Fogel v. Chestnutt

• Decision Date: 30 December 1975
• Docket Number: No. 39,D,39
• Citation: 533 F.2d 731
• Parties: Fed. Sec. L. Rep. P 95,393 Rosalind FOGEL and Gerald Fogel, Plaintiffs-Appellants, v. George A. CHESTNUTT, Jr., et al., Defendants-Appellees. ocket 74-2582.
• Court: U.S. Court of Appeals — Second Circuit

Page 731

533 F.2d 731

Fed. Sec. L. Rep. P 95,393

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

No. 39, Docket 74-2582.

United States Court of Appeals Second Circuit.

Argued Sept. 22, 1975.

Decided Dec. 30, 1975.

Abraham L. Pomerantz, New York City (Richard M. Meyer, William E. Haudek, Daniel W. Krasner, and Pomerantz, Levy, Haudek & Block, New York City, of counsel), for plaintiffs-appellants.

Clendon H. Lee, New York City (Rogers, Hoge & Hills, New York City, of counsel), for defendants-appellees (other than American Investors Fund, Inc. Nominal Defendant).

Dewey, Ballantine, Bushby, Palmer & Wood, New York City (Edward N. Sherry, Judson A. Parsons, Jr., and Martin J. Schwartz, New York City), for Lord, Abbett & Co., as amicus curiae.

Before FRIENDLY, HAYS and FEINBERG, Circuit Judges.

FRIENDLY, Circuit Judge:

More than four years after the First Circuit decided Moses v. Burgin, 445 F.2d 369 (1971), reversing 316 F.Supp. 31 (D.Mass.1970), concerning the duty of the managers of a mutual fund to recapture brokerage commissions for the benefit of the fund, this court is confronted with the problem for the first time. In reviewing Judge Wyatt's dismissal on the merits of a recapture action in the District Court for the Southern District of New York, 383 F.Supp. 914 (1974), we must determine whether we agree with the First Circuit's decision and, if so, whether it applies to the somewhat different facts here at issue. With some qualifications our answers to both questions are in the affirmative. We therefore reverse and remand for the determination of damages.

I. The Root of the Problem.

The present is one of what we understand to be a large number of derivative stockholders actions brought on behalf of mutual funds against investment advisers, distributors, and directors of both, ¹ primarily in consequence of remarks in the SEC's Report on the Public Policy Implications of Investment Company Growth (PPI) 16,172-73 (1966), House Report No. 2337, 89th Cong.2d Sess.

The basic factual situation giving rise to the recapture problem is well described in Judge Wyatt's opinion, 383 F.Supp. at 916-18, in the opinion of Judge Wyzanski, 316 F.Supp. 31 (D.Mass.1970), and the reversing opinion of the First Circuit in Moses v. Burgin, supra in PPI, and in countless law review notes and articles both before and after Moses. ² Accordingly we shall endeavor to be brief in our statement of the problem and will assume familiarity with the typical structure of the externally managed open-end mutual fund, a mere shell whose investment and management functions are performed by an adviser and whose sales are handled either by the adviser (or the fund itself) in the case of no-load funds or by a distributor (which may or may not be identical with the adviser) in the case of load funds.

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; ³ 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 of whom were not the best qualified to execute the particular order placed with them. Hence there developed the practice of relying on a few executing brokers who were then instructed to "give-up" a portion of their commissions, sometimes as much as 75%, to another broker whom the fund manager wished to reward. On NYSE this was permitted only in favor of another member, but six of the seven regional exchanges permitted "give-ups" in favor of non-members as well, provided they were members of the National Association of Securities Dealers, Inc. (NASD).

There was an obvious tension between the give-up and those representations made by the investment company in its prospectuses which investors would be likely to understand as meaning that the amounts paid to the investment adviser constituted the fund's cost for management and investment advice and, in the case of "load" funds, that the amounts retained by the distributor constituted the cost of sales. In fact, the management-directed "give-ups" to non-executing brokers represented additional amounts that were being paid for advising, selling or both, and the true costs of these services were thus higher than the advisory fee or the sales load. To the extent that a management company restricted its own research because of what was being furnished by brokers who were rewarded with give-ups or that a distributor retained for itself a larger part of the sales load than would have been competitively feasible in the absence of give-ups, the stipulated management fees yielded greater profits than they otherwise would have. The practice entailed other evils unnecessary here to detail. Still, if there was no way for a fund to "recapture" the excess of the fixed and unvarying commissions over what the executing broker would willingly accept, something was to be said for using the excess to reward brokers who had served the fund in some fashion rather than simply overpaying the executing broker. The SEC put its finger on the problem as early as 1963 when it said in its Report of the Special Study of Securities Markets, House Doc. No. 95, 88th Cong. 1st Sess. p. 234:

The Special Study concludes and recommends:

1. The pattern of reciprocal business in the mutual fund industry is unique. The economies of the volume of securities transactions generated by the mass purchasing power of the funds for the most part are of minor benefit to the funds themselves. The primary beneficiaries are their investment advisers and their frequently related principal underwriters, who to a large extent use reciprocity to reward the sales efforts of fund retailers, thereby increasing their own rewards. The use by fund advisers of investment advice and research provided by brokerage firms in return for fund brokerage, without diminution of their investment advisory fees, is another indication of the manner in which they are the primary beneficiaries of reciprocal business. This unbalanced reciprocal structure is a direct outgrowth of a minimum commission rate structure which prohibits volume discounts and rebates. In the broad study of the commission rate structure recommended to the Commission in chapter VI-I, appropriate consideration should be given to the desirability and appropriate form of a volume discount from the viewpoint of mutual funds.

As developed by Mr. Justice Blackmun in Gordon v. New York Stock Exchange, Inc., --- U.S. ----, ----, 95 S.Ct. 2598, 45 L.Ed.2d 463 (1975), 43 U.S.L.W. 4958, 4961-62, reform of the commission rate structure had a long gestation period. Meanwhile a few adviser-underwriters decided to recapture for their funds some of the spread between the fixed and unvarying commissions payable to executing brokers and the lesser amounts the latter were willing to accept on large orders. In a discussion of this development, at 172-73, PPI echoed the Special Study's criticisms of mutual fund reciprocal and give-up practices and continued in a passage meriting full quotation, pp. 172-73:

(a) Use of brokerage commissions to benefit the funds

(i) Reducing advisory fees. As has been noted, subsidiaries of four adviser-underwriters that maintain their own retail sales forces among them three of the largest, Investors Diversified Services, Inc., Waddell & Reed, Inc., and Channing Financial Corp., as well as the smaller Imperial Financial Services, Inc. are now members of the Pacific Coast Stock Exchange. These subsidiaries execute orders for the funds on the Pacific Coast Stock Exchange. More important, however, they obtain a considerable amount of nonfund business from broker-dealers who are dual members of the Pacific Coast Stock Exchange and other exchanges in return for fund brokerage business on other exchanges, primarily the NYSE. All the net profits of IDS's subsidiary and about 40 to 50 percent of the net profits of Waddell & Reed's and of Imperial Financial Services' subsidiaries have been applied to reduce advisory fees payable by the funds in those complexes.

Widespread emulation by institutional investors of the precedent set by these four complexes could have a marked effect on the economics of the securities industry. Within the framework of the existing commission rate structure it is a method whereby mutual fund shareholders can derive greater benefits than they have heretofore received from fund brokerage commissions. However among dealer-distributed funds the important role that portfolio brokerage plays in the competition for dealer favor has kept fund managers, with few exceptions, from using exchange memberships to reduce costs of the funds.

Similar competitive factors have also operated against the use, for the benefit of the funds and their shareholders, of regional exchange rules permitting give-ups to any member of the NASD on transactions executed on those exchanges. It would not be inconsistent with those rules for dealer-distributed funds to direct give-ups to their adviser-underwriters, all of whom are NASD members, for the purpose of applying these give-ups to reduce the advisory fees payable by the funds. Unless and until such procedures become widespread, any adviser-underwriter to a dealer-distributed fund who chose to utilize fund brokerage in this manner would place itself at a disadvantage in...