Source: https://law.justia.com/cases/federal/appellate-courts/F2/533/731/238822/
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Matched Legal Cases: ['§ 36', '§ 36', '§ 3', '§ 15', '§ 44', '§ 2', '§ 188', '§ 15', '§ 80', '§ 24', '§ 14']

Fed. Sec. L. Rep. P 95,393rosalind Fogel and Gerald Fogel, Plaintiffs-appellants, v. George A. Chestnutt, Jr., et al., Defendants-appellees, 533 F.2d 731 (2d Cir. 1975) :: Justia
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Fed. Sec. L. Rep. P 95,393rosalind Fogel and Gerald Fogel, Plaintiffs-appellants, v. George A. Chestnutt, Jr., et al., Defendants-appellees, 533 F.2d 731 (2d Cir. 1975)
US Court of Appeals for the Second Circuit - 533 F.2d 731 (2d Cir. 1975)
Argued Sept. 22, 1975. Decided Dec. 30, 1975
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.
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.
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:
After trial Judge Wyatt rendered an opinion dismissing the action on the merits, 383 F. Supp. 914. Accepting the principle "that defendants were under a duty by all proper means to secure for Fund the return of excess brokerage commissions," he concluded it had not been shown "that defendants could have properly secured any return for Fund," 383 F. Supp. at 920. Assuming arguendo that Moses v. Burgin had been correctly decided, he viewed it as distinguishable on the ground that the fund there concerned was a load fund whose shares were sold by an affiliated underwriter, who was qualified as a "dealer" within the NASD definition of that term and who was in fact a member of the NASD entitled to receive customer-directed give-ups on certain regional exchanges until the abolition of such give-ups on December 5, 1968. Recognizing that NASD membership was not required for membership on the Philadelphia-Baltimore-Washington Exchange, Judge Wyatt ruled that such membership6 "would require defendants to pretend that the new subsidiary was a broker, when in fact it was not, for the purpose of securing a preference over other investors by recapturing a part of the fixed commissions" and that this would have run counter to public policy, 383 F. Supp. 920-21. The plaintiffs have appealed.7 III.
the reasoning on which the proposed rule is based is that if, as pointed out (in PPI) a mutual fund manager has various means at his disposal to recapture for the benefit of the fund a portion of the commissions paid by the fund, he is under a fiduciary duty to do so. Furthermore, diversion of such commissions to benefit an investment company manager may be viewed as additional compensation to the manager for handling the portfolio transactions of the fund within the meaning of, and in violation of, Section 17(e) (1) of the Investment Company Act. The proposed rule therefore reflects a duty on the part of mutual fund managers as fiduciaries not to use commissions paid by their beneficiaries for the benefit of the fiduciary when practices, procedures, and rules of the markets in which such fiduciaries act permit their beneficiaries to receive tangible benefits in the form of reduction of the charges now borne by them.
During 1968 there were various communications between the SEC and NYSE, recounted in Gordon v. New York Stock Exchange, supra, --- U.S. at ----, 95 S. Ct. 2598, 43 U.S.L.W. at 4961, which culminated in the establishment of a volume discount for orders exceeding 1,000 shares and other alterations in rates. In a letter proposing the volume discount, NYSE also stated that it would be impossible to determine the impact of the interim schedule so long as give-ups continued. Accepting the NYSE proposals in a letter of August 30, 1968, released as a formal decision "Approving Interim Commission Rate Measures," SEC Chairman Cohen replied:
Having achieved establishment of the volume discount, the SEC then turned to another objective, bringing about competitive rates on large orders. The history of this endeavor is also recounted in the Gordon opinion, --- U.S. at ----, 95 S. Ct. 2598, 43 U.S.L.W. at 4962. On February 4, 1972, the SEC issued a Policy Statement on the Future Structure of the Securities Markets, CCH Federal Securities Law Reports No. 409. This wide-ranging statement included several passages bearing on the problems here presented. One was this, pp. 42-43:
The contract argument is as follows: The Certificate of Incorporation of the Fund provided in P 3(c) (iv) that:
When we pass to the theory of breach of fiduciary duty, we are confronted initially with the question of the applicable standard. The Moses court predicated federal jurisdiction on § 36 of the Investment Company Act prohibiting " 'gross misconduct or gross abuse of trust' " 445 F.2d at 373, and seemingly also held, 445 F.2d at 384, that defendants' conduct violated that standard as the First Circuit had interpreted it in Aldred Investment Trust v. SEC, 151 F.2d 254, cert. denied, 326 U.S. 795, 66 S. Ct. 486, 90 L. Ed. 483 (1946). Taking a less expansive view of § 36 as originally enacted, we have held that the Act implicitly established a federal standard of fiduciary duty in respect of dealings between a mutual fund and its adviser. Brown v. Bullock, 294 F.2d 415, 421 (2 Cir. 1961); Rosenfeld v. Black, 445 F.2d 1337, 1345 (2 Cir. 1971), a duty which the 1970 amendment makes explicit "with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company, or by the security holders thereof, to such investment adviser or any affiliated person of such investment adviser" the situation presented here.
We agree with the First Circuit, 445 F.2d at 376, that 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, see id.; Comment, Duties of the Independent Director in Open-End Mutual Funds, 70 Mich. L. Rev. 696, 698-99 (1972); Mundheim, Some Thoughts on the Duties and Responsibilities of Unaffiliated Directors of Mutual Funds, 115 U. of Pa.L.Rev. 1058, 1060-61 (1967). Chief Judge Aldrich went on to quote from the SEC's decision in Imperial Financial Services, Inc., CCH Fed.Sec.L.Rep. P 77,287 at 82,464 (1965), as we do in the margin.13 He emphasized that the communication of information must be "effective," bearing in mind that the independent directors are not full-time employees and that "neither their activities nor their experience" may be "primarily connected with the special and often technical problems of fund operation." He concluded:
Our agreement with the First Circuit in this regard is a proper projection of Mills v. Electric Auto-Lite Co., Inc., 396 U.S. 375, 90 S. Ct. 616, 24 L. Ed. 2d 593 (1970). Apart from the salutary prophylactic effects of such a rule, courts can have little confidence in post litem motam expressions by independent directors as to what they would have done if management had put all the facts before them. Under the best of circumstances there is bound to be doubt about the independence of the "unaffiliated" or now the "disinterested" director, see Note, Duties of the Independent Director in Open-End Mutual Funds, 70 Mich. L. Rev. 696, 701 (1972). These should not be enhanced by recognizing a post hoc reconstruction of mental processes as a defense.
Broker is defined as follows, this being an elaboration of the definition in § 3(a) (4) of the Securities Exchange Act:
Agreeing with the last point and admitting some force in the others, we do not find the provisions so unambiguous as to justify the defendants' thinking that NASD membership was unattainable. The Adviser and the Fund are distinct entities, one owned by the management group and the other by the investors. Many brokers have nothing to do with the execution or clearing of orders, functions which they confide to others. So far as concerns the reference to "others" rather than "another," the Adviser in the present case originates transactions for many investors in addition to the Fund; if that were not enough, something might be said for piercing the corporate veil and regarding the Adviser as acting "for the account of" the Fund's shareholders. Perhaps most important of all, such few SEC releases and court decisions as exist point to a construction of the term "broker" which could well include an adviser placing buy and sell orders for the portfolio of a mutual fund. See Distributions of Variable Annuities by Insurance Companies: Broker-Dealer Registration and Regulation Problems under the Exchange Act of 1934, Exchange Act Release No. 8389, Fed.Sec.L.Rep. P 77,594 (1968) (in the context of § 15(a) (1) of the Securities Exchange Act); Fogel v. Chestnutt, Fed.Sec.L.Rep. P 92,133 (S.D.N.Y. 1968) (construing "broker" for purposes of jurisdiction under § 44 of the Investment Company Act); see also 2 Loss, Securities Regulation 1295-96 (1961); 5 id. 3355-56 (1969).
The rejection of the testimony thus was based not so much on contradictions within it as on the judge's disagreement with it as a correct interpretation of NASD's rules, a disagreement stemming in considerable measure from his view that it would have been "deceptive and improper" for the Adviser or an affiliate to have become a NASD member and therefore entitled to give-ups and discounts. The latter, however, is a separate issue, to be discussed below. Since the NASD's rules are fairly susceptible of the construction urged by plaintiffs, the testimony of the NASD's general counsel that the organization would have so interpreted them, carries the day for the plaintiffs on the issue whether NASD membership was achievable. Cf. Udall v. Tallman, 380 U.S. 1, 16-17, 85 S. Ct. 792, 13 L. Ed. 2d 616 (1965).
Two preliminary observations are in order. Amicus greatly relies on decisions construing substantive provisions in statutes like the Interstate Commerce Act, 49 U.S.C. §§ 2, 10, and the New York Insurance Law §§ 188, 209, 273; but the closest the Securities Exchange Act comes to such a provision is the somewhat back-handed direction in the Maloney Amendment, § 15A(b) (8), that the SEC shall not permit registration of a national securities association unless its rules "are not designed to permit unfair discrimination between customers or issuers." While it is doubtless true, as urged by amicus, that exchanges and their members are under a duty to comply with their constitutions and rules filed with the SEC, an exchange has a substantial degree of power to interpret its own rules. Officers of both the PBW and Pacific Coast Exchanges testified that these exchanges did not consider give-ups to affiliates of an investment adviser, discounts (in the case of the Pacific Coast Exchange) or institutional membership (in the case of the PBW Exchange) to constitute violations of their anti-rebate rules.
The amount for which defendants are to be held liable will depend on the attempt, difficult but ineluctable, of seeking to find what would have been. In deciding this we must mediate between the two principles, given expression in cases arising under the antitrust laws, that while "a defendant whose wrongful conduct has rendered difficult ascertainment of the precise damages suffered by the plaintiff, is not entitled to complain that they cannot be measured with the same exactness and precision as would otherwise be possible," Eastman Kodak Co. v. Southern Photo Materials Co., 273 U.S. 359, 379, 47 S. Ct. 400, 405, 71 L. Ed. 684 (1927),31 yet recovery "cannot be had unless it is shown, that, as a result of defendants' acts, damages in some amount susceptible of expression in figures resulted." Keogh v. Chicago & Northwestern Ry., 260 U.S. 156, 165, 43 S. Ct. 47, 50, 67 L. Ed. 183 (1922). The Moses court held the defendants (other than unaffiliated directors) liable for Crosby's failure to avail itself of NASD recapture (the only method there being pressed) on all transactions on the PBW and Pacific Coast Exchanges, since any lesser measure of recovery would mean that the business judgment defense, although foreclosed on the issue of liability because of lack of effective disclosure to unaffiliated directors, would be entering through the back door. In a footnote, 445 F.2d at 385, n. 25, the court added that the district court "may well find that at a reasonable interval after a final determination to bank give-ups should have been made," during which interval the unfeasibility of achieving give-ups except on the PBW and Pacific Coast Exchanges might have been ascertained," proper practice would have been, consistent with best execution, to make as many transactions as possible on the two favorable exchanges."32
A 1971 article stated there had been fifty. Butowsky, Fiduciary Standards of Conduct Revisited Moses v. Burgin and Rosenfeld v. Black, 17 New York Law Forum 735, 736 (1971), see also Comment, Mutual Funds and Independent Directors: Can Moses Lead to Better Business Judgment, 1972 Duke Law Journal, 429, 430 n. 8. Some such suits have been settled, e. g., Weiss v. Chalker, 55 F.R.D. 168 (S.D.N.Y. 1972), 59 F.R.D. 533 (S.D.N.Y. 1973). Another action has recently been dismissed on the merits, although on grounds differing, at least in considerable part, from those adopted by the district court in the instant case. Tannenbaum v. Zeller, CCH Federal Securities Law Reports P 95,257 (Carter, D. J., 1975)
In addition to the articles cited in n. 1, see The Use of Brokerage Commissions to Promote Mutual Fund Sales, 68 Colum. L. Rev. 334 (1968); Conflict of Interest in the Allocation of Mutual Fund Brokerage Business, 80 Yale L.J. 372 (1970); Miller and Carlson, Recapture of Brokerage Commissions by Mutual Funds, 46 N.Y.U. L. Rev. 35 (1971); Fiduciary Obligations of Mutual Fund Managers in Portfolio Transactions, 22 Syracuse L.Rev. 1107 (1971); Note, 60 Georgetown L.J. 1594 (1972); Note, 13 Wm. & Mary L.Rev. 530 (1971)
Allocated to Allocated to brokers who brokers who had provided had assisted Brokerage helpful in the sale of fees information Fund Shares 1964 $ 275,000 $ 162,000 $ 113,000 1965 387,000 247,000 140,000 1966 551,668 261,913 289,755 1967 1,995,087 935,966 1,059,121 1968 3,122,160 2,022,457 1,099,703 1969 2,489,281 1,196,059 1,293,222 1970 2,059,234 1,108,667 950,000
A separate action, Fogel v. Chestnutt, 67 Civ. 60 (S.D.N.Y.), was brought in January, 1967, charging that I.O.S. Ltd., there a defendant, had caused a corporation which it dominated to cause the Fund to use a particular broker when that broker's research and advisory services were channeled to I.O.S. and not to the Fund. See Fogel v. Chestnutt, 296 F. Supp. 530 (1969). This case was "statistically closed" on April 25, 1975
A member was to be deemed to have such a purpose only if 80% of its securities business was "effected for or with persons other than affiliated persons" or was one of eight described categories. PBW challenged the validity of the rule, but this challenge was dismissed on jurisdictional grounds, PBW v. SEC, 485 F.2d 718 (3 Cir. 1973), cert. denied, 416 U.S. 969, 94 S. Ct. 1992, 40 L. Ed. 2d 558 (1974)
15 U.S.C. § 80a-2(a) (3). Since the expanded requirement, although it does affect a present defendant, does not decisively tip the interested/disinterested balance, we shall use the term "independent" throughout to indicate persons either not "affiliated" prior to the 1970 amendments or not "interested" thereafter.
1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 ------------------------------------------------------------------------------- George A. Chestnutt, Jr.* (affiliated) (interested) ------------------------------------------------------------------------------- Stanley Sabel* (affiliated) (interested) ------------------------------------------------------------------------------- John Currier* (unaffiliated) (interested) ------------------------------------------------------------------------------- Eliz. Sullivan (affiliated) Warren K. Greene* (interested) (affiliated) ------------------------------------------------------------------------------- Richard Radcliffe (unaffiliated) Wm. Semmes(disinterested) ------------------------------------------------------------------------------- Frank G. Fowler (unaffiliated) (disinterested) ------------------------------------------------------------------------------- Francis L. Veeder (unaffiliated) (disinterested) ------------------------------------------------------------------------------- P. Murtaugh Wm. May vacant Eugene Ulrich (unaffiliated) (unaffil.) (disinterested) ------------------------------------------------------------------------------- * Defendants who were served.
With respect to tender offer fees, the amicus brief contends that the adviser's passing these on to a fund would violate (a) Article III, § 24, of the NASD's Rules of Fair Practice, as held by the district court in Moses v. Burgin, supra, 316 F. Supp. at 48, (b) the Williams Amendment to the Securities Exchange Act, § 14(d) (7), and (c) the SEC's rule 10b-13. We disagree. Amicus also points to a proposed amendment to 10b-13, published in Securities Exchange Act Release No. 9920 (1972), which would have made recapture unlawful. The SEC would scarcely have proposed this if recapture was already unlawful. The SEC never adopted the amendment; instead it issued Release No. 10102 discussed in n. 24 supra
See also Story Parchment Paper Co. v. Paterson Parchment Paper Co., 282 U.S. 555, 563, 51 S. Ct. 248, 75 L. Ed. 544 (1931); Bigelow v. RKO Radio Pictures, Inc., 327 U.S. 251, 264-65, 66 S. Ct. 574, 90 L. Ed. 652 (1946)