Fogel v. Chestnutt, 68 Civ. 2855.

• Decision Date: 29 October 1974
• Docket Number: No. 68 Civ. 2855.,68 Civ. 2855.
• Citation: 383 F. Supp. 914
• Parties: Rosalind FOGEL and Gerald Fogel, Plaintiffs, v. George A. CHESTNUTT, Jr., et al., Defendants.
• Court: U.S. District Court — Southern District of New York

383 F. Supp. 914

Rosalind FOGEL and Gerald Fogel, Plaintiffs, v. George A. CHESTNUTT, Jr., et al., Defendants.

No. 68 Civ. 2855.

United States District Court, S. D. New York.

October 29, 1974.

Pomerantz, Levy, Haudek & Block, New York City, for plaintiffs; Richard M. Meyer, Daniel W. Krasner, New York City, of counsel.

Rogers, Hoge & Hills, New York City, for defendants Chestnutt, Jr., Currier, Sabel, Greene, Chestnutt Corp., and American Investors Corp.; Clendon H. Lee, Frederick A. Nicoll, New York City, of counsel.

Rogers & Wells, New York City, for American Investors Fund, defendant; William F. Koegel, New York City, of counsel.

WYATT, District Judge.

This is the decision after trial without a jury on the issue of liability alone. There will be judgment for defendants on this issue.

Plaintiffs are and have been since January 11, 1963 holders of record of shares of capital stock of American Investors Fund, Inc. (Fund), a New York corporation. Fund is a diversified open-end management investment company registered as such under the Investment Company Act of 1940 (15 U.S.C. § 80a-1 and following ("the 1940 Act"); see §§ 80a-3, 80a-4, 80a-5, 80a-8). Fund is one of the many companies usually called a "mutual fund". Fund does not charge a "sales load" (commission) on its shares sold (15 U.S.C. §§ 80a-2(a) (35), 80a-10(d).

Fund was organized in 1957 and had for some time as its investment adviser, American Investors Corporation. Since July 19, 1966, the investment adviser of Fund has been Chestnutt Corporation (Adviser), a Connecticut corporation which acquired all the assets of American Investors Corporation. For simplicity the term "Adviser" will usually be meant to include American Investors Corporation. The Adviser manages Fund and acts under an investment advisory contract between it and Fund.

George A Chestnutt, Jr. (George), for whom the Adviser is named, is president and principal stockholder (47%) of the Adviser and president and a director of Fund. He has been the chief figure in Fund and in the Adviser.

The action was commenced on July 11, 1968, and is a derivative one on behalf of Fund (a nominal defendant). The action is also said to be brought "representatively" for all other "shareholders of the Fund similarly situated"; what this means is not clear.

The named defendants are the Advisor, its predecessor (American Investors Corporation) and the seven directors of Fund when the action was commenced. Four of these individual defendants were served and defended: George, Currier, Greene, and Sabel. Currier is a director of Fund and owns voting common stock (2%) of the Adviser; he is a corporate executive in the women's wear field. Greene is vice president and a director of Fund and vice president and a small stockholder (0.4%) of the Adviser. Sabel is a lawyer and a director of Fund; before his retirement in 1971, Sabel was senior vice president and secretary of Fund and was also vice president, secretary, director, and substantial stockholder (16%) of the Adviser (he may still be a substantial stockholder of the Adviser).

The complaint named three other directors of Fund who were not served and did not appear: Fowler, Radcliffe, and Veeder.

Jury trial was demanded by plaintiffs.

The complaint in one count avers a claim that the Adviser and the individual defendants enriched themselves at the expense of Fund by the use of "reciprocal brokerage" and "give-ups". Specifically, the charge is that defendants violated the 1940 Act "by failing to recapture brokerage commissions for the Fund" (Post-Trial memo for plaintiffs, p. 2).

The complaint avers that this Court has jurisdiction under the 1940 Act and also under the Investment Advisers Act of 1940 (15 U.S.C. § 80b-1 and following) and the Securities Exchange Act of 1934 (15 U.S.C. § 78a and following; "the 1934 Act"). Plaintiffs appear to rely solely on the 1940 Act.

By order filed June 29, 1973, it was directed that "the issue of liability will be tried separately and before the issue of damages". The Court was advised at that time that the action would be tried without a jury.

A pretrial order signed September 4, 1973 (but for some reason not filed until October 4, 1973) noted that the right to a jury trial had been waived by "both parties".

Without opposition by defendants, the plaintiffs were permitted to serve and file a supplemental complaint, the principal (if not only) function of which was to bring the complaint down to date. The supplemental complaint was filed on August 24, 1973 (a copy with verification added was filed on August 30, 1973). No order was made that defendants plead to the supplemental complaint (Fed.R. Civ.P. 15(d)); note was taken of this situation at trial and new paragraphs of the supplemental complaint were "deemed denied" (SM 6; SM references are to pages of the stenographic minutes).

It is difficult to tell the time period for which this action is brought. Based on the averments in paragraphs 21(a) and 23(a) of the supplemental complaint, it would appear to be from January 1, 1965 down to date. For reasons which will appear, however, the claim as to give-ups must end on December 5, 1968, and the claim as to reciprocal brokerage must end on July 15, 1973. Counsel for plaintiffs insist (SM 65) that membership on two regional exchanges would have yielded preferences thereafter, but, as will appear, SEC Rule 19b-2 prohibited this, effective March 15, 1973.

1.

Since 1964, Fund has had either eight or seven directors.

With respect to directors, the parties have used the terms "affiliated" and "unaffiliated" but have not defined these terms. The 1940 Act uses the expression "interested persons" in referring to directors (15 U.S.C. § 80a-10(a)) which is elsewhere defined to include an "affiliated person" (15 U.S.C. § 80a-2(a) (19) (A) (i)) which latter term is elsewhere defined (15 U.S.C. § 80a-2(a) (3)). For purposes of this action, an affiliated director may be considered as one connected with or having an interest in Advisor, as opposed to an independent director, having no connection with or interest in Adviser.

Since 1964, Fund has had either three independent directors out of seven or four independent directors out of eight. Fund has had four affiliated directors. Currier is counted as an affiliated director because, while not employed by Advisor, he has owned 2% of the voting common stock of Adviser.

Fund and Adviser had the same counsel. Sabel and his firm were counsel to both until 1971 or 1972. Clendon H. Lee, whose wife has been for a long time the owner of a small amount (1%) of the voting common stock of Adviser, became special counsel to Fund in 1965 and his law firm has acted as counsel to Fund since at least April 28, 1972.

Under the investment advisory contract, Adviser manages and advises Fund, furnishes all offices to Fund, pays all officers and employees of Fund, and in short does everything for Fund.

Fund pays nothing for expenses except fees to directors.

Under the investment advisory contract, Fund pays the Adviser for its services on an annual rate of a percentage of the net asset value of Fund. These payments have been substantial, ranging from $187,000 in 1964 to $1,557,000 in 1969.

2.

The charges in this action had their origin in the size of the transactions made on stock exchanges by mutual funds and other institutions. As these transactions developed, they involved buying and selling large blocks of shares and at the rates fixed by the exchanges (no quantity discounts) the brokerage commissions became so great that members of the exchanges could execute fund transactions at a cost of only a small part of the commissions which had to be charged. Naturally, exchange members were eager for mutual fund business and would have been willing to rebate part of their commissions to the customer mutual funds but were prevented by exchange rules from doing so.

In this climate, brokers had a strong motive to give help to managers of mutual funds by (a) selling shares of the fund or (b) supplying the manager with investment research and advice, or (c) doing both. The manager of the mutual fund would then allocate part of its brokerage business to such helpful brokers, and could see that the commissions earned by such helpful brokers bore a relation to the value of the sales efforts and of the research and advice. Those allocated orders were known as "reciprocals".

For some funds, especially big funds, it became undesirable to allocate brokerage orders on the basis of the value of non-brokerage services rendered. This was principally because sales of the mutual fund shares were made by many independent brokers or dealers; to send brokerage transactions through so many brokers would not be prudent from a management standpoint, this for many good reasons.

To meet this situation, the brokers and mutual fund managers worked out the technique of the "give-up".

The give-up technique was that the broker who executed the fund transaction surrendered a part of his commission to other brokers designated by the customer fund, acting of necessity through the fund manager. In this way, the fund manager could spread the commissions on fund executions among a number of brokers, who, although they had nothing to do with execution of the transaction, had been otherwise helpful in selling fund shares or in giving investment advice or both.

Brokers executing transactions for mutual funds were willing to give up as much as 75% or more of their commissions.

As might be expected, the Securities and Exchange Commission (SEC) became concerned with the influence of fund and other institutional transactions on the structure of the market for securities, as well as with the fixed rates (without quantity discounts) charged under exchange rules. It was this last feature which had resulted in the development of reciprocals and give-ups.

The give-up technique was not without its limits. Because of a rule...