Petition — Weiss v. Temporary Investment Fund, Inc.

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82-1592 — eme Court, U.S.

MAR 26 1983

IN THE

Supreme Court of the tui? ore

OCTOBER TERM, 1982

MELVYN I. WEISS, Custodian for

GARY MICHAEL WEISS, U/NY/UGMA,

Petitioner,

TEMPORARY INVESTMENT FUND, INC., PROVIDENT INSTITU-

TIONAL MANAGEMENT CORPORATION, SHEARSON LOEB

RHOADES, INC., RUSSELL W. RITCHIE, ROBERT R. FOR

TUNE, HENRY M. WATTS, JR., DR. RALPH A. YOUNG,

THOMAS S. GATES, and G. WILLING PEPPER,

Respondents.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS FOR

THE THIRD CIRCUIT

270 Madison Avenue

New York, NY 10016

(212) 689-5300

DANIEL W. KRASNER

| Attorney for Petitioner

Of Counsel:

FRED TAYLOR ISQUITH

JEFFREY G. SMITH

WOLF HALDENSTEIN ALDER

FREEMAN & HERZ

270 Madison Avenue

New York, New York 10016

(212) 689-5300

QUESTION PRESENTED FOR REVIEW

Is the demand on directors requirement of Fed. R. Civ. P.

23.1 applicable to security holder suits under section 36(b) of

the Investment Company Act of 1940? The question is com-

prised of two subquestions:

1. Does an investment company possess an implied right of

action under section 36(b)?

2. If so, did Congress intend security holder actions under

section 36(b) to be subject to the demand requirement of Rule

23.1?

This Court tias recently granted a writ of certiorari to review

these very same issues. Fox v. Reich & Tang, Inc., 692 F.2d 250

(2d Cir. 1982), cert. granted sub nom. Daily Income Fund, Inc.

* Ter, US... ares 7, 3965).

TABLE OF CONTENTS

PAGE

QUESTION PRESENTED FOR REVIEW ........... i

EEE PORPMEMLPERE RENE, occ ccccccccccecsccaccce Vv

a 2

ee la ce hesbescctcecsvccccece 2

I 2

Sg od 3

REASONS FOR GRANTING THE WRIT........... 4

Ea wwe bs We beccs veccecavces 6

CCE CC Lea acdebesceccccscoscccece 13

APPENDIX

Opinion of the Court of Appeals dated November 12,

i ee eek s oKS oes evccnbeseccvecs la

Judgment of the Court of Appeals dated November 12,

EE ES a 49a

Order of the Court of Appeals dated December 30,

1982, denying petition for rehearing ............... Sla

Opinion of the District Court (Schwartz, J.) dated June

ee DOC eE Est vessrvatassceceseces 53a

Order of the District Court (Schwartz, J.) dated June 17,

errs cls Scie cise wesdeespestess. 69a

Opinion of the District Court (Schwartz, J.) dated

i Sick ks aes eebs ae ceesasoeecece Tla

PAGE

Order of the District Court (Schwartz, J.) dated August

a! So Reka k oe ian ag cans ok bd Nastee WeeN eS 77a

Provisions of Section 36(b)

Investment Company Act of 1940.............0055 79a

Provisions of Rule 23.1

Federal Rules of Civil Procedure................6. 8la

TABLE OF AUTHORITIES

Cases PAGE

Brown v. Bullock, 294 F.2d 415 (2d Cir. 1961) ........ 12

Burks v. Lasker, 441 U.S. 471 (1979) .............00% 4,5,9

Esplin v. Hirschi, 402 F.2d 94 (10th Cir. 1968), cert.

Seas PU CRO vidas bcohecadudnendeewe 12

Fox v. Reich & Tang, Inc., 692 F.2d 250 (2d Cir. 1982),

cert. granted sub nom. Daily Income Fund, Inc. vy.

ee a EE Pp ROOD ae wisieinde 6th i, 4, 6,9

Grossman v. Johnson, 674 F.2d 115 (ist Cir.), cert.

denied, 459 U.S. ___, 103 S.Ct. 85 (1982) ......... 4,6,9

Hillsboro Nat’! Bank v. Commissioner, 455 U.S. 906

RS es oe 4

Jerozal v. Cash Reserve Management, Inc., [Current]

Fed. Sec. L. Rep. (CCH) € 99,019 (S.D.N.Y. Aug. 10,

nb oe i oes frost a bbe has pee eo awed 12

Levit v. Johnson, 334 F.2d 815 (lst Cir. 1964), cert.

ee Mees ee RENEE ncn coco s cnved dbeko chee 12

Merrill Lynch, Pierce, Fenner & Smith v. Curran, ___

Se eas Se Ps DO MERE yo ne dead acsacbeeie 11-12

Middlesex County Sewerage Authority v. National Sea

Clammers Association, 453 U.S. 1 (1981)........... 11

Piper v. Chris-Craft Industries, 430 U.S. 1 (1977) ..... 11

Taussig v. Wellington Fund, Inc., 313 F.2d 472 (3d Cir.

1963), cert. d2nied, 374 U.S. 806 (1963)............ 12

Texas Industries, Inc. v. Radcliff Materials, Inc., 451

Se ON oa 5's viendo 600s ee eRbRS eEDM Ren Come 11

Touche Ross & Co. v. Reddington, 442 U.S. 560 (1979) 11

PAGE

Transamerica Mortgage Advisers, Inc. v. Lewis, 444

Se EP AOE Scud own she cadaevnea aay dane 11

Weiss v. Temporary Investment Fund, Inc., 692 F.2d 928

PA RRRERE RES p apeien i-Ale, 8 M 2 et passim

Weiss v. Temporary Investment Fund, Inc., 516 F. Supp.

665 (D. Del. 1981), motion for reargument denied,

a ee es Dae Care EP. WIC ecccccaceccceasees 2-3

Statutes and Rules of Procedure

Commodity Exchange Act

REE Mo ou cle wa niewenle dk bears ote ue eee 1]

rR a 2'S u's agile awn crulknn'e bake i ef passim

Investment Company Act of 1940

ars. a PL « Koccchobucaboctebeuwne i et passim

Rules of the Supreme Court of the United States, Rule

Pia hea sicdcavecobads tal dpe nduidensnedstee 4

Miscellaneous

H.R. Rep. No. 2337, 89th Cong., 2d Sess. (1966)...... 7-8

S. Rep. No. 184, 91st Cong., Ist Sess. (1969) ......... 8-9

No.

IN THE

Supreme Court of the United States

OCTOBER TERM, 1982

MELVYN I. WEISS, Custodian for

GARY MICHAEL WEISS, U/NY/UGMA,

Petitioner,

TEMPORARY INVESTMENT FUND, INC., PROVIDENT INSTITU-

TIONAL MANAGEMENT CORPORATION, SHEARSON LOEB

RHOADES, INC., RUSSELL W. RITCHIE, ROBERT R. FoR.

TUNE, HENRY M. WATTS, JR., DR. RALPH A. YOUNG,

THOMAS S. GATES, and G. WILLING PEPPER,

Respondents.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS FOR

THE THIRD CIRCUIT

Petitioner, Melvyn I. Weiss, respectfully prays that a writ of

certiorari issue to review that part of the judgment of the

United States Court of Appeals for the Third Circuit entered

on November 12, 1982, which affirmed a judgment of the

United States District Court for the District of Delaware

entered on June 17, 1981, dismissing petitioner’s suit under

section 36(b) of the Investment Company Act of 1940 (the

“ICA”), 15 U.S.C. § 80a-35(b), for failure to comply with the

demand on directors requirement of Rule 23.1 of the Federal

Rules of Civil Procedure.

OPINIONS BELOW

The opinion of the United States Court of Appeals for the

Third Circuit and the dissenting opinion of Judge Gibbons,

dated November 12, 1982, are reported at 692 F.2d 928 and are

reproduced in the Appendix to this petition at pages la to 29a

and 29a to 48a, respectively.’ The opinion of the United States

District Court for the District of Delaware, dated June 17,

1981, is reported at 516 F. Supp. 665. (53a-68a.) A second

opinion of the district court, dated August 27, 1981, denying

petitioner’s motion for reargument and for leave to file an

amended complaint, is reported at 520 F. Supp. 1098. (7la-

75a.)

JURISDICTION

The court of appeals issued its opinion and entered judg-

ment on November 12, 1982. (49a-50a.) A petition for re-

hearing and suggestion for rehearing en banc was denied on

December 30, 1982. (Sla-52a.) This petition is filed within

ninety days of the denial of the petition for rehearing. Jurisdic-

tion of this Court is invoked under 28 U.S.C. § 1254(1).

STATUTES INVOLVED

The statute and rule involved are section 36(b) of the ICA

and Rule 23.1 of the Federal Rules of Civil Procedure; both

are reproduced in the Appendix. (79a-81a.)

1 Hereafter, materials included in the Appendix will be referenced

paranthetically as: (Xa-Ya).

STATEMENT OF THE CASE’

Petitioner is the custodian for a minority shareholder of the

Temporary Investment Fund, Inc. (the “Fund”), a money

market fund. Petitioner instituted this action under section

36(b) of the ICA against Provident Institutional Management

Corporation (“PIMC”), the Fund’s investment adviser, and

Shearson Loeb Rhoades, Inc. (“Shearson”), the Fund’s under-

writer/distributor, to recover allegedly excessive fees paid by

the Fund to PIMC and Shearson. The complaint acknowl-

edged that no demand had been made upon the directors of the

Fund, but asserted that demand on an investment company’s

directors is not a prerequisite for a section 36(b) security holder

action against an investment company’s adviser.

The defendants moved to dismiss the complaint on several

grounds, including failure to satisfy the Rule 23.1 demand

requirement. The district court dismissed the action, conclud-

ing that demand is a precondition to a section 36(b) share-

holder suit. Having determined that demand was required in

order to ensure that intracorporate remedies are exhausted

prior to suit, the district court also denied petitioner’s subse-

quent motion for leave to make a demand upon the Fund’s

directors and to file an amended pleading.

On appeal, a divided panel of the court of appeals held that

the Rule 23.1 demand requirement is applicable to section

36(b) security holder actions and affirmed the judgment of the

district court. The majority ruled that an investment company

has an implied right of action against its investment adviser

z This statement of the case is taken from the circuit court’s opinion,

as relevant to the issues on this petition. Petitioner’s complaint also alleged,

against PIMC, Shearson, and the Fund’s directors, other, related violations

of federal securities and banking laws and state common law. Petitioner’s

complaint against James Louis Robertson, a director of the Fund, was

dismissed by the district court for inadequate service of process. That

dismissal was not appealed.

under section 36(b) and that Rule 23.1 applies to shareholder

actions under section 36(b) because the right of the shareholder

to sue is derived from the company’s implied right. The

majority further held that the language and legislative history

of section 36(b) evidenced no Congressional intent to “bypass

the directors.” Judge Gibbons, in dissent, concluded that there

was no support in section 36(b), its legislative history, or the

prior relevant decisions of this Court for an implied corporate

right of action under section 36(b) and that, to the contrary,

the statute and this Court’s prior decision in Burks ». Lasker,

441 U.S. 471 (1979), set forth a policy inconsistent with the

application of Rule 23.1 to section 36{b) actions. A petition for

rehearing en banc was denied.

REASONS FOR GRANTING THE WRIT

The decision of the court of appeals that shareholder actions

under section 36(b) must comply with the demand on directors

requirement of Rule 23.1 is in direct and irreconcilable conflict

with a recent decision of the Court of Appeals for the Second

Circuit on the same matter, Fox v. Reich & Tang, Inc., 692

F.2d 250 (1982), cert. granted sub nom. Daily Income Fund,

Inc. v. Fox, ___ U.S. ____ (March 7, 1983).’ Since a petition

for writ of certiorari has been granted in the Second Circuit

case, granting this petition will not add to the burden of this

Court. If this petition is denied, however, and if the decision of

the Second Circuit is upheld, petitioner in this case will be left

with the anomalous result of having this Court uphold his

position, but having no remedy because he lost below. Peti-

tioner, therefore, respectfully requests that his petition be

granted and be consolidated for argument with Fox.‘

3 Grossman v. Johnson, 674 F.2d 115 (ist Cir.), cert. denied, 459 U.S.

___, 103 S.Ct. 85 (1982), is another circuit court opinion on the same issue.

4 This Court’s Rule 37.3 permits such consolidation. See also Hills-

boro Nat’! Bank v. Commissioner, 455 U.S. 906 (1982) where certiorari was

granted and cases consolidated for argument of common issues.

Further, the court of appeals has decided an important

question of federal law—the interrelationship of Rule 23.1 and

the Congressionally created security holder action under sec-

tion 36(b) of the I[CA—which has not been settled by this

Court. The decision of the court of appeals has a dramatically

limiting effect on the Congressional goal of protecting invest-

ment company shareholders from excessive advisory fees. The

court of appeals’ decision also contradicts the rationale of

Burks v. Lasker, 441 U.S. 471 (1979), and, if permitted to

stand, will undermine the important protections Congress

mandated for investment company shareholders when it

amended the ICA and added section 36(b).

Finally, the decision of the court of appeals rests upon a

faulty premise: that an investment company has an implied

right of action against its investment adviser under section

36(b). The premise is in error. It contradicts both the purpose

and legislative history of section 36(b) and ignores this Court’s

recent rulings limiting creation of new implied rights of action

under the securities laws.

Thus, this petition for a writ of certiorari should be granted

because the decision below (1) creates a conflict between the

circuits, (2) involves an important question of federal law

which has not been settled by this Court, and (3) is erroneous

and conflicts with the rationale of prior decisions of this

Court.

ARGUMENT

Three federal courts of appeals have now decided the issue

presented by this case. The Court of Appeals for the First

Circuit held that a Rule 23.1 demand on directors is required in

a shareholder action brought under section 36(b). Grossman v.

Johnson, 674 F.2d 115, cert. denied, 459 U.S. ___., 103 S.Ct.

85 (1982). The Court of Appeals for the Second Circuit, after

careful consideration, and noting its conflict with the First

Circuit, unanimously held that since an investment company,

itself, has no right of action under section 36(b), Rule 23.1

does not apply and no demand is required. Fox v. Reich &

Tang, Inc., 692 F.2d 250 (1982), cert. granted sub nom. Daily

Income Fund, Inc. v. Fox, _. U.S. ___. (March 7, 1983). In

the opinion below, the Third Circuit, noting its conflict with

the Second Circuit, held that investment companies do have an

implied right of action under section 36(b), that Congress

evidenced no intent to exempt section 36(b) actions from the

provisions of Rule 23.1, and, thus, demand is required. Judge

Gibbons, in a carefully reasoned opinion, dissented and gener-

ally agreed with the Second Circuit’s Fox opinion.

The conflict between the circuits is clear, direct, and irrecon-

cilable on this important question.

The decision below, if allowed to stand, will seriously

undermine the central policy of protection for investment

company security holders embodied in section 36(b) of the

ICA, which was added to the ICA in 1970. The purpose of the

amendment was to permit security holders of investment com-

panies to bring actions to recover excessive advisory fees

unimpeded by directorial interference.

The court of appeals stated that the 1970 amendments to the

ICA were generally designed to strengthen the watchdog role of

unaffiliated directors of investment companies. It ignored

extensive legislative history documenting Congressional aware-

ness and concern that investment company directors were not

and could not be effective checks against advisory fee abuses.

Thus, the court of appeals erroneously concluded that imposi-

tion of Rule 23.1 requirements on section 36(b) actions would

further the Congressional goal of strengthening the hand of the

unaffiliated directors of investment funds.

The legislative history of the ICA, however, makes it clear

that in enacting section 36(b) Congress was concerned exclu-

sively with protecting shareholders’ interests, notwithstanding

the unaffiliated directors. The legislative history demonstrates

Congressional awareness of the historic failure of even unaf-

filiated directors to protect shareholders with respect to advi-

sory fees:

It has been the Commission’s experience in the adminis-

tration of the Act that in general the unaffiliated directors

have not been in a position to secure changes in the level

of advisory fee rates in the mutual fund industry.

Securities and Exchange Commission Report on “Public Policy

Implications of Investment Company Growth,” Report of the

Committee on Interstate and Foreign Commerce, H.R. Rep.

No. 2337, . th Cong., 2d Sess. 131 (1966).

Congress was also aware that the failure was not historic

happenstance, or caused by lack of directorial power or venal

motivation, but was structural:

The unaffiliated directors, as the only potentially disin-

terested persons in the management of most investment

companies, can and should play an active role in repre-

senting the interests of shareholders not only in connec-

tion with management compensation but in other areas

where the interests of the professional managers may not

coincide with those of the company and its public inves-

tors. Strengthening the voice of truly disinterested direc-

tors in investment company affairs is important to the

protection of public shareholders. But even a requirement

that all of the directors of an externally managed invest-

ment company be persons unaffiliated with the com-

pany’s adviser-underwriter would not be an effective

check on advisory fees and other forms of management

compensation.

The unaffiliated directors are not in a position to bargain

on an equal footing with the adviser on matters of such

crucial importance to it. They are not free, as a practical

matter, to terminate established management relationships

when differences arise over the advisory fees or other

compensation. This reflects, in large part, the adviser-un-

derwriter permeation of investment company activities to

an extent that makes rupture of the existing relationships

a difficult and complex step for most companies. For

these reasons, arm’s-length bargaining between the unaf-

filiated directors and the managers on these matters is a

wholly unrealistic alternative.

Id. at 148.

Congress added section 36(b) to the ICA to remedy the

problem:

In the case of management fees, the committee believes

that the unique structure of mutual funds has made it

difficult for the courts to apply traditional fiduciary

standards in considering questions concerning manage-

ment fees.

Therefore your committee has adopted the basic principle

that, in view of the potential conflicts of interest involved

in the setting of these fees, there should be effective

means for the courts to act where mutual fund share-

holders or the SEC believe there has been a breach of

fiduciary duty. This bill would make it clear that, as a

matter of Federal law, the investment adviser or mutual

fund management company has a fiduciary duty with

respect to mutual fund shareholders. \t provides an effec-

tive method whereby the courts can determine whether

there has been a breach of this duty by the adviser or by

certain other persons with respect to their compensation

from the fund.

Report of the Senate Committee on Banking and Currency, S.

Rep. No. 184, 91st Cong., Ist Sess. 2 (1969) (emphasis added).

This Court has already held in recognition of the relative

impotence of investment company directors in dealing with

advisory fee questions that section 36(b) claims are not subject

to the business judgment rule. They cannot be dismissed or

circumscribed by board action:

[W]hen Congress did intend to prevent board action from

cutting off derivative suits, it said so expressly. Section

36(b), . . . , performs precisely this function for deriva-

tive suits charging breach of fiduciary duty with respect to

adviser’s fees.

Burks v. Lasker, 441 U.S. at 484 (citations and footnote

omitted).

The proper relationship between Rule 23.1 and section 36(b)

is not a hollow issue of procedural nicety without substantive

implications. It relates directly to the control mutual fund

management will have over section 36(b) actions.

The court below felt that shareholder exhaustion of intracor-

porate remedies, even in the absence of directorial power to

terminate the claim, gave purpose to the Rule 23.1 demand

requirement for section 36(b) actions. But the one year statute

of limitations provided in section 36(b)(3) argues strongly

against allowing the routine delays inherent in the Rule 23.1

demand process.* Such delays, particularly if post-suit demand

is not allowed, as the circuit court held below (29a), may result

in significant diminution of recoveries, contrary to Congress’

purpose, merely to support the chimerical hope that the direc-

tors will, upon demand, do what the Congress found them

5 In the Grossman case, 674 F.2d 115, the record on appeal indicates

that despite an order of the district court directing a prompt response to

plaintiff's post-complaint demand, over six months elapsed until the invest-

ment company’s board rejected the demand. Such delays in responding to a

demand are not unusual. In the Fox case, the Second Circuit discussed this

issue, 692 F.2d at 261-2.

structurally incapable of doing—adequately resolving, intra-

corporately or otherwise, advisory fee abuses.

The issue is an important federal question which this Court

should resolve.

The central error in the decision below is its holding that an

investment company has an implied private right of action

under section 36(b). The court of appeals’ inference of a new

implied right of action, while essential to its holding, defies

logic and completely contradicts both this Court’s prior deci-

sions regarding implied private rights of action and the legisla-

tive history of section 36(b).

This new implied right of action was created by the court of

appeals solely for the purpose of requiring a Rule 23.1 demand

here. Congress did not see fit to legislate such a claim. To date,

not one reported case exists where a mutual fund or its

directors have attempted to assert such a claim. Nevertheless,

the court below, solely in order to bring the shareholder claim

within the ambit of Rule 23.1, created this implied corporate

claim. It then asserted that the section 36(b) shareholder claim

was derived from that new implied claim. In fact, the only

claim Congress created was a new action granting investment

company shareholders direct, not derivative, access to federal

courts. Congress did not deem it necessary to traverse the

circuitous route of deriving that claim from a corporate right.

Neither should the courts.

Rule 23.1 applies only to “a derivative action brought by one

or more shareholders . . . to enforce a right of a corporation

. . the corporation . . . having failed to enforce a right

which may properly be asserted by it . . .” A shareholder’s

action to recover for his investment company excessive advi-

sory fees is governed by Rule 23.1 only if such investment

company may properly assert an action itself, or through its

directors, under section 36(b) and if the shareholder’s action is

derived from such company action. But section 36(b) only

provides for “[aJn action . . . under this subsection by the

Commission or by a security holder of such registered invest-

ment company on behalf of such company. . .”

Recent decisions of this Court teach that, absent a strong

indication of Congressional intent to the contrary, courts

should not read implied rights of action into a statute which

expressly provides for only particular statutory actions.

Middlesex County Sewerage Authority v. National Sea Clam-

mers Association, 453 U.S. 1, 13 (1981); Texas Industries, Inc.

v. Radcliff Materials, Inc., 451 U.S. 630, 639 (1981). This is

pa ticularly so with respect to federal securities regulation.

Transamerica Mortgage Advisers, Inc. v. Lewis, 444 U.S. 11

(1979); Touche Ross & Co. v. Reddington, 442 U.S. 560

(1979); Piper v. Chris-Craft Industries, 430 U.S. 1 (1977).

The court of appeals majority claims that the new implied

right of action it finds under section 36(b) falls within the

exception recognized by this Court in Merrill Lynch, Pierce,

Fenner & Smith v. Curran, _. U.S. ____., 102 S. Ct. 1825

(1982). But, as Judge Gibbons points out in dissent, Curran is

quite to the contrary. In Curran this Court was asked to

determine whether previously implied rights of action under

the Commodity Exchange Act survived or would be rejected as

a result of the 1974 amendments to that statute which had

made substantial changes in the statutory scheme, including

the addition of new statutory remedies, but which had left

intact the provisions under which the courts had previously

implied rights of action. This Court held that since Congress

was aware of the earlier judicially implied rights of action and

expressed no desire to eliminate them, one could infer that by

not repealing the implied rights Congress intended to retain

them.

Section 36(b), on the other hand, was newly codified by the

1970 amendments. It created a totally new cause of action with

carefully crafted standards and a very short siatute of limita-

tions. There was no previous judicial record recognizing im-

plied rights of action under section 36(b) prior to the 1970

amendments because it did not yet exist.° Curran, therefore,

offers no assistance to the court of appeals in discovering an

implied right of action under a new section creating a limited

new cause of action, and is, indeed, to the contrary.

Finally, the court of appeals’ opinion does not offer even

one reason why Congress might have intended to imply a new

corporate cause of action when it could simply have added

investment companies, their directors, or even their unaffil-

iated directors to the list of statutorily recognized plaintiffs.

Conversely, there are many cogent reasons why Congress did

not permit investment companies to assert section 36(b) claims.

First, the legislative history, as pointed out in both the majority

and dissenting opinions below, reflected Congressional con-

cern that board action had been ineffective with respect to

restraining advisory fees in the past and that there was no

reason to expect improvements in the future, because the

ineffectiveness was structural.

Second, as Judge Gibbons suggests in dissent, Congress may

have not given the company or its directors a claim in order to

avoid situations where fund directors might try to pre-empt

SEC or shareholder action with “sweetheart” litigation be-

tween boards and advisers.

Third, the statute itself indicates that Congress did net

expect, or intend, that section 36(b) claims be raised by

6 Implied rights of action under the ICA were recognized by the courts

before the 1970 amendments under previously enacted sections of the ICA

prohibiting waste, conversion, gross misconduct, etc. Esplin v. Hirschi, 402

F.2d 94 (10th Cir. 1968), cert. denied, 394 U.S. 928 (1969); Levit v. Johnson,

334 F 2d RIS (let Cir, 1964), cert. denied, 379 U.S. 96! (1965); Taussig v.

Wellington Fund, Inc., 313 F.2d 472 (3d Cir. 1963), cert. denied, 374 U.S. 806

(1963); Brown v. Bullock, 294 F.2d 415 (2d Cir. 1961). Such implied rights of

action were found under sections 15, old 36 (which became 36(a) in the 1970

amendments), 37 and 48, and, in light of Curran, would appear to continue

with the same vitality after the 1970 amendments. Jeroza/ v. Cash Reserve

Management, Inc., |Current] Fed. Sec. L. Rep. (CCH) ¢ 99, 019 (S.D.N.Y.

Aug. 10, 1982). The existence of these implied rights of action before the

1970 amendments should not, however, cause the courts to imply a new right

of action under section 36(b).

investment companies: Section 36(b)(2) directs courts hearing

claims arising under the section to give “such consideration

. . a§ is deemed appropriate” to board approval and share-

holder ratification of challenged fee arrangements. Such a

proviso, which applies to ai// claims under the section, is

obviously directed to non-board challenges to fee agreements—

i.e., challenges by the SEC or by shareholders—and not, at

least not in any way that makes sense or can be fitted into the

legislative scheme, to actions by the company itself.

The court of appeals erred by creating a new implied right of

action under section 36(b) in the total absence of statutory

language or legislative history supporting such an implied

right. Even the majority below appears to concede that without

such an implied corporate right of action a shareholder's

section 36(b) action does not seek “to enforce a right which

may properly be asserted by” his investment company, and,

thus, a Rule 23.1 demand is not required.

The judgment of the court of appeals is erroneous and

contrary to this Court’s prior decisions.

CONCLUSION

For the foregoing reasons, a writ of certiorari should issue to

the United States Court of Appeals for the Third Circuit.

Respectfully submitted,

DANIEL W. KRASNER

270 Madison Avenue

New York, New York 10016

(212) 689-5300

Attorney for Petitioner

March 24, 1983

APPENDIX

”

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

No. 81-2688

aol

MELVIN I. WEISS, Custodian for GARY MICHAEL WEISS,

U/NY/UGMA,

Appellant,

—/)—

TEMPORARY INVESTMENT FUND, INC., PROVIDENT INSTITU-

TIONAL MANAGEMENT CORPORATION, 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

Before:

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 Halderstein 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:

Willkie, 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

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 prior to com-

mencing 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 contracts with its investment advisers. The

district judge dismissed the action for failure to satisfy the

demand requirement, Weiss v. Temporary Investment Fund,

Inc., 516 F.Supp. 665 (D. Del. 1981), and denied the appellant

leave to replead after making a demand, Weiss v. Temporary

Investment Fund, Inc., 520 F.Supp. 1098 (D. Del. 198.1).

Appellant Weiss contends that the ICA was a product of

Congress’ recognition of potential conflicts of interest in the

management of investment companies and that the ICA’s

legislative history and statutory scheme, which reflect that

concern, are inconsistent with the requirement of shareholder

demand. After reviewing that legislative history and statutory

scheme and the purposes of the demand requirement, we

perceive no such inconsistency. We conclude that the contribu-

tions 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 complaint

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 Temporary Invest-

ment Fund, Inc. (the Fund). The Fund is a no-load open-end

investment company, commonly referred to as a “money

market fund,” whose objective is to increase the current in-

come 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 adviser, Provi-

dent Institutional Management Corporation (the Adviser), a

wholly-owned subsidiary of Provident National Bank (Provi-

dent). Under a sub-advisory agreement, Provident receives

seventy-five percent of the Adviser's fees, in return for which it

supplies, inter alia, investment 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 Administration

and Distribution Agreement with the Fund.

1 In January 1980, when the advisory contracts at issue were ap-

proved, the board consisted of six members.

The terms of the Advisory and Administration Agreements

(collectively referred to as “advisory contracts”) 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 per-

cent 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 assets, to more than $2

billion when suit was commenced in 1980. This phenomenon

has produced a commensurate 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 fiduciary duties to the Fund

under section 36(b) of the ICA by receiving “excessive and

unreasonable” compensation. 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 fiduciary duties by partici-

pating or acquiescing in the advisory contracts; that share-

holder approval of the fee arrangements was secured through

misleading proxy statements in violation section 14(a) of the

Securities Exchange Act of 1934, 15 U.S.C. § 78(n)(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 order requiring that the

Adviser and Shearson repay all excessive fees to the Fund, and

an order requiring the individual 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 alleged violations. Amended Complaint at 4 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) suit and was not excused

as futile, dismissed the complaint.? Having determined that

intra-corporate remedies should be exhausted first, the court

found it unnecessary (o address the other challenges to the

complaint. The court subsequently denied Weiss’ motion seek-

ing leave to make a demand on the directors and to file an

amended complaint if demand was refused. Weiss appeals

fro.n 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 explicitly excuse

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 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 payments, for breach

fiduciary duty in respect of such compensation or

such registered investment company or the

thereof to such investment adviser or person. With respect to any

such action the following provisions shall apply:

shareholders from the demand requirement of Rule 23.1, Weiss

advances two theories to support 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 require-

ment of shareholder demand. Although he presents a number

of discrete arguments to support this latter thesis, their com-

mon predicate is that Congress, perceiving directors of invest-

ment companies to be ineffective checks on advisory fee levels,

structured section 36(b) to permit shareholders to bypass the

directors. Before considering Weiss’ specific contentions, we

must describe the contours of section 36(b) and other relevant

provisions of the ICA.

(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, or of contracts or other arrangements providing for

such compensation or payments, and ratifications or ap-

proval of such compensation or payments, or of contracts or

other arrangements providing for such compensation or pay-

ments, by the shareholders of such investment company, shall

be given such consideration by the court as is deemed appro-

priate under all 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 compensa-

tion or payments. No award of damages 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 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.

15 U.S.C. § 80a-35(b 1976)

B. The Statutory Scheme

The management of an investment company is distinguished

by its reliance on external management and investment ad-

visers. See, e.g., Burks v. Lasker, 441 U.S. 471, 480-85 (1979);

Tannenbaum vy. Zeller, 552 F.2d 402 (2nd Cir.), cert. denied,

434 U.S. 934 (1977); Note, Mutual Fund Independent Direc-

tors: Putting a Leash on the Watchdogs, 47 Fordham L. Rev.

568 (1979) [hereinafter cited as Fordham Note]. Typically, an

external organization such as Shearson creates the investment

fund and appoints the initial board of directors. The board

then enters into a contract with one or more external compa-

nies 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 receive underwriting fees or brokerage commis-

sions if they also serve in those capacities. This web of

financial ties among the fund and its advisers invites several

conflicts of interest. In negotiating advisory fees, for example,

directors affiliated with the adviser face the competing interests

of the adviser, who seeks high fees, 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 frequent portfolio transactions that

may dissipate the earnings of the investors. See Fordham Note,

supra p. 7, at 570-71.

The ICA was intended to minimize the potential conflicts

arising from the creation, sale, and management of an invest-

ment 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-deal-

ing by the directors 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 safeguard was

insufficient to stem the burgeoning advisory fees. Recognizing

that a company’s dependency on its adviser limited the in-

fluence 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

explicity authorizes suits by the Securities and Exchange Com-

mission and the fund’s shareholders to enforce that duty. By

increasing the standard of care owed by the advisers, Congress

sought to ease the difficult burden faced by shareholders trying

to prove that advisory contracts violated common law prohibi-

tions 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 payments re-

ceived from the investment company. A showing of personal

misconduct by the defendant is not required. The recovery of

excessive fees is limited to those paid by the investment

company during the one-year period prior to initiation of the

suit.

Additional responsibility for monitoring management fees

were also imposed on directors. The 1970 amendments require

directors to investigate and evaluate advisory fee contracts,

demand thet a majority of disinterested 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 quaiifi-

cations of the independent directors serving on the board. /d.

§§ 80a-2(19), 80a-10a.* The essence of the amendments, as the

Supreme Court has noted, is to place these unaffiliated direc-

tors in the role of “independent watchdogs” charged with

supervising the management of the company. Burks v. Lasker,

supra, 441 U.S. at 484.

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 ties or substantial financial or

professional relationships with the investment company or its advisers, or

who have beneficial or legal interests in securities issued by the adviser or

underwriter.

10a

With this background in mind, we turn to Weiss’ arguments

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 briefs, we

must consider a threshold contention—advanced by Weiss for

the first time at oral argument—that a shareholder suit under

section 36(b) is not a derivative action and thus not subject to

Rule 23.1.°

Weiss apparently relies on the rule’s requirement that the

right enforced by a shareholder by one which “may properly be

asserted” by the corporation.® The ICA, however, 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 duties. If the Fund cannot sue, Weiss’

theory proceeds, then a section 36(b) cause of action does not

derive from a right that “may properly be asserted” by the

Fund. We disagree.

We can approach this issue in several ways. One approach,

adopted by the First Circuit in Grossman v. Johnson, 674 F.2d

115 (ist Cir. 192), cert. denied, 51 U.S.L.W. 3245 (U.S. Oct. 5,

1982), views an investment company’s right to sue its advisers

5 The belated nature of this argument is evidenced by Weiss’ plead-

ings, which characterize the action as one brought “derivatively on behalf of

the Fund.” Amended Complaint at 2(b).

6 Rule 23.1 states in pertinent part:

In a derivative action brought by one or more shareholders or

members to enforce a right of a corporation, . . . the corporation

. . having failed to enfi «re a right which may properly be

asserted by it, the complaint shall allege with particularity the

efforts, if any, made by the 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.

The Rule establishes other derivative suit requirements such as contempora-

neous ownership of stock by the plaintiff when the alleged wrong occurred.

These additional requirements are not at issue in this appeal and references

here to “Rule 23.1” are limited to the demand requirement unless otherwise

noted.

as a necessary, if not explicit, corollary of the right of action

conferred on shareholders by section 36(b). In holding that an

investment company has a direct cause of action under section

36(b), the Grossman court stated:

We cannot believe . . . that, for example, a new and

independent board of directors, intent on recovering ex-

cessive fees from the investment adviser, would be pre-

cluded 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 particularity

that the company also did. A suit ‘on behalf of such

company’ (a phrase which is more than merely one ‘for

the benefit of the company’) is normally a derivative

action that company itself could bring.

Id. at 120 (footnotes omitted).’ Along similar lines, the Su-

preme Court noted in Burks v. Lasker, supra, 441 U.S. at 477,

that “[a] derivative suit is brought by shareholders to enforce a

claim on behalf of the corporation” (emphasis supplied), and

the Court thereafter referred without comment to a section

36(b) suit as derivative, id. at 484.

We agree with the First Circuit’s reasoniug 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 provides the generally

accepted framework for determining whether a statute creates

an implied right of action.* Our application of the Cort test

leads us to the same conclusion as the First Circuit.

7 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 right of action by

a Statute expressly authorizing suit by shareholders is somewhat atypical of

12a

Cort counsels consideration of four factors:

First, is the plaintiff ‘one of the class for whose especial

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 legislative intent, explicit or im-

plicit, 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 plain-

tiff? 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 company itself. S. Rep. No. 184, 91st

Cong., Ist Sess., reprinted in 1970 U.S. Code Cong. & Ad.

News 4897, 4902. Moreover, as Weiss concedes, any recovery

obtained in a shareholder suit reverts to the investment com-

pany and not to the plaintiff.

The second factor, ascertainment of Congress’ intent, 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 Exchange, Inc., No. 82-1051, slip

the cases employing the Cort test. Three recent Supreme Court opinions

illustrate the usual application of the Cort test in situations where the statute

fails to specify either a private remedy or a cause of action for the particular

relief sought. See Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Curran, 102

S. Ct. 1825 (1982) (finding private rights of action for violations of the

Commodity Exchange Act); Middlesex County Sewerage Authority v. Na-

tional Sea Clammers Ass'n, 453 U.S. 1 (1981) (finding no implied private

right of action for damages under the Federal Water Pollution Control Act

or the Marine Protection, Research, and Sanctuaries Act of 1972); Texas

Industries, Inc. v. Radcliff Materials, Inc., 451 U.S. 630 (1981) (antitrust

laws to not give rise to implied right of contribution).

l3a

op. at 6, 10 (3d Cir. Sept. 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 conclusion is

unaffected by this absence of express authorization for, as the

Supreme Court noted in canvassing the same legislative history,

silence regarding the powers of the board of directors 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 origi-

nal). 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 amendment

supports this construction of the legislative history. We are

required to look at this “contemporary legal context” to

determine whether the company had a right to sue when the

statute was enacted. If such right existed, we need only deter-

mine whether Congress intended 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 that a

shareholder’s right to sue derivatively was implied by former

9 The common law predecessor to 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

44 5924, 5926, 5927 (rev. perm. ed. 1980). Congress found the burden of

proving corporate waste “unduly restrictive” and created the fiduciary duties

in section 36(b) to reduce the burden of invalidating advisory contracts. S.

Rep. No. 184, 91st Cong., Ist Sess. 5(1969), reprinted in 1970 U.S. Code

Cong. & Ad. News 4897, 4901. Because the common law action was

derivative, we assume Congress expected the federal action to be derivative

as well.

l4a

section 36 (now section 36(a)), which authorizes SEC enforce-

ment 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 de-

rivatively to recapture excessive brokerage fees paid by the

mutual fund). “Where Congress adopts a new law incorporat-

ing 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 shareholder 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 company 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

Congressional intent to deprive the company of its right to sue

the company’s adviser.

The third and fourth factors of the Cort test follow ineluc-

tably 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 exces-

sive advisory fees. From a practical standpoint, in fact, the

company’s financial resources and knowledge of the chal-

lenged transaction may render it an even more effective litigant

than the shareholder. Finally, the express cause of action

conferred by Congress upon shareholders ipso facto federalizes

this type of litigation; hence implication of a companion

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 company 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

15a

& 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(b) CONSISTENT WITH THE DE-

MAND REQUIREMENT?

Even if a section 36(b) suit is derivative, Weiss insists that the

ICA excuses such suits from Rule the 23.1 demand require-

ment. As we have noted, he concedes that the statute does not

do so expressi,, bui contends that the legislative history and

statutory scheme of section 36(b) manifest Congress’ intent to

eliminate this prerequisite to suit.

At the outset we note that Weiss must overcome the pre-

sumption the Rule 23.1, like all Federal Rules of Civil Proce-

dure, applies to any civil suit brought in federal district court

unless inconsistent with an Act of Congress. Fed. R. Civ. P. 1;

see 28 U.S.C. § 2071 (1976). Abrogation of a rule of procedure

generally is inappropriate “[i]n the absence of a direct expres-

sion by Congress of its intent to depart from the usual course

of trying ‘all suits of a civil nature’ under the Rules established

for that purpose.” Califano v. Yamasaki, 442 U.S. 683, 700

(1979). Repugnancy of a statute to a civil rule is not to be

lightly implied. Rather, “a subsequently enacted statute should

be so construed as to harmonize with the Federal Rules if that

is at all feasible.” Grossman v. Johnson, supra, 674 F.2d at

122-23 (quoting 7 Moore’s Federal Practice 4 86.04[4] at 86-22

(2d ed. 1980)); accord Fox v. Reich & Tang, Inc., 94 F.R.D. 94

(S.D.N.Y. 1982), rev’d on other grounds, No. 82-7296 (2d Cir.

Oct. 26, 1982).

A. Does the Legislative History Reflect Congress’ Intent to

Require Demand?

Weiss relies on the legislative history accompanying the 1970

amendments, passages of which reflect Congress’ perception

that even unaffiliated directors had not been able to secure

changes in the advisory fee levels. For example, he quotes from

l6a

the Securities and Exchange Commission Report on Invest-

ment Companies, H.R. Rep. No. 2337, 89th Cong., 2d Sess.

(1966):

It has been the Commission’s experience in the adminis-

tration of the Act that in general the unaffiliated directors

have not been in a position to secure changes in the level

of advisory fee rates in the mutual fund industry.

The analysis of the shareholder fee litigation not only

underscores the need for changes in existing statutory

provisions relating to management compensation in the

investment company industry, but points to the direction

which these changes should take. It makes clear the need

to incorporate into the Act a clearly expressed and readily

enforceable standard that would measure the fairness of

compensation paid by investment companies for services

furnished by those who occupy a fiduciary relationship to

such companies.

The right of the Commission as well as investment com-

pany shareholders to take action against violations of the

Statutory standard of reasonableness is essential to effec-

tive enforcement.

Id. at 131, 143, 146 (emphasis supplied by appellant). Second,

he invokes the Congressional intention to establish a mecha-

nism by which the shareholders and courts could enforce the

investment adviser’s fiduciary duty. The report accompanying

the 1970 amendments states:

In the case of management fees, the committee believes

that the unique structure of mutual funds has made it

difficult for the courts to apply traditional fiduciary

standards in considering questions concerning manage-

ment fees.

Therefore your committee has adopted the basic principal

that, in view of the potential conflicts of interest involved

17a

in the setting of these fees, there should be effective

means for the court to act where mutual fund share-

holders or the SEC believe there has been a breach of

o fiduciary duty.

S. Rep. No. 184, 91st Cong., Ist Sess., reprinted in 1970 U.S.

Code Cong. & Ad. News 4897, 4898 (emphasis supplied by

appellant).

These passages do not reflect a “direct expression by Con-

gress” of its intent to eliminate the demand requirement.

Expressions that shareholders and the SEC need increased

judicial access in order to insure the reasonableness of advisory

fees do not denote an intent to bypass the directors completely.

On the contrary, the legislative history is replete with references

to Congress’ intent to preserve, not preempt, the role of

management in negotiating advisory fees. The Senate Report

emphasizes this point:

{Section 36(b)] is not intended to authorize a court to

substitute its business judgment for that of the mutual

fund’s board of directors in the area of management

fees. . . . 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 fidu-

ciary duty with respect to management compensation.

The section is not intended to shift the responsibility for

managing an investment company in the best interest of

its shareholders from the directors of such company to

the judiciary.

S. Rep. No. 184, 91st Cong., Ist Sess., reprinted in 1970 U.S.

Code Cong. & Ad. News 4897, 4902-03. The clear intent of

Congress was to install management as “the first line of

defense for the individual investor” against any self-dealing by

the adviser. Fox v. Reich & Tang, Inc., supra, 94 F.R.D. at 96.

As the Supreme Court noted in Burks v. Lasker, supra, 441

U.S. at 484-85, the 1970 amendments were designed to place

the unaffiliated directors in a “watchdog” role. Requiring that

18a

shareholders make a demand upon the directors is fully conso-

nant with this purpose.

Requiring demand also accords with the legislative history,

which itself alludes to the continued operation of the demand

requirement. During Congressional hearings on the proposed

amendments to the ICA, then SEC Chairman Hamer Budge

assured the committee that providing shareholders with a cause

of action would not encourage nuisance suits: “As we have

pointed out previously, there are adequate safeguards under the

Federal Rules of Civil Procedures [sic] and under this bill to

prevent unjustified shareholder litigation.” Hearings on H.R.

11995, S. 2224, H.R. 13754 and H.R. 14737 Before the

Subcomm. of Commerce and Finance of the House Comm. on

Interstate and Foreign Commerce, 9\st Cong., Ist Sess. 201

(1969); accord id. at 860. It is clear to us that this statement

refers to Rule 23.1 and its demand requirement. Contrary to

Weiss’ suggestion, the legislative history reflects an implicit

understanding that Rule 23.1 would apply—an understanding

which comports with the purposes of Section 36(b).

B. Is the Statutory Scheme Consistent with the Requirement

of Shareholder Demand?

Weiss’ final arguments regarding the alleged inapplicability

of Rule 23.1 spring from his contention that the structure of

section 36(b) is inconsistent with the requirement of share-

holder demand, and that Congress therefore did not contem-

plate demand as a prerequisite to suit. Weiss make three

arguments. The first two require only brief discussion; the

third merits more extensive treatment.

1. The Effect of the One-Year Limitation on Recovery

Weiss asserts that demand cannot be required because: (1)

section 36(b) limits the recovery of unreasonable fees to those

that were paid during the one-year period prior to commence-

ment of suit; (2) once a shareholder plaintiff makes a demand,

the directors can delay a response while the excessive fees

continue to be paid; and (3) Congress could not have intended

19a

to interpose the demand requirement because the time con-

sumed by the directors in responding to demand would time-

bar claims to recover fees paid out by the investment fund. At

least one court has indentified this statutory provision as a

basis for suggesting, in dictum, that demand should not be a

prerequisite to a section 36(b) suit. See Blatt v. Dean Witter

Reynolds Intercapital, Inc., 528 F. Supp. 1152, 1155 (S.D.N-Y.

1982).

We recognize that in some cases, demand will postpone the

filing of suit and thereby move forward the one-year period

allowed for the recovery of fees. In most instances, however,

this will not reduce the allowable recovery. In any event, we do

not see why demand cannot be promptly made and expedi-

tiously considered.'’ Notwithstanding Weiss’ intimations to the

contrary, demand is a simple procedure thai is not burdensome

to the shareholders. We therefore do not believe that the

one-year limitation period compels the conclusion that Con-

gress intended to eliminate the demand requirement. ''

2. The Analogy to Section 16(b) of the Securities Exchange

act of 1934

Weiss advances a somewhat tortured analogy between sec-

tion 36(b) of the ICA and section 16(b) of the Securities

Exchange Act of 1934, 15 U.S.C. § 78p(b) (1976), which

allows shareholders to recover illegal insider “short swing”

profits. Suits brought under section 16(b) are exempt from the

contemporaneous ownership requirement of Rule 23.1 Blau v.

Mission Corp., 212 F.2d 77, 79 (2d Cir.), cert. denied, 347 U.S.

1016 (1954). Weiss perceives similarities between insider trading

10 ~—s— The First Circuit, in rejecting the identical argument, suggested that

the district court could allow suit to go forward without waiting for a

response if the directors unduly postpone a response to demand. Grossman

v. Johnson, supra, 674 F2d at 122. We intimate no view here concerning the

propriety of that suggestion.

11 Additionally we note that the short statute of limitations may reflect

a Congressional view of the ICA as designed to ameliorate the situation

prospectively rather than to establish a long damage period.

20a

and “insider” advisory fees. He suggests that section 36(b), like

section 16(b), is an instrument of public policy which should

not be hampered by procedural restrictions such as the demand

requirement of Rule 23.1.

Without reaching the merits of the statutory analogy, we

simply note that it is irrelevant: suits to recover short swing

profits under section 16(b) are subject to the demand require-

ment by the very terms of that statute, which states that a

shareholder may institute an action “if the issuer 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) (1976). We therefore join the First Circuit in rejecting

this argument as specious. See Grossman v. Johnson, supra,

674 F.2d at 120.

3. The Relationship Between Shareholder Demand and the

Exercise of the Directors’ Business Judgment

The heart of Weiss’ challenge based on the statutory scheme

is his assertion that shareholder demand is superfluous because

that scheme effectively precludes the Fund’s directors from

taking action in response to any such demand. The premise of

his argument is the Supreme Court’s suggestion that the ICA

deprives the directors of their authority to exercise their busi-

ness judgment to terminate a section 36(b) suit. In Burks v.

Lasker, supra, the Court stated:

when Congress . . . intended to prevent board action

from cutting off deriviative suits, it said so expressly.

Section 36(b) . . . performs precisely this function for

derivative suits charging breach of fiduciary duty with

respect to adviser’s fees.

441 U.S. at 484. Although section 36(b) was not directly at

issue in Burks, the Court’s interpretation of that section

influenced its holding that other sections of the ICA do not

deprive directors of their authority to terminate derivative suits

under the shield of the business judgment rule. Prudence

dictates that we accede to this strong signal from the Court

2la

that directors may not terminate suits under section 36(b),

notwithstanding our perception that the statement’s import is

unclear. See infra pp. 21-22.

Weiss then argues that if a suit’s termination is precluded, it

would be inconsistent to require demand as a prerequisite to

initiation: if directors are too self-interested to be allowed to

cut off shareholder suits in the exercise of their business

judgment, they must be presumed to be too self-interested to

respond objectively to a shareholder demand. Relying in part

upon our observation in Cramer v. General Telephone and

Electronics Corp., 582 F.2d 259, 274 (3d Cir. 1978). cert.

denied, 439 U.S. 1129 (1979), that the business judgment rule

is “inextricably linked” to the demand requirement, Weiss

essentially concludes that the Court's inclination to disregard

business judgment in this context makes the demand require-

ment superfluous and inefficient.

Our opinion in Lewis v. Curtis, 671 F.2d 779 (1982), lends

some credence to Weiss’ position.'* Lewis involved a share-

holder complaint alleging that demand would have been futile

because the directors had participated in an allegedly self-in-

terested transaction.'® In evaluating this claim, we stated that

the futility of demand turns on the disinterestedness of the

directors, not on the nature of the alleged wrongdoing. We also

noted that the relevant standard of disinterestedness is the

same as that used to determine whether a court should defer to

the board’s business judgment not to pursue a lawsuit on

behalf of the corporation.

There is no reason why a court, in deciding whether a

board is sufficiently interested to excuse demand, should

12 Lewis was published after the briefs in this appeal were filed.

13 The directors were accused of entering into a wasteful settlement

agreement with a shareholder. Pursuant to the agreement the shareholder

abandoned his proxy contest in which he was seeking a seat on the

corporation's board. The complaint also alleged details of a larger scheme by

the directors to retain control of the corporation by, among other things,

obtaining long-term employment contracts for several directors and reducing

the number of directors on the board.

22a

not be informed by the same factors used to determine

whether a court should defer to the board’s decision not

to pursue the action. The board will lack such disin-

terestedness if plaintiff’s allegations, taken as true, would

show that, under state law, a court should not defer to the

board’s decision not to pursue the lawsuit. . . .

Some courts have suggested that directors may not be

sufficiently interested in a transaction to excuse demand,

yet are interested enough to be unable to assert the

protection of the business judgment rule. . . . On the

other hand, formulating different standards for the two

issues is . . . difficult. . . . [Wje do not think that we

should apply different standards of “interestedness” to

cases in which plaintiff has made no dema: d and to those

in which a demand has been made and rejected.

Id. at 785-86 (citations omitted). Since (according to Weiss’

argument) directors are too self-interested to terminate share-

holder suits, the logical extension of Lewis would be to say that

they are so interested that demand should be excused in this

case as a matter of law.

Although Weiss’ argument is superficially alluring, we find it

ultimately unpersuasive. First, to the extent that it is based on

Burks, see supra p. 19, the argument rests on rather uncertain

footing. Weiss would read Burks as standing for the proposi-

tion that directors may not terminate shareholder suits because

directors are too interested in advisory fee transactions. While

this is not an implausible reading of Burks, we do not find the

Supreme Court’s rationale so easy to discern. Section 36(b)(2)

accords the advisory fee actions of directors only “such consid-

eration by the Court as is deemed appropriate under the

circumstances.” Burks understandably concluded that Con-

gress intended less judicial deference to directors’ actions

regarding advisory fees than is ordinarily associated with the

business judgment rule. But we are unable to divine from that

opinion a per se rule that investment company directors are

presumed to be self-interested, and we decline to adopt Weiss’

suggested rule on such a speculative basis.

23a

Weiss also reads too much into our statement in Cramer,

supra, that the demand requirement and the business judgment

rule are “inextricably linked.” 582 F.2d at 274. Rather, as the

district court noted below, see 516 F. Supp. at 670 n.13, the

policies underlying each doctrine are distinct.

The demand requirement originated as a judicially-created

device that forced shareholders to exhaust intracorporate reme-

dies before beginning suit. As explained in one of the earliest

expositions of the principle:

{I]t is . . . important that before the shareholder is

permitted in his own name to institute and conduct a

litigation which usually belongs to the corporation, 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. He must make an

earnest, not a simulated effort, with the managing body

of the corporation, to induce remedial action on their

part.

Hawes v. Oakland, 104 U.S. 450, 460-61 (1882).'* The require-

ment reflects judicial cognizance of the prerogatives and exper-

tise of the directors as stewards of the corporate welfare. One

commentator summarized this purpose as follows:

Forcing shareholders to exhaust intracorporate remedies

by first making demand on directors allows the directors a

chance to occupy their usual status as managers of the

corporation’s affairs, giving the corporation an opportu-

nity to take control of a suit that will be brought on its

behalf. The demand requirement thus furthers a principle

basic to corporate organization, that the management of

the corporation be entrusted to its board of directors.

14 The Court’s holding in Hawes was adopted in 1882 as Equity Rule

94, and was modified in 1912 by Equity Rule 27 to allow allegations of the

* futility of demand. Equity Rule 27 became Federal Rule of Civil Procedure

23(b) which, in turn, was promulgated as Rule 23.1 in 1966.

24a

Note, The Demand and Standing Requirements in Stockholder

Derivative Actions, 44 U. Chi. L. Rev. 168, 171 (1976). When

faced with a demand by a shareholder, the directors have a

number of options. They can exercise their discretion to accept

the demand and prosecute the action, to resolve the grievance

internally without resort to litigation, or to refuse the demand.

It is at this point that the business judgment rule comes into

play.

The business judgment rule eludes precise categorization, as

it assumes different shapes in different settings. See Duesen-

berg, The Business Judgment Rule and Shareholder Derivative

Suits: A View from the Inside, 60 Wash. U.L.Q. 311 (1982). In

its traditional form, the rule protects directors from personal

liability for business decisions by presuming that they acted in

good faith and with reasonable care. See Johnson v. True-

blood, 629 F.2d 287, 292 (3d Cir. 1980) (even in a facially

self-dealing transaction, the rule assumes directors were “exer-

cising their sound business judgment rather than responding to

any personal motivations”), cert. denied, 450 U.S. 999 (1981).

In shielding directors from the hazards of hindsight challenges

to the wisdom of particular decisions, the rule serves two

important functions.

Were courts, with perfect retrospective vision, to second-

guess the judgment of officers and directors in their

decisionmaking function, they would be injecting them-

selves into a management role for which they were neither

trained nor competent. Such judicial action would also be

taking a step to discourage others from performing these

desired and essential societal activities. One pragmatic

objective of the business judgment rule, then, is to keep

courts out of a role they are ill-equipped to perform.

Another is to encourage others to assume entrepreneurial

and risk-taking activities by protecting them against per-

sonal liability when they have performed in good faith

and with due care, however unfortunate with conse-

quence. Both are of monumental social utility.

Duesenberg, supra, 60 WASH. U.L.Q. at 314 (footnotes omit-

ted).

25a

Because the considerations involved in imposing the demand

requirement and invoking the business judgment rule are

distinct, their applicability is not necessarily coincidental. In

fact, this Court so noted in Cramer: “(While the demand

requirement of Rule 23.1 should be rigorously enforced, we do

not think that the business judgment of the directors should be

totally insulated from judicial review.”'* The American Law

Institute recently expressed a similar view in its proposed

Restatement on Principles of Corporate Governance and

Structure § 7.02, at 270-71 (Tent. Draft No. 1, 1982):

It is not inconsistent for a court to employ a strict

standard with respect to the excusal of demand, but then

to refuse to accept a decision by the same board of

directors to seek termination of the same action. . . . As

some decisions have emphasized, the focus at the demand

state should be on the issue of whether the corporation

may take over the suit and either prosecute it or adopt

other internal corrective measures, and not on the later

question of whether a decision not to sue should be

respected by the court. At the demand stage, the possibil-

ity should not be foreclosed that a demand will induce the

board to consider issues and crystallize policies which

otherwise might not be given attention (e.g., new account-

ing controls, revised corporate policy statements or even a

change in personnel or remuneration). The demand rule

can have efficacy even where the board ultimately rejects

the action and the court ultimately permits the plaintiff to

sue.

In particular, as we noted in Cramer, the demand requirement

gives management the opportunity to pursue alternative reme-

dies and to avoid unnecessary litigation. 582 F.2d at 275.

We find the distinction particularly important here in light of

Congress’ clear intent to enhance the independence of directors

15 At issue in Cramer was whether a determination by a disinterested

committee of directors that a litigation was not in the best interests of the

corporation barred a shareholder suit alleging violations in connection with

GTE’s foreign payments. The plaintiff had not made a rule 23.1 demand,

however, and we affirmed dismissal of the suit on that ground.

26a

and their responsibility for advisory fees. The ICA and its

amendments were designed to erase potential conflicts of

interest inherent in the structure of investment companies by

placing the unaffiliated directors in a substantial management

role and providing them with authority to act as checks on

advisory fees. Congress explicitly empowered the directors to

redress challenges to advisory fees by imposing on directors a

duty to evaluate the advisory fees and by authorizing them to

terminate investment adviser contacts without penalty upon the

giving of sixty days notice. 15 U.S.C. § 80a-15(a)(3)(1976)."°

To allow shareholders to bypass the directors would undermine

the role shaped for directors by the ICA. The opportunity to

resolve the shareholder grievance without resort to litigation

may, in fact, be especially important if the directors are not

able to terminate the suit. In that event the Rule 23.1 demand

provides the only opportunity for the Fund to avert a lawsuit

through internal corrective measures.'’

Finally, the different purposes served by the business judg-

ment rule and the demand requirement show that the wooden

transposition of Lewis to this statutory context is inappro-

priate. Lewis was concerned with the futility of demand. It

involved an inquiry which is “intensely factual” and requires

particularized pleading by the plaintiff. See Vernars v. Young,

539 F.2d 966, 968 (3d Cir. 1976). In a conventional shareholder

suit, the evaluation of the directors’ decision to refuse demand

or terminate suit is equally factual, and it makes sense, as we

16 As appellees note, the directors can respond to a timely shareholder

demand by (1) negotiating a rebate of fees, (2) satisfying the shareholder that

the fees are reasonable in terms of the investment services provided, (3)

persuading the shareholder that litigation would adversely affect share-

holders’ interests, (4) accepting the demand and instituting suit, or (5)

refusing the demand.

17 Weiss’ argument is also undermined by reference to § 16(b) of the

Securities Exchange Act of 1934, 15 U.S.C. § 78p(b) (1976) which he invoked

in another context. See supra pp. 18-19. In a § 16(b) action, where there is no

power by the corporation to terminate, see Burks v. Lasker, supra, 441 U.S.

at 484, n.13; Cramer, 582 F.2d at 276 n.22, there is an express demand

requirement.

27a

stated in Lewis, to emplcy the same standard of interestedness.

However, a statutory presumption of interestedness cannot

substitute for the factual inquiry needed to determine whether

a demand on directors “would be likely to prod them to correct

a wrong.” Lewis, supra, 671 F.2d at 785."

In sum, to read the ICA’s statutory scheme as depriving

directors of the opportunity te respond to a shareholder

grievance would undermine the very purpose of the ICA—to

strengthen management of the Fund by its independent direc-

tors. We attribute no such inconsistent intent to the Congress

and conclude that the demand requirement of Rule 23.1

applies to section 36(b) actions.'”

IV. THE ALLEGED FUTILITY OF DEMAND

Weiss contends that even if his section 36(b) claim is subject

to the Rule 23.1 demand requirement, such demand would

have been futile for all counts of his complaint. The complaint

alleges that demand is unnecessary because (1) Shearson and

the Adviser control and dominate the Fund and its directors;

(2) all of the Fund’s directors have participated or acquiesced

in the Adviser’s breach of fiduciary duty; and (3) the hostility

of the directors to the claim was evidenced by the filing of an

answer to the initial complaint. Amended Complaint at 4 37.

The district court found that the allegations of the Adviser’s

and Shearson’s control over the directors were inadequate to

excuse demand: Weiss failed to provide proof sufficient to

overcome the fact that four of the six directors who approved

the transaction were not “interested” under the terms of the

18 Relying in part on Lewis, the Second Circuit suggested in Fox v.

Reich & Tang, supra, that the demand requirement would serve no function

in the § 36(b) context. “[I]t is possible to infer that Congress . . . believed

directors would always be so ‘interested’ that demand would inevitably be

‘excused.’ ” /d., slip op. at n.13. Having already explained our conclusion to

the contrary, we simply note the tentative nature of the Second Circuit's

language.

19 As oted above, see supra p. 14, we must presume that the federal

rules apply to this action unless expressly displaced by Congress.

28a

ICA, 15 U.S.C. § 80a-2(a)(19)(1976). The district court also

rejected Weiss’ effort to use the company’s answer to the

complaint as evidence of the directors’ hostility to suit. Apply-

ing the edict of this court that futility “must be gauged at the

time the derivative action is commenced, not afterward with

the benefit of hindsight,” see Cramer v. General Telephone &

Electronics Corp., supra, 582 F.2d at 276, the district court

concluded that opposition expressed after suit was filed could

not excuse demand.

Finally, the court turned to the allegation that the directors’

participation in the transaction made demand unnecessary. The

court first noted that simply naming the directors as defen-

dants cannot automatically excuse demand on the theory that

they would have to decide whether to sue themselves.” The

court then applied the test enunciated in /n re Kauffman

Mutual Fund Actions, 479 F.2d 257 (\st Cir.), cert. denied, 414

U.S. 857 (1973), which states that mere approval of the

challenged transaction is insufficient to demonstrate futility of

demand unless the complaint alleges facts showing that the

transaction was motivated by self-interest or bias. The Court

found that Weiss’ complaint failed to allege that the directors

stood to gain any personal advantage from approval of the

advisory contracts; rather, it challenged the directors’ action

only as a breach of their statutory and common law fiduciary

duties. The court accordingly ruled that the pleadings failed to

assert a basis for excusing demand.*! We agree with the

analysis of the district court that these allegations are insuffi-

cient to excuse demand and affirm on that basis.

20 This conclusion was cited with approval in our decision in Lewis v.

Curtis, supra, 671 F.2d at 785.

21 Lewis v. Curtis, supra, which was decided after the district court’s

decision below, does not mandate a different conclusion. As did Kauffman,

Lewis held that the futility of demand turns on the interestedness of the

directors rather than the nature of the wrongdoing. See supra pp. 20-21.

Unlike this case, however, Lewis involved specific allegations of a self-in-

terested transaction by all the directors. See 671 F.2d at 787.

29a

V. DENIAL OF WEISS’ MOTION TO REPLEAD AFTER

MAKING DEMAND

Finally, Weiss contends that the district court abused its

discretion in refusing him leave to replead after a demand on

the Fund’s directors. He relies principally on Markowitz v.

Brody, 90 F.R.D. 542 (S.D.N.Y. 1981), in which the court

stayed dismissal for ninety days in order to allow plaintiff the

opportunity to make a demand.

We reject this contention as well. The law of this circuit

makes clear that demand after a complaint has been filed is

impermissible since it would “reduce the demand requirement

of the rule to a meaningless formality.” Schlensky v. Dorsey,

574 F.2d 131 (3d Cir. 1978). We recognize that application of

this rule in this context may seem costly given the Act’s

limitation on recovery to the excessive fees received during the

year immediately prior to the filing of suit. Nevertheless,

requiring demand before the filing of suit affords directors

“the opportunity to decide in the first instance whether and in

what manner action should be taken.” /d. A demand after suit

is filed would usurp this prerogative.

The district court’s judgment dismissing the complaint will

be affirmed.

GIBBONS, Circuit Judge, dissenting.

This is an appeal from a judgment dismissing a multi-count

complaint by a shareholder of a money market fund for failure

to comply with the demand requirement of Rule 23.1 of the

Federal Rules of Civil Procedure.' I agree with the majority

that the district court properly dismissed all causes of action

pleaded in the complaint except that based upon section 36(b)

1 The district court's opinion is reported. Weiss v. Temporary Invest-

ment Fund, Inc., 516 F. Supp. 665 (D. Del. 1981). Plaintiff also appeals from

the o urt’s denial of his subsequent motion for leave to comply with Rule

23.1 and to file an amended complaint. 520 F. Supp. 1098 (D. Del. 1981).

30a

of the Investment Company Act of 1940? (ICA). As to that

claim ! would reverse.

Plaintiff Melvyn I. Weiss, custodian for his son, Gary M.

Weiss, is a shareholder of the Temporary Investment Fund,

Inc. (Fund), a no-load, open end, diversified investment com-

pany, or “money market fund.” In 1980, Weiss brought a

shareholder’s derivative suit against the Fund, the Provident

Institutional Management Corp. (Provident), which acts as the

Fund’s investment adviser, Shearson Loeb Rhoades, Inc.

(Shearson), the Fund’s underwriter which also performs ad-

ministrative duties for the Fund, and seven directors of the

Fund. Weiss alleges that Provident and Shearson breached

their fiduciary duties under section 36(b) of the ICA by

receiving excessive and unreasonable compensation for

management services. Weiss further alleges that the various

defendants participated in or acquiesced in various breaches of

fiduciary obligations owed the Fund and in violations of the

Securities Exchange Act of 1934,’ the Banking Act of 1933,‘

the ICA* and the common law. The complaint acknowledges

that no demand was made on the directors of the Fund to

bring a similar action but alleges that such a demand would be

futile. The district court, however, concluded that the plain-

tiff’s failure to make such a demand pursuant to Rule 23.1 was

fatal to the action, and dismissed it.° Subsequent!y, Weiss filed

2 15 U.S.C. § 80a-35(b)(1976).

3 Specifically Section 14(a), 15 U.S.C. § 78n(a)(1976), and Rule 14a-9,

17 C.F.R. § 240 (1977), adopted thereunder.

4 Specifically Sections 16 and 21, 12 U.S.C. §§ 24 & 378(a)(1976).

5 Specifically Sections 20(a), 1(b)(2), 15(a) and 15(b), 15 U.S.C.

§$§ 80(a)-1-80a-52.

6 The court also dismissed the complaint as to defendant Robertson

for insufficient service of process on him. Plaintiff does not challenge that

ruling on appeal, so we leave the court’s judgment in that respect undis-

turbed.

3la

a motion for reargument requesting that the court grant him

leave to file an amended complaint after making a demand on

the directors. He also asked the court to reconsider its deter-

mination of non-compliance with Rule 23.1. The district court

refused to reconsider, or to grant leave to make a demand.

Rule 23.1 of the Federal Rules of Civil Procedure specifies

several pleading requirements “[i]n a derivative action brought

by one or more shareholders or members to enforce a right of

a corporation or of an unincorporated association, the corpo-

ration or association having failed to enforce a right which

may properly be asserted by it. . .” Fed. R. Civ. P. 23.1.

Among those requirements is that of pleading that a demand

has been made on the directors to enforce a right which the

corporation may properly assert.’ Rule 23.1 finds its genesis in

Equity Rule 94, 104 U.S. IX (Jan. 23, 1882), which adopted as

an Equity Rule the Supreme Court’s holding in Hawes v.

Oakland, 104 U.S. 450 (1881)." The Court in Haws stated that

before the shareholder is permitted in his own name to

institute and conduct a litigation which usually belongs to

7 The demand requirement of Rule 23.1 reads:

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.

Fed. R. Civ. P. 23.1.

8g Rule 23.1 was promulgated in 1966. It substantially restated prior

Rule 23(b) adopted in 1937 which in turn was a transcription of Equity Rule

27. Equity Rule 27, established in 1912, was itself a slight modification of

Equity Rule 94 adopted in 1882. The demand requirement of Equity Rule 94

read:

[the complaint] must also set forth with particularity the efforts of

the plaintiff to secure such action as he desires on the part of the

managing directors or trustees, and, if necessary, of the share-

holders, and the causes of his failure to obtain such action.

104 U.S. at X.

32a

the corporation, 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. He must

make an earnest, not a simulated effort, with the manag-

ing body of the corporation, to induce remedial action on

their part, and this must be made apparent to the court.

104 U.S. at 460-61. This judicially-created demand require-

ment has survived with slight modification in Rule 23.1. Hawes

was decided, and Equity Rule 94 was promulgated, during the

regime of Swift v. Tyson, 41 U.S. (1 Pet.) 1 (1842), when

federal courts were free to establish their own equitable reme-

dial jurisprudence. See Judiciary Act of 1789, ch. 20, § 11, |

Stat. 926; Process Act of May 8, 1792, ch. 36, § 2, 1 Stat. 276

(1850). There was, therefore, no need to decide whether Equity

Rule 94, with its demand requirement, was substantive law or

merely a procedural provision.

Two developments changed that indifference. One was the

1938 merger of law and equity. “he other was the Supreme

Court’s decision in Guaranty Trust Co. v. York, 326 U.S. 99

(1945), applying the Erie Railroad Co. v. Tompkins, 304 U.S.

64 (1938), choice of law to prevent the application of a federal

equitable remedial rule in a diversity case. In light of that

holding, the procedural or substantive character of the demand

requirement of Rule 23.1 becomes important.

It is clear that Congress did not deal with the Erie choice of

law question with respect to Rule 23.1. The Federal Rules of

Civil Procedure were promulgated by the Supreme Court on

December 20, 1937 and reported to Congress on January 3,

1938. Erie v. Tompkins was argued to the Court on January

31, 1938, and was decided in April 1938. Congress adjourned

on June 16, 1938 and the Rules took effect September 16,

1938. That chronology of events makes it highly unlikely that

Congress examined the remedial! versus procedural aspects of

the demand clause in Rule 23.1. The origins of Rule 23.1 are of

little help, since, as indicated above, the question in 1882 of

whether Rule 23.1 was procedural or substantive need not have

33a

been asked. We are left, therefore, with the task of construing

a Federal Rule of Civil Procedure in such a manner as to

ensure its validity in actions involving state law claims. See,

e.g., Hanna v. Plumer, 380 U.S. 460 (1965).

This court has held that a plaintiff-shareholder’s obligation

to make a demand on the corporate directors before pursuing a

derivative claim is inextricably linked to the state law business

judgment rule. Cramer v. GTE Corp., 582 F.2d 259, 274 (3d

Cir. 1978), cert. denied, 439 U.S. 1129 (1979). “Once the

shareholder has made a demand upon the directors, the direc-

tors are then able to determine whether in their opinion a suit

on behalf of the corporation would comport with the best

interests of the corporation.” /d. at 275. The directors can

pursue remedies alternative to litigation, can terminate merit-

less causes of action, and can determine whether litigation cost

and other adverse effects on business relationships with poten-

tial defendants would outweigh any potential recovery from

the lawsuit. The directors’ decision to allow suit or not is

insulated from judicial review by the business judgment rule.

The rule is a substantive one, intended to enforce the elected

management's responsibility for operating the corporation,

while insulating it from liability for good faith mistakes made

while performing its duties. See Briggs v. Spaulding, 141 U.S.

132, 146-148 (1891).

Subsequent to our decision in Cramer v. GTE Corp., 582

F.2d 259, the Supreme Court had occasion to make explicit

what was implicit in the Cramer discussion; that the substan-

tive business judgment rule is a rule of state, not federal law.

In Burks v. Lasker, 441 U.S. 471 (1979), the Court considered

whether state or federal law governs the power of a corpora-

tion’s directors to terminate a derivative suil, and ruled:

We hold today that federal courts should apply state law

governing the authority of independent directors to dis-

continue derivative suits to the extent such law is consis-

tent with the policies of the [federal statutes relied upon).

Id. at 486.

34a

It is clear, then, that the business judgment rule which Rule

23.1 enforces is not a product of federal substantive law. If the

rule is to be considered valid under Erie, it must now be

regarded as the procedural means whereby federal courts

ensure that the underlying substantive state law business judg-

ment rule is implemented. The Rule 23.1 demand requirement

is, therefore, a procedural device that since Erie is animated by

the existence of an underlying substantive content. As a neces-

sary corollary, if it is determined that for a given cause of

action the directors do not have the substantive power under

the relevant law to prevent or to terminate the derivative

action, then the demand requirement of Rule 23.1 is not

activated since its application would serve no meaningful

purpose. A fortiori, if the cause of action is one which the

corporation could not bring on its own behalf, Rule 23.1

cannot apply. This is plain from the text of the rule, and would

be required as a matter of choice of law in any event.

The issue, thus, is the choice of law to be made in determin-

ing whether the underlying cause of action admits to the

application of a state law business judgment rule which a Rule

23.1 demand would effectuate. In diversity cases or for pen-

dent state law claims, the relevant substantive law is constitu-

tionally mandated to be state law and, hence, a Rule 23.1

demand requirement is always triggered by the state business

judgment rule. In non-diversity cases, Erie is of no relevance

with respect to the elements of the cause of action. Yet as the

Supreme Court makes clear in Burks v. Lasker, 441 U.S. 471,

federal courts ordinarily look to state corporate law for the

existence of an applicable business judgment rule. The federal

courts’ adoption of state corporate law when deciding the

scope of the corporate directors’ powers to terminate or to

prevent derivative suits is merely a rule of statutory construc-

tion. It is based on a judicial determination that Congress in

creating federal causes of action does so against a background

of state corporate law to which federal courts must refer even

though the cause of action is based on federal law. See Burks

v. Lasker 441 U.S. at 478-79. See also Johnson v. Railway

Express Agency, 421 U.S. 454, 465 (1975). That general propo-

3Sa

sition is qualified, however, by the requirement that the state

may not contravene the policies of the federal law with respect

to which the business judgment question arises. See, @.g.,

Burks v. Lasker, 441 U.S. at 478-79. The demand requirement

under Rule 23.1 is applicable even to federal causes of action

because the state law business judgment rule applies unless the

relevant federal law preempts exercise of business judgment. A

demand is required only if the corporation may assert the cause

of action relied upon, and the substantive law giving rise to the

cause of action permits the directors to terminate it in the

exercise of their business judgment.

For all causes of action asserted by Weiss except that under

section 36(b) of the ICA, a demand is required because they

depend on state law, or on non-preemptive federal law, and the

directors may exercise business judgment to take over or to

terminate the claim. Of course, the business judgment rule is

inapplicable, as a matter of state law, where the directors’

judgment is not in good faith, is the product of self-dealing or

is made under the influence of persons suspected of wrongdo-

ing. Moreover, the directors’ discretion is not unbounded, and

courts may examine their action to determine whether it is

within the permissible bounds of that discretion.

Weiss urges that for all counts a demand on the Fund

directors should be excused as futile. Like the majority, | am

unconvinced. We previously stated that:

The Supreme Court and, following it, the Courts of

Appeals have repeatedly stated and applied the doctrine

that a stockholder’s derivative action, whether involving

corporate refusal to bring anti-trust suits or some other

controversial decision concerning the conduct of cor-

porate affairs, can be maintained only if the stockholder

shall allege and prove that the directors of the corporation

are personally involved or interested in the alleged

wrongdoing in a way calculated to impair their exercise of

business judgment on behalf of the corporation, or that

36a

their refusal to sue reflects bad faith or breach of trust in

some other way.

Landy v. FDIC, 486 F.2d 139, 149 (3d Cir. 1973), cert. denied,

416 U.S. 960 (1974), quoting Ash v. International Business

Machines, Inc., 353 F.2d 491, 493 (3d Cir. 1965), cert. denied,

384 U.S. 927 (1966). Weiss’ allegations do not, however, state

with particularity reasons why the directors would not be able

properly to make the choice whether to sue. “Instead of being

‘a statement of appropriate and convincing facts’ that a de-

mand would have been futile, [plaintiff's allegations consti-

tute] merely a vague, conclusory statement.” Landy v. Federal

Deposit Insurance Corporation, 486 F.2d at 148 (citation omit-

ted). Thus I agree that the District Court did not err in

dismissing those state law and federal law claims as to which

the state law business judgment rule clearly applies.

IV.

Whether Rule 23.1 applies to a claim asserted under section

36(b) of the ICA depends on (1) whether such a claim is one

belonging to the corporation, and (2) if it is, whether it is one

as to which the state law business judgment rule may as a

matter of federal substantive law apply. Section 36(b) is part of

a group of amendments, enacted in 1970, to the Investment

Company Act of 1940. Congress decided that mutual funds

deserved special regulation because:

Mutual funds, with rare exception, are not operated by

their own employees. Most funds are formed, sold, and

managed by external organizations, 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. . . .

Because of the unique structure of this industry the

relationship between mutual funds and their investment

adviser is not the same as that usually existing between

buyers and sellers or in conventional corporate relation-

37a

ships. Since a typical fund is organized 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 mutual fund industry in the same manner as

they do in other sectors of the American economy.

S. Rep. No. 184, 91st Cong., 2d Sess. 5, reprinted in 1970 U.S.

Code Cong. & Ad. News 4897, 4901.

The primary method by which Congress sought to control

the peculiar problems of mutual funds was the requirement

that at least 40% of fund directors be independent. These

“unaffiliated” directors are given the main burden of supervis-

ing the management and the finances of the fund. See Burks v.

Lasker, 441 U.S. at 482-83. In certain areas of the funds’

dealings, however, Congress did not leave matters to final

resolution by the unaffiliated directors. Rather, it mandated

alternative forms of regulation. One area of special concern is

the compensation paid by a mutual fund to its adviser. The

Senate Report vividly points up that concern:

In the case of management fees, the committee believes

that the unique structure of mutual funds has made it

difficult for the courts to apply traditional fiduciary

standards in considering questions concerning manage-

ment fees.

Therefore your committee has adopted the basic princi-

ple that, in view of the potential conflicts of interest

involved in the setting of these fees, there should be

effective means for the courts to act where mutual fund

shareholders or the SEC believe there has been a breach

of fiduciary duty. This bill would make it clear that, as a

matter of Federal law, the investment adviser or mutual

fund management company has a fiduciary duty with

respect to mutual fund shareholders. It provides an eftec-

tive method whereby fhe courts can determine whether

there has been a breach of this duty by the adviser or by

38a

certain other persons with respect to their compensation

from the fund.

S. Rep. No. 184, 91st Cong., 2d Sess. 2, reprinted in 1970 U.S.

Code Cong. & Ad. News 4897, 4898 (emphasis added). Refer-

ring to what is now section 36(b), the Senate Report observes:

This section is not intended to authorize a court to

substitute its business judgment for that of the mutual

fund’s board of directors in the area of management fees.

It does, however, authorize the court to determine

whether the investment adviser has committed a breach of

fiduciary duty in determining or receiving the fee.

= * *

Directors of the fund, including the independent direc-

tors, have an important role in the management fee area.

A responsible determination regarding the management

fee by the directors including a majority of disinterested

directors is not to be ignored. While the ultimate responsi-

bility for the decision in determining whether the fidu-

ciary duty has been breached rests with the court,

approval of the management fee by the directors and

shareholder ratification is to be given such weight as the

court deems appropriate in the circumstances of a particu-

lar case.

* * =

Under this proposed legislation either the SEC or a

shareholder may sue in court on a complaint that a

mutual fund’s management fees involve a breach of

fiduciary duty.

Id. at 4902-03 (emphasis added). This report plainly discloses

that while the court must afford deference to the views of fund

directors, the ultimate responsibility for deciding whether the

fees are so high as to be regarded as a breach of fiduciary duty

is judicial. Nowhere in the legislative history of section 36 is

there any suggestion that fund directors—even unaffiliated

directors—can seek such a judicial determination. Only the

39a

SEC and shareholders are indicated. With that illuminating

legislative history in mind we turn to the statute as enacted.

Prior to 1970, section 36 of the ICA authorized the SEC to

seek an injunction barring persons in a fiduciary relationship

to a fund from acting in such capacity if they were in the five

years prior to the action guilty of “gross misconduct or gross

abuse of trust.” Investment Companies Act of 1940, Pub. L.

No. 76-768, § 36, 54 Stat. 841 (1940). No other relief was

authorized. In 1970 section 36 was amended to eliminate the

“gross misconduct or gross abuse of trust” standard so as to

authorize an SEC suit if the fiduciary “has engaged. . . or is

about to engage in any act or practice constituting a breach of

fiduciary duty involving personal misconduct in respect of any

registered investment company. . . .” 15 U.S.C. § 80a-35(a)

(1976). The relief available in an SEC suit was also enlarged so

as to permit not only orders barring future participation as a

fiduciary, but also “such injunctive or other relief against such

person as may be reasonable in the circumstances. . . .”

At the same time an entirely new remedy, dealing specifically

with adviser compensation, was added in a new subsection

36(b).” It authorizes an action “by the Commission, or by a

9 Section 36(b) reads:

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 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 plaintiff

shall have the burden of proving a breach of fiduciary duty.

(footnote continued)

security holder of such registered investment company, against

such investment adviser, . . . for breach of a fiduciary duty in

respect of ... compensation... .” 15 U.S.C. § 80a-

35(b)( 1976).

There are several significant features to the 1970 amendment

to section 36. In the 1940 Act, the Section dealt only with SEC

enforcement, and the sole remedy was to bar the offender from

the investment ‘company industry. Section 36 created no cause

of action, express or implied, in favor of a fund. The 1970

(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 compensa-

tion or payments. No award of damages 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 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.

(5) 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.

1S U.S.C. § 80a-35(b)(1976).

4la

amendments both carried forward and broadened the SEC

enforcement powers in section 36(a). Plainly the “other relief”

available under that section would include an accounting which

would inure to the benefit of a defrauded fund—not to the

SEC. Yet there is no suggestion that the fund could plead a

cause of action for the same relief which would be available

under section 36(a) in an action by the SEC. As Judge Tyler

observed:

section 36(a) of the Investment Company Act, 15 U.S.C.

§ 80a-35(a), authorizes the SEC to bring actions against

certain individuals or companies for breaches of fiduciary

duty involving personal misconduct. Section 36(a), how-

ever, authorizes an action by the SEC, not by private

individuals. Although this should not be read to prohibit

suits by individuals when other sections of the Investment

Company Act are violated, when only a general breach of

fiduciary duty is alleged, a private suit should more

properly be brought in state court.

Monheit v. Carter, 376 F. Supp. 334, 342 (S.D.N.Y. 1974). A

section 36(a) action by the SEC may be considered “deriva-

tive” in the sense that it may right a wrong committed against a

fund, and may even obtain relief in favor of a fund, but it

certainly is not “derivative” in the sense that the section 36(a)

cause of action belongs to the fund in the first instance. It is

only to such a cause of action that Rule 23.1 has any applica-

tion.

Turning to the new cause of action created in section 36(b)

with respect to adviser compensation, we cannot, in determin-

ing legislative intention, overlook the significant fact that

Congress chose to house it not in a separate provision, but as

an amendment to a section which from the beginning dealt

with public rather than private enforcement. While Subsection

36(b) does not say in as many words “a state law business

judgment rule cannot terminate an action under this section,”

permitting the directors of a fund to exercise business judg-

ment in order to prevent an SEC action would be inconsistent

with the provision that

42a

{iJn 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 compen-

sation or payments. . . shall be given such consideration

by the court as is deemed appropriate under all the

circumstances.

15 U.S.C. § 80a-35(b)(2) (1976). Whereas under the typical

state law business judgment rule the disinterested directors’

decision exercised in good faith binds the court, under section

36(b) the court must make aa independent judgment. More-

over, no distinction is made, in this respect, between an action

brought by the SEC and one brought by a shareholder. It

seems to me, therefore, that by creating the SEC cause of

action and the shareholder action in the same sentence, and

housing both in a section of the ICA which historically dealt

with public rather than private enforcement, Congress dis-

closed a rather clear intention that the stockholder action be a

variety of private attorney general action, i.e., outside the

control of the fund’s directors. That intention is strongly

confirmed by the excerpts from the Senate Report quoted

above. It is confirmed, moreover, by the absence of any

provision in section 36(a) or (b) for a cause of action by the

fund itself.

The majority concludes, despite the absence of any provision

in section 36 for a suit by the fund, that the cause of action

does belong to the fund, and thus falls within the terms of Rule

23.1. To affirm, the majority must make this assertion, for if

the security holders’ cause of action is not one which the fund

could assert, it is not derivative, at least not in the sense of

Rule 23.1. The majority, however, points to no legislative

history suggesting that the fund can bring a Section 36(b) suit.

I do not believe the omission of a provision for suits by the

fund itself was inadvertent. If the fund were authorized to sue,

a litigated or, more significantly, a consent judgment would

raise serious questions of the preclusive effect of the judgment

of any subsequent action by the SEC or a shareholder.'® The

10 See 13 Fletcher Cyc. Corp. § 6043 (Permanent Ed.) and cases cited

therein.

‘i

most likely interpretation is that Congress intended to create a

cause of action solely bythe SEC, or by a shareholder acting in

a privaie attorney-geéneral capacity, so as to preclude consent

judgments eritered into by the fund and which might have the

effect of precluding the judicial review of director judgment

mandated by 15 U.S.C. § 80a-35(b)(2). Such an intention is

suggested by legislative history indicating that one of the

reasons for expressly allowing suit to be brought by either the

SEC or a security holder was the congressional assessment that

the fund directors could aot effectively deal with adviser

compensation. The Senate Report stated that the 1970 amend-

ments to the ICA were predicated on the SEC’s 1966 report

and recommendations on investment companies. “Public Pol-

icy Implication of Investment Company Growth,” Report of

the Committee on Interstate and Foreign Commerce, H.R.

Rep. No. 2337, 89th Cong., 2d Sess. (1966). In that report, the

SEC indicated its judgment that:

The unaffiliated directors, as the only potentially disin-

terested persons in the management of most investment

companies, can and should play an active role in repre-

senting the interests of shareholders not only in connec-

tion with management compensation but in other areas

where the interests of the professional managers may not

coincide with those of the company and its public inves-

tors. Strengthening the voice of truly disinterested direc-

tors in investment company affairs is important to the

protection of public shareholders. But even a requirement

that all of the directors of an externally managed invest-

ment company be persons unaffiliated with the com-

pany’s adviser-underwriter would not be an effective

check on advisory fees and other forms of management

compensation.

The unaffiliated directors are not in a position to

bargain on an equal footing with the adviser on matters of

such crucial importance to it. They are not free, as a

practical matter, to terminate established management

relationships when differences arise over the advisory fees

44a

or other compensation. This reflects, in large part, the

adviser-underwriter permeation of investment company

activities to an extent that makes rupture of the existing

relationships a difficult and complex step for most com-

panies. For these reasons, arm’s-length bargaining be-

tween the unaffiliated directors and the managers on these

matters is a wholly unrealistic alternative.

Id. at 148 (emphasis supplied). It seems unlikely that Congress

intended that the unaffiliated directors, by bringing and set-

tling a section 36(b) suit, could accomplish the very result that

the SEC regarded as an unrealistic alternative. Thus I do not

believe that section 36(b) grants “a right which may properly

be asserted by [the fund].” Fed. R. Civ. P. 23.1.

Even if, contrary to its plain language and probable pur-

pose, section 36(b) were to be construed as creating “a right

which may properly be asserted by [the fund],” id., there

would still remain the question whether the disinterested direc-

tors of the fund may, in the exercise of business judgment,

prevent a judicial examination, sought by the SEC or a security

holder, of advisers fees. Other aspects of the section support a

negative answer. There is a one year period of limitation. 15

U.S.C. § 80a-35(b)(3). Such a short period suggests that inter-

vention by fund directors was not contemplated, for if a claim

were to be delayed until the directors were notified and were

given a chance to consider the advisability of a given action,

the statutory period would quickly run out. By adjusting fees

prospectively, while delaying the decision on whether to sue for

fees already paid, fund managers could significantly reduce

recovery. The normal delays incident to corporate decision-

making are incompatible with a one year period of limitation,

and director involvement therefore must have been discounted

by Congress. Another aspect suggesting the inapplicability of

the business judgment rule to section 36(b) is the circumscribed

nature of a 36(b) cause of action. Recovery is limited to actual

damages capped by the total compensation paid. Recovery can

only be had from the recipients of compensation, and liability

cannot be the predicate for an injunction severing an invest-

ment adviser from a fund. These limitations on the section

4Sa

36(b) remedy minimize the intrusion by the Section upon the

directors’ responsibility to operate the fund, and suggest the

absence of any serious erosion of the management responsibil-

ity conferred by state law.

I conclude, therefore, that the Rule 23.1 demand require-

ment does not apply to a section 36(b) action, because the

Section does not provide “a right which may properly be

asserted by [the fund]”, and because even assuming such a

right, section 36(b)(2) preempts any state law business judg-

ment rule which would be furthered by the demand require-

ment.

This interpretation of section 36(b) has been anticipated by

the Supreme Court. In Burks v. Lasker, 441 U.S. at 484, the

Court stated that:

{[w]hen Congress . . . intend[ed] to prevent board ac-

tion from cutting off derivative suits, it said so expressly.

Section 36(b), . . ., 15 U.S.C. § 80a-35(b)(2), added to

the [Investment Company] Act in 1970, performs pre-

cisely this function for derivative suits charging breach of

fiduciary duty with respect to adviser’s fees.

The holding in Burks vy. Lasker that the state law business

judgment rule permits independent directors to terminate de-

rivative suits based on federal statutes so long as the rule is

consistent with the policies of the federal statutes in issue, puts

the quoted statement in context. The application of business

judgment to terminate a section 36(b) suit is inconsistent with

the policy of that section. The majority treats the statement of

the Burks Court as a mere dictum which this court can

disregard. If it is dictum, it is dictum of the most compelling

sort. The quoted passage was not a passing reference, but was

integrally tied to the Court’s holding and reasoning. The Court

supported its position about fund directors’ power to terminate

other derivative actions by pointing to section 36(b) as an

example of Congress, in clear terms, preventing director veto.

The Burks reasoning depends, therefore, on the quoted dictum

with respect to section 36(b) and it cannot be disregarded by

this intermediate court.

46a

The Court of Appeals for the Second Circuit, which in

matters relating to the federal securities law carries particular

authority, confronted with the identical problem, reached the

same conclusion with respect to section 36(b) as I reach.

Moreover it concluded, as I do, that Rule 23.1 is inapplicable

because, as Burks v. Lasker teaches, it is designed to imple-

ment the business judgment rule only in cases where directors

can control a lawsuit. Fox v. Reich & Tang, Inc. and Daily

Income Fund, Inc., No. 82-7296, slip op. (2d Cir. Oct. 26,

1982).

Despite the unambiguous statement in Burks v. Lasker that

section 36(b) is an instance in which Congress has precluded

the application of any state law business judgment rule, the

Court of Appeals for the First Circuit recently affirmed the

dismissal of a section 36(b) action for failure to plead com-

pliance with the demand requirement of Rule 23.1. Grossman

v. Johnson, 674 F.2d 115 (ist Cir. 1982). With deference, | am

not persuaded by that court’s interpretation of the statute, its

treatment of the legislative history, or its reading of Burks v.

Lasker. Thus while the Grossman v. Johnson opinion supports

the defendants, I would not follow it. I find particularly

unpersuasive the Grossman court's treatment of 15 U.S.C.

§ 80a 35(b)(2)(1976). While acknowledging that the section

“can easily be read to give the court, rather than the directors,

the ultimate power to decide the propriety of the fees,” it

reasoned that a demand would not be futile, because the

directors’ “decision to side with the complainant (entirely or in

part) would have important consequences, and even their

knowledgable disagreement with the demand might be deemed

worthy by the court of grave consideration under § 36(b)(2).”

674 F.2d at 121. Section 36(b)(2) explicitly directs the court to

give the directors’ views “such consideration. . . as is deemed

appropriate under all the circumstances.” 15 U.S.C. § 80a

356(b)(2)(1976). Obviously those views can be made known

during the course of the lawsuit. But the court’s obligation to

take the directors’ views into account does not, even under the

Grossman court’s analysis permit the directors to terminate or

to prohibit the security holders’ action. Thus the demand

47a

which that court required served no purpose but to delay

judicial inquiry and to insulate more payments to the invest-

ment adviser from such judicial review by operation of the

short statute of limitations in section 36(b)(3). Since the direc-

tors’ business judgment is to be considered relevant to a section

36(b) claim only to the limited extent that the court must take

the directors’ views into account, any state law business judg-

ment rule is clearly supplanted. What must be reconciled is

section 36(b)(2) and Rule 23.1. No federal policy suggests itself

which would support a mechanistic application of the demand

requirement when the only purpose to be served is to give the

directors an opportunity to make t'ieir views known to the

court. That can be done in an appropriate pleading.

The majority’s analysis, relying on Cort v. Ash, 422 U.S. 66

(1975), is as flawed as that of the Grossman court. It must be

noted that the Cort v. Ash test for implying causes of action in

favor of parties not mentioned in a federal statute has been

significantly contradicted by subsequent cases such as 7exas

Industries, Inc. v. Radcliff Materials, Inc., 451 U.S. 630, 639

(1981), and Middlesex County Sewerage Auth. v. National Sea

Clammers Ass'n, 453 U.S. 1, 13 (1981). We must look for a

clear indication of congressional intent to afford such a cause

of action. Neither the statutory language nor its legislative

history contains any such indication of an intent to permit an

investment fund to control a section 36(b) claim and thereby

insulate it from judicial review. Indeed, as I have outlined

above, a contrary intent is the most likely.

Finally, the majority’s reliance on Merrill Lynch, Pierce,

Fenner & Smith v. Curran, 102 S. Ct. 1825 (1982), is an

extreme misinterpretation of that authority. The Curran case

found a congressional intention, when amending the Commod-

ity Exchange Act by the Commodity Futures Trading Act of

1974, to recognize that prior to the amendment lower federal

courts had implied causes of action from the former although

it did not expressly provide for them. No cause of action had

been implied for the entirely new cause of action created in

section 36(b) because that cause of action did not exist at the

48a

time Congress last spoke. The suggestion that the Curran

analysis applies because a fund could bring a common law

action against an adviser for corporate waste demonstrates

confusion about the nature of the problem which the Curran

Court addressed. Common law causes of action are not “im-

plied” from federal statutes. They exist as a matter of state

law. Moreover, the suggestion ignores the clear intention, in

section 36(b), to create a right to recover overcharges which

could not be recovered under the state common law of waste.

Since the governing federal law does not permit direct

control over section 36(b) actions, it supplants the applicable

state law business judgment rule. No section 36(b) policy

would be advanced by applying the demand requirement of

Rule 23.1 to section 36(b) actions. Absent an underlying

substantive rule of law which the pleading requirements of

Rule 23.1 would advance, their application serves no useful

purpose. The trial court erred, therefore, in dismissing the

complaint for failure to plead that a demand had been made

on the directors. The judgment appealed from should be

affirmed insofar as it dismissed all claims other than that

predicated on section 36(b), but reversed insofar as it dismissed

that claim.'’ Thus I dissent from the jvdgment of this court

insofar as it affirms the dismissal of the section 36(b) claim.

11 I also agree that the district court did not abuse its discretion by

denying plaintiff leave to make subsequent demand on the directors and to

replead.

49a

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

No. 81-2688

MELVYN I. WEISS, Custodian for GARY MICHAEL WEISS,

U/NY/UGMA,

Appellant,

anf ==

TEMPORARY INVESTMENT FUND, INC., PROVIDENT INSTITU-

TIONAL MANAGEMENT CORPORATION, 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

Present: GIBBONS, SLOVITER and BECKER,

Circuit Judges.

50a

JUDGMENT

This cause came on to be heard on the record from the

United States District Court for the District of Delaware and

was argued by counsel on April 2, 1982.

On consideration whereof, it is now here ordered and ad-

judged by this Court that the judgment of the said District

Court, entered August 27, 1981, be, and the same is hereby

affirmed. Costs taxed against appellant.

ATTEST:

Chief Deputy Clerk

November 12, 1982

Sla

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

No. 81-2688

aoe

MELVYN I. WEISS, Custodian for GARY MICHAEL WEISS,

U/NY/UGMA,

Appellant,

—

TEMPORARY INVESTMENT FUND, INC., PROVIDENT INSTITU-

TIONAL MANAGEMENT CORPORATION, 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)

SUR PETITION FOR REHEARING

—§+

Present: SEITZ, Chief Judge,

ALDISERT, ADAMS, GIBBONS, HUNTER, WEIS, GARTH, HIG-

GINBOTHAM, SLOVITER and BECKER,

Circuit Judges

fee

52a

The petition for rehearing filed by appellant Melvyn I. Weiss

in the above entitled case having been submitted to the judges

who participated in the decision of this court and to all the

other available circuit judges of the circuit in regular active

service, and no judge who concurred in the decision having

asked for rehearing, and a majority of the circuit judges of the

circuit in regular active service not having voted for rehearing

by the court in banc, the petition for rehearing is denied.

JUDGE GIBBONS would grant rehearing.

By the Court,

/s/ Edward Becker

Judge

Dated: December 30, 1982

53a

IN THE UNITED STATES DISTRICT COURT

FOR THE DISTRICT OF DELAWARE

Civil Action No. 80-230

MELVYN I. WEISS, Custodian for GARY MICHAEL WEISS,

U/NY/U.G.M.A.,

Plaintiff,

—against—

TEMPORARY INVESTMENT FUND, INC., PROVIDENT INSTITU-

TIONAL MANAGEMENT CORPORATION, SHEARSON LOEB

RHOADES INC., RUSSELL W. RICHIE, ROBERT I, FORTUNE,

JAMES LOUIS ROBERTSON, HENRY M. WATTS, JR., DR.

RALPH A. YOUNG, THOMAS S. GATES, G. WILLING PEP.

PER,

Defendants.

Joseph A. Rosenthal, Esq., and Kevin Gross, Esq., Morris and

Rosenthal, P.A., Wilmington, Delaware; of counsel: Daniel W.

Krasner, Esq., and Robert Lewin, Esq., Wolf Haldenstein

Adler Freeman & Herz, New York, New York; attorneys for

plaintiff.

Rodman Ward, Esq., Skadden, Arps, Slate, Meagher & Flom,

Wilmington, Delaware; for defendant Temporary Investment

Fund, Inc.

Robert K. Payson, Esq., Potter, Anderson & Corroon,

Wilmington, Delaware; Of Counsel: Peter M. Mattoon, Esq.,

Richard Z. Freemann, Jr., Esq., and John B. Langel, Esq.,

Ballard, Spahr, Andrews & Ingersoll, Philadelphia, Pennsylva-

nia; attorneys for defendant Provident Institutional Manage-

ment Corporation.

54a

Charles F. Richards, Jr., Esq., Richards, Layton & Finger,

Wilmington, Delaware; Of Counsel: David L. Foster, Esq.,

Richard E. O’Connell, Esq., and James B. Eisenberg, Esq.,

Willkie Farr & Gallagher, New York, New York; attorneys for

defendant Shearson Loeb Rhoades Inc.

S. Samuel Arsht, Esq., and William T. Allen, Esq., Morris,

Nichols, Arsht & Tunnell, Wilmington, Delaware; Of Counsel:

Morris R. Brooke, Esq., James M. Sweet, Esq., and James C.

Ingram, Drinker Biddle & Reath, Philadelphia, Pennsylvania;

attorneys for defendants Richie, Fortune, Robertson, Watts,

Jr., Young, Gates and Pepper.

OPINION

Dated: June 17, 1981

Wilmington, Delaware

SCHWARTZ,—District Judge

Plaintiff Melvyn I. Weiss, acting as custodian for his son,

Gary M. Weiss (jointly referred to as “Weiss”), is a shareholder

of the Temporary Investment Fund, Inc. (the “Fund”).' The

Fund is a no-load, open end, diversified investment company

whose objective is to maximize current income consistent with

perservation of capital, and is commonly known as a “money

market fund.” Provident Institutional Management Corpora-

tion (the “Adviser”), a wholly owned subsidiary of Provident

National Bank (“Provident”), serves as the Fund’s investment

adviser. Pursuant to a Sub-Advisory Agreement with its sub-

sidiary, the Adviser, Provident National Bank supplies the

Fund with all necessary investment advisory services. Shearson

Loeb Rhoades, Inc. (“Shearson”) is the underwriter for the

Fund and, pursuant to an Administration and Distribution

1 All facts are taken from the amended complaint and are presumed

true for the purpose of defendants’ motions to dismiss.

55a

Agreement (the “Distribution Agreement”), has performed

administrative functions for the Fund.

On May 7, 1980, Weiss brought this shareholder's derivative

suit against the Fund, the Adviser, Shearson and seven direc-

tors of the Fund. In an amended complaint filed on January 7,

1981, Weiss alleges four separate causes of action. First, Weiss

alleges that the Adviser and Shearson have breached their

fiduciary duty under section 36(b) of the Investment Company

Act of 1940° (the “Act”) in that they have received excessive

and unreasonable compensation for the management services

they have performed on behalf of the Fund. Second, plaintiff

alleges that the Fund’s Advisory Agreement and Distribution

Agreement are void because they were the product of the

directors’ breach of their fiduciary duties to the Fund, because

the Adviser and Shearson dominated and controlled the con-

duct of the directors in connection with the approval of the

Investment Advisory and Distribution Agreements, and be-

cause shareholder approval of the Advisory Agreement was

obtained through the use of false and misleading proxy mate-

rials. Third, Weiss contends that the Banking Act of 1933

makes it illegal for the Adviser to act as investment adviser to

the Fund because it is a wholly owned subsidiary of Provident,

a national bank.’ Finally, Weiss alleges that Shearson has

2 Section 36(b), 15 U.S.C. § 80a-35(b), provides in pertinent part:

(T]he 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

payments, for breach of fiduciary duty in respect of such compen-

sation or payments paid by such registered investment company or

by the security holders thereof to such investment adviser or person.

3 Section 21 of the Banking Act of 1933, 12 U.S.C. § 378, subject to

certain exceptions enumerated in section 16 of the Act, 12 U.S.C. § 24,

makes it unlawful

(footnote continued)

S6a

breached its fiduciary duty to the Fund under the Investment

Company Act in that it receives several million dollars in

compensation per year from the Fund while rendering virtually

no services of value to the Fund. The relief sought by Weiss

includes a judgment declaring the Advisory Agreement and the

Distribution Agreement void, an order requiring that the

Adviser and Shearson repay to the Fund all excessive fees paid

to them by the Fund, and an order requiring the individual

defendants to pay to the Fund damages caused by violations of

the Investment Company Act and the Securities Exchange Act.

Now before the Court are various motions to dismiss filed

by the defendants. The individual defendants, the Adviser, and

Shearson all move to dismiss the complaint for failure to

satisfy the demand on directors requirement of Rule 23.1 of

the Federal Rules of Civil Procedure.* The individual defen-

dants move to dismiss on the grounds that (1) the action

created under section 36(b) of the Investment Company Act

lies only against recipients of alleged excessive compensation;

(2) there is no implied private right of action under sections

1(b) and 15 of the Investment Company Act; and, (3) the

Court does not have the power to hear any pendent state

claims against the directors. In addition, defendants Gates,

Robertson, Pepper and Fortune move to dismiss on the ground

that there has been no effective service of process upon them.

Shearson moves to dismiss on the ground that there is no cause

of action against it under section 36(b) of the Investment

[flor any person, firm, corporation, association, business trust, or

other similar organization, engaged in the business of issuing,

underwriting, selling, or distributing, at wholesale or retail, or

through syndicate participation, stocks, bonds, debentures, notes,

or other securities, to engage at the same time to any extent

whatever in the business of receiving deposits subject to check or to

repayment upon presentation of a passbook, certificate of deposit,

or other evidence of debt, or upon request of the depositor. . . .

4 It is settled in this Circuit that defendants other than the corporation

on whose behalf the derivative claim is asserted have standing to raise the

defense of failure to comply with the requirements of Rule 23.1. See

Shiensky v. Dorsey, 574 F.2d 131, 142 (3d Cir. 1978).

57a

Company Act. The Adviser moves to dismiss on the grounds

that the complaint does not state an action against it under the

Banking Act of 1933, sections 1(b) and 15 of the Investment

Company Act, the Bank Holding Company Act, or common

law, and the complaint does not satisfy the verification re-

quirements of Rule 23.1. Shearson and the Adviser also move

to strike plaintiff's demand for a jury trial.

For the reasons explained below, the Court concludes that

plaintiff has failed to satisfy the demand requirement of Rule

23.1. In addition, the complaint must be dismissed as to

defendant Robertson because of insufficient service of process.

The Court deems it unnecessary to address the scope and

existence of the causes of action alleged or the other claims

raised in view of its determination that intracorporate remedies

should first be exhausted.

1. The Demand Requirement

Rule 23.1 of the Federal Rules of Civil Procedure states in

pertinent part that a shareholder’s deriv ve complaint shall

“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.” The amended

complaint states the following reasons for failure to make a

demand upon the directors of the Fund to take up the cause of

action: (1) derivative claims under section 36(b) are exempt

from the demand requirements of Rule 23.1; (2) demand

would be futile because Shearson and the Adviser control and

dominate the Fund and its directors; (3) demand would be

futile because the directors are named as defendants and they

participated and/or acquiesced in the wrongs alleged; and, (4)

the Fund’s filing of an answer seeking dismissal of the suit

demonstrates the opposition of the directors to plaintiff's

claim and the futility of demand. Amended Complaint, { 37.

Plaintiff has not pointed to any authority which persuades

the Court that Congress intended that shareholder derivative

actions brought pursuant to section 36(b) of the Investment

58a

Company Act be exempt from the demand requirement.

Nothing in the language of section 36(b)’ expressly excuses

demand in actions brought by shareholders under that statute,

nor does anything in the legislative history of section 36(b)

indicate that Congress intended to eliminate the demand re-

quirement. The legislative materials cited by plaintiff simply

make clear the intent of Congress to create a federal cause of

action by which security holders of investment companies

could judicially challenge excessive compensation paid to in-

vestment advisers. Nothing in the legislative history expressly

or implicitly reveals a Congressional concern that the demand

requirement imposed by the Federal Rules of Civil Procedure

was frustrating efforts by shareholders to attack fee provisions

of investment advisory contracts. Rather, to the extent that the

1970 amendments sought to eliminate existing hurdles to share-

holders’ derivative suits challenging investment advisers’ fees

as excessive, they were intended to eliminate the requirement

commonly imposed by the courts that the shareholder establish

that payment of the fees constituted a “waste of corporate

assets.”° Although Congress may have considered, and then

5 See note 2, supra.

6 See, e.g., S. Rep. No. 184, 9ist Cong., Ist Sess., reprinted in [1970

U.S. Code Cong. & Ad. News 4897, 4901; 115 Cong. Rec. 13,699 (1969)

(remarks of Sen. Brooke); /nvestment Company Amendments Act of 1969:

Hearings on S. 34 and S. 296 Before the Senate Comm. on Banking and

Currency, 91st Cong., Ist Sess. 19-20 (1969) (testimony of SEC Commis-

sioner Hugh F. Owens).

The leading case applying the doctrine of “corporate waste” to derivative

actions challenging investment advisers’ fees was Saxe v. Brady, 184 A.2d 602

(Del. Ch. 1962). Under this doctrine, if the stockholders have ratified the

investment advisory contract, a derivative suit will succeed only if the

plaintiff establishes that “what the corporation has received is so inadequate

in value that no person of ordinary, sound business judgment would deem it

worth what the corporation has paid.” /d. at 610. Application of the

corporate waste doctrine virtually insulated investment advisory fees from

judicial scrutiny. See Report of the Securities and Exchange Commission on

the Public Policy Implications of Investment Company Growth, H.R. Rep.

No. 2337, 89th Cong., 2d Sess. 141-43 (1966).

59a

rejected, the possibility of imposing special procedural require-

ments on derivative suits under the Investment Company Act,’

there is no evidence of any Congressional intent to dispense

with the preexisting requirements of Rule 23.1 of which Con-

gress was undoubtedly aware.*

This conclusion is consistent with other decisions interpret-

ing section 36(b). Two other district courts recently have

rejected claims that the demand requirement is inapplicable to

actions brought under section 36(b). See Markowitz v. Brody,

No. 80 Civ. 2602 (RJW), slip op. at 15-18 (S.D.N.Y. May 20,

1981); Grossman v. Johnson, No. 77-3015-T, slip op. at 11-13

(D. Mass. April 7, 1981), following Untermeyer v. Fidelity

Daily Income Trust, 79 F.R.D. 36, 45-46 (D. Mass.), vacated

on other grounds, 580 F.2d 22 (Ist Cir. 1978). Even in Boyko v.

Reserve Fund, Inc., 68 F.R.D. 692 (S.D.N.Y. 1975), upon

which plaintiff relies heavily, the court specifically stated that

its conclusion that demand on directors in section 36(b) suits

will be presumed futile when there is at least one affiliated or

7 See Investment Company Amendments of Act of 1969: Hearings on

S. 34 and S. 296 Before the Senate Comm. on Banking and Currency, 9\st

Cong., Ist Sess. 30 (letter of SEC Commissioner Owens opposing suggested

requirement that suing shareholder represent either 1% of fund's outstanding

shares or $250,000 in net asset value of fund) (1969).

8 Indeed, in responding to a question expressing concern about the

potential for nuisance suits under legislation which would authorize share-

holders to bring an action against investment advisers, SEC Chairman Budge

stated that “there are adequate safeguards under the Federal Rules of Civil

Procedures [sic] and under this bill to prevent unjustified shareholder

litigation.” Mutual Fund Amendments: 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 (1969).

The Court also finds unpersuasive Weiss’s analogy to section 16(b) of the

Securities Exchange Act of 1934, 15 U.S.C. § 78p(b). Rather than dispensing

with demand, section 16(b), by express language, creates its own demand

requirement. Cf. Markowitz v. Brody, No. 80 Civ. 2602 (RJW), slip op. at

8-14 (S.D.N.Y. May 20, 1981) (rejecting argument that, by analogy to section

16(b), the contemporaneous ownership requirement of Rule 23.1 should not

apply to section 36(b) actions).

60a

interested director on a fund’s board should not be “construed

as a holding that Rule 23.1 has been in any way abrogated by

Section 36(b).” /d. at 696. Finally, plaintiff's reliance upon

Burks v. Lasker, 441 U.S. 471 (1979), is misplaced. In Burks

the Supreme Court held that under certain circumstances the

disinterested directors of an investment company, pursuant to

the business judgment rule, may terminate a derivative suit

brought under the Investment Company and Investment Ad-

visers Acts against other directors of the company. Although

there is dictum in Burks to the effect that disinterested direc-

tors do not have the power to terminate derivative suits

brought under section 36(b),” that is not authority for the

proposition that demand need not be made on the directors in

the first place. As the Court noted in Burks, Congress intended

that independent directors act as ‘watchdogs” who would

supply a check on management of investment companies and

represent .he interests of shareholders; these “watchdogs” were

therefore entrusted with “the primary responsibility for look-

ing after the interests of the funds’ shareholders.” 441 U.S. at

484-85 (footnote omitted).'’ It would be inconsistent with this

Congressional scheme to permit shareholders in all instances to

initiate derivative actions under section 36(b) without first

presenting their claims to the independent directors. The inde-

pendent directors, consistent with their obligation to represent

shareholder interests, might be persuaded to take up the

9 “And when Congress did intend to prevent board action from

cutting off derivative suits, it said so expressly. Section 36(b), 84 Stat. 1428,

1S U.S.C. § 80a-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. No similar provision exists for derivative suits of the kind

involved in this case.” 441 U.S. at 484 (footnote omitted).

10 Among the responsibilities assigned to the disinterested directors of

mutual funds are review and approval of underwriting and investment

advisory contracts, appointment of other disinterested directors to fill certain

vacancies on the board, and selection of the fund's accountants. See 15

U.S.C. §§ 80a-15(c), 80a-16(b), 80a-31(a); Burks v. Lasker, supra, 441 1.S. at

483.

6la

shareholder's claim.'' The directors, on the other hand, might

be in a position to resolve the grievance without litigation,'? or

to persuade the complaining shareholder that the claim is

unjustified or that its prosecution would not be in the best

interests of the company. See Note, The Demand and Standing

Requirements in Stockholder Derivative Actions, 44 U. Chi. L.

Rev. 168, 171-72 (1976). Thus, even if the independent direc-

tors may not terminate a section 36(b) suit after demand has

been made and rejected, the shareholders and the investment

company are better served by requiring that demand nonethe-

less be made unless it is shown that demand would be futile."

11 It is unsettled whether an investment company may itself bring an

action against its adviser under section 36(b). In Boyko v. Reserve Fund,

Inc , supra, the court reached the questionable conclusion that Congress

presumed that the directors of a mutual fund would inevitably be hostile to a

section 36(b) action against its investment adviser and therefore did not

create such a cause of action in mutual funds themselves. See 68 F.R.D. at

695-96 & n.2. By contrast, in Markowitz v. Brody, supra, the court ventured

in dictum that a private right of action in favor of mutual funds should be

implied from section 36(b). Slip op. at 22 n.12. Even if a mutual fund is

precluded from suing under section 36(b), however, it may have a common

law action against the adviser. See Untermeyer, supra, 79 F.R.D. at 45-46 &

n.30.

12 The directors’ power to terminate unilaterally an investment advi-

sory contract under section 15(a)(3) of the Investment Company Act, 15

U.S.C. § 80a-15(a)(3), would give the board an important bargaining chip in

negotiating with the adviser for recovery of excessive compensation.

13. ~— Although it has been stated that the demand requirement is “inextri-

cably linked” to the business judgment rule, Cramer v. General Telephone

and Electronics Corp., 582 F.2d 259, 274 (3d Cir. 1978), cert. denied, 439

U.S. 1129 (1979), it is important to distinguish the analysis appropriate when

a court considers whether dctnand should have been made and that called for

when it decides whether a properly initiated derivative suit should be

terminated because of the “business judgment” of the corporation's directors

that prosecution of the suit would not be in the corporation's interests.

The Rule 23.1 demand requirement is a procedural device intended to

further the policy that an individual shareholder ordinarily should not usurp

the responsibility of corporate management to determine whether and how to

pursue a corporate claim. See 3B Moore's Federal Practice 4 23.1. 15(4] (2d

62a

Il. Whether Demand Woutd be Futile

Having determined that the demand requirement applies to

plaintiff's section 36(b) claim, as well as to his other derivative

claims, it is now necessary to determine whether demand

would have been futile and therefore may be excused.

Weiss alleges in his complaint three reasons in support of his

position that demand would be futile: (1) Shearson and the

ed. 1980). Thus the question of demand and whether it is required is

primarily addressed to the issue of who will assert a corporate claim—the

corporation or a shareholder. A court will excuse demand only when

objective facts persuade it that the corporation will not take up the suit or

otherwise act to redress the shareholder's grievances. See, e.g., Nussbacher v.

Continental Illinois National Bank & Trust Co., 518 F.2d 873, 878-79 (7th

Cir. 1975), cert. denied, 424 U.S. 928 (1976) (demand excused because

directors’ opposition to prior, nearly identical lawsuit, was loud and clear

message that board would under no circumstances take the action desired by

the shareholder).

A decision to excuse demand, however, does not reflect upon the merits of

a derivative action, and there will be some cases in which demand is futile,

but the corporation is nonetheless able to terminate the suit after it has been

properly initiated by the shareholder. Thus in Nussbacher, supra, the court

observed that its determination that demand was futile did not require

resolution of the question whether the board could terminate the action

pursuant to the business judgment rule. See 518 F.2d at 878. Application of

this “business judgment rule” requires reference to state corporation law,

which furnished the standards to be applied when the requisite demand has

been made or demand has been excused, and the corporation’s board of

directors seeks to terminate a suit on the ground that the litigation is not in

the best interests of the corporation. See Burks v. Lasker, supra, 441 U.S. at

477-80, 486. If the directors have no interest in the challenged transaction,

the courts will generally defer to a good faith decision of the board not to

pursue a cause of action. Even if a derivative suit charges a majority of the

directors of a corporation with self-dealing or other breach of fiduciary duty,

and demand has therefore been excused, the corporation may still move to

terminate the action by asserting the “business judgment” of a committee of

independent directors that litigation is not in the corporation's best interests.

In that case, however, the courts are likely to closely scrutinize a corporate

decision to terminate derivative litigation, and the court may indeed be

required to apply its own independent business judgment and decide whether

litigation is in the corporation's interests. See, ¢.g., Zapata Corp. v.

Maldonado, No. 113-1980, slip op. at 28 (Del. May 13, 1981); Cramer,

supra, $82 F.2d at 275.

63a

Adviser control and dominate the Fund and its directors; (2)

the directors have knowingly acquiesced in the transactions

complained of; and, (3) the directors have made clear their

opposition to plaintiff's claim by causing the Fund to file an

answer asserting that plaintiff's claims lack merit.

Weiss alleges that demand would be futile because the

Adviser and Shearson “control and dominate” the directors.

Yet, it is uncontested that at the time the original complaint

was filed four of the Fund’s six directors were “disinterested

persons” under the Investment Company Act.'* Thus, when

this action was commenced, a majority of the Fund’s board of

directors was composed of those persons entrusted by Con-

gress with “responsibility for looking after the interests of the

[Fund's] shareholders.” Burks vy. Lasker, supra, 441 U.S. at

485 (footnote omitted). Weiss offers no factual support for his

assertion that these independent directors are controlled and

dominated by the Adviser and Shearson and would therefore

be unable to fairly weigh the merits of his claims. Instead,

Weiss offers the conclusory statement, without supporting

facts, that the directors “were selected for their positions by

Shearson and the Adviser and they are beholden to them for

their d'rectorial offices with the Fund and consider their

directorial offices with the Fund a matter of great value and

prestige in the business community.” Amended Complaint,

q 37(c). The question whether a director is controlled by a third

party, however, is “an intensely factual one,” and Rule 23.1

14 =A seventh director, also not an “interested person,” was elected after

the complaint was filed. See Doc. No. 17 at 5. Section 10a) of the

Investment Company Act, 15 U.S.C. § 80a-10(a), requires that no more than

60% of the members of the board of an investment company be “interested

persons” of the company. The class of “interested persons” is very broad and

includes virtually anyone with a financial, employment, or personal connec-

tion with an investment company or its investment adviser, any broker or

dealer registered under the Securities Exchange Act of 1934, and any person

affiliated with such a broker or dealer. See section 2(a)(19) of the Act, 15

U.S.C. § 80a-2(a)(19).

64a

requires that a plaintiff “assert the facts from which it is

believed an inference of control could be drawn.” Vernars vy.

Young, 539 F.2d 966, 968 (3d Cir. 1976).'° A recent case, also

involving claims that a mutual fund paid its investment adviser

excessive compensation, rejected as inadequate a similar con-

clusory allegation that a board of directors with a majority of

independent directors was controlled and dominated by the

fund’s investment adviser. See Grossman v. Johnson, supra,

slip op. at 8; accord Jones v. Equitable Life Assurance Society,

409 F. Supp. 370, 373 (S.D.N.Y. 1975); Kusner v. First Penn-

sylvania Corp., 395 F. Supp. 276, 284-85 (E.D. Pa. 1975),

rev'd on other grounds, 531 F.2d 1234 (3d Cir. 1976). Since

Weiss has pleaded no specific facts from which the Court may

infer that the Fund’s board of directors is controlled by either

the Adviser or Shearson, that is no basis for excusing de-

mand.’°

The next asserted ground for excusing demand is the allega-

tion that the directors participated in and approved of the

transactions at issue and are themselves named as defendants.

In particular, the complaint alleges that the directors gave

“rubber stamp” approval to the Advisory and Distribution

Agreements (4 22), that they approved the Advisory Agree-

18 Cf. Cramer, supra, $82 F.2d at 276-77 (when 10 directors were not

involved in alleged fraudulent activities, no basis for concluding they were

dominated by four director-defendants).

16 The Court declines to follow the conclusion in Boyko v. Reserve

Fund, Inc., supra, 68 F.R.D. at 696-97, that futility of demand should be

presumed whenever there is at least one interested director on a mutual

fund’s board. The decision in Boyko rested on the determination that

“Congress assumed that the directors of the investment company would be

antagonistic toward, and unlikely to prosecute, an action against the Fund's

advisors for breach of fiduciary duty with respect to the receipt of compensu-

tion.” Jd. at 696. This reading of the legislative history, however, is inconsis-

tent with that of the Supreme Court in Burks v. Lasker, supra, in which the

Court found no basis for presuming that the independent “watchdog”

directors “could never be ‘disinterested’ where their codirectors or invest-

ment advisers were concerned.” 441 U.S. at 485 n.15.

65a

ment even though they knew the Adviser was receiving 25% of

the advisory fees after having subcontracted out all advisory

functions (¢ 24), and that the directors solicited shareholder

approval of the advisory agreement with proxy materials con-

taining a false and misleading statement ({ 26).

Notably, the complaint does not allege that the directors, in

approving the Advisory and Distribution Agreements, were

engaged in any kind of self-dealing or otherwise stood to

obtain any personal advantage from approval of these con-

tracts. Rather, the core of the allegations against ihe directors

is that they breached statutory and common law fiduciary

duties to the shareholders by approving contracts requiring

payment of excessive fees for investment advisory services. The

weight of legal authority convinces me that such allegations of

approval of or acquiescence in the transactions challenged do

not excuse demand upon the directors.

The leading case on the question of whether demand is

required on directors who have approved or acquiesced in the

challenged transaction is Jn re Kauffman Mutual Fund Ac-

tions, 479 F.2d 257 (Ist Cir.), cert. denied, 4)4 U.S. 857 (1973).

In Kauffman a shareholde

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