JILL S. KAMEN, PETITIONER V. KEMPER FINANCIAL SERVICES, INC., AND
CASH EQUIVALENT FUND, INC.

   No. 90-516

   In The Supreme Court Of The United States

   October Term, 1990

   On Writ Of Certiorari To The United States Court Of Appeals For The
Seventh Circuit

   Brief For The Securities And Exchange Commission As Amicus Curiae
In Support Of Petitioner

           TABLE OF CONTENTS
   Question Presented
   Interest of the Securities and Exchange Commission
   Statement
   Summary of argument
   Argument:
      The court of appeals erred in formulating a universal
      demand requirement as a matter of federal
      common law
      A. Shareholder allegations of proxy violations are
         properly characterized as direct actions
      B. Demand and futility requirements for shareholder
         derivative actions under the Investment
         Company Act should be drawn from state law
         1. State law supplies the demand requirements
            applicable to federal derivative actions, unless
            state requirements are inconsistent with
            federal policy
         2. Maryland law, which excuses demand when
            it would be futile, is not inconsistent with
            the policy of the Investment Company Act
         3. The court of appeals' federal demand requirement
            is unworkable, and, if not properly restricted,
            could infringe shareholder
            rights under the Investment Company Act
   Conclusion

                          QUESTION PRESENTED

   Whether a shareholder alleging a proxy violation under Section 20
(a) of the Investment Company Act, 15 U.S.C. 80a-20 (a), and seeking
relief in favor of the investment company, is required by federal law
to make a demand on the directors of the company to bring the action
even when such a demand would be futile.

          INTEREST OF THE SECURITIES AND EXCHANGE COMMISSION

   The Securities and Exchange Commission is responsible for the
administration and enforcement of the federal securities laws,
including the Investment Company Act of 1940, 15 U.S.C. 80a-1, et seq.
 Private securities actions provide "'a most effective weapon in the
enforcement' of the securities laws and are 'a necessary supplement to
Commission action.'" Bateman Eichler, Hill Richards, Inc. v. Berner,
472 U.S. 299, 310 (1985), quoting J.I. Case Co. v. Borak, 377 U.S.
426, 432 (1964).  The standards governing demand requirements in
shareholder derivative actions under the securities laws often have a
significant impact on the disposition of those actions.  The
Commission has a strong interest, therefore, in the development of
correct principles to govern such requirements.

                               STATEMENT

   1. Petitioner Jill S. Kamen is a shareholder of respondent Cash
Equivalent Fund, Inc. (Fund), a money market mutual fund registered
under the Investment Company Act of 1940, 15 U.S.C. 80a-1, et seq.
The Fund's investment adviser and manager is respondent Kemper
Financial Services, Inc. (KFS).  Petitioner filed a complaint on
behalf of the Fund in the United States District Court for the
Northern District of Illinois, alleging violations of two provisions
of the Act by KFS.  As amended, the complaint alleges that KFS charged
the Fund excessive fees, in violation of Section 36(b) of the Act, 15
U.S.C. 80a-35(b).  The complaint also alleges that KFS caused the
Fund's directors to distribute a proxy statement, soliciting
shareholder approval to continue the investment management agreement
between KFS and the Fund, that was materially misleading in violation
of Section 20(a) of the Act, 15 U.S.C. 80a-20(a).  /1/ Pet. App. 33a,
85a-93a.

   Petitioner's proxy claim alleges that the proxy statement
misleadingly compared the fees and services required under KFS's
agreement with the Fund to those required under KFS's agreement with
another fund for which it acted as manager, the Kemper Money Market
Fund, Inc. (MM).  According to the complaint, although the proxy
statement accurately described the services rendered to the Fund and
MM as being similar, it misleadingly described the fees charged to MM.
 The resulting impression, the complaint alleges, was that KFS's fees
to MM were as high or higher than those to the Fund, when in fact
KFS's fees to MM were substantially lower.  The complaint further
alleges that as a result of the misleading solicitation, the Fund's
shareholders approved KFS's management agreement, thus causing damage
to the Fund and its shareholders.  As relief, the complaint requests
the payment of damages to the Fund.  Pet. App. 90a-91a, 93a.

   The complaint also alleges that petitioner had not made a demand on
the Fund or its directors to maintain the proxy action because demand
would have been futile.  In support of the assertion of futility, the
complaint states that three of the ten directors had a personal
financial interest in KFS;  that the Fund's president had served as
KFS's president and owned stock in its parent;  and that the
disinterested directors currently receive an aggregate of $300,000
annually for serving as directors of Kemper group funds.  The
complaint also asserts that the proxy statement was solicited by the
Fund's directors, whose culpability would tend to be established if
this suit were successful, and that demand would be tantamount to
asking the directors to sue themselves.  The complaint further alleges
that KFS controlled the Fund and its directors, and that the directors
and the Fund had manifested their opposition to the action by moving
to dismiss the original complaint.  Finally, the complaint alleges
that requiring demand would be inconsistent with the policies
underlying Section 20 of the Act.  Pet. App. 86a, 92a-93a.

   2. The district court dismissed the Section 20 claim on the ground
that petitioner's allegations of the futility of demand failed to
comply with the requirements of Rule 23.1 of the Federal Rules of
Civil Procedure.  /2/ Pet. App. 46a-56a.  Examining the complaint in
light of federal cases addressing the futility exception, the court
concluded that petitioner did not particularize sufficient reasons for
failing to make demand on the Fund's directors.  Rather, petitioner's
"generalized allegations" of futility "have been consistently rejected
by the courts as inadequate under Rule 23.1." Pet. App. 51a.  /3/

   3. The court of appeals affirmed the dismissal of petitioner's
proxy claim.  /4/ Although agreeing with the district court that
petitioner's allegations of futility were inadequate, Pet. App. 6a,
17a, the court of appeals went on to formulate a new rule, as a matter
of federal common law, that demand on directors is a universal
requirement in cases in which shareholders bring derivative actions
under a federal statute;  futility never excuses demand.  Id. at 20a.
The court said:  "(C)laims of futility should be tested by making the
demand rather than by arguing about hypotheticals.  If the firm
declines to sue, the court can decide whether the board's decision is
entitled to respect under state corporate law." Ibid.

   In explaining its holding, the court acknowledged that it is
theoretically correct that demand should be excused if the courts
would not honor the board's decision not to sue.  But the court
observed that in practice it is difficult to resolve contested claims
that demand would be a futile gesture.  Pet. App. 14a-15a.  Claims of
futility, the court thought, are hotly contested because of the
principle embraced by some States that when a shareholder makes a
demand, review of the board's decision not to sue is conducted under
the highly deferential business judgment standard.  Id. at 12a.  The
court rejected that principle, however, concluding that "when the
demand requirement comes from federal common law, the making of a
demand does not affect the standard with which the court will assess
the board's decision not to sue." Id. at 13a.  Having "sever(ed) the
link between demand and the standard of review," the court concluded
that the difficulties in determining whether demand is futile "are not
worth incurring." Id. at 14a.

   In formulating these principles, the court declined to consider
whether proxy claims are properly characterized as derivative actions
at all for purposes of Rule 23.1, because that point had not been
raised by petitioner.  Pet. App. 6a-7a.  The court also noted that it
could be argued that demand requirements should be drawn from state
corporate law, but it declined to consider that argument because
petitioner did not rely on the law of Maryland, where the Fund is
incorporated, until filing her reply brief.  Id. at 8a-9a.  Finally,
the court recognized that Supreme Court decisions from the early years
of the century arguably established a federal futility exception to
the demand requirement.  Id. at 18a, citing Doctor v. Harrington, 196
U.S. 579 (1905);  Delaware & Hudson Co. v. Albany & Susquehanna R.R.,
213 U.S. 435, 447 (1909).  But the court of appeals concluded that
those decisions had either been overruled sub silentio, or were out of
step with contemporary developments in corporate law;  accordingly,
the court concluded that neither case prevented it from abandoning the
futility exception as a matter of federal common law.  Pet. App. 20a.

                          SUMMARY OF ARGUMENT

   A. A claim that a misleading proxy statement was used to solicit
shareholder votes is a direct shareholder action that does not
implicate the requirement of demand applicable to derivative actions.
The essence of a derivative action is the shareholder's assertion, on
behalf of the corporation, of a legal claim that the corporation has
against the directors, officers, or third parties.  The demand
requirement exists in such cases to preserve the primacy of corporate
directors in managing the enterprise's affairs.  But where the
underlying claim belongs directly to shareholders, demand is not
necessary.  Cf. Daily Income Fund, Inc. v. Fox, 464 U.S. 523 (1984).
That is the situation in this case.

   Petitioner's action asserts a violation of the shareholders' right
to receive truthful and complete information about questions presented
to shareholders for a vote.  It follows from the purpose of federal
proxy regulation -- to protect the shareholders' right to honest
disclosure -- that a shareholder's proxy action does not assert a
claim that belongs to the corporation.  Accordingly, the demand
requirement, and the body of principles designed to determine when
demand is excused, does not apply in this context.

   B. On the assumption that a demand requirement is at issue here,
the court of appeals erred in formulating a universal demand
requirement as a matter of federal common law, thus abolishing any
exception for cases in which demand would be futile.  The issue in
this case is governed by Burks v. Lasker, 441 U.S. 471 (1979), which
held that rules establishing the powers of corporate directors are
generally drawn from state law, unless those rules are inconsistent
with federal policy.  Burks involved a core issue of corporate law --
the power of disinterested directors to terminate derivative
litigation.  Here too, the issue of demand on directors is a core
issue of corporate law that should be controlled, absent a conflict
with federal policy, by state law.

   The law of Maryland, the State of the Fund's incorporation,
recognizes a futility exception to the demand requirement.  Nothing in
the policy of the Investment Company Act is inconsistent with a
futility exception.  Although the Act creates disinterested directors
who serve a valuable watchdog function in investment companies, no
federal policy is frustrated by excusing demand on a board of
directors when it would be futile.

   The court of appeals' federal demand requirement is also
objectionable on its own terms.  Not only would it complicate the
selection of state rules applicable to the directors' efforts to
terminate derivative actions, it could dilute the standards under
which those efforts are reviewed by the courts, contrary to federal
policy.  Those difficulties provide added reasons for adhering to the
approach of Burks v. Lasker of borrowing state law on internal
corporate affairs unless federal policy requires otherwise.

                               ARGUMENT

   THE COURT OF APPEALS ERRED IN FORMULATING A UNIVERSAL DEMAND
REQUIREMENT AS A MATTER OF FEDERAL COMMON LAW

   A. Shareholder Allegations Of Proxy Violations Are Properly
Characterized As Direct Actions

   Before applying any demand requirement, the threshold inquiry is
whether a particular claim is a derivative action within the meaning
of Rule 23.1 of the Federal Rules of Civil Procedure.  The rule
applies to "a derivative action brought by one or more shareholders *
* * to enforce a right of a corporation * * *, the corporation * * *
having failed to enforce a right which may properly be asserted by
it(.)" Fed. R. Civ. P. 23.1 (emphasis added).  In our view, a
shareholder's proxy suit asserts a legal claim belonging to the
shareholder himself, and is not subject to a requirement that the
shareholder must make demand on the directors as a prerequisite to
maintaining the action.  /5/

   1. Shareholder derivative actions originated in equity as the
consolidation of two distinct claims:  first, the claim by a
shareholder that the corporation has failed to assert a corporate
right, and, second, the claim by the corporation against the
directors, officers, or third parties who are liable to it.  See Hawes
v. Oakland, 104 U.S. 450, 452 (1882);  Ross v. Bernhard, 396 U.S. 531,
534-535 (1970);  Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984);  13
W. Fletcher, Cyclopedia of the Law of Private Corporations Sections
5941.1, 5946 (1984 rev. ed. & Supp. 1990);  Block, Radin & Rosenzweig,
The Role of the Business Judgment Rule in Shareholder Litigation at
the Turn of the Decade, 45 Bus. Law. 469, 470-471 (1990).  Because the
purpose of the action is to allow shareholders to protect corporate
rights, "(t)he heart of the action is the corporate claim." Ross v.
Bernhard, 396 U.S. at 539.  See Daily Income Fund, Inc. v. Fox, 464
U.S. 523, 528-529 (1984);  Cohen v. Beneficial Loan Corp., 337 U.S.
541, 548 (1949) (in a derivative action, the shareholder steps into
the corporation's shoes and seeks in its right "the restitution he
could not demand in his own");  Meyer v. Fleming, 327 U.S. 161, 167
(1946) (derivative suit "enforce(s) a corporate claim * * * where the
management * * * declines to take the proper and necessary steps to
assert the rights which the corporation has").

   The demand requirement is integrally tied to the character of a
derivative action as the assertion of a corporate claim.  It reflects
the principle that the management of the corporation is entrusted to
its directors, not its shareholders.  As the Court explained in United
Copper Securities Co. v. Amalgamated Copper Co., 244 U.S. 261, 263
(1917), "(w)hether or not a corporation shall seek to enforce in the
courts a cause of action for damages is, like other business
questions, ordinarily a matter of internal management and is left to
the discretion of the directors(.)" Directors, exercising business
judgment, "may sometimes properly waive a legal right vested in the
corporation in the belief that its best interests will be promoted by
not insisting on such right." Corbus v. Alaska Treadwell Gold Mining
Co., 187 U.S. 455, 463 (1903), see also Ashwander v. TVA, 297 U.S.
288, 343 (1936) (Brandeis, J., concurring);  Delaware & Hudson Co. v.
Albany & Susquehanna R.R., 213 U.S. 435, 446 (1909).

   But the purposes of the demand requirement define the limits of its
application.  For example, if the corporation is not authorized to
assert a particular cause of action, shareholders need not make a
demand on the directors to do so.  In Daily Income Fund, Inc. v. Fox,
supra, the Court applied that principle, holding that the provisions
of Rule 23.1 are inapplicable to a claim by a security holder under
Section 36(b) of the Investment Company Act, 15 U.S.C. 80a-35(b), that
an investment adviser has breached its fiduciary duty with respect to
the receipt of compensation from the company.  The Court explained
that Section 36(b) expressly authorizes security holders and the SEC
to enforce such claims, but does not authorize the investment company
itself to do so.  Since the claim is not one that the company could
assert, it is not a derivative action under Rule 23.1.  464 U.S. at
534-542.  An analogous principle applies if the cause of action arises
not from the invasion of the corporation's legal rights, but from the
invasion of the shareholders' legal rights.  In that setting, the
cause of action is not "derived from the corporation," Cohen v.
Beneficial Loan Co., 337 U.S. at 549, and is not properly subject to
its control.  Cf. Smith v. Sperling, 354 U.S. 91, 99 (1957)
(Franfurter, J., dissenting) (contrasting derivative action from the
"wholly different situation * * * which arises when the corporation is
charged with invasion of the stockholder's independent right").

   2. In light of those principles, a shareholder's claim based on a
proxy violation is a direct action that does not implicate the
requirement of demand.  A proxy claim asserts a violation of a
shareholder's own right to truthful and complete information in
communications used to solicit his vote.  Section 14(a) of the
Securities Exchange Act of 1934, 15 U.S.C. 78n(a) -- the original
provision in the securities laws regulating the solicitation of
proxies -- was intended to "control the conditions under which proxies
may be solicited with a view to preventing the recurrence of abuses
which (had) frustrated the free exercise of the voting rights of
stockholders." H.R. Rep. No. 1383, 73d Cong., 2d Sess. 14 (1934).  The
provision's purpose is to guarantee that persons soliciting proxies
will provide "an explanation to the stockholder of the real nature of
the questions for which authority to cast his vote is sought." S. Rep.
No. 792, 73d Cong., 2d Sess. 12 (1934).  See J. I. Case Co. v. Borak,
377 U.S. 426, 431 (1964);  Mills v. Electric Auto-Lite Co., 396 U.S.
375, 381 (1970).  In 1940, Congress likewise empowered the SEC to
prescribe proxy-solicitation rules for investment companies "as
necessary or appropriate in the public interest or for the protection
of investors." 15 U.S.C. 80a-20(a) (emphasis added).  See S. Rep. No.
1775, 76th Cong., 3d Sess. 17 (1940).

   It follows from the purpose of federal proxy regulation that when a
shareholder's vote is secured through a false or misleading proxy
statement, it is the personal right of the shareholders to "(f)air
corporate suffrage" that is violated.  H.R. Rep. No. 1383, supra at
13.  When the shareholder sues to vindicate that right, the action
asserts a direct infringement of federal requirements enacted for his
benefit;  the claim does not "derive" from an invasion of legal rights
belonging to the corporation.  Accordingly, the conceptual
underpinning for requiring demand in a derivative case -- that the
right in question belongs to the corporation -- is absent.  /6/

   It would be deeply ironic if directors could secure the
shareholders' votes through a misleading proxy statement, and then
insist that a shareholder seeking redress make demand on the directors
before suing.  Cf. Galef v. Alexander, 615 F.2d 51, 63 (2d Cir. 1980)
(purposes of the proxy provision "would quite clearly be frustrated"
if a director sued for proxy violations "were permitted to cause the
dismissal of that action simply on the basis of his judgment that its
pursuit was not in the best interests of the corporation").  /7/ Even
if the directors could not obtain the outright dismissal of a proxy
claim in all instances when the shareholder did not make demand, the
demand requirement would impose an unwarranted procedural hurdle with
potential delay and additional costs that would obstruct the
shareholders' assertion of their right to truthful proxy statements.

   Characterizing a proxy claim as a direct action does not deprive
directors of means to oppose a suit they believe to be contrary to the
shareholders' interests.  /8/ The corporation is frequently named as a
nominal defendant in proxy litigation to obtain complete relief, and,
where it is not, it may intervene as a party under the customary
standards for intervention.  In that capacity, the corporation may
urge that the complaint lacks merit, or that the relief sought would
not be "in the best interests of the shareholders as a whole." Cf.
Mills v. Electric Auto-Lite Co., 396 U.S. at 388.

   Nor should the type of relief sought by a shareholder's proxy
action affect the analysis.  To be sure, a proxy action may loosely be
called derivative -- "in the broad sense of that word" -- if it seeks
a monetary recovery in the corporation's favor.  See Fox, 464 U.S. at
535 n.11.  Indeed, in J. I. Case Co. v. Borak, 377 U.S. at 431, the
Court described the implied private right for proxy violations as
including derivative as well as direct claims.  /9/ That description
reflects the hybrid aspect of a proxy action like petitioner's:  the
action asserts a violation of shareholder rights, but seeks recovery
for the benefit of the corporation.  /10/ But, as Fox illustrates, not
all suits seeking a recovery for the benefit of the corporation
qualify as derivative actions in the relevant sense.  "(T)he
provisions (of Rule 23.1) regarding demand assume a lawsuit that could
be controlled by the corporation's board of directors." Fox, 464 U.S.
at 533.  When the legal claim could not properly be controlled by the
board, the rules developed to protect the directors' primacy in
overseeing corporate affairs do not apply.

   B. Demand and Futility Requirements For Shareholder Derivative
Actions Under The Investment Company Act Should Be Drawn From State
Law

   On the assumption that petitioner's action is viewed as a
derivative one that implicates the demand requirement, the court of
appeals erred in its novel formulation of a federal demand rule.
Asserting the power to make federal common law, the court of appeals
imposed a universal demand requirement in all derivative actions
arising under a federal statute, thereby eliminating the traditional
exception for futility.  In our view, the court of appeals should not
have confronted the demand question armed solely with federal common
law, without initial consultation of state corporate law.  In this
case, as in Burks v. Lasker, 441 U.S. 471 (1979), state law furnishes
the applicable rule unless it conflicts with federal policy.

   1. State law supplies the demand requirements applicable to federal
derivative actions, unless state requirements are inconsistent with
federal policy

   Because petitioner's cause of action arises under a federal
statute, federal law governs the incidents of the action;  "state law
does not operate of its own force." Burks v. Lasker, 441 U.S. at 480;
Sola Elec. Co. v. Jefferson Elec. Co., 317 U.S. 173, 176 (1942);
D'Oench, Duhme & Co. v. FDIC, 315 U.S. 447, 471-472 (1942) (Jackson,
J., concurring).  But federal law may look to state sources to derive
the appropriate rule of decision, particularly in an area in which the
States enjoy primary responsibility.  See Reconstruction Finance Corp.
v. Beaver County, 328 U.S. 204, 210 (1946) (applying state property
law);  De Sylva v. Ballentine, 351 U.S. 570, 580 (1956) (applying
state domestic relations law).  The substantive law of corporations
belongs to this category.  Although federal principles may, "where the
facts require(), control the appropriateness of redress despite the
provisions of state corporation law," J. I. Case Co. v. Borak, 377
U.S. at 434, "the first place one must look to determine the powers of
corporate directors is in the relevant State's corporation law."
Burks, 441 U.S. at 478.  See Cort v. Ash, 422 U.S. 66, 84 (1975);  cf.
Milwaukee v. Illinois, 451 U.S. 304, 313-314 (1981).

   In Burks v. Lasker, the Court considered which law -- state or
federal -- applies when an independent committee of directors seeks to
terminate a shareholder's derivative claim under the Investment
Company Act.  /11/ 441 U.S. at 475.  The Court held that the issue
should be resolved by applying a two-step analysis.  First, because
"(c)orporations are creatures of state law * * * and it is state law
which is the font of corporate directors' powers," that body of law
should be consulted as an initial matter.  Id. at 478.  Federal law
for corporations, the Court explained, "is largely regulatory and
prohibitory in nature -- it often limits the exercise of directorial
power, but only rarely creates it." Ibid.  Consequently,
"congressional legislation is generally enacted against the background
of existing state law" which is not displaced "simply because a
plaintiff's cause of action is based upon a federal statute." Ibid.
Second, a court must determine whether state law permits action that
is prohibited by federal law or is inconsistent with underlying
federal policy;  if it does, federal policy prevails.  Id. at 479.
This "'consistency' test guarantees that '(n)othing that the state can
do will be allowed to destroy the federal right.'" Id. at 480, quoting
Board of County Comm'rs v. United States, 308 U.S. 343, 350 (1939).
/12/

   The analysis in Burks governs the issue of director demand in this
case.  The demand requirement, like the authority of disinterested
directors to terminate derivative litigation, expresses a policy with
respect to the management of a corporation's internal affairs.  The
preeminent reason for requiring demand is to further "a principle
basic to corporate organization, that the management of the
corporation be entrusted to its board of directors." Note, The Demand
and Standing Requirements in Stockholder Derivative Actions, 44 U.
Chi. L. Rev. 168, 171 (1976);  Hawes v. Oakland, 104 U.S. at 462;
Daily Income Fund, Inc. v. Fox, 464 U.S. at 530.  Demand may also
serve to stimulate alternative dispute resolution, to allow the
corporation to assert the derivative claim directly, and to discourage
"strike" suits.  See D. DeMott, Shareholder Derivative Actions:  Law
and Practice Section 5:03, at 26-27 (1987);  Block, Radin &
Rosenzweig, supra, at 472-473;  Aronson v. Lewis, 473 A.2d 805,
811-812 (Del. 1984);  13 W. Fletcher, supra, Section 5963.  Each of
those reasons reflects substantive policy choices about the internal
management of corporate affairs.  Indeed, in the law of some States,
the demand requirement is interwoven with the power of disinterested
directors to terminate derivative litigation.  See Spiegel v.
Buntrock, 571 A.2d 767 (Del. 1990).  Accordingly, state requirements
with respect to demand, which are found in the law of every State, see
D. DeMott, supra, Section 5:03, at 23, should be given effect in
federal derivative litigation in the absence of a conflict with
federal policy.  /13/

   Rule 23.1 of the Federal Rules of Civil Procedure does not require
courts to fashion a body of federal law to govern demand.  /14/ On its
face, the Rule does not establish a specific requirement of demand,
but simply requires that "(t)he complaint shall * * * allege with
particularity the efforts, if any, made by the plaintiff to obtain the
action the plaintiff desires from the directors * * * and the reasons
for the plaintiff's failure to obtain the action or for not making the
effort" (emphasis added).  The Rule does not discuss the consequences
of omitting to make demand, nor does it address when, if ever, demand
is excused.  Its purpose is to establish a pleading requirement, with
substantive standards to be supplied from another source.  Starrels v.
First Nat'l Bank, 870 F.2d 1168, 1170 (7th Cir. 1989).  Indeed,
construing Rule 23.1 to create substantive standards for demand would
conflict with the Rules Enabling Act, 28 U.S.C. 2072, which provides
that rules of civil procedure may not "abridge, enlarge or modify any
substantive right." See Mississippi Publishing Corp. v. Murphee, 326
U.S. 438, 445-446 (1946);  Sibbach v. Wilson & Co., 312 U.S. 1, 14
(1941);  cf. Bangor Punta Operations, Inc. v. Bangor & A. R.R., 417
U.S. 703, 708 n.4 (1974).  /15/

   2. Maryland law, which excuses demand when it would be futile, is
not inconsistent with the policy of the Investment Company Act

   Applying the approach established in Burks, the first step is to
select a body of state law.  Here, the relevant law is that of
Maryland, the State in which the Fund is incorporated.  See CTS Corp.
v. Dynamics Corp., 481 U.S. 69, 89 (1987).  Maryland law does not
require that demand be made in all derivative actions;  rather, it
embodies a traditional exception that demand is excused if it would be
futile.  See Parish v. Maryland & Virginia Milk Producers Ass'n, 250
Md. 24, 81-84, 242 A.2d 512, 544-545 (1968).  /16/

   The second step is to measure the requirements of state law against
federal policy.  In our view, nothing in the Act overrides Maryland's
recognition of a futility exception to making demand.  To begin with,
the Act contains no express provision requiring shareholders to make
demand on the directors prior to bringing a derivative action.  In
contrast, Congress created a demand requirement for actions under
Section 16(b) of the Securities Exchange Act of 1934, 15 U.S.C.
78p(b), and made Section 16(b) applicable to closed-end investment
companies.  /17/ 15 U.S.C. 80a-29(f).  Cf. General Motors Corp. v.
United States, 110 S. Ct. 2528, 2532 (1990).  Nor is Maryland's
recognition of a futility exception inconsistent with the policies of
the Act.  Indeed, it would be anomalous to conclude that the Act's
policies impose greater restrictions on investment company
shareholders than are imposed on other shareholders in publicly held
companies, as the Act was intended to fortify, not undermine,
shareholder protection.  See 15 U.S.C. 80a-1(b) (2).

   The Act does rely heavily on disinterested directors to protect
shareholder interests, see Daily Income Fund, Inc. v. Fox, 464 U.S. at
536-537;  Burks v. Lasker, 441 U.S. at 470-471.  But that reliance
does not imply a requirement of universal demand.  The Act requires
that 40% of the company's board consist of independent directors who
are neither "affiliated" nor "interested" persons as defined in the
Act, 15 U.S.C. 80a-2(a) (19), 80a-10(a), and entrusts those directors
with a variety of responsibilities, including the review and approval
of the investment adviser and principal underwriter's contracts, 15
U.S.C. 80a-15(c), the appointment of directors to fill certain
vacancies, 15 U.S.C. 80a-16(b), and the selection of the company's
outside auditor, subject to shareholder ratification, 15 U.S.C.
80a-31(a).

   But "(a)ttention must be paid as well to what Congress did not do."
Burks, 441 U.S. at 483.  Although Congress intended the independent
directors to serve as "'watchdogs' to protect shareholder interests,"
id. at 485, it did not give directors absolute power;  rather,
Congress also gave shareholders an important voice in company affairs.
 It is particularly relevant to the proxy claims here that the Act
requires the initial investment advisory agreement to be approved not
only by the disinterested directors, but also by "the vote of a
majority of the (company's) outstanding voting securities." 15 U.S.C.
80a-15(a) and (c).  In addition, the Act identifies several
significant business changes that cannot be made without a similar
level of shareholder approval.  15 U.S.C. 80a-13(a).  /18/ Indeed, in
the critical area of policing against fiduciary breaches by the
investment adviser involving compensation, Congress determined to rely
exclusively on shareholders and the SEC, not the disinterested
directors, to bring suit to safeguard shareholder interests.  15
U.S.C. 80a-35(b);  Fox, 464 U.S. at 534-535.  These inroads on what
would normally be management prerogatives reveal that Congress did not
intend to leave the protection of shareholder rights entirely in the
hands of the disinterested directors.  Rather, Congress carefully
strengthened the role of disinterested directors in certain quite
specific ways, and limited the board's authority in others.  It is
reasonable to assume that where Congress did not see fit to act, the
background rules of state corporate law ordinarily continue to
operate.

   In our view, no policy found in the statutory scheme dictates a
displacement of the traditional futility exception by a universal
demand requirement.  The law of Maryland, like that of most other
jurisdictions, recognizes that demand generally fulfills valuable
corporate purposes, but occasionally plays no useful role in
regulating derivative claims.  It is not necessary to further the
policies of the Act that Maryland law be supplanted by a federal rule.

   3. The court of appeals' federal demand requirement is unworkable,
and, if not properly restricted, could infringe shareholder rights
under the Investment Company Act

   The court of appeals purported to formulate a federal
universal-demand requirement after "sever(ing) the link between demand
and the standard of review" applied to the directors' decision not to
sue.  In so holding, the court expressed its disagreement with those
States that treat the making of demand as having significant
consequences for the standard of review.  Pet. App. 12a-14a, 20a.  But
the court's attempt to liberate the demand requirement from the
subsequent course of derivative proceedings gives rise to perplexing
and unresolved complications.  Moreover, the application of a
universal demand requirement could, in certain cases, undermine
investor protection.  Both of those considerations counsel strongly
against adoption of the court of appeals' sharp break with state law.

   a. In the law of most States, the demand requirement does not exist
in isolation;  it is part of a larger web of principles for
determining when directors can obtain the dismissal of a derivative
claim.  The law of Delaware well illustrates the interdependence of
principles in this area.  In Delaware law, there are two categories of
derivative cases:  those in which demand is required, and those in
which it is excused.  /19/ In "demand required" cases, if a
shareholder files a derivative action after the board has rejected his
demand, the board's refusal to sue is tested under the deferential
standards of the business judgment rule.  Under those standards, the
board's rejection of demand "will be respected unless it was
wrongful." Zapata Corp. v. Maldonado, 430 A.2d 779, 784 (Del. 1981).
The shareholder must carry the burden of establishing facts to
overcome the directors' decision.  /20/ In "demand excused" cases,
however, an entirely different standard applies.  After the
shareholder initiates the derivative action, the board is not ousted
of power to terminate it;  although self-interested directors cannot
act for the board, disinterested directors may still express the
corporation's viewpoint that the suit should be dismissed.  Id. at
785-786.  /21/ But if disinterested board members make that
determination, their decision is tested against a dual standard:  (1)
the directors must shoulder the burden of establishing the
independence and good faith of their committee, and the reasonableness
of its investigation, and (2) the court has discretion to apply its
independent business judgment to determine whether dismissal of the
action is in the corporation's best interest.  Id. at 788-789;  Kaplan
v. Wyatt, 499 A.2d 1184, 1192 (Del. 1985).  /22/

   The creation of a universal demand requirement, as a matter of
federal law, undercuts the application of Delaware's two-tier regime.
At best, the elimination of the demand-excused category would be a
source of confusion about how to apply that branch of Delaware law.
If demand is made and rejected, is the applicable standard the
business judgment rule or the Zapata two-part test?  Does the standard
depend on whether demand would have been excused under Delaware law?
And who bears the burden of proof?  Delaware law supplies no answers
to those questions.  It eliminates the possibility that a shareholder
who makes demand may still assert that demand was excused;  if demand
is made, the business judgment rule applies.  Spiegel v. Buntrock, 571
A.2d 767, 777 (1990).  The federal universal-demand requirement
disregards that "the entire question of demand futility is
inextricably bound to issues of business judgment and the standards of
that doctrine's applicability." Aronson v. Lewis, 473 A.2d at 812.

   At worst, the newly minted federal standard would operate to
undermine settled state precedents in needless tension with the
holding of Burks v. Lasker.  Under Burks, the authority of
disinterested directors to terminate derivative litigation is governed
by state law, absent inconsistency with federal policy.  But if courts
are unable to identify the applicable state rule -- as may well happen
after a shareholder complies with a federal universal demand
requirement -- they would necessarily end up improvising new rules to
fit particular cases.  Not only would that run counter to Burks, it
also clashes with the chief objective of the Seventh Circuit's rule:
to simplify derivative litigation.  Rather than ushering in an era of
simplicity, the court of appeals' rule bids fair to entangle
derivative suits in a protracted process of searching for rules to
bridge the gap between state and federal requirements.

   b. The court's universal demand requirement could also have
troubling, and, in our view, impermissible, consequences for the
enforcement of claims under the Investment Company Act.  Although the
court of appeals purported not to determine the standard for reviewing
the board's decision not to sue after a shareholder makes demand, the
court seemed to endorse the view that all litigation decisions by
disinterested directors would be reviewed under the deferential
standards of the business judgment rule.  Pet. App. 10a-11a, 15a, 17a.

   The directors' opinion that a derivative action is inimical to the
shareholders' best interests may be perfectly valid;  the costs of
pursuing a particular corporate claim may outweigh the benefits.  But
the standards for reviewing that determination must be consistent with
the purpose of the Investment Company Act to protect shareholders
against conflicts of interest by corporate directors.  15 U.S.C.
80a-1(b) (2).  The precise standards that should govern are not at
issue here, and are a matter covered by state law in the first
instance.  But we believe that in certain circumstances, shareholders
must be able to pursue suits on behalf of their companies even when
directors object.  See Burks, 441 U.S. at 481 ("(P)otential conflicts
may justify some restraints upon the unfettered discretion of even
disinterested mutual fund directors, particularly in their
transactions with the investment adviser.").  Simplifying the law of
demand is an admirable goal, but it is not a goal that justifies
compromising the ability of shareholders to protect themselves, and
the corporation, from improper transactions resulting from conflicts
of interest.  /23/

   c. The difficulties with the court of appeals' holding -- both in
accommodating the federal demand requirement to the surrounding legal
rules derived from state law, and in avoiding undue infringement of
investor protection -- flow from a single source:  the court's
departure from the framework of analysis established by Burks v.
Lasker, supra.  State law governing shareholder derivative actions may
be subject to criticism on policy grounds, as the court of appeals
thought.  Nevertheless, if inadequacies in policy require an overhaul
of corporate governance rules, the proper bodies to address that
issue, if federal law has not done so, are the legislatures and courts
of the States.  /24/ Burk's approach "relieves federal courts of the
necessity to fashion an entire body of federal corporate law out of
whole cloth." 441 U.S. at 480.  This case illustrates the wisdom and
vitality of that approach.

                      * * * * *

   Petitioner's proxy claim is properly characterized as a direct
action that is not subject to a requirement of demand.  Alternatively,
if a demand requirement does apply here, Maryland's recognition of a
futility exception to demand is controlling.  In our view, the initial
examination of Maryland law, and its application to petitioner's
allegations, should be undertaken by the courts below.  Cf. Burks v.
Lasker, 441 U.S. at 486;  United States v. Kimbell Foods, Inc., 440
U.S. 715, 740 (1979).

                              CONCLUSION

   The judgment of the court of appeals should be reversed.

   Respectfully submitted.

   KENNETH W. STARR

      Solicitor General

   JOHN G. ROBERTS, JR.

      Deputy Solicitor General

   MICHAEL R. DREEBEN

      Assistant to the Solicitor General

   JAMES R. DOTY

      General Counsel

   PAUL GONSON

      Solicitor

   JACOB H. STILLMAN

      Associate General Counsel

   LUCINDA O. McCONATHY

      Assistant General Counsel

   RANDALL W. QUINN

   BRIAN F. McNALLY

      Attorneys Securities and Exchange Commission

   JANUARY 1991

   /1/ Section 20(a) of the Act, 15 U.S.C. 80a-20(a), is virtually
identical to the proxy provision of the Securities Exchange Act of
1934, Section 14(a), 15 U.S.C. 78n(a).  Rule 20a-1 under the Act, 17
C.F.R. 270.20a-1, adopts the rules promulgated under Section 14(a) of
the Exchange Act, 17 C.F.R. 240.14a-1.

   /2/ Rule 23.1 applies to shareholder derivative actions and
requires a shareholder to allege "with particularity" his efforts, if
any, to obtain the action desired from the directors, and "the reasons
for the (shareholder's) failure to obtain the action or for not making
the effort."

   /3/ The court also dismissed petitioner's claim under Section 36(b)
of the Act, on the basis that petitioner was not an adequate class
representative.  Pet. App. 73a-77a, 79a, 84a.

   /4/ It reversed the dismissal of petitioner's Section 36(b) claim,
Pet. App. 22a-29a, but rejected her request for a jury trial.  Id. at
29a-32a.  Because the grant of certiorari is limited to the first
question presented by the petition, no issue under Section 36(b) is
before this Court.

   /5/ Petitioner's complaint alleges that her action is brought on
behalf of the Fund, Pet. App. 86a, and she conceded the applicability
of Rule 23.1 in the court of appeals.  Consequently, that court noted
but did not address the issue whether the action is properly treated
as direct in nature.  Pet. App. 7a.  Although the petition does not
challenge the applicability of Rule 23.1, the question presented is
framed broadly enough to encompass that issue, see Sup. Ct. R.
14.1(a), and the Court has discretion to address it as an "antecedent"
question that is "ultimately dispositive of the present dispute."
Arcadia v. Ohio Power Co., 111 S. Ct. 415, 418 (1990).

   /6/ The corporation may also bring a proxy claim in certain
circumstances, but in such a case, the claim is properly viewed as
deriving from a violation of the shareholders' rights.  See Piper v.
Chris-Craft Indus., Inc., 430 U.S. 1, 32 & n.21 (1977).

   /7/ In Galef, the Second Circuit held that federal policy precludes
defendant directors in a Section 14(a) action from summarily
dismissing that claim pursuant to the business judgment rule.  615
F.2d at 64;  see id. at 64 n.20 (reserving the issue of whether a
committee of disinterested directors could, consistent with federal
policy, terminate a proxy suit on business judgment grounds).

   /8/ Nor does it prevent investment company directors from
fulfilling their statutory duties.  Although the Act requires
disinterested directors who serve as "watchdogs" for investors, see
infra at 19, nothing in the Act or its policies empowers those
directors to control direct shareholder actions.

   /9/ The Court has since made clear that the cause of action
recognized in Borak flows from the violation of all of the
shareholders' rights, and that "(t)he Borak Court was thus focusing on
all stockholders -- the owners of the corporation -- as the
beneficiaries" of the proxy provision.  Piper v. Chris-Craft Indus.,
Inc., 430 U.S. at 32 & n.21.  Borak's characterization of the action
before it as "derivative" did not rely on the factors governing
whether an action is considered derivative under traditional concepts,
see Hawes v. Oakland, 104 U.S. at 460, or contemporary jurisprudence,
see Daily Income Fund, Inc. v. Fox, supra.  Above all, nothing in
Borak indicates that the Court had in mind the corporate management
issues underlying the demand requirement as applied to true derivative
actions.  At most, the relief authorized by Borak is derivative;  the
underlying claim is not.  Cf. Mills, 396 U.S. at 388 (discussing
"derivative" relief).

   /10/ Of course, a particular proxy action may seek direct damages
to be paid to the shareholder plaintiffs, and have no element that
could be viewed as derivative.  See, e.g., Virginia Bankshares, Inc.
v. Sandberg, No. 89-1448 (argued Oct. 9, 1990).  Other actions may
simultaneously seek, as alternative relief, the direct payment of
damages to shareholders and other forms of relief for the
corporation's benefit.  See Mills, 396 U.S. at 388-389.  A rule
distinguishing proxy claims by the form of relief sought, requiring
demand for some but not for others, would produce nothing but
confusion.

   /11/ In Burks, shareholders of an investment company filed a
derivative action against the company's directors and its investment
adviser, alleging that the defendants had breached their duties under
the Act and the common law by purchasing a particular issuer's
commercial paper without making an adequate independent investigation
of its quality and safety.  441 U.S. at 473-474.  In response to the
action, the board appointed a quorum of independent directors to
determine the company's position in the case.  Following an
investigation, the committee determined that the suit was contrary to
the shareholders' interest, and sought its dismissal.  Id. at 474.
The court of appeals held that the Investment Company Act deprived
disinterested directors of the power to terminate such derivative
litigation.  Id. at 475.  This Court reversed, holding that federal
law had a narrower sweep.  Id. at 480-485.

   /12/ The approach marked out in Burks contrasts with the approach
for choosing between state and federal law in selecting a statute of
limitations for a federal claim that lacks an express limitations
period.  See SEC Amicus Brief, Lampf Pleva Lipkind Prupis & Petigrow
v. Gilbertson, No. 90-333 (to be argued Feb. 19, 1991) (arguing that a
five-year federal limitations period should be applied to implied
actions under Rule 10b-5).  (We have provided copies of our brief in
Lampf to the parties here.) The different test prescribed in Burks can
be explained as a response to the characteristic relationship between
state and federal law in corporate matters:  federal law generally
imposes restrictions on internal management, rather than providing
"the source of authority for managerial power." 441 U.S. at 478.  In
contrast, there is no similar division of responsibilities between the
state and federal governments in devising statutes of limitations.

   /13/ As this Court noted in Fox, 464 U.S. at 530-531, the demand
requirement that was established as a matter of federal common law in
Hawes v. Oakland, supra, and later codified in Equity Rule 94, 104
U.S. ix-x (1882), served the additional purpose of preventing the
collusive manufacture of diversity jurisdiction.  That policy, along
with other policies designed to reduce federal court adjudication of
state claims, continues to be reflected in Rule 23.1.  Fox, 464 U.S.
at 531 n.6.  But the major purpose of the demand requirement is to
promote substantive policies regarding the litigation of corporate
claims.  Id. at 532-533;  id. at 544 n.2 (Stevens, J., concurring)
("It cannot be doubted that (the demand) requirement, designed to
improve corporate governance, is one of substantive law.").

   /14/ In Fox, the Court reserved this issue of whether Rule 23.1
establishes a demand requirement as a matter of federal procedure.
464 U.S. at 532 n.8;  see also id. at 543-544 (Stevens, J.,
concurring) (arguing that Rule 23.1 "concerns itself solely with the
adequacy of the pleadings;  it creates no substantive rights").

   /15/ As the court of appeals noted (Pet. App. 18a-20a), this Court
developed a demand requirement, and exceptions to it, in a line of
cases decided before Erie R.R. v. Tompkins, 304 U.S. 64 (1938).
Whether or not those cases can be distinguished as the court of
appeals suggested -- and whether, after Erie, they carry weight apart
from their persuasive force, see Clearfield Trust Co. v. United
States, 318 U.S. 363, 367 (1943) -- our essential point is this:  this
Court's decision in Burks v. Lasker, supra, makes clear that those
early decisions do not control the analysis of what is required, in a
federal action, with respect to core issues of corporate law such as
demand.  Likewise, we do not believe that the court of appeals was
justified in overlooking state law because the issue was not raised
until the reply brief.  The court evidently appreciated the relevance
of Burks in this context, and at the very least should not have
crafted a generally applicable rule of federal common law on the basis
of a procedural peculiarity of the case before it.

   /16/ Currently, the majority of investment companies are organized
in Maryland or Massachusetts.  Massachusetts, like Maryland,
recognizes a futility exception.  See Houle v. Low, 407 Mass. 810, 813
n.3, 556 N.E.2d 51, 53 n.3 (1990).  We express no view on how Maryland
applies its futility exception;  that issue is one for the lower
courts.  Compare Burt v. Danforth, 742 F. Supp. 1043, 1047-1049 (E.D.
Mo. 1990) (finding that Maryland futility exception excuses demand
more readily than federal law) with Zimmerman v. Bell, 585 F. Supp.
512, 514 (D. Md. 1984) (treating Maryland and federal futility
exceptions as equivalent).

   /17/ Section 16(b) provides that a shareholder may bring an action
in behalf of the issuer to recover certain short-swing profits "if the
issuer shall fail or refuse to bring such suit within sixty days after
request or shall fail diligently to prosecute the same thereafter."
See also Cramer v. General Tel. & Elec. Corp., 582 F.2d 259, 276 n.22
(3d Cir. 1978) (board's decision not to sue does not preclude
subsequent shareholder action), cert. denied, 439 U.S. 1129 (1979).

   /18/ These include a change in classification from a diversified to
a nondiversified company;  the borrowing of money, issuance of senior
securities, or purchase or sale of commodities or real estate not in
accordance with the company's registration statement;  the deviation
from policy with respect to investment in an industry or group of
securities as set forth in the registration statement, or from any
policy deemed fundamental by the company (see 15 U.S.C. 80a-8(b) (3));
 or the cessation of being an investment company.  15 U.S.C. 80a-13(a)
(1) to (4).

   /19/ Demand is excused if "under the particularized facts alleged,"
the complaint creates "a reasonable doubt" that "(1) the directors are
disinterested and independent" or that "(2) the challenged transaction
was otherwise the product of a valid exercise of business judgment."
Aronson v. Lewis, 473 A.2d at 814;  Pogostin v. Rice, 480 A.2d 619,
624 (Del. 1984).  See Block, Radin & Rosenzweig, supra, at 475-480.

   /20/ Delaware cases state that, where applicable, the business
judgment rule protects director decisions absent "gross negligence,"
and that the directors' decision will be honored "(a)bsent an abuse of
discretion." Aronson v. Lewis, 473 A.2d at 812 & n.6.

   /21/ The usual mechanism is for the board to delegate authority to
a committee of distinterested directors, who investigate the claim
with the advice of counsel, and determine the corporation's position.
This was the approach employed in Burks v. Lasker.

   /22/ Delaware's approach has also been followed by several federal
courts applying state law.  See Rosengarten v. Buckley, 613 F. Supp.
1493, 1499-1500 (D. Md. 1985) (Maryland law);  Peller v. Southern Co.,
(1987-88 Transfer Binder) Fed. Sec. L. Rep. (CCH) Paragraph 93,714, at
98,311 (N.D. Ga. 1988) (Georgia law);  Abella v. Universal Leaf
Tobacco Co., 546 F. Supp. 795, 797-800 (E.D. Va. 1982) (Virginia law).
 See also Joy v. North, 692 F.2d 880, 891 (2d Cir. 1982) (construing
Connecticut law to adopt Delaware's approach, but also requiring
independent review in a demand-excused case of the merits of the
decision not to sue), cert. denied, 460 U.S. 1051 (1983);  Alford v.
Shaw, 358 S.E.2d 323, 327-328 (N.C. 1987) (following Delaware
approach, but also requiring court to evaluate independently in all
cases the merits of decision not to sue).  In contrast, several
jurisdictions have adopted procedures providing for less extensive
judicial review of the decision not to pursue the suit.  See, e.g.,
Auerbach v. Bennett, 47 N.Y.2d 619, 393 N.E.2d 994, 419 N.Y.S.2d 920
(1979);  Gaines v. Haughton, 645 F.2d 761, 770-772 (9th Cir. 1981)
(applying California law), cert. denied, 454 U.S. 1145 (1982).  The
law is in a state of flux in this field.  See D. DeMott, supra,
Sections 5:04 to 5:06.

   /23/ If, contrary to our submission, the Court embraces some
formulation of a federal universal-demand requirement, we urge the
Court to make clear that its holding does not dictate application of
the business judgment rule, or any particular standard, in reviewing
the directors' decision.  That issue need not be reached in this case,
since no director decision is at issue, and it should be left for
another day.

   /24/ The American Bar Association and the American Law Institute
have each proposed model corporate law codes that provide for
universal demand, but differ as to the appropriate standard of
judicial review.  The ABA recommends that refusal of demand be
reviewed under a business judgment standard, with the burden of proof
shifting to the corporation if a majority of the board is not
independent.  See Changes in the Model Business Corporation Act --
Amendments Pertaining to Derivative Proceedings, 45 Bus. Law.  1241
(1990).  The ALI, in contrast, allows independent judicial review of
the board's decision, whether or not a majority is independent.
Principles of Corporate Governance:  Analysis and Recommendations
Sections 7.08, 7.10, 7.11 (Tent. Drafts Nos. 8 & 9, 1988 & 1989),
reproduced at Block, Radin & Rosenzweig, supra, at 501-503.  The
Commission takes no position on these recommendations.