Tannenbaum v. Zeller

• Decision Date: 04 March 1977
• Docket Number: D,No. 576,576
• Citation: 552 F.2d 402
• Parties: , Fed. Sec. L. Rep. P 95,900 Susan TANNENBAUM, Plaintiff-Appellant, v. Robert G. ZELLER et al., Defendants-Appellees. ocket 75-7503.
• Court: U.S. Court of Appeals — Second Circuit

Page 402

552 F.2d 402

47 A.L.R.Fed. 559, Fed. Sec. L. Rep. P 95,900

Susan TANNENBAUM, Plaintiff-Appellant, v. Robert G. ZELLER et al., Defendants-Appellees.

No. 576, Docket 75-7503.

United States Court of Appeals, Second Circuit.

Argued Feb. 9, 1976.

Finally Submitted May 20, 1976.

Decided March 4, 1977.

Leonard I. Schreiber, New York City (Abraham J. Brill, New York City, of counsel), for Susan Tannenbaum.

Marvin Schwartz, New York City (Mark I. Fishman and Sullivan & Cromwell, New York City, of counsel), for F. Eberstadt & Co., Inc., F. Eberstadt & Co., Managers and Distributors, Inc., and Robert G. Zeller.

Robert D. Mercurio, New York City (E. Roger Frisch, and Walsh & Frisch, New York City, of counsel), for Chemical Fund, Inc.

Harvey L. Pitt, Gen. Counsel, Paul Gonson, Associate Gen. Counsel, Jacob H. Stillman, Asst. Gen. Counsel, Edward A. Scallet, Atty., SEC, Washington, D. C., for Securities and Exchange Commission, amicus curiae. ^*

Before LUMBARD and TIMBERS, Circuit Judges, and BRYAN, District Judge. ^**

FREDERICK van PELT BRYAN, District Judge:

The plaintiff in this derivative action is a shareholder of Chemical Fund Inc., a mutual fund (the Fund). She sued on behalf of the Fund against the Fund's investment adviser, F. Eberstadt & Co., Managers and Distributors, Inc., its parent company, F. Eberstadt & Co., Inc., and Robert G. Zeller, a principal of the Fund, its investment adviser, and the parent company, for alleged unlawful failure to recapture portfolio brokerage commissions for the benefit of the Fund and for alleged inadequate disclosure of the Fund's brokerage practices to Fund shareholders.

After trial without a jury before Judge Robert L. Carter in the Southern District of New York on the question of liability only, judgment was entered dismissing the complaint. Judge Carter's opinion below is reported at 399 F.Supp. 945 (S.D.N.Y.1975). Plaintiff appeals from that judgment.

The appeal presents troublesome questions concerning the duties of investment advisers and directors of mutual funds with respect to recapture of portfolio brokerage commissions for the benefit of the fund. The applicable legal principles were largely laid down by this court in Judge Friendly's comprehensive opinion in Fogel v. Chestnutt, 533 F.2d 731 (2d Cir. 1975), cert. denied, 429 U.S. 824, 97 S.Ct. 77, 50 L.Ed.2d 86, 45 U.S.L.W. 3250 (1976), which approved with some qualifications the holdings of the First Circuit in Moses v. Burgin, 445 F.2d 369 (1st Cir.), cert. denied, 404 U.S. 994, 92 S.Ct. 532, 30 L.Ed.2d 537 (1971), the only previous court of appeals decision dealing with the recapture problem. A basic question here is whether application of the Fogel and Moses principles to the facts in the case at bar requires reversal of the dismissal of the complaint by the court below.

The essential questions which we find presented and our rulings thereon are as follows:

(A) Did the manager and interested Fund directors have a duty to recapture excess commissions for the benefit of the Fund either under the Fund's charter or under the various agreements between the Fund and the adviser?

We hold they did not.

(B) Did the manager and interested directors violate their duty of disclosure to the independent directors under Moses and Fogel ?

We hold they did not.

(C) Did failure to recapture violate section 36 of the Investment Company Act of 1940?

We hold it did not.

(D) Did the proxy statements for the years 1967-1971 violate the disclosure provisions of the federal securities laws?

We hold they did and remand for determination of what damages, if any, were caused by such violations.

I.

At the outset, a review of the background of the recapture problem in the mutual fund industry is in order. Since Judge Friendly's opinion in Fogel, and the authorities there cited, ¹ cover this subject in considerable detail, the discussion here will be limited to what is essential for an understanding of the problems presented in this case.

The mutual fund industry is in many ways unique, which in part explains the specific federal regulatory legislation concerning it. See, e. g., Investment Company Act of 1940, 15 U.S.C. § 80a-1, et seq.; Investment Advisers Act of 1940, 15 U.S.C. § 80b-1, et seq. A mutual fund is a "mere shell," a pool of assets consisting mostly of portfolio securities that belongs to the individual investors holding shares in the fund. The management of this asset pool is largely in the hands of an investment adviser, an independent entity which generally organizes the fund and provides it with investment advice, management services, and office space and staff. The adviser either selects or recommends the fund's investments and rate of portfolio turnover, and operates or supervises most of the other phases of the fund's business. The adviser's compensation for these services is a fee which is usually calculated as a percentage of the fund's net assets, and thus fluctuates with the value of the fund's portfolio. Portfolio transactions are carried out by brokers selected by the adviser, who receive commissions at the regular rates therefor. The sale of fund shares to new investors is generally the responsibility of a "principal underwriter" who is usually the adviser itself or a close affiliate. Actual sales are made by brokers or dealers selected by the underwriter, and the sales charge or "load" is divided between the selling broker or dealer and the underwriter. ²

This management structure contrasts sharply with that of a typical corporation. In the usual corporate situation, the interests of management and shareholders are identical on most matters. Since the officers who run the corporation are paid directly by the corporation and usually have a substantial equity investment in it, they devote themselves to profit maximization and thus act in the best interests of both the corporation and themselves. Control of a mutual fund, however, lies largely in the hands of the investment adviser, an external business entity whose primary interest is undeniably the maximization of its own profits.

While the management and shareholders of a mutual fund have certain parallel interests (such as improving the quality of investment performance by increasing the value of the fund's portfolio and thus raising both the value of fund shares and the investment adviser's fee), there are important areas in which their interests may conflict. These include the level of management fees and sales charges, and various aspects of portfolio transactions. Mundheim, Some Thoughts on the Duties and Responsibilities of Unaffiliated Directors of Mutual Funds, 115 U.Pa.L.Rev. 1058, 1059-60 (1967). The situation caused by this unique mutual fund structure was serious enough to prompt the observation by the First Circuit that "self-dealing is not the exception but, so far as management is concerned, the order of the day." Moses v. Burgin, supra, at 376. See Galfand v. Chestnutt Corp., 545 F.2d 807, 808 (2d Cir. 1976).

Congress sought to minimize the possibilities of abuse of position by mutual fund managers by means of the Investment Company Act of 1940, 15 U.S.C. § 80a-1, et seq. This statute expanded the disclosure provisions already applicable to the industry under the Securities Act of 1933, 15 U.S.C. § 77a, et seq., and the Securities Exchange Act of 1934, 15 U.S.C. § 78a, et seq., and imposed specific requirements as to the structure and operation of mutual funds. See Comment, Mutual Funds and Independent Directors: Can Moses Lead to Better Business Judgment?, 1972 Duke L.J. 429, 433-35. Thus what was then section 10 of the Investment Company Act of 1940, 54 Stat. 806, required that at least 40 percent of a mutual fund's board of directors not be officers or employees of the investment company or "affiliated" with its investment adviser. This key provision was designed to place the unaffiliated directors in the role of "independent watchdogs" who would assure that, in accordance with the preamble of the Investment Company Act, mutual funds would operate in the interest of all classes of their securities holders, rather than for the benefit of investment advisers, directors, or other special groups. The Act also placed specific restrictions on insider transactions, 15 U.S.C. § 80a-17, and required that the contracts governing the relationship between a fund and its investment adviser be approved by investors and reexamined periodically, 15 U.S.C. § 80a-15(a). ³

While the 1940 Acts succeeded in correcting a number of obvious abuses which had been prevalent in the mutual fund industry prior to their enactment, it became apparent in the early 1960's that problems still remained. Believing that the existing regulatory scheme then relying on "unaffiliated" directors to police the industry had proved inadequate, the SEC set in motion a series of developments which raised for the first time the question of the recapture of portfolio brokerage commissions for the benefit of the fund, and eventually culminated in the Securities Act Amendments of 1975.

In Fogel, Judge Friendly summarized the origins of the recapture controversy:

At the root of the recapture problem was the historic practice of the New York Stock Exchange (NYSE) and other exchanges of charging a fixed rate of commission on each share traded regardless of the size of the transaction (except for the odd-lot differential). Since the costs of executing an order do not vary in accordance with size, the large sales and purchases at the command of investment advisers of mutual funds were particularly attractive orders. At first fund managers allocated their brokerage business to reward brokers who had been helpful in selling the fund's shares, in furnishing advice, or in doing both; orders allocated as rewards were known as "reciprocals." However, as the business grew, the practice of reciprocals resulted, especially for the large funds, in using too many brokers, some...