Weiss v. Temporary Inv. Fund, Inc.

• Citation: 692 F.2d 928
• Decision Date: 12 November 1982
• Docket Number: No. 81-2688,81-2688
• Parties: Fed. Sec. L. Rep. P 98,865 Melvyn I. WEISS, Custodian for Gary Michael Weiss, U/NY/UGMA, Appellant, v. TEMPORARY INVESTMENT FUND, INC., Provident Institutional Management Corporation, Shearson Loeb Rhoades, Inc., Russell W. Richie, Robert R. Fortune, James Louis Robertson, Henry M. Watts, Jr., Dr. Ralph A. Young, Thomas S. Gates, G. Willing Pepper, Appellees.
• Court: United States Courts of Appeals. United States Court of Appeals (3rd Circuit)

Page 928

692 F.2d 928

Fed. Sec. L. Rep. P 98,865

Melvyn I. WEISS, Custodian for Gary Michael Weiss, U/NY/UGMA, Appellant, v. TEMPORARY INVESTMENT FUND, INC., Provident Institutional

Management Corporation, Shearson Loeb Rhoades, Inc., Russell

W. Richie, Robert R. Fortune, James Louis Robertson, Henry

M. Watts, Jr., Dr. Ralph A. Young, Thomas S. Gates, G.

Willing Pepper, Appellees.

No. 81-2688.

United States Court of Appeals, Third Circuit.

Argued April 2, 1982.

Decided Nov. 12, 1982.

Morris & Rosenthal, P.A., Wilmington, Del., Wolf Haldenstein Adler Freeman & Herz, New York City, for appellant; Daniel W. Krasner (argued), Jeffrey G. Smith, Wolf Haldenstein Adler, Freeman & Herz, New York City, of counsel.

Peter M. Mattoon, Richard Z. Freemann, Jr. (argued), Philadelphia, Pa., for appellee, Provident Institutional Management Corp., Ballard, Spahr, Andrews & Ingersoll, Philadelphia, Pa., of counsel.

David L. Foster, Paula J. Mueller, New York City, for appellee, Shearson Loeb Rhoades, Inc.; Willkie, Farr & Gallagher, New York City, of counsel.

Morris R. Brooke, James M. Sweet, James C. Ingram, Philadelphia, Pa., for appellees, Russell W. Richie, Robert R. Fortune, James Louis Robertson, Henry M. Watts, Jr., Dr. Ralph A. Young, Thomas S. Gates and G. Willing Pepper; Drinker Biddle & Reath, Philadelphia, Pa., of counsel.

Before GIBBONS, SLOVITER and BECKER, Circuit Judges.

OPINION OF THE COURT

EDWARD R. BECKER, Circuit Judge.

The principal question presented in this appeal is whether a shareholder of an investment company must make a demand on directors pursuant to Fed.R.Civ.P. 23.1 prior to commencing suit under section 36(b) of the Investment Company Act of 1940 (ICA), 15 U.S.C. Secs. 80a-35(b) (1976), to challenge the company's contracts with its investment advisers. The district judge dismissed the action for failure to satisfy the demand requirement, Weiss v. Temporary Investment Fund, Inc., 516 F.Supp. 665 (D.Del.1981), and denied the appellant leave to replead after making a demand, Weiss v. Temporary Investment Fund, Inc., 520 F.Supp. 1098 (D.Del.1981).

Appellant Weiss contends that the ICA was a product of Congress' recognition of potential conflicts of interest in the management of investment companies and that the ICA's legislative history and statutory scheme, which reflect that concern, are inconsistent with the requirement of shareholder demand. After reviewing that legislative history and statutory scheme and the purposes of the demand requirement, we perceive no such inconsistency. We conclude that the contributions of the demand requirement to corporate governance mandate application of Rule 23.1 to section 36(b) suits. We also conclude that the circumstances alleged in the complaint do not warrant excusing such a demand as futile, and the district judge did not err in denying leave to replead. We therefore affirm.

I. INTRODUCTION

A. Factual and Procedural Background

Plaintiff-appellant Melvyn I. Weiss, as custodian for his son Gary Michael Weiss, is a shareholder of the Temporary Investment Fund, Inc. (the Fund). The Fund is a no-load open-end investment company, commonly referred to as a "money market fund," whose objective is to increase the current income of its shareholders through investments in a variety of prime money market obligations. The Fund is managed by a seven-member board of directors elected by its shareholders. ¹

Under an Advisory Agreement, the management of the Fund's portfolio is entrusted to its investment adviser, Provident Institutional Management Corporation (the Adviser), a wholly-owned subsidiary of Provident National Bank (Provident). Under a sub-advisory agreement, Provident receives seventy-five percent of the Adviser's fees, in return for which it supplies, inter alia, investment research services, computer facilities, and operating personnel. Shearson Loeb Rhoades, Inc. (Shearson) serves as underwriter for the Fund and performs other administrative functions under its Administration and Distribution Agreement with the Fund.

The terms of the Advisory and Administration Agreements (collectively referred to as "advisory contracts") provide that the fees received by the Adviser and Shearson are computed as a percentage of the Fund's assets. The percentage rate is scaled downward: Shearson and the Adviser each received .175 percent of the first $300 million in assets, .15 percent of the next $300 million, and .125 percent of the third $300 million. For average net assets in excess of $900 million, the rate is fixed at .1 percent. The recent popularity of money market funds has dramatically increased the Fund's assets, to more than $2 billion when suit was commenced in 1980. This phenomenon has produced a commensurate increase in the fees received by the Adviser and Shearson.

On May 7, 1980, Weiss brought a shareholder suit on behalf of the Fund against the Adviser, Shearson, and seven directors of the Fund. One count of the complaint charges that Shearson and the Adviser breached their fiduciary duties to the Fund under section 36(b) of the ICA by receiving "excessive and unreasonable" compensation. The basis of this count is the advisory contracts, which Weiss contends permit the Adviser to receive twenty-five percent of the fees without performing any services and fail to provide for any reduction in fees after the Fund's assets exceed $900 million. Additional counts allege that all defendants breached their fiduciary duties by participating or acquiescing in the advisory contracts; that shareholder approval of the fee arrangements was secured through misleading proxy statements in violation of section 14(a) of the Securities Exchange Act of 1934, 15 U.S.C. Sec. 78n(a) (1976); and that the management and fee arrangements violate the Banking Act of 1933, 12 U.S.C. Secs. 24, 378(a) (1976), the ICA, and common law fiduciary duties. As relief, the plaintiff sought a judgment declaring the Advisory Agreement and the Distribution Agreement void, an order requiring that the Adviser and Shearson repay all excessive fees to the Fund, and an order requiring the individual defendants to reimburse the Fund for damages caused by their violations of the ICA and the Securities Exchange Act.

The complaint acknowledges that no demand was made on the directors of the Fund. It asserts, however, that demand is not a prerequisite for the section 36(b) count and that demand would have been futile as to all counts because the directors are controlled by the Fund's advisers and because they participated in the alleged violations. Amended Complaint at p 37.

The defendants moved to dismiss the complaint on a number of grounds, including the plaintiff's failure to satisfy the Rule 23.1 demand requirement. The district court, concluding that demand is required for a section 36(b) suit and was not excused as futile, dismissed the complaint. ² Having determined that intra-corporate remedies should be exhausted first, the court found it unnecessary to address the other challenges to the complaint. The court subsequently denied Weiss' motion seeking leave to make a demand on the directors and to file an amended complaint if demand was refused. Weiss appeals from all three rulings.

As we indicated at the outset, section 36(b) is the principal focus of our attention. Its relevant portions are set forth in the margin. ³ Although section 36(b) does not explicitly excuse shareholders from the demand requirement of Rule 23.1, Weiss advances two theories to support his position that demand is not required. First, he argues that because the statute does not authorize a cause of action by the corporation, a section 36(b) suit is not derivative and is thus not governed by Rule 23.1 at all. Alternatively, he asserts that the legislative history and the statutory scheme supersede the policies underlying the requirement of shareholder demand. Although he presents a number of discrete arguments to support this latter thesis, their common predicate is that Congress, perceiving directors of investment companies to be ineffective checks on advisory fee levels, structured section 36(b) to permit shareholders to bypass the directors. Before considering Weiss' specific contentions, we must describe the contours of section 36(b) and other relevant provisions of the ICA.

B. The Statutory Scheme

The management of an investment company is distinguished by its reliance on external management and investment advisers. See, e.g., Burks v. Lasker, 441 U.S. 471, 480-85, 99 S.Ct. 1831, 1838-41, 60 L.Ed.2d 404 (1979); Tannenbaum v. Zeller, 552 F.2d 402 (2d Cir.), cert. denied, 434 U.S. 934, 98 S.Ct. 421, 54 L.Ed.2d 293 (1977); Note, Mutual Fund Independent Directors: Putting a Leash on the Watchdogs, 47 Fordham L.Rev. 568 (1979) [hereinafter cited as Fordham Note]. Typically, an external organization such as Shearson creates the investment fund and appoints the initial board of directors. The board then enters into a contract with one or more external companies who manage the fund and provide investment services. In addition to receiving fees for these two functions (which may be performed by the same outside adviser), the independent advisers may receive underwriting fees or brokerage commissions if they also serve in those capacities. This web of financial ties among the fund and its advisers invites several conflicts of interest. In negotiating advisory fees, for example, directors affiliated with the adviser face the competing interests of the adviser, who seeks high fees, and the investors, who want low fees in order to maximize their return on investment. Similarly, an adviser who also serves as broker has an incentive to increase its fees through frequent portfolio transactions that may dissipate the earnings of the investors. See Fordham Note, supra p. 932, at 570-71.

The ICA was intended to minimize the potential conflicts arising from the creation, sale, and management of an investment...