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Weiss v. Temporary Investment Fund Inc.

November 12, 1982

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



ON APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF DELAWARE.

Gibbons, Sloviter and Becker, Circuit Judges. Gibbons, Circuit Judge, dissenting.

Author: Becker

Opinion OF THE COURT

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. §§ 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.*fn1

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. § 78n(a) (1976); and that the management and fee arrangements violate the Banking Act of 1933, 12 U.S.C. §§ 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 P37.

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.*fn2 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.*fn3 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, 60 L. Ed. 2d 404, 99 S. Ct. 1831 (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 company such as a mutual fund by external investment advisers. S. Rep. No. 184, 91st Cong., 1st Sess., reprinted in 1970 U.S. Code Cong. & Ad. News 4897, 4901. As originally enacted in 1940, the ICA's principal device to prevent self-dealing by the directors was the requirement that at least forty percent of the board members be independent -- that is, that they have neither a direct nor an indirect financial interest in the company or its adviser. 15 U.S.C. § 80a-10(a) (1976). Over time, however, it became apparent that this safeguard was insufficient to stem the burgeoning advisory fees. Recognizing that a company's dependency on its adviser limited the influence of arms-length bargaining in keeping advisory fees competitive, Congress enacted section 36(b) as part of the 1970 amendments to the ICA. That section imposes on the adviser a fiduciary duty with respect to compensation for its services and explicitly authorizes suits by the Securities and Exchange Commission and the fund's shareholders to enforce that duty. By increasing the standard of care owed by the advisers, Congress sought to ease the difficult burden faced by shareholders trying to prove that advisory contracts violated common law prohibitions against "corporate waste." See infra note 9. The remedy under 36(b) is an action against the recipient of the allegedly excessive payments for actual damages resulting from the breach of fiduciary duty, not to exceed actual payments received from the investment company. A showing of personal misconduct by the defendant is not required. The recovery of excessive fees is limited to those paid by the investment company during the one-year period prior to initiation of the suit.

Additional responsibility for monitoring management fees were also imposed on directors. The 1970 amendments require directors to investigate and evaluate advisory fee contracts, demand that a majority of disinterested directors approve the contracts, and permit the directors to terminate contracts without financial penalty upon sixty days' notice. 15 U.S.C. § 80a-15(c) (1976). The amendments also tightened the qualifications of the independent directors serving on the board. Id. §§ 80a-2(19), 80a-10a.*fn4 The essence of the amendments, as the Supreme Court has noted, is to place these unaffiliated directors in the role of "independent watchdogs" charged with supervising the management of the company. Burks v. Lasker, supra, 441 U.S. at 484.

With this background in mind, we turn to Weiss' arguments that suits under section 36(b) are not subject to Rule 23.1.

II. IS A SECTION 36(b) ACTION DERIVATIVE ?

Before addressing the arguments set forth in the briefs, we must consider a threshold contention -- advanced by Weiss for the first time at oral argument -- that a shareholder suit under section 36(b) is not a derivative action and thus is not subject to Rule 23.1.*fn5 Weiss apparently relies on the rule's requirement that the right enforced by a shareholder be one which "may properly be asserted" by the corporation.*fn6 The ICA, however, explicitly authorizes suits only by the SEC and by the shareholders and does not state that the Fund itself may sue its advisers for breach of fiduciary duties. If the Fund cannot sue, Weiss' theory proceeds, then a section 36(b) cause of action does not derive from a right that "may properly be asserted" by the Fund. We disagree.

We can approach this issue in several ways. One approach, adopted by the First Circuit in Grossman v. Johnson, 674 F.2d 115 (1st Cir. Mass. 1982), cert. denied, 459 U.S. 838, 103 S. Ct. 85, 74 L. Ed. 2d 80 (1982), views an investment company's right to sue its advisers as a necessary, if not explicit, corollary of the right of action conferred on shareholders by section 36(b). In holding that an investment company has a direct cause of action under section 36(b), the Grossman court stated:

We cannot believe . . . that, for example, a new and independent board of directors, intent on recovering excessive fees from the investment adviser, would be precluded from suing under section 36(b). That section is explicit that recovery by a shareholder is to be on behalf of the investment company and that his suit must be brought on the same behalf. With those clear requirements, Congress could well have believed that, though it was appropriate to specify that the Commission and shareholders had the new statutory cause of action under section 36(b), see Moses v. Burgin, 445 F.2d 369, 373 n.7 (1st Cir. 1971), it was unnecessary to say with particularity that the company also did. A suit 'on behalf of such company ' (a phrase which is more than merely one 'for the benefit of the company ') is normally a derivative action that the company could itself bring.

Id. at 120 (footnotes omitted).*fn7 Along similar lines, the Supreme Court noted in Burks v. Lasker, supra, 441 U.S. at 477, that "[a] derivative suit is brought by shareholders to enforce a claim on behalf of the corporation" (emphasis supplied), and the Court thereafter referred without comment to a section 36(b) suit as derivative, id. at 484.

We agree with the First Circuit's reasoning as far as it goes, but we expand our analysis to consider the test enunciated in Cort v. Ash, 422 U.S. 66, 45 L. Ed. 2d 26, 95 S. Ct. 2080 (1975). Cort provides the generally accepted framework for determining whether a statute creates an implied right of action.*fn8 Our application of the Cort test leads us to the same conclusion as the First Circuit.

Cort counsels consideration of four factors:

First, is the plaintiff 'one of the class for whose especial benefit the statute was enacted, ' -- that is, does the statute create a federal right in favor of the plaintiff? Second, is there any indication of legislative intent, explicit or implicit, either to create such a remedy or to deny one? Third, is it consistent with the underlying purposes of the legislative scheme to imply such a remedy for the plaintiff? And finally, is the cause of action one traditionally relegated to state law, in an area basically the concern of the States, so that it would be inappropriate to infer a cause of action based solely on federal law.

Cort v. Ash, supra, 422 U.S. at 78 (citations omitted). With respect to the first factor, we have no difficulty in concluding that an investment company is the intended beneficiary of section 36(b). The legislative history states that the fiduciary duty imposed on advisers, one of the major innovations of the statute, is owed to the company itself. S. Rep. No. 184, 91st Cong., 1st Sess., reprinted in 1970 U.S. Code Cong. & Ad News 4897, 4902. Moreover, as Weiss concedes, any recovery obtained in a shareholder suit reverts to the investment company and not to the plaintiff.

The second factor, ascertainment of Congress' intent, is the principal focus of the Cort inquiry. Merrill Lynch, Pierce, Fenner & Smith v. Curran, 456 U.S. 353, 102 S. Ct. 1825, 1839, 72 L. Ed. 2d 182 (1982); see Walck v. American Stock Exchange, Inc., 687 F.2d 778, 781, 783 (3d Cir. 1982). We find nothing in the legislative history of the ICA that suggests an intent to deprive the company of a direct remedy. Neither, we must concede, do we find an explicit expression by Congress that the investment company is authorized to sue its adviser. But our conclusion is unaffected by this absence of express authorization for, as the Supreme Court noted in canvassing the same legislative history, silence regarding the powers of the board of directors is to be expected: "The ICA does not purport to be the source of authority for managerial power; rather, the Act functions primarily to 'impos[e] controls and restrictions on the internal management of investment companies. '" Burks v. Lasker, supra, 441 U.S. at 478 (citation omitted) (emphasis in original). Thus we may properly infer from this legislative silence that Congress did not intend to restrict the company's right to sue.

The state of the law at the time of the 1970 amendments supports this construction of the legislative history. We are required to look at this "contemporary legal context" to determine whether the company had a right to sue when the statute was enacted. If such a right existed, we need only determine whether Congress intended to preserve the preexisting remedy. See Merrill Lynch, Pierce, Fenner & Smith v. Curran, supra, 102 S. Ct. at 1839. In this regard, we agree with the district court's observation, see 516 F. Supp. at 670 n.11, that the company possessed (and still possesses) a cause of action against the adviser at common law.*fn9 We also note that a shareholder's right to sue derivatively was implied by former section 36 (now section 36(a)), which authorizes SEC enforcement of the ICA's regulatory scheme. See, e.g., Moses v. Burgin, 445 F.2d 369 (1st Cir. 1971) (finding implied right of action under former section 36 for shareholder to sue derivatively to recapture excessive brokerage fees paid by the mutual fund). "Where Congress adopts a new law incorporating sections of a prior law, Congress can be presumed to have had knowledge of the interpretation given to the incorporated law, at least insofar as it affects the new statute." Merrill Lynch, Pierce, Fenner & Smith v. Curran, supra, 102 S. Ct. at 1841 n. 66. Against this legal backdrop at the time of the amendments, Congress' assumption that the shareholder suit was derivative from the company's right of action becomes clear, as does the correctness of the First Circuit's conclusion that Congress assumed the company enjoyed a direct cause of action and there was no need to so specify. In sum, the second Cort criterion is met for the reasons set forth by the First Circuit in Grossman and because we find no evidence of a Congressional intent to deprive the company of its right to sue the company's adviser.

The third and fourth factors of the Cort test follow ineluctably from the preceding discussion. Providing the investment company with a cause of action fully accords with the purposes of section 36(b) by providing another means to recover excessive advisory fees. From a practical standpoint, in fact, the company's financial resources and knowledge of the challenged transactions may render it an even more effective litigant than the shareholder. Finally, the express cause of action conferred by Congress upon shareholders ipso facto federalizes this type of litigation; hence implication of a companion remedy for the investment company does not intrude upon an area "traditionally relegated to state law." Thus application of the four-pronged test of Cort v. Ash compels us to conclude that the investment company has a cause of action against the advisers for breach of the fiduciary duties imposed by section 36(b). We are aware that the Court of Appeals for the Second Circuit recently reached the opposite conclusion. Fox v. Reich & Tang, Inc., 692 F.2d 250 (2d Cir. 1982). After careful consideration of the court's reasoning, however, we remain convinced that the investment company has a cause of action and that a § 36(b) action is derivative.

III. IS SECTION 36(b) CONSISTENT WITH THE DEMAND REQUIREMENT ?

Even if a section 36(b) suit is derivative, Weiss insists that the ICA excuses such suits from the Rule 23.1 demand requirement. As we have noted, he concedes that the statute does not do so expressly, but contends that the legislative history and statutory scheme of section 36(b) manifest Congress' intent to eliminate this prerequisite to suit.

At the outset we note that Weiss must overcome the presumption that Rule 23.1, like all Federal Rules of Civil Procedure, applies to any civil suit brought in federal district court unless inconsistent with an Act of Congress. Fed. R. Civ. P. 1; see 28 U.S.C. § 2072 (1976). Abrogation of a rule of procedure generally is inappropriate "in the absence of a direct expression by Congress of its intent to depart from the usual course of trying 'all suits of a civil nature ' under the Rules established for that purpose." Califano v. Yamasaki, 442 U.S. 682, 683, 700, 61 L. Ed. 2d 176, 99 S. Ct. 2545 (1979). Repugnancy of a statute to a civil rule is not to be lightly implied. Rather, "a subsequently enacted statute should be so construed as to harmonize with the Federal Rules if that is at all feasible." Grossman v. Johnson, supra, 674 F.2d at 122-23 (quoting 7 Moore's Federal Practice para. 86.04[4] at 86-22 (2d ed. 1980)); accord Fox v. Reich & Tang, Inc., 94 F.R.D. 94 (S.D.N.Y. 1982), rev'd on other grounds, 692 F.2d 250 (2d Cir. 1982).

A. Does the Legislative History Reflect Congress' Intent to Require Demand ?

Weiss relies first on the legislative history accompanying the 1970 amendments, passages of which reflect Congress' perception that even unaffiliated directors had not been able to secure changes in the advisory fee levels. For example, he quotes from the Securities and Exchange Commission Report on Investment Companies, H.R. Rep. No. 2337, 89th Cong., 2d Sess. (1966):

It has been the Commission's experience in the administration of the Act that in general the unaffiliated directors have not been in a position to secure changes in the level of advisory fee rates in the mutual fund industry.

The analysis of the shareholder fee litigation not only underscores the need for changes in existing statutory provisions relating to management compensation in the investment company industry, but points to the direction which these changes should take. It makes clear the need to incorporate into the Act a clearly expressed and readily enforceable standard that would measure the fairness of compensation paid by investment companies for services furnished by those who occupy a fiduciary relationship to such companies.

The right of the Commission as well as investment company shareholders to take action against violations of the statutory standard of reasonableness is essential to effective enforcement.

Id. at 131, 143, 146 (emphasis supplied by appellant). Second, he invokes the Congressional intention to establish a mechanism by which the shareholders and courts could enforce the investment adviser's fiduciary duty. The report accompanying the 1970 amendments states:

In the case of management fees, the committee believes that the unique structure of mutual funds has made it difficult for the courts to apply traditional fiduciary standards in considering questions concerning management fees.

Therefore your committee has adopted the basic principle that, in view of the potential conflicts of interest involved in the setting of these fees, there should be effective means for the court to act where mutual fund shareholders or the SEC believe there has been a breach of fiduciary duty.

S. Rep. No. 184, 91st Cong., 1st Sess., reprinted in 1970 U.S. Code Cong. & Ad News 4897, 4898 ...


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