Petitioners Reply Brief — Burks v. Lasker

FOR ARGU Minna

Supreme Court, U.S.

FILED

No. 77-1724 ~ «JAN 9 4979

MICHAEL RODAK, JR

— ., CLERK

Supreme Court of the United States

October Term, 1978

HARRY G. BURKS, Jr., et al.,

Petitioners,

Vv.

HOWARD M. LASKER, ef ano.,

Respondents. #

7

PETITIONERS’ REPLY BRIEF

~

January 8, 1979

DANIEL A. POLLACK

MARTIN I. KAMINSKY

61 Broadway

New York, New York 10006

Counsel for Petitioners Burr,

Chalker, Haire, Hutchison and

Anchor Corporation

LEONARD JOSEPH

JOHN M. FRIEDMAN, JR.

140 Broadway

New York, New York 10005

Counsel for Petitioners Burks,

Hopkins, Kemmerer, Monroney,

Phillips and Wade

EUGENE P. SOUTHER

ANTHONY R. MANSFIELD

63 Wall Street

New York, New York 10005

Counsel for Petitioner

Fundamental Investors, Inc.

INDEX

PAGE

A. The essential differences between the parties .. . 1

B. The “mootness” argument .................. 3

C. Reply to plaintiffs’ specific points ............ 4

SE Se EE BF 0.60 us coucccivvccsevsues

I Te cnc l es cae sccstcsceees 10

Si ee 16

ts vesku wha Vinewaudwied 18

Mr: oso bis eneeebes¥esweees 24

Gg So Sg na 30

‘3

Citations

CASES: PAGE

Alleghany Corp. v. Kirby, 344 F.2d 571 (2d Cir.

1965), cert. dismissed sub nom. Holt v. Al-

leghany Corp., 384 U.S. 28 (1966) ...13, 17n,* 23n*

Auerbach v. Bennett, 64 A.D.2d 98, 408 N.Y.S.

BE Ge (SR RRO, BOOP oo 6h 665 sccdensseavass 21

Bankers Trust Co. v. Mallis, 435 U.S. 381 (1978) 4n*

Benintendi v. Kenton Hotel, 294 N.Y. 112, 60

PU Se Bee CRED ikceeccckesnasecntaked 10

Blish v. Thompson Automatic Arms Corp., 30

Del. Ch. 538, 64 A.2d 581 (1948) ........ 14, 15, 16

Brody v. Chemical Bank, 482 F.2d 1111 (2d

Cir.), cert. denied, 414 U.S. 1104 (1973) .... 16n*

Brody v. Chemical Bank, 517 F.2d 932 (2d Cir.

SED .. 0'n 0k oh naneedein a baeeun oseaneiets 17n*

Brooks v. American Export Industries, Inc., 68

F.R.D. 506 (S.D.N.Y. 1975) ............... 12

Chabot v. Empire Trust Co., 301 F.2d 458 (2d

Gk SE ecb cuctuinadeheedsarneeieacse 7

Cohen v. Beneficial Industrial Loan Corp., 337

a Pe SUE cdr iVndues edawecenas kceus 3n*

Corbus v. Alaska Treadwell Gold Mining Co.,

Se Se CD nko vaxn eevee ned ouannin 27

Cort v. Ash, 422 U.S. 66 (1975) .............. 18

Cramer v. General Tel. & Elec. Corp., 582 F.2d

eet ke ree rey ye 13, 23, 26

Crowley v. Commodity Exchafige, Inc., 141 F.2d

Se Eee a SE Wihnse Kii sb Gckortankedans 10

Daugherty v. Ball, 43 F.R.D. 329 (C.D. Cal.

hac tv aku snwkeb cus e deeds <5 dae as , 18

SS -

PAGE

Gall v. Exxon Corp., 418 F. Supp. 508 (S.D.N.Y.

SPO cena eee eG UEOe Makes 660 cc cess 17& n*

Goodwin v. Castleton, 19 Wash.2d 748, 144 P.2d

Te I ee ERE UR ede ccccces. 14, 17n*

Heit v. Baird, 567 F.2d 1157 (ist Cir. 1977) .... 12

Hutchinson v. Fidelity Inv. Ass’n, 106 F.2d 431

OES 18

In re Kauffman Mutual Fund Actions, 479 F.2d

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

ES EE ES

In re Penn Central Securities Litigation, 335 F.

Supp. 1026 (E.D. Pa. 1971) ...............

Katz v. Aspinwall, 342 F. Supp. 286 (N.D Ala.

1971), aff'd on opinion below, 459 F.2d 1045

(Sth Cir.), cert. denied, 409 U.S. 1000 (1972)

Kessler & Co. v. Ensley Co., 129 F. 397

(C.C.N.D. Ala. 1904) ........... 0.00 c eee

Levitt v. Johnson, 334 F.2d 815 (1st Cir. 1964),

cert. denied, 379 U.S. 961 (1965) ...........

Marco v. Bank of New York, 272 F. Supp. 636

(S.D.N.Y. 1967), aff'd, 398 F.2d 628 (2d Cir.

UME ER ER Gara nemnccancccccces

Marcus v. Textile Banking Co., 38 F.R.D. 185

Ne ee cei cctcccccces

Matter of Winfield & Co., [1971-72 Transfer

Binder] Fed. Sec. L. Rep. (CCH) { 78,530

TE

Mayer v. Adams, 37 Del. Ch. 298, 14) A.2d 458

SR mi bawOeians Chee ee Gawescvcrecdecess

PUNE dW ed de redeenscaecdeceeccccesvccces

12, 13

17

iV

PAGE

Moreland v. Rucker Pharmacal Co., Inc., 63

F.R.D. 611 (W.D. La. 1974) .............. 18

Nelson v. Pacific Southwest Airlines, 399 F. Supp.

Be CHARA. GRE, SIGOP. onc cin cncdcsdideades 14, 15

Phillips v. Bradford, 62 F.R.D. 681 (S.DN.Y.

SPUD | oc crdcnkawelve vedanta tae cntens 12

Potter v. Patee, 493 S.W.2d 58 (Mo. Ct. App.

I I a 10

S. Solomont & Sons Trust, Inc. v. New England

Theatres Operating Corp., 326 Mass. 99, 93

See GEE & Feccekacanaaneeederees 17

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

PRED, aitawdinbidddith adda ddmteen tans as 18

Stott v. Stott Realty Co., 246 Mich. 267, 224

Py en sc Nak pce sbi ob Senwaeeb<h 10

Swanson v. Traer, 249 F.2d 854 (7th Cir. 1957) 17n*

Twisp Min. & Smelt. Co. v. Chelan Min. Co., 16

Wash.2d 264, 133 P.2d 300 (1943) .......... 10, 11

Untermeyer v. Fidelity Daily Income Trust, 580

Fae GEE GG ED ba oCb eines cckucekas 12n*

Wolf v. Barkes, 348 F.2d 994 (2d Cir.), cert. de-

nied sub nom. Wolf v. Blair, 382 U.S. 941

CE hd be he ss inc cede eee 14, 18, 19

STATUTES AND RULES:

Delaware Corporation Law, § 141(b) and (k),

Del. Code tit. 8, § 141(b) and (k) (1975) .... 26

8 EY 0 Ser ee 19&n*, 20

Fed. R. Civ. P., Rule 23.1 .. . 11, 16n,** 18, 19, 20, 21, 22

Investment Company Act of 1940, 54 Stat.789,as

amended, 15 U.S.C. §§ 80a-1 et seq. (1976 ed.) 4, 7, 29

PAGE

Investment Company Act of 1940, § 1, 54 Stat.

789, 15 U.S.C. § 80a-1 (1976 ed.) ........... 5

Investment Company Act of 1940, § 1(b) (2), 54

Stat. 789, 15 U.S.C. § 80a-1(b)(2) (1976 ed.) 5

Investment Company Act of 1940, § 2(a) (19),

84 Stat. 1413, 15 U.S.C. § 80a-2(a) (19) (1976

a 6a rE eee nb eeugineseuasap ease 8, 25

Investment Company Act of 1940,\§ 17, 54 Stat.

815, as amended, 84 Stat. 1420, 15 U.S.C.

EE MED eleccscscneixvescpecce 5,6

Investment Company Act of 1940, § 17(h), 54

Stat 815, 15 U.S.C. § 80a-17(h) (1976 ed.) .. 6

LEGISLATIVE MATERIALS:

S. Rep. No. 91-184, 91st Cong., Ist Sess. (1969),

reprinted in 3 U.S. Code Cong. & Ad. News

tn: cheeece din leona skihins eps 2n,* 8, 9n*

H R. Rep. No. 91-1392, 91st Cong., 2d Sess.

PES a yr ee 9

ADDITIONAL AUTHORITIES:

2 Fletcher, Cyclopedia of the Law of Private

Corporations § 421 (Perm. ed., 1969 rev. vol.) 1]

Folk, The Delaware General Corporation Law:

a Commentary and Analysis (1972) ........ 17n*

Miller, Problems of Giving Notice in Class Ac-

tions, 58 F.R.D. 313 (1973) .............-. 19

3B Moore’s Federal Practice {| 23.80{1] at 23-505

dl chan bedvdusetancuovees 19n*

Simeone, Procedural Problems of Class Suits, 60 .

Mich. L. Rev. 905 (1961-62) .............. 19

Williams, A Challenge to Mutual Funds, SEC

News Release, May 17, 1978 ..............-. 9

@ No. 77-1724

IN THE

Supreme Court of the United States

October Term, 1978

HARRY G. BURKS, Jr., et ai.,

Petitioners,

v.

HOWARD M. LASKER, et ano.,

Respondents.

PETITIONERS’ REPLY BRIEF

In this Reply Brief we deal with the following matters:

A. the essential differences between the parties; B. the

“mootness” argument; C. the specific points raised by

plaintiffs.

A.

The essential differences between the parties

Respondents’ Brief contains two principal contentions:

(1) that disinterested directors of a mutual fund consti-

tuting less than a numerical majority of the Board, even

though they be a valid quorum, can never terminate

derivative litigation commenced by a stockholder (Respon-

dents’ Brief, Points I-III), and (2) that these particular

disinterested directors, on the facts of this case, should not

be permitted to terminate this particular stockholders’ deriv-

ative litigation (Respondents’ Brief, Point V).

The position taken by plaintiffs in Points I-III, which

was substantially adopted by the Court of Appeals, is de-

fective in its absolutism—it is an extreme position, at vari-

ance with basic principles of corporate governance, and one

which could force large public mutual funds to maintain

2

unwarranted litigation at the command of one unrealistic or

ill-motivated stockholder. Under plaintiffs’ view of the mat-

ter, one stockholder can arrogate the power of the Board to

himself merely by filing a derivative action naming all or

a majority of the directors of the fund as defendants.

Such a result would gravely undermine the role of direc-

tors, particularly disinterested directors, and would de-

stroy an “important shareholder protection device” (See

SEC Brief, p. 22).

Plaintiffs erroneously contend that defendants seek the

absolute power to terminate stockholder derivative litiga-

tion. To the contrary, defendants do and always have

maintained that the disinterested directors have the

power provided they make a good faith exercise of busi-

ness judgment. Implicit in that basic concept are a

number of elements, all of which have been discussed

in our original brief. Accordingly, plaintiffs have the

matter backwards when they contend, as they do, that

defendants seek an absolute out—it is plaintiffs who,

under any and all circumstances, refuse to credit the dis-

interested directors’ exercise of business judgment.

The position taken by plaintiffs in Point V, where they

indiscriminately vilify the individuals in this case,* is un-

* Plaintiffs attack not only the individuals in this case, but the

entire mutual fund industry. ir criticism of the i is based

on outdated source material and the self-interested views of members

of the class action bar (e.g., Messrs. Pomerantz, Bernstein, etc.). The

_ Most recent Congressi findings in this area, by the Senate Com-

mittee on Banking and Currency, at the time of the important 1970 ~«

amendments, contained the following statement (S. Rep. No. 91-184,

9ist Cong., Ist Sess. at 4 (1969), reprinted in 3 U.S. Code Cong. &

Ad. News 4897 at 4900 (1970) ):

Massy Bonn nigga Ba on the whole the investment

company industry reflects diligent management competent

oomaen” [footnote omitted] high standards of conduct of

the industry since 1940 in the areas specifically covered in the

statute are in sharp contrast to the derelictions in the handling

of other people’s money regrettably present in the investment

company industry in the 1920’s and 1930's.” Moe

founded and contrary to the record evidence. Plaintiffs’

unsupported charges are in conflict with the findings of the

District Court, the observations of the Court of Appeals

and the position of the SEC, as will be documented below

in our specific reply to Point V. Plaintiffs, alone, the “self-

chosen representatives and volunteer champions” in the

words of Mr. Justice Jackson,* perceive evil in this intra-

corporate resolution of a corporate matter. Their charges

of impropriety are unfounded and becloud the important

and fundamental issue before this Court.

B.

The “mootness” argument

Plaintiffs suggest that the writ of certiorari granted in

this case should be dismissed as “moot” ( Respondents’

Brief, p. 13). The asserted basis of this suggestion is that

in 1978—more than three years after the disinterested direc-

tors exercised their business judgment to terminate this

action—Anchor ceased to be the investment adviser to

Fundamental and, therefore, it is no longer true that allow-

ing this action to go forward would place Fundamental in

an adversary relationship with its investment adviser.

This argument is wholly without force for several rea-

sons: (1) the issue tendered to this Court as the basis for

granting certiorari was whether the disinterested directors

had the power to exercise their business judgment to termi-

nate this derivative action—not whether one or more of

the reasons relied on by the directors for doing so was

good and sufficient; (2) the possibility of creating an ad-

versary relationship was only one of many factors relied

on by the disinterested directors in reaching their decision

to seek termination of this action (see Petitioners’ Brief,

* Cohen v. Beneficial Industrial Loan Corp., 337 U.S. 541, 549

(1949).

basis

cumstances”* which was k

and

iy

‘el

gsfe

2

Appeals has

yon try my Fh L3, TS

Appeals, ie. that the disinterested

nate this stockholders’ derivative

and the basic issue presented have remained

out the entire course of proceedings.

5

disinterested directors lack the power to seek to terminate

stockholder derivative litigation (Respondents’ Brief, pp.

16-20). In support of their argument, plaintiffs rely on

Sections | and 17 of the Investment Company Act of 1940

—their reliance is misplaced.

Neither Section 1 nor Section 17 deals directly or in-

directly with the power of disinterested directors to termi-

nate stockholder derivative litigation which they determine

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

shareholders.

Section | is merely a generalized policy statement,

enunciated 38 years ago at the time of the passage of the

original statute—it has no applicability whatsoever to the

issue raised in this case. Section 1(b) (2), the particular

national public interest and the interest of investors are

adversely affected

operated, managed, or their portfolio securities are

selected, in the interest of directors, officers, invest-

thereof, in the interest of underwriters, brokers, or

dealers, in the interest of special classes of their

ee cee Ste anaes SS Se ee

mpanies or persons engaged in other lines

of busines, rather than inthe interest of all clase

of such companies’ security holders. .

Shilieiitis Wiad teat bs dad Gna th tention ood

as the one at bar—it is addressed to self-dealing and

other such abuses by insiders. Here the decision to forego

litigation was made by a quorum of outside directors who

eee ee eee ae we ey &

to have acted “in good faith in all that they did.”

Similarly, Section 17, by its own terms, has no applic-

ability to the issue raised in this case—that section deals.

among other things, with sales to and purchases of securi-

ties from funds by insiders, borrowing of money by in-

siders, ctc., Lc. matters not even remotely involved in this

case. Section 17(h), the particular subsection on which

plaintiffs rely, provides in pertinent part:

“After one year from the effective date of this

title, neither the charter, certificate of incorpora-

tion, articles of association, indenture of trust, nor

the by-laws of any registered investment company,

nor any other instrument pursuant to which such

a company is organized or administered, shall con-

aliens antes

Brief, p. 19). This borders on the absurd. Fundamental's

quorum provisions are the normal, straightforward provi-

sions found in the by-laws and/or charters of virtually

every corporaticn of any kind, and they do not exculpate

7

directors to manage the affairs of the fund in the best

interests of all shareholders.

Chabot v. Empire Trust Co., 91 F.2d 458 (2d Cir.

plaintiffs there had to post $35,000 as security in order to

maintain their action. The Court held that this clause

had the practical effect of shielding the trustee from lia-

bility by preventing lawsuits. The quorum provisions of

Fundamental’s by-laws and charter do not shield anybody

from anything—they simply set forth how many directors

Se ee ee See © Oe Sees ane, ©

Levitt v. Johnson, 334 F.2d 815 (ist Cir. 1964), cert.

denied, 379 U.S. 961 (1965) also cited by plaintifi

spor.dents’ Brief, p. 20). has nothing to do with Section

17 and has no bearing on this case. In that case, which

involved the special Massachusetts shareholder demand

sain, Gio question Setere Go Count vias wietier o Comend

pany Act of 1940. serene -poar dion fan er meyer

of whether directors can, in any event, exercise their busi-

ness judgment to terminate a derivative action.

Plaintiffs next argue, in Point I B, at Ge ponen

Act of 1940 do not include the power to terminate stock

As the SEC has said in its amicus brief filed in this

case (SEC Brief, pp. 20-21):

“The court of appeals appears to have relied on

the fact that the Act does not specifically grant the

disinterested directors authority to terminate on-

going derivative litigation. But the Act does not

purport to withdraw such powers cither, and it

does not set out every duty and power of such di-

authority of the company's directors under the

Act, it did so expressly.

. >-

salieadah tn Gy coemiiansae of Gs aia 0 ae

not do so.”

In support of their argument in Point I B, plaintiffs

pany pag i ge ea ine ong oe oad

ents’ Brief, p. 24).

ab op-ed aemamineen eae ..” and that

in this regard.” In support of their claim, plaintiffs cite page

4901 of the reprint of the Senate Report. Examination of

ee te a

sn for Guten’ cae tae aoe te

2(a)(19) to remedy criticisms of the prior category of

“unaffiliated” directors. S. Rep. No. 91-184, 91st Cong.

Ist Sess. at 32-33 (1969), reprinted in 3 US. Code

Cong. & Ad. News 4897 at 4927-28 (1970). Contrary to

plaintiffs’ misleading statements, Congress most assuredly

did conclude that disinterested directors were sufficiently

independent to protect shareholder interests. Again, as

the SEC has said in its amicus brief in this case (SEC

paeccceny

. The premise of the court of appeals—that

dimerted der ar incapable of ating inde

Sinn det taaeaatr entainemteen check on

management and to provide a means for the repre-

sentation of shareholder interests." H.R. Rep. No.

91-1382, Dist Cong., 2d Sess. 13 (1970).” *

Finally, the remarks of Chairman Williams of the SEC

on the Lasker case, quoted in Respondents’ Bricf, pp. 28-

29 n.*, were made without benefit of a reading of the

record. In any event, the official position of the SEC is set

forth in its amicus brief, from which there is no indication

of a dissent by Chairma. Williams.

* See also 5. . No, 91-184, Dist , Ist Sess, at 32-33

eee eee oe U.S. Code Cong. & Ad. 4897 at 4927-28

( ):

“The function of these | [prior Sections 2(a)(3)

and 10] with respect to ed directors is to supply an in-

Spensees nee on and to a means for the

ee o interests in investment company

“Your committee believes that the definition of ‘affiliated

person’ aoraee Sunpere e= caw SES COGS SS GENGEIRY Greet

this purpose. . —— a

yposec ee SS) SS on oe

ficiencie by Tete pron’ Othe

othe act which would e the term

10

Reply to Poim U

Plaintiffs argue, in Point Il, that a “minority of direc-

tors” has no power to prevent or halt derivative litigation

(Respondents’ Brief, pp. 30-31)—this is erroneous.

The pertinent inquiry is whether or not there is a duly

constituted quorum—not whether the quorum is a major-

ity or minority of the directors. In this case 5 of 11 direc-

tors (constituting more than a quorum) acted with the

full power of the Board—would plaintiffs have viewed the

matter any differently if 6 of 11 had acted? would 6 of

11 have been any more independent than 5 of 117 The

numbers test that plaintiffs seek to impose is wholly arti-

ficial and has no support in applicable corporate law.

tows beth seerlés Gat 6 Gnasan ar an a

power of the Board. Indeed, a majority of a quorum may

act with the full power of the Board—this is a fundamental

principle of law which plaintiffs seek to overturn.

As the Court stated in Benintendi v. Kenton Hotel,

294 N.Y. 112, 119, 60 N.E.2d 829, 831-32 (1945):

“the very idea of a ‘quorum’ is that, when that

required number of persons goes into session as

a body, the votes of a majority thereof are sufficient

for binding action.”

See also Crowley v. Commodity Exchange, 141 F.2d 182,

188-89 (2d Cir. 1944).

A quorum is empowered to act whether it is a majority

or a minority of the Board. See, ¢.g.: Potter v. Patee, 493

S.W.2d 58, 64 (Mo. Ct. App. 1973), motion denied; Twisp

Min. & Smelt. Co. ¥. Chelan Min. Co., 16 Wash.2d 264,

290, 133 P.2d 300, 310-11 (1943); Stott. v Stott Realty Co.,

246 Mich, 267, 271-72, 224 N.W. 623, 624 (1929).

As the Court stated in Twisp, supra (16 Wash.2d at

290, 133 P.2d at 311), referring to 2 Fletcher, Cyclopedia

of Corporations § 421:

“A careful study of Fletcher will, in our opinion,

reveal that the text recognizes that the number of

directors of a corporation necessary to constitute

a quorum may be fixed by the by-laws, if not in-

compatible with the articles or statutory law, and

that a majority of that quorum may decide any

question coming properly before such meeting,

although the number of directors present may be

less than a majority of the entire board.”

Plaintiffs also argue, in Point II, that if a minority of

directors could terminate stockholder derivative litigation

it “would unsettle the whole doctrine of shareholder

demand and excuse therefrom”—this, too, is erroneous.

First, it is simply incorrect to contend that the concept

of a “majority” is an inherent or essential part of the

demand rule. Rule 23.1 does not mention either a majority

or a minority. There is nothing in the temand rule that

bars a lawful minority quorum from passing on a demand

by a putative derivative suit plaintiff. If and when a de-

mand is made on the directors, nothing requires all the

directors, or even a majority of them, to function on the

demand. As with any other corporate business, in the

absence of an express by-law or charter provision to the

contrary, any duly constituted quorum of the Board can

function in response to the demand; and, when it does,

the vote of a majority of the quorum would be sufficient.

Second, demand is properly excused only when it

would be “futile”, not whenever a majority of the Board

12

is named as defendants.* In some cases, demand is futile

where a majority of the Board is named as defendants,

but that is not always the case. If it were, derivative plain-

tiffs could consign the demand rule to oblivion with the

stroke of a pen by simply naming all directors defendants,

irrespective of their true role in the matter. The test

is: can a plaintiff allege facts that show that demand would

be futile? See, e.g., Heit v. Baird, 567 F.2d 1157, 1162 (1st

Cir. 1977); In re Kauffman Mutual Fund Actions, 479 F.

2d 257, 265 (1st Cir.), cert. denied, 414 U.S. 857 (1973);

Brooks v. American Export Industries, 68 F.R.D. 506, 511

(S.D.N.Y. 1975); Phillips v. Bradford, 62 F.R.D. 681, 688

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

The Court of Appeals held in Heit, supra (567 F.2d at

1162):

“The plaintiff attempts to make up for the com-

plaint’s deficiencies in respect to Rule 23.1 by point-

ing out that more than a majority of the present

board of directors are defendants in this suit and

thereby in a position where they would not assent

to its prosecution. To credit this argument, how-

ever, would be to permit an obvious bootstrap to

relieve putative plaintiffs of their obligations under

Rule 23.1. Merely naming disinterested directors as

defendants does not allow the prosecutor of a deri-

vative suit to avoid his duty to make a demand on

them. [citation omitted]”

* Untermeyer vy. Fidelity Daily Income Trust, 580 F.2d 22 (ist

Cir. 1978), relied upon by plaintiffs, does not hold to the con :

The Court of Appeals, on the unusual facts of that case, held mere

that demand was futile, and that the District Court erred in specula-

ting that the interested directors, who were charged with “self-

benefiting” misdeeds, would abstain from voting on the demand to

sue themselves. No such issue is presented at bar.

—_*

13

Finally, but perhaps most important, plaintiffs miscon-

ceive the purpose and significance of the demand rule. The

demand rule is designed to protect against unwarranted

shareholder litigation, and to insure that whenever possible

the decision to pursue or not to pursue a corporate claim

is made by the Board of Directors of the corporation,

whose function and responsibility it is to manage the cor-

poration. See, e.g., /n re Kauffman Mutual Fund Actions,

supra (479 F.2d at 263). The demand rule is not a share-

holder’s permit to sue. Plaintiffs would have this Court

rule, in effect, that satisfaction of the demand rule forever

vests a shareholder with a proprietary interest in and con-

trol of the corporate claim he seeks to assert derivatively.

The claim, however, belongs to the corporation, not to one

or two of its stockholders, and the legally elected directors

are the ones who must be able to assert continuing control

over the claim.

The demand rule cannot and does not paralyze a cor-

poration from acting or reacting to evolving circum-

stances after the case has been commenced. The demand

rule comes into play only at the time the derivative action

is commenced. Cramer v. General Telephone & Elec.

Corp., 582 F.2d 259, 276 (3d Cir. 1978).

The cases have always recognized that, so long as they

act in good faith and independently, the corporation’s di-

rectors have the right and power, based upon subsequent

developments, to take over the claim and pursue or end

it, as the directors deem best for the corporation.

Thus, the corporation itself took over the claim in /n

re Penn Central Securities Litigation, 335 F.Supp. 1026,

1040 (E.D.Pa. 1971) and in the underlying litigation

which gave rise to Alleghany Corp. v. Kirby, 344 F.2d 571

(2d Cir. 1965), cert. dismissed, 384 U.S. 28 (1966). And

14

the directors were permitted to make direct contact with

the alleged wrongdoers to settle and discontinue the un-

derlying claim, notwithstanding the pendency of the de-

rivative action in Wolf v. Barkes, 348 F.2d 994, 997 (2d

Cir.), cert. denied, 382 U.S. 941 (1965) and Goodwin v.

Castleton, 19 Wash. 2d 748, 757-58, 144 P.2d 725, 729-30

(1944). And a quorum of disinterested directors was per-

mitted to take other corporate action to remove the basis

for the claim and thus compel termination of a derivative

action against insiders in Blish v. Thompson Automatic

Arms Corporation, 30 Del.Ch. 538, 583, 64 A.2d 581, 604

(1948). See also: Meyer v. Fleming, 327 U.S. 161, 167-68

(1946); Nelson v. Pacific Southwest Airlines, 399 F.Supp.

1025, 1031 (S.D.Cal. 1975).

The rule proposed by plaintiffs would allow one or two

dissentient stockholders to force the corporation on an

unalterable course regardless of whether that course con-

tinues to be in the best interests of the corporation. Such

a rule might unwisely commit the corporation to action

not in its best interests. As the Court stated in Goodwin,

supra (19 Wash. 2d at 763-64, 144 P.2d at 732-33):

“The mere circumstances that a lone stock-

holder, or a group of such individuals, has initiated

a derivative action, and has alleged the existence

of facts entitling him or them to maintain the suit

in place of the corporation, do not of themselves

establish the propriety of the action or the necessity

for its continued maintenance, for otherwise, by

this device the corporation, its officers, and di-

rectors, and the majority stockholders would at

once be conclusively shorn of their powers of

management and discretion in the conduct of those

affairs which are of vital concern to the corpora-

tion and all its stockholders.

*- *

15

“ ... Their right in such matters is not com-

pletely forestalled by the mere fact that a single

stockholder or a group of stockholders has taken

the initiative by instituting a derivative action.”

In Blish, supra (30 Del. Ch. 538, 64 A.2d 581), two

years after a derivative action had been filed to nullify

certain transfers of stock to two of the inside directors,

a quorum of disinterested directors met and voted to

ratify the issuance of the shares, thereby mooting and ef-

fecting termination of the derivative action. The Supreme

Court of Delaware upeld the action of the distinterested

directors which had the effect of terminating the derivative

action even though the action had been validly com-

menced and was not frivolous, stating (30 Del. Ch. at 583,

64 A.2d at 604):

“The contention made by the appellant that

the ... ratification was ineffective, since such oc-

curred subsequent to the day that this suit was in-

Stituted below, is without merit. Courts generally

look vith apprehension upon ratification of previ-

ous corporate acts after an action has been insti-

tuted questioning the validity of such acts. How-

ever, in the absence of fraud, subsequent action by

the Board within director authority will be held to

be valid.”

The relationship of the demand rule to the business

judgment power of the directors was properly recognized

in Nelson, supra (399 F.Supp. 1025). Whether a demand

must be made is determined at the outset of the action,

i.e., when the claim is first asserted. The fact that the

composition of the Board may change thereafter, so that

demand would no longer be futile, does not necessarily

16

require the shareholder plaintiff to make a new demand.*

However, the new directors can, on their own initiative,

determine the future course of the action (399 F. Supp.

at 1031):

“. .. the plaintiffs are not required to seek to have

the new directors intervene in the suit. Though

the plaintiffs may be bound by the decision of the

board, it is the board itself which must initiate

such activity. [citation omitted]” :

At bar, of course, the directors did themselves initiate the

activity at issue, i.e., the motion to dismiss.

Reply to Point III

Plaintiffs argue, in Point III A, that under Delaware !aw

a minority of directors cannot prevent commencement of

a derivative action, and, therefore, should not be per-

mitted to effect a termination of a derivative action, i.e.,

that “Delaware precedents are the same as under Federal

Rule 23.1” (Respondents’ Brief, pp. 35-36 ).** None of the

cases cited by plaintiffs at pp. 35-36 of their brief deals

with the business judgment powers of directors. Applicable

Delaware authority clearly recognizes the power of a quo-

rum of the directors to manage the affairs of the corpora-

tion, including the power to make decisions to prosecute

or cause the termination of litigation on behalf of the

corporation. McKee v. Rogers, 18 Del. Ch. 81, 85-86, 156

A. 191, 193 (Ch. 1931). See also: Blish v. Thompson

* If, however, the plaintiff files an amendec complaint or seeks

to assert a new claim after the composition of the Board has changed,

a new demand is necessary. See, e.g., Brody v. Chemical Bank, 482

F.2d 1111 (2d Cir.), cert. denied, 414 U.S. 1104 (1973).

** As shown supra, Reply to Point II, plaintiffs are in error in

their arg. nent that satisfaction of Rule 23.1 by a derivative plaintiff

forever after renders directors powerless to act in the best interests

of the corporation.

17

Automatic Arms Corp., 30 Del. Ch. 538, 583, 64 A.2d

581, 604 (1948).

Plaintiffs also argue, in Point III A, that under Delaware

_ law directors may not ratify a fraud (Respondents’ Brief,

pp. 36-38). This argument misses the point. First, there

was no fraud here, but only an investment loss in the

ordinary course of operations. Second, the directors did

not ratify anything; they exercised their business judgment

in what they believed to be the best interests of Funda-

mental. The courts have repeatedly rejected this argument

advanced by plaintiffs, and recognized that

“The question whether it is good judgment to

sue is quite apart from the question of ratification.”

S. Solomont & Sons Trust, Inc. v. New England Theatres

Operating Corp., 326 Mass. 99, 111, 93 N.E.2d 241, 247

(1950). Accord: Kessler & Co. v. Ensley Co., 129 F. 397,

399 (C.C.N.D. Ala. 1904); Gall v. Exxon Corp., 418

F.Supp. 508, 518n.18 (S.D.N.Y. 1976). The District Court

also correctly drew this distinction (A.19), and the Court

of Appeals did not disturb this portion of the District

Court’s opinion.*

* The plaintiffs’ argument, moreover, overlooks the numerous

cases where the courts have upheld the power of disinterested direc-

tors not to pursue litigation, even though arguably nonratifiable con-

duct was at issue. See, e.g., Brody v. Chemical Bank, 517 F.2d

932 (2d Cir. 1975) (involving federal securities acts and fraud

claims); Alleghany Corp. v. Kirby, 344 F.2d 571, 573 (2d Cir.

1965), cert. dismissed, 384 U.S. 28 (1966) (involving fraud claims) ;

Swanson v. Traer, 249 F.2d 854, 859 (7th Cir. 1957) (involvin

fraudulent conspiracy); Gall v. Exxon Corp., 418 F.Supp. 508,

516 (S.D.N.Y. 1976) (involving illegal payments); Goodwin v.

Castleton, 19 Wash.2d 748, 764, 144 P.2d 725, 733 (1944)

(involving fraud claims). Plaintiffs’ reliance on Mayer v. Adams,

37 Del.Ch. 298, 141 A.2d 458 (1958), is misplaced. The only

issue presented in Mayer was the necessity for a demand on share-

holders; the role of directors in deciding whether to pursue proposed

derivative claims was not an issue. Finally, plaintiffs’ use of Professor

Folk (Respondents’ Brief, p. 39 n.*) is misleading: he was obviously

talking about fraud in the exercise of business judgment, not fraud in

the underlying claim. See Folk, THE DELAWARE GENERAL CORPORA-

TION Law: A COMMENTARY AND ANALYsIS 76 (1972).

of the ah, deter eet wr

and Il, pp. 4-16 and SEC Brief, pp. 20-23.

Reply to Point IV

gpesgy ten. om a TS ee ee

approval procedures do not apply to this situation

enh ho aiaiaen ath toe The notice and judicial ap-

ee Ne ee ag

prarerwelg eapepfios tenn geibives. y= + Fer

as at bar. See, e.g. Wolf v. Barkes, 348 F.2d 994, 996-97

(2d Cir.), cert. denied, 382 U.S. 941 (1965); Karz v.

Aspinwall, 342 F Supp. 286, 288 (N.D. Ala. 1971), aff'd,

459 F.2d 1045 (Sth Cir.), cert. denied, 409 US. 1000

(1972); Daugherty v. Ball, 43 F.R.D. 329, 335 (C.D. Cal.

1967); Marcus v. Textile Banking Co., 38 F.R.D. 185, 187

(S.D.N.Y. 1965). See also’ Hutchinson v. Fidelity Inv.

Ass'n, 106 F.2d 431, 436 (4th Cir. 1939); Moreland v.

Rucker Pharmacal Co., Inc., 63 F_ RD. 611, 614-15 (W.D.

La. 1974); Miller, Problems of Giving Notice in Class

Actions, 58 F.R.D. 313, 331 (1973); Simeone, Procedurai

Problems of Class Suits, 60 Mich. L.Rev. 905, 934 (1962).

As the Court stated in Marcus, supra (38 F.RD. at

187), in refusing to order notice of a dismissal of a deriva-

tive suit for lack of jurisdiction:

“The purpose of the provision is the protec-

tion . . . against the unjust or unfair settlements

in case a plaintil who starts the action becomes

eee ee ee ee

il a

20

securities laws, the corporation negotiated se.tlements di-

moved to enjoin the settlements, claiming that they were

legally ineffective without notice to the stockholders and

approval by the Court pursuant to then Rule 23(c) [now

Rule 23.1]. The Court of Appeals affirmed the denial of

ee a a ee

their objection Sudes Briony ucts (008 9.26 ot 996.

97):

. If we go behind the letter to the prime ‘mis-

chief and defect ee

woctholde and his attorey got the sum paid in

de, edo trom peliciee the Gnas

tion of the corporate claim, he may well assist in

ee ee ee

cilia tub 4h eas ett uatinal Oo Geiiatean

ee a

* Judge Friendly also noted (348 F.2d at 997 2.4):

“The SEC oops to provide ‘a the Investment

oe ay Ay AA ong aad ics e_ forced

that could be the target of . the provision

not enacted. [citations omitted)” ” se

21

The same considerations apply at bar, where plaintiffs

Auerbach Vv. Bennett, 64 A.D. 2d 98, 408 N.Y.S.2d 83

(2d Dept. 1978), is mischaracterized by plaintiffs (Respond-

ents’ Brief, p. 50). First, as a state court case, Auerbach

did not deal with Rule 23.1. Moreover, in the very next

sentence following the quotation by plaintiffs, the Court

added (64 A.D.2d at 108, 408 N.Y.S.2d at 88):

“That is not to say that after the usual discovery

and deposition stages of the action have been com-

priate vehicle to terminate the action when the record

sil db Gee aie etl) te eae od ho

decision of the committee.”

The Court held merely that (id.):

granted.” (emphasis supplied)

The other cases under Rule 23. l cited by r aintif

Brief, p. 50). This is most ¢ i

contend deowhese in thelr brief that the Distict Court

should have ordered the mailing of notice to all shareholders

and conducted “a full exploration of the relevant circum-

merits” wo weigh the propriety of the dsmisal under Rul

tors of a mutual fund do have the power to terminate stock-

as the SEC points out. the business judgment rule is itself

r nt shareholder protection device” (SEC Brief,

p. 22). ;

onus > Ges Ginttan cane ts Celle Sls en

(3) their judgment must be reasonable (SEC Brief, pp. 16-

20.) The SEC acknowledges that its first two criteria were

met in this case (SEC Brief, pp. 23-24) but suggests that

ee ee

ram's decison at “he reasoned jgment” (A 38) whic

23

Es, 58, SEND Sp Suara cane “a reasoned de-

ermination™ (see SEC Brief, p. 20 n.16).*

Moreover, necessarily implicit in the finding of good

faith by the District Court wos the conclusion that the

gy «See tio

of the reasonableness of the directors’ Sain a her om

readily be made from the record now before this Court. In

fact, the SEC states (SEC Brief, p. 25 1.21):

“Although we suggest a remand, this Court

could determine — mahicne if it wist '

We do not believe a remand is necessary or appro-

priate here. tty habe aay esigmusen 7 eamandines

exercise of business judgmer in this case falls * “outside

re. . nied Sibaiins & Slesvenie Corn $82

wher thr a ore GS 1978). The record evidence over-

m4 138-139) and that they were eutiedy indepent

(A.142-143, 147-150).

24

Reply to Point V

Se Oe ee Jisintere:

56-62). Plaintiffs, alone, are of this view.

The District Court found, after extensive discovery on

the issue (A.28):

“Plaintiffs have not adduced any factual sup-

pan Oe Oe ee ee eee

“Meine out hat he ve minty

The SEC, which examined the record in this case and

filed an amicus brief wrote (SEC Brief, p. 23):

“We S not db mery- the district court's findin,

ing record evidence that the disinte =

to carp and cavil about the disintereste

25

mittee, and two of the three members of that committee

were, at all times, disinterested directors as that term is

defined in Section 2(a)(19) of the Investment Company

Act of 1940. Next, all of the disinterested directors were

ominat.d for election by the full board of directors,

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

directors. Finally, all of the disinterested directors were

elected by the stockholders as their lawful representatives

(A.142-143). The root of the error of plaintiffs’ position

is their mistaken notion that merely by naming a disin-

terested director a defendant in a derivative action, he or

she, without more, is disqualified, both prospectively and

retrospectively, from functioning as a director. If this

were the rule, plaintiffs in derivative actions could control

the corporate destiny without any restraint by merely

naming all directors as defendants.

Plaintiffs also contend that the five disinterested direc-

tors were not independent because of “a long history of

social and business relationships with a number of defend-

ants” (Respondents’ Brief, p. 59). This is an utter dis-

tortion, as a reading of the record shows. The District

Court made this finding (A.28):

“Although each of the minority directors knew

ee ce on oe cme 2 GF Sn wes

ominated, the relationships which existed between

the minority directors | and the defendant directors

were de minimis. .

At another point in their brief, plaintiffs assert that

“Each member of the quorum had been screened, se-

lected and nominated for office by Anchor and the indi-

vidual defendants who, as majority directors, at all times

had the absolute power to effect their removal.” (Respond-

ents Brief, p. 8). Plaintiffs offer no citation of authority

26

—either record or legal—for these assertions. The fact

is that Anchor did not screen, select or nominate any

director (A.142-143) and neither Anchor nor any com-

bination of the so-called majority directors had any power

to remove the so-called minority directors—all directors

served, in accordance with law, until their terms expired

and their successors were duly elected and qualified. Dela-

ware Corporation Law, § 141 (b) and (k), Del. Code

tit. 8, § 141(b) and (k) (1975).

Plaintiffs also argue, in Point V B, that the action has

“merit” (Respondents’ Brief, p. 63). The disinterested

directors and their special counsel, Judge Fuld, found other-

wise (A.82), but the important point is that they carefully

considered the merits, as the District Court found (A.

36).* Even assuming, arguendo, that the action has

“merit”, that is only one of many factors to be considered in

arriving at a sound business judgment. And the law is,

and always has been, as stated in Cramer, supra (582 F.2d

at 275):

“Even if a particular suit has some merit, the

litigation costs and the adverse effect on the busi-

ness relationship between the corporation and the

* Plaintiffs erroneously contend that Judge Fuld “overlooked”

Matter of Winfield & Co., Inc. (R ts’ Brief, p. 63). First,

there is no evidence in the record that Judge Fuld failed to consider

that case. Second, that case is not in point: it was an uncontested

SEC enforcement proceeding involving an investment adviser who,

in recommending purchase i securities by the fund, relied

on unsubstantiated representatiuns of other ne described by

him as “research sources” but who, in fact, had a substantial eco-

nomic interest in such restricted securities. No such facts are present

here: Anchor relied, among other thi on the “Prime” rating of

Penn Central by NCO (a subsidiary of Dun & Bradstreet), the fore-

most independent commercial paper rating in the country

(A.86, 122). In addition, Anchor was about Penn

Central since Penn Central Company had been a recent equity hold-

ing of Fundamental (A.125). Finally, since Matter of Winfield &

Co., Inc., was an SEC enforcement no finding of scienter

was necessary for liability. To the contrary, in a private damage ac-

tion such as this one, as Judge Fuld correctly concluded, proof of

“fraudulent intent” is essential to recovery (A.94).

Ee

27

potential defendant might outweigh any potential

recovery in the lawsuit.”

This Court long ago stated in Corbus v. Alaska Tread-

well Gold Mining Co., 187 U.S. 455, 463 (1903):

“The directors may sometimes properly waive a

legal right vested in the corporation in the belief

that its best interests will be promoted by not in-

sisting on such right.”

Plaintiffs make numerous overstatements and mis-

statements throughout their brief with respect to the

merits. For example, plaintiffs assert that the Court of

Appeals made “a further finding that the plaintiffs’ claims

were substantial and meritorious” (emphasis supplied)

(Respondents’ Brief, p. 10). This is false. The Court of

Appeals nowhere found or even stated that plaintiffs’

claims were meritorious. The Court of Appeals said only

“. . . we cannot say that, following a trial on the merits,

the defendants would be found free from liability for the

Fund’s losses.” (A.43) This hardly constitutes a finding

of meritoriousness of plaintiffs’ claims by the Court of

Appeals.

Plaintiffs also misleadingly assert that Anchor “violated

two out of the three investment guidelines which it had

established to safeguard the Fund”, i.e., the 10° guideline

and the buy-back guideline (Respondents’ Brief, p. 3). This

is false. As to the 10% guideline, Fundamental purchased

$20 million out of a total! of $200 million of Penn Central

commercial paper outstanding, and, thus, was within its

guideline (A.109-110, 122). And, as to the buy-back guide-

line, Anchor believed on the basis of its prior talks with

Goldman, Sachs & Co., which had always bought back

paper previously, that it had such an understanding (A.84,

121-122). Goldman, Sachs & Co., under the pressure of the

situation, simply failed to honor its commitment in this case

(A.124).

28

Other examples of overstatement and misstatement by

plaintiffs with respect to the merits abound. However,

since they are essentially an attempt to re-argue facts

found by the District Court, and do not affect the funda-

mental issue before this Court, no further response will be

made in this brief.

Plaintiffs next argue, in Point V C, that the minority

directors were misinformed by Mr. Haire and by Mr.

Souther (Respondents’ Brief. pp. 68-73). The District

Court made express findings to the contrary.

As to Mr. Haire, the District Court found (A.35):

“The court is of the opinion that Haire’s state-

ments 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 minority

directors reached a different conclusion: that pros-

ecution of the suit ‘would necessarily cause the

Fund to seek to obtain a different investment ad-

viser immediately.’ ’’*

As to Mr. Souther, the District Court found that his

participation was “equally innocent” (A.32). The full

findings as to Mr. Souther by the District Court are set

forth at A.32-33 and will not be reprinted here in the

interest of brevity. Plaintiffs now also claim that a memo-

* The claim that Mr. Haire “misled” the disinterested directors

is exposed as baseless by a review of the discovery proceedings.

Plaintiffs read Mr. Haire’s statement to Mr. , who testified

flatly “I differ with Mr. Haire on his conclusion.” (Stephens Tr.

116-119.) Mr. Haire had one view as to whether Anchor could con-

tinue to act; the disinterested directors had another view. Mr. Haire

did not mislead anyone about anything.

29

randum prepared for the disinterested directors, at their

request, by Mr. Souther’s firm (A.158-161), was “biased”;

however, the memorandum is factually and legally correct

and plaintiffs did not and could not demonstrate other-

wise.

The final argument raised by plaintiffs in Point V D,

to wit, that because Anchor is no longer the investment

adviser, the continued prosecution of this action cannot

possibly injure Fundamental, has been dealt with earlier

in this Reply Brief at pp. 3-4. The adversary relationship

was just one of many factors considered and relied upon

by the disinterested directors in reaching their conclusion

that this derivative litigation was contrary to the best in-

terests of Fundamental and its shareholders and should be

terminated. The numerous other factors are set forth in

the moving affidavit of Mr. Kendall (A.77-79), the minutes

(A.137-141) and the letter of Mr. Stephens (A.131-136).

* * *

Respondents’ Brief is, in sum, a “skillful assemblage of

suspicions, surmises and conjectures.”* Reflection upon

the true issue in this case leads one inescapably back to

this proposition: plaintiffs and the Court of Appeals would

have this Court rule that disinterested directors of a mu-

tual fund, who constitute a quorum and have been found

to be truly disinterested and independent, are incapaci-

tated, as a matter of law, from exercising their business

judgment to terminate a stockholder’s derivative action

they find to be contrary to the best interests of the fund

and its shareholders. The per se disqualification of the

disinterested directors is in conflict with the intent of Con-

gress as expressed in the Investment Company Act of 1940

and does violence to sound and logical principles of cor-

porate governance.

* Marco v. Bank of New York, 272 F. Supp. 636, 640 (S.D.N.Y.

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

30

CONCLUSION

The judgment of the Court of Appeals should be

reversed and the Complaint should be dismissed.

Respectfully submitted,

DANIEL A. POLLACK

MARTIN I. KAMINSKY

61 Broadway

New York, New York 10006

Counsel for Petitioners Burr,

Chalker, Haire, Hutchison and

Anchor Corporation

LEONARD JOSEPH

JOHN M. FRIEDMAN, JR.

140 Broadway

New York, New York 10005

Counsel for Petitioners Burks,

Hopkins, Kemmerer, Monroney,

Phillips and Wade

EUGENE P. SOUTHER

ANTHONY R. MANSFIELD

63 Wall Street

New York, New York 10005

Counsel for Petitioner

Fundamental Investors, Inc.

January 8, 1979