Appendix — Burks v. Lasker
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APPENDIX
IN THE
Supreme Court of the United States
October Term, 1978
No. 77-1724
Harry G. Burks, Jr., et al.,
Petitioners,
Howarp M. Lasker, ef ano..
Respondents.
ON WRIT OF CERTIORARI TO THE UNITED STATES
COURT OF APPEALS FOR THE SECOND CIRCUIT
PETITION FOR CERTIORARI FILED JUNE 2, 1978
CERTIORARI GRANTED OCTOBER 2, 1978
—
INDEX
Relevant Docket Entries .................cccecces
Oprmnions or THE District Court AND
Court or APPEALS:
First Opinion of the District Court, 404 F.Supp.
I
Unreported Opinion and Order of the District
Court Denying Reargument, January 6, 1976 ...
Second Opinion of the District Court, 426 F.Supp.
Oe SMT, CIUUD vn caccccecccesccudccavas
Opinion of the Court of Appeals, 567 F.2d 1208 (2d
re crn eerie | s:
Ns do teen te eh endess Hudbcnes he 48s
Papers on Motion To Dismiss: ;
Affidavit of Roger T. Wickers sworn to January 27,
1975, in Support of Motion to Dismiss .........
Affidavit of Leon T. Kendall sworn to January 23,
1975, in Support of Motion to Dismiss .........
Exhibit A to Affidavit of Leon T. Kendall, Bio-
graphical sketch of Stanley H. Fuld (not re-
printed in Appendix)
Exhibit B to Affidavit of Leon T. Kendall, Report
of Stanley H. Fuld to Board of Directors of
Fundamental Investors, Ine., dated December
re er ee ee eee
Exhibit C to Affidavit of Leon T. Kendall, Sup-
plemental Report of Stanley H. Fuld to Board
of Directors of Fundamental Investors, Inc.,
A.
. 81
Gated Doeoswmber BG, BOGE ...cccccceccccceses i \.112
Exhibit D to Affidavit of Leon T. Kendall, Min-
utes of meeting of Board of Directors of Fund-
amental Investors, Inc., dated December 18,
MOPS cb vetendceuccessecssesdievacaccucdesse d \. 117
Attachments to Minutes of December 18,
ee ee Pere rrr rrr. t
il
Exhibit E to Affidavit of Leon T. Kendall, Letter
from William J. Stephens to Leon T. Kendall,
dated December 31, 1974 ...........0-+-00055 A. 131
Exhibit F to Affidavit of Leon T. Kendall, Min-
utes of meeting of the Board of Directors of
Fundamental Investors, Inc., dated January 6,
SS, (ihn eos ck b 0 Ned hbhee ban eNaedahee A. 137
PAGE
Supplemental Affidavit of Roger T. Wickers sworn
to May 7, 1975, in Support of Motion to Dismiss A. 142
Excerpts from Defendants’ Reply Memorandum,
referred to in Supplemental Affidavit of Roger
ee WE coc 24 Kh Ca kee ee ak eae aueeses A. 143
Papers on RENEWED Motion To Dismiss:
Affidavit of Roger T. Wickers sworn to July 23,
1976, in Support of Renewed Motion to Dismiss A. 145
Affidavit of James C. Sargent sworn to September
17, 1976, in Opposition to Renewed Motion to
NN ie Cee ied uence cach nese ene ile ONO
Excerpt from minutes of meeting of Board of
Directors of Fundamental Investors, Inc. of
ee NE es by oc Ca dkenees icenestiscess-> &
Seward & Kissel Memorandum dated January 6,
DE vdeateluctcbewsucobeawdet subanskcae es A. 158
Reply Affidavit of Roger T. Wickers, sworn to
November 9, 1976, in support of Renewed Motion
ba TE. cn nay cdlbawe cenbdesstncestheseens 4 A. 162
Appendix A to Reply Memorandum in Support
of Renewed Motion to Dismiss, Chart of Rela-
tionship of Disinterested Directors and De-
IEE OP a eg ig AEG ERIE RED OS TE OPO
Orders of Court of Appeals, March 9, 1978, Denying
Rehearing and Rehearing in bane ............... A.170
A.1
Relevant Docket Entries
United States District Court for the
Southern District of New York
February 5, 1973—Filed complaint and issued summons.
November 12, 1973——Filed Orvex that the motion of defend-
ants is hereby granted and ordered, that all further
actions are stayed until twenty days following the trial
or other determination of the claims asserted by Funda-
mental Investors, Inc. against Goldman, Sachs & Co. in
the action entitled: Welch Foods, Inc., et al. v. Goldman,
Sachs & Co., 70 Civ. 4811 (the Welch action), or until
further order of this Court; ordered that this order is
granted without prejudice to an application by plaintiffs
to vacate the same should it appear that the claims
asserted by Fundamental Investors, Inc. against Gold-
man, Sachs & Co. in the Welch action are not being
prosecuted with reasonable diligence——Gurfein, Jr.
(m/n)
February 8, 1975—Filed deft. Fundamental Investors,
Ine.’s affdvt. and notice of motion to dismiss under Rule
12(b)—ret. 2-20-75.
September 26, 1975—Filed Oprrnton #43128 .. . that the
motion under Rule 12(b) by Tue Fwwnp, joined by all
defendants is denied without prejudice to renew the same
upon the completion of discovery.—So ordered—Werker,
J.m/n
October 14, 1975—Filed pltf’s affdvt. and notice of motion
for reargument of Court’s opinion #43128—ret. 10-27-75.
January 7, 1976—Filed Order that plaintiffs’ motion for
reargument based on Judge Gagliardi’s decision on Boyko
v. The Reserve Fund, Inc., is denied. Werker, J. m/n.
A.2
Docket Entries
July 30, 1976—Filed deft. Fundamental Investors affdt. of
Roger Wickers in support of renewed motion to dismiss.
September 20, 1976—Filed deposition of Louis Frederick
Laun dtd. 4-6-76.
September 20, 1976—Filed deposition of William J.
Stephens dtd. 2-26-76.
September 20, 1976—Filed deposition of Mary S. O’Connor
dtd. 3-9-76.
September 20, 1976—Filed deposition of John R. Haire dtd.
2-10-76.
September 20, 1976—Filed deposition of Beryl Robichaud
dtd. 3-9-76.
September 20, 1976—Filed deposition of Leon T. Kendall
dtd. 2-26-76.
September 20, 1976—Filed continued deposition of Leon T.
Kendall dtd. 3-24-76.
September 20, 1976—Filed plaintiffs’ deposition exhibits
(re depositions of Haire, Kendall, O’Connor, Stephens,
Robichaud and Laun).
January 12, 1977—Filed Ortnion #45516 . . . Summary
judgment is granted to the defendants—Werker, J. m/n.
January 17, 1977—Filed JupemMent anp Orper that defend-
ants have judgment against the plaintiffs dismissing the
complaint.—Clerk. m/n.
January 27, 1977—Filed pltfs notice of appeal to the USCA
for the 2nd Circuit from final judgment dismissing action
and from prior rulings that produced final judgment.—
copies mailed.
A. 3
Relevant Docket Entries
United States District Court of Appeals
for the Second Circuit =
August 31, 1977—Argument heard (By: Lumbard, Oakes,
Meskill, C.J.J.)
January 11, 1978—Judgment reversed, Lumbard, C.JJ.
January 25, 1978—Filed petition for rehearing and rehear-
ing en bane, appellee, pfs.
March 9, 1978—Filed order denying petition for rehearing.
March 9, 1978—Filed order denying petition for rehearing
en banc.
June 2, 1978—Call from Supreme Court that petition was
filed today.
October 6, 1978—Filed certified copy of order of Supreme
Court that writ of certiorari is hereby granted [October
2, 1978].
OPINIONS OF THE DISTRICT COURT
AND
COURT OF APPEALS
A.9
First Opinion of the District Court
UNITED STATES DISTRICT COURT,
S.D. NEW YORK.
Sept. 24, 1975.
As Amended October 17, 1975.
fay
Vv
Howarp M. Lasker and Irvine Go.pBera,
Plaintiffs,
Vv.
Harry G. Burks, Jr., et al.,
Defendants.
No. 73 Civ. 552 (HF W.)
MemoranpuM Decision anp OrDER
Werke, District Judge.
This is a shareholders’ derivative action brought bv
two stockholders on behalf of Fundamental Investors, Inc.
(‘‘Fundamental’’ or the ‘‘Fund’’), a registered investment
company under the Investment Company Act of 1940, 15
U.S.C. § 80a-1 et seq. The defendants are the Fund’s invest-
ment adviser, Anchor Corporatien (‘*Anchor’’), a regis-
tered investment adviser under the Investment Advisers
Act of 1940, 15 U.S.C. § 80b-1 ef seq., and several former
and present members of the Board of Directors 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 detail below the coin-
A.6
First Opinion of the District Court
plaint charges that in connection with the purchase of the
Penn Central paper the defendants violated various sec-
tions of the Investment Company Act, the Investment Ad-
visors Act and the common law. The Fund, joined by all
defendants, has now moved under Rule 12(b) of the Fed-
eral Rules of Civil Procedure to dismiss this action on the
ground that the independent members of the Board of Di-
rectors of the Fund have unanimously determined that, in
their business judgment, this action is contrary to the best
interests of the shareholders of the Fund.
BacKGROUND
The Fund made its purchases of Penn Central 270-day
notes from Goldman, Sachs & Co., in lots of $5 million each
on November 26, December 2, 4 and 8, 1969. Unfortunately
for the Fund and other holders of Penn Central commercial
paper, Penn Central, on June 21, 1970, filed a petition for
reorganization under section 77 of the Bankruptcy Act
with the result that the notes were not paid at maturity
or at any time to date. Faced with the possibility of a sub-
stantial loss, the Fund and other plaintiffs instituted suit
in the Southern District of New York on November 4, 1970
against Goldman, Sachs & Co., for rescission of their pur-
chases of the Penn Central Notes. That action was entitled
Welch Foods, Inc. v. Goldman, Sachs & Co., D.C., 398
F.Supp. 1393 (the ‘‘ Welch’’ action).
The instant derivative suit was filed on February 5,
1973. Jurisdiction was predicated on section 44 of the In-
vestment Company Act of 1940 (15 U.S.C. § 80a-43), section
214 of the Investment Advisers Act of 1940 (15 U.S.C. § 80b-
14) and pendent jurisdiction. The complaint alleges that
in making the purchases of Penn Central commercial paper
A.7
First Opinion of the District Court
the Fund and Anchor relied solely and exclusively on Gold-
man, Sachs & Co., and made no independent investigation
of the financial condition of Penn Central or the quality of
its commercial paper. By failing to make an independent
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 responsibilities as
members of the Fund’s Board of Directors. Had an inde-
pendent investigation been made it is alleged that a num-
ber of material adverse facts concerning the financial con-
dition of the Penn Central and the quality of its commercial
paper would have been learned. As a result of their actions,
or inactions, the defendants are charged with engaging 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 violated section 206, the antifraud section of the
Investment Advisors Act of 1940. Plaintiffs also claim that
the defendants violated their common law fiduciary duty to
the Fund and that Anchor, aided and abetted by the diree-
tors, breached its investment advisory contract with the
Fund.
The complaint goes on to allege that from November 238,
1969 to June 21, 1970, the date Penn Central filed for re-
organization, the financial condition of the Penn Central
deteriorated. During this period it is alleged that Anchor
and the Fund directors failed to commence a thorough and
adequate investigation of, and keep under continuous re-
view, the financial condition of Penn Central and the quality
and safety of its commercial papers. It is also alleged that
during this period the Fund’s directors failed in their obli-
A.8
First Opinion of the District Court
vations to make adequate attempts to resell the Penn Cen-
tral commercial paper it held and that Anchor failed to
advise the Fund of the advisability of selling the commer-
cial 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 defendants breached their common
law fiduciary duty; and that Anchor, aided and abetted,
hy the Fund's directors breached its investment advisory
contract. Finally, the complaint alleges that the defend-
ants 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 contraven-
tion of the Fund’s registration statement filed pursuant
to section 8(b) of the Investment Company Act.
Subsequent to the filing of this derivative action, all
defendants moved to stay this action pending the resolution
of the claims of Fundamental in the Welch action. The
stay was granted by Judge Gurfein on November 12, 1973.
Fundamental’s claims against Goldman, Sachs & Co., in
the Welch action were settled on July 9, 1974. The terms
of the settlement 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.
With the settlement of the Welch action, Fundamental
had to determine what position to take in this suit. It is
necessary to set forth in detail the actions taken by the
Fund’s Board of Directors since it forms the basis of the
defendants’ motion to dismiss. /
Fundamental’s Board of Directors met on July 24, 1974
to review the settlement of the Welch action and to decide
A.9
First Opinion of the District Court
what position to take in this derivative action. Since five
of the directors are defendants in this action and one is a
director of Anchor, the Board determined that the remain-
ing five directors who they considered disinterested would,
acting as a quorum pursuant to the bylaws,' 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
(ourt 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 interviewing officers and employees of the Fund
and analyzing th 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
viclstion by Anchor or by the Fund directors of any provi-
sida ef statute or of any common law or contractual obliga-
tion to the Fund, in connection with the aequisition and re-
‘ Section | of Article Eight of the Certificate of Incorporation of
Fundamental provides that:
“The number of directors which shall constitute the whole
board of directors shall be such as from time to time shall be
fixed by or in the manner provided ir the by-laws which shall
also provide the number of directors which shall contsitute -a
quorum; provided, that in no case shall a quorum be less than
one-third of the total number of directors nor less than two
directors.”
Section 4 of Article Six of the By-Laws of Fundamental provides
that:
“Quorum: Except as otherwise provided by law, the Certifi-
cate of Incorporation, or these By-Laws, at all meetings of the
Board of Directors one-third of the directors then in office, but
not less than three directors shall be necessary for the transaction
of business.”
A. 10
First Opinion of the District Court
tention of the Penn Central commercial paper.’’ (Dee. 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. e., (1) seek realignment so as to become 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 dismissed; and (3) take
a neutral position and permit the action to proceed for the
t'und’s benefit under the auspices of the present plaintiffs.
After the disinterested directors reviewed his report
and submitted questions to him, Judge Fuld sent a supple-
mental memorandum to the disinterested directors on De-
cember 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 consider Judge Fuld’s memoranda. The
directors met with Judge Fuld; John R. Haire, Chairman
and Chief Executive of Anchor; Donald L. Kemmerer and
Checles F, Phillips, unaffiliated directors of Fundamental ;
and Eugene Souther, litigation counsel to Fundamental in
this action. Questions were posed by the directors to all of
these in attendance concerning the merits of the derivative
action and the alternatives open to the Fund’s Board. The
disinterested directors again met in private and decided
to give additional consideration to the problem and convey
any questions to the designated Chairman of the dis-
interested directors, Leon T. Kendall.
A second special meeting of the disinterested directors
was held on January 6, 1975. Upon review of the alter-
A. 11
First Opinion of the District Court
natives available, the directors present unanimously de-
termined *? that the prosecution of this action was contrary
to the best interests of the shareholders of Fundamenta!
and that counsel should be directed to seek dismissal of
the action. The factors considered by the directors 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 Anchor, dis-
traction of its personnel and the likely inability for
it to attract and maintain personnel during pendency
of the action necessarily would be harmful to the
shareholders of Fundamental;
(c) If the action were to proceed against Anchor
with the acquiescence or under the control of Funda-
mental, the adversary relationship that would be
created between Fundamental and Anchor and the
attendant serious distraction of Anchor’s personnel
from their efforts on behalf of the shareholders of
Fundamental would leave us no practical alternative
but to re-remove Anchor as investment adviser and
to seek to retain a new investment adviser; this
would necessarily result in delay, uncertainty and
an inevitable lapse in the management of Funda-
mental’s affairs to the serious detriment of its share-
holders ;
2 One director, Mary S. O’Connor, was not present at the meeting.
She had previously told Mr. Kendall what her decision was. That vote
was cattieeed by Mrs. O’Connor at a special meeting of the disin-
terested aaden held on January 22, 1975. Even without her
presence, four directors would constitute a quorum.
A. 12
First Opinion of the District Court
(d) Anchor had acted in good faith and in what
it believed was in the best interests of Funda-
mental’s shareholders in purchasing the Penn
Central comercial paper ;
(e) Anchor had acted reasonably and had fol-
lowed proceedures prudent at the time in lizht of the
then generally held belief that commercial paper was
equivalent to cash;
(f) A vast number of other institutional in-
vestors, including many major banks in New York
City and throughout the country and certain major
mutual funds, had also believed that Penn Central
was a sound business enterprise and had purehased
Penn Central commercial paper at the time, and
many such investors still held that paper when Penn
Central petitioned for reorganization ;
(x) To take no position at all and thereby to al-
low two of the more than 90,000 sharehoiders to de-
termine the course of this action would not be a deci-
sion at all, but au avoidance of our obligation to all
the shareholders;
(h) Chief Judge Fuld’s advice that an invest-
ment adviser is not a guarantor of Uie investments
it makes and can only be charged for breaches of
contract 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;
A. 13
First Opinion of the District Court
(i) Given Chief Judge Fuld’s opinion, if the
action were to proceed, there could be unnecessary
costs to the shareho!ders of Fundamental for legal
fees, both for its own counsel and for the director
defendants, who would be entitled to reimbursement
of counse! fees if they were found to be liable to
Fundamental; and
(j) Even if there were a recovery of the theoret-
ical maximum amount of damages, the net result to
the shareholders of Fundamental would be little more
than a net recovery of 10 cents per share, or ap-
proximately 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 shareholders which proceeding with
this action might produce.’’
Discussion
The Fund now argues that the extensive consideration
given to the alternatives available to the independent direc-
tors culminating in their decision to seek dismissal of this
suit was a good faith exercise of business judgment which
eannot be upset by the two shareholder plaintiffs who
would force Fundamental to maintain this action. The
plaintiffs, of course, dispute this position. After empha-
sizing, the merits of the claims they have asserted and
criticizing the conclusions reached by Judge Fuld, plaintiffs
make the following arguments in opposition to the defend-
ants’ motion to dismiss: (1) because of the broad regulatory
legislation embodied in the Investment Company and Invest-
ment Advisers Act, the decision whether to prosecute viola-
tions of that Act is not a matter of ‘‘business judgment’’ to
A. 14
First Opinion of the District Court
be decided by directors of a regulated fund; (2) to seek
dismissal of the action would be tantamount to an unlawful
ratification of defendants’ conduct; (3) if a majority of the
board’s directors are disqualified, the existence of a ‘‘dis-
interested’’ minority is irrelevant; (4) as a matter of law
the minority directors are not ‘‘disinterested;’’ (5) the
minority directors gave undue deference to Anchor in
making their decisions; and (6) the motion is premature
and defective under Rule 23.1. These arguments will now
be considered.
At the outset, the obvious should be stated—a share-
holder’s derivative suit is an action brought on behalf of a
corporation in which any recovery runs in favor of the cor-
poration. Ordinarily, it is the corporation which would
seek 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 bringing suit.* The purpose of
* Rule 23.1 provides: ;
“In a derivative action brought by one or more shareholders
or members to enforce a right of a corporation or of an unin-
corporated association, the corporation or association having
failed to enforce a right which may properly be asserted by it,
the complaint shall be verified and shall allege (1) that the
plaintiff was a shareholder or member at the time of the trans-
action of which he complains or that his share or membership
thereafter devolved on him by operation of law, and (2) that the
action is not a collusive one to confer jurisdiction on a court of
the United States which it would not otherwise have. The
complaint shall also allege with particularity the efforts, if any,
made by the plaintiff to obiain the action he desires from the
directors or comparable authority and, if necessary, from the
shareholders or members and the reasons for his failure to obtain
the action or for not making the effort. The derivative action
may not be maintained if it appears that the plaintiff does not
fairly and adequately represent the interests of the shareholders
or members similarly situated in enforcing the right of the cor-
poration or association. The action shall not be dismissed or
compromised without the approval of the court, and notice of
the proposed dismissal or compromise shall be given to share-
holders or members in such manner as the court directs.”
A.15
First Opinion of the District Court
that ‘‘demand”’ rule ‘‘is to give the derivative corporation
itself the opportunity to take over a suit which was brought
on its behalf in the first place, and thus to allow the directors
the chance to occupy their normal status as conductors of
the corporation’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 (1st 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.t While no set formula has been developed for deter-
mining 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 pre-
sents the rather unique situation where a designated inde-
pendent minority of a Board has taken unilateral action
with respect to a suit brought on behalf of the corporation.
The decision of the independent directors was made after
the settlement of the Welch action which put an end to the
stay in this suit. Plaintiffs argue that even if suit were
instituted at the present time (i.e., after settlement of the
Welch action no prior demand on the Fund’s Board would
have been necessary because the majority of directors
would be disqualified. To allow a minority of the Board
to seek dismissal of the suit would, it is argued, destroy the
role of ‘‘presumptive disqualification.’’
* No issue has been raised concerning whether a demand on the
shareholders was necessary. Plaintiffs’ complaint alleges that under
applicable law and the Certificate of Incorporation and By-Laws of
the Fund, the directors and officers are vested with the management
of the Fund. Complaint €7(b).
A. 16
First Opinion of the District Court
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 deriva-
tive causes of action in plaintiff’s complaint because the
allegations in the complaint were insufficient to excuse a
demand on the Board of Directors. Plaintiff had alleged
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 Seeond Cireuit 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 complaint 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 commenced
would have been futile. The district court again dismissed
the derivative counts and the Second Circuit affirmed on the
reasoning that a demand should have been made on the new
directors. Brody, supra at 934.
In this case, within a short period after settlement
of the Welch action and the dissolution of the stay, the
Board of Directors met and designated the independent
directors to make a decision as to the Fund’s position in
this suit. In the Court’s view, the independent minority of
directors had the power to decide what position the Fund
should take. This is consistent with the policy that a cor-
poration be given the opportunity 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 alternative.
See 3B J. Moore, Federal Practice § 23.1.19, at 23.1-252-53
(2d ed. 1974) quoted in Brody, supra at 934.
a
A.17
First Opinion of the District Court
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 direc-
tors can be used as a ground for dismissal. Defendants
rely on a line of cases which hold that absent fraud or cor-
ruption or other disqualifying factor, the good faith busi-
ness judgment of the directors not to bring suit is final.
See, e.g., Hawes v. Oakland, 104 U.S. 450, 26 L.Ed. 827
(1881); Corbus v. Alaska Treadwell Gold Mining Co., 187
U.S, 455, 23 S.Ct. 157, 47 L.Ed. 256 (1903) ; United Copper
Securities Co. v. Amalgamated Copper 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. TBM, 353 F.2d 491 (3d Cir.
1965), cert. denied, 384 U.S. 927, 86 S.Ct. 1446, 16 L.Bu 2d
531 (1966) ; In re Kauffman Mutual Fund Actions, 479 F.2d
257 (1st Cir.), cert. denied, 414 U.S. 857, 94 S.Ct. 161, 38
L.Ed.2d 107 (1973). Cf. Allegheny Corp. v. Kirby, 344
F.2d 571 (2d Cir. 1965), cert. dismissed, 384 U.S. 28, 86 S.Ct.
1250, 16 L.Ed.2d 335 (1966).
As the Supreme Court recognized in United Copper,
supra, the decision whether or not to sue is a matter of
internal management, 244 U.S. at 263, 37 S.Ct. 509. Absent
fraud or corruption or other factors, the stockholders can-
not force the corporation to sue.
‘‘(Stockholders] cannot secure the aid of a court to
correct what appear to them to be mistakes of judg-
ment 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. Voiley Authority, 297 U.S. 288, 348, 56 S.Ct.
466, 481, 80 L.Ed. 688 (1936).
A. 18
First Opinion of the District Court
The reasoning behind the ‘‘ business judgment rule’’ and
its application to derivative suits was recently discussed in
this district in Bernstein v. Mediobanca, Docket #73 Civ.
3549, (S.D.N.Y. Dee. 24, 1974) (Connor, J.). There the
Court reaffirmed the business judgment rule although sum-
mary judgment was denied, with leave to renew, because
possible evidence of bad faith on the part of the Board of
Directors in deciding not to sue was in the possession of the
defendants and plaintiff was given an opportunity to dis-
cover it.
This court cannot accept plaintiffs’ argument that
because the allegations of the complaint concern viola-
tions of the Investment Company Act and the Investment
Advisers Act, the Board has no power to exercise its busi-
ness judgment becauge of the strong public policies behind
those Acts. Unlike § 16(b) of the Securities Exchange Act
which allows shareholders to bring suit if the directors de-
cline a demand, Congress has made no such statutory pro-
vision 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 ac-
tion. Brown v. Bullock, 194 F.Supp. 207 (S.D.N.Y., aff’d
204 F.2d 415 (2d Cir. 1961); Bolger v. Laventhol, Krek-
stein, Horwath & Horwath, 381 F.Supp. 260 (S.D.N.Y.
1974). It does not necessarily follow that because the right
is implied a derivative suit should always be allowed de-
spite the good faith exercise of business judgment by the
directors not to sue. This court ‘s of the opinion that ab-
sent a statutory exception, whether a cause of action is ex-
pressly authorized or is ‘‘implied’’ the directors of a cor-
poration should be given the chance to perform their duties
in running the business of the corporation including whether
A. 19
First Opinion of the District Court
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.
The court must also reject plaintiffs’ argument that
the decision not to sue was tantamount to an illegal
ratification. 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 Prerequisite To a Derivative Suit,
73 Harv.L.Rev. 746, 762 (1960); Rogers v. American Can
Co., 305 F.2d 297 (3d Cir. 1962), the question of busi-
ness judgment is separate from the question of ratification.
S. Solomont &€ Sons Trust v. New England Theatres Oper-
ating Corp., 326 Mass. 99, 93 N.I0.2d 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 Cop-
per, supra; Ash v. IBM, supra (antitrust violations).
Another question which has _ been considered is
whether the merits of the plaintiffs’ claim should be con-
sidered in deciding whether the directors decision should
be upheld. To do so would place the Court in the position
of substituting its judgment for that of the directors 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 decision 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 Kendall
Affidavit | 22—which led the directors to their decision.
If the minority directors were truly disinterested and
independent the court will not substitute its judgment for
A. 20
First Opinion of the District Court
that of the Board. Plaintiffs have not argued that the
minority directors have acted fraudulently or corruptly.
They have argued that they are not disinterested or inde-
pendent because they occupy similar positions with other
funds in the Anchor group and that Anchor controls the
selection and nomination of the Fund’s directors. This
assertion has been denied and it is alleged by the movant
that these directors were nominated by a three man Diree-
tors 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 respect to the rela-
tionships of the minority directors and the Qualifications
Committee to determine whether the minority 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 con-
duct their discovery within 90 days from the date hereof.
The motion is denied without prejudice to renew the
same upon the completion of discovery.
So ordered. ;
A. 21
Unreported Opinion and Order of the
District Court Denying Reargument
UNITED STATES DISTRICT COURT
Sovuruern District or New York
Oo
Howarp M. Lasker anv Irvine GOLDBERG,
Plaintiffs,
against
Harry G. Burks, Jr., Eowarp B. Burr, Tomas F. CHALKER,
Joun R. Harre, Harvey C. Hopkins, 8S. P. Hurcainson,
Donato L. Kemmerer, A. S. Mrke Monroney, CHARLES
F. Pumuirs, Jeprna Wave, Ancuor Corp., and Funpa-
MENTAL Investors, INc.,
Defendants.
Ly
—
ORDER
Henry F. Werxer, D. J.
Plaintiffs’ motion for reargument based on Judge
Gagliardi’s decision in Boyko v. The Reserve Fund, Inc.,
74 Civ. 3419 (S.D.N.Y. Sept. 31, 1975) is denied. 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 re.
ceipt of compensation. The question of who should deter-
mine 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 general claim of violation of fiduciary
duty and where no cause of actiou is given in the statute
to a security holder on such a claim.
So ordered.
Dated: New York, New York
January 6, 1976
Henry F. Werker
U.S.D.J.
‘ isis | =
A, 22
Second Opinion of the District Court
UNITED STATES DISTRICT COURT,
S. D. NEW YORK.
Jan. 7, 1977.
—— *
—
Howarp M. Lasker and Irvine GoLpBErc,
Plaintiffs,
Vv.
Harry G. Burks, Jr., et al.,
Defendants.
No. 73 Civ. 552 (HF'W).
()PINION
Werker, District Judge.
This action, brought derivatively by two shareholders on
behalf of Fundamental Investors, Ine. (‘‘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 defendants are An-
chor Corporation (‘‘Anchor’’), the régistered investment
adviser to the Fund, and several past and present members
of the Fund’s Board of Directors (‘‘Board’’). The defen-
dants 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 ex-
A. 23
Second Opinion of the District Court
ercise of its business judgment, that maintenance of the suit
would not be in the best interests of the shareholders of the
Fund. In a memorandum decision on that motion, 404 F.
Supp. 1172, this court held that the business judgment rule '
applied to the actions of the Fund and that it enabled the
minority directors of the Board to seek dismissal of this
suit provided only that they were ‘‘truly disinterested and
independent.’’ However, the court permitted the plaintiffs
to conduct discovery for a designated period of time to de-
termine whether the minority directors were in fact disin-
terested or independent, 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 deniel
because, for various reasons, the minority directors did not,
and could not, exercise their independent business judgment
in moving to terminate this action.
' Under the rule,
““*. . . Questions of policy of management, ew of con-
tracts or action, adequacy of consideration, la appropriation
of corporate funds to advance corporate interests, are left solely
to their honest and unselfish decision, for their powers therein
are without limitation and free from restraint, and the exercise of
them for the common and general interests 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
N.Y. 113, 124, 100 N.E. 721, 724. Indeed, although the con-
cept of ‘responsibility’ is firmly 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 fraud, or improper motive, or
personal interest.” Bayer v. Beran, 49 N.Y.S.2d 2, 6 (Sup. Ct.
1944).
A. 24
Second Opinion of the District Court
I
The facts surrounding this action have been described
at length in my earlier memorandum decision ; nevertheless,
some repetition of that discussion will facilitate an under-
standing 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 fiduci-
ary duties by relying exclusively upon the representations
of Goldman, Sachs & Co. (a seller of commercial paper),
rather than independently investigating the quality and
safety of the Penn Central 270-day notes purchased by the
Fund. It is further alleged 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 fiduciaries 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-
tion; and that during this period of decline all of the defen-
dants failed to investigate and review the financial condi-
tion of the Penn Central and the quality and safety of its
commercial paper. It is also alleged that during this period
Anchor failed to recommend, 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. Gold-
man, Sachs & Co., 398 F.Sapp. 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. 25
Second Opinion of the District Court
a stay of further proceedings in this action pending resolu-
tion 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, Gold-
man, 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
lo in the instant action. Briefly, the Board determined that
five of its members were dininterested (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 Ap-
peals, to review the circumstances surrounding 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 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 directors 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.
* Under Article Eight of the Certificate of Incorporation of Funda-
mental, 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 mem-
bers, there was no problem here.
A. 26
Second Opinion of the District Court
The minority directors also questioned several of the de-
fendants before deciding at a second special meeting of the
disinterested quorum, held on January 6, 1975, to seek dis-
missal of the instant action.’ An affidavit submitted by the
chairman of the disinterested quorum as part of the earlier
motion to dismiss recounts ten factors that the disinterested
quormn considered in arriving at its decision. The relevant
portion of that affidavit appears in my earlier decision, 404
F.Supp. at 1176-77.
II
On the defendants’ initial motion to dismiss, 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 judgment ‘‘defense.’’ The
court also reviewed the claim of the plaintiffs that the
strong public policy behind the Investment Company Act of
1940, 15 U.S.C. § 80a-1, et seq., and the Investment Advisers
Act of 1940, 15 U.S.C. § 80b-1, et seq., precluded application
of the business judgment rule to the actions of mutual funds.
The court observed that
‘‘absent a statutory exception whether a cause of ac-
tion is expressly authorized or is ‘implied’ the direc-
tors 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. 404 F.Supp. at 1180.
Both of these contentions have been reasserted in sub-
stantially unchanged form in the plaintiffs’ papers in oppo-
* As was noted in my earlier decision in this matter, although one
of the five minority directors voted by proxy, even without her vote,
the presence of four directors at the meeting constituted a quorum.
A. 27
Second Opinion of the District Court
sition to the renewed motion to dismiss. While a certain de-
gree of tenacity is the mark of accomplished 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 recon-
sider arguments 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 be-
fore: whether the minority directors were disinterested and
independent.
Since the parties have each submitted affidavits and
excerpts from the extensive 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.
Ill
The plaintiffs first contend that the structure of the
mutual fund industry, which subjects mutual funds to ex-
tensive control by their investment advisers, precludes a
finding of independence in this instance.* Specifically, they
* In this regard, plaintiffs note Chief Judge Kaufman’s recent state-
ment that:
“The relationship 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 selects its
portfolio and administers its daily business. Compensation for
these services 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.”
re: v. Chestnutt Corp., Civ. No. 76-7156 (S.D.N.Y. Nov.
4, 1976).
A. 28
Second Opinion of the District Court
maintain that the large number of shareholders in the Fund
coupled with the small size of each sharehkolder’s interest,
makes proxy contests impossible to wage and ensures that
the Board will only contain directors amenable to the poli-
cies of the Fund’s management.’ The plaintiffs also sug-
gest that the service of each minority director for compen-
sation on the boards of other ‘‘Anchor’’ funds demon-
strates their inability to act independently. In this vein,
the plaintiffs maintain that business and personal relation-
ships among the defendants and minority directors make
it impossible to conclude that the disinterested quorum
acted independently; that even if the minority directors
acted in good faith, their lovalties must have been divided.
Plaintiffs have not adduced any factual support for
their conelusion that the members of the disinterested quo-
rum 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 ex-
isted between the minority directors and the defendant
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.
There is also no reason to conclude that the busi-
ness judgment rule is inapplicable merely because each
minority director receives remuneration for service on th»
boards of other ‘‘ Anchor’’ funds. Most corporate directors
receive some compensation for their services, but absent a
showing of improper motive they have always been per: .
® At about the time that the minority directors determined to seek
the dismissal of this action, there were approximately 141,000 share-
holders in the Fund. No shareholder had a beneficial interest greater
than one percent.
A. 29
Second Opinion of the District Court
mitted to apply their business judgment to decisions in-
volving derivative suits brought against the corporations
they serve. See e.g., Warshaw vy. Calhoun, 43 Dei.Ch. 148,
221 A.2d 487 (Sup.Ct.1966). I am not persuaded that there
is any meaningful distinction between remuneration by one
corporation rather than several corporations similar in
structure. This is not, after all, an instance where it is
alleged that a minority director received payments from
the investment adviser or other persons whose interests
conflict with those of the Fund.
The plaintiffs’ contention that a minority director of
a mutual fund can never act independently given the re-
lationship between mutual funds and their advisers par-
allels, to some extent, their previously rejected argument
that the business judgment rule should not apply to mutual
funds registered under the Investment Company Act of
1940. In making this claim, plaintiffs apparently rely upon
Fogel v. Chestnuti, 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 stockholders 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 trans-
actions on the theory that the affiliated directors had ‘‘in-
tentionally misled and misinformed the [f]und’s unaffili-
ated directors by telling them that such recapture was not
available to the [f]und.’’ Jd. at 737.
Writing for the Fogel panel, Judge Friendly observed
that :
‘Congress had mandated independent directors in
order ‘to supply an independent check on manage-
A. 30
Second Opinion of the District Court
ment and to provide a means for the representation
of shareholder interests in investment company af-
fairs.’ [citation omitted]. The minimum requirement
to enable the [f]und’s independent directors to dis-
charge 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
disinterested counsel furnished to the independent
directors.”
Id. at 749-50.
Significantly, Judge Friendly went on to observe that:
‘“‘If this had been done and the independent di-
rectors had concluded that, because of legal doubts,
business considerations 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 directors were
furnished with disinterested counsel who analyzed the lgal
consequences of each alternative available to the disin-
terested quorum. Morcover, the affidavit of the quorum
chairman and the minutes 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.
A. 31
Second Opinion of the District Court
IV
The plaintiffs next contend that the lack of true inde-
pendence and disinterestedness on the part of the minority
directors is apparent from the manner in which they decided
to seek dismissal in the instant action. In support of this
claim, plaintiffs point to the actions of Roger T. Wickers,
an Anchor vice-president who formerly served as the secre-
tary to the Fund, and Fugene P. Souther, who was retained
as special counsel to the Fund for the purposes of this liti-
gation, as well as to the circumstances surrounding the meet-
ings of the minority directors.
At the direction of defendant Haire, Wickers explored
the possibility of retaining special counsel for the disin-
terested quorum. After contacting several distinguished
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 pro-
posed 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 different states.
The plaintiffs maintain that ‘‘the inappropriateness of
Wickers role as intermediary is manifest,’’ but I disagree.
The plaintiffs have not set forth any facts in support
of their suggestion that Wickers improperly influenced the
deliberations of the disinterested quorum. Instead they
have engaged in totally unsubstantiated supposition. For
example, plaintiffs contend that Wickers retained Judge
Fuld, but the sworn. affidavit of Wickers and the deposition
of at least one minority director establish that Judge Fuld
was retained by the minority directors to act upon instrue-
tions communicated to him at the direction of the disin-
A. 32
Second Opinion of the District Court
terested 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 ad-
ministrative details of Judge Fuld’s inquiry or that
Wickers’ actions reduced the independence of the minority
directors.
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(a)(19)(A)(iv)* because his law firm had acted as
legal counse) to the Fund during the last two fiscal years.
They question whether the minority directors could arrive
at a disinterested decision when they were advised by an
attorney who was ‘‘interested.’’ Second, the plaintiffs con-
tend that it was improper for his firm to counsel parties
with divergent interests, namely the Fund and the disin-
terested quorum.
All attorneys providing legal counsel to mutual funds
hecome, by definition, “interested persons’’ for some period
* Even if Wickers did retain Judge Fuld for the minority directors,
I see nothing improper in that. In fact, in Fogel, supra, Judge Friendly
suggested that it was desirable for disinterested counsel to be “fur-
nished” to the independent directors.’
* Under the statute:
“(19) ‘Interested person’ of another person means—
(A) when used with respect to an investment company—
* * * ” »
(iv) oe nae ae
at any time since the beginning of the last two fiscal years of
ee ee See ae See eee Oe
Dany .
.
A. 33
Second Opinion of the District Court
of time. Under §10 of the Investment Company Aet, 15
U.S.C. §80a-10, only 60 percent of the members of the
board of a registered company may be interested persons.
Designating Souther as an interested person, therefore,
only serves to limit his participation on the Board as a
director. It does not mean that the minority directors were
interested in the suit, that their deliberations were some-
how subject to improper influence or that they lacked tie
necessary degree of independence.
Plaintiffs nevertheless suggest that in accordance with
Judge Frankel’s recent decision in Papilsky v. Berndt,
CCH Fed.See.L. Rep. § 95,027 (S.D.N.Y. 1976), it was im-
proper for Souther to advise both the Fund and the minority
directors. However, in Papilsky the law firm advising the
fund also served as the investment adviser’s counsel, and,
as Judge Frankei noted, there was no ‘‘suggestion to the
Board that, because of the possible conflict of interest, the
independent directors should seek disinterested counsel.’’
Jd. at 90, 133. In the instant action, independent legal ad-
vice for the minority directors was not only recommended,
it was also obtained. Moreover, there was no conflict of
interest on the part of Souther or his law firm: they were
retained to represent the Fund in the instant action and it
was the disinterested quorum, acting for the Fund, which
gave them their instructions as to how to proceed.
The plaintiffs also contend that the presence of
several defendants during the initial presentations of Judge
Fuld and Souther at the first special meeting of the dis-
interested quorum demonstrates the minority directors’ lack
of independence. But the minutes of that meeting and the
deposition testimony show that the minority directors in-
,vited those defendants to join the meeting so that they could
A. 34
Second Opinion of the District Court
answer questions raised by the minority directors. The
minutes of the meeting also indicate that all of the de-
fendants and counsel were excused before the disinterested
quorum determined in executive session that it wished to
review the pertinent documents and formulate further ques-
tions to be answered before reaching any decision.
In this context plaintiffs point to the allegedly mislead-
ing nature of statements made to the minority directors by
defendant Haire. The minutes of the first special meeting
of the disinterested quorum state that Haire ‘‘questioned
the ability of Anchor 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 testimony at his dis-
position that he ‘‘never at any time had any doubt that
[Anchor] could continue to effectively serve the [F]und
if . . . requested to continue or permitted to continue by
the board or the shareholders.’’ Apparently to underscore
the materiality of Haire’s discouraging words to the mi-
nority directors, plaintiffs note the contents of an affidavit
by the chairman of the disinterested quorum. ‘In that affi-
davit, the quorum,chairman states that in reaching their
decision the directors considered that:
‘*(e) If the action were to proceed against Anchor
with the acquiescence or under the control of Funda-
mental, the adversary relationship that would be
created between Fundamental and Anchor and the
attendant serious distraction of Anchor’s personnel
from their efforts on behalf of the shareholders of
Fundamental would leave us no practical alternative
but to remove Anchor as investment advisor and to
seek to retain a new investment advisor; this would
A. 35
Second —— of the District Court
necessarily result in delay, uncertainty and an inevi-
table lapse in the management of Fundamental’s
affairs to the serious detriment of its share-
holders .. .’’
The court is of the opinion that Haire’s statements
are neither inconsistent nor misleading. His assertions
only indicate 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 that the minor-
ity directors reached a different conclusion: that prosecu-
tion of the suit ‘‘would necessarily cause the Fund to seek
to obtain a different investment adviser immediately.’’
Even if the minority directors erred in this determination,
as I have noted in my previous decision, the court cannot
upset their reasoned judgment without some showing that
the independence of the disinterested quorum was imper-
missibly curtailed. The plaintiffs have not presented any
such evidence.
V
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. Lit-
ton, 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
fiduciary responsibilities to the corporation and its stock-
holders. The defendants argue that the plaintiff must
shoulder the evidentiary burden because it is the exercise
of business judgment by corporate directors which is chal-
A. 36
Second Opinion of the District Court
lenged. 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 plain-
tiffs both involve self-dealing by corporate fiduciaries and
are inapplicable here. As I noted in my earlier decision
in this matter, the plaintiffs ‘‘have not argued that the
minority directors have acted fraudulently or corruptly.’’
404 F.Supp. at 1180. Moreover, the question before the
court is not whether the defendants breached their fiduciary
obligations to the corporation, but whether suit can pro-
ceed against them at all given the decision of the nonde-
fendant minority directors to seek dismissal of this action.
It is therefore incumbent upon the plaintiffs to
establish that the minority directors actions lacked inde-
pendence. Marco v. Bank of New York, supra. The unsup-
ported contentions of the plaintiffs clearly fail to meet this
burden and, accordingly, it is the opinion of this court that
the defendants, both corporate and individual, cannot be
required to proceed to a trial. I[ hasten to add, however,
that even if the defendants 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 instant motion
show that the minority directors carefully evaluated the
opinions tendered by both counsel involved in this action,
that they considered the merits of the derivative claims
asserted in the complaint, that they discussed the facts and
circumstances surrounding the purchase and retention of
the notes with several of the defendant directors and that
A. 37
Second Opinion of the District Court
they communicated extensively among themselves before
reaching a decision to seek dismissal of this suit.
To conclude that the disinterested quorum acted
in response to pressure and without justification to
immunize Anchor and the defendant directors from pos-
sible liability would require this court to presume that bias
exists based upon circumstances which seem entirely inno-
cent. For example, as has been noted, the plaintiffs suggest
that a finding of improper influence 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 the existence of casual relation-
ships among the directors, without more, cannot be taken
as an indication that the minority directors were unable to
reach an independent business decision. Similarly, be-
cause the Investment Company Act terms an attorney
whose advice is sought to be an ‘‘interested person,’’ plain-
tiffs seek to suggest that the minority directors had an
interest 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.
“In a similar effort to brand a minority director as interested,
plaintiffs point to the following testimony by director Stephens:
“T remember commenting [at the July 24, 1974 board meeting]
on what constituted a disinterested director because in my opinion
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.”
or
A. 38
Second Opiaion of the District Court
The court of appeals for this circuit has recently
cautioned that summary judgmert may not be granted
unless, drawing all reasonable inferences in favor
of the nonmovant, no material factual issue is shown. Hey-
man v. Commerce and Industry Insurance Co., 524 F.2d
1317 (2d Cir. 1975). However, the party opposing the
motion must adduce something beyond conclusory allega-
tions. 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 ve-
hind the business judgment cloak. Accordingly, the de-
fendants are granted summary judgment.
SO ORDERED.
A. 39
Opinion of the Court of Appeals
No. 23, Docket 77-7060.
UNITED STATES COURT OF APPEALS,
Seconp Circuit.
Argued Aug. 31, 1977.
Decided Jan. 11, 1978.
ray
——
Howanrp M. Lasker and Irvine Gopsere,
Plaintiffs-Appellants,
v.
Haney G. Burks, Jz., Eowarp B. Burr, Tuomas F. Cuacxen,
Joun R. Hame, Harvey C. Hopkins, 8S. P. Hurcuson,
Dowarp L. Kemmerer, A. S. Mrxe Mowroney, Cuanres F.
Pairs, Jeeroa H. Wave, Ancnor Corporation AND
FounpaMenTat Investors, Inc.,
Defendants- Appellees.
i.
a
Lumsarp, Cireuit Judge:
This appeal by two mutual fund shareholders raises
an important question of first impression: can minority
directors: 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 non-
frivolous stockholder’s derivative action against the fund’s
majority directors and its investment adviser? We are of
the view that to permit such action by those ‘‘independent’’
‘— A A A Sa
A. 40
Opinion of the Court of Appeals
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
distriet 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. § 80a-1 to -52, and
the Fund’s registered investment alviser, Anchor Cor-
poration. The plaintiffs sought to recover losses sustained
by the Fund in connection with its purchase between No-
vember 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 viola-
tions of (§ 13(a)(3) and 36 of the Investment Company
Act, 15 USC. §§ 80a-13(a)(3), 80a-35 (1970), breach of
their commen-law fiduciary duties, violations of 4 206 of the
Investment Advisers Act, 15 U.S.C. § 80b-6 (1970), and
breach of Anchor's investment advisory contract with the
Fund.
It is undisputed that Anchor never made any » indueee-
dent investigation of Penn Central’s financial situation be-
fore the Fund’s purchase of the notes. Moreover, although
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 Gold-
? An open-end investment is defined in § 5(a)(1) of the
Investment Company Act, 15 USC. > eee (1970), as an
investment company that offers “for sale has outstanding any re-
decsiniiie enadiilies ef ettdh fe to Geo loser.” “Investment
is defined in § 3(a) of the Act, 15 U.S.C. § 80a-3(a) (1970).
A. 41
Opinion of the Court of Appeals
man, Sachs, or otherwise to realize on the investment. On
June 21, 1970, Penn Central filed a petition for reorganiza-
tion which is still in process in the Eastern 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
heen 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
percent 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
diseussed the pending Lasker case. They decided that five
of the statutorily disinterested direcvors, none of whom
were involved in the derivative action,‘ should decide what
action should be taken regarding the Lasker case, and act
2 In addition to the Fund, Welch Foods, Inc., C. R. Anthony
Company, and Younker Brothers, Inc. sued Goldman, Sachs in a
action. See Welch Foods Inc. v. Goldman, Sachs & Co., 398
F. . 1393 (S.D.N.Y. 1974).
* See Welch Foods Inc. v. Goldman, Sachs & Co., 398 F.Supp.
1393 (jury verdict $.D.N.Y. 1974).
* Of the remaining six directors of the eleven member board, all
were defendants to the Lasker action and/or affiliated with Anchor.
A. 42
Opin:on of the Court of Appeals
accordingly on behalf of the entire board. This procedure
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 in-
struction, W.ckers 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
directors 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 investment
adviser is required to conduct independent research regard-
ing its investment recommendations. He further cautioned
that it was ‘‘impossible to predict . . . what a trier of fact
will find, particularly in complex cireumstances.’”’ After
considering the special counsel’s reports, on January 6,
1975, the minority directors instructed counsel 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.
—_- — ~~
* Under the Fund's bylaws and Delaware la
the Fund's twelve member board of directors constituted Sone >
~. the entire board. Del.Code tit. 8, § 141 (1975); Fundamental
nvestors, Inc., Certificate of Incorporation, Article EIGHTH: Fun-
damental Investors, Inc., Bylaws section 4, Article VI.
The five directors appointed to review the Lasker action were:
Leon Kendal, elected to the board in June 1974; Beryl Robichaud,
1975; Mary OCeane, Gaued in tae lofted tee
: onnor, in June 1972; i
became a director in the fall of 1971. a
A. 43
Opinion of the Court of Appeals
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 independ-
ent. As a factual issue had been raised regarding whether
the minority directors were independent and disinterested,
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 Werk-
er on January 7, 1977. In his second opinion, 426 F.Supp.
844 (S.D.N.Y.1977), Judge Werker found no factual sup-
port for the conclusion that the minority directors had not
acted independently. In accordance with his earlier opin-
ion, 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 defend-
ants 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 litiga-
tion brought by mutual fund stockholders against the fund’s
investment adviser and its majority directors for breach of
their fiduciary duties. On the contrary, the findings of Con-
gress, the statutory scheme, and the relevant case law per-
suade us that the statutorily disinterested directors of a reg-
istered 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 directors are affiliated, for
breach of fiduciary duties.
A. 44
Opinion of the Court of Appeals
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. §§ 80a-1 to -52
(1970), and the Investment Advisers Act (IAA), 15 U.S.C.
§§ 80b-1 to -21 (1970). Congress acted after receiving a
report from the Securities and Exchange Commission which
showed that investment funds were organized by invest-
ment advisers; that the funds were administered under
contracts that where 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 per-
sons affiliated with the adviser. Congress found that nu-
merous practices in the management of such funds adverse-
ly 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
benefitted the managers and adversely affected the stock-
holders of the fund.’
The ICA provides that no more than 60% of a regis-
tered company’s board of directors can be ‘‘intereste.
persons’ affiliated with the investment adviser.” More-
over, it gives the statutorily disinterested directors, usually
referred to as *‘independent directors,’’ certain powers to
supervise management and auditing arrangements.” Thus,
* See SEC, Report on the Study of Investment Trusts and Invest-
ment Companies. pt. 3, 1-49, 1922 (1940). See also Comment,
Duties of the Independent Directors in Open-End Mutual Funds, 70
Mich.L.Rev. 696, 701 (1972).
* See 15 U.S.C. § 80a-1 (1970).
“See 15 U.S.C. §§ 80a-10, 80a-2(a)(3), (19) (1970).
* See generally Comment, Duties of the Independent Director in
Open-End Mutual Funds, 70 Mich.L.Rev. 696 (1972).
A. 45
Opinion of the Court of Appeals
section 15(c) of the ICA, 15 U.S.C. § 80a-15(c) (1970),
imposes on the disinterested directors the duty to review
and approve the contracts of the investment adviser and
the principal underwriter; section 16(b), 15 U.S.C. § 80a-
16(b) (1970), provides that the statutorily disinterested
directors will appoint other disinterested directors to fill
vacancies resulting from the assignment of the advisory
contracts; and section 32(a), 15 U.S.C. § 80a-31(a) (1970),
requires that the accountants who prepare the investment
company’s Securities and Exchange Commission financial
filings 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 complaint
could survive that approval.
Congress has not heen satisfied, moreover, that the
presence 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 to the ad-
viser and the priniepal underwriter. See 15 U.S.C. 6 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 disin-
terested directors on the boards of mutual funds was not
sufficient to protect funds against overreaching investment
advisers."”
See 1970 U.S.Code C & Admin.News, pp. 4897, 4901. In
1970 both the ICA and the IAA were substantially amended. Sce
Act of December 14, 1970, Pub.L. No. 91-547, 84 Stat. 1413.
— ~
eee
A. 46
Opinion of the Court of Appeals
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 ad-
visory contract without fully disclosing to the fund’s di-
rectors the ramifications of the changes. Writing for the
panel, Chief Judge Kaufman observed that, ‘‘[¢)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
selects its portfolio and administers its daily business.’’ Id.
at 808. See also Tannenbaum v. Zeller, 552 F.2d 402 (2d
Cir. 1977).
Moreover, in many instances where no specific authority
is granted by statute the courts have inferred that stock-
holders may bring suit. See, e.g., Abrahamson v. Flesch-
ner, 568 F.2d 862 at 873 (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 liability
which may amount to many millions of dollars, and fore-
close the stockholders from continuing such litigation, while
at the same time stockholders by statute are empowered
to recover excess fees paid the adviser and underwriter.
In the ordinary routine of running an investment trust,
the disinterested directors must constantly deal with inte-
rested directors in a spirit of accommodation. Indeed, they
are compelled for the most part to rely on the information
and expert advice provided by the adviser and the majority
directors."" The continued service of the statutorily disin- ~
'' See Comment, supra note 9, at 702.
A. 47
Opinion of the Court of Appeals
terested directors, for which in this case they were paid
from $11,000 to $13,000 per annum"?, depends almost entire-
ly on the establishment of satisfactory working arrange
ments between them and the majority responsible for their
selection, It 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 decision would be likely to result in con-
siderabie expense and liability for the individuals con-
cerned,.’* 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 re-
quires. It follows that disinterested directors of an invest-
ment company do not have the power to foreclose the con-
tinuation 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 company to termin-
ate a shareholder derivative suit which the court finds to be
frivolous.
Our conclusion makes it unnecessary to consider the find-
ings of the district court that the disinterested directors
were sufficiently independent to determine that the litigation
'2 In addition to their role as directors of the Fund, each of the
five minority directors served on the boards of five other Anchor
SS See eee a sat on a sixth Anchor
relat ,
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).
A. 48
Opinion of the Court of Appeals
be ended.'* We have no doubt that the five minority direc-
tors acted in good faith in all that they did.
Reversed and remanded for further proceedings.
'* 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 nature of the
investment company and its symbiotic relationship with its investment
adviser, smal odds cana a Ge Uieameen anen adie
by directors of other types Moreover, none of these
cases involves the situation ag my where the terminating directors owe
their position as directors to the defendants in the suit.
COMPLAINT
A. 49
Complaint
UNITED STATES DISTRICT COURT
SourHrrn District or New York
73 Civ. 552 (HFW)
tt.
a
Howarp M. Lasker and Irvine “oLpBERG,
Plaintiffs,
against
Harry G. Burks, Jr., Eowarp B. Burr, THomas F’. CHALKER,
Joun R. Hame, Harvey C. Hopkins, ©. P. Hutcutison,
DonaLp L. Kemmerer, A. S. Mrke Monroney, Cuarzes F.
Puiturs, JeptHa H. Wane, AncHor Corporation, and
FuNDAMENTAL Investors, Inc.,
Defendants.
4)
a
Puatntirrs Demanp TRIAL By Jury
Plaintiffs cllege on information and belief, except as to
Paragraphs 2 and 6, which are alleged upon knowledge by
each of said plaintiffs:
1. The jurisdiction of this Court over this action is
based upon Section 44 of the Investment Company Act of
1940 (15 U.S.C. § 80a-43), Section 214 of the Investment
Advisers Act of 1940 (15 U.S.C. § 80b-14) and principles of
pendent jurisdiction.
2. Plaintiff Howard M. Lasker is, and at the time of the
transactions complained of was, the beneficial owner of
shares of Fundamental Investors, Inc. (the ‘‘Fund’’).
A. 50
Complaint
Plaintiff Irving Goldberg is, and at the time of the trans-
actions complained of was, the record owner of shares of
the Fund. Plaintiffs bring this action derivatively on behalf
and in the right of the Fund.
3. The Fund is, and at the time of the transactions com-
plained of was, a corporation organized under the laws of
the State of Delaware and a registered investment company
under the Investment Company Act of 1940.
4. Defendant Anchor Corporation (the ‘‘ Adviser’’) is,
and at the time of the transactions complained of was, a cor-
poration organized under the laws of the State of Delaware
and a registered investment adviser under the Investment
Advisers Act of 1940.
5. Defendants 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 and Jeptha H. Wade (the ‘‘ Fund
directors’’) were directors of the Fund at all times men-
tioned.
6. This action is not brought collusively to confer upon
this Court jurisdiction which it otherwise would not have
and plaintiffs will fairly and adequately represent the inter-
ests of the Fund and its stockholders in enforcing the
Fund's rights.
7. (a) No demand has been made by the plaintiffs upon
the Board of Directors of the Fund to institute this action
against the individual defendants and the Adviser because
the Fund’s Board of Directors is dominated and controlled
by the Adviser and the individual defendants continue to be
a majority of the Fund’s Board of Directors and they have
A. 51
Complaint
participated, cooperated and aided and abetted in the
wrongful acts, transactions and delinquencies complained
of. No action could or would be permitted to be instituted
by the Fund without the consent of the Fund directors.
The Fund’s Board of Directors for a considerable time has
been fully aware of the wrongful acts herein alleged and has
nevertheless failed to take action. Consequently, any de-
mand upon the Fund’s Board of Directors would be futile
and useless and any such action that would be instituted by
the Board of Directors on behalf of the Fund would be
friendly to the defendants, would not be diligently prose-
cuted and would be hostile to the interests of the Fund and
its stockholders.
(b) No demand has been made upon the stockholders of
the Fund to institute this action on behalf of the Fund be-
cause under applicable law and the certificate of incorpora-
tion and by-laws of the Fund, its directors and officers are
vested with the management of the Fund, including the in-
stitution of all actions on behalf of the Fund, and the stock-
holders as a body cannot by resolution compel the directors
to institute suit on behalf of the Fund. A resolution by the
stockholders of the Fund directing the institution of this
action would be futile and useless because the prosecution
of the action would be placed in the control of the Fund’s
Board of Directors, the majority of whom are defendants
and who had knowledge of and participated, cooperated and
aided and abetted in the wrongs alleged herein. Further-
more, the stockholders of the Fund are very numerous and
the solicitation of proxies from such a large number of
stockholders would place an unreasonable and useless bur-
den and expense on plaintiffs, and extended delays would
result which would be harmful and seriously prejudicial to
the prosecution of this action.
A. 52
Complaint
Fimst Ciam ror Reuier
8. Plaintiffs repeat and reallege Paragraphs 1 through
7 of the Complaint.
9. This claim arises under Section 36 of the Investment
Company Act of 1940.
10. On the following dates and in the amounts indicated,
the Fund purchased interest bearing commercial paper of
Penn Central Transportation Company (‘‘ Penn Central’’)
in the Southern District of New York from Goldman, Sachs
& Co. (**Goldman, Sachs’’), which acted as principal, by
use of the mails and the means and instrumentalities of in-
terstate commerce:
Amount of
Date of Purchase Purchase
November 28, 1969 ............ $ 5,000,000
December 2, 1969 ............ 5,000,000
December 4, 1969 ............ 5,000,000
December 8, 1969 ............ 5,000,000
$20,000,000
11. At all relevant times the Fund directors were re-
sponsible for determining the basic investment policies of
the Fund and the Adviser acted as investment adviser to
the Fund and was responsible for making recommendations
to the Fund with respect to purchase and sale of all invest-
ments, including commercial paper. During 1969 the Ad-
viser received, pursuant to its investment advisory contract,
in excess of $4,500,000 from the Fund for investment super-
visory and corporate administrative services and in excess
of $300,000 in net sales commissions as principal under-
writer of the Fund’s shares.
A. 53
Complaint
12. In making the purchases alleged in Paragraph 10,
the Fund directors and the Adviser relied solely and ex-
clusively on Goldman, Sachs and made no independent in-
vestigation of the financial condition of Penn Central or
the quality of its commercial paper including, where feasi-
ble, among other things, the following: examination and
analysis of quarterly or more frequent financial statements ;
calculation of debt-equity ratios; obtaining of lists of open
bank lines of credit and inquiry as to whether any such
were used; calculation of the ratio of current assets to
current liabilities; examination and analysis of debt posi-
tion to check for defaults; review of the appropriate
Docket of the Interstate Commerce Commission with re-
spect to the proposed issuance of commercial paper by
Penn Central; verifying creditworthiness of issuer with
custodian bank; inquiry with respect to maximum amount
of bank lines of credit ever used; examination of percentage
of commercial paper outstanding backed by usable lines of
credit; obtaining cash flow statement, if available. In fail-
ing to make the foregoing investigation, the Adviser failed
to meet its responsibility as the Fund’s investment adviser,
for which investment management and advice it received
the very substantial compensation set forth in Paragraph
11. The Fund directors knew or should have known of, and
acquiesced in, the failure by the Adviser to meet its re-
sponsibility and failed to meet their responsibilities ax
members of the Fund’s Board of Directors.
13. If the Fund directors and the Adviser had made
an independent investigation of the financial condition of
Penn Central and the quality of its commercial paper in
connection with the Fund’s purchase of Penn Central com-
mercial paper (including a review of material available in
A. 54
Complaint
the public press), they would have learned at least the fol-
lowing material adverse facts.
(a) The commercial paper of Penn Central was
not prime quality commercial paper;
(b) Goldman, Sachs had made inadequate inde-
pendent investigation of the financial condition and
affairs of Penn Central and was not continually re-
viewing the same to ascertain whether Penn (Central
commercial paper was of prime quality or to eval-
uate the advisability of purchases of said commercial
paper by the Fund;
(c) Penn Central had for some time been facing
severe cash shortages and difficulties in obtaining
financing to meet its operating expenses, improve-
ment costs and debt maturities ;
(d) Penn Central had for some time been unable
to obtain long-term financing and had, since at least
as early as 1968, become almost completely depend-
ent upon short-term, high interest financing, had
been required to maintain substantial compensating
balances at its lending banks and had no present
prospects for obtaining long-term financing;
(ec) Penn Central had virtually exhausted all
possibilities to obtain bank loans, had already
pledged virtually all of its assets to its bank creditors
and had no assets to pledge or otherwise use to ob-
tain further loans or financing or to cover or meet
its commercial paper obligations ;
(f) Penn Central was using the funds which it
obtained from the sales of its commercial paper to
A. 55
Complaint
refinance its debt maturities rather than for its cur-
rent operating expenses ;
(x) Penn Central was undergoing extraordinarily
large and rapidly increasing operating losses and
working capital deficits ;
(h) During 1970 Penn Central would have to
have available far in excess of $200,000,000 merely
to meet debt maturities and interest costs and would
have to raise other substantial and unavailable sums
to meet its other anticipated expenses ;
(i) In an application by Penn Central to the
Interstate Commerce Commission for approval to
issue commercial paper, the Interstate Commerce
Commission and its staff had expressed serious con-
cern over the heavy dependence of Penn Central
upon short-term financing ;
(j) Penn Central had no firm commitments by
commercial banks to assure that it would have suffi-
cient funds to redeem its outstanding commercial
paper at maturity, and did not have bank lines of
credit sufficient for that purpose;
(k) Most banks were at or near their legal or
practical lending limits with respect to Penn Central
and were looking to reductions of their loans rather
than increases and it was highly doubtful that Penn
Central could obtain authorization from the Inter-
state Commerce Commission to issue additional com-
mercial paper beyond the $200,000,000 then author-
ized ;
(1) In November 1969 Penn Central reported a
loss of approximately $40,200,000 for the first nine
A. 56
Complaint
months of 1969 as compared to a loss of approxi-
mately $13,800,000 for the comparable period in
1968 ;
(m) On or about November 29, 1969, the Board
of Directors of Penn Central’s parent company
omitted that corporation’s regular fourth quarter
dividend.
14. On June 21, 1970 Penn Central filed a petition for
reorganization under Section 77 of the Bankruptcy Act (11
U.S.C. § 205).
15. The Penn Central commercial paper held by the
Fund was not paid at maturity and is presently in default
and the Fund has not received any payment with respect
to such commercial paper up to the date of this Complaint,
thereby resulting in a loss to the Fund of $20,000,000 plus
accrued interest.
16. By reason of the foregoing, defendants, in contra-
vention of Section 36 of the Investment Company Act of
1940, engaged in acts and practices constituting gross mis-
conduct and a gross abuse of trust in respect of the Fund.
Seconp CLam For Rewer
17. Plaintiffs repeat and reallege Paragraphs 1 through
7 and Paragraphs 10 through 15 of the Complaint.
18. This claim arises under Section 206 of the Invest-
ment Advisers Act of 1940.
19. By reason of the foregoing, the Adviser, in contra-
vention of Section 206 of the Investment Advisers Act of
A. 57
Complaint
1940, by use of the mails and the means and instrumentali-
ties of interstate commerce, engaged in transactions, prac-
tices and a course of conduct which operated as a fraud and
deceit upon the Fund and engaged in acts, practices and a
course of conduct which were fraudulent.
Turep Cuam For Reuier
20. Plaintiffs repeat and reallege Paragraphs 1 through
7 and Paragraphs 10 through 15 of the Complaint.
21. By reason of the foregoing, the defendants violated
their common law fiduciary duty to the Fund and are jointly
and severally liable and accountable to the Fund for all loss
and damage which it has suffered and will suffer by reason
of the acts, transactions and delinquencies complained of.
Fovurtsa Ciaim For Reiser
22. Plaintiffs repeat and reallege Paragraphs 1 through
7 and Paragraphs 10 through 15 of the Complaint.
23. By reason of the foregoing, the Adviser breached
its investment advisory contract with the Fund and the
Fund directors participated and aided and abetted in the
breach of said investment advisory contract in that the
Adviser failed to make an independent investigation of
the financial condition of Penn Central and the quality
and safety of its commercial paper and the Fund directors
acquiesced in such failure, thereby damaging the Fund as
alleged, and the defendants are jointly and severally liable
A. 58
Complaint
and accountable to the Fund for all loss and damage which
it has suffered and will suffer by reason of the breach of
the investment advisory contract complained of.
Fiera Cram For Revier
24. Plaintiffs repeat and reallege Paragraphs 1 through
7 and Paragraphs 10 through 15 of the Complaint.
25. This claim arises under Section 36 of the Invest-
ment Company Act of 1940.
26. From November 28, 1969 to June 21, 1970, the date
of the filing of a petition for the reorganization of Penn
Central under Section 77 of the Bankruptcy Act, the finan-
cial condition of Penn Central worsened steadily and Penn
Central commercial paper became an increasingly poor in-
vestment.
27. During the period from November 28, 1969 to June
21, 1970, the Adviser and the Fund directors failed to com-
mence a thorough and adequate investigation of, and keep
under continuous review, the financial condition of Penn
Central and the quality and safety of its commercial paper.
28. If such investigation and review had been made (in-
cluding a review of material available in the publie press),
the Adviser and the Fund directors would have learned at
least the material adverse facts, among others, set forth at
subparagraphs (a)-(m), inclusive, of Paragraph 13 of this
(Complaint as well as at least the following material adverse
facts:
(a) Penn Central’s losses for 1969 had increased
to approximately $56,300,000 from approximately
$5,100,000 for 1968;
A. 59
Complaint
(b) The losses of Penn Central for the first quar-
ter of 1970 were approximately $62,700,000 ;
(c) On or about February 12, 1970, Penn Central
repurchased at face value $10,000,000 of its com-
mercial paper from Goldman, Sachs;
(d) Penn Central had virtually exhausted its
ability to obtain short term financing in the United
States;
(e) Penn Central and its parent company had
begun to borrow heavily at high interest rates in Eu-
rope from borrowers who were relatively unsophisti-
cated about Penn Central ;
(f) On or about April 22, 1970, there commence!
a rapid run on Penn Central commercial paper ani
it became virtually impossible for Goldman, Sachs
to resell Penn Central commercial paper as it became
due ;
(g) On or about May 9, 1970, high Penn Central
officials met with the Secretary of the Treasury with
respect to emergency Government assistance for the
failing railroad ;
(h) On or about May 15, 1970 Standard and
Poor’s reduced the credit rating of Penn Central's
parent company from BBB to BB.
29. During the period from November 28, 1969 to June
21, 1970, the Fund directors failed in their obligations to
make adequate attempts to resell (as did Goldman, Sachs
as referred to in subparagraph (c) of Paragraph 28) the
Penn Central commercial paper held by the Fund and the
Adviser failed to advise the Fund of the advisability of
making such attempts.
a% <i
2 BW Ere oS
—_—_—e—_— =
A. 60
Complat
30. During the period frem November 28, 1969 through
June 21, 1970, the Adviser, pursuant to its investment ad-
visory contract, continued to be compensated by the Fund
for investment supervisory and corporate administrative
services at an annual rate in excess of $4,500,000 and con-
tinued to receive net sales commissions as principal under-
writer of the Fund’s shares at an annual rate in excess of
$300,000.
31. By reason of the foregoing, defendants, in contra-
vention of Section 36 of the Investment Company Act of
1940, engaged in acts and practices constituting gross mis-
conduct and a gross abuse of trust in respect of the Fund.
Sixtu Ciam For Revrer
32. Plaintiffs repeat and reallege Paragraphs 1 through
7, Paragraphs 10 through 15 and Paragraphs 26 through 30
of the Complaint.
33. This claim arises under Section 206 of the Invest-
ment Advisers Act of 1940.
34. By reason of the foregoing, the Adviser, in contra-
vention of Section 206 of the Investment Advisers Act of
1940, by the use of the mails and the means and instru-
mentalities of interstate commerce, engaged in transactions,
practices and a course of conduct which operated as a fraud
and deeeit upon the Fund and engaged in acts, practices and
a course of conduct which were fraudulent.
Seventu Cram For Reuier
35. Plaintiffs repeat and reallege Paragraphs 1 through
7, Paragraphs 10 through 15 and Paragraphs 26 through 30
of the Complaint.
A. 61
Complaint
36. By reason of the foregoing, the defendants violated
their common law fiduciary duty to the Fund and are jointly
and severally liable and accountable to the Fund for all loss
and damage which it has suffered and will suffer by reason
of the acts, transactions and delinquencies complained of.
Ercutx Cram For Revier
37. Plaintiffs repeat and reallege Paragraphs 1 through
7, Paragraphs 10 through 15 and Paragraphs 26 through 30
of the Complaint.
38. By reason of the foregoing, the Adviser breached its
investment advisory contract with the Fund and the Fund
directors participated and aided and abetted in the breach
of said investment advisory contract in that the Adviser
failed to commence a thorough and adequate uivestigation
of, and keep under continuous review, the financial condition
of Penn Central and the quality and safety of its commer-
cial paper and the Fund directors acquiesced in such failure,
thereby damaging the Fund as alleged, and the defendants
are jointly and severally liable and accountable to the Fund
for all loss and damage which it has suffered and will suffer
by reason of the breach of the investment advisory contract
complained of.
NiytH Cram For Revier
39. Plaintiffs repeat and reallege Paragraphs 1 through
17, Paragraphs 10 through 15 and Paragraphs 26 through
30 of the Complaint.
40. This claim arises under Section 13(a)(3) of the In-
vestment Company Act of 1940.
A. 62
Complaint
41. The Fund’s registration statement filed with the
Securities and Exchange Commission pursuaut to Section
8(b) of the Investment Company Act of 1940 states, as a
fundamental policy, that the Fund may not hold more than
10% of the securities (voting and non-voting) of any one
issuer.
42. During the period from November 28, 1969 to June
21, 1970, the date of the filing of a petition for reorganiza-
tion of Penn Central under Section 77 of the Bankruptcy
Act, the outstanding commercial paper of Penn Central
dropped from $200,000,000 to approximately $82,000,000.
43. The $20,000,000 of Penn Central commercial paper
held by the Fund constituted the holding of more than 10%
of the securities of a single issuer.
44. The Fund directors and the Adviser failed in their
responsibility to ascertain that the Fund’s holding of Penn
Central commercial paper deviated from the fundamental
policy set forth in the Fund’s registration statement filed
with the Securities and Exchange Commission pursuant to
Section 8(b)(2) of the Investment Company Act of 1940.
45. By reason of the foregoing, the defendants, in con-
travention of Section 13(a)(3) of the Investment Company
Act of 1940, caused the Fund to deviate from the fundamen-
tal policy recited in its registration statement filed with the
Securities and Exchange Commission pursuant to Section
8(b)(2) of the Investment Company Act of 1940.
Wuererore, plaintiffs demand judgment against the
defendants as follows:
(a) That the Fund directors and the Adviser be
required to account to the Fund for all loss and
A. 63
Complaint
damage sustained and to be sustained by the Fund
as a result of the wrongful acts, transactions and
delinquencies complained of.
(b) That plaintiffs recover the costs and dis-
bursements of this action including reasonable fees
to plaintiffs’ attorneys and accountants.
(c) That plaintiffs have such other and further
relief as may be just and proper.
Aranow, Bropsky, BoHLincer,
Benetar, Erxnnorn & Dann
By s/ Herpert A. Erxnnorn
(A Member of the Firm)
Attorneys for Plaintiffs
Office & P.O. Address
469 Fifth Avenue
New York, New York 10017
(212) 889-1470
(Verification )
PAPERS ON MOTION TO DISMISS
A. 65
Affidavit of Roger T. Wickers, Sworn to
January 27, 1975 in Support of
Motion to Dismiss
UNITED STATES DISTRICT COURT
Soutuern District or New York
73 Civ. 552 (HFW)
f.
Vv
Howarp M. Lasker, et ano.,
Plaintiffs,
against
Harry G. Burks, Jr., et al.,
Defendants.
ty
Vv
Srate or New York /
County or New York |
Rocer T. Wickers, being duly sworn, deposes and says:
1. I am Senior Vice President of Fundamental Inves-
tors, Ine. (‘‘Fundamental’’), the party on whose behalf
this derivative action is allegedly brought, and I submit
this affidavit in support of the motion by Fundamental to
dismiss this action.
2. I have personal knowledge of the facts set forth in
this affidavit, and I bring them to the attention of this
Court to supplement the principal moving affidavit of Leon
T. Kendall, sworn to January 23, 1975.
3. Fundamental is an open-end investment company
(commonly known as a ‘‘mutual fund’’) registered under
the Investment Company Act of 1940.
A. 66
Affidavit of Wickers in Support of Motion to Dismiss
4. Anchor Corporation (‘‘Anchor’’) is the investment
adviser to Fundamental.
5. On November 26, 1969 Fundamental, which had a
portfolio at that time worth approximately one billion
dollars, purchased from Goldman, Sachs & Co., a commercial
paper dealer, $20 million of 270-day notes of Penn Central
Transportation Company as a short-term investment of un-
employed cash.*
6. On June 21, 1970 Penn Central Transportation Com-
pany filed a Petition for Reorganization under the federal
bankruptcy laws, and the notes were not paid at maturity,
nor have they been paid to date. Penn Central Transporta-
tion Company is still in the process of being reorganized
under the jurisdiction of Honorable John R. Fullam, United
States District Judge for the Eastern District of Pennsyl-
vania.
7. On November 4, 1970 Fundamental initiated an action,
with three other plaintiffs,** in the United States District
Court for the Southern District of New York against Gold-
man, Sachs & Co. (‘‘the Welch action’’) for rescission of
the'r purchases of the notes of Penn Central Transporta-
tion Company. The Board of Directors of Fundamental has
kept this matter under continuous review since that time.
%. Nearly three vears after the purchase of the Penn
Central Transportation Company commercial paper by
Fundamental, two stockholders of Fundamental commenced
* The as actually made in four $5,000,000 amounts
on November 26, December 2, 4 and 8, 1969.
** The three other plaintiffs were Welch Foods Inc., C. R. An-
thony Company and Younker Brothers.
A. 67
Affidavit of Wickers in Support of Motion to Dismiss
the instant derivative action (‘‘the Lasker action’’) alleged-
ly on behalf of Fundamental, On July 30, 1973, on motion
of all defendants, Judge Gurfein stayed the Lasker action
pending the resolution of the claims of Fundamental in the
Welch action.
% On July 9, 1974 the claims of Fundamental in the
Welch action were settled as follows: Goldman, Sachs & Co.
took back the notes, paid Fundamental $5,250,000 in cash
and assigned to Fundamental a 73.75% interest in the pro-
ceeds of the $20 million of notes in the reorganization pro-
ceedings.
10. On July 24, 1974, following the settlement of the
claims of Fundamental in the Welch action, the Board of
Directors of Fundamental retained Honorable Stanley H.
Fuld, former Chief Judge of the State of New York as
Special Counsel to advise and consult with it regarding this
matter.
11. On December 18, 1974 and January 6, 1975, the
Board of Directors of Fundamental met at special meetings.
Following the deliberations, described in detail in the Ken-
dall affidavit, by a wholly disinterested quorum consisting
of five members of the Board of Directors,* none of whom
was a director at the time of the events complained of and
none of whom is a defendant in the Lasker action, the Board
of Directors, acting solely by these five wholly disinterested
persons, resolved that it was not in the best interests of
the shareholders of Fundamental for the Lasker action to
* The five wholly disinterested directors are: Leon T. Kendall,
ge Laun, Mary S. O'Connor, Beryl Robichaud and William
ephens.
A. 68
Affidavit of Wickers in Support of Motion to Dismiss
continue against Anchor and the other defendants, and in-
structed litigation counsel to Fundamental in this action
(Messrs. Seward & Kissel) to move to dismiss this action.
All other defendants have joined in this motion by
Fundamental.
ConcLusiIon
The Board of Directors of Fundamental, acting by a
wholly disinterested quorum, has determined that in its
business judgment, this action allegedly brought on behalf
of Fundamental is contrary to the best interests of Funda-
mental and its shareholders. Accordingly, this action
should be dismissed.
s/ Rocer T. WickKers
Sworn to before me
January 27, 1975
A. 69
Affidavit of Leon T. Kendall, Sworn to January 23, 1975,
in Support of Motion to Dimiss
UNITED STATES DISTRICT COURT
Sovtnern District or New York
73 Civ. 552 (HFW)
f).
~~
Howarp M. Lasker, et ano.,
Plaintiffs,
against
Harry G. Burks, Jr., et al.,
Defendants.
nH.
“”
State or New York
County or New York
Leon T. Kenpa, being duly sworn, deposes and says:
1. I am a director of Fundamental Investors, Ine.
(‘‘Fundamental’’), the mutual fund on whose behalf this
derivative action has allegedly been brought. I am fully
familiar with the facts set forth below and make this affi-
davit in support of Fundamental’s motion to dismiss this
action. The basis of this motion is that by unanimous vote
the Board of Directors of Fundamental (acting by a wholly
disinterested quorum) determined that this action is con-
trary to the best interests of the shareholders of Funda.
mental.
2. I attended the meeting of the Board of Directors of
Fundamental held on July 24, 1974. Following a discussion
of the settlement of Fundamental’s action against Goldman,
Sachs & Co. (‘‘the Welch action’’), the Board of Directors
reviewed the status of this action. The Board of Directors
determined that the five directors who (a) are not affiliated
in any way with the investment adviser, Anchor Corpora-
tion (‘‘Anchor’’), (b) were not directors at the time of the
events alleged in the complaint and (c) are not defendant»
in this action (‘‘the five disinterested directors’’) would.
<=
a?
A. 70
Affidavit of Kendall in Support of Motion to Dismiss
acting as a quorum pursuant to the by-laws, constitute th
Board of Directors to decide what position Fundamental
should take regarding this action.
The Five Disinterested Directors
+. For the Court’s information, the following is a brief
description of the five disinterested directors, together with
the vear in which each became a director:
Year
Elected
Name to Board Background
Leon T. Kendall 1974 President of Mortgage Guaranty
Insurance C Milwaukee,
Wisconsin (a York Stock Ex.
change listed compan a with assets
approaching $800,000,000). Vice
President and Economist of the New
York Stock Exchange from 1964 to
1967. President of the Association
of Stock Exchange Firms from 1967
to 1972 and thereafter President of
The Securities Industry Association
until 1974.
Lovis F. Laun 1971 Deputy Administrator of the Small
Business Administration, Washing-
ton, D.C.; until 1971, Vice President
of Celanese C ion, manufac-
turer of synthetic fibers.
Mary S. O'Connor 1972 Director and Member of the Execu-
tive and Trust Committees of the
Central Home Trust Company of
Elizabeth, New Jersey, since 1959;
Assistant Vice President of Interna-
tional Business Machines
tion from 1943 to 1947.
Dr. Beryl Robichaud 1973 Senior Vice President, McGraw-Hill,
Inc., New York, New York. Direc-
tor, Aetna Life and Casualty Corpo-
ration.
William J. Stephens 1973 Director, Jones and
A.71
Affidavit of Kendall in Support of Motion to Dismiss
Retention of Chief Judge Fuld as Special Counsel
4. To assist in our consideration, at the July 24 meet-
ing, we five decided to retain special counsel. Pursuant to
that decision, after reviewing his background and qualifica-
tions, we retained Hon. Stanley H. Fuld, former Chief
Judge of the State of New York, to review all of the rele-
vant aspects of this matter and to analyze the pertinent
facts and relevant law and authorities. A copy of a bio-
graphical sketch of Chief Judge Fuld is attached as Exhibit
A.
5. After several months of investigation, Chief Jud:
Fuld reported the results of his analysis of the facts and
law in a memorandum dated December 5, 1974, a copy of
which is attached as Exhibit B. Chief Judge Fuld reported
that he had reviewed the complaint in this action and the
relevant documents and depositions in the Welch action.
He had also reviewed the files of Fundamental and Anchor
relating to the purchase of the Penn Central commercial
paper, and interviewed officers of Fundamental and Anchor
who had knowledge of the relevant events. In addition,
Chief Judge Fuld reviewed the corporate documents of
Fundamental, studied the applicable statutes and regula-
tions and conducted the necessary legal research.
Oy Chief Judge Fuld advised us that
“Asa 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 provision of
statute or of any common law or contractual obliga-
tion to the Fund, in connection with the acquisition
and retention of the Penn Central commercial pa-
per.’’ (p. 2).
A. 72
Affidavit of Kendall in Support of Motion to Dismiss
7. After receiving Chief Judge Fuld’s December 5,
1974 opinion, each of us carefully reviewed it and several
of us had questions regarding the subjects covered in the
opinion and the alternatives which were available to the
directors of Fundamental.
8. In response to questions raised by the five disinter-
ested directors and on further review of his own, on Decem-
her 18, 1974 Chief Judge Fuld delivered a supplemental
analysis and opinion to the Board. A copy of his supple-
mental analysis and opinion is annexed as Exhibit C. Chief
Judge Fuld had advised in his December 5 memorandum
that it was up to the five disinterested directors, in the
exercise of their discretion and business judgment, to de-
termine what course Fundamental should follow. As previ-
ously noted, Chief Judge Fuld had advised us that in his
opinion there was no violation of law by Anchor or by the
directors of Fundamental. In his supplemental opinion, he
went on to add that even if there were a possible claim, Fun-
damental did not necessarily have to prosecute that claim:
he advised us 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.
The December 18, 1974 Meeting:
Exploration of the Facts and Law
9. After receiving Chief Judge Fuld’s supplemental
opinion of December 18, 1974, the five disinterested directors
met alone in a series of special meetings devoted exclusively
to this subject. In that first special meeting I was desig-
A. 73
Affidavit of Kendall in Support of Motion to Dismiss
nated to be Chairman of the five disinterested directors.
We reviewed the supplemental opinion and discussed fur-
ther the questions each of us had with respect to the facts,
the law and the alternatives available. We also determined
the procedure we would follow in conducting our inquiry,
including the subjects to be dealt with, the order in which
we would deal with them and whom we would question.
10. Following our private discussion, we invited the
following persons to join the special meeting for the pur-
pose of responding to our questions: Chief Judge Fuld;
John R. Haire, Chairman and Chief Executive of Anchor;
Donald L. Kemmerer and Charles F.. Phillips, who are, and
at the time of the events complained of, were unaffiliated
directors of Fundamental; and Eugene P. Souther, Esq.,
litigation counsel to Fundamental in this action. As Chair-
man, I presided at that meeting and Mr. Souther served as
Secretary. Minutes of that special meeting are annexed
as Exhibit D.
11. The attached minutes show the order in which we
proceeded ix that meeting and the substance of our dis-
cussions. Eaeh of us had given substantial consideration
to the issues in preparation for the meeting and we pursued
our questions in what I believe was a thoughtful and search-
ing fashion.
12. The five disinterested directors asked Chief Judge
Fuld, among other things, for his opinion as to (a) the
merits of each of the claims made in this action, (b) whether
Anchor had followed proper procedure under the cireum-
stances at the time in determining to purchase and retain
the Penn Central commercial paper, (¢c) the standards the
A.74
Affidavit of Kendall in Support of Motion to Dismiss
five disinterested directors should apply in determining
what course of action to pursue, and (d) the alternatives
available to the Board. Chief Judge Fuld gave us his
opinion on these subjects and emphasized that in making
our decision we should exercise our good faith business
judgment as to what was in the best interests of the share-
holders of Fundamental.
15. Our questions to Mr. Souther pertained to the practi-
eal implications of each alternative. We discussed the
nature and extent of pre-trial discovery and trial prepara-
tion to be expected, the cost, and the business interruption
that might be experienced by Anchor and how that might
adversely affect the interest of the shareholders of Funda-
mental. We also discussed the effect, if any, of the earlier
decision of the Board of Directors to settle its case against
Goldman, Sachs, and the subsequent jury award to the re-
maining plaintiffs in the Welch action.
14. We then interrogated John Haire. Our discussions
with him are summarized in the annexed minutes and, to
avoid repetition, will not be detailed here. Suffice it to say
that the five disinterested directors had thought long and
hard about the questions before them. All of us had care-
fully reviewed Chief Judge Fuld’s thoughtful analysis. So
armed, and with the advantage of hindsight, we critically
examined the decision to purchase the Penn Central com-
mercial paper, the information available to Anchor at the
time, the consideration Anchor gave before purchasing that
paper, the procedure Anchor followed in making the in-
vestment, the information available to the Board of Di-
rectors at the time with respect to that purchase and other
purchases of commercial paper, the identity of other ‘‘so-
A. 75
Affidavit of Kendall in Support of Motion to Dismiss
phisticated investors’? who had purchased Penn Central
commercial paper during the relevant period, the identity
of those purchasers of such paper who held it at the time
of the Penn Central reorganization, the anticipated effect
on the shareholders of Fundamental if this action were to
be prosecuted either under the control of Fundamental or
under the control of the two shareholders who brought it,
the anticipated effect on the investment adviser from the
continued prosecution of the action and how that would
affect Fundamental’s shareholders, and the ability .*
Anchor to respond in damages should a judgment against
it be obtained.
15. After excusing Messrs. Phillips, Kemmerer and
Haire, we five continued our discussion with Chief Judge
Fuld, reviewing the subjects which had been considered
during the earlier part of the meeting and the criteria we
should apply in reaching our decision.
16. When there were no more questions, we excused
Chief Judge Fuld and Mr. Souther. In that private portion
of the meeting we agreed that we wished to give further
consideration to the subject and adopted a procedure for
that consideration. Each director would give further separ-
ate thought to the matter and convey any additional ques-
tions to me for response. IT was to secure replies to these
questions through our special counsel and litigation counsel.
We agreed not to have any contact with anyone affiliated
with Anchor until we had reached our decision.
December 18, 1974—January 6, 1975: Further
Reflection by the Disinterested Directors
17. During late December and early January I per-
sonally spoke by telephone with each of the other four dis-
A. 76
Affidavit of Kendall in Support of Motion to Dismiss
interested directors and gathered the questions they wanted
answered. Indicative of the consideration we were each
giving to the matter is the letter written to each of us by
William J. Stephens on December 31, 1974. A copy of that
letter is attached as Exhibit E.
18. I reviewed the questions for Chief Judge Fuld in
a conference call with him and Mr. Souther on January 3,
1975. The essence of that conversation was to reconfirm
that we were to make our decision, whatever it was to be,
in the exercise of our good faith business judgment as to
what was in the best interests of the shareholders of Funda-
mental. Because the telephone connection at times was not
satisfactory, I thereafter personally spoke with Chief Judge
Fuld and repeated the discussion.
The Meeting of January 6, 1975:
The Vote to Dismiss
19. The second special meeting of the Board of Di-
rectors to review this subject was held on January 6, 1975.
The other directors present were: Louis F. Laun, Dr. Beryl
Robichaud and William J. Stephens. Mrs. Mary 8. O’Con-
nor was abroad, but she and I had spoken by telephone and
she had told me her decision as to the action Fundamental
should take. In addition, Mr. Souther was also present to
act as Secretary of the meeting.
20. Following the review and approval of the minutes
of the first special meeting, I reported to the Board the
events that had transpired since our last meeting, including
my telephone conversation on January 3 with Chief Judge
A.77
Affidavit of Kendall in Support of Motion to Dismiss
Fuld. Mr. Souther then replied to certain questions from
Board members. The questions and his answers are sum-
marized in the minutes of that special meeting, a copy of
which is attached as Exhibit F. We all confirmed that we
had not communicated with any officer or employee of
Anchor since the December 18, 1974, special meeting.
21. We then reviewed in detail each of the alternatives
available to Fundamental. Our consideration is summarized
in the minutes of the meeting. Our overriding and only con-
sideration was what course was in the best interests of the
shareholders of Fundamental.
22. We decided that the prosecution of this action was
contrary to the best interests of the shareholders of Funda-
mental and that counsel should be directed to seek to dismiss
the action. Among the factors we considered were:
(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 Anchor, distrac-
tion of its personnel and the likely inability for it to
attract and maintain personnel during pendency of
the action necessarily would be harmful to the share-
holders of Fundamental ;
(c) If the action were to proceed against Anchor
with the acquiescence or under the control of Funda-
mental, the adversary relationship that would be
created between Fundamental and Anchor and the
attendant serious distraction of Anchor’s personnel
from their efforts on behalf of the shareholders of
Fundamental would leave us no practical alternative
A. 78
Affidavit of Kendall in Support of Motion to Dismiss
but to remove Anchor as investment adviser and to
seck to retain a new investment adviser; this would
necessarily result in delay, uncertainty and an inevit-
able lapse in the management of Fundamental’s af-
fairs to the serious detriment of its shareholders ;
(ad) Anchor had acted in good faith and in what
it believed was in the best interests of Fundamental’s
shareholders in purchasing the Penn Central com-
mercial paper ;
(e) Anchor had acted reasonably and had fol-
lowed procedures prudent at the time in light of the
then generally held belief that commercial paper was
equivalent to cash;
(f) A vast number of other institutional investors,
including many major banks in New York City and
throuvhout the country and certain major mutual
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 for 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
A. 79
Affidavit of Kendall in Support of Motion to Dismiss
statutes and regulations. Chief Judge Fuld had
analyzed 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 ae-
tion 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 defend-
ants, who would be entitled to reimbursement of
counsel fees if they were found not to be liable to
Fundamental: and
(j) Even if there were a recovery of the theoreti-
cal maximum amount of damages, the net result to
the shareholders of Fundamental would be little more
than a net recovery of 10 cents per share, or approxi-
mately 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 Funda-
mental’s shareholders which proceeding with this
action might produce.
23. After several hours of consideration, on motion of
Mr. Louis F. Laun, seconded by Dr. Beryl Robichaud, the
five disinterested directors (Mrs. O’Connor’s vote being
cast by me in accordance with her instructions to me")
unanimously deeided to instruct counsel to move to dismiss
the action as being contrary to the best interests of the
shareholders of Fundamental.
* Mrs. O'Connor reaffirmed her vote in the presence of all of us at
a special meeting held for that purpose on January 22, 1975.
A. 80
Affidavit of Kendall in Support of Motion to Dismiss
24. I therefore respectfully urge that this Court grant
Fundamental’s motion to dismiss the complaint.
s/ Leon T. Kenpaui
Sworn to before me
January 23, 1975
Central commercial paper. At the outset I set forth the
relevant facts which, despite the volume of material in-
volved, may be summarized relatively briefly, and then
consider the applicable law and the possible courses of
action to be followed by the current Fund directors.
Facts
The Fund has in recent years had large amounts of
cash on hand, partly to be available to pay for securities
1 The action by the Fund resulted in a settlement described below
(infra, p. 9).
A. 81
Exhibit B to Affidavit of Leon T. Kendall, sworn to January 23,
19753—Report of Stanley H. Fuld to Board of Directors of
Fundamental Investors, Inc. dated December 5, 1974
(Letterhead of)
STANLEY H. FULD
425 Park Avenue
New York, N.Y. 10022
December 5, 1974
PRIVILEGED AND CONFIDENTIAL
Board of Directors
of Fundamental Investors, Ine.
Westminster at Parker
Elizabeth, New Jersey
Dear Sirs:
In November and December of 1969, Fundamental In-
vestors, Inc. (the ‘‘Fund’’) purchased, in four separate lots,
commercial paper of Penn Central Transportation Com-
pany (‘‘Penn Central’’) from Goldman, Sachs & Co., in the
aggregate amount of $20,000,000. On June 21, 1970, Penn
Central filed a petition for reorganization under Section 77
of the Bankruptcy Act, and the commercial paper was not
paid at maturity.
In February, 1973, a stockholders’ derivative suit was
brought against Anchor Corporation (*‘ Anchor’’), the Fund
and the directors of the latter, based in substance on the
claim that Anchor (the Fund’s investment adviser) and the
Fund’s directors, in both the purchase and the retention of
the Penn Central commercial paper, breached statutory and
other obligations to the Fund by virtue of the fact that they
‘*relied solely and exclusively on Goldman, Sachs and made
no independent investigation of the finances of Penn Cen-
tral or the quality of its commercial paper.’’ (see p. 10 be- »
low).
A. 82
Fuld Report
You retained me as special counsel to advise you with
respect to the future course of action to be followed in
connection with the investment made by the Fund in the
commercial paper of Penn Central.
I have reviewed the complaint in the derivative action,
the relevant pleadings and depositions in the action entitled
‘*Welch Foods, Inc., et al. v. Goldman, Sachs & Co.”’
brought by several parties, including the Fund, in the
United States District Court for the Southern District of
New York.' I have also had the files of the Fund and of
its adviser, Anchor, relating to the purchase of that com-
mercial paper reviewed. I have interviewed certain officers
and employees of the Fund and have also had certain other
officers and employees of the Fund interviewed, the Fund’s
constituent documents and the applicable statutes and
regulations reviewed, and the necessary legal research
conducted,
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 provision of statute or of any
common law or contractual obligation to the Fund, in con-
nection with the acquisition and retention of the Penn
Central commgfcial Paper. At the outset I set forth the
which, deSpite the volume of material in-
be summarized relatively briefly, and then
consider the applicable law
relevant facets
volved, may
and the possible courses of
action to he followed by tha curreut Fund directors.
Facts
The Fund has in recent years had large amounts of
cash on hand, partly to be available to pay for securities
1 The action by the Fund resulted in a settlement described below
(infra, p. 9).
A. 83
Fuld Report
which the Fund managers found it desirable to purchase,
and partly to be available for redemptions of Fund shares.
During the latter part of 1965 Anchor, in order to increase
the Fund’s income, began to invest part of its temporarily
idle cash in commercial paper. Responsibility for deter-
mining the amounts and maturities of the commercial
paper purchased was placed in the office of the Fund’s
Treasurer, an employee of Anchor, who, in consultation
with the various Fund managers and in the light of their
projected purchases and of other cash needs of the Fund,
decided how much money could be invested and for how
many days.
Until the Fall of 1969 all commercial paper was pur-
chased directly from among a group of eight issuers ini-
tially selected and approved by the Fund’s Investment
Committee.* In order to provide added liquidity in case of
an unexpected need for cash by the Fund, the Treasurer
insisted that each issuer agree to repurchase its paper
from the Fund on demand. Purchases were made on vir-
tually a daily basis, and officials of these issuers were in
frequent telephone communication with the Fund’s Treas-
urer, to negotiate the amounts, rates and maturities of
paper which might be purchased by the Fund. Because he
was continually purchasing paper from these companies,
the Treasurer sought, through periodic questioning of
these officials, review of published quarterly financial state-
ments and inquiry of the Fund’s bank custodian, to keep
current on the credit status of the issuers, including the
* These eight companies were among the nation’s major finance
companies: General Motors Acceptance Corporation, Sears Roebuck
Acceptance Corp., Montgomery Ward Credit Corp., J. C. Penney
Credit Corporation (now J. C. Penney Financial Corporation), C.1.T.
Financial Corporation, Commercial Credit Co., Ford Motor Credit
Company, and Chrysler Financial Corporation
A. 84
Fuld Report
extent of their outstanding commercial paper and of their
unused bank lines.
From time to time Anchor was solicited by dealers who
sought to sell to the Fund the commercial paper of indus-
trial companies which did not sell their paper directly.
Initially the paper sold by dealers offered substantially the
same rate of return as that of direct issuers, but afforded
less flexibility since the amounts, rates and maturities were
fixed in advance whereas direct issuers could negotiate by
telephone concerning these matters in order to meet the
Fund’s needs on a given date.
By the Fall of 1969 the rate differential, or rate of re-
turn spread, between dealer and direct paper had widened
and the volume of paper and the variety of issuers offered
by dealers increased to the point where the Fund’s specific
needs could be met. Arthur M. Kesselhaut, the Fund’s
Treasurer, brought this to the attention of John Haire,
President of Anchor and of the Fund, and suggested that
some dealer-placed commercial paper be purchased for the
Fund. Haire approved the making of purchases from
dealers, provided that certain guidelines were adhered to,
similar to those followed in connection with purchases
made directly from issuers. These were principally that
the paper should bear a National Credit Office rating of
‘*prime’’, no more than 10% of the outstanding paper of
any issuer should be purchased, and the dealer should agree
to repurchase the paper at the Fund’s request. Kesselhaut
discussed these requirements with representatives of Gold-
man, Sachs & Co., Lehman Commercial Paper Incorporated
and A. G. Becker & Co. Incorporated, large dealers in
commercial paper. In addition to the requirements stated
above, he also insisted that the issuer be listed on a na-
tional securities exchange.
A. 85
Fuld Report
In the course of his discussions with Goldman, Sachs &
Co., Kesselhaut was told that ‘‘each company they [Gold-
man, Sachs] represented was analyzed by a credit man
at Goldman and that they had current financial information
on every company they represented’’, the implication to
him being that they ‘‘knew as much about the company as
could be known’’. Kesselhaut understood that the two other
dealers likewise made a current credit analysis of the com-
panies whose paper they offered.
Several weeks after the Fund had begun to purchase
paper from dealers, a representative of Goldman, Sachs &
Co. called and offered Arthur Burach, Kesselhaut’s assist-
_ant, $20 million of commercial paper of each of Penn Central
and Chrysler Corporation, yielding 9% for 270 days (the
maximum maturity of such paper). Kesselhaut was inter-
ested in the offer since he believed that interest rates had
turned downward and would continue to fall, and he saw an
opportunity to obtain a favorable rate of interest for a
maximum period.
The approval of one of the three Fund managers was
normally required in connection with each purchase of com-
mercial paper, but because of the size and duration of the
proposed purchase a conference was held, attended by
Robert Daniel (chairman of Anchor’s Investment Com-
mittee), Kesselhaut, and all three of the Fund managers,
Robert Baines, Ronald Welburn and Bryant Hanley.’ The
discussion dealt with the principle of a purchase of 270-day
paper as well as the availability of the cash required, and
the two purchases were approved from this point of view.
However, since net all the cash was immediately available
* This is Kesselhaut’s firm recollection. When interviewed, Baines
and Welburn did not recall the meeting but acknowledged that they
had either initialled approval of the purchase or had been told of the
purchase shortly after it was made.
A. 86
Fuld Report
a schedule of purchases of Penn Central paper was adopted,
with $5 million each to be purchased on four separate occa-
sions at intervals of several days during the period Novem-
ber 28, 1969 to December 8, 1969. The $20,000,000 of
Chrysler paper was likewise to be purchased in four equal
$5,000,000 installments at about the same time. The finan-
cial condition of Penn Central was not discussed.
In making purchases of commercial paper from dealers,
including the Penn Central paper, Kesselhaut believed that
the Fund was sufficiently protected by (i) the ‘‘ prime”? rat-
ing given by the National Credit Office, one of the principal
national rating organizations, (ii) the current credit analysis
of each issuer which—based on representations by Goldman,
Sachs & Co. and the other dealers—he believed was being
performed by the dealer and formed the basis for the
dealer's recommendation which he understood was implicit
in its offer of the paper, (iii) the short-term nature of the
investment, (iv) the fact that the issuer was a listed com-
pany whose name he reeognized and the Fund managers
were likely to also recognize, and (v) the likelihood that the
Fund manager who approved the purchase would have
alerted him to any seriously adverse information which he
possessed about the issuer and which Kesselhaut himself
might not have had. Beeause of this belief that the criteria
established by Anchor provided sufficient protection—a
belief buttressed by the financial community’s general ac-
ceptance of commercial paper as a safe money-market in-
strument——-Kesselhaut did not undertake, or have any other
employee of Anchor perform, an independent analysis of the
financial condition of issuers (including Penn Central)
whose paper was offered to him by dealers, or any continu-
ing review during the period in which the purchased paper
was held by the Fund.
A. 87
Fuld Report
An article appeared in the May 18, 1970 issue of Bar-
ron’s entitled ‘‘Beautiful Balloon? Rapid Growth of the
Commercial Paper Market May Be Risky.’’ The article
did not mention Penn Central but expressed a general con-
cern about the safety of commercial paper. Prompted by
the article, the Fund sought to reduce the amount of its
Penn Central and Chrysler commercial paper holdings by
requesting Goldman, Sachs & Co. to repurchase half of both
holdings, but Goldman, Sachs refused to repurchase the
Penn Central paper.
As stated earlier, on June 21, 1970 a petition for re-
organization of Penn Central was filed and its commercial
paper was not paid at maturity.
The Action Against Goldman, Sachs & Co.
Late in 1970 the Fund and three other parties com-
menced a suit against Goldman, Sachs & Co. in which the
Fund sought to recover its $20 million investment. The
complaint alleged that, in connection with the sales of Penn
Central commercial paper, Goldman, Sachs made numerous
misstatements of material facts and omitted to state numer-
ous material facts in violation of Section 12(2) and Section
17(a) of the Securities Act of 1933, Section 10(b) of the
Securities Exchange Act of 1934, Section 352-e of the Gen-
eral Business Law of the State of New York, and the com-
mou law. In July, 1974, the Fund with the approval of its
full Board of Directors settled its suit against Goldman,
Sachs, and received $5,250,000 in cash; although the Fund
also retained a 73.75% interest in the commercial paper
whch will make it whole if the notes are paid, the likelihood
of any additional amounts being recovered as a result of
this settlement is, at the present time, uncertain.
A. 88
Fuld Report
The three other plaintiffs in the action pressed the case
to trial, and on October 9, 1974 a jury verdict was rendered
in their favor for $3,000,000—the amount of their loss—plus
interest. The jury, in reaching this verdict, must of neces-
sity have concluded that Goldman, Sachs & Co. had withheld
from its customers material non-public information concern-
ing Penn Central.
The Derivative Action
In February, 1973 a derivative action entitled Lasker et
al. v. Burks et al. was commenced by two shareholders of the
Fund in the United States District Court for the Southern
District of New York against Anchor and all of the directors
of the Fund who were in office when the Penn Central paper
was purchased and held. The Fund is a nominal defendant
in the suit.
The complaint alleges that the Fund’s purchases of the
Penn Central paper were made by Anchor and the Fund’s
directors in sole reliance upon Goldman, Sachs & Co., with-
out an independent investigation of Penn Central’s financial
condition or the quality of its commercial paper, and that
such an investigation would have revealed a number of ma-
terial adverse facts concerning Penn Central. The failure
to make such an investigation is alleged to constitute a fail-
ure by Anchor to meet its responsibilities as the Fund’s
adviser; and it is also alleged that the Fund directors knew
(or should have known) of, and acquiesced, in Anchor’s
failure to meet its responsibilities.
The complaint further recites that Anchor and the Fund
directors failed to conduct a continuous review of the finan-
cial condition of Penn Central subsequent to the purchase
of the paper—which review would have revealed a number
of other material advexse facts—and that they failed to
make adequate attempts to resell the paper.
es meee
ae av
A. 89
Fuld Report
It is asserted that the foregoing conduct was in violation
of (i) Section 36 of the Investment Company Act of 1940,
(ii) Seetion 206 of the Investment Advisers Act of 1940,
(iii) the defendants’ common law fiduciary duty to the
Fund, and (iv) the terms of the advisory contract between
Anchor and the Fund.
Finally, the complaint alleges that, when the amount of
Penn Central commercial paper outstanding fell far below
the initial $200,000,000, the Fund’s holdings became much
more than 10%, thus violating the Fund’s fundamental pol-
icy that it would not ‘‘hold’’ more than 10% of the ‘‘out-
standing securities’’ of a single issuer. This is claimed to
constitute a violation of Section 13(a)(3) of the Investment
Company Act of 1940.
The Lasker suit had been stayed pending the resolution
of the suit brought by the Fund against Goldman, Sachs &
Co., and the defendants (including the Fund) have not yet
filed their answers. With the settlement in the latter suit
concluded, the plaintiffs in the derivative suit have indi-
eated their intention to carry it forward.
Discussion oF Law
The complaint in the derivative action sets forth what
appear to be all of the possible grounds for asserting liabil-
ity against Anchor and the Fund directors for the loss
which the Fund incurred because of its purchase of the
Penn Central commercial paper (the ‘‘Penn Central loss’’).
Accordingly, in considering whether such liability exists and
if so what action you should take in order to enforce it, I
shall treat the various claims contained in the complaint.
A. 90
Fuld Report
Section 36 of the Investment Company Act
It is my opinion that neither Anchor nor any Fund direc-
tor is liable to the Fund under Section 36 of the Investment
Company Act of 1940 for the Penn Central loss.
Section 36—as it read at the time of the Fund’s pur-
chase of the Penn Central paper and until after the Penn
Central bankruptey proceedings were begun—authorized
the Securities and Exchange Commission to bring an action
against an officer, director or investment adviser of a regis-
tered investment company for ‘‘gross misconduct or gross
abuse of trust in respect of ‘‘the investment company. A\l-
though Section 36 expressly provides for actions to be
brought by the Commission, the courts have held that pri-
vate suits may likewise be brought under its provisions.
Brown v. Bullock, 194 F. Supp. 207 (S.D.N.Y. 1961), aff'd.
294 F.2d 415 (2d Cir. 1961); Moses v. Burgin, 445 F.2d 369
(1st Cir. 1971).
It seems clear—from the legislative history of Section
36, from a 1970 amendment to that section, and from
judicial interpretation—that the use of the language ‘‘ gross
misconduct or gross abuse of trust’’ was deliberate and was
designed to cover the type of conduct it explicitly describes
and not mere negligence. Initially, Section 36 was drafted
so as to make the proseribed conduct a criminal act, and the
word ‘‘gross’’? was ‘‘added to insure that only the more
serious kinds of abuse’’, not mere negligence, ‘‘would be
subject to sanctions’? and render a person guilty of a crime.
See Eisenberg & Phillips, ‘‘Mutual Fund Litigation—-New
Frontiers for the Investment Company Act,’’ 62 Columbia
Law Review 73, 99. Although the criminal sanctions were
removed from the draft bill and replaced by the provision
for actions brought by the Commission, the language de-
scribing the prohibited conduct remained. In Rosenfeld v.
ee ee
A. 91
Fuld Report
Black, 445 F.2d 1337 (2d Cir. 1971), although the court held
that an investment adviser to a mutual fund violated a
fiduciary duty when it realized profits in connection with the
appointment of a new adviser upon its recommendation, the
court did not predicate its decision on Section 36, saying of
that provision (p. 1346):
‘*Words and remedies such as these were clearly ad-
dressed to highly reprehensible conduct [citation
omitted]; we would not dream of suggesting, much
less holding, that [the adviser’s] actions were so
culpable.’’
Indeed, an amendment to Section 36, made in December
1970—about a year after Anchor had purchased the Penn
Central paper and some six months after the petition for its
reorganization had been filed—serves to point up the dis-
tinction between Section 36’s earlier standard of ‘‘ gross’
misconduct or ‘‘gross’’ abuse of trust and mere ‘‘nonfeas-
ance of duty’? or the like. The amendment, added a new
subsection ‘*(b)’’ dealing with a breach of fiduciary duty in
connection with the adviser’s compensation, and at the same
time deleted, from what became subsection ‘*(a)’’, the
words ‘‘gross misconduct or gross abuse of trust’’ and au-
thorized Commission action where there is ‘ta breach of
fiduciary duty involving personal misconduct’’. In explain-
ing the change, the Senate Committee on Banking and Cur-
reney wrote (Part F, Senate Report No. 91-184 to Accom-
pany S. 2224 at 36):
‘;@ * @
your committee does not intend to limit the
Commission under this section to situations where an
actual intent to violate the law can be shown or to
acts of affirmative misconduct. In appropriate cases,
A. 92
Fuld Report
nonfeasance of duty or abdication of responsibility
would constitute a breach of fiduciary duty involving
personal misconduct.’’ (emphasis supplied)
Under these circumstances I conclude that even if—con-
trary to the opinion expressed herein—Anchor were deemed
to have breached an obligation to the Fund in relying to the
extent it did on Goldman, Sachs and on the National Credit
Office, there was clearly no ‘‘gross misconduct or gross
abuse of trust’* in connection with the purchase of the Penn
Central paper or its retention. The conditions adopted by
Anchor for the purchase of dealer paper were believed by
it to constitute a sufficient safeguard and, in reaching that
conclusion, Anchor clearly acted reasonably and in good
faith. Accordingly, in my opinion there is no liability under
Section 36 on the part of Anchor or the directors of the
Fund.
Section 206 of the Investment Advisers Act
It is also my opinion that neither Anchor nor any Fund
director is liable under Section 206 of the Investment Ad-
visers Act of 1940 for the Penn Central loss.
Section 206 is the anti-fraud section of that statute,
corresponding with Section 17(a) of the Securities Act of
1933 and Section 10(b) of the Securities Exchange Act of
1934 and Rule 10b-5 thereunder. Section 206 reads, in
pertinent part, as follows:
‘Tt shall be unlawful for any investment adviser,
by use of the mails or any means or instrumentality
of interstate commerce, directly or indirectly—
A. 93
Fuld Report
(1) to employ any device, scheme, or artifice
to defraud any client or prospective client;
(2) to engage in any transaction, practice, or
course of business which operates as a fraud or
deceit upon any client or prospective client;
(4) to engage in any act, practice, or course
of business which is fraudulent, deceptive, or
manipulative. ...’’
Section 206, like Section 17(a) and 10(b), does not ex-
pressly provide for civil liability. The courts have held
that Sections 17(a) and 10(b) do give rise to civil liability,
and very recently the District Court for the Southern
District of New York expressly decided that Section 206
likewise confers a private right of action. Bolger v. Laven-
thol, Krekstein, Horwath «& Horwath, CCH Fed. See. L.
Rep. 94,618 (S.D.N.Y. 1974).!
The leading case under Section 206 of the Investment
Advisers Act is SEC v. Capital Gains Research Bureau,
Inc., 375 U.S. 180 (1963), in which the Supreme Court held
that the SEC could obtain an injunction requiring an in-
vestment adviser to disclose its practice of purchasing a
security shortly before recommending a purchase to its
clients for long-term investment and then selling at a pro-
fit immediately after the rise in price caused by the clients’
purchases. The Court held that the absence of misrepre-
sentations and an intent to injure was immaterial in an
injunctive action by the Commission, but acknowledged that
it ‘fis not necessary in a suit for equitable or prophylactic
relief to establish all the elements required in a suit for
4 It should be noted that there are two recent decisions in other
districts to the contrary.
A. 94
Fuld Report
monetary damages.’ 375 U.S. at 193. This distinction
between the elements required in an injunctive suit and a
damage action is also present in suits arising under Sec-
tion 10(b).
My research has discovered no case which considers
whether some form of fraudulent intent is essential to es-
tablish a private right of action‘ under Section 206. In
the absence of relevant authority under Section 206, it is
likely that the courts would look to the analogous provis-
ions of Section 10(b). The rule in the Second Cireuit has
long been that some element of scienter (i.e., knowledge or
wilfulness) is essential in suits brought under Section 10(b),
see Fischman v. Raytheon Mfq. Co., 188 F.2d 783 (2d Cir.
1951), and the rule continues to be that ‘‘mere negligence
is insufficient." Leasco Corporation v. Taussig, 473 F.2d
777. 785 (2d Cir. 1972); Shemtob v. Shearson, Hammill &
C'o., 448 F.2d 442 (2d Cir. 1971). Moreover, the District
Court for the Southern District in Jones Memorial Trust v.
Tsai Investment Services, Inc., 367 F. Supp. 491 (1973),
recently considered Section 206 in a ease in which the plain-
tiff sought damages for the diminution in value of its in-
vestment portfolio, claiming that the investment adviser
had mismanaged ‘‘the process of researching and recom-
mending investment transactions.’’ The Court found no
eredible evidence of such mismanagement, stating in the
course of its opinion (at 497):
‘‘The plain words of Section 206 of the Invest-
ment Advisers Act of 1940 make no mention of mis-
management, but speak solely and exclusively to
concealment and misrepresentation.’’
In my opinion the element of fraudulent intent is neces-
sary to establish a private cause of action under Section
A. 95
Fuld Report
206. Consequently, since for the reasons stated in my dis-
cussion of Section 36, there is a total absence of any such
intent, it follows that there is no liability under Section
206 on the part of Anchor or the Fund directors.
Common Law Liability of Anchor for the Purchase
Concededly, Anchor did not make its own independent
investigation of the financial condition of the issuers whose
commercial paper was offered to it by selected dealers. It
did, however, adopt a number of safeguards which it be-
lieved provided sufficient protection, particularly with re-
spect to short-term money market instruments which had
general acceptance in the financial community: (1) the pa-
per had to be rated ‘‘prime’’ by National Credit Office, one
of the principal rating organizations in the country, which
presumably made an appropriate credit investigation; (2)
the paper had to be recommended by a nationally known
and respected investment banking firm, which had repre-
sented that it performed its own credit analysis of the is-
suer; and (3) the name of the issuer had to be recognized
by the Fund Treasurer, and presumably by the Fund man-
ager who also approved the purchase—the presumption
being that, if either knew of any reason not to purchase the
issuer’s paper, he would so indicate. The Penn Central
paper met these conditions; in connection with item (3)
above, it should be noted that Penn Central was undoubted-
lv regarded generally as a mainstay of the nation’s trans-
portation system, and that its viability appeared unques-
tioned.
It is my opinion that, in purchasing the Penn Central
paper under these circumstances, Anchor acted in good faith
and in what should be regarded as a reasonable and prudent
A. 96
od
Fuld Report
manner. Accordingly, if the rule applicable to investment
advisers is the same as that applicable to corporate directors
(who must act ‘‘in good faith and with that degree of dili-
gence, care and skill which ordinarily prudent men would
exercise under similar circumstances in like position’’),°
or as the rule applicable in general to trustees (who must
use ‘‘such care and skill as a man of ordinary prudence
would exercise in dealing with his own property’’),* I
believe it is clear that Anchor is not liable for the Pcnn
Central loss on account of its purchase of the paper.
Because this rule refers to ‘‘ordinarily’’ prudent men
or to men of ‘‘ordinary’’ prudence, it may be argued that
it is inadequate in the case of an investment adviser which
holds itself out as possessing special skills and competence.
The rule generally applicable to persons who hold them-
selves out in this manner is that they must act with ‘‘the
skill and knowledge normally possessed by members of
[their] profession or trade’’;’ similarly, if a trustee pro-
cures his appointment as trustee by representing that he
has greater skill than that of a man of ordinary prudence,
‘‘he is under a duty to exercise such skill.’** This is the
rule which I believe should apply to the present case.
I have found no authority, however, which attempts to
spell out precisely what this means in the case of an invest-
ment adviser.* In my opinion the test is one of reasonable-
* See, e.g., N.Y. Business Corporation Law, § 717, N.J. Business
Corporation Act § 14A:6-14.
“ See, Restatement, Second, Trusts § 174.
7 See, Restatement, Second, Torts § 299A.
* See, Restatement, Second, Trusts § 174.
* Indeed, in Jones Memorial Trust v. Tsai Investment Services,
Inc., 367 F. Supp. 491 (S.D.N.Y. 1973) the court stated that there
was no evidence whatever produced at the trial as to what the standard
of care is for a properly managed investment advisory service.
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ness and prudence under the circumstances, and it is also
my opinion that Anchor met that test, unless—whtith~ap-
pears unlikely—there can be developed substantial evidence
that, in 1969, no investment adviser would or did rely in the
purchase of commercial paper on the combination of factors
relied on by Anchor.
In this connection it is noteworthy that among the pur-
chasers of Penn Central paper after Anchor’s purchases
were American Express Company, California Institute of
the Arts, Carnegie-Mellon University, Franklin Savings
Bank, Getty Oil Corp., Marine Midland Bank, United States
Trust Company of New York and University of Southern
California.
I must point out, however, that in the absence of any
authority, the contention can be made—as it is in the com-
plaint in the derivative action—that since an investment
adviser maintains an organization trained in financial ana!y-
sis and performs such analysis of a very large number of
companies, and since it is paid for investment management
which presumably is based on this analysis, such an adviser
should, as a matter of law, be held to a duty to make its
own investigation and analysis, as well as its own inde-
pendent decision based thereon for every purchase, not only
of longer-term investments but also of short-term money
market instruments such as commercial paper.
In support of such a contention it could be pointed out
that an investment adviser is for some purposes a fiduciary,
and that as a general rule a trustee (i.e., a fiduciary) must
not rely on a third party to select investments (Restate-
ment, Second, Trusts, §171). I turn now to this argument.
The rule as set forth by §171 of the Restatement of
Trusts is as follows:
‘‘The trustee is under a duty to the beneficiary
not to delegate to others the doing of acts which the
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Fuld Report
trustee can reasonably be required personally to per-
form.”’
This is amplified by Comment h, which states:
‘*A trustee cannot properly delegate to another
power to select investments. ’’
The cases in which this rule has been invoked to hold a
trustee liable have involved a virtually complete delegation
of the trustee’s powers and functions. For example, in Meck
v. Behrens, 252 P.91 (Wash. 1927), the trustees had by con-
tract turned over to a corporation the entire administration
of the trust property, and In re Shintaffer’s Estate, 4 P. 2d
764 (Kans. 1931) an executor had authorized another indi-
vidual to make investments without any supervision by the
executor.
I have found no case which holds that a trustee may not
decide to make—or retain—an investment based upon the
recommendation of a qualified professional, under cireum-
stances such as those in which Anchor acted. On the con-
trary, in In re Kohler’s Estate, 33 A.2d 920 (Pa. 1943), the
court refused to surcharge an exeeutrix who had entered
into an ageney agreement with a trust company which was
to make such investments as she should authorize and was
to suggest suitable investments. The cour
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