kaminsky, New York City, for

defendants Anchor Corp., Burr, Chalker,

Haire & Hutchinson.

Dewey, Ballantine, Bushby, Palmer &

Wood, New York City, for defendants

Burks, Hopkins, Kemmerer, Monroney,

Phillips and Wade.

OPINION

WERKER, District Judge.

This action, brought derivatively by two

shareholders on behalf of Fundamental In-

vestors, Inc. (“Fundamental” or the

“Fund”), a registered investment company,

seeks to recover damages resulting from

the Fund’s purchase of $20 million in 270-

day notes issued by the now bankrupt Penn

Central Transportation Company. The de-

fendants are Anchor Corporation (“An-

chor’), the registered investment adviser to

the Fund, and several past and present

members of the Fund's Board of Directors

(“Board”). The defendants previously

moved to dismiss this suit under Rule 12(b)

of the Federal Rules of Civil Procedure

because a voting quorum of disinterested

directors found, in the exercise of its busi-

ness judgment, that maintenance of the suit

wou'd not be in the best interests of the

shareholders of the Fund. In a memoran-

dum decision on that motion, 404 F.Supp.

1172, this court held that the business judg-

ment rule! applied to the actions of the

limitation and free from restraint, and the exer-

cise of them for the common and generai inter-

ests of the corporation may not be questioned,

although the results show that what they did

was unwise or inexpedient.’ Politz v. Wabash

R. Co, 207 NY. 113, 124, 100 N.E. 721, 724.

Indeed, although the concept of ‘responsibility’

SS -- ._....

17a

LASKER v. BURKS 847

Cite as 426 F.Supp. 844 (1977)

Fund and that it enabled the minority di-

rectors of the Board to seek dismissal of

this suit provided only that they were “tru-

\y disinterested and independent.” How-

ever, the court permitted the plaintiffs to

conduct discovery for a designated period of

time to determine whether the minority

directors were in fact disinterested or inde-

pendent, and the motion to dismiss* was

denied without prejudice to renew at the

close of discovery. In accordance with that

decision, the defendants have now renewed

their motion to dismiss the instant action.

The plaintiffs continue to argue that the

motion should be denied because, for vari-

ous reasons, the minority directors did not,

and could not, exercise their independent

business judgment in moving to terminate

this action.

I

The facts surrounding this action have

been described at length in my earlier mem-

orandum decision; nevertheless, some repe-

tution of that discussion will facilitate an

anderstanding of the court’s action upon

the present motion by the defendants.

The complaint alleges, among other

things, that Anchor breached its statutory,

contractual and common law fiduciary

duties by relying exclusively upon the rep-

resentations of Goldman, Sachs & Co. (a

seller of commercial paper), rather than in-

jependently investigating the quality and

safety of the Penn Central 270-day notes

purchased by the Fund. It is further ai-

eged that the defendant directors knew or

should have known of Anchor's failure to

meet its responsibility; that they violated

their common law duties as corporate fidu-

ciaries by acquiescing in Anchor's omis-

sions; that the financial condition of the

Penn Central steadily worsened during the

period from November 28, 1969 to June 21,

1970, the date that it filed for reorganiza-

‘ion; and that during this period of decline

» firmiy fixed in the law, it is only in a most

unusual and extraordinary case that directors

are held liable for negligence in the absence of

'raud. of improper motive, or personal inter-

‘st Bayer v. Beran, 49 N.Y.S.2d 2, 6 (Sup.Ct.

144)

all of the defendants failed to investigate

and review the financial condition of the

Penn Central and the quality and safety of

its commercial paper. It is also alleged that

during this period Anchor failed to recom-

mend, and the defendant directors failed to

attempt, sale of the Penn Central paper

held by the Fund.

Prior to the institution of this action, the

Fund and other plaintiffs brought suit

against Goldman, Sachs seeking rescission

of their purchases. See Welch Foods, Inc.

v. Goldman, Sachs & Co., 398 F.Supp. 1393

(S.D.N.Y. 1974) (the “Welch” action). On

the motion of all defendants to this action,

Judge Gurfein, then a district court judge,

granted a stay of further proceedings in

this action pending resolution of the Fund's

claims in Welch. Thereafter, on July 9,

1974 the Fund agreed to settle its claims

against Goldman, Sachs. Under the terms

of the settlement agreement, Goldman,

Sachs was to take back the notes and the

Fund was to receive $5,250,000 in cash and

a 73.75 percent interest in any proceeds of

the notes obtained during the course of the

Penn Central reorganization proceeding.

With the claims of Fundamental in the

Welch matter resolved, the Board once

again faced the question of what to do in

the instant action. Briefly, the Board de-

termined that five of its members were

disinterested (the “disinterested quorum” or

“minority directors”) and therefore able to

determine the proper course of action for

the Fund.* The disinterested quorum then

retained the Honorable Stanley H. Fuld,

former Chief Judge of the New York Court

of Appeals, to review the circumstances sur-

rounding the purchase and retention of the

Penn Central notes and prepare an opinion

for its consideration. In a memorandum to

the disinterested quorum dated December 5,

1974, Judge Fuld concluded that neither

Anchor nor the defendant directors of the

2. Under Articie Exght of the Certificate of In-

corporation of Fundamental, a quorum of the

Board may not be less than one-third of the

total number of directors. Since the full Board

consisted of ten members, there was no prob-

lem here

848 426 FEDERAL SUPPLEMENT

Fund had violated the law “in connection

with the acquisition or retention of the

Penn Central commercial paper.” Judge

Fuld’s memorandum discussed several posi-

tions that the disinterested quorum could

take on behalf of the Fund, one of which

was concluding that the suit lacked merit

and moving to dismiss. The minority di-

rectors met with Judge Fuld at a special

meeting of the disinterested quorum held

on December 18, 1974 and requested that he

submit a further memorandum before they

took any action. The minority directors

also questioned several of the defendants

before deciding at a second special meeting

of the disinterested quorum, held on Janu-

ary 6, 1975, to seek dismissal of the instant

action’ An affidavit submitted by the

chairman of the disinterested quorum as

part of the earlier motion to dismiss re-

counts ten factors that the disinterested

quorum considered in arriving at its deci-

sion. The relevant portion of that affidavit

appears in my earlier decision, 404 F.Supp.

at 1176-77.

II

On the defendants’ initial motion to dis-

miss, this court considered and rejected the

contention of the plaintiffs that the merits

of their derivative claim should color the

court’s consideration of the business judg-

ment “defense.” The court also reviewed

the claim of the plaintiffs that the strong

public policy behind the Investment Compa-

ny Act of 1940, 15 U.S.C. § 30a-1, et seq.,

and the Investment Advisers Act of 1340,

15 U.S.C. § 806-1, et seq., precluded appli-

cation of the business judgment rule to the

actions of mutual funds. The court ob-

served that

3. As was noted in my earlier decision in this

matter, although one of the five minority di-

rectors voted by proxy, even without her vote,

the presence of four directors at the meeting

constituted a quorum.

4. In this regard, plaintiffs note Chief Judge

Kaufman's recent statement that:

“The relationship between investment advis-

ers and mutual funds is fraught with potential

conflicts of interest. The typical fund ordinari-

18a

“absent a statutory exception whether a

cause of action is expressly authorized or

is ‘implied’ the directors of a corporation

should be given the chance to perform

their duties in running the business of the

corporation, including whether to prose-

cute a cause of action. 404 F.Supp. at

1180.

Both of these contentions have been reas-

serted in substantially unchanged form in

the plaintiffs’ papers in opposition to the

renewed motion to dismiss. While a certain

degree of tenacity is the mark of accom-

plished counsel, what the plaintiffs now

seek is an opportunity to reargue the

court's prior decision after the time to do so

has passed. To accede to that request

would require the court to reconsider argu-

ments previously rejected without having

been shown that there is a need to do so.

Consequently, the court will only consider

the question it did not reach before: wheth-

er the minority directors were disinterested

and independent.

{1} Since the parties have each sub-

mitted affidavits and excerpts from the ex-

tensive deposition testimony to assist in the

disposition of the instant motion, the court

must treat the motion as one for summary

judgment under Rule 56 of the Federal

Rules of Civil Procedure. Rule 12(b), Fed.

R.Civ.P.

III

The plaintiffs first contend that the

structure of the mutual fund industry,

which subjects mutual funds to extensive

control by their investment advisers, pre-

cludes a finding of independence in this

instance.‘ Specifically, they raaintain that

the large number of shareholders in the

Fund coupled with the small size of each

ly ts only a shell, organized and controiled dy 3

separately owned investment company adviser,

which selects its portfolio and admunisters its

daily business. Compensation for these serv-

ices is determined under an advisory contract,

the terms of which are all too often dictated to

unwary or negligent fund directors and fund

shareholders by the investment adviser.” Gal-

fand v. Chestnutt Corp., Civ. No. 76-7156 (S D.

N.Y. Nov. 4, 1976).

TERT a Ee ee Se a

19a

LASKER v. BURKS 849

Cite as 426 F.Supp. 844 (1977)

shareholder's interest, makes proxy contests

impossible to wage and ensures that the

Board will only contain directors amenable

to the policies of the Fund's management.®

The plaintiffs also suggest that the service

of each minority director for compensation

on the boards of other “Anchor” funds dem-

onstrates their inability to act independent-

ly. In this vein, the plaintiffs maintain

that business and personal relationships

among the defendants and minority di-

rectors make it impossible to conclude that

the disinterested quorum acted indepen-

dently; that even if the minority directors

acted in good faith, their loyalties must

have been divided.

{2} Plaintiffs have not adduced any fac-

tual support for their conclusion that the

members of the disinterested quorum acted

other than independently. Although each

of the minority directors knew someone on

the Board at the time that he or she was

nominated, the relationships which existed

between the minority directors and the de-

fendant directors were de minimis, even as

they are stated by the plaintiffs, and do not

suggest that the business judgment rule

should not be applied.

{3} There is also no reason to conclude

that the business judgment rule is inappli-

cable merely because each minority director

receives remuneration for service on the

hoards of other “Anchor” funds. Most cor-

porate directors receive some compensation

for their services, but absent a showing of

improper motive they have always been

permitted to apply their business judgment

to decisions involving derivative suits

brought against the corporations they

serve. See, e. g., Warshaw v. Calhoun, 43

Del.Ch. 148, 221 A.2d 487 (Sup.Ct.1966). I

am not persuaded that there is any mean-

ingful distinction between remuneration by

one corporation rather than several corpo-

rations similar in structure. This is not,

after all, an instance where it is alleged

that a minority director received payments

5. At about the time that the minority directors

determined to seek the dismissal of chis action.

(here were approximately 141,000 shareholders

from the investment adviser or other per.

sons whose interests conflict with those of

the Fund.

[4] The plaintiffs’ contention that a mi-

nority director of a mutual fund can never

act independently given the relationship be-

tween mutual funds and their advisers par-

allels, to some extent, their previously re-

jected argument that the business iudc

ment rule should not apply to mutual funds

registered under the Investment Company

Act of 1940. In making this claim, plain-

tiffs apparently rely upon Fogel v. Chest-

nutt, 533 F.2d 731 (2d Cir. 1975), cert. de

nied, 429 U.S. 824, 97 S.Ct. 77, 50 L.Ed.2d

86 (1976), but that decision is inapposite.

In the Fogel case, two mutual! fund stock-

holders brought a derivative suit on behalf

of a mutual fund against several affiliated

fund directors and the advisor to the fund.

The plaintiffs sought to recapture a portion

of the brokerage commissions paid on fund

transactions on the theory that the affiliat-

ed directors had “intentionally misied and

misinformed the [f]und’s unaffiliated di-

rectors by telling them that such recapture

was not available to the [fJund.” Jd. at 737.

Writing for the Foge/ panel, Judge

Friendly observed that:

“Congress had mandated independent di-

rectors in order ‘to supply an independent

check on management and to provide a

means for the representation of share-

holder interests in investment company

affairs.’ (citation omitted]. The mini-

mum requirement to enable the [f]und’s

independent directors to discharge these

duties with respect to recapture was a

careful investigation of the possibilities

performed with an eye eager to discern

them rather than shut against them, and,

if these possibilities were found to be

real, a weighing of their legal difficulties |

and their economic pros and cons. It

would have been still better to have the

investigation of recapture methods and

their legal consequences performed by

in the Fund. No shareholder had a beneficia:

interest greater than one percent.

20a

850 426 FEDERAL SUPPLEMENT

disinterested counsel! furnished to the in-

dependent directors.”

Id. at 749-50.

Significantly, Judge Friendly went on to

observe that:

“If this had been done and the indepen-

dent directors had concluded that, be-

cause of legal doubts, business considera-

tions or both, the [f]und should make no

effort at recapture, we would have a

different case.”

Id. at 750. ;

In the instant action, the minority di-

rectors were furnished with disinterested

counsel who analyzed the legal conse-

quences of each alternative available to the

disinterested quorum. Moreover, the affi-

davit of the quorum chairman and the min-

utes of the special meetings indicate that

the minority directors acted only after they

had fully considered the options available to

them. Clearly, then, under Fogel it was

proper for them to determine what the

Fund's posture would be.

IV

The plaintiffs next contend that the lack

of true independence and disinterestedness

on the part of the minority directors is

apparent from the manner in which they

decided to seek dismissal in the instant ac-

tion. In support of this claim, piaintiffs

point to the actions of Roger T. Wickers, an

Anchor vice-president who formerly served

as the secretary to the Fund, and Eugene P.

Souther, who was retained as special coun-

sel to the Fund for the purposes of this

litigation, as well as to the circumstances

surrounding the meetings of the minority

directors.

At the direction of defendant Haire,

Wickers explored the possibility of retain-

6. Even if Wickers did retain Judge Fuld for the

minority directors, | see nothing improper in

that. In fact, in Fogei, supra, Judge Fnendiy

suggested that it was desirable for disinterested

counsel to be “furnished” to the independent

directors.

7. Under the statute:

“(19) ‘Interested person’ of another person

means—

ing special counsel for the disinterested

quorum. After contacting several distin-

guished attorneys, Wickers reported that

Judge Fuld would be available to serve the

minority directors and, at a Board meeting

held on July 24, 1974, it was Wickers who

proposed that a disinterested quorum act

for the Fund in the instant action. Wickers

also coordinated the arrangements for

Judge Fuld’s investigation for the minority

directors, who were residents of several dif-

ferent states.

The plaintiffs maintain that “the inap-

propriateness of Wickers role as intermedi-

ary is manifest,” but I disagree. The piain-

tiffs have not set forth any facts in support

of their suggestion that Wickers improperly

influenced the deliberations of the disinter-

ested quorum. Instead they have engaged

in totally unsubstantiated supposition. For

example, plaintiffs contend that Wickers

retained Judge Fuld, but the sworn affida-

vit of Wickers and the deposition of a least

one minority director estabiish that Judge

Fuld was retained by the minority directors

to act upon instructions communicated to

him at the direction of the disinterested

quorum.® In the absence of some factual

support for the plaintiffs’ allegations, the

court cannot conclude that it was improper

for Wickers to coordinate the administra-

tive details of Judge Fuld’s inquiry or that

Wickers’ actions reduced the independence

of the minority directors.

{5] It is the court’s opinion that the role

of Souther was equally innocent. The

plaintiffs advance two reasons why it was

inappropriate for him to participate as he

did in the deliberations of the disinterested

quorum. First, they note that he was an

“interested person” within the meaning of

§ 2 of the Investment Company Act, 15

U.S.C. § 80a-2(aX19)AMiv)? because his

(A) when used with respect to an investment

company—

* > . . * .

(iv) any person or partner or employee of

any person who at any time since the begin-

ning of the last two fiscal years of sucn

company has acted as legal counsel! for such

company -

ae ee!

218

LASKER v. BURKS 851

Cite as 426 F.Supp. 844 (1977)

jaw firm had acted as legal counsel to the

Fund during the last two fiscal years.

They question whether the minority di-

rectors could arrive at a disinterested deci-

sion when they were advised by an attorney

who was “interested.” Second, the plain-

riffs contend that it was improper for his

firm to counsel parties with divergent inter-

ests, namely the Fund and the disinterested

quorum.

All attorneys providing legal counsel to

mutual funds become, by definition, “inter-

ested persons” for some period of time.

Under § 10 of the Investment Company

Act, 15 U.S.C. § 80a~10, only 60 percent of

the members of the board of a registered

company may be interested persons. Desig-

nating Souther as an interested person,

’ therefore, only serves to limit his participa-

tion on the Board as a director. It does not

mean that the minority directors were in-

terested in the suit, that their deliberations

were somehow subject to improper influ-

ence or that they lacked the necessary de-

gree of independence.

Plaintiffs nevertheless suggest that in ac-

cordance with Judge Frankel’s recent deci-

sion in Papilsky v. Berndt, CCH Fed.Sec.L.

Rep. © 95,027 (S.D.N.Y.1976), it was improp-

er for Souther to advise both the Fund and

the minority directors. However, in Papil-

>t the law firm advising the fund also

served as the investment adviser’s counsel,

and, as Judge Frankel noted, there was no

‘suggestion to the Board that, because of

che possible conflict of interest, the inde-

vendent directors should seek disinterested

counsel.” Id. at 90, 133. In the instant

action, independent legal advice for the mi-

nority directors was not only recommended,

‘ was also obtained. Moreover, there was

no conflict of interest on the part of South-

<t or his law firm: they were retained to

"epresent the Fund in the instant action

and it was the disinterested quorum, acting

-¢ the Fund, which gave them their in-

*‘ructions as to how to proceed.

(6) The plaintiffs also contend that the

oresence of several defendants during the

ritial presentations of Judge Fuld and

Svuther at the first special meeting of the

disinterested quorum demonstrates the mi-

nority directors’ lack of independence. But

the minutes of that meeting and the deposi-

tion testimony show that the minority di-

rectors invited those defendants to join the

meeting so that they could answer ques-

tions raised by the minority directors. The

minutes of the meeting also indicate that

all of the defendants and counsel were ex-

cused before the disinterested quorum de-

termined in executive session that it wished

to review the pertinent documents and for-

mulate further questions to be answered

before reaching any decision.

In this context plaintiffs point to the

allegediy misleading nature of statements

made to the minority directors by defend-

ant Haire. The minutes of the first special

meeting of the disinterested quorum state

that Haire “questioned the ability of An-

chor to attract and retain the highly quali-

fied personnel they want and need if [the

instant action] were being pursued with the

acquiescence, if not under the control, of

the Fund.” The plaintiffs consider this to

be in sharp disagreement with Haire’s testi-

mony at his disposition that he “never at

any time had any doubt that [Anchor] could

continue to effectively serve the [FJund if

2.2 requested to continue or permit-

ted to continue by the board or the share-

holders.” Apparently to underscore the

materiality of Haire’s discouraging words

to the minority directors, plaintiffs note the

contents of an affidavit by the chairman of

the disinterested quorum. In that affida-

vit, the quorum chairman states that in

reaching their decision the directors con-

sidered that:

“(c) If the action were to proceed against

Anchor with the acquiescence or under

the control of Fundamental, the adver-

sary relationship that would be created

between Fundamental and Anchor and

the attendant serious distraction of An-

chor’s personnel from their efforts on be-

half of the shareholders of Fundamental

would leave us no practical alternative

but to remove Anchor as investment ad-

visor and to seek to retain a new invest-

ment adviser; this would necessarily re-

sult in delay, uncertainty and an inevita-

ble lapse in the management of Funda-

mental’s affairs to the serious detriment

of its shareholders as

(7] The court is of the opinion that

Haire’s statements are neither inconsistent

nor misleading. His assertions only indi-

cate that he believed it would have been

difficult, but not impossible, for Anchor to

have continued its service to the Fund faced

with this lawsuit. The affidavit of the

disinterested quorum chairman shows only

the the minority directors reached a differ-

ent conclusion: that prosecution of the suit

“would necessarily cause the Fund to seek

to obtain a different investment adviser

immediately.” Even if the minority di-

rectors erred in this determination, as |

have noted in my previous decision, the

court cannot upset their reasoned judgment

without some showing that the independ-

ence of the disinterested quorum was im-

permissibly curtailed. The plaintiffs have

not presented any such evidence.

Vv

Finally, the plaintiffs contend that under

Perlman v. Feldman, 219 F.2d 173, 178 (2d

Cir.), cert. denied, 349 U.S. 952, 75 S.Ct. 880,

99 L.Ed. 1277 (1955), and Pepper v. Litton,

308 U.S. 295, 306, 60 S.Ct. 238, 84 L.Ed. 281

(1939), the defendant directors bear the

burden of proving by clear and convincing

evidence that they did not breach their fi-

duciary responsibilities to the corporation

and its stockholders. The defendants argue

that the plaintiff must shoulder the eviden-

tiary burden because it is the exercise of

business judgment by corporate directors

which is challenged. Bellis v. Thal, 373

F.Supp. 120, 124 (E.D.Pa.1974), aff'd, 510

F.2d 969 (3d Cir. 1975); Marco v. Bank of

New York, 272 F.Supp. 636, 639 (S.D.N-Y.

1967), aff'd, 398 F.2d 628 (2d Cir. 1968);

Warshaw v. Calhoun, supra.

The Perlman and Pepper cases relied

upon by the plaintiffs both involve self-

dealing by corporate fiduciaries and are in-

applicable here. As I noted in my earlier

decision in this matter, the plaintiffs “have

rx a ES ee

22a

852 426 FEDERAL SUPPLEMENT

acted fraudulently or corruptly.” 404

F.Supp. at 1180. Moreover, the question

before the court is not whether the defend.

ants breached their fiduciary obligations to

the corporation, but whether suit can pro

ceed against them at all given the decision

of the nondefendant minority directors to

seek dismissal of this action.

[8,9] Itis therefore incumbent upon the

plaintiffs to establish that the minority di-

rectors actions lacked independence. Marco

v. Bank of New York, supra. The unsup-

ported contentions of the plaintiffs cleariy

fail to meet this burden and, accordingly, it

is the opinion of this court that the defend-

ants, both corporate and individual, cannot

be required to proceed to a trial. I hasten

to add, however, that even if the defend-

ants are required as a matter of law to

negate any suggestion of unfairness arising

from the decision to abandon the derivative

claims raised in this suit they have done so.

The exhibits presented to the court on both

the earlier motion to dismiss and the in-

stant motion show that the minority di-

rectors carefully evaluated the opinions ten-

dered by both counsel involved in this ac-

tion, that they considered the merits of the

derivative claims asserted in the complaint,

that they discussed the facts and circum-

stances surrounding the purchase and re-

tention of the notes with several of the

defendant directors and that they communi-

cated extensively among themselves before

reaching a decision to seek dismissal of this

suit.

[10,11] To conclude that the disinterest-

ed quorum acted in response to pressure

and without justification to immunize An-

chor and the defendant directors from pos-

sible liability would require this court to

presume that bias exists based upon circum-

stances which seem entirely innocent. For

example, as has been noted, the plaintiffs

suggest that a finding of improper influ-

ence must follow from the fact that the

minority directors each knew someone on

the Board when they were first selected for

nomination or election to the Board. But

oh» autchameae aff gaat eoblsatloaawitasn aaneee

THOMPSON v. YUE

Cite as 426 F.Supp. 853 (1977)

the directors, without more, cannot be tak-

en as an indication that the minority di-

rectors were unable to reach an indepen-

dent business decision. Similarly, because

the Investment Company Act terms an at-

torney whose advice is sought to be an

“interested person,” plaintiffs seek to sug-

gest that the minority directors had an in-

terest in the contested transaction which

went beyond a generalized concern for the

security of the Fund.’ But here again it

was obviously reasonable for the minority

directors to consult with interested persons,

rather than reaching a decision without

speaking to either the directors involved in

the transaction or counsel.

{12,13} The court of appeals for this

circuit has recently cautioned that summary

judgment may not be granted unless, draw-

ing all reasonable inferences in favor of the

nonmovant, no material factual issue is

shown. Heyman v. Commerce and Industry

Insurance Co., 524 F.2d 1317 (2d Cir. 1975).

However, the party opposing the motion

must adduce something beyond conclusory

allegations. Donnelly v. Guion, 467 F.2d

290 (2d Cir. 1972). Here, there has been no

showing by the plaintiffs of facts which, if

proven, would prohibit the defendants from

hiding behind the business judgment cloak.

Accordingly, the defendants are granted

summary judgment.

SO ORDERED.

.

8. In a similar effort to brand a minority di-

rector as interested, plaintiffs point to the fol-

lowing testimony by director Stephens:

“I remember commenting [at the July 24,

1974 board meeting] on what constituted a

disinterested director because in my opinion

Joseph THOMPSON et al.

v.

Victor YUE.

Civ. A. No. 76-1126.

United States District Court,

D. New Jersey.

Jan. 10, 1977.

Personal injury action was brought in

Federal District Court, sitting in New Jer-

sey, as result of automobile accident in Que-

bec, Canada, involving Illinois plaintiffs and

2 New Jersey defendant. On defendant’s

motion for summary judgment on grounds

that suit was time barred by Quebec’s one-

year personal injury statute of limitations,

the District Court, Barlow, J., held that

New Jersey's conflicts of law principles

were binding on the court; and that, on the

basis of its factual contacts with the case,

New Jersey's substantive law would be ap-

plied, including its two-year limitation peri-

od.

Defendant's motion for summary judg-

ment denied.

1. Federal Courts 2409

Federal court sitting in diversity is

bound to apply choice of law rules of forum

state.

2. Federal Courts o=409

In personal injury action initiated in

federal court sitting in New Jersey, arising

from automobile accident which occurred in

Quebec, Canada, involving Illinois plaintiffs

and New Jersey defendant, New Jersey's

conflicts of law principles were applicable

and binding on court.

3. Limitation of Actions <=2(1)

Where suit is brought on foreign cause

of action in New Jersey court, court will

not employ state’s statute of limitations but

no director could be disinterested, but I was

told that was the proper term.

Later Stephens explained that he didn't like the

term “disinterested” since he certainly was not

“uninterested.”

ae \

a2

&

242

UNITED STATES COURT OF APPEALS

For tHe Secoyno Crecorr

—_—

-

No. 23—September Term, 1977.

(Argued August 31, 1977 Decide’ Januarr 11. 1978.)

Docket No. 77-7060

_—_

Howarp M. Lasker and Invryc Gotpserc,

Plaintiffs-d ppellants,

—vVv—

Hargsy G. Burgs, Jr., Enwarp B. Beer. Teosas F.

Cuatger, Jonn R. Hame, Harvey C. Hoperss, S. P.

Hotcuison, Donatp L. Kemmerer, A. S. Mint Movy-

nowey, Cuartes F. Pumuips, Jeprga H. Wane. Axycror

Corporation and FcypaMentaL Investors, Ixc..

Defendants-Appellees.

Before:

Louusarp, Oakes and Mesar,

Circuit Judges.

SS

Appeal from dismissal in the Southern District. Werker,

J., of stockholder derivative suit against directors of mutual

fund and fund’s investment adviser.

Reversed.

—

-

AytaHoyy L. Tersien:, New York, \.Y. (Aranow

Brodsky Bohblinger Benetar & Einhorn.

Steven Mallis, Herbert A. Einhorn. David

991

[i ...._.sd_ eee eee

a

= ( 26a

J. Sweet and Richard N. Gray, New York,

N.Y., on the brief), for Plaintiffs-d ppel-

lants.

Dayret A. Pottacz, New York, N.Y., for

Defendants-A ppellees.

Sewarp & KEusser, Evcenss P. Socrzee and

Aytuowy BR. Mansrrevp, New York, N.Y.,

on the brief, for Defendant-dAppellee Funda-

mental Investors, Inc.

Potzack & Kamrysgy and Muartrs I. Kawrsser,

New York, N.Y., on the brief, for Defen-

dants-Appellees Anchor Corporation, Ed-

ward B. Burr, Thomas F. Chalker, John R.

Haire and S. P. Hutchison.

Dewey, BatLaytrse, Brsasy, Parmer & Woop,

Lzonarp Joserx, Jony M. Frrepsay, J:.,

New York, N.Y., on the brief, for Defen-

dants-Appellees Harry G. Burks, Jr., Har-

vey C. Hopkins, Donald L. Kemmerer, A. S.

Mike Momroney, Charles L. Phillins and

Jeptha H. Wade.

ener

Lumsagp, Circuit Judge:

This appeal by two mutual fund shareholders raises an

important question of first impression: Can minoritr di-

rectors of a registered mutual fund, who were nominated

by the majority directors of the fund to be “independent”

directors pursuant to the requirements of the Investment

Company Act, 15 U.S.C. §80a-10(a), terminate a nonfrivo-

lous stockholder’s derivative action against the fund’: ma-

jority directors and its investment adviser? We are of

the view that to permit such action by those “independent”

992

minority directors of a registered mutual fund would be

contrary to the public interests which Congress has sought

to protect. Accordingly, we reverse the judgment of the

district court which dismissed the complaint and remand

for further proceedings.

Howard Lasker and Irving Goldberg commenced this

derivative action in February, 1973, against individuals

who had been directors of Fundamental Investors. Inc.

(the Fund), an open-end investment company’ registered

under the Investment Company Act, 15 U.S.C. ‘S80a-1 to

52, and the Fund’s registered investment adviser, Anchor

Corporation. The plaintiffs sought to recover losses sus-

tained by the Fund in connection with its purchase between

November 28 and December 8, 1969, of $20 million in Penn

Central 270-day notes from Goldman, Sachs & Co. The

derivative complaint charged the defendants with riola-

tions of $413(a)(3) and 36 of the Investment Company Act.

15 U.S.C. §§80a-13(a)(3), 80a-35 (1970), breach of their

common-law fiduciary duties, violations of 4206 of the In-

vestment Advisers Act, 15 U.S.C. §S0b-6 (1970), and breach

of Anchor’s investment advisory contract with the Fund.

It is undisputed that Anchor never made any indepen-

dent investigation of Penn Central’s financial situation

before the Fund’s purchase of the notes. Moreover, al-

though reports of Penn Central’s operations in early 1970

showed mounting losses, it was not until May that the

Fund officers made any attempt to resell any part of the

notes to Goldman, Sachs, or otherwise to realize on the

investment. On June 21, 1970, Penn Central filed a petition

for reorganization which is still in process in the Eastern

1 An open-end investment company is defined in §5(a)(1) of the In-

vestment Company Act, 15 U.S.C. {30a-5(a)(1) (1970), as an invest-

ment company tbat offers “for sale or bas outstanding acy redeemable

securities of which it is the issuer.” “Investment compacr” is deized

in $3(a) of the Act, 15 U.S.C. $80a-3(a) (1970).

993

at SE ee SEs OWA 2 TT 6 TE RS NRO Pe er

Pe LEK. A

27a

District of Pennsylvania. Consequently, the Fund’s Penn

Central notes were not paid at maturity.

In November 1970, the Fund, joined by three other note-

holders,’ sued Goldman, Sachs in the Southern District of

New York for recovery of their losses arising from their

purchases of Penn Central notes. In July 1973, then Dis-

trict Judge Gurfein stayed the instant action, which had

been commenced five months earlier, pending resolution of

the suit against Goldman, Sachs. That suit was settled on

behalf of the Fund in July 1974. Under the settlement,

Goldman, Sachs took back the Fund’s Penn Central notes,

paid the Fund $5,250,000, and assigned to the Fund a 73.75

per cent interest in the proceeds of the notes in the reor-

ganization proceedings. The Fund’s co-plaintiffs did not

settle, and the jury rendered verdicts in their favor against

Goldman, Sachs for the full amount of their claims.’

On July 24, 1974, the Fund’s board of directors met and

discussed the pending Lasker case. They decided that five

of the statutorily disinterested directors, none of whom

were involved in the derivative action,‘ should decide what

action should be taken regarding the Lasker case, and act

accordingly on behalf of the entire board.‘ This procedure

2 In addition to the Fund, Weich Foods, Inc., C.R. Anthony Company,

and Younker Brothers, Inc. sued Goldman, Sachs in a single action. See

Weich Foods Inc. v. Goldman, Sachs ¢ Co., 398 F.Supp. 1393 (S3.D.N.Y.

1974).

3 See Welch Foods Inc. v. Goldman, Sachs ¢ Co. No. 70 Civ. 4811

(jury verdict S.D.N.Y. 1974).

4 Of the remaining six directors of the eleren member board, all were

defendants to the Lasker action and/or affliated with Anchor.

5 Under the Fund’s bylaws and Delaware corporate law, fire of the

Fund’s twelve member board of directors coastituted a quorum of the

entire board. Del. Code tit. 8, §141 (1975); Fusdamenta] Investors.

Ine., Certificate of Incorporation, Article EIGHTH: FunJamental Ip-

vestors, Inc., Bylaws section 4, Article VT.

The fire directors appointed to review the Lasker action were: Leon

Kendall, elected to the board in June 1974; Berri Rohichaud, elected

994

28a

had been discussed prior to the July board meeting by the

defendant John R. Haire, president of the Fund and chair-

man of Anchor’s board of directors, and Roger Wickers, an

officer of both the Fund and Anchor. Upon Haire’s instruc-

tion, Wickers had ascertained that Stanley H. Fuld, former

chief judge of the New York Court of Appeals, would be

available to serve as special counsel. The minority direc-

tors agreed to consider what should be done about the

Lasker case, and instructed Wickers to retain Judge Fuld

to advise them.

Judge Fuld, in his report of December 5, 1974, supple-

mented on December 18, 1974, concluded, on the basis of

the information furnished to him, that neither Anchor nor

the Fund directors would be found liable under federal

or state law. At the same time, Judge Fuld pointed out the

absence of legal authority on whether a mutual fund’s in-

vestment adviser is required to conduct independent re-

search regarding its investment recommendations. He fur-

ther cautioned that it was “impossible to predict ... what

a trier of fact will find, particularly in complex circum-

stances.” After considering the special counsel’s reports,

on January 6, 1975, the minority directors instructed coun-

sel for the Fund to seek dismissal of the Lasker action on

the ground that it was their business judgment that further

prosecution of the action would not be in the best interests

of the Fund.

Judge Werker, in passing on the motion to dismiss, held

that the minority directors, in the exercise of their business

judgment, had the power to bar further prosecution of the

case, provided they were truly disinterested and indepen-

dent. As a factual issue had been raised regarding whether

the minority directors were independent and disinterested,

in September 1973; William Stephens. elected in September, 1975; Marr

O'Connor, elected in June 1972; and Louis Laun, who became 2 direstor

in the fall of 1977.

995

he granted discovery on that issue. Lasker v. Burks, 404

F.Supp. 1172 (S.D.N.Y. 1975). After such discovery, the

motion to dismiss was renewed and granted by Judge

Werker on January 7, 1977. In his second opinion, 426

F.Supp. 844 (S.D.N.Y. 1977), Judge Werker found no fac-

tual support for the conclusion that the minority directors

had not acted independently. In accordance with his earlier

opinion, he dismissed the complaint. . |

From what this record discloses regarding the Fund’s

investment in Penn Central notes on Anchor’s advice, we

cannot say that, following a trial on the merits, the defen-

dants would be found free from liability for the Fund’s

losses. We see nothing in the findings of Congress, the

legislation regulating investment companies and their ad-

visers, or in the decisions of the courts which suggests

that under such circumstances disinterested directors, such

as the five who acted here, have the power to terminate

litigation bronght by mutual fund stockholders against the

fand’s investment adviser and its majority directors for

breach of their fiduciary duties. On the contrary, the find-

ings of Congress, the statutory scheme, and the relevant

case law persuade us that the statutorily disinterested di-

rectors of a registered investment company were never

meant to have the final word in determining whether it is

in the best interest of a mutual fund to press claims against

their co-directors, and the adviser with which those di-

rectors are affiliated, for breach of fiduciary duties.

In response to disclosure of grave abuses in the manage-

ment of investment companies, Congress in 1940 enacted

the Investment Company Act (ICA), 15 U.S.C. &480a-1 to

52 (1970), and the Investment Advisers Act (TAA). 15

U.S.C. §§80b-1 to -21 (1970). Congress acted after receir-

ing a report from the Securities and Exchange Commission

which showed that investment funds were orzanized br in-

vestment advisers; that the funds were administered under

996

contracts that were highly favorable to the advisers; that

the directors of the funds were selected by the investment

adviser; and that the board was usually dominated by

persons affiliated with the adviser.’ Congress found that

numerous practices in the management of such funds ad- -

versely affected the national public interest and the interest

of investors. Accordingly, Congress declared it to be the

policy and purpose of the ICA to mitigate and eliminate

those aspects of the conduct and administration of the

funds which benefited the managers and adversely af-

fected the stockholders of the fund.’

The ICA provides that no more than 60% of a registered

company’s board of directors can be “interested persons”

affiliated with the investment adviser." Moreover, it gives

the statutorily disinterested directors, usually referred to

as “independent directors,” certain powers to supervise

management and auditing arrangements.’ Thus, section

15(c) of the ICA, 15 U.S.C. §80a-15(c) (1970), imposes

on the disinterested directors the duty to review and ap-

prove the contracts of the investment adviser and the prin-

cipal underwriter; section 16(b), 15 U.S.C. 480a-16(b)

(1970), provides that the statutorily disinterested directors

will appoint other disinterested directors to fil vacancies

resulting from the assignment of the advisorr contracts;

and section 32(a), 15 U.S.C. §80a-31(a) (1970), requires

that the accountants who prepare the investment com-

pany’s Securities and Exchange Commission financial fil-

6 See SEC, Report on the Study of Investment Trusts and [srestment

Companies, pt. 3, 1-49, 1922 (1940). See also Commest. Duties of the

Independent Direetors in Open-Ead Mutual Funds, 70 Mich.L.Rev. 694,

701 (1972). P

7 15 U.S.C. §80a-1 (1970).

$ See 15 U.S.C. §§80a-10, 80a-2(a) (2), (19) (1979).

9 See generally Commest, Duties of the Indepenlent Director in Open-

End Mutual Funds, 70 Mich.L.Rev. 696 (1972).

997

31a

ings be selected by the statutorily disinterested directors.

We conclude, therefore, that the statutes were designed to

interpose statutorily disinterested directors as a check on

the actions of the majority directors controlled by the in-

vestment adviser. It would be contrary to the legislative

purpose to permit the independent minority to be used

to approve majority action so that no stockholder com-

plaint could survive that approval.

Congress has not been satisfied, moreover, that the pres-

ence of disinterested directors who observe their duties

will be sufficient protection to the stockholders, as it has

specifically provided in section 36(b) that shareholders

may sue derivatively to recover excessive fees paid to the

adviser and the principal underwriter. See 15 U.S.C. §80a-

35(b) (1970). Section 36(b) was enacted as a part of the

1970 amendments, which resulted in part from the Senate

report which indicates that the mere presence of disinter-

ested directors on the boards of mutual funds was not suf-

ficient to protect funds oe overreaching investment

advisers.”*

We have been sensitive to the need for protection of the

public interest in accordance with the views of Congress.

Thus, in Galfand v. Chestnutt, 545 F.2d 807 (2d Cir. 1976),

we found that the investment adviser had abused its posi-

tion of trust by securing a favorable modification of its

advisory contract without fully disclosing to the fund’s

directors the ramifications of the changes. Writing for the

panel, Chief Judge Kaufman observed that, “[t]he rela-

tionship between investment advisers and mutual funds is

fraught with potential conflicts of interest. The typical

fund ordinarily is only a shell, organized and controlled

by a separately owned investment company adviser, which

10 See 1970 U.S. Code Cong. & Admin. News, 4897, 4901. In 1970 both

the ICA and the IAA were substantially amended. See Act of December >

14, 1970, Pub.L.No. 91-547, 84 Stat. 1413.

998

selects its portfolio and administers its daily business.”

Id. at $08. See also Tannenbaum v. Zeller, 552 F.2d 402

(2d Cir. 1977). -

Moreover, in many instances where no specific saline

is granted by statute the courts have inferred that stock-

holders may bring suit. See, e.g., Abrahamson v. Fleschner,

No. 75-7203, slip op. at 6227-29 (2d Cir. Feb. 25, 1977) and

cases cited therein. It would surely be anomalous to hold

that the statutorily disinterested directors could determine

not to pursue litigation against their co-directors for lia-

bility which may amount to many millions of dollars, and

foreclose the stockholders from continuing such litigation,

while at the same time stockholders by statute are em-

powered to recover excess fees paid the adviser and under-

writer.

In the ordinary routine business of running an invest-

ment trust, the disinterested directors must constantly deal

with interested directors in a spirit of accommodation. In-

deed, they are compelled for the most part to rely on the

information and expert advice provided br the adviser and

the majority directors.** The continued service of the

“statutorily” disinterested directors, for which in this case

they were paid from $11,000 to $13,000 per annum, de-

pends almost entirely on the establishment of satisfactory

working arrangements between them and the majority re-

sponsible for their selection. It is asking too much of hu-

man nature to expect that the disinterested directors will

view with the necessary objectivity the actions of their

colleagues in a situation where an adverse decision would

be likely to result in considerable expense and liability for

11 See Comment, supra note 9, at 702.

12 In addition to their role as directors of the Furcd. each of the fra

minority directors served on the boards of fire other Anchor aAliated

funds, and all but one of the directors sat oo a sirth Anchor relare

board.

999

32a

the individuals concerned." Correspondingly, it cannot be

expected that the public or the Fund’s stockholders would

believe that these five statutorily disinterested directors

could act with that impartiality and objectivity which the

public interest requires. It follows that disinterested direc-

tors of an investment company do not have the power to

foreclose the continuance of nonfrivolous litigation brought

by shareholders against majority directors for breach of

their fiduciary duties. Of course here we do not reach the

. question of whether a court should defer to the decision -

of statutorily disinterested directors of an investment com-

pany tc terminate a shareholder derivative suit which the

court finds to be frivolous.

Our conclusien makes it unnecessary to consider the find-

ings of the district court that the disinterested directors

were sufficiently independent to determine that the litiga-

tion be ended.'* We have no doubt that the five minority

directors acted in good faith in all that they did.

Reversed and remanded for further proceedings.

13 See Fogel v. Chestnutt, 533 F.2d 731, 750 (2d Cir. 1975); Nutt, A

Study of Mutual Fund Independent Directors, 120 U.Pa.L.Rev. 179, 216

(1971).

14 Similarly, the plethora of cases cited by counsel dealing with the

powers of boards of directors to terminate stockholder derivative suits

and the effect of the demand requirement under Fed.R.Civ.P. 23.1 are

inapposite. We base our decision on the unique oature of the investment

company and its symbiotic relationship with its investment adviser; we

need not reach questions of the exercise of similar power by directors

of other types of corporations. Moreover, none of these cases inrolres

the situation here, where the termicating directors owe their position as

directors to the defendacts in the suit.

1900

COO ——