Saxe v. Brady

• Decision Date: 10 September 1962
• Parties: Sidney SAXE and Harriet K. Saxe, Plaintiffs, v. William G. BRADY, Jr., Hugh W. Long, Thomas F. Chalker, Clarence J. Reese, John S. Tilney, Donald L. Kemmerer, Fundamental Investors, Inc., Hugh W. Long and Company, Incorporated, Morris M. Townsend and Townsend Corporation of America and Investors Management Company, Julian K. Roosevelt, T. Kennedy Stevenson, Roger Tuckerman, William H. Lough, S. W. Smith, Howard C. Sheperd and William M. Spencer, Defendants.
• Court: Court of Chancery of Delaware

Page 602

184 A.2d 602

40 Del.Ch. 474

Sidney SAXE and Harriet K. Saxe, Plaintiffs, v. William G. BRADY, Jr., Hugh W. Long, Thomas F. Chalker Clarence J. Reese, John S. Tilney, Donald L. Kemmerer Fundamental Investors, Inc., Hugh W. Long and Company Incorporated, Morris M. Townsend and Townsend Corporation of America and Investors Management Company, Julian K Roosevelt, T. Kennedy Stevenson, Roger Tuckerman, William H. Lough, S. W. Smith, Howard C. Sheperd and William M. Spencer, Defendants.

Court of Chancery of Delaware, New Castle County.

Sept. 10, 1962.

Reargument Denied Sept. 24, 1962.

Ernest S. Wilson, Jr., Wilmington, and Stanley L. Kaufman, Irwin M. Taylor and Shephard S. Miller, of Kaufman, Taylor & Kimmel, New York City, for plaintiffs.

Robert H. Richards, Jr., of Richards, Layton & Finger, Wilmington, and Alfred Jaretzki, Jr., and Marvin Schwartz, of Sullivan & Cromwell, New York City, for defendants Fundamental Investors, Inc., Reese, Stevenson, Lough and Spencer.

Richard F. Corroon, of Berl, Potter & Anderson, Wilmington, and Milton Pollack and Paul Baris, New York City, for defendants Hugh W. Long & Co., Inc., Investors Management Co., Brady, Long and Chalker.

The other defendants are not before the court.

SEITZ, Chancellor.

Plaintiffs became investors in 1952 in Fundamental Investors, Inc. ('Fund'), a Delaware corporation registered as an open-end investment company under the provisions of the Investment Company Act of 1940. They have brought this action on its behalf against its directors, investment adviser, and parent of its investment adviser.

Plaintiffs charge that the fees paid to Fund's investment adviser pursuant to a contract whereby the latter receives annually an amount equal to 1/2 of 1% of the average daily net assets of the Fund are 'unreasonable, excessive and an illegal waste and spoilation of the Fund's assets'. The payment of the fees and annual renewal of the contract are said to have resulted from breaches of fiduciary duty by the individual defendants in this suit.

The corporate defendants, Investment Management Company ('IMC') and Hugh W. Long and Company, Incorporated ('Long Inc.'), are charged with having colluded with the individual defendants in negotiating the advisory contract and having shared in the unlawful profits thereby derived. IMC is the investment adviser of the Fund and Long Inc. its principal underwriter.

The advisory relationship between the Fund and IMC arose in 1939 (Fund was organized in 1933) and has continued since that time. In 1941, Long Inc. became the underwriter of Fund's shares, and that relationship also has remained unbroken. In 1950, Long, Inc. acquired part ownership of IMC. By further acquisition of IMC's shares, IMC became by 1954 a wholly-owned subsidiary of Long Inc. Therefore, at all times relevant to this controversy (plaintiffs have limited their claims to fees paid in the period 1955-1960) Long Inc. has been the underwriter of the Fund and IMC, its wholly-owned subsidiary, the investment adviser.

The relationships which Long Inc. and IMC perfected with Fund have been duplicated in every material respect with two other mutual funds, Diversified Investment Fund, Inc. ('DIF') and Diversified Growth Stock Fund, Inc. ('DGSF'). The advisory contract with these two funds was acquired by IMC in 1954 at the same 1/2 of 1% rate. Both these funds however are considerably smaller in net asset value, and the fees earned under the contracts have consequently been less. The persons who serve as directors and officers of Fund serve in the same capacity with DIF and DGSF. Also, any investor in Fund, DIF, or DGSF has the privilege of exchanging his investment in the shares of that fund for the shares of one of the others.

In 1960, IMC and Long Inc. organized a fourth fund known as Westminister Fund Inc. ('WF') for certain specialized investment purposes. The advisory fee is charged at the same 1/2 of 1% rate. Investors in WF, a considerably smaller fund, cannot convert their shares into those of one of the three other funds.

The structure of Fund as an investment company and the terms of the advisory contract between Fund an IMC complied in every way with the formal requisites of the Investment Company Act. It is conceded by plaintiffs that only four of the ten directors of Fund are 'affiliated' directors within the language of § 15 of the Act, 15 U.S.C.A. § 80a-15. At least three of these directors have a substantial stock interest in Long Inc., a publicly-held corporation. The contract itself containing both the compensation arrangement and certain provisions whose inclusion was required by law was approved by Fund's stockholders in March 1954. At that time 99.3% of the shares actually voting voted in favor of the contract. Thereafter Fund's stockholders received periodic reports which disclosed both the rate and the dollar amount of the fee for the particular year.

In April 1960, the contract was submitted again to the stockholders for their approval. The accompanying proxy statement disclosed the pendency and nature of the present litigation. It also disclosed the affiliations of Fund's directors, the relationship between IMC and Long Inc., and the profits of the IMC-Long Inc. combined enterprise as well as the rate and dollar amount of the advisory fee. Of the 76% of Fund's shares participating in the vote, 99.1% ratified and approved continuance of the contractual arrangement theretofore existing.

Plaintiffs say that 'formal' compliance with the Act and 'formal' ratification do not bar plaintiffs' right to recover in Fund's behalf. Plaintiffs attack each of the many factors which defendants contend will insulate them from liability. Thus, plaintiffs say that either the so-called 'non-affiliated' directors were in fact dominated by the interested directors, or, if they were not so dominated, they failed affirmatively to protect Fund's pecuniary interest by passively renewing the annual contract. Plaintiffs argue that the Investment Company Act cast a distinct burden on the non-affiliated directors to exercise vigilance in Fund's behalf.

IMC and the affiliated directors are said to have acted selfishly and in their own interest without regard for the Fund to which they all owed a fiduciary's loyalty. They are said to have manipulated the non-affiliated directors to their own ends either by direct control or by use of misleading or incomplete information. It is claimed that Long Inc. participated in the alleged wrongs.

Finally, plaintiffs challenge the validity of the purported ratification in April 1960. Plaintiffs correctly state the well-settled rule to be that a waste of corporate assets is incapable of ratification without unanimous stockholder consent. Whether a waste of assets is present here is of course the very issue for decision.

Plaintiffs also say that ratification was ineffective for another reason. In effect they argue that the information submitted to the stockholders in the 1960 proxy statement did not fully set forth all the material facts. Plaintiffs point to a plethora of factual material which they contend, if presented to the stockholders, would have enabled them accurately to assess the merits of a continued contractual relation with IMC. Failure to supply this information they say vitiates the effect of the ratification.

I think it can fairly be said that the central issue to be decided is whether the fees paid to IMC under the advisory contract were 'legally excessive' or not. Cf. Meiselman v. Eberstadt (Del.Ch.), 170 A.2d 720. Plaintiffs do not contend that there is any other ground for liability.

In this type of case a court first looks to the nature of the director action. There is no allegation or proof of actual fraud on the part of any of the directors, or indeed any of the defendants. No cause of action is asserted based on the provisions of the Investment Company Act. Plaintiffs' case therefore rests on the charge that certain of the defendants were illegally benefitted by the continuance of the advisory contract and that these parties by various means obtained approval of the contract by the non-affiliated directors who under federal law were obligated to guard the Fund's interest against any such abuse.

Assuming without deciding that the action of the nonaffiliated directors in approving the management contract must be considered as the action of an interested board, what is the effect here of the purported stockholders' ratification?

Plaintiffs contend that there was no valid ratification because the information submitted to the stockholders in the 1960 proxy statement was incomplete and misleading. They argue that the omissions were of such a nature that the court must disregard the vote of the stockholders and leave the burden of proof of fairness upon the defendants. In making such contention plaintiffs have proceeded on the tacit premise that ratification is applicable either to all of their claims or none. The court adopts the same approach.

Plaintiffs' principal objection to the proxy statement is that it failed to reveal the extent of the profits being made by IMC under its advisory contracts with the group of funds that it managed. Therefore, it is said, the stockholders of Fund were unable to determine the cost to IMC of providing advisory services. The proxy statement does in fact contain the profit figure of IMC for the year 1959 as it appears on IMC's books. Apparently what plaintiffs are contending is that by an improper allocation of part of the expenses of Long Inc. to IMC, IMC was able to understate the true amount of its profits.

The dispute with regard to the accuracy of the profit figure arises in the following manner: Prior to the consolidation of Long Inc. and IMC in 1954, separate financial records were maintained by Long Inc. and IMC. This same system of separate records was maintained even after Long Inc. purchased the balance of the outstanding...