Petition — Daily Income Fund, Inc. v. Fox
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No. 82-/20 fu Lirfes
IN THE
Supreme Court of the United States |
October Term, 1982
DAILY INCOME FUND, INC. and
REICH & TANG, INC.
Petitioners,
v.
MARTIN FOX,
Respondent.
PETITION FOR WRIT OF CERTIORARI
TO THE UNITED STATES COURT OF APPEALS
FOR THE SECOND CIRCUIT
DANIEL A. POLLACK*
FREDERICK P. SCHAFFER
61 Broadway (Suite 2500)
New York, New York 10006
(212) 952-0330
Counsel for Petitioner
Daily Income Fund, Inc.
GEORGE C. SEWARD
ANTHONY R. MANSFIELD
Wall Street Plaza
New York, New York 10005
(212) 248-2800
Counsel for Petitioner
Reich & Tang, Inc.
January 14, 1983 *Counsel of Record
Question Presented for Review
Is a shareholder’s derivative action under § 36(b) of the
Investment Company Act of 1940 exempt from the direc-
tor demand requirement of Rule 23.1 of the Federal Rules
of Civil Procedure?
iil
TABLE OF CONTENTS
PAGE
Opinions Below .. ... «+s <«sssssauenee eee 2
Jurisdiction..... 2 0 0 0 06-6 35h 6 8 Mie nnn 2
Statutes Involved. .... 2... s0<ssscu seu 2
Statement of the Case. ... <i <.ss= 085s eae 2
Reasons for Granting the Writ . i .:s3.sseuegeeee 4
Conclusion . .. ..s..<«0s0s sus nese 14
TABLE OF AUTHORITIES
CASES:
Brown v. Bullock, 194 F. Supp. 207 (S.D.N.Y.),
aff’d, 294 F.2d 415 (2d Cir. 1961).............. 12
Burks v. Lasker, 441 U.S. 471 (1979) ............ 4, 6,
9n.7, 11, 13
Cort v. Ash, 422 U.S. @ (97S). . ses eee )
Fox v. Reich & Tang, Inc., 94 F.R.D. 94 (S.D.N.Y.
1962). . 0.20 0c ccccc cen u us eee nena ye EE
Fox v. Reich & Tang, Inc., 692 F.2d 250 (2d Cir.
$OBZ). wo co ceee coc uuu eee 2,9 &n.7, 10
Grossman v. Johnson, 674 F.2d 115 (Ist Cir.), cert.
denied, ___ U.S. ___, 103 S.Ct. 85 (1982)... 4,5&
n.5
Hawes v. Oakland, 104 U.S. 450 (1882).......... 7
PAGE
Lerman v. ITB Management Corp., 58 F.R.D. 153
TB A ee ee 7
Merrill Lynch, Pierce, Fenner & Smith v. Curran,
Soy f Se fF eee 10, 12n.8
Mills v. Esmark, Inc., 91 F.R.D. 70 (N.D. Ill. 1981) 7
Moses v. Burgin, 445 F.2d 369 (lst Cir.), cert.
denied, 404 U.S. 994 (1971). ........ 0c cee eee 12
Weiss v. Sunasco, Inc., 316 F.Supp. 1197 (E.D. Pa.
NETS Cancis a 06ks Seek apenas ska ens awe 7
Weiss v. Temporary Investment Fund, _ F.2d
, CCH Fed. Sec. L. Rep. ¢ 98,865 (3d Cir.,
Mn. . oh) cs ak vet aneucane koev Caw eee 4,
5 &n.5
STATUTES:
Section 36(b) of the Investment Company Act of
Ge Bs So BO. (re ry passim
Rule 23.1 of the Federal Rules of Civil Procedure passim
OTHER AUTHORITIES:
S. Rep. No. 184, 91st Cong., Ist Sess., reprinted in
1970 in 1970 U.S. Code Cong. and Admin. News
YS CR EES ran rp eet SLT RRR EOF ae 6
Note, The Demand and Standing Requirements in
Stockholder Derivative Actions, 44 U. Chi. L.
ED cote ss se dab a) don sabe gvawees 7
W. Fletcher, Cyclopedia of the Law of Private
Corporations (rev. perm. ed. 1980) ............ 12
IN THE
Supreme Court of the United States
October Term, 1982
No. 82-____
DAILY INCOME FUND, INC.
Petitioner,
Vv.
MARTIN FOX,
Respondent.
PETITION FOR WRIT OF CERTIORARI
TO THE UNITED STATES COURT OF APPEALS
FOR THE SECOND CIRCUIT
Petitioner, Daily Income Fund, Inc. (“the Fund”) re-
spectfully prays that a writ of certiorari issue to review
the judgment of the United States Court of Appeals for
the Second Circuit entered in this proceeding on October
26, 1982.'
1 Reich & Tang, Inc., the investment adviser to the Fund (and
the other defendant in this action) supports this petition in all
respects. Pursuant to Rule 28.1 of the Rules of this Court, the
following is a list of all parent companies, subsidiaries (except wholly
owned subsidiaries) and affiliates: the Fund—none; Reich & Tang,
Inc.—August Associates and Centennial Associates.
2
Opinions Below
The opinion of the District Court (Hon. Kevin T.
Duffy) is reported at 94 F.R.D. 94 (S.D.N.Y. 1982). The
opinion of the Court of Appeals is reported at 692 F.2d
250 (2d Cir. 1982). Both are reproduced in the appendix
to this petition.’
Jurisdiction
The judgment of the Court of Appeals was entered on
October 26, 1982. This Court’s jurisdiction is invoked
pursuant to 28 U.S.C. § 1254(1).
Statutes Involved
The statutes and rules involved are Section 36(b) of the
Investment Company Act of 1940 (the “ICA”), 15 U.S.C.
§ 80a-35(b) and Rule 23.1 of the Federal Rules of Civil
Procedure (“Rule 23.1”).
Statement of the Case
Respondent, a minority shareholder of the Fund, a
money market fund, instituted a derivative action under
§ 36(b) of the ICA against Reich & Tang, Inc. (“the
Adviser”), the investment adviser to the Fund, to recover
allegedly excessive advisory fees. The Fund was also
named as a defendant.
The Board of Directors of the Fund consists of five
individuals: three unaffiliated directors and two who are
2 All page references to the appendix are in parentheses and are
followed by the letter “a.”
3
affiliated with the Adviser. Thus, a majority of the Board
of Directors of the Fund is unaffiliated.’
No demand was made by respondent on the directors to
obtain the relief he desired. Respondent simply took
matters into his own hands and, without advance notice,
commenced litigation, allegedly on behalf of the Fund, in
violation of the director demand requirement of Rule
aati.
The Fund promptly moved to dismiss the action for
failure by respondent to comply with the director demand
requirement of Rule 23.1, and that motion was granted
by the District Court. The District Court reasoned, based
on a thorough review of the legislative history of the ICA,
that “. . . under the statutory mandate the board of
directors of an investment company is to be the first line
of defense for the individual investor against any self
dealing into which an adviser might be tempted.” (Sa).
The District Court therefore held that “. . . a Rule 23.1
demand is a sine qua non in this type of litigation.” (Sa).
On appeal, the Court of Appeals reversed, holding that
Rule 23.1 does not apply to actions brought under § 36(b)
of the ICA. The Court of Appeals reasoned that § 36(b)
actions are not derivative because an investment company
does not itself possess the right to bring an action against
its adviser for return of allegedly excessive fees.
This petition followed.
3 The unaffiliated directors are: W. Giles Mellon, Professor of
Business Administration in the Graduate School of Business Ad-
ministration, Rutgers University; Alan J. Patricof, head of a private
investment corporation and Dr. Yung Wong, managing Director of a
venture capital investment firm. The affiliated directors are: Joseph
H. Reich, President and Treasurer of the Fund, and Oscar L. Tang,
Chairman of the Board and Secretary of the Fund.
Reasons for Granting the Writ
The decision of the Court of Appeals—holding that
actions under § 36(b) of the ICA are exempt from the
director demand requirement of Rule 23.1—is in direct
and irreconcilable conflict with the recent decisions of
two other federal courts of appeals on the same matter,
i.e. the Courts of Appeals for the First and Third Cir-
cuits: Grossman v. Johnson, 674 F.2d 115 (1st Cir.), cert.
denied, _.. ~ U.S. ___, 103 S.Ct. 85 (1982); Weiss v.
Temporary Investment Fund, _. F.2d ____, CCH Fed.
Sec. L. Rep. ¢ 98,865 (3d Cir., Nov. 12, 1982).
In addition, the Court of Appeals has decided an
important question of federal law (i.e. the appropriate
interrelationship of two federal statutes, the ICA and the
Federal Rules of Civil Procedure) which has not been, but
should be, settled by this Court.* The decision, while
appearing to be merely procedural, effects a substantive
change in the law with far-reaching consequences.
Further, the decision is in conflict witn the rationale of
Burks v. Lasker, 441 U.S. 471 (1979), and, if permitted to
stand, will undermine the fundamental principle of cor-
porate self-governance in the mutual fund industry.
Finally, the decision of the Court of Appeals rests upon
a fauity central premise, i.e. that an investment company
itself has no right of action under § 36(b) and, therefore,
a shareholder’s action under § 36(b) is not truly derivative
and does not trigger the director demand requirement of
Rule 23.1. This premise is erroneous and does violence to
4 As the Court of Appeals itself noted, resolution of the issue
has “important ramifications for suits brought pursuant to § 36(b).”
(1Sa).
5
the language of Rule 23.1, to the purpose of the ICA, and
to this Court’s recent rulings on implied rights of action.
In sum, a writ of certiorari should be granted because
the decision of the Court of Appeals: (1) creates a conflict
between the circuits; (2) involves an important question
of federal law which has not been, but should be, settled
by this Court, and (3) is erroneous.
Two other federal courts of appeals have decided the
precise issue presented herein, and both have reached the
opposite conclusion from that of the Court of Appeals
for the Second Circuit. After careful consideration, the
Courts of Appeals for the First and Third Circuits re-
jected every argument relied on by the Court of Appeals
for the Second Circuit and held that a demand on the
directors is required in a shareholder’s action brought
under § 36(b) of the ICA. Grossman v. Johnson, 674 F.2d
115 (1st Cir.), cert. denied, ___. ~ U.S. ___., 103 S.Ct. 85
(1982); Weiss v. Temporary Investment Fund, _. F.2d
____, CCH Fed. Sec. L. Rep. € 98,865 (3d Cir., Nov. 12,
1982). These opinions are also reproduced in the appen-
dix to this petition.
The conflict between the circuits is direct and irrecon-
cilable on this important matter.*
5 All three decisions were rendered in 1982. The Second Circuit
noted in this case that its decision conflicted with that of the First
Circuit in Grossman (23a), and the Third Circuit noted in Weiss that
its decision conflicted with that of the Second Circuit in this case
(80a).
6
Il.
The decision below, if allowed to stand, will undermine
the fundamental principle of corporate self-governance
embodied in the ICA.
The 1970 amendments to the ICA make clear that it
was Congress’ intent to preserve and strengthen, rather
than eliminate, the role of the unaffiliated directors with
respect to advisory fees. The Senate Report, which is the
basic document in the legislative history of § 36(b), states:
“These provisions highlight the fact that the section
is not designed to ignore concepts developed by the
courts as to the authority and responsibility of direc-
tors. Indeed, this section is designed to strengthen
the ability of the unaffiliated directors to deal with
these matters and to provide a means by which the
Federal courts can effectively enforce the federally-
created fiduciary duty with respect to management
compensation. The section is not intended to shift
the responsibility for managing an investment com-
pany in the best interest of its shareholders from the
directors of such company to the judiciary.”
S. Rep. No. 184, 91st Cong., Ist Sess., reprinted in 1970
U.S. Code Cong. & Admin. News 4897, 4902-03.
Thus, as this Court recognized in Burks v. Lasker, 441
U.S. 471, 484-85 (1979):
“In short, the structure and purpose of the ICA
indicate that Congress entrusted to the independent
directors of investment companies . . . the primary
responsibility for looking after the interests of the
funds’ shareholders.” (footnote omitted)
-
The District Court below similarly recognized that Con-
gress’ intent was to make the board of directors of an
investment company “the first line of defense for the
individual investor against any self-dealing into which an
adviser might be tempted.” (Sa). Allowing a shareholder
to bypass the board of directors and bring a § 36(b)
action without even making a demand upon the directors
is inconsistent with that purpose.
The director demand requirement is based on a policy
favoring exhaustion of intracorporate remedies. As this
Court held in Hawes v. Oakland, 104 U.S. 450, 460-61
(1882), before a shareholder may commence a derivative
action,
“ . . he should show to the satisfaction of the court
that he has exhausted all the means within his reach
to obtain, within the corporation itself, the redress of
his grievances, or action in conformity to his
wishes.”
This same purpose is the basis for the demand require-
ment of Rule 23.1:
“The purpose of the demand requirement of Rule
23.1 is to allow a corporation to activate intracor-
porate remedies to address shareholder complaints
prior to resorting to judicial intervention.”
Mills v. Esmark, Inc., 91 F.R.D. 70, 72 (N.D.IIl. 1981).
See also Lerman v. ITB Management Corp., 58 F.R.D.
153, 157-58 (D.Mass. 1973); Weiss v. Sunasco, Inc., 316
F.Supp. 1197, 1206 (E.D.Pa. 1970); Note, The Demand
and Standing Requirements in Stockholder Derivative
Actions, 44 U. Chi. L. Rev. 168, 171 (1976).
8
In view of the oversight role with respect to advisory
fees which Congress gave to the unaffiliated directors of
an investment company, the policy of exhaustion of
intracorporate remedies has especially clear application to
shareholder’s derivative actions brought under § 36(b) of
the ICA.
Faced with a timely demand, the directors can respond
in a number of ways. If they find the claim has merit,
they can (1) negotiate with the adviser to obtain a return
of fees, (2) terminate the contract if the adviser refuses,
and/cr (3) institute a § 36(b) action.® If the directors find
the claim lacks merit, they might nevertheless succeed in
avoiding litigation by convincing the complaining share-
holder that the fees are reasonable or that litigation would
adversely affect all shareholders’ interests.
In sum, the ICA imposes upon the directors the duty to
evaluate advisory fees. To exempt § 36(b) actions from
the director demand requirement of Rule 23.1 would
allow a single shareholder to bypass the duly elected
directors and force an investment company into expensive
and time-consuming litigation. In this era of burgeoning
caseloads, the director demand requirement is a particu-
larly important protection against expensive and possibly
unwarranted litigation.
6 The Court of Appeals held that an investment company
cannot itself bring a § 36(b) action. As shown below, that holding is
erroneous. Moreover, even if an investment company has no right of
action under § 36(b), a shareholder's action is still derivative and
Rule 23.1 still applies. The other alternatives open to an investment
company allow it an opportunity to resolve the shareholder’s griev-
ance without resort to | tigation.
9
Ill.
The central error in the Court of Appeals’ decision is
its conclusion that an investment company does not itself
have a right of action under § 36(b) and that, accord-
ingly, a shareholder’s action under § 36(b) is not (in the
words of Rule 23.1) one “to enforce a right which may
properly be asserted by it.” (18a). That holding ignores
this Court’s decisions as to the applicable framework for
determining whether a statute creates an implied right of
action and conflicts with the fundamental purpose of the
ICA.
A.
In Cort v. Ash, 422 U.S. 66, 78 (1975), this Court held
that the following factors should be considered on the
issue of a statutory implied right of action:
“First, is the plaintiff ‘one of the class for whose
especial benefit *he statute was enacted,’—that is,
does the statute create a federal right in favor of the
plaintiff? Second, is there any indication of legisla-
tive intent, explicit or implicit, either to create such a
remedy or to deny one? Third, is it consistent with
the underlying purposes of the legislative scheme to
imply such a remedy for the plaintiff? And finally, is
,
7 The Court of Appeals also relied for its holding on this
Court’s suggestion in Burks v. Lasker, supra, 441 U.S. at 484, that
directors may not terminate suits under § 36(b). The Court of
Appeals reasoned from this premise that the traditional reasons for a
director demand do not apply. (36-37a). However, as just demon-
strated, that conclusion does not follow, because a demand furthers
the policy behind the exhaustion of intracorporate remedies even if
the directors cannot terminate a § 36(b) action.
10
the cause of action one traditionally relegated to
state law, in an area basically the concern of the
States, so that it would be inappropriate to infer a
cause of action based sclely on federal law.”
Last term, this Court placed the following gloss upon the
framework set forth in Cort:
“In determining whether a private cause of action is
implicit in a federal statutory scheme when the stat-
ute by its terms is silent on that issue, the initial focus
must be on the state of the law at the time the
legislation was enacted. More precisely, we must
examine Congress’ perception of the law that it was
shaping or reshaping. When Congress enacts new
legislation, the question is whether Congress in-
tended to create a private remedy as a supplement to
the express enforcement provisions of the statute.
When Congress acts in a statutory context in which
an implied private remedy has already been recog-
nized by the courts, however, the inquiry logically is
different. Congress need not have intended to create
a new remedy, since one already existed; the question
is whether Congress intended to preserve the preex-
isting remedy.” (footnote omitted)
Merrill Lynch, Pierce, Fenner & Smith v. Curran, —
U.S. ___, 102 S. Ct. 1825, 1839 (1982).
The Court of Appeals in this case did not specifically
evaluate any of these factors. Although it recognized that
the legislative history of § 36(b) was silent as to whether
an investment company could bring an action to recover
excessive advisory fees, it construed that silence as mili-
tating against an implied right of action (29a). Its ra-
tionale for that conclusion was that “(t}he relationship of
1]
a fund to its adviser makes it part of the problem in a way
that precludes it from being part of the solution, at least
at the litigation stage.” (34-35a). That conclusion is pre-
mised upon a fundamentally unsound view of the purpose
of the ICA, as set forth in the legislative history and as
interpreted by this Court in Burks v. Lasker, supra.
As this Court recognized in Burks, the thrust of the
1970 amendments to the ICA was to increase the partici-
pation of the unaffiliated directors in the operation of
mutual funds. To deny the directors an opportunity to
exercise that power would undercut the whole Congres-
sional effort to enhance the role of unaffiliated directors.
Although Burks dealt with a different ulttmate issue, it
aptly appraised the role Congress assigned to the unaffili-
ated directors in the 1970 amendments to the ICA:
“Indeed, it would have been paradoxical for Con-
gress to have been willing to rely largely upon
‘watchdogs’ to protect shareholder interests and yet,
where the ‘watchdogs’ have done precisely that,
require that they be totally muzzled.” (footnote omit-
ted)
Burks v. Lasker, supra, 441 U.S. at 485. Thus, an implied
corporate right of action under § 36(b) is not at all
inconsistent with the purpose of the ICA. To the contrary,
it furthers the role of the directors as “watchdogs” and
provides another means (in addition to suits by the SEC
and shareholders) to recover excessive advisory fees.
Since an implied corporate right of action furthers the
purpose of the ICA, the Court of Appeals for the Second
Circuit erred in construing Congress’ silence on this
matter as indicating an intent to deprive an investment
company of the right to bring an action against its
adviser.
12
In addition, the Court of Appeals overlooked the state
of the law at the time Congress enacted § 36(b). The
common law predecessor to a § 36(b) action was a share-
holder’s suit against the adviser for “corporate waste,”
which was clearly derivative. 13 W. Fletcher, Cyclopedia
of the Law of Private Corporations 44 5924, 5926-27
(rev. perm. ed. 1980). Moreover, a shareholder’s implied
right of action under former § 36 of the ICA (now
§ 36(a)), was uniformly held to be derivative. E.g. Moses
v. Burgin, 445 F.2d 369 (1st Cir.), cert. denied, 404 U.S.
994 (1971); Brown v. Bullock, 194 F. Supp. 207, 245
(S.D.N.Y.), aff'd, 294 F.2d 415 (2d Cir. 1961). In light of
this background, Congress can and should be presumed
to have known in 1970 that an investment company had
its own right of action against its adviser.* Since there is
no evidence that Congress intended to abolish this pre-ex-
isting right of an investment company to bring an action
to recover excessive advisory fees, the Court of Appeals
erred in holding that an investment company has no right
of action under § 36(b).
Even if (contrary to our analysis) an investment com-
pany does not itself have a right of action under § 36(b),
a shareholder's action under § 36(b) is derivative and
must be preceded by a director demand.
Rule 23.1 requires director demand “[i)n a derivative
action brought by one or more shareholders or members
to enforce a right of a corporation. . . , the corporation
. . . having failed to enforce a right which may properly
x “Where Congress adopts a new law incorporating sections of
a prior law, Congress can be presumed to have had knowledge of the
interpretation given to the incorporated law.” Merrill Lynch, Pierce,
Fenner & Smith v. Curran, supra, \02 S.Ct. at 1841 n. 66.
13
be asserted by it...” Neither the language nor the
purpose of Rule 23.1 supports the Court of Appeals’
holding that an action is “derivative” only if the right that
a shareholder seeks to enforce is one that the corporation
could assert in a lawsuit. That holding confuses the
concepts of “right” and “remedy.” Regardless of whether
an investment company has a remedy under § 36(b)—it is
beyond dispute that it has a right not to be charged
excessive advisory fees.
Under § 36(b) a shareholder is permitted to bring an
action against an investment advisor “on behalf of” an
investment company. This provision clearly makes a
shareholder’s action derivative. As this Court noted in
Burks v. Lasker, supra, 441 U.S. at 477, “[a] derivative
suit is brought by shareholders to enforce a claim on
behalf of the corporation.” (emphasis supplied) This
Court then went on to refer to § 36(b) suits as “deriva-
tive”. Id. at 484.
Moreover, the policy underlying the director demand
requirement of Rule 23.1—that of favoring exhaustion of
intra-corporate remedies—is applicable to a shareholder's
action under § 36(b) regardless of whether the investment
company can itself bring such an action. As demonstrated
above, the directors of an investment company have a
number of methods to resolve a shareholder's grievance
concerning advisory fees without resorting to litigation.
The Court of Appeals set at naught these other remedies
because of its belief that, as a practical matter, they would
not be effeciive (19-20a n.7). That belief is unsupported
and conflicts with the whole purpose of the ICA to make
the unaffiliated directors the “independent watchdogs” of
an investment company’s interests. Burks v. Lasker, su-
pra, 441 U.S. at 484.
14
In sum, the central premise of the Court of Appeals’
decision is erroneous: an investment company has its own
right of action under § 36(b), and even if it does not, a
shareholder's action under § 36(b) is derivative and must
comply with the director demand requirement of Rule
23.1.
Conclusion
For the foregoing reasons, a writ of certiorari should
issue to the United States Court of Appeals for the
Second Circuit.
Respectfully submitted,
January J4, 1983
DANIEL A. POLLACK*
FREDERICK P. SCHAFFER
61 Broadway (Suite 2500)
New York, New York 10006
(212) 952-0330
Counsel for Petitioner
Daily Income Fund, Inc.
GEORGE C. SEWARD
ANTHONY R. MANSFIELD
Wall Street Plaza
New York, New York 10005
(212) 248-2800
Counsel for Reich & Tang, Inc.
*Counsel of Record
APPENDIX
Decision of the District Court
la
>—
No. 81 Civ. 2602 (KTD).
United States District Court,
S. D. New York.
March 29, 1982.
=
MARTIN Fox,
Plaintiff,
—
REICH & TANG, INC. and Daily Income Fund, Inc.,
Defendants.
_
Money market investment company shareholder
brought derivative action against the company and the
investment adviser to the company to recover allegedly
excessive advisory fees paid by the company to the invest-
ment adviser. On the defendants’ motion to dismiss, the
District Court, Kevin Thomas Duffy, J., held that: (1) the
shareholder was required to make demand on the com-
pany board of directors prior to bringing suit, and (2) the
shareholder’s failure to make such a demand was not
excused by his unsubstantiated allegtion that all the com-
pany directors were involved in the wrongdoing and were
necessarily hostile to his claim.
Motion granted.
2a
Milberg, Weiss, Bershad & Specthrie, New York City,
for plaintiff; Richard M. Meyer, New York City, of
counsel.
Seward & Kissel, New York City, for defendant Reich &
Tang, Inc.; Anthony R. Mansfield, New York City, of
counsel.
Pollack & Kaminsky, New York City, for defendant
Daily Income Fund, Inc.; Daniel A. Pollack, Edward T.
McDermott, Frederick P. Schaffer, New York City, of
counsel.
++—_.
OPINION & ORDER
KEVIN THOMAS Durry, District Judge:
Martin Fox, a shareholder of Daily Income Fund, Inc.
(“Fund”), sued the Fund, a money market investment
company, and Reich & Tang, Inc. (“R&T”), the invest-
ment adviser to the Fund, to recover allegedly excessive
advisory fees paid by the Fund to R&T. Plaintiff’s deriva-
tive suit is premised on Section 36(b) of the Investment
Company Act of 1940, 15 U.S.C. § 80a-35(b), which
places a fiduciary duty on an investment adviser with
respect to compensation for services.' R&T is alleged to
have breached that duty.
l 15 U.S.C. § 80a-35(b) provides in relevant part:
(b) For the purposes of this subsection, the investment
adviser of a registered investment company shall be deemed
to have a fiduciary duty with respect to the receipt of
compensation for services, or of payments of a material
nature, paid by such registered investment company, or by
the security holders thereof, to such investment adviser or
any affiliated person of such investment adviser. An action
may be brought under this subsection by the Commission, or
3a
Defendants move to dismiss plaintiff's complaint for
failing to plead that a demand was made on the Fund’s
board of directors prior to the filing of its complaint.
Federal Rule of Civil Procedure 23.1 expressly states that
a derivative suit complaint:
shall also allege with particularity the efforts, if any,
made by the plaintiff to obtain the action he desires
from the directors or comparable authority. . . and
the reasons for his failure to obtain the action or for
not making the effort.
Plaintiff concedes that no demand was made and suggests
that Section 36(b) does not require such a demand.
The issues presented to this Court are two-fold: one,
whether a demand is required in a Section 36(b) action
and, two, if a demand is mandated, whether plaintiff is
excused from the strictures of Fed.R.Civ.P. 23.1. The
by a security holder of such registered investment company
on behalf of such company, against such investment adviser,
or any affiliated person of such investment adviser, or any
other person enumerated in subsection (a) of this section who
has a fiduciary duty concerning such compensation or pay-
ments, for breach of fiduciary duty in respect of such
compensation or payments paid by such registered invest-
ment company or by the security holders thereof to such
investment adviser or person. With respect to any such
action the following provisions shall apply:
es . . . . @
(2) In any such action approval by the board of directors
of such investment company of such compensation or pay-
ments, or of contracts or other arrangements providing for
such compensation or payments, and ratification or approval
of such compensation or payments, or of contracts or other
arrangements providing for such compensation or payments,
by the shareholders of such investment company, shall be
given such consideration by the court as is deemed appropri-
ate under all the circumstances.
4a
answers to these questions have apparently resulted in a
split within this district. Judge Ward recently held in
Markowitz v. Brody, et al., 90 F.R.D. 542 (S.D.N.Y.1981)
that Section 36(b) does not obviate the need for a Rule
23.1 demand. In direct contrast, Judge Lasker states in
dictum that “a demand on the directors of the Fund was
not intended to be a prerequisite to suit under § 36(b).”
Blatt v. Dean Witter Reynolds Intercapital Inc., et al.,
528 F.Supp. 1152, 1155 (S.D.N.Y.1981). Plaintiff argues
that the Blart decision should control this case for the
following reasons: (1) the board of directors inability to
terminate a Section 36(b) action renders any demand
futile; (2) the legislative history supports plaintiff’s con-
tentions; and (3) a suit maintained under Section 16(b),
an analogous section, need not comply with Rule 23.1. I
do not find any of these arguments to be persuasive.
DISCUSSION
Before I begin to address plaintiff’s three arguments, I
must start my discussion of the question presented neither
with the particular section of the Investment Company
Act in issue nor with the Federal Rules of Civil Proce-
dure, but with the overall congressional intent behind the
Investment Company Act and its requirement that there
be “unaffiliated” persons on the board of directors of
investment companies. Clearly in mandating this type of
membership on the decision making board of an invest-
ment company, Congress recognized the need for protec-
tion of investors from unscrupulous investment advisors
who might be in a position to mulct the public investor.
The advisor to an investment company is entrusted with
enormous amounts of money collected from the public
shareholders and also with the day-to-day management of
Sa
those funds. S.Rep.No.184, 91st Cong., Ist Sess. (1969)
reprinted in {1970} U.S.Code Cong. & Admin.News,
4897, 4903, 4910. The temptation for self dealing whether
through inflated fees or other nefarious schemes is self-
evident.
It was to inhibit such self dealing that Congress insisted
that directors unaffiliated with either the investment advi-
sor or the Fund’s principal underwriter constitute forty
percent of the board of an investment company, 15
U.S.C. § 80a-10. “Since the adviser and underwriter are
usually the same or related entities, a majority of the
directors of most funds [including the Daily Income
Fund] are unaffiliated with their managers.”
S.Rep.No.184, 91st Cong., Ist Sess. (1969) reprinted in
[1970] U.S.Code Cong. & Admin.News at p. 4901. Thus,
under the statutory mandate the board of directors of an
investment company is to be the first line of defense for
the individual investor against any self dealing onto which
an advisor might be tempted. Foge/ v. Chesnutt, 668 F.2d
100 at 104 (2d Cir. 1981); Moses v. Burgin, 445 F.2d 369,
376 (Ist Cir.), cert. denied, 404 U.S. 994, 92 S.Ct. 532, 30
L.Ed. 2d 547 (1971).
To require that an individual shareholder must first
bring a problem to the board of an investment company
therefore is not unreasonable. The unaffiliated directors
can easily solve the problem (if it be real) without the
need for litigation and its concomitant expense to the
investment company. Thus, absent extraordinary circum-
stances, a Rule 23.1 demand is a sine qua non in this type
of litigation. To hold otherwise is to rule that the congres-
sional enactment of the Investment Company Act is, in
the main, ineffective, and the arguments advanced by
plaintiff do not lead to such an anomalous result.
6a
1. Termination of a Section 36(b) Suit
Mr. Fox correctly states that a Section 36(b) suit cannot
be terminated by the Fund’s board of directors. Burks v.
Lasker, 441 U.S. 471, 484, 99 S.Ct. 1831, 1840, 60
L.Ed.2d 404 (1979); Markowitz, supra, 90 F.R.D. at 559.
However, it does not logically follow that this safeguard
obliterates any need for compliance with Rule 23.1. Even
assuming, as plaintiff suggests, that the Fund’s board of
directors, which consists of three disinterested and two
interested members, are hostile to his claim, this is not
adequate justification for abandonment of the Federal
Rules of Civil Procedure. The underlying basis for impos-
ing the demand requirement on a derivative suit plaintiff
extends beyond providing an opportunity for director
termination. Directors should be given an opportunity to
redress an aggrieved plaintiff without resort to litigation,
Untermeyer v. Fidelity Daily Income Trust, et al., 79
F.R.D. 36, 42 (D.Mass.1978), or to institute a private
right of action themselves.’ Acceptance of plaintiff's
argument would foreclose any opportunity for prelitiga-
tion director involvement and as such is untenable.
2. Lesiglative History
Mr. Fox’s bare contention that a demand on the Fund
director’s in a Section 36(b) suit is futile and consequently
unnecessary and unreasonable, is not sufficient reason to
ignore Rule 23.1. A “statute should be so construed as to
harmonize with the Federal Rules if that is at all feasi-
ble.” 7 Moore’s Federal Practice ¢ 86.04[4] at 4966.
2 It is unsettled whether or not the directors are empowered to
maintain a private right of action. Fogel v. Chestnutt, 668 F.2d 100,
112, (2d Cir. 1981); Markowitz, supra, 90 F.R.D. at 557 n.12;
Untermeyer, supra, 79 F.R.D. at 46 n.30.
Ja
Section 36(b) silence on the necessity of demand on the
directors assumes compliance with Rule 23.1. The Federal
Rules may, however, be superseded by congressional
enactments that “abridge, enlarge or modify any substan-
tive right.” 28 U.S.C. § 2072.
{I]t is plain to the Court that a security holder’s right
to sue under Section 36(b) would in no way be
modified or abridged within the meaning of 28
U.S.C. § 2072 simply by requiring compliance with
Rule 23.1 . . . Section 2072 is not triggered by an
instance where application of the federal rules would
be unreasonable, but only in a case where the rules
directly conflict with substantive rights. No such
conflict exists here.
Markowitz, supra, 90 F.R.D. at 555.
The legislative history provides scant basis for conclud-
ing that statutory disharmony exists with the traditional
demand requirement. Plaintiff cites passages from a Sen-
ate Committee Report expressing guarded concern for the
directors’ ability to “secure changes in the level of advi-
sory fee rates in the mutual fund industry.”
H.R.Rep.No.2337, 89th Cong., 2d Sess. (1966) at 131.
Congress’s proper concern with the issue of investment
adviser compensation does not raise the presumption that
Congress intended to abrogate Rule 23.1 nor has plaintiff
presented this Court with any language supporting such a
presumption.
In 1970, Section 36(b) was added to the Investment
Company Act to “specify that the adviser has a fiduciary
duty with. respect to compensation for services of other
payments paid by the fund ... to the adviser.”
S.Rep.No.184, 91st Cong., Ist Sess. (1969), reprinted in
8a
[1970] U.S.Code Cong. & Admin.News at 4902. The
enactment of Section 36(b),
is not designed to ignore concepts developed by the
courts as to the authority and responsibility of direc-
tors. Indeed, this section is designed to strengthen
the ability of the unaffiliated directors to deal with
these matters and to provide a means by which the
Federal courts can effectively enforce the federally-
created fiduciary duty with respect to management
compensation. The section is not intended to shift
the responsibility for managing an investment com-
pany in the best interests of its shareholders from the
directors of such company to the judiciary.
Id. at 4903. This legislative history supports defendants’
position that the congressional motivation behind Section
36(b) was to combine forces between the unaffiliated
directors and the Federal courts to adequately and equita-
bly supervise the amount of advisory fees. Plaintiff’s
inference that this supervision can only occur at the
sacrifice of Rule 23.1 is unreasonable and unwarranted. It
would indeed be inconsistent with the expressed motives
of the 1970 Amendments “to have been willing to rely
largely upon ‘watchdogs’ [unaffiliated directors] to pro-
tect shareholder interests and yet, where the ‘watchdogs’
have done precisely that, require that they be totally
muzzled.” Burks, supra, 441 U.S. at 485, 99 S.Ct. at
1840.
Judge Lasker’s decision in Blatt ignored the congres-
sional imperative for independent management of money
market funds and mistakenly presumed, in reliance on
Boyko yv. Reserve Fund, Inc., 68 F.R.D. 692
(S.D.N.Y.1975) (LPG), that the directors of an invest-
ment company are uniformly antagonistic to “an action
9a
against the Fund’s advisors for breach of fiduciary duty
with respect to the receipt of compensation.” /d. at 696.
Section 10 of the Investment Company Act which man-
dates that directors unaffiliated with both the investment
advisor and the fund’s principal underwriter comprise
forty percent of an investment company’s board of direc-
tors, refutes on its face the presumption of hostility found
in both the Blatt and Boyko decisions. Unless plaintiff is
prepared to contest the true “disinterest” of each unaffi-
liated director, these independent board members will
continue to examine with a discerning eye, as Congress
intended, the payments of advisory fees. Without diligent
observation of Rule 23.1 these directors will be denied an
opportunity to fulfill the congressional mandate.
The importance of director involvement in the instant
case is underscored in Section 36(b)(2), which provides
that director approval of any advisory fees “shall be given
such consideration by the court as is deemed appropriate
under all the circumstances.” 15 U.S.C. § 80a-35(b)(2).
This provision permits the court to scrutinize the directors
judgment in approving adviser compensation and to eval-
uate whether the “deliberations of the directors were a
matter of substance or a mere formality.” S.Rep.No.184,
91st Cong., Ist Sess. (1969) reprinted in [1970] U.S.Code
Cong. & Admin.News at 4910. Rule 23.1, which fosters
director input, is crucial to the court’s determination and
despite plaintiff’s arguments, it will not be ignored.
3. Section 16(b)
Plaintiff's final argument rests on an ill conceived
analogy between Section 16(b)’ of the Securities Exchange
3 “Section 16(b) authorizes actions on behalf of a corporation
to recover short-swing profits realized by corporate insiders as a
10a
Act of 1934, 15 U.S.C. § 78p(b), and Section 36(b).
Plaintiff cites cases for the proposition that Rule 23.1
does not apply to Section 16(b) cases, Dottenheim v.
Murchison, 227 F.2d 737 (Sth Cir. 1955), cert. denied, 351
U.S. 919, 76 S.Ct. 712, 100 L.Ed. 1451 (1957); Blau v.
Mission Corp., 212 F.2d 77 (2d Cir.), cert. denied, 347
U.S. 1016, 74 S.Ct. 872, 98 L.Ed. 1138 (1954). However,
these cases dealt with the contemporaneous ownership
requirement of Rule 23.1 and not the demand clause at
issue here. Thus, plaintiff’s reliance on this case law is
misplaced. This crucial distinction destroys plaintiff's
suggested analogy between Section 16(b) and Section
36(b).
I am convinced that Rule 23.1 and Section 36(b) can
and should co-exist compatibly. Plaintiff's arguments do
not persuade me otherwise. Plaintiff's failure to make a
Rule 23.1 demand on the fund directors is grounds for
dismissal of the complaint unless Mr. Fox’s failure to
make such a demand may be excused by some extraor-
dinary circumstances.
Plaintiff's complaint states at paragraph 14:
No demand has been made by the plaintiff upon
the Fund or its directors to institute or prosecute this
action for the reason that no such demand is required
under § 36(b) of the Act. Moreover, all of the direc-
tors are beholden to R&T for their positions and
have participated in the wrongs complained of in this
action. Their initiation of an action like the instant
one would place the prosecution of this action in the
hands of persons hostile to its success.
result of their purchases and sales of the corporation's equity securi-
ties.” Markowitz, supra, 90 F.R.D. at 551.
lla
This averment, besides being inconsistent with plaintiff's
argument that the directors cannot maintain their own
action, presents no adequate grounds for disobedience
with Rule 23.1. The contention that all the Fund directors
are involved in the wrongdoing and necessarily hostile to
plaintiff's claim is unfounded. First of all, this presump-
tion is contrary to the congressional entrustment of sur-
veillance responsibilities to the unaffiliated directors
discussed supra. Burks, supra, 441 U.S. at 486, 99 S.Ct.
at 1841. Secondly, plaintiff’s only proof of the potential
hostility of the Fund directors to the instant case is found
in the Fund’s proxy statement dated September 4, 1981.
This statement, issued four months after plaintiff filed his
complaint discusses the instant litigation: “The Manager
and the Corporation believe that the advisory fees paid by
the Corporation have not been and are not excessive, and
the Manager and the Corporation intend to deny and
contest the material allegations of the complaint.” at
p. 10. This post-complaint hindsight cannot excuse Mr.
Fox’s failure to make a demand on the directors before
filing his complaint.
Plaintiff has presented no justification for his noncom-
pliance with Rule 23.1. Plaintiff alternatively requests
that if this Court rules unfavorably, leave be granted to
file an amended complaint. The rule in this Circuit is that
leave to file amended complaints is usually freely granted
absent prejudice to the parties. State Teachers Retirement
Board vy. Fluor Corp., 654 F.2d 843, 856 (2d Cir. 1981). In
the instant case, prejudice to the directors would result
from plaintiff’s dilatory amendment. One of the purposes
of Rule 23.1 is to allow the directors to respond to
plaintiff’s claim prior to the initiation of a lawsuit.
Allowing plaintiff to now file an amended complaint
l2a
would make a mockery of the demand requirement. See
Shlensky v. Dorsey, 574 F.2d 131, 141 (3d Cir. 1978);
Weiss v. Temporary Investment Fund, Inc., 520 F.Supp.
1098 (D.C.Del.1981).
Thus, defendants’ motion to dismiss is granted and
plaintiff is denied leave to file an amended complaint.
SO ORDERED.
Decision of the Court of Appeals
l3a
aoe
No. 74, Docket 82-7296.
United States Court of Appeals,
Second Circuit.
Argued September 16, 1982.
Decided October 26, 1982.
7
MARTIN Fox,
Plaintiff-Appellant,
—
REICH & TANG, INC. and
DAILY INCOME FUND, INC.,
Defendants-Appellees.
aoe
Shareholder appealed from dismissal by the United
States District Court for the Southern District of New
York, Kevin Thomas Duffy, J., 94 F.R.D. 94, of share-
holder’s action to recover allegedly excessive fees paid by
investment company to its adviser. The Court of Appeals,
Irving R. Kaufman, Circuit Judge, held that: (1) invest-
ment company did not possess right of action under
section of Investment Company Act of 1940 that provides
right of action to recover excessive fees by Securities and
Exchange Commission or by security holder, and (2)
demand requirement of Federal Rule of Civil Procedure
l4a
governing derivative actions was inapplicable to share-
holder’s suit.
Reversed and remanded.
+
Richard M. Meyer, New York City (Milberg, Weiss,
Bershad & Specthrie, New York City, of counsel), for
plaintiff-appellant.
Daniel A. Pollack, New York City (Pollack & Kaminsky,
Frederick P. Schaffer, New York City, of counsel), for
defendant-appellee Daily Income Fund, Inc.
Seward & Kissel, New York City (Anthony R. Mans-
field, New York City, of counsel), for defendant-appellee
Reich & Tang, Inc.
aoe
Before FEINBERG, Chief Judge, and
FRIENDLY and KAUFMAN, Circuit Judges.
—-
IRVING R. KAUFMAN, Circuit Judge:
This case presents an issue of first impression in this
Circuit. The question before us is whether, in a share-
holder action brought pursuant to § 36(b) of the Invest-
ment Company Act of 1940 to recover allegedly excessive
fees paid by an investment company to its adviser,' the
| Section 36(b) imposes upon the investment adviser of a
registered investment company “a fiduciary duty with respect to the
receipt of compensation for services.” 15 U.S.C. § 80a-35(b). It
creates a cause of action for breach of that duty, id., and specifically
limits “[aJny award of damages. . . to the actual damages resulting
from the breach of fiduciary duty[,]. . . in no event exceed[ing] the
15a
shareholder plaintiff is required to plead that a “demand”
was made on the company’s board of directors prior to
filing of the complaint.’ At first blush, resolution of this
question would seem to require merely clarification of a
technical pleading rule. As our discussion makes clear,
however, analysis of the issue is not uncomplicated, nor is
our conclusion without important ramifications for suits
brought pursuant to § 36(b).
Because this case comes to us from a dismissal at the
pleading stage, the factual record is sparse. Martin Fox, a
shareholder of Daily Income Fund, Inc. (“the Fund”),
brought this action on behalf of the Fund to recover
allegedly excessive fees paid by the Fund to its investment
adviser, Reich & Tang, Inc. (“R & T”). The Fund, an
open-end investment company of the type commonly
referred to as a “money-market fund,” pursues as its
basic business strategy the goal of achieving high current
income levels while preserving capital. To this end, it
invests in a portfolio of short-term money market instru-
ments, principally United States government and federal
agency obligations, obligations of major banks, and
prime commercial paper. The Fund experienced a dra-
matic surge in its assets, in a relatively short period of
amount of compensation or payments received from [the] investment
company. . . .” Ihe legislative history reveals that Congress created
this somewhat particularized fiduciary duty with specific reference to
the recurring problem of payment of excessive adviser and manage-
ment fees, e.g., S.Rep. No. 184, 91st Cong., Ist Sess. 5-6 (1969),
reprinted in 1970 U.S.Code Cong. & Ad.News 4897, 4901-02.
2 This pleading requirement in the federal courts is embodied
in Federal Rule of Civil Procedure 23.1, the text of which is set out at
note 6.
l6a
time. As of June 80, 1978, the Fund’s net assets were
approximately $75 million. Less than three years later, on
April 15, 1981, they had reached a level of $775,000,000.
Precisely this sort of “dramatic growth”’ impelled enact-
ment of the 1970 amendments to the Investment Com-
pany Act of 1940, and, in particular, § 36(b), which
created a cause of action for return of excessive adviser
fees. Because fees are usually calculated as a percentage
of assets, substantial portfolio appreciation brings with it
the risk of unduly high adviser compensation. See S.Rep.
No. 184, 91st Cong., Ist Sess. 6 (1969), reprinted in 1970
U.S.Code Cong. & Ad.News at 4902; see also J. Barnard,
Jr., Reciprocal Business, Sales Charges and Management
Fees, in 1966 Fed. B.A. Conference on Mutual Funds
127-29,
Despite this substantial increase in Fund assets, no
adjustment was made in the rate at which R & T was to be
paid for investment advice and other management ser-
vices rendered. R & T's fee was originally set one-half of
One percent of the Fund’s net assets, and it remains fixed
at that rate. Consequently, yearly payments by the Fund
to its adviser increased from approximately $375,000 in
3 S.Rep. No. 184, 91st Cong., Ist Sess. 3 (1969), reprinted in
1970 U.S.Code Cong. & Ad.News at 4899. After passage of the
Investment Company Act of 1940, the industry experienced a period
of relative stability. During the first year 436 companies registered,
pursuant to the Act, At the end of fiscal year 1959, the number of
companies had increased to only 453 with aggregate assets of about
$20,000,000,000, By 1966, just seven years later, 727 companies were
registered, representing assets of nearly $50 billion. 1966 SEC
Ann.Rep. 100. Not surprisingly, that same year Congress requested
the Securities and Exchange Commission to investigate this matter.
The SEC's findings, and recommendations for legislative action are
contained in Report on the Public Policy Implications of Investment
Company Growth, reprinted in H.R.Rep. No. 2337, 89th Cong., 2d
Sess. (1966) (“/966 SEC Report”).
17a
1978, to a projected $3,875,000 in 1981. During the fiscal
year ending June 30, 1980, R & T received more than
$2,000,000 in management fees from the Fund. It is this
extraordinary leap in fees of which Fox complains.
Fox’s complaint alleged that management of the assets
of a money market fund requires no detailed analysis of
industries (or of large individual industrial concerns), nor
the retention of a large staff of highly paid, sophisticated
securities analysts. Essentially, he claimed that investment
decisions are more or less routine, concentrated as they
are in the relatively limited realm of “turning over”
, money market investments with a small number of insti-
tutions. In short, Fox alleged that R & T was continuing
to provide the services it had always rendered, for what
had become an exorbitant amount of money.
Rather than approach the Fund’s directors with his
grievance, Fox chose to allege in his complaint that no
“demand” is required under § 36(b).* In response, the
4 Fox's complaint asserted, in addition to this legal conclusion,
that “all of the [Fund's] directors are beholden to R & T for their
positions and have participated in the wrongs complained of in this
action. Their initiation of an action like the sib 84 would place
the prosecution of this action in the hands of persons hostile to its
success.” Apparently by way of response, the Fund notes that a
majority of its Board of Directors, three of five, are “disinterested
directors.” We need not deal with the effect of these statements.
Some courts have held demand will be excused when a plaintiff
shows that a majority of the investment company’s directors possess
an interest in the subject matter of the lawsuit sufficient to conclude
that it would have been futile to ask for board action. E.g.,
Markowitz v. Brody, 90 F.R.D. 542, §§6 (S.D.N.Y. 1981). Yet, the
mere presence of a majority of directors not directly employed by the
adviser may not automatically result in the conclusion that a demand
will be required. See Lewis v. Curtis, 671 F.2d 779, 785-86 (3d Cir.
1982). Because we agree with Fox that a § 36(b) action is exempt
from the director demand requirement of Rule 23.1, we do not pass
on the excuse issue.
18a
Fund (later joined by R & T) moved to dismiss for failure
to comply with Rule 23.1. After noting that the issue had
resulted in a split among the district courts in this Cir-
cuit, Judge Duffy concluded that a Rule 23.1 demand
was required in a § 36(b) suit, and dismissed the com-
plaint. Fox appealed. For the reasons stated below, we
disagree with the district court’s conclusion, 94 F.R.D.
94, and reverse. P
We begin by noting that the Rule 23.1 demand require-
ment applies only when a corporation or association has
“failed to enforce a right which may properly be asserted
by it.”° We agree with Fox that the rule applies only when
s Indeed, the conflict between previous district court cases
could not be more stark. In Markowitz v. Brody, supra, 90 F.R.D. at
§54-S5, Judge Ward concluded that Rule 23.1 applies to § 36(b)
shareholder suits. Accord, Gartenberg v. Merrill Lynch Asset
Management, Inc., 91 F.R.D. §24, §26-28 (S.D.N.Y.1981). In direct
contrast, Judge Lasker has stated: “a demand on the directors of the
fund was not intended to be a prerequisite to suit under § 36(b).”
Blatt v. Dean Witter Reynolds Intercapital, Inc., $28 F.Supp. 1152,
1188 (S.D.N.Y.1982) (dictum). Cf. Bovko v. Reserve Fund, Inc., 68
F.R.D. 692, 696 (S.D.N.¥Y.1975) (Gagliardi, J.) (when at least one
affiliated or interested director on mutual fund board, futility of
demand will be presumed, and, therefore, Rule 23.1 will be satisfied).
6 Fed.R.Civ.P. 23.1 provides, in its entirety:
Derivative Actions by Shareholders
In a derivative action brought by one or more shareholders
or members to enforce a right of a corporation or of an
unincorporated 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 transaction 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
19a
the specified entity has an opportunity to “assert,” in a
court, the same action under the same rule of law on
which the shareholder plaintiff relies. Thus, if the Fund
may not sue pursuant to § 36(b), no demand upon its
board of directors will be required. In rejecting the
Fund’s argument that even if it cannot bring an action
under § 36(b), a demand must be made upon its directors
to utilize other, informal means to “enforce its right” to
return of excessive adviser fees, Brief of Defendant-Ap-
pellee Daily Income Fund, Inc. at 5-6, we announce no
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
obtain the action he desires from the directors or comparable
authority and, if necessary, from the shareholders or mem-
bers, 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 tairly and
adequately represent the interests of the shareholders or
members similarly situated in enforcing the right of the
corporation 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 shareholders or members in such manner as the
court directs.
7 As indicated, we disagree that availability of informal
methods of attempting to recoup excessive adviser fees is sufficient to
trigger the demand requirement of Rule 23.1. Moreover, we find the
examples given by the Fund—negotiating with the Adviser to obtain
a refund, and terminating the contract, Brief for Defendant-Appellee
Daily Income Fund, Inc. at 5-6—not persuasive. Negotiations may
well fail, and termination of the contract, although perhaps depriving
the adviser of future business, may not effect the remedy sought by
the shareholder plaintiff, which is the return of excessive fees.
Additionally, “a mutual fund cannot, as a practical matter sever its
relationship with [its] adviser.” S.Rep. 184, 91st Cong., Ist Sess. §
(1969), reprinted in 1970 U.S.Code Cong. & Ad.News at 4901.
Moreover, given the directors’ past relationship with the adviser in
approving the contract in the first place, 1S U.S.C. § 80a-15(c), the
20a
new rule of law. As long ago as the beginning of this
century, the Supreme Court construed Equity Rule 94,
104 U.S. ix (1882), the precursor of Rule 23.1, and
determined that its nearly identical language’ referred to
“a suit founded on a right of action existing in the
corporation itself, and in which the corporation itself is
the appropriate plaintiff.” Delaware & Hudson Co. v.
Albany & Susq. R.R., 213 U.S. 435, 447, 29 S.Ct. 540,
$43, §3 L.Ed. 862 (1909); see also Ross v. Bernhard, 396
U.S. §31, §34-35, 90 S.Ct. 733, 735-736, 24 L.Ed.2d 729
(1970).
Accordingly, we turn initially to the question whether
an investment company can bring an action under § 36(b)
of the Investment Company Act of 1940.
A
Our starting point, as in every case involving construc-
tion of a statute, is examination of the language utilized
likelihood that negotiations will prove effective is highly speculative.
See Blatt v. Dean Witter Reynolds Intercapital, Inc., supra, $28
F.Supp. at 1186 (dictum). In reaching this conclusion, we do not
ignore the salutary purpose served by requiring complaining share-
holders to first “activate intracorporate remedies,” Mills v. Esmark,
Inc., 91 F.R.D. 70, 72 (N.D.1I.1981). Rather we conclude that a
demand will not be mandated unless, should intracorporate efforts
prove insufficient, the corporation itself may bring suit. /d. (quoting
Hawes v. Oakland, 104 U.S. 480, 460-61, 26 L.Ed. 827 (1882)).
8 Equity Rule 94 provided, in relevant part:
Every bill brought by one or more stockholders in a
corporation against the corporation and other parties
founded upon the rights which may properly be asserted by
the corporation . . . must. . . set forth with particularity
the efforts of the plaintiff to secure such action as he desires
on the part of the managing directors. . .
Eq.R. 94, 104 U.S. ix (1882) (emphasis added).
2la
by Congress. Ernst & Ernst v. Hochfelder, 425 U.S. 185,
197, 96 S.Ct. 1375, 1382, 47 L.Ed.2d 668 (1976). The
second sentence of § 36(b) is quite clear that an action
may be brought under that subsection only “by the
[Securities and Exchange] Commission, or by a security
holder of [a] registered investment company on behalf of
such company.”” No action by the investment company is
9 The full text of § 36(b) is as follows:
1S U.S.C. § 80a-35. Breach of fiduciary duty
(b) For the purposes of this subsection, the investment
adviser of a registered investment company shall be deemed
to have a fiduciary duty with respect to the receipt of
compensation for services, or of payments of a material
nature, paid by such registered investment company, or by
the security holders thereof, to such investment adviser or
any affiliated person of such investment adviser. An action
may be brought under this subsection by the Commission, or
by a security holder of such registered investment company
on behalf of such company, against such investment adviser,
or any affiliated person of such investment adviser, or any
other person enumerated in subsection (a) of this section who
has a fiduciary duty concerning such compensation or pay-
ments, for breach of fiduciary duty in respect of such
compensation or payments paid by such registered invest-
ment company or by the security holders thereof to such
investment adviser or person. With respect to any such
action the following provisions shall apply:
(1) It shall not be necessary to allege or prove that any
defendant engaged in personal misconduct, and the plaintiff
shall have the burden of proving a breach of fiduciary duty.
(2) In any such action approval by the board of directors
of such investment company of such compensation or pay-
ments, and ratification or approval of such compensation or
payments, or of contracts or other arrangements providing
for such compensation or payments, by the shareholders of
such investment company, shall be given such consideration
by the court as is deemed appropriate under all the circum-
stances.
(3) No such action shail be brought or maintained against
any person other than the recipient of such compensation or
22a
authorized. When Congress has provided specific and
elaborate enforcement provisions, and entrusted their use
to particular parties, we will not lightly assume an unex-
pressed intention to create additional ones. See Middlesex
County Sewerage Auth. v. National Sea Clammers Ass’n,
453 U.S. 1, 13-18, 101 S.Ct. 2615, 2622-2624, 69 L.Ed.2d
335 (1981).
Appellee points to the words “on behalf of such com-
pany,” and argues they demonstrate that the right of the
shareholder created by § 36(b) is derivative, and therefore
the director demand requirement of Rule 23.1 applies, as
it does to other “derivative” actions in the federal courts.
The words “on behalf of” do not create by implication
a statutory right of the company itself to sue, from which
the stockholders’ right may be said to be “derivative.”
payments, and no damages or other relief shall be granted
against any person other than the recipient of such compen-
sation or payments. No award of damages shall be recover-
able for any period prior to one year before the action was
instituted. Any award of damages against such recipient shall
be limited to the actual damages resulting from the breach of
fiduciary duty and shall in no event exceed the amount of
compensation or payments received from such investment
company, or the security holders thereof, by such recipient.
(4) This subsection shall not apply to compensation or
payments made in connection with transactions subject to
section 80a-17 of this title, or rules, regulations, or orders
thereunder, or to sales loans for the acquisition of any
security issued by a registered investment company.
(S$) Any action pursuant to this subsection may be brought
only in an appropriate district court of the United States.
(6) No finding by a court with respect to a breach of
fiduciary duty under this subsection shall be made a basis (A)
for a finding of a violation of this subchapter for the
purposes of sections 80a-9 and 80a-48 of this title, section
780 of this title, or section 80b-3 of this title, or (B) for an
injunction to prohibit any person from serving in any of the
capacities enumerated in subsection (a) of this section.
23a
These words, which apply as much to the Securities and
Exchange Commission as to a private security holder,
signify only that either party so entitled to bring an action
under § 36(b) must do so to seek return of excessive
management fees to the company treasury and not to
individual or governmental coffers. The action is not,
strictly speaking, “derivative” in the sense of deriving
from a right properly asserted by the corporation, but
rather constitutes individual security holders as “private
attorneys general” to assist in the enforcement of a duty
imposed by the statute on investment advisers.
We recognize that the one Court of Appeals to have
considered the question reached a different conclusion.
Grossman vy. Johnson, 674 F.2d 115 (1st Cir.), cert.
denied, ___._ U.S. , 103 S.Ct. 85, 73 L.Ed.2d—
(1982). In rejecting the argument that because § 36(b)
explicitly provides for, it therefore only permits, suit by
the SEC or a security holder, the First Circuit stated:
We cannot believe, however, that, for example, a new
and independent board of directors, intent on recov-
ering excessive fees from an investment adviser,
would be precluded from suing under section 36(b).
Id. at 120. Equally cogent is our belief that this situation
was regarded as so remote or unlikely that the legislature
chose not to provide for it, and was wary of permitting
the Fund to control the suit, see Burks v. Lasker, 441
U.S. 471, 483-84, 99 S.Ct. 1831, 1839-1840, 60 L.Ed.2d
404 (1979). Moreover, the Grossman court offers scant
support for its conclusion that the Fund may sue. It
refers, first, to the ‘ton behalf of’’ language in the
statute. We have already indicated the meaning we attach
to that phrase. Similarly, we are unpersuaded by the
argument that ‘‘Congress could well have believed that,
24a
though it was appropriate to specify that the Commission
and shareholders had the new statutory cause of action[,]
. . it Was unnecessary to say with particularity that the
company also did.’* /d. This seems totally inconsistent
with what we would expect Congress to have done. If
Congress had intended to provide the company with a
cause of action, it would have passed a statute saying so,
in which case the derivative right of a shareholder to
initiate suit would have followed automatically. A mere
statement of what Congress ‘‘could have believed’ seems
to us not enough. Congress has not expressed, anywhere
at all, the policy appellee would have us adopt.
Moreover, as the First Circuit itself notes, § 36(b)(3)
‘*‘directly forbids’’ an action against any person ‘‘other
than the recipient of . . . compensation or payments [for
adviser services].’’ Yet, the opinion relies on the proceed-
ing in that case having been brought against ‘‘forbidden”’
defendants (the ‘‘disinterested’’ directors and the Fund
itself) as support for its conclusion that a § 36(b) suit is a
typical derivative suit. The idea, apparently, is that
Grossman was operating under the assumption that a
§ 36(b) action is the standard derivative action, in which
the complaining shareholder would join the company and
its directors, ‘‘in the ordinary fashion,’ after the corpo-
ration had declined to initiate the suit as a plaintiff. See
H. Henn, Handbook of the Law of Corporations and
Other Business Enterprises § 358 at 750 (2d ed. 1970). It
is difficult to understand how a defect in a pleading—or a
misreading of § 36(b)—can take precedence over the clear
dictates of a statute.
The language of a statute controls when sufficiently
clear in its context. Ernst & Ernst v. Hochfelder, supra,
425 U.S. at 201, 96 S.Ct. at 1384. Nevertheless, mindful
2Sa
of our obligation to supplement application of rules of
Statutory construction by searching for ‘‘persuasive evi-
dence of a contrary legislative intent,’’ Transamerica
Mortgage Advisors, Inc. v. Lewis, supra, 444 U.S. 11 at
21, 100 S.Ct. 242 at 247, 62 L.Ed.2d 146 we move now to
an examination of the legislative history of § 36(b).
B
Prior to enactment of the Investment Company Act of
1940, open-end investment companies,’” or mutual funds,
played a minor role in the world of finance. In 1940,
investment companies held assets of approximately $2.1
billion; of this sum, mutual funds accounted for $450
million. 1/966 SEC Report 2. The 1940 Act was directed at
the most flagrant self-dealing and other abuses within the
investment company industry. See United States v.
Deutsch, 451 F.2d 98, 108 (2d Cir. 1971), cert. denied,
404 U.S. 1019, 92 S.Ct. 682, 30 L.Ed.2d 667 (1972). It
prohibits, for example, most transactions between invest-
ment companies and their advisers. 15 U.S.C. § 80a-17.
Generally, the Act requires at least forty percent of a
fund's board of directors to be ‘‘unaffiliated’’ with the
adviser, and it mandates that payment for management
and other investment advice be the subject of a contract
between the fund and the adviser which has received both
shareholder and director approval, 15 U.S.C. § 80a-15(a),
(c). Moreover, a duty is imposed on the directors of a
fund to evaluate the terms of the adviser contract. 15
U.S.C. 80a-15(c).
10 An “open-end” company is one which continually offers
shares for sale and will redeem outstanding shares at their propor-
tionate net asset value. 1§ U.S.C. § 80a-S(a)(1).
26a
The 1940 Act proved most successful in controlling the
serious problems covered by its broad brush approach.
Indeed, an ironic measure of its success has been the
public’s growing confidence in the investment company
industry, which led to a period of extraordinary growth in
the number of investors and in net asset levels of the
funds. In turn, this expansion created a specific and
largely unforeseen problem. Because adviser fees are
usually calculated at a percentage of a fund’s net assets,
and vary in proportion as portfolio value goes up or
down, a period of sustained industry success would—and
did—yield substantially increased fees. But the Act ‘‘did
not provide any mechanism by which the fairness of
management contracts could be tested in court.’’ S.Rep.
No. 184, 91st Cong., Ist Sess. 5 (1969), reprinted in 1970
U.S. Code Cong. & Ad.News at 4901.
What the drafters of the 1940 Act did foresee, in a
general way, was the possibility that the future success of
the industry might entail the need for statutory change.
As a result, a section of the original statute provided (and
still states) that the SEC may study the ramifications of
‘‘any substantial further increase in size of investment
companies . . . involving the protection of investors or
the public interest,’ and present recommendations for
legislative change. 15 U.S.C. § 80a-14(b). Accordingly, in
1958, the Commission authorized the securities research
unit of the Wharton School of Finance and Commerce of
the University of Pennsylvania to study investment com-
panies and report its findings. The Wharton Report
identified the salient issues, but made no proposals.
Subsequently, the Commission undertook further re-
search, and presented the results and recommendations
for detailed amending legislation in its Report on the
=
27a
Public Policy .Implications of Investment Company
Growth, transmitted to Congress in 1966.
The 1/966 SEC Report reiterated the Wharton unit's
findings. It concluded that mangement fees tended to be
fixed at the traditional level of one-half of one percent of
the fund’s net assets. It noted that they markedly ex-
ceeded fees charged by investment advisers to other insti-
tutional clients and the cost of management to those
funds which manage themselves. Moreover, no evidence
existed to demonstrate a willingness on the part of the
advisers to provide services at a ‘‘reasonable’’ rate, not
necessarily a percentage of assets. The Report further
stated that the 1940 Act was not equipped to deal with
this emerging problem, and that shareholder suits, al-
though occasionally forcing settlements, basically had
been ineffective. 1966 SEC Report 84-149. To deal with
this issue, the SEC recommended amending the Act to
require that mangement fees be ‘treasonable.’’ Reason-
ableness was to be determined by reference to various
criteria, including the fees paid for similar services by like
institutions, the nature and quality of services rendered,
and any other factors determined to be appropriate in the
public interest. The SEC was to have an enforcement
action available to it (as in fact it does under present
§ 36(b)), and would also possess the right to intervene in
private shareholder suits. /d. at 143-47. Nowhere does the
Report mention an action brought by the investment
company itself.
The standard of ‘‘reasonableness’’ proposed in the
1966 SEC Report was contained in the first bills consid-
ered by Congress, H.R.9510, 90th Cong., Ist Sess. § 8(d)
(1967) and S.1659, 90th Cong., Ist Sess. § 8(d) (1967).
Not surprisingly, it was met by vigorous industry opposi-
28a
tion, see generally Hearings on §.1659 Before the Senate
Comm, on Baking and Currency, 90th Cong., Ist Sess.,
pt. 1, at 191-201 (°'/967 Senate Hearings’’); Investment
Company Act Amendments of 1967; Hearings on
H.R.9510, H.R.9511 Before the Subcomm, on Commerce
and Finance of the House Comm. on Interstate and
Foreign Commerce, 90th Cong., Ist Sess., ser, 90-21, pt,
1, at 237-43 (1967) (statemeni of John R. Haire, chair-
man-elect, Investment Company Institute), and neither
bill passed. The industry claimed fees were already rea-
sonable, the legislation would encourage ‘‘strike’’ suits,
and the SEC would be empowered to regulate a competi-
tive industry. 1/967 Senate Hearings at 191-92, 202. In one
sense, of course, the relative merits of each side of this
debate are irrelevant. The ultimate passage of § 36(b)
settled the issue and expressed the legislative conclusion
that imposing a ‘‘fiduciary duty’’ and leaving its exegesis
to the judiciary'' provided the best solution. This decision
represented the compromise reached by industry repre-
1] E.e@., 1§ U.S.C, § 80a-35(b)(2); see 1967 Senate Hearings at
1016:
It is for Congress to decide in each case just what mix of
administrative and judicial participation is best adapted to
the problem in hand. One end of the spectrum provides more
in administrative expertise and uniformity, the other more in
those qualities of restraint, freedom from bureaucratic rigid-
ity, Open-mindedness and good sense that judges like to
believe are special attributes of courts.
(Statement of Judge Henry J. Friendly)
The quoted language goes to the question whether case-by-case
judicial evaluation of allegations of excessive adviser fees, on the one
hand, or an administrative procedure which would also weigh in-
dustry-wide factors, on the other, is best suited to adjudication of
shareholder complaints. Congress apparently believed, along with my
brother Friendly, that courts possessed sufficient good qualities to
make them appropriate forums in which § 36(b) complaints might be
heard.
29a
sentatives and the SEC. See Hearings on H.R.11995,
§.2224, H.R.13754, H.R.14737 Before the Subcomm, on
Commerce and Finance of the House Comm, on Inter-
state and Foreign Commerce, 91st Cong., Ist Sess., ser.
91-33, pt. 1, at 138 (1969) (''/969 House Hearings’’), On
the other hand, that the focus of legislative inquiry, from
the introduction of the first bills through a period of
several years until enactment, remained fixed on this
question, is of special significance for our purpose. The
normal conclusion to be drawn from intensive—and ex-
clusive—Congressional scrutiny of a particular subject is
that Congress did not concern itself with others. Put
differently, if the voluminous legislative history of § 36(b)
and its unsuccessful predecessors persuades us that Con-
gress’s first order of business was now to make share-
holder suits (and SEC enforcement actions) effective,
rather than whether it might also be useful to sanction
suit by a fund, we would be hard-pressed to conclude that
Congress intended to empower the courts to permit a
fund to sue.
It is obviously difficult, under the best of circum-
stances, to prove a negative. Because the extensive legisla-
tive history of § 36(b) neither approves nor disapproves
suits brought directly by mutual funds, it cannot be
shown to a certainty (and perhaps never to the satisfac-
tion of those disposed to believe otherwise) that Congress
foreclosed their use of the section. What can be shown, in
this instance, ‘s that the Congressional approach to a
specific problem—excessive adviser fees—consisted of,
first, identifying the source of that problem; next, deter-
mining why the 1940 Act, in other respects effective, had
been and would continue to be incapable of remedying it;
and finally, amending the relevant portion of the Act. If,
therefore, the source of the problem is inconsistent with a
30a
corporate right of action as a solution, we can say with
confidence that Congress never intended to create one.
Moreover, if the flaw in the 1940 Act was unrelated to the
unavailability of a suit by the fund, our conclusion
becomes virtually certain, since we know that the statu-
tory lacuna was filled by a provision conspicuous for its
failure to name the fund as a potential plaintiff.
Several years of careful study indicated that the prob-
lem derived from the peculiar nature of the mutual fund
industry (seen in light of its rapid growth):
Mutual funds, with rare exceptions, are not oper-
ated by their own employees. Most funds are
formed, sold, and managed by external organiza-
tions, that are separately owned and operated. These
separate organizations are usually called investment
advisers. The advisers select the funds’ investments
and operate their businesses. For these services they
receive management or advisory fees. These fees are
usually calculated at a percentage of the funds’ net
assets and fluctuate with the value of the funds’
portfolio.
Because of the unique structure of this industry the
relationship between mutual funds and their invest-
ment adviser is not the same as that usually existing
between buyers and sellers or in conventional cor-
porate relationships. Since a typical fund is or-
ganized by its investment adviser which provides it
with almost all management services and because its
shares are bought by investors who rely on that
service, a mutual fund cannot, as a practical matter
sever its relationship with the adviser. Therefore, the
forces of arm's-length bargaining do not work in the
3la
mutual fund industry in the same manner as they do
in other sectors of the American economy.
It is noted . . . that problems arise due to the
economies of scale attributable to the dramatic
growth of the mutual fund industry. In some in-
stances these economies of scale have not been
shared with investors. Recently there has been a
desirable tendency on the part of some fund man-
agers to reduce their effective charges as the fund
grows in size. Accordingly, the best industry practice
will provide a guide.
S.Rep. No. 184, 91st Cong., Ist Sess. 5-6 (1969), re-
printed in 1970 U.S. Code Cong. & Ad. News at 4901-02;
see also 1966 SEC Report 131; H.R.Rep. No. 1382, 91st
Cong., 2d Sess. 7 (1970); Galfand v. Chestnutt Corp., 545
F.2d 807, 808 (2d Cir. 1976).
Additionally, the requirement that a percentage of the
directors of the investment company be ‘‘independent”’
of the adviser and underwriter, 15 U.S.C. § 80a-10, and
that they annually approve the adviser contract, 15
U.S.C. § 80a-15, cannot seriously be expected to induce
arm's-length bargaining. As the SEC long ago recog-
nized, any so-called independent directors would ‘‘ob-
viously have to be satisfactory to the dominating
stockholders who are in a position to continue to elect a
responsive board.’’ Petroleum & Trading Corp., 11
S.E.C. 389, 393 (1942); see 1969 House Hearings, ser.
90-22 at 696-97 (testimony of SEC Chairman Manuel F.
Cohen).
32a
In sum, the root of the excessive adviser fee problem is
basically incompatible with a corporate right of action as
an effective solution. We believe the Senate Committee
on Banking and Currency (referring to the pill eventually
passed) had in mind exactly the plaintiffs it named and no
others when it stated: **[Y]our committee has adopted the
basic principle that, in view of the potential conflicts of
interest involved in the setting of [adviser] fees, there
should be effective means for the court to act where
mutual fund shareholders or the SEC believe there has
been a breach of fiduciary duty.’’ S.Rep. No. 184, 91st
Cong., Ist Sess. 1 (1969), reprinted in 1970 U.S. Code
Cong. & Ad.News at 4898. Neither the parties’ briefs nor
Our own research has disclosed any indication in the
comprehensive legislative history of § 36(b) that suits by
directors themselves were to be expected or encouraged:
Although we agree with Judge Duffy that Congress in-
tended the directors would perform a ‘‘watchdog’’ func-
tion, see also Burks v. Lasker, supra, 441 U.S. at 484, 99
S.Ct. at 1840; Boyko v. Reserve Fund, Inc., supra, 68
F.R.D. at 695-96 n.2, it defies logic to conclude their
contemplated role included suing their advisers.
Moreover, the 1940 Act was not deficient or ineffective
because a fund could not use it. By the time consideration
of the 1970 Amendments was at hand, it had become
clear that shareholders were hard pressed to prove a
‘*gross abuse of trust,’ the standard of old § 36. Saxe v.
Brady, 40 Del.Ch. 474, 184 A.2d 602 (1962) (Seitz, Ch.),
decided under traditional corporate law concepts, pro-
vided the model adhered to by federal courts in suits
alleging excessive management fees. See Kurach v. Weiss-
man, 49 F.R.D. 304, 305-06 (S.D.N.Y. 1970). In Saxe,
mutual fund shareholders challenged adviser fees
amounting to one-half of one percent of net assets. The
33a
adviser contract had been approved almost unanimously
by the shareholders. Chancellor Seitz (now Chief Judge
of the Third Circuit Court of Appeals) concluded that the
adviser fee level must be evaluated according to the usual
legal rules applicable to shareholder ratification cases:
When the stockholders ratify a transaction, the
interested parties are relieved of the burden of prov-
ing the fairness of the transaction. The burden then
falls on the objecting stockholders to convince the
court that no person of ordinary, sound business
judgment would be expected to entertain the view
that the consideration was a fair exchange for the
value which was given.
Saxe v. Brady, supra, 40 Del.Ch. at 486, 184 A.2d at 610.
In concluding that plaintiffs must show “actual waste,”
or a fee level so high as to be “unconscionable,” id., the
Chancellor noted that a 0.5% adviser fee rate was com-
mon and that the shareholders had approved the adviser
contract virtually unanimously. /d. at 489, 184 A.2d at
611-12. Since these determinative factors were inevitably
present, showing “actual waste” and overcoming a pre-
sumption of “sound business judgment” was well nigh
impossible. Kurach v. Weissman, supra, 49 F.R.D. at
305-06; Goodman v. Von Der Heyde, [1969-1970 Transfer
Binder] Fed.Sec.L.Rep. (CCH) € 92,541 (S.D.N.Y.1969);
Lessac v. Television-Elecs. Fund, [1967-1969 Transfer
Binder] Fed.Sec.L.Rep. ¢ 92,305 (S.D.N.Y.1968); see Ro-
senfeld v. Black, 445 F.2d 1337, 1345-46 (2d Cir.1971).
Recognizing that shareholder plaintiffs had difficulty sus-
taining their burdens, Congress changed only the stan-
dard of duty. Cf. Burks v. Lasker, supra, 441 U.S. at
483-84, 99 S.Ct. at 1839-1840 (1979).
34a
Despite the long odds, shareholders did sue for return
of allegedly excessive fees. Starting in 1959, over fifty
suits were instituted under common law principles and
pursuant to the 1940 Act. /966 SEC Report 132. What
happened is instructive. Advisers were sometimes willing
to settle, because even Save left open the possibility that
the point might be reached at which “profits
outstripp[ed] any reasonable relationship to expenses and
effort even in a legal sense.” 40 Del.Ch. at 498, 184 A.2d
at 616-17. Given the substantial sums at stake, this
willingness is not surprising. For precisely the opposite
reason—that is, the slim likelihood of success on the
merits—courts felt constrained to approve settlements,
even when the terms were something less than desirable.
E.g., Jurach vy. Weissman, supra, 49 F.R.D. at 305. This
confluence of inconsistent, but complementary, motives
resulted in reduction of adviser fees in individual cases,
but the effect on the industry as a whole was insignifi-
cant. In 1967, SEC Chairman Manuel Cohen noted that
“(tlhe median advisory fee paid by the 59 externally
managed mutual funds with net assets of $100 million or
more in fiscal years ending in 1966 was still 0.48 percent,
down only 0.02 percent from the traditional 0.50 percent
rate.” 1967 Senate Hearings, pt. 1, at 14-15. Obviously,
the pressure to settle was analytically unrelated to the
identity of the plaintiff.
Our retracing of the analysis employed by Congress,
and of its extensive documentation, persuades us that an
investment company was not intended to possess a right
of action under § 36(b). The relationship of a Fund to its
adviser makes it a part of the problem in a way that
precludes it from being part of the solution, at least at the
3Sa
litigation stage. The provision for evaluation of the ad-
viser contract, 15 U.S.C. § 80a-15(c), and the general
tightening of the powers of disinterested directors, e.g.,
15 U.S.C. §§ 80a-2(a)(19); 80a-10(a); 80a-15(c), provide
for “an independent check on management. . . and the
representation of shareholder interests in investment com-
pany affairs,” S.Rep. No. 184, 91st Cong., Ist Sess. 32
(1969), reprinted in 1970 U.S.Code Cong. & Ad.News at
4927. We take this language to be nothing more nor less
than a declaration by Congress that it was imposing
duties on the directors to run the ongoing business of the
Fund in a responsible manner, and with due regard for
investors. Cf. United States v. National Ass’n of Sec.
Dealers, 422 U.S. 694, 705 n. 13, 95 S.Ct., 2427, 2436 n.
13, 45 L.Ed.2d 486 (1975)(1940 Act concerned with im-
posing controls on “internal management [and] practices
of investment companies”). These functions and duties
having proved ineffective in a particular case, at least in
the eyes of the complaining shareholder plaintiff, the
iss'ie for Congressional scrutiny was how to particularize
the already existing statute to make judicial relief a
genuine possibility. Experience with shareholder suits had
demonstrated that the Saxe standard, drawn from pre-ex-
isting corporate law principles but applied to the invest-
ment company industry, was useless. The fiduciary duty
standard was imposed, and courts were empowered to
view “all the circumstances,” 15 U.S.C. § 80a-35(b)(2).
The extensive number of suits brought under the earlier,
less favorable law suggested that shareholders would
move with alacrity pursuant to the new one. Given the
nature of the problem and reasons for the 1940 Act’s
failure to remedy it, creating a corporate right of action
36a
would have made little sense and we conclude Congress
never intended to do so.”*
We have not as yet considered the applicability of Rule
23.1 head-on. Instead, we posed the analytically prece-
dent question, whether a Fund may use § 36(b), and
thereby trigger the rule. Our answer, that Rule 23.1 does
not apply because the Fund has no right of action,
renders superfluous any extensive discussion of the policy
behind requiring demand. Nonetheless, because we be-
lieve neither policy nor logic compels application of the
demand requirement to actions for return of excessive
adviser fees, we briefly discuss the distinctiveness of
§ 36(b).
Unlike the board in the common variety of derivative
Suit, the directors have no power to terminate a § 36(b)
action. Other provisions of the Investment Company Act.
e.g., 1S U.S.C. § 80a-13(a)(3), governed by state rules to
the extent they are not inconsistent with federal law, leave
unanswered the question whether independent directors
of an investment company may terminate suit. Burks v.
Lasker, supra, 441 U.S. at 483-86, 99 S.Ct. at 1839-184!.
“[W)hen Congress . . . intend[ed] to prevent board ac-
tion from cutting off derivative suits, it said so expressly.
Section 36(b) . . . , added to the act in 1970, performs
precisely this function. . . .” Jd. at 484, 99 S.Ct. at 1840
(citation omitted). Since directors cannot cut off a suit
12 We agree with the First Circuit, Grossman v. Johnson, supra,
674 F.2d at 121, that debate over the legislative history “end[s] in a
draw,” but we proceed under a different assumption, that § 36(b)
does not permit an action by the investment company, and reach the
opposite conclusion that Congress intended no demand requirement
would apply.
37a
and § 36(b) does not authorize them to institute one, and
because shareholder plaintiffs are necessarily challenging
fees the directors evaluated and approved, 15 U.S.C.
§ 80a-15; see Rosenfeld v. Black, supra, 445 F.2d at 1345,
the traditional reason for the demand requirement simply
does not apply. See Note, The Demand and Standing
Requirements in Stockholder Derivative Actions, 44
U.Chi.L.Rev. 168, 171-72 (1976)."°
Moreover, although requiring demand normally im-
poses only minor hardship on the complaining share-
holders, in a § 36(b) suit the consequences can be severe.
Section 36(b) expressly limits recovery to excessive fees
paid up to one year prior to the commencement of suit.
15 U.S.C. § 80a-35(b)(3). The demand requirement im-
plies a reasonable time in which directors may analyze the
issues and determine whether they believe the company
has a grievance. The delay caused by this process would,
in many cases,’* have the untoward result of precluding
13 One court, analogizing Burks v. Lasker, concluded that the
question whether a board of directors is sufficiently “interested” in
the challenged transaction to excuse demand shall be resolved by
reference to “the same factors used to determine whether a court
should defer to the board’s decision not to pursue the action” Lewis
v. Curtis, supra, 671 F.2d at 785. Under this view, the termination
and excuse issues are functions of the same indicia of “interested-
ness.” Burks may be regarded as recognizing the Congressional
determination that directors in § 36(b) actions are never sufficiently
disinterested to permit them to terminate suit, 441 U.S. at 484, 99
S.Ct. at 1840. Viewing these two principles in tandem, it is possible to
infer that Congress also believed directors would always be so
“interested” that demand would inevitably be “excused.” This is but
another way of saying Congress intended that § 36(b) suits would be
exempt from Rule 23.1.
14 — At oral argument, Fox’s counsel referred to the case where
the fund may have awarded a substantial one-time payment for
allegedly remarkable services. No doubt other examples could be
cited.
38a
full recovery of excessive fees while the directors deter-
mined whether they had acted against the interests of the
shareholders in approving the contract initially. We do not
believe Congress was unaware of this pitfall.
IV
In a different contest, Justice Jackson eloquently
described the origin and rationale of the derivative suit:
Equity came to the relief of the stockholder, who
had no standing to bring civil action at law against
faithless directors and managers. Equity, however,
allowed him to step into the corporation's shoes and
to seek in its right the restitution he could not
demand in his own. It required him first to demand
that the corporation vindicate its own rights, but
when, as was usual, those who perpetrated the
wrongs also were able to obstruct any remedy, equity
would hear and adjudge the corporation’s cause
through its stockholder with the corporation as a
defendant, albeit a rather nominal one. This remedy,
born of stockholder helplessness, was long the chief
regulator of corporate management and has afforded
no small incentive to avoid at least grosser forms of
betrayal of stockholders’ interests. It is argued, and
not without reason, that without it there would be
little practical check on such abuses.
Cohen v. Beneficial Loan Corp., 337 U.S. 541, 548. 69
S.Ct. 1221, 1226, 93 L.Ed. 1528 (1949). In holding that a
Rule 23.1 demand will not be required in a shareholder
Suit brought pursuant to § 36(b) of the Investment Com-
pany Act, we do not ignore the appropriateness, in the
typical derivative suit alleging corporate wrongdoing, of
first asking the corporation to “vindicate” what are, after
39a
all, “its own rights.” We conclude, however, that in the
unique context of a § 36(b) lawsuit, the shareholder need
not afford the fund an opportunity to vindicate its rights
because such a requirement would be an empty, unfruitful
and dilatory exercise.
The judgment of the district court is reversed and the
case is remanded.
Decision of the Court of Appeals for the First Circuit in
Grossman v. Johnson
4la
os
No. 81-1348.
United States Court of Appeals,
First Circuit.
Argued Nov. 5, 1981.
Decided March 29, 1982.
—s
STANLEY M. GROSSMAN,
Plaintiff-Appellant,
— a
EDWARD C. JOHNSON, 3rd, et al.,
Defendants-Appellees.
+
Shareholder brought derivative action on behalf of
investment fund. The United States District Court for the
District of Massachusetts, Joseph L. Tauro, J., dismissed
the suit, 89 F.R.D. 656, and plaintiff appealed. The Court
of Appeals, Davis, Judge, sitting by designation, held
that: (1) in adding amendment to Investment Company
Act to prescribe separate statutory claim for excessive
advisory fees to investment adviser, Congress neither
repealed nor limited demand provision of rule, under
which complaint to enforce right of corporation or unin-
corporated association must allege with particularity ef-
forts if any made by plaintiff to obtain action he desires
from directors or comparable authority and, if necessary,
42a
from shareholders or members, and reasons for failure to
obtain such action or for not making the effort; (2) where
shareholder claims to be excused from compliance with
such rule requirement, proper excuse of control or
domination calls for particularized allegations and spe-
cific facts, and mere “participation” or “acquiescence”
by directors in level of challenged advisory fees is insuffi-
cient excuse where corporate activity is normal one of
setting and paying advisory fees, and allegation that
directors had already announced firm opposition to suit
was equally unavailable where disinterested directors’
position did not preclude their first consideration of
plaintiff's demand; and (3) on claim of failure to recap-
ture excessive underwriting commissions, discounts and
spreads paid by fund on its purchases of securities,
shareholder's allegations of excuse for failing to make
demand before bringing suit, i.e., that directors all had
conflict of interest, was insufficient.
Affirmed.
>
Richard M. Meyer, Washington, D.C., with whom
Avram G. Hammer, Boston, Mass., and Milberg, Weiss,
Bershad & Specthrie, New York City, were on brief, for
appellant.
James S. Dittmar, Boston, Mass., with whom Berman,
Dittmar & Engel, P. C., Boston, Mass., was on brief, for
appellees Edward C. Johnson, 3d, et al.
E. Milton Farley, III, Richmond, Va., with whom
Sumner H. Babcock, E. Susan Garsh, Bingham, Dana &
Gould, Boston, Mass., John W. Riely, Joseph C. Kearfott
43a
and Hunton & Williams, Richmond, Va., were on brief,
for appellees Dwight L. Allison, Jr., et al.
Jerome P. Facher, Boston, Mass., with whom Harry T.
Daniels, James R. Gomes, Hale & Dorr, Peter M. Sa-
paroff, and Gaston Snow & Ely Bartlett, Boston, Mass.,
were on brief, for appellee Fidelity Municipal Bond
Fund, Inc.
Richard A. Kirby, Sp. Counsel, Washington, D. C.,
with whom Ralph C. Ferrara, Gen. Counse!, Paul Gon-
son, Sol., Edward F. Greene, Gen. Counsel, Jacob H.
Stillman, Associate Gen. Counsel, Robert Mills and
Louis C. Whitsett, Attys., Washington, D.C., were on
briefs, for the Securities and Exchange Commission,
amicus curiae.
+
Before CAMPBELL, and Bownes, Circuit Judges,
and Davis,* Judge.
+
Davis, Judge.
Plaintiff-appellant Stanley M. Grossman brought this
derivative action in the District Court for Massachusetts,
under the Investment Company Act of 1940, as amended,
15 U.S.C. §§ 80a-1 ef seg. (1976) (the Act).' He is and
has been a shareholder of Fidelity Municipal Bond Fund,
Inc. (“the Fund”), a registered open-end investment com-
° Of the United States Court of Claims, sitting by designation.
l For the purposes of our iimited disposition, we rest on facts
alleged by plaintiff in his amended complaint, and merely capsule the
facts and proceedings.
t4ta
pany, and he sues the Fund's investment adviser, Fidelity
Management & Research Company (“FMR”), the corpo-
ration that is the sole owner of that adviser (“FMR
Corp.”), the affiliated directors of the Fund, as well as
most of the unaffiliated directors (whom we shall call
“disinterested”).* Against these defendants, Grossman
makes two charges: (a) breach of fiduciary duty to the
Fund with respect to the allegedly excessive amount of
advisory fees paid to FMR by the Fund; and (b) breach of
fiduciary duty to the Fund by failing to recapture (or have
recaptured) excessive underwriting commissions, dis-
counts and spreads paid by the Fund on its purchases of
securities. Before instituting the suit, plaintiff made no
demand on the Fund or its directors to bring or prosecute
an action on either of these two bases.
Defendants moved to dismiss the complaint, asserting,
as One point, that plaintiff had failed to comply with Rule
23.1 of the Federal Rules of Civil Procedure, governing
demand by shareholders in derivative actions. During the
lengthy argument on those motions, the District Court
Suggested that it might be advisable, it might even end the
controversy, for plaintiff to send a demand letter to the
directors specifying his position, although the litigation
had already commenced. After consideration, plaintiff
did make such demand.
The District Court then stayed action on the motion
and ordered the “disinterested” directors’ to review the
2 The “affiliated” directors own 5% or more of the shares of
FMR Corp. and are officers and directors of FMR. The “unaffi-
liated” directors do not have those connections with FMR and FMR
Corp.
3 These were the “unaffiliated” director defendants, plus one
unaffiliated director who had not been sued though he had previously
48a
demand and report back to the court. These directors
delegated responsibility to a Special Committee composed
of the two directors who were not defendants (see note 3,
supra). The latter retained a former Chairman of the
Securities and Exchange Commission (and his outside law
firm) to make a study and render a report on the issues
presented by plaintiff's demand. A lengthy report was
made, concluding that there had been no statutory viola-
tion or breach of fiduciary duty on either branch of the
suit, and recommending that the Special Committee seek
to have this suit dismissed. The Committee accepted that
recommendation.
Defendants then moved to dismiss the amended compa-
lint,* and, alternatively, for summary judgment, urging
two grounds which the District Court considered: (a) the
failure to make a proper and timely demand, and (b) the
court should accept the Special Committee’s good faith
“business judgment” that the suit should be terminated.
In the decision now before us, the District Court accepted
both of these contentions, alternatively. 89 F.R.D. 656
(1981). Judgment was entered for defendants. For the
reasons to be given in Parts I, II and III of this opinion,
we affirm on the former ground, by-passing the latter.
Rule 23.1 of the Rules of Civil Procedure (“Derivative
Actions by Shareholders”) declares:
joined the board, and one unaffiliated director who became a board
member after the suit had been brought (and accordingly was not
sued).
4 In the course of the proceedings plaintiff had been permitted
to file an amended complaint.
46a
In a derivative action brought by one or more
shareholders or members to enforce a right of a
corporation or of an unincorporated 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 transaction 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 obtain 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 deriva-
tive 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 corporation 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 shareholders or members in such manner
as the court directs.
Plaintiff urges that Rule 23.1 is wholly inapplicable to
that portion of his case charging the payment of excessive
advisory fees to the investment adviser (FMR), which is
brought under the special provisions of section 36(b) of
47a
the Act, 15 U.S.C. § 80a-35(b)(1976). In this segment of
our opinion we consider that contention.*
Section 36(b), added in 1970, prescribes a separate
statutory claim for excessive advisory fees to an invest-
ment adviser.” The Securities and Exchange Commission
5 Plaintiff also says that, even if Rule 23.1 applies, he was
excused from making a demand on the directors for this aspect of his
complaint. We discuss that point in Part Il, infra. As for the
recapture of commissions, Grossman does not argue that Rule 23.1 is
wholly inapplicable; he mainly says, instead, that he was excused
from making a demand. We also consider that argument in Part II,
infra. On both sectors of his case, plaintiff insists, in addition, that
the demand he made after the beginning of the suit was adequate
compliance with Rule 23.1. Part III, infra, deals with that premise.
The Securities and Exchange Commission, which participated in
this appeal as amicus curiae, takes no position on the applicability of
the demand provisions of Rule 23.1 or the alleged excuses for
noncompliance.
6 The relevant parts of section 36(b) read:
“(b) For the purposes of this subsection, the investment
adviser of a registered investment company shall be deemed
to have a fiduciary duty with respect to the receipt of
compensation for services, or of payments of a material
nature, paid by such registered investment company, or by
the security holders thereof, to such investment adviser or
any affiliated person of such investment adviser. An action
may be brought under this subsection by the Commission, or
by a security holder of such registered investment company
on behalf of such company, against such investment adviser,
or any affiliated person of such investment adviser, or any
other person enumerated in subsection (a) of this section who
has a fiduciary duty concerning such compensation or pay-
ments [including directors], for breach of fiduciary duty in
respect of such compensation or payments paid by such
registered investment company or by the security holders
thereof to such investment adviser or person. With respect to
any such action the following provisions shall apply:
(1) It shall not be necessary to allege or prove that any
defendant engaged in personal misconduct, and the plaintiff
shall have the burden of proving a breach of fiduciary duty.
48a
and security holders of the investment company are
specifically authorized to sue “on behalf of such com-
pany” to recover such fees. The section (among other
limitations) places on the plaintiff the burden of proof of
showing a breach of fiduciary duty, restricts monetary
relief to actual damages and to the persons receiving such
compensation, establishes a one-year statute of limita-
tions on recovery, and provides that approval or ratifica-
tion by the paying company’s directors of the
compensation to the investment adviser “shall be given
such consideration by the court as is deemed appropriate
under all the circumstances.”
There is no express reference to Rule 23.1 or to demand
by the suing shareholder, but plaintiff gives several rea-
sons why, in his view, the structure, terms, and purpose of
the provision show that the Rule is wholly inapplicable to
such excessive fee suits. We divide these arguments into
(2) In any such action approval by the board of directors
of such investment company of such compensation or pay-
ments, or of contracts or other arrangements providing for
such compensation or payments, and ratification or approval
of such compensation or payments, or of contracts or other
arrangements providing for such compensation or payments,
by the shareholders of such investment company, shall be
given such consideration by the court as is deemed appropri-
ate under all the circumstances.
(3) No such action shall be brought or maintained against
any person other than the recipient of such compensation or
payments, and no damages or other relief shall be granted
against any person other than the recipient of such compen-
sation or payments. No award of damages shall be recover-
able for any period prior to one year before the action was
instituted. Any award of damages against such recipient shall
be limited to the actual damages resulting from the breach of
fiduciary duty and shall in no event exceed the amount of
compensation or payments received from such investment
company, or the security holders thereof, by such recipient.”
49a
three groups, first, those that we believe to have little
merit, second, those that have substantial weight but are
subject to countervailing arguments which likewise have
merit, and then we discuss the considerations we believe
to tip the balance against plaintiff on this question.
A.l. Appellant says initially that Rule 23.1 must be
wholly inapplicable because, though the statute says that
suit must be brought on behalf of the investment com-
pany and in that sense is a “derivative” action, section
36(b) does not permit an action by the investment com-
pany itself (but only by the SEC or a security holder). We
cannot believe, however, that, for example, a new and
independent board of directors, intent on recovering
excessive fees from the investment adviser, would be
precluded from suing under section 36(b)." That section is
explicit that recovery by a shareholder is to be on behalf
of the investment company and that his suit must be
brought on the same behalf. With those clear require-
ments, Congress could well have believed that, though it
was appropriate to specify that the Commission and
shareholders had the new statutory cause of action under
section 36(b), see Moses v. Burgin, 445 F.2d 369, 373 n.7
(Ist Cir. 1971), it was unnecessary to say with particular-
ity that the company also did. A suit “on behalf of such
7 The first sentence of Rule 23.1, supra, requires that “the
corporation or association [shall have] failed to enforce a right which
may properly be asserted by it” (emphasis added).
x One reason why the directors might wish to use section 34(b),
instead of employing a more conventional corporate suit, is that
subsection (1) expressly removes the need to allege or prove “personal
misconduct” on the part of any defendant. In addition, the general
standard for recovery might be easier under section 36(b) than in a
non-statutory action.
50a
company” (a phrase which is more than merely one “for
the benefit of the company”) is normally a derivative
action that the company could itself bring.
Plaintiff, whose complaint and amended complaint
both allege that he brings this action “derivatively on
behalf of the Fund,” seems to have originally agreed that
his suit under this section could have been brought by the
Fund. Although subsection (3) directly forbids an action
under section 36(b) against any person “other than the
recipient of such compensation or payments, and no
damages or other relief shall be granted against any
person other than the recipient of such compensation or
payments”—barring as defendants, in this instance, the
“disinterested” directors and the Fund itself—this whole
proceeding (including that part under section 36(b)) was
brought against those “forbidden” defendants,’ ap-
parently on the correct assumption that this is a derivative
suit to enforce rights the Fund could itself enforce, and in
which the company and its directors should be joined in
the ordinary fashion.
2. Another of plaintiff’s points we reject outright is the
analogy to section 16(b) of the Securities Exchange Act of
1934, 15 U.S.C. § 78p(b) (1976) (“profits from purchase
and sale of security within six months”), which has been
held excluded from certain non-demand parts of Rule
23.1. Dottenheim v. Murchison, 227 F.2d 737, 739-741
(Sth Cir. 1955), cert. denied, 351 U.S. 919, 76 S.Ct. 712,
100 L.Ed. 1451 (1956); Blau v. Mission Corp., 212 F.2d
77, 79 (2d Cir.), cert. denied, 347 U.S. 1016, 74. S.Ct. 872,
98 L.Ed. 1138 (1954). On the demand point, however,
section 16(b) is plainly inapposite because it embodies its
9 This is also true of the amended complaint.
Sla
own express demand requirement different from that in
Rule 23.1.'° If anything, that special demand provision
indicates that Congress considered a demand essential for
a shareholder suit even though Congress may have dis-
pensed with other aspects of what is now Rule 23.1.
3. A related argument we cannot accept is that section
36(b) speaks of suit by a “security holder”, a term which
it is said could cover pure debenture holders or other bare
creditors who, not being shareholders or members, can-
not comply with the demand aspects of Rule 23.1 The
simple answer, we think, is that Congress used the general
term “security holder” in section 36(b) to cover share-
holders of mutual funds and like investors akin to stock-
holders, whom Rule 23.1 undoubtedly fits. The phrase
was not designed to allow mere creditors to make use of
section 36(b)."'
B. Plaintiff makes three stronger arguments for total
exclusion of the demand requirement of Rule 23.1—but
each seems to us to have a substantial counterbalance.
1. Grossman’s chief claim .. that a demand would be
futile because the directors, even the “disinterested” ones,
cannot by themselves terminate a section 36(b) suit
10 Suit may be brought “if the user shall fail or refuse to bring
such suit within sixty days after request or shall fail diligently to
prosecute the same thereafter * * * " 15 U.S.C. § 78p(b).
11 ~The legislative history of § 36(b) speaks of suits thereunder
by “shareholders”. See S.Rep.No. 184, 9lst Cong., Ist Sess., re-
printed in [1970] U.S.Code Cong. & Ad.News 4897, 4910;
H.R.Rep.No. 2337, 89th Cong., 2d Sess. 143, 146 (1966) (SEC
report); 115 Cong.Rec. 13699 (1969); /nvestment Company Act
Amendments of 1969: Hearings of the Senate Committee on Banking
and Currency, 91st Cong., Ist Sess. 1-2 (1969).
S2a
through the good faith exercise of reasonable “business
judgment”. We do not today decide whether or not the
directors are so disabled—but it is undeniable that there
are very serious reasons for accepting that proposition.
Burks v. Lasker, 441 U.S. 471, 484, 99 S.Ct. 1831, 1840,
60 L.Ed.2d 404 (1979), a case on the directors’ power to
terminate a suit under other portions of the Act where
section 36(b) was not involved, expressly contrasted the
latter provision: “And when Congress did intend to
prevent board action from cutting off derivative suits, it
said so expressly. Section 36(b), 84 Stat. 1428, 15 U.S.C.
§ 80—a—35(b)(2), added to the Act in 1970, performs
precisely this function for derivative suits charging breach
of fiduciary duty with respect to adviser’s fees.”'* The
Supreme Court was referring to § 36(b)(2) (note 6, supra)
which can easily be read to give the court, rather than the
directors, the ultimate power to decide the propriety of
the fees.
‘Nevertheless, even on that interpretation of the statute,
a demand would not be futile. It would give the indepen-
dent directors the opportunity to study the problem and
decide whether to accede, in whole or in part, to the
complainant’s views. When it added § 36(b), Congress
also deliberately strengthened the position of independent
directors, including their dealing with advisory fees. See
Burks v. Lasker, supra, 441 U.S. at 482-485, 99 S.Ct. at
1839, 1840-1841. They were not designed to be ciphers or
to be overlooked. Although the court would decide for
itself (on the view we accept arguendo) the merits of the
12. Though this statement may technically have been “dictum” in
the sense that Burks did not itself involve section 36(b), the Court's
observation formed an integral part of its reasons for holding that
the directors had broader powers under other parts of the Act. The
statement was by no means gratuitous or obiter.
S3a
claim of excessive compensation, the independent and
disinterested directors still have a substantial role. Surely,
their decision to side with the complainant (entirely or in
part) would have important consequences, and even their
knowledgeable disagreement with the demand might be
deemed worthy by the court of grave consideration under
§$ 36(b)(2).
2. Plaintiff's appeal to the legislative history (of the
1970 amendments) to show that section 36(b) was ex-
empted from the demand requirement of Rule 23.1
seems, at the very best for him, to end in a draw. There
was, as he points out, emphasis on the prior ineffective-
ness of independent directors with respect to advisory
fees, the need for strengthening then section 36, and the
significant role of the courts in determining the proper
level of fees. See the S. E. C. 1966 Report on Investment
Companies, H.R.Rep. No. 2337, 89th Cong., 2d Sess.,
131, 143, 146 (1966); Investment Company Act Amend-
ments of 1960: Hearings of the Senate Committee on
Banking and Currency, 91st Cong., Ist Sess. 1-2 (1969);
S.Rep. No. 184, 91st Cong., Ist Sess., 2, 6-7, reprinted in
[1970] U.S. Code Cong. & Ad. News 4897, 4898, 4903;
115 Cong.Rec. 13699 (1969). But these themes are all
fully consistent with the continued operation of the de-
mand part of Rule 23.1, which would not impede or
contradict any of the stated purposes. Indeed, the history
shows an equal and concurrent stress on the authority and
responsibility of the directors. S.Rep. No. 184, 91st
Cong., Ist Sess. 7, reprinted in [1970] U.S. Code Cong. &
Ad.News 4897, 4903. (“The section [section 36(b)] is not
intended to shift the responsibility for managing an in-
vestment company in the best interest of its shareholders
54a
from the directors of such company to the judiciary”; and
“the section is not designed to ignore concepts developed
by the courts as to the authority and responsibility of
directors”). At the same time, there was a concern to
discourage unjustified derivative suits. H.R.Rep. No.
1382, 91st Cong., 2d Sess. 8 (1970); Mutual Fund Amend-
ments; Hearings on H.R, 11995, S. 2224, H.R. 13754 and
H.R. 14737 Before the Subcomm. on Commerce and
Finance of the House Comm, on Interstate and Foreign
Commerce, 9\st Cong., Ist Sess. 201, 662, 860 (1969).
That aim is closely connected with Rule 23.1, which has
such a goal among its functions.
When the inquiry narrows down to the continued
relevance of the Federal Rules, especially Rule 23.1, there
is some direct indication that the Rules were or may have
been regarded as barriers to unjustified derivative suits.
The Chairman of the Securities and Exchange Commis-
sion so reported. /d. at 201 (“ * * * there are adequate
safeguards under the Federal Rules of Civil Procedures
[sic] and under this bill to prevent unjustified shareholder
litigation”); to the same effect, see id. at 860, where the
Chairman specifically mentioned “e.g. Rule 23, FRCP”
as one of the “sufficient safeguards against frivolous or
harassing lawsuits.” Plaintiff cites a comment of another
Commissioner disfavoring “the interposition of proce-
dural obstacles”, /nvestment Company Act Amendments
Act of 1969: Hearings on S. 34 and S. 296 Before the
Senate Comm. on Banking and Currency, 9\st Cong., Ist
Sess. 30 (1969), but this was a reference, not to the
demand requirement of Rule 23.1, but to a proposed
provision that a suing shareholder must own a specified
percentage of stock or represent a stated amount of the
investment fund’s assets.
5Sa
3. Lastly, plaintiff invokes the short one-year limita-
tion period on damages" as sufficient reason for exempt-
ing § 36(b) cases from the demand provision of Rule
23.1—the time taken by demand-and-response before
institution of an action would, it is argued, diminish the
period and the amount of recovery. The truth is, however,
that ordinarily the demand requirement could change the
particular one-year period for which recovery was allow-
able but would not reduce the one-year recovery period,
and probably not decrease the amount. In the unusual
case in which the amount of recovery could actually be
reduced by directors’ dawdling or the taking of excessive
time to reply to a demand, a district court could allow
suit to go forward without awaiting a response. See Mills
v. Esmark, Inc., 91 F.R.D. 70, 73 (N.D.II1.1981).
C. The residue of our discussion (to this point) is that
there is no strong reason for wholly excluding section
36(b) from the demand requirement, or for thinking that
Congress intended that result. In subpart A, supra, we
have rejected some of plaintiff's contentions outright,
and in subpart B we have found that each of his more
substantial points has a fair and equivalent counterpoise.
The decisive factor, we must conclude, is that there is no
persuasive indication that, in adopting section 36(b),
Congress wished to repeal or limit the demand provision
of Rule 23.1 which has long been a general part of our
federal law of practice and procedure, governing almost
all derivative actions in federal courts.
In the absence of a “clear inconsistency” or a demon-
strated congressional purpose to exclude one or more of
13 Section 36(b)(3) (note 6, supra) provides: “No award of
damages shall be recoverable for any period prior to one year before
the action was instituted.”
S6a
the Federal Rules, “a subsequently enacted statute should
be so construed as to harmonize with the Federal Rules if
that is at all feasible.” 7 Moore’s Federal Practice,
€ 86.04[4] at 86-22 (2d ed. 1980); United States v. Gustin-
Bacon Division, Certain-Teed Products Corp., 426 F.2d
$39, $42 (10th Cir.), cert. denied, 400 U.S. 832, 91 S.Ct.
63, 27 L.Ed.2d 63 (1970); see also, 4 C. Wright & A.
Miller, Federal Practice & Procedure, § 1001 at 30-31
(1969 ed.)'* That harmonization is quite feasible for
section 36(b). Perhaps for such actions the demand re-
quirement of Rule 23.1 may tend toward the status of a
legal vermiform appendix—the provision’s utility may be
reduced sharply in § 36(b) litigation—but the demand
requirement still has a function to perform and is not
totally without purpose or effect. In those -ircumstances
it is not for the courts to hold inapplicable the demand
requirement “which continues a long tradition in the
federal courts,” Heit v. Baird, 567 F.2d 1157, 1160 (Ist
Cir. 1977), where Congress has not done so, explicitly or
by solid implication.'’
14 Compare this principle with the canon against implied repeals
of the statutes in the absence of clear intention to do so or re-
pugnancy of the later to the earlier legislation. Morton v. Mancari,
417 U.S. $35, S81, 94 S.Ct. 2474, 2483, 41 L.Ed.2d 290 (1974);
Georgia v. Pennsylvania R. R., 324 U.S. 439, 456-57, 65 S.Ct. 716,
725-726, 89 L.Ed. 1051 (1945).
1S in General Telephone Co. v. EEOC, 446 U.S. 318, 100 S.Ct.
1698, 64 L.Ed.2d 319 (1980), the Supreme Court ruled—on the basis
of a “straightforward” reading of § 706 of the Civil Rights Act of
1964, the legislative intent underlying the 1972 to Title VII, and the
enforcement procedures under Title Vil—that the EEOC's enforce-
ment action was not properly characterized as a “class action”
subject to the procedural requirements of Rule 23. As we have said,
comparable factors are absent here.
In addition to the court below, three district courts have passed
directly on the applicability of the demand requirement of Rule 23.1
57a
If, as we have held in Part I, supra, a § 36(b) action is
not exempt from the demand portion of Rule 23.1, we
must confront Grossman’s secondary argument that, in
any event, he was excused (as to the 36(b) portion of his
suit) from making demand. He takes a parallel position
for the “recapture” part of his action (which is not
brought under § 36(b) and as to which plaintiff makes no
claim of a complete exemption from the Rule). Rule 23.1
mandates that the complaint “shall also allege with parti-
cularity the efforts, if any, made by plaintiff to obtain the
action he desires from the directors * * * and the reasons
for his failure to obtain the action or for not making the
effort.” In this circuit that requirement has been “vigor-
ously enforced.” Heit v. Baird, supra, 567 F.2d at 1160.
“The futility of making the demand required by Rule 23.1
must be gauged at the time the derivative action is
commenced, not afterward with the benefit of hindsight.”
Cramer v. General Telephone & Electronics Corp., 582
F.2d 259, 276 (3d Cir. 1978), cert. denied, 439 U.S. 1129,
99 S.Ct. 1048, 59 L.Ed.2d 90 (1979).
1. On the advisory fees (the § 36(b) claim), plaintiff's
only excuses are that the Fund’s directors were controlled
by or affiliated with FMR, had participated in the alleged
to suits under section 36(b). Two have held Rule 23.1 applicable.
Markowitz v. Brody, 9 F.R.D. 542, 548-49, 554-55, 559-61
(S.D.N.Y. 1981); Weiss v. Temporary Investment Fund, Inc., 5\6
F.Supp. 665, 668-70 (D.Del. 1981), rehearing denied, 520 F.Supp.
1098 (1981). One court held primarily that demand was futile in that
instance and therefore excused under Rule 23.1, but was also “in-
clined to agree with plaintiffs that a demand on the directors of the
Fund was not intendei to be a prerequisite to suit under § 36(b).”
Blatt v. Dean Witter Reynolds Intercapital, Inc., §.D.N.Y., 528
F.Supp. 1152 (1982).
58a
wrong, and had announced their opposition to the suit.
All three reasons are inadequate. Of the eight Fund
director-defendants, only three were affiliated with FMR;
five were unaffiliated and “disinterested.”’° As the court
said in Untermever v. Fidelity Daily Income Trust, 580
F.2d 22, 23 (Ist Cir. 1978), and Jn re Kauffman Mutual
Fund Actions, 479 F.2d 257, 264 (1st Cir.), cert. denied,
414 U.S. 857, 94 S.Ct. 161, 38 L.Ed.2d 107 (1973), a
majority of disinterested directors negatives general alle-
gations of control-by-the-adviser, comparable to those
plaintiff makes here. A proper excuse of control or
domination calls for particularized allegations and spe-
cific facts—which are absent both in the initial and the
amended complaint.
As for mere ‘participation” or “acquiescence” by the
directors in the level of the challenged advisory fees, that
generality, too, is an insufficient excuse where the cor-
porate activity is the normal one of setting and paying
advisory fees; on this point, there also are no particulars
asserting that a majority of the directors engaged in a
“facially improper transaction.” Bare allegations of
“wrongful participation” or “acquiescence” are not
enough in this circuit. See /n re Kauffman Mutual Fund
Actions, supra, 479 F.2d at 264-65; Heit v. Baird, supra,
567 F.2d at 1160-62.
The third allegation, that the directors had already
announced their firm opposition to the suit, is equally
unavailing. Apart from the critical fact that the statement
on which plaintiff relies in his amended complaint did not
precede the suit but was part of a motion to dismiss the
initial complaint, there is no doubt whatever that, in
16 One disinterested director (who was apparently such at the
time suit was begun) was not sued.
59a
context, the disinterested directors’ position did not pre-
clude their fair consideration of plaintiff's demand.
2. The primary excuse for failing to make demand on
the “recapture” element of the case is that the directors
all had a conflict of interest.'* The gist of this claim is that
FMR should have recovered a substantial portion of
underwriting commissions, discounts and spreads paid on
the Fund’s purchases of municipal bonds, but failed to do
so “because FMR received from the underwriters substan-
tial benefits in the form of research, statistical and other
information in connection with FMR’s functions as in-
vestment adviser fo the other funds which it manages”
(emphasis added). The posited conflict-of-interest arises
because all the Fund’s directors are directors or trustees
of other funds managed by FMR, and as such directors or
trustees (it is asserted) would have an interest adverse to
recapture for the Fund, so that the other funds could
continue to receive the information they need and want.
We can assume arguendo that there might arguably be
some duty to recapture as charged in the complaint, but
the difficulty with plaintiff's general assumption of “con-
flict of interest,” as an excuse for not making demand, is
17 ‘The full statement was: “The Disinterested Directors have no
basis for believing that suit against FMR for the practices alleged in
the Complaint is justified. They are anxious, however, to evaluate
any information which Grossman has which suggests that it is. If
they concluded that suit is justified, the Fund's best interests demand
that they bring suit. They will do so.”
As ground for his excuse, Grossman quotes only the first sentence,
omitting the remainder.
18 Plaintiff also says, on this phase, that the directors had
announced their firm opposition to the merits of his recapture claim.
On that, the answer we have already given (see note 17, supra, and
text) suffices.
60a
that he fails to set forth with any specificality, as Rule
23.1 and our decisions require, the factual grounds why
this putative “conflict of interest” was in fact an actual
one. The conflicting status of the Fund’s directors here
was at best tenuous and conditional, not direct, stark,
apparent and “unmistakable” as in Delaware & Hudson
Co. v. Albany & Susquehanna Railroad, 213 U.S. 435, 29
S.Ct. 540, 53 L.Ed. 862 (1909). The responsibility both
for supplying the information to the other funds and for
recapture was, not on the other funds, but on FMR, with
which a majority of the Fund’s board were unconnected.
The same is true of the financial detriment of recapture,
which would fall on FMR; the other funds would not be
interested in that money. They may be concerned with
continuing to receive the information,’’ but there is no
allegation or reason to believe that they would not be
satisfied if FMR obtained it elsewhere than from under-
writers, brokers or dealers. Although there is an allega-
tion that recapture would diminish the amount of
information supplied by the latter, there is no assertion
that FMR (which had the duty to supply it) would not be
able to, or would not, fill the gap from another source,
nor is there any assertion that the other funds would have
to pay FMR higher fees in order to obtain the inforina-
tion they wanted. To charge a true conflict of interest the
plaintiff should have at least spelled out the likelihood of
one, not left the court with the bare possibility that the
defendants might conceivably have the incentive to vote
or push against recapture because of their interests as
directors of the other funds. Heit v. Baird, supra, 567
F.2d at 1161-62, indicates tht the bare possibility or mere
19 There are, however, no particularized allegations on the
necessity Or importance of the other funds’ continuing to receive the
information.
6la
allegation that the directors could have a self-interested
purposed (there, to retain control of the corporation;
here, to advance the interests of the other funds) is not
enough if, as in this case, there can be valid corporate
reasons for taking the position challenged in the com-
plaint—or if there is in fact no conflict because of other
circumstances not negated by plaintiff. Conversely, “the
antagonism between the directory and the corporate in-
terest” must be shown to be “unmistakable,” or deemed
futile, to excuse demand. Delaware & Hudson Co. vy.
Albany & Susquehanna Railroad, 213 U.S. 435, 447, 29
S.Ct. 540, 543, 53 L.Ed. 862 (1909); Jn re Kauffman
Mutual Fund Actions, supra, 479 F.2d at 263.
The final question is whether plaintiff's post-litigation
demand cured his failure to make one before beginning
the action. Rule 23.1 specifically calls upon the complaint
to show that demand was made or was properly excused;
there is no provision for thereafter remedying an omis-
sion in the same suit, especially after the defendants have
moved to dismiss because of the absence of a demand.
The terms of the Rule have generally been followed by
other appellate courts. Lucking v. Delano, 117 F.2d 159,
160 (6th Cir. 1941) (“Obviously the filing of the complaint
cannot be regarded as a demand to sue, for by starting
the action [plaintiffs] have usurped the field”); Shlensky
v. Dorsey, 574 F.2d 131, 141-42 (3rd Cir. 1978) (“The
contemplated showing of demand made upon the direc-
tors after the filing of the shareholders’ derivative com-
plaints could not have satisfied the demand requirements
of the rule”); Galef v. Alexander, 615 F.2d 51, 59 (2d Cir.
1980) (“Rule 23.1 * * * is essentially a requirement that a
62a
stockholder exhaust his intracorporate remedies before
bringing a derivative action”).
Though this court has not yet ruled squarely on the
precise point, it has observed that the rule of demand is to
alert the director before suit is instituted. Jn re Kauffman
Mutual Fund Actions, supra, 479 F.2d at 263, we said
that “to be allowed, sua sponte, to place himself in charge
without first affording the directors the opportunity to
occupy their normal status, a stockholder must show that
his case is exceptional,” i.e. that demand is excused
(emphasis added). The same postulate was expressed in
Heit v. Baird, supra, $67 F.2d at 1162 (n.6): “The purpose
of the demand requirement is, of course, to require resort
to the body legally charged with conduct of the com-
pany’s affairs before licensing suit in the company’s name
by persons not so charged” (emphasis added). Under this
court’s practice of vigorous enforcement of the Rule
(Heit v. Baird, 567 F.2d at 1160; see also In re Kauffman
Mutual Fund Actions, 479 F.2d at 263, 267), and of the
generally “strict view” the court takes “of the require-
ment of prior demand” (Untermeyer v. Fidelity Daily
Income Trust, 580 F.2d 22, 23 (Ist Cir. 1978)), these
statements should be, and are, now embodied in an
explicit holding.
It makes no difference that in this instance the belated
demand was made at the suggestion of the District Court.
The judge’s colloquy with counsel shows that the court
was simply making that suggestion, as the opinion below
says, “in the hope that expensive and lengthy litigation
could be avoided”; if the directors responded favorably
to plaintiff, in whole or in part, that would clearly be the
result. Grossman then made his demand voluntarily, with
his expressed understanding “that the demand letter
63a
would not be deemed a waiver by any party of rights
which it otherwise possessed.” There was no direction by
the court and no agreement that the late demand would
rectify the initial failure to make a demand prior to suit.
IV
Because we hold that the suit must be dismissed be-
cause plaintiff did not make the necessary demand before
suing, we refrain from considering the District Court’s
alternative holding that, in any event, defendants are
entitled to judgment on the ground that their “alleged
actions are protected by and comply with the require-
ments of the business judgment rules.”
Affirmed.
Decision of the Court of Appeals for the Third Circuit in
Weiss v. Temporary Investment Fund
6Sa
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
No. 81-2688
MELVYN I. WEISS, Custodian for
GARY MICHAEL WEISS, U/NY/UGMA,
Appellant
v.
TEMPORARY INVESTMENT FUND, INC., PROVI-
DENT INSTITUTIONAL MANAGEMENT COR-
PORATION, SHEARSON LOEB’ RHOADES,
INC., RUSSELL W. RICHIE, ROBERT R. FOR-
TUNE, JAMES LOUIS ROBERTSON, HENRY M.
WATTS, JR., DR. RALPH A. YOUNG. THOMAS S
GATES, G. WILLING PEPPER
Appellees
(D.C. Civil No. 80-00230)
ON APPEAL FROM THE UNITED STATES DISTRICT
COURT FOR THE DISTRICT OF DELAWARE
Argued April 2, 1982
Betore: GIBBONS, SLOVITER and
BECKER, Circuit Judges
(Opinion Filed November 12, 1982)
Morris and Rosenthal, P.A.
One Customs House Square
Post Office Box 1070
Wilmington, Delaware 19899
Wolf Haldenstein Adler
Freeman & Herz
270 Madison Avenue
New York, New York 10016
Of Counsel:
Daniel W. Krasner ( Argued)
Jeffrey G. Smith
Wolf Haldenstein Adler
Freeman & Herz
Attorneys for Appellant
Peter M. Mattoon
Richard Z. Freemann, Jr. (Argued)
Of Counsel:
Ballard, Spahr. Andrews & Ingersoll
30 South 17th Street
Philadelphia, Pa. 19103
Attorneys for Appellee,
Provident Institutional
Management Corporation
David L. Foster
Paula J. Mueller
Of Counsel:
Wilkie, Farr & Gallagher
One Citicorp Center
153 East 53rd Street
New York. New York 10022
Attorneys for Appellee.
Shearson Loeb Rhoades, Inc.
Morris R. Brooke
James M. Sweet
James C. Ingram
67a
Of Counsel:
Drinker Biddle & Reath
1100 PNB Building
Broad and Chestnut Streets
Philadelphia, Pa. 19107
Attorneys for Appellees,
Russell W. Richie,
Robert R. Fortune,
James Louis Robertson,
Henry M. Watts, Jr.,
Dr. Ralph A. Young,
Thomas S. Gates,
G. Willing Pepper
OPINION OF THE COURT
BECKER, Circuit Judge
The principal question presented in this appeal is
whether a shareholder of an investment company must
make a demand on directors pursuant to Fed. R. Civ. P.
23.1 pnor to commencing suit under section 36(b) of the
Investment Company Act of 1940 (ICA), 15 U.S.C.
§§80a-35(b) (1976), to challenge the company's con-
tracts with its investment advisers. The district judge
dismissed the action for failure to satisfy the demand re-
quirement, Weiss v. Temporary Investment Fund, Inc.,
516 F. Supp. 665 (D. Del. 1981), and denied the appel-
lant leave to replead after making a demand, Weiss v.
Temporary Investment Fund, Inc., 520 F. Supp. 1098
(D. Del. 1981).
Appellant Weiss contends that the ICA was a prod-
uct of Congress’ recognition of potential conflicts of in-
terest in the management of investment companies and
that the ICA's legislative history and statutory scheme,
which reflect that concern, are inconsistent with the re-
68a
quirement of shareholder demand. After reviewing that
legislative history and statutory scheme and the pur-
poses of the demand requirement, we perceive no such
inconsistency. We conclude that the contributions of the
demand requirement to corporate governance mandate
application of Rule 23.1 to section 36(b) suits. We also
conclude that the circumstances alleged in the com-
plaint do not warrant excusing such a demand as futile,
and the district judge did not err in denying leave to
replead. We therefore affirm.
1. INTRODUCTION
A. Factual and Procedural Background
Plaintiff-appellant Melvyn I. Weiss, as custodian for
his son Gary Michael Weiss, is a shareholder of the Tem-
porary Investment Fund, Inc. (the Fund). The Fund is a
no-load open-end investment company. commonly re-
terred to as a “money market fund,” whose objective is to
increase the current income of its shareholders through
investments in a variety of prime money market
obligations. The Fund is managed by a seven-member
board of directors elected by its shareholders. '
Under an Advisory Agreement, the management of
the Fund's portfolio is entrusted to its investment advis-
er, Provident Institutional Management Corporation
(the Adviser), a wholly-owned subsidiary of Provident
National Bank (Provident). Under a sub-advisory agree-
ment, Provident receives seventy-five percent of the Ad-
viser's fees, in return for which it supplies, inter alia, in-
vestment research services, computer facilities. and
operating personnel. Shearson Loeb Rhoades, Inc.
(Shearson) serves as underwriter for the Fund and per-
forms other administrative functions under its Adminis-
tration and Distribution Agreement with the Fund.
1. In January 1980, when the advisory contracts at issue were
approved, the board consisted of six members.
69a
The terms of the Advisory and Administration
Agreements (collectively referred to as “advisory con-
tracts’) provide that the fees received by the Adviser and
Shearson are computed as a percentage of the Fund's
assets. The percentage rate is scaled downward:
Shearson and the Adviser each received .175 percent of
the first $300 million in assets, .15 percent of the next
$300 million, and .125 percent of the third $300 million.
For average net assets in excess of $900 million, the rate
is fixed at .1 percent. The recent popularity of money
market funds has dramatically increased the Fund's as-
sets, to more than $2 billion when suit was commenced
in 1980. This phenomenon has produced a commensu-
rate increase in the fees received by the Adviser and
Shearson.
On May 7, 1980, Weiss brought a shareholder suit
on behalf of the Fund against the Adviser, Shearson, and
seven directors of the Fund. One count of the complaint
charges that Shearson and the Adviser breached their fi-
duciary duties to the Fund under section 36(b) of the
ICA by receiving “excessive and unreasonable” compen-
sation. The basis of this count is the advisory contracts,
which Weiss contends permit the Adviser to receive
twenty-five percent of the fees without performing any
services and fail to provide for any reduction in fees after
the Fund's assets exceed $900 million. Additional
counts allege that all defendants breached their fidu-
ciary duties by participating or acquiescing in the advi-
sory contracts; that shareholder approval of the fee ar-
rangements was secured through misleading proxy
statements in violation of section 14(a) of the Securities
Exchange Act of 1934, 15 U.S.C. §78n(a) (1976); and
that the management and fee arrangements violate the
Banking Act of 1933, 12 U.S.C. §§24, 378(a) (1976), the
ICA, and common law fiduciary duties. As relief, the
plaintiff sought a judgment declaring the Advisory
Agreement and the Distribution Agreement void, an or-
70a
der requiring that the Adviser and Shearson repay all ex-
cessive fees to the Fund, and an order requiring the indi-
vidual defendants to reimburse the Fund for damages
caused by their violations of the ICA and the Securities
Exchange Act.
The complaint acknowledges that no demand was
made on the directors of the Fund. It asserts, however,
that demand is not a prerequisite for the section 36(b)
count and that demand would have been futile as to all
counts because the directors are controlled by the
Fund's advisers and because they participated in the al-
leged violations. Amended Complaint at €37.
The defendants moved to dismiss the complaint on
a number of grounds, including the plaintiff's failure to
satisfy the Rule 23.1 demand requirement. The district
court, concluding that demand is required for a section
36(b) @uit and was not excused as futile, dismissed the
complaint.2, Having determined that intra-corporate
remedies should be exhausted first, the court found it
unnecessary to address the other challenges to the com-
plaint. The court subsequently denied Weiss’ motion
seeking leave to make a demand on the directors and to
file an amended complaint if demand was refused.
Weiss appeals from all three rulings.
As we indicated at the outset, section 36(b) is the
principal focus of our attention. Its relevant portions are
set forth in the margin.’ Although section 36(b) does not
2 The court also dismissed the action against defendant
James L. Robinson for insufficient service of process. That portion
of the district court's order has not been appealed.
3. Section 36(b) provides, in relevant part:
For the purposes of this subsection, the investment adviser
of a registered investment company shall be deemed to have a
fiduciary duty with respect to the receipt of compensation for
to such investment adviser or any affiliated person of such in-
Tla
explicitly excuse shareholders from the demand require-
ment of Rule 23.1, Weiss advances two theories to sup-
port his position that demand is not required. First, he
argues that because the statute does not authorize a
cause of action by the corporation, a section 36(b) suit is
not derivative and is thus not governed by Rule 23.1 at
all. Alternatively, he asserts that the legislative history
and the statutory scheme supersede the policies
underlying the requirement of shareholder demand. Al-
though he presents a number of discrete arguments to
support this latter thesis, their common predicate is that
Congress, perceiving directors of investment companies
to be ineffective checks on advisory fee levels, structured
section 36(b) to permit shareholders to bypass the direc-
tors. Before considering Weiss’ specific contentions, we
must describe the contours of section 36(b) and other
relevant provisions of the ICA.
vestment adviser. An action may be brought under this
subsection by the Commission, or by a security holder of such
registered investment company on behalf of such company,
against such investment adviser, or any affiliated person of
such investment adviser, or any other person enumerated in
subsection (a) of this section whe has a fiduciary duty concern-
ing such compensation or payments, for breach of fiduciary
duty in respect of such compensation or payments paid by such
registered investment company or by the security holders
thereof to such investment adviser or person. With respect to
any such action the following provisions shall apply:
(1) It shall not be necessary to allege or prove that any
defendant engaged in personal misconduct, and the plain-
tiff shall have the burden of proving a breach of fiduciary
duty
(2) In any such action approval by the board of direc-
tors of such investment company of such compensation or
payments. or of contracts or other arrangements providing
for such compensation or payments, and ratification or ap-
72a
B. The Statutory Scheme
The management of an investment cornpany is dis-
tinguished by its reliance on external management and
investment advisers. See, e.g., Burks v. Lasker, 441 US.
471, 480-85 (1979); Tannenbaum v. Zeller, 552 F.2d
402 (2d Cir.), cert. denied, 434 U.S. 934 (1977): Note,
Mutual Fund Independent Directors: Putting a Leash
on the Watchdogs, 47 Fordham L. Rev. 568 (1979)
{hereinafter cited as Fordham Note}. Typically, an exter-
nal organization such as Shearson creates the invest-
ment fund and appoints the initial board of directors.
The board then enters into a contract with one or more
external companies who manage the fund and provide
investment services. In addition to receiving fees for
these two functions (which may be performed by the
same outside adviser), the independent advisers may re-
ceive underwriting fees or brokerage commissions if
they also serve.in those capacities. This web of financial
ties among the fund and its advisers invites several con-
NOTE — (Continued)
proval of such compensation or payments. or of contracts
or other arrangements providing for such compensation or
payments, by the shareholders of such investment com-
pany, shall be given such consideration by the court as is
deemed appropriate under all the circumstances.
(3) No such action shall be brought or maintained
against any person other than the recipient of such com-
pensation or payments, and no damages or other relief
shall be granted against any person other than the recipi-
ent of such compensation or payments. No award of dam-
ages shall be recoverable for any period prior to one year
before the action was instituted. Any award of damages
against such recipient shall be limited to the actual dam-
ages resulting from the breach of fiduciary duty and shall
in no event exceed the amount of compensation or pay-
ments received from such investment company, or the se-
curity holders thereof, by such recipient.
15 U.S.C. §80a-35(b) (1976).
73a
flicts of interest. In negotiating advisory tees. tor exam-
ple, directors affiliated with the adviser tace the compet-
ing interests of the adviser. who seeks high tees. and the
investors, who want low fees in order to maximize their
return on investment. Similarly. an adviser who also
serves as broker has an incentive to increase its fees
through trequent portfolio transactions that may dissi-
pate the earnings of the investors. See Fordham Note.
supra p. 7, at 570-71
The ICA was intended to minimize the potenual
conflicts ansing from the creation, sale. and manage-
ment of an investment company such as a mutual fund
by external investment advisers. S. Rep. No. 184, 91st
Cong.. Ist Sess.. reprinted in 1970 U.S. Code Cong. &
Ad. News 4897, 4901. As originally enacted in 1940, the
ICA's principal device to prevent self-dealing by the di-
rectors was the requirement that at least forty percent of
the board members be independent — that is, that they
have neither a direct nor an indirect financial interest in
the company or its adviser. 15 U.S.C. §80a-10(a) (1976).
Over time, however. it became apparent that this safe-
guard was insufficient to stem the burgeoning advisory
fees. Recognizing that a company’s dependency on its
adviser limited the influence of arms-length bargaining
in keeping advisory fees competitive, Congress enacted
section 36(b) as part of the 1970 amendments to the
ICA. That section imposes on the adviser a fiduciary
duty with respect to compensation for its services and
explicitly authorizes suits by the Securities and Ex-
change Commission and the fund's shareholders to en-
force that duty. By increasing the standard of care owed
by the advisers, Congress sought to ease the difficult
burden faced by shareholders trving to prove that adviso-
ry contracts violated common law prohibitions against
“corporate waste.” See infra note 9. The remedy under
36(b) is an action against the recipient of the allegedly
excessive payments for actual damages resulting from
the breach of fiduciary duty, not to exceed actual pay-
74a
ments received from the investment company. A show-
ing of personal misconduct by the defendant is not re-
quired. The recovery of excessive fees is limited to those
paid by the investment company during the one-year pe-
nod prior to initiation of the suit.
Additional responsibility for monitoring manage-
ment fees were also imposed on directors. The 1970
amendments require directors to investigate and evalu-
ate advisory fee contracts, demand that a majority of dis-
interested directors approve the contracts, and permit
the directors to terminate contracts without financial
penalty upon sixty days’ notice. 15 U.S.C. §80a-15(c)
(1976). The amendments also tightened the qualifica-
tions of the independent directors serving on the board.
Id. §§80a-2(19), 80a-10a.* The essence of the amend-
ments, as the Supreme Court has noted, is to place these
unaffiliated directors in the role of “independent
watchdogs” charged with supervising the management
of the company. Burks v. Lasker, supra, 441 U.S. at 484.
With this background in mind, we turn to Weiss’ ar-
guments that suits under section 36(b) are not subject
to Rule 23.1
Il. IS A SECTION 36(b) ACTION DERIVATIVE?
Before addressing the arguments set forth in the
bnefs, we must consider a threshold contention — ad-
vanced by Weiss for the first time at oral argument —
that a shareholder suit under section 36(b) is not a de-
rivative action and thus is not subject to Rule 23.1.°
4. Independent directors are those who are not “interested” in
the company or its advisers. The amendments define “interested
person” to include persons who have close family Wes or substanual
financial or professional relauonships with the investment company
or its advisers, or who have beneficial or legal interests in securitiesé
issued by the adviser or underwriter.
5. The belated nature of this argument is evidenced by Weiss’
pleadings, which characterize the action as one brought “derivative-
lv on behalf of the Fund.” Amended Complaint at €2(b).
7Sa
Weiss apparently relies on the rule's requirement that
the right enforced by a shareholder be one which “may
properly be asserted” by the corporation.” The ICA, how-
ever, explicitly authorizes suits only by the SEC and by
the shareholders and does not state that the Fund itself
may sue its advisers for breach of fiduciary duues. If the
Fund cannot sue, Weiss’ theory proceeds, then a section
36(b) cause of action does not derive trom a nght that
“may properly be asserted” by the Fund. We disagree.
We can approach this issue in several ways. One ap-
proach, adopted by the First Circuit in Grossman 1
Johnson, 674 F.2d 115 (1st Cir. 192), cert. dented, 51
U.S.L.W. 3245(U.S. Oct. 5, 1982), views an investment
company’s right to sue its advisers as a necessary, if not
explicit, corollary of the mght of action conferred on
shareholders by section 36(b). In holding that an invest-
ment company has a direct cause of action undér section
36(b), the Grossman court stated:
We cannot believe. . . that, forexample, a new and
independent board of directors, intent on recovering
excessive fees from the investment adviser, would
be precluded from suing under section 36(b). That
section is explicit that recovery by a shareholder is
to be on behalf of the investment company and that
6. Rule 23.1 states in pertinent part
In a denvative action brought by one or more shareholders or
members to entorce a right of a corporation, the corpora-
uon. . . having failed to enforce a mght which may properly be
asserted by it. the complaint shall allege with particularity the
efforts, if any, made by the plainuff to obtain the action he de-
sires from the directors. . . and the reasons for his failure to
obtain the action or for not making the effort.
The Rule establishes other derivative suit requirements such as
contemporaneous ownership of stock by the plainuff when the al-
leged wrong occurred. These additional requirements are not at is-
suc in this appeal and references here to “Rule 23.1” are limited to
the demand requirement unless otherwise noted.
76a
his sult must be brought on the same behalf. With
those clear requirements. Congress could well have
believed that. though it was appropriate to specify
that the Commission and shareholders had the new
statutory cause of action under section 36(b), see
Moses v. Burgin, 445 F.2d 369, 373 n.7 (1st Cir.
1971), it was unnecessary to say with particularity
that the company also did. A suit ‘on behalf of such
company (a phrase which is more than merely one
‘tor the benefit of the company’) is normally a de-
rivauve acuon that the company could itself bring.
Id. at 120 (footnotes omitted). Along similar lines, the
Supreme Court noted in Burks v. Lasker, supra, 441
U.S. at 477. that “!a) derivative suit is brought by share-
holders to entorce a claim off behalf of the corporation”
emphasis supplied), and the Court thereafter referred
without comment to a sec tion 36(b) suit as derivative, id.
at 454
We agree with the First Circuit's reasoning as far as
it goes. but we expand our analysis to consider the test
enunciated in Cort v. Ash, 422 U.S. 66 (1975). Cort pro-
vides the generally accepted framework for determining
whether a statute creates an implied right of action.’
The Second Circuit has rejected this argument. Fox v
Reich & Tang. Inc.. No. 82-7296 (2d Cir. October 26, 1982); see
infra pp. 13-14
8 We recognize that implication of the corporation's night of
acuon by a statute expressly authorizing suit by shareholders is
somewhat atypical of the cases employing the Cort test. Three re-
cent Supreme Court opinions illustrate the usual applicauon of the
Cort test in situations where the statute fails to specify either a pn-
vate remedy or a cause of action for the particular relief sought. See
Mernll Lynch. Pierce. Fenner & Smith. Inc. v. Curran, 102 S. Ct.
1825 (1982) (finding private nghts of action for violations of the
Commodity Exchange Act). Middlesex County Sewerage Authority
\¥ National Sea Clammers Ass'n. 453 U.S 1 (1981) (finding no im-
phed pr ate mght of acuon for damages under the Federal Water
77a
Our application of the Cort test leads us to the same con-
clusion as the First Circuit.
Cort counsels consideration of four factors:
First. is the plaintiff ‘one of the class for whose espe-
cial benefit the statute was enacted,’ — that is, does
the statute create a federal right in favor of the
plaintiff? Second. is there any indication of legisla-
tive intent. explicit or implicit, either to create such
a remedy or to deny one? Third, is it consistent with
the underlying purposes of the legislative scheme to
imply such a remedy for the plaintiff? And finally, is
the cause of action one traditionally relegated to
state law, in an area basically the concern of the
States. so that it would be inappropriate to infer a
cause of action based solely on federal law.
Cort v. Ash, supra, 422 U.S. at 78 (citations omitted).
With respect to the first factor, we have no difficulty in
concluding that an investment company is the intended
beneficiary of section 36(b). The legislative history
states that the fiduciary duty imposed on advisers, one of
the major innovations of the statute, is owed to the com-
pany itself S. Rep. No. 184, 91st Cong., Ist Sess.. re-
printed in 1970 U.S. Code Cong. & Ad. News 4897,
4902. Moreover. as Weiss concedes, any recovery ob-
tained in a shareholder suii reverts to the investment
company and not to the plaintiff.
The second factor, ascertainment of Congress’ in-
tent, is the principal focus of the Cort inquiry. Merrill
Lynch, Pierce, Fenner & Smith v. Curran, 102 S. Ct.
1825, 1839 (1982); see Walck v. American Stock Ex-
change, Inc., No. 82-1051, slip op. at 6, 10 (3d Cir. Sept.
Pollution Control Act or the Marine Protection. Research, and Sanc-
tuaries Act of 1972): Texas Industries. Inc. v. Radcliff Materials.
Inc., 451 U.S. 630 (1981) (antitrust laws do not give rise to implied
right of contribution).
78a
1, 1982). We find nothing in the legislative history of the
ICA that suggests an intent to deprive the company of a
direct remedy. Neither, we must concede, do we find an
explicit expression by Congress that the investment
company is authorized to sue its adviser. But our conclu-
sion is unaffected by this absence of express authoriza-
tion for, as the Supreme Court noted in canvassing the
same legislative history, silence regarding the powers of
the board of directors is to be expected: “The ICA does
not purport to be the source of authority for managerial
power; rather, the Act functions primarily to ‘impos|{e|
controls and restrictions on the internal management of
investment companies." Burks v. Lasker, supra, 441
U.S. at 478 (citation omitted) (emphasis in original).
Thus we may properly infer from this legislative silence
that Congress did not intend to restrict the company's
right to sue.
The state of the law at the time of the 1970 amend-
ments supports this construction of the legislative histo-
ry. We are required to look at this “contemporary legal
context” to determine whetlaer the company had a right
to sue when the statute was enacted. If such a right ex-
isted, we need only determine whether Congress intend-
ed to preserve the preexisting remedy. See Merrill
Lynch, Pierce, Fenner & Smith v. Curran, supra, 102 S.
Ct. at 1839. In this regard, we agree with the district
court’s observation, see 516 F. Supp. at 670 n.11. that
the company possessed (and still possesses) a cause of
action against the adviser at common law.’ We also note
9. The common law predecessor to a section 36(b) action was a
suit against the adviser for “corporate waste.” an action traditionally
deemed to be derivative. 13 W. Fletcher. Cyclopedia of the Law of
Private Corporations ©€5924. 5926. 5927 (rev. perm. ed. 1980)
Congress found the burden of proving corporate waste “unduly re-
strictive” and created the fiduciary duties in section 36(b) to reduce
the burden of invalidating advisory contracts. S. Rep. No. 184. Qlst
Cong., Ist Sess. 5 (1969), reprinted in 1970 U.S. Code Cong. & Ad
News 4897, 4901. Because the common law action was denvative.
we assume Congress expected the federal action to be derivative as
well.
79a
that a shareholder’s right to sue derivatively was implied
by former section 36 (now section 36(a)), which author-
izes SEC enforcement of the ICA’s regulatory scheme.
See, e.g., Moses v. Burgin, 445 F.2d 369 (1st Cir. 1971)
(finding implied right of action under former section 36
for shareholder to sue derivatively to recapture excessive
brokerage fees paid by the mutual fund). “Where Con-
gress adopts a new law incorporating sections of a prior
law, Congress can be presumed to have had knowledge
of the interpretation given to the incorporated law, at
least insofar as it affects the new statute.” Merrill Lynch,
Pierce, Fenner & Smith v. Curran, supra, 102 S. Ct. at
1841 n.66. Against this legal backdrop at the time of the
amendments, Congress’ assumption that the share-
holder suit was derivative from the company’s right of
action becomes clear, as does the correctness of the First
Circuit’s conclusion that Congress assumed the com-
pany enjoyed a direct cause of action and there was no
need to so specify. In sum, the second Cort criterion is
met for the reasons set forth by the First Circuit in
Grossman and because we find no evidence of a Con-
gressiona! intent to deprive the company of its right to
sue the company’s adviser.
The third and fourth factors of the Cort test follow
ineluctably from the preceding discussion. Providing the
investment company with a cause of action fully accords
with the purposes of section 36(b) by providing another
means to recover excessive advisory fees. From a practi-
cal standpoint, in fact, the company’s financial resources
and knowledge of the challenged transactions may ren-
der it an even more effective litigant than the
shareholder. Finally, the express cause of action con-
ferred by Congress upon shareholders ipso facto federal-
izes this type of litigation; hence implication of a com-
panion remedy for the investment company does not
intrude upon an area “traditionally relegated to state
law.” Thus application of the four-pronged test of Cort v.
Ash compels us to conclude that the investment com-
80a
pany has a cause of action against the advisers for
breach of the fiduciary duties imposed by section 36(b).
We are aware that the Court of Appeals for the Second
Circuit recently reached the opposite conclusion. Fox v.
Reich & Tang, Inc.. No. 82-7296 (2d Cir. Oct. 26. 1982).
After careful consideration of the court's reasoning.
however, we remain convinced that the investment
company has a cause of action and that a §36(b) action
is derivative.
Ill. IS SECTION 36:6, CONSISTENT WITH THE DE-
MAND REQUIREMENT?
Even if a section 36(b> suit is derivative. Weiss in-
sists that the ICA excuses su
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