Fox v. Reich & Tang, Inc.

• Decision Date: 26 October 1982
• Docket Number: No. 74,D,74
• Parties: Fed. Sec. L. Rep. P 98,845 Martin FOX, Plaintiff-Appellant, v. REICH & TANG, INC. and Daily Income Fund, Inc., Defendants-Appellees. ocket 82-7296.
• Court: U.S. Court of Appeals — Second Circuit

Page 250

692 F.2d 250

Fed. Sec. L. Rep. P 98,845

Martin FOX, Plaintiff-Appellant, v. REICH & TANG, INC. and Daily Income Fund, Inc., Defendants-Appellees.

No. 74, Docket 82-7296.

United States Court of Appeals,

Second Circuit.

Argued Sept. 16, 1982.

Decided Oct. 26, 1982.

Richard M. Meyer, New York City (Milberg, Weiss, Bershad & Specthrie, New York City, of counsel), for plaintiff-appellant.

Daniel A. Pollack, New York City (Pollack & Kaminsky, Frederick P. Schaffer, New York City, of counsel), for defendant-appellee Daily Income Fund, Inc.

Seward & Kissel, New York City (Anthony R. Mansfield, New York City, of counsel), for defendant-appellee Reich & Tang, Inc.

Before FEINBERG, Chief Judge, and FRIENDLY and KAUFMAN, Circuit judges.

IRVING R. KAUFMAN, Circuit Judge:

This case presents an issue of first impression in this Circuit. The question before us is whether, in a shareholder action brought pursuant to Sec. 36(b) of the Investment Company Act of 1940 to recover allegedly excessive fees paid by an investment company to its adviser, ¹ the shareholder plaintiff is required to plead that a "demand" was made on the company's board of directors prior to filing of the complaint. ² At first blush, resolution of this question would seem to require merely clarification of a technical pleading rule. As our discussion makes clear, however, analysis of the issue is not uncomplicated, nor is our conclusion without important ramifications for suits brought pursuant to Sec. 36(b).

I

Because this case comes to us from a dismissal at the pleading stage, the factual record is sparse. Martin Fox, a shareholder of Daily Income Fund, Inc. ("the Fund"), brought this action on behalf of the Fund to recover allegedly excessive fees paid by the Fund to its investment adviser, Reich & Tang, Inc. ("R & T"). The Fund, an open-end investment company of the type commonly referred to as a "money-market fund," pursues as its basic business strategy the goal of achieving high current income levels while preserving capital. To this end, it invests in a portfolio of short-term money market instruments, principally United States government and federal agency obligations, obligations of major banks, and prime commercial paper. The Fund experienced a dramatic surge in its assets, in a relatively short period of time. As of June 30, 1978, the Fund's net assets were approximately $75 million. Less than three years later, on April 15, 1981, they had reached a level of $775,000,000. Precisely this sort of "dramatic growth" ³ impelled enactment of the 1970 amendments to the Investment Company Act of 1940, and, in particular, Sec. 36(b), which created a cause of action for return of excessive adviser fees. Because fees are usually calculated as a percentage of assets, substantial portfolio appreciation brings with it the risk of unduly high adviser compensation. See S.Rep. No. 184, 91st Cong., 1st Sess. 6 (1969), reprinted in 1970 U.S.Code Cong. & Ad.News at 4902; see also J. Barnard, Jr., Reciprocal Business, Sales Charges and Management Fees, in 1966 Fed. B.A. Conference on Mutual Funds 127-29.

Despite this substantial increase in Fund assets, no adjustment was made in the rate at which R & T was to be paid for investment advice and other management services rendered. R & T's fee was originally set at one-half of one percent of the Fund's net assets, and it remains fixed at that rate. Consequently, yearly payments by the Fund to its adviser increased from approximately $375,000 in 1978, to a projected $3,875,000 in 1981. During the fiscal year ending June 30, 1980, R & T received more than $2,000,000 in management fees from the Fund. It is this extraordinary leap in fees of which Fox complains.

Fox's complaint alleged that management of the assets of a money market fund requires no detailed analysis of industries (or of large individual industrial concerns), nor the retention of a large staff of highly paid, sophisticated securities analysts. Essentially, he claimed that investment decisions are more or less routine, concentrated as they are in the relatively limited realm of "turning over" money market investments with a small number of institutions. In short, Fox alleged that R & T was continuing to provide the services it had always rendered, for what had become an exorbitant amount of money.

Rather than approach the Fund's directors with his grievance, Fox chose to allege in his complaint that no "demand" is required under Sec. 36(b). ⁴ In response, the Fund (later joined by R & T) moved to dismiss for failure to comply with Rule 23.1. After noting that the issue had resulted in a split among the district courts in this Circuit, ⁵ Judge Duffy concluded that a Rule 23.1 demand was required in a Sec. 36(b) suit, and dismissed the complaint. Fox appealed. For the reasons stated below, we disagree with the district court's conclusion, 94 F.R.D. 94, and reverse.

II

We begin by noting that the Rule 23.1 demand requirement applies only when a corporation or association has "failed to enforce a right which may properly be asserted by it." ⁶ We agree with Fox that the rule applies only when the specified entity has an opportunity to "assert," in a court, the same action under the same rule of law on which the shareholder plaintiff relies. Thus, if the Fund may not sue pursuant to Sec. 36(b), no demand upon its board of directors will be required. In rejecting the Fund's argument that even if it cannot bring an action under Sec. 36(b), a demand must be made upon its directors to utilize other, informal means to "enforce its right" to return of excessive adviser fees, Brief of Defendant-Appellee Daily Income Fund, Inc. at 5-6, ⁷ we announce no new rule of law. As long ago as the beginning of this century, the Supreme Court construed Equity Rule 94, 104 U.S. ix (1882), the precursor of Rule 23.1, and determined that its nearly identical language ⁸ referred to "a suit founded on a right of action existing in the corporation itself, and in which the corporation itself is the appropriate plaintiff." Delaware & Hudson Co. v. Albany & Susq. R.R., 213 U.S. 435, 447, 29 S.Ct. 540, 543, 53 L.Ed. 862 (1909); see also Ross v. Bernhard, 396 U.S. 531, 534-35, 90 S.Ct. 733, 735-736, 24 L.Ed.2d 729 (1970).

Accordingly, we turn initially to the question whether an investment company can bring an action under Sec. 36(b) of the Investment Company Act of 1940.

A

Our starting point, as in every case involving construction of a statute, is examination of the language utilized by Congress. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 197, 96 S.Ct. 1375, 1382, 47 L.Ed.2d 668 (1976). The second sentence of Sec. 36(b) is quite clear that an action may be brought under that subsection only "by the [Securities and Exchange] Commission, or by a security holder of [a] registered investment company on behalf of such company." ⁹ No action by the investment company is authorized. When Congress has provided specific and elaborate enforcement provisions, and entrusted their use to particular parties, we will not lightly assume an unexpressed intention to create additional ones. See Middlesex County Sewerage Auth. v. National Sea Clammers Ass'n, 453 U.S. 1, 13-15, 101 S.Ct. 2615, 2622-2624, 69 L.Ed.2d 435 (1981).

Appellee points to the words "on behalf of such company," and argues they demonstrate that the right of the shareholder created by Sec. 36(b) is derivative, and therefore the director demand requirement of Rule 23.1 applies, as it does to other "derivative" actions in the federal courts.

The words "on behalf of" do not create by implication a statutory right of the company itself to sue, from which the stockholders' right may be said to be "derivative." These words, which apply as much to the Securities and Exchange Commission as to a private security holder, signify only that either party so entitled to bring an action under Sec. 36(b) must do so to seek return of excessive management fees to the company treasury and not to individual or governmental coffers. The action is not, strictly speaking, "derivative" in the sense of deriving from a right properly asserted by the corporation, but rather constitutes individual security holders as "private attorneys general" to assist in the enforcement of a duty imposed by the statute on investment advisers.

We recognize that the one Court of Appeals to have considered the question reached a different conclusion. Grossman v. Johnson, 674 F.2d 115 (1st Cir.), cert. denied, --- U.S. ----, 103 S.Ct. 85, 73 L.Ed.2d ----, (1982). In rejecting the argument that because Sec. 36(b) explicitly provides for, it therefore only permits, suit by the SEC or a security holder, the First Circuit stated:

We cannot believe, however, that, for example, a new and independent board of directors, intent on recovering excessive fees from an investment adviser, would be precluded from suing under section 36(b).

Id. at 120. Equally cogent is our belief that this situation was regarded as so remote or unlikely that the legislature chose not to provide for it, and was wary of permitting the Fund to control the suit, see Burks v. Lasker, 441 U.S. 471, 483-84, 99 S.Ct. 1831, 1839-1840, 60 L.Ed.2d 404 (1979). Moreover, the Grossman court offers scant support for its conclusion that the Fund may sue. It refers, first, to the "on behalf of" language in the statute. We have already indicated the meaning we attach to that phrase. Similarly, we are unpersuaded by the argument that "Congress could well have believed that, though it was appropriate to specify that the Commission and shareholders had the new statutory cause of action[,] ... it was unnecessary to say with particularity that the company also did." Id. This seems totally inconsistent with what we would expect Congress to have done. If Congress had intended to provide the company with a cause of action, it would have passed a statute saying so, in which case the derivative right of a...