Galfand v. Chestnutt Corp.

• Decision Date: 04 November 1976
• Docket Number: Nos. 202,D,315,s. 202
• Citation: 545 F.2d 807
• Parties: Fed. Sec. L. Rep. P 95,768 Mildred GALFAND, on behalf of herself and on behalf of American Investors Fund, Inc., Plaintiff-Appellee and Cross-Appellant, v. CHESTNUTT CORPORATION, Defendant-Appellant, and American Investors Fund, Inc., Nominal Defendant. ockets 76-7156, 76-7170.
• Court: U.S. Court of Appeals — Second Circuit

Page 807

545 F.2d 807

Fed. Sec. L. Rep. P 95,768

Mildred GALFAND, on behalf of herself and on behalf of American Investors Fund, Inc., Plaintiff-Appellee and Cross-Appellant, v. CHESTNUTT CORPORATION, Defendant-Appellant and American Investors Fund, Inc., Nominal Defendant.

Nos. 202, 315, Dockets 76-7156, 76-7170.

United States Court of Appeals Second Circuit.

Argued Oct. 6, 1976.

Decided Nov. 4, 1976.

Clendon H. Lee, New York City, for defendant-appellant.

Ronald Litowitz, New York City (Kreindler & Kreindler and Edward A. Grossmann, New York City, Lyman & Ash, Philadelphia, Pa., of counsel), for plaintiff-appellee and cross-appellant.

Before KAUFMAN, Chief Judge, and MANSFIELD and MESKILL, Circuit Judges.

IRVING R. KAUFMAN, Chief Judge:

The relationship between investment advisers and mutual funds is fraught with potential conflicts of interest. The typical fund ordinarily is only a shell, organized and controlled by a separately owned investment company adviser, which selects its portfolio and administers its daily business. Compensation for these services is determined under an advisory contract, the terms of which are all too often dictated to unwary or negligent fund directors and fund shareholders by the investment adviser.

The vulnerability of mutual fund shareholders to unscrupulous advisers prompted Congress to enact Section 20 of the Investment Company Amendments Act of 1970, 15 U.S.C. § 80a-35(b), ¹ imposing a fiduciary duty on the investment adviser with respect to its receipt of compensation for services rendered to the fund. We are called upon to consider whether, in securing a mid-term modification of its advisory contract with American Investors Fund, Inc. (AIF), Chestnutt Corporation observed its duty of uncompromising fidelity to the interests of AIF security owners. In addition, we are required to decide whether the proxy statement sent to AIF shareholders contained material misstatements or omissions in violation of 15 U.S.C. § 80a-20(a) and the Security and Exchange Commission's Rule 14a-9. We hold that Chestnutt Corporation abused its position of trust by acquiring from the mutual fund, without full disclosure to the AIF Board of Directors, a patently one-sided revision of the advisory contract and that it subsequently violated Rule 14a-9 in obtaining shareholder ratification of the new contract on the basis of a misleading proxy statement. Accordingly, we affirm the judgment of the district court. We also remand, for the reasons hereinafter set forth, for a recalculation of damages.

I.

A brief recitation of the facts will facilitate understanding the legal issues presented for review. AIF was founded in 1957 by George A. Chestnutt, Jr., who became and remains both a Director and President of the Fund. Like other mutual funds, AIF provided small investors an opportunity to pool their venture capital to obtain the benefits of professional financial advice and diversification at a relatively modest cost. The Fund was unusual, however, in that it offered its security holders an investment strategy inspired by the principles of what was characterized as Chartism. ²

This policy was devised by Mr. Chestnutt, who managed the Fund's investments through his control of the investment adviser, appellant Chestnutt Corporation. ³ The adviser, in addition to supervising the Fund's portfolio, furnished office space and clerical personnel, and paid both the salaries of the Fund's executives and all promotional expenses relating to Fund sales. ⁴ In return, Chestnutt Corporation received quarterly reimbursement of its expenses and a fee calculated as follows:

The fee was subject, however, to an "expense ratio limitation". ⁵ Total charges to the Fund, including the fee, but excluding interest and taxes, could not exceed 1% of the value of the Fund's average monthly net assets for any year. Chestnutt Corporation's successful effort to increase this expense ratio limitation to 1 1/2% spawned the current litigation.

Prior to 1973, Chestnutt Corporation's fee was not seriously threatened by the expense ratio limitation. But by May of that year a general deterioration of securities prices had resulted in a sharp decline in the value of the Fund's assets. ⁶ Inflation simultaneously was causing a rapid increase in the adviser's expenses. In an effort to limit rising costs, Chestnutt Corporation initiated a program of redemptions designed to eliminate shareholder accounts too small to justify service costs. The economies thus achieved, however, caused still greater reduction in the Fund's net asset value. This ominous conjunction of factors led Mr. Chestnutt to believe that, under the 1% expense ratio limitation provided by the two-year advisory contract in force since September 1, 1972, Chestnutt Corporation would be required to begin paying rebates to the Fund within two years.

To forestall this eventuality, Mr. Chestnutt decided to increase the expense ratio limitation to 1 1/2%. Acquiescence of the AIF Board of Directors was not difficult to obtain. Chestnutt first proposed revision of the advisory contract at the May 21, 1973, Board meeting. The measure was approved without any difficulty at the next meeting, on June 5. The directors of the Fund gave the proposal cursory scrutiny at best. Mr. Chestnutt at no time gave any indication that by this action, the Fund was foregoing a possible rebate in 1973; nor did he present any evidence to support his gloomy assertions that current trends threatened the financial viability of the investment adviser. ⁷ It is clear from the record that Mr. Chestnutt's personal domination was such that the directors never considered for a moment opposing his suggestion.

Having secured the Board's consent, Mr. Chestnutt sought shareholder ratification of the proposed increase in the expense ratio limitation. The next Annual Meeting was scheduled for July 17, 1973. On June 21 proxy materials were mailed to the Fund's security holders. The materials justified the contract revision as one resulting from "cost increases over which neither the Fund nor the Adviser can exercise control," ignoring entirely the decline in the Fund's net asset value, an equally prominent factor in the "squeeze" on Chestnutt Corporation's profits. The proxy statement added, moreover, that "no higher costs would have been incurred by the Fund had the proposed new agreement been in effect in 1972," although Chestnutt knew the amended contract was likely to increase the ultimate compensation due the investment adviser in 1973.

Despite the effort of appellee Mildred Galfand, suing derivatively on behalf of the Fund, to secure a preliminary injunction, ⁸ the Annual Meeting was held as scheduled on July 17 and the new advisory contract was ratified by a wide margin. The modification in the expense ratio took effect on September 1, 1973. Galfand, meanwhile, continued to pursue her remedy at law. A change in venue from the Eastern District of Pennsylvania to the Southern District of New York was subsequently granted, Galfand v. Chestnutt, 363 F.Supp. 296 (E.D.Pa.1973), and on July 23, 1975, Judge Brieant, after a trial without a jury, found that Chestnutt Corporation breached its fiduciary duty to AIF in securing the expense ratio increase and made false and misleading statements in the proxy materials to obtain shareholder approval of the revamped advisory agreement, in violation of 15 U.S.C. § 80a-20(a) and Rule 14a-9, 17 C.F.R. § 240.14a-9 (1976). ⁹

II.

Congress, in imposing a fiduciary obligation on investment advisers, plainly intended that their conduct be governed by the traditional rule of undivided loyalty implicit in the fiduciary bond. ¹⁰ It is axiomatic, therefore, that a self-dealing fiduciary owes a duty of full disclosure to the beneficiary of his trust. Former Chief Judge Friendly stated the principle succinctly:

under the scheme of the Investment Company Act an investment adviser is "under a duty of full disclosure of information to . . . unaffiliated directors in every area where there was even a possible conflict of interest between their interests and the interests of the fund" a situation which occurs much more frequently in the relations between a mutual fund and its investment adviser than in ordinary business corporations . . .

Fogel v. Chestnutt, 533 F.2d 731, 745 (2d Cir. 1975), cert. denied, --- U.S. ----, 97 S.Ct. 77, 50 L.Ed.2d 86 (1976), (citing Moses v. Burgin, 445 F.2d 369, 376 (1st Cir.), cert. denied, 404 U.S. 994, 92 S.Ct. 532, 30 L.Ed.2d 547 (1971)). ¹¹ Moreover, even where a fiduciary has made full disclosure, it is the duty of a federal court to subject the transaction to rigorous scrutiny for fairness. See Pepper v. Litton, 308 U.S. 295, 306-07, 60 S.Ct. 238, 84 L.Ed. 281 (1939). ¹² We believe it is clear that, in applying these standards, Chestnutt's conduct in obtaining approval of the contract modification must be found to have fallen far short of the elevated norm Congress expected.

A thorough search of the record reveals no evidence that Chestnutt, in discussing the issue with the AIF directors, made any reference to the fact or even suggested that the Fund would lose a rebate if the expense ratio were raised to 1 1/2% of average monthly net assets. And, although the financial soundness of the investment adviser is of proper concern to a mutual fund, Chestnutt failed to support his Cassandran prophecies of possible bankruptcy with financial statements or corroborating figures. Had he supplied the AIF Board of Directors with data more recent than the 1972 annual report, it would have been apparent that Chestnutt Corporation had ample assets ¹³ and substantial income despite recent unfavorable trends. Chestnutt appears to have ignored completely his duty to promote responsible directorial judgment by supplying information sufficient to enable the Fund's Board to evaluate the new contract "with an eye eager to discern . . . rather than shut...