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BROWN v. BULLOCK

March 9, 1961

Ethel BROWN and Harry Brown, Plaintiffs,
v.
Hugh BULLOCK, Arthur F. Burns, Robert E. Clark, Nathaniel P. Hill, John M. Hincks, Grayson Kirk, Harris J. Nelson, Frank Pace, Jr., Maxwell D. Taylor, Calvin Bullock, Ltd., and Dividend Shares, Inc., Defendants



The opinion of the court was delivered by: HERLANDS

Does the amended complaint against the eleven defendants state a claim upon which relief can be granted under the Investment Company Act of 1940, 15 U.S.C.A. § 80a-1 et seq.?

The question is raised by motions pursuant to F.R.Civ.P., rule 12(b)(1) and (6), 28 U.S.C.A., made by the attorneys for defendants Calvin Bullock, Ltd., Hugh Bullock and Robert E. Clark, and by the attorneys for defendants Arthur F. Burns, Grayson Kirk and Frank Pace, Jr.

 The motions are opposed by the plaintiffs and, to the extent that certain questions of law are involved, by the Securities and Exchange Commission as amicus curiae.

 Because the facts well-pleaded in the amended complaint and the inferences reasonably flowing therefrom are deemed admitted arguendo, the pending motions raise only issues of law. However, counsel differ radically in their formulation of those issues. It has thus become necessary to analyze the allegations of the amended complaint in detail in order to place the issues in correct and sharp focus.

 The Investment Company Act of 1940 will be referred to as 'the 1940 Act' or 'the Act'; the Securities Act of 1933, 15 U.S.C.A. § 77a et seq., as 'the 1933 Act'; the Securities Exchange Act of 1934, 15 U.S.C.A. § 78a et seq., as 'the 1934 Act'; the defendant Dividend Shares, Inc., as the 'Fund'; the defendant Calvin Bullock, Ltd., as the 'Management Company'; the Securities and Exchange Commission, as the 'Commission'; and the amended complaint as 'the complaint.'

 Allegations of the Complaint. Jurisdiction

 Jurisdiction rests on the Act and 'on the principles of pendent jurisdiction' (par. 1). There is no allegation or claim of diversity of citizenship.

 Plaintiffs

 Plaintiffs are and have been shareholders of the Fund since October 14, 1955 and at the times of the transactions complained of (par. 2(a)).

 Capacities in Which Plaintiffs Are Suing

 The action is brought by plaintiffs 'derivatively on behalf of the Fund and representatively on behalf of themselves and all other shareholders of the Fund similarly situated' (par. 2(b)).

 'The Fund has about 100,000 shareholders, scattered all over the United States and foreign countries. Their identity is subject to frequent changes by reason of sales of new shares and redemptions of old ones' (par 20(d)).

 'The shareholders constitute a class so numerous as to make it impracticable to bring them all before the Court. Plaintiffs will fairly insure their adequate representation' (par. 21).

 The Fund, Its Organization and Character

 The Fund, a Maryland corporation organized on July 25, 1932 with its principal office at One Wall Street, Manhattan, N.Y., was and is 'registered under the Act as a diversified open-end management investment company' (pars. 3, 17). Its shares 'have been and are being offered for sale and sold to the public on a continuous basis' (par. 3).

 The Nine Individual Defendants and Two Corporate Defendants

 The nine individual defendants are the directors of the Fund. They have served as such directors since prior to October 14, 1955, except that defendants Burns and Kirk became directors in 1958, and defendants Clark and Taylor in 1959. Since prior to October 14, 1955 and to date, defendant Bullock has been the president of the Fund (par. 4).

 The two corporate defendants are the Fund and the Management Company.

 Net Asset Value of the Fund

 The net asset value of the Fund was $ 188,548,815 on October 31, 1955 and $ 254,701,160 on April 30, 1960. Its high was $ 267,612,897 on October 31, 1959 (par. 5).

 The Management Company

 The Management Company, a corporation with its principal office at One Wall Street, Manhattan, N.Y., was and is 'the investment adviser of the Fund' and 'the principal underwriter and sole distributor of the shares of the Fund' (par. 6).

 The Management Company was and is 'the investment adviser' of two other domestic diversified open-end management investment companies known as Bullock Fund, Ltd. ('Bullock Fund') and Nation-Wide Securities Company, Inc. ('Nation-Wide') (par. 12(a)).

 The operative facts of the occurrences and transactions giving rise to the plaintiffs' claim, as pleaded (cf. Schwartz v. Eaton, 2 Cir., 1959, 264 F.2d 195, 196 note 2, 197 note 3, will be spotlighted by collating related allegations of the complaint. The following recitals are quoted from the complaint or are close paraphrases.

 The Complete Domination and Control of the Fund by the Defendant-Management Company and the Defendants Bullock and Clark.

 I.

 The Management Company has two contracts (annually extended) with the Fund: an 'underwriting' contract and an 'investment advisory' contract. By the underwriting contract, the Management Company was and is the principal underwriter of the Fund and the sole distributor of the Fund's shares (par. 11). By the investment advisory contract the Management Company was and is the investment adviser of the Fund (pars. 6, 10). The Management Company supervises the Fund's portfolio securities and pays certain of the Fund's expenses (par. 10).

 Defendant Bullock is the president of both the Management Company and the Fund. He is also a director of both companies. He owns a majority of the shares of the Management Company (par. 7).

 Defendant Clark, the executive vice-president of the Management Company, is a director of both companies (par. 7).

 Officers or associates of the Management Company are the three vice-presidents, the secretary and the treasurer of the Fund (par. 7).

 II.

 The defendants Bullock, Clark and the Management Company completely dominated and controlled the Fund, not only by virtue of their above-indicated intimate and interlocking relationship, but also by their:

 A. Selecting and nominating each of the Fund's directors (par. 8). These directors receive substantial compensation as such Fund directors and also receive additional substantial compensation as directors of other investment companies, for which latter positions they were likewise selected by Bullock, Clark and the Management Company (par. 8). The Fund's directors are either affiliated with or beholden to Bullock, Clark and the Management Company (par. 8).

 B. Dominating and controlling: (1) the Fund's board of directors; (2) the Fund's management; (3) the Fund's personnel; and (4) the Fund's business and affairs (par. 9(a)).

 The Wrongful Transactions Concerning the Investment Advisory Contract and Its Yearly Extensions.

 I.

 The relative positions of the defendants in such transactions were as follows: Bullock, Clark and the Management Company 'caused' the transactions. The other eight defendants 'participated or acquiesced in' such transactions 'with knowledge or notice of their wrongful character' (par. 9(b)).

 II.

 The voting of the Investment Advisory Contract and its yearly extensions took place under the following circumstances:

 A. Since prior to 1955, the Fund's board of directors has annually voted to continue the investment advisory contract with the Management Company (par. 10).

 B. The adoption of that contract and its yearly extensions was the result of 'the arbitrary action, collusion, gross negligence or reckless disregard of duty of the individual defendants and the Management Company' (par. 15(a)).

 The individual defendant-directors of the Fund 'abdicated their functions' by acts of commission and omission (par. 15(c)), in that they 'made no effort to ascertain whether' some organization other than the Management Company could be secured to supply the same investment advisory services 'on terms more advantageous to the Fund' and they made no effort to persuade or bargain at arm's length with the Management Company to supply such services on terms more advantageous to the Fund (par. 15(b)).

 C. Since prior to 1955, false and misleading proxy statements (filed with the Commission and mailed to the Fund's shareholders) were used by the defendants to bring about the election of the defendant-directors of the Fund and to induce inaction by the Fund's stockholders with respect to their statutory right (under the Act, section 15(a)(3)) to terminate the investment advisory contract or to seek its renegotiation on terms more favorable to the Fund (par. 19).

 'The proxy statements represented to the shareholders that the investment advisory arrangements between the Fund and the Management Company were 'similar to the arrangements between Calvin Bullock, Ltd. (i.e., the Management Company) and five other companies.' The reference to 'five other companies' was intended to and did include the Bullock Fund and Nation-Wide' (par. 19(b)).

 'Such representation was, to defendants' knowledge or notice, an untrue statement of a material fact and omitted to set forth facts necessary in order to prevent said representation, in the light of the circumstances under which it was made, from being materially misleading, in that the investment advisory arrangements of the Management Company with the Fund called for a substantially larger fee than the corresponding arrangements of the Management Company with the Bullock Fund and with Nation-Wide' (par. 19(c)).

 III.

 The operation and character of the Investment Advisory Contract and its yearly extensions involved the following features:

 A. For the five fiscal years of 1955 to 1959 and the six months ended April 30, 1960, the Management Company received from the Fund investment advisory fees totaling $ 4,421,435 (par. 10).

 B. The investment advisory fees charged by the Management Company to the Fund were and are one-half of one percent of the first $ 100,000,000 net assets and one-quarter of one percent of any excess above $ 100,000,000 (par. 12). The Management Company did and now does act as the investment adviser of Bullock Fund, Ltd. and Nation-Wide Securities Company, Inc. The Management Company's services to the Fund have been and are 'substantially the same in nature and extent' as its services to the Bullock Fund and Nation-Wide. Nevertheless, the investment advisory fees charged by the Management Company to the Bullock Fund and to Nation-Wide were and are 'much smaller, proportionately and absolutely, than those charged by it to the Fund' (par. 12).

 C. This method is 'grossly unfair' for the stated reason that once the net assets exceed $ 100,000,000 the fixed percentage of one-quarter of one percent is not scaled down as the value of the net assets increases, although the services of the Management Company remain constant regardless of the net asset value of the Fund. This arrangement will become increasingly more harmful to the Fund (par. 13).

 D. The amounts received by the Management Company from the Fund as investment advisory fees 'were and are excessive and out of proportion to the value of the services performed, as the defendants knew or should have known' (par. 16).

 E. The payments of the investment advisory fees by the Fund and their receipt by the Management Company, under the above-stated conditions and circumstances, constituted:

 (1) An 'unlawful and willful conversion' by the defendants of the Fund's moneys, property and assets to the use of the Management Company. This was a violation of section 37 of the Act (par. 17).

 (2) 'Gross abuse of trust, gross misconduct, willful misfeasance, bad faith, gross negligence or reckless disregard of official and contractual duties by the defendants' (par. 17). This was a violation of the statutory duties imposed upon the defendant-directors as directors and upon the defendant-Management Company as investment adviser. These duties were imposed by the Act, sections 1(b)(2), 10, 15, 17(h) and (i), and 36 (par. 17).

 (3) A breach by the defendants of 'their fiduciary duties to the Fund' to the defendants' benefit and profit and 'a gift, waste and a spoliation of the assets of the Fund' to the defendants' benefit and profit. This was a 'violation of New York and Maryland laws' (par. 17).

 F. The following were and are the results of the defendants' use of false proxy statements referred to above:

 (1) The defendant-directors were elected and they voted the yearly extensions of the investment advisory contract (par. 19).

 (2) 'The shareholders of the Fund failed to exercise their rights to terminate the investment advisory contract' under the Act, section 15(a)(3) or to seek its renegotiation on terms more favorable to the Fund (par. 19(g)).

 (3) The Fund and its shareholders suffered great damage (par. 19(g)).

 (4) The defendants profited (par. 19(g)).

 (5) The defendants' use of such false proxy statements was a violation of the Act, sections 20(a) and 34(b) and a violation of the Commission's Rules 270.20a-1(a) and X-14A-9 (par. 19(d)).

 IV.

 By reason of the above-stated premises the investment advisory contract and its yearly extensions are 'void,' the invalidity appearing more particularly as follows:

 A. The contract and its yearly extensions are rendered void by virtue of the Act, section 47(b) and New York and Maryland law (par. 18).

 B. The above-described use of false proxy statements invalidated the elections of the defendant-directors of the Fund (par. 19(e)).

 C. Inasmuch as the invalidly elected defendant-directors of the Fund lacked the power to exercise the functions of directors of the Fund, the yearly extensions of the investment advisory contract were illegal and void so far as concerns the defendants, by virtue of the Act, section 47(b) and New York and Maryland law (par. 19(f)).

 The Wrongful Transactions Concerning the Underwriting Contract and Its Yearly Extensions.

 I.

 The relative positions of the defendants in such transactions were as follows: Bullock, Clark and the Management Company 'caused' the transactions. The other eight defendants 'participated or acquiesced in' such transactions 'with knowledge or notice of their wrongful character' (par. 9(b)).

 II.

 The voting of the Underwriting Contract and its yearly extensions took place under the following circumstances:

 A. Since prior to 1955, the Fund's board of directors has annually voted to continue the Underwriting Contract with the defendant-Management Company (par. 11).

 B. The adoption of the Underwriting Contract and its yearly extensions was the result of 'the arbitrary action, collusion, gross negligence or reckless disregard of duty of the individual defendants and the Management Company' (par. 15(a)).

 The individual defendant-directors of the Fund 'abdicated their functions' by acts of commission and omission (par. 15(c)), in that they 'made no effort to ascertain whether' some organization other than the Management Company could be secured to supply the same underwriting services on terms more advantageous to the Fund and they made no effort to persuade or bargain at arm's length with the Management Company to supply such services on terms more advantageous to the Fund (par. 15(b)).

 III.

 The operation and character of the Underwriting Contract and its yearly extensions involved the following features:

 A. The Management Company did and does charge the following salesload for selling the Fund's shares: eight and two-thirds percent of the sales price on transactions under $ 10,000; seven and one-half percent on transactions involving from $ 10,000 to $ 24,999, and smaller percentages on larger transactions (par. 14).

 Pursuant to the Underwriting Contract, the Management Company did and now does act as 'the principal underwriter and sole distributor' of the Fund's shares. Under this contract, the Management Company 'charges the purchasers of the shares' the salesload or commission above-stated (par. 11).

 The Management Company was and is the principal underwriter and sole distributor of the shares of Nation-Wide Securities Company, Inc., another domestic diversified open-end management investment company. The salesload charged by the Management Company, in the case of Nation-Wide, was and is seven and one-half percent of the sales price on transactions under $ 25,000; and smaller percentages on larger transactions. The sale of the Fund's shares did and does require 'no greater efforts or expenses than the sale of the shares of Nation-Wide' (par. 14).

 B. For the five fiscal years of 1955 to 1959, the Management Company realized from the sales of the Fund's shares (and after deducting all commissions and charges paid to agents or other investment dealers) a sum totaling $ 2,168,966 (par. 11).

 C. The amounts received by the Management Company as salesload were and are 'excessive and out of proportion to the value of the services performed, as the defendants knew or should have known' (par. 16).

 D. 'Such excessive payments and the receipt thereof by the Management Company,' under the above-stated conditions and circumstances, constituted:

 (1) An 'unlawful and willful conversion' by the defendants of the Fund's moneys, property and assets to the use of the Management Company. This was a violation of the Act section 37 (par. 17).

 (2) 'Gross abuse of trust, gross misconduct, willful misfeasance, bad faith, gross negligence or reckless disregard of official and contractual duties by the defendants.' This was a violation of the statutory duties imposed upon the defendant-directors as directors and upon the defendant-Management Company (par. 17). These duties were imposed by the Act, sections 1(b)(2), 10, 15, 17(h) and (i), and 36 (par. 17).

 (3) A breach by the defendants of 'their fiduciary duties to the Fund' to the defendants' benefit and profit and 'a gift, waste and spoliation of the assets of the Fund' to the defendants' benefit and profit. This was a 'violation of New York and Maryland laws' (par. 17).

 IV.

 By reason of the premises, the Underwriting Contract and its yearly extensions are 'void' by virtue of the Act, section 47(b) and New York and Maryland law (par. 18).

 Futility of Demand on Fund's Board of Directors.

 'Demand on the Board of Directors of the Fund to bring this action would be futile since all or at least a majority of the directors participated in the wrongful transactions complained of' (par. 20).

 Futility and Lack of Necessity of Demand on Fund's Shareholders.

 'Demand on the shareholders of the Fund to bring this action is unnecessary and would be futile because':

 (a) The transactions are 'incapable of ratification by less than the unanimous vote of all shareholders' because the transactions 'were in violation of law, constituted gifts and waste of corporate assets and a fraud on the Fund' (par. 20(a)).

  (b) 'The shareholders cannot by resolution or otherwise require the Fund or its Board of Directors to bring an action' (par. 20(b)).

  (c) 'Even if the shareholders were to direct the Board of Directors to bring this action, its control would lie in the hostile hands of the directors, who could not be entrusted with its effective prosecution' (par. 20(c)).

  (d) For reasons detailed, a proxy fight with the management would be prohibitively expensive, dilatory, and undesirable from the viewpoint of possible laches and time-bar (par. 20(d)).

  Impracticability of Bringing All Shareholders Before the Court

  The shareholders (about 100,000) are so numerous as to make it impracticable to bring them all before the Court (par. 21).

  Prayer for Relief

  Plaintiffs pray for judgment:

  1. 'Declaring the investment advisory contract and its extensions to be null and void.'

  2. 'Declaring the underwriting contract and its extensions to be null and void.'

  3. Requiring the Management Company and the individual defendants 'to repay the investment advisory fees to the Fund.'

  4. Requiring the Management Company and the individual defendants 'to account to the Fund and its shareholders for profits and damages.'

  5. 'Allowing plaintiffs the costs and expenses of this action, including reasonable counsel fees.'

  The Issues. This one-count complaint, cast in terms of both a derivative and representative stockholder's action, charges violations of the following eight sections of the Act. Charging Paragraphs 1940 Act Title 15 U.S.C.A. Subject of Complaint //////-- ///////////////-- /////-- //////////-- § 15(a) (3) § 80a-15(a) (3) Stockholders' right 17(b) and 19(g) to terminate advisory contracts § 17(h) and (i) § 80a-17(h) and (i) Invalidity of 17(b) exculpatory clauses § 20(a) § 80a-20(a) Proxy solicitation 19(a)(b)(c)(d)(e) (SEC Rules under the 1940 Act, ) ( Rule 20a-1; 17 C.F.R. 270.20a-1. ) (SEC Rules under § 14(a) of the ) ( 1934 Act, § 78n of title 15 U.S.C.A., ) ( Rule X-14A-9, 17 C.F.R. 240.14a-9 ) § 34(b) § 80(a)-33(b) Untrue statements in 19(d) any document transmitted pursuant to the Act § 36 § 80a-35 Gross misconduct and 17(b) gross abuse of trust § 37 § 80a-36 Willful conversion 17(a) § 44 § 80a-43 Jurisdiction of suits 1 at law and in equity § 47(b) § 80a-46 Invalidity of contracts 18 and 19(f) violating the Act

  The dispositive issues are:

  I. Whether the statutory provisions upon which the plaintiffs' claim is based created any duties owing by the defendants to the Fund or to the plaintiffs.

  II. Whether the defendants' acts as alleged in the complaint violated any of those duties.

  III. Whether the plaintiffs can bring this action in this court to enforce the liabilities and duties created by the Act.

  These issues pose a problem of statutory interpretation requiring a view in depth. It is interpretation of the various statutory provisions -- not fragmented into isolated sections nor subject to mere black-letter reasoning -- as integrated parts of a remedial enactment possessing a fundamental unity of specific policy and stated objectives.

  The Act regulates the entire investment company industry. Congress sought to regulate that industry as comprehensively as the banking and insurance businesses are regulated. The Act is pervasive in scope and detail. In addition, the Commission is given broad power to promulgate rules, regulations and orders.

  The Act is to be sharply contrasted with the much narrower Securities Act of 1933 and the Securities and Exchange Act of 1934. The 1933 and 1934 Acts articulated only a policy of disclosure and securities registration and the regulation of certain securities practices. On the other hand, the 1940 Act placed the investment company business under close but workable regulation. One of the cogent reasons for the passage of the 1940 Act was the inadequacy of the 1933 and 1934 Acts to cope with the grave abuses and evils that had developed in some quarters of the investment company business.

  Those abuses and evils documented in fastidious and convincing detail were placed before the Senate and House Committees by the special investigating staff of the Securities and Exchange Commission. The investigation lasted four years. Comprehensive hearings were held. Technical studies and survey reports, case memoranda and comparative legislative studies, subject by subject, were submitted to the Congressional committees.

  The investment companies industry, through counsel and company executives, submitted their views on the record. These industry representatives worked in close cooperation with the Commission's staff. Industry recognized the abuses and evils; sought their elimination; and welcomed regulation, not only for the protection of the public and the investors, but for the good of legitimate companies.

  Eventually, the representatives of industry and the Commission expressed their agreement in a written memorandum dated May 13, 1940. This embodied the framework of an acceptable statute. The product of that compromise agreement was the 1940 Act.

  In terms of draftsmanship, the 1940 Act was to some extent built upon the cognate provisions of the 1933 and 1934 Acts, the Public Utility Holding Company Act of 1935, 15 U.S.C.A. § 79 et seq., the Trust Indenture Act of 1939, 15 U.S.C.A. § 77aaa et seq., and other regulatory statutes. But to a major degree, the 1940 Act was freshly designed and constructed to meet realistically the particular requirements and the special problems of the investment company business.

  The foregoing barest outline is fulsomely documented in the following records of the 76th Congress, 3d Session:

  Senate Report No. 1775 (Report to accompany S. 4108), June 6, 1940, Committee on Banking and Currency. (S. 4108 was a substitute for S. 3580, introduced March 14, 1940.)

  Hearings before a Subcommittee of the Committee on Banking and Currency, U.S. Senate, on S. 3580, Part 1 (April 2, 3, 4, 5, 8, 9, and 10, 1940); Part 2 (April 12, 15, 16, 17, 18, 19, 22, 23, 24, 25, and 26, ...


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