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GALFAND v. CHESTNUTT

July 23, 1975

MILDRED GALFAND, on behalf of herself and on behalf of AMERICAN INVESTORS FUND, INC., Plaintiff,
v.
GEORGE A. CHESTNUTT, JR., and CHESTNUTT CORPORATION, Defendants, and AMERICAN INVESTORS FUND, INC., Nominal Defendant



The opinion of the court was delivered by: BRIEANT

FINDINGS AND CONCLUSIONS

 Brieant, J.

 This shareholder's derivative action was commenced on July 6, 1973 in the United States District Court for the Eastern District of Pennsylvania, seeking a preliminary injunction to restrain American Investors Fund from conducting its annual shareholders meeting set for July 17, 1973.

 Plaintiff owns 86 whole shares of American Investors Fund, a New York corporation ("AIF" or the "Fund"), an open-end no-load mutual fund registered under the Investment Company Act of 1940 (15 U.S.C. § 80a-1, et seq., the "Act").

 In addition to the Fund itself, defendants are Chestnutt Corporation, a Connecticut corporation, which is AIF's investment adviser, and George A. Chestnutt, Jr., President and Director of the Fund and President, Director and owner of 47% of the shares of the adviser.

 This Court has subject matter jurisdiction pursuant to 15 U.S.C. § 80a-35(b).

 On July 11, 1973, the Honorable Raymond J. Broderick, United States District Judge, Eastern District of Pennsylvania, held a hearing on plaintiff's motion for an injunction. On the same day, defendants moved to transfer the action to this Court, pursuant to 28 U.S.C. § 1404(b). On July 13, 1973, Judge Broderick denied plaintiff's motion for a preliminary injunction. [Decision reported at 363 F. Supp. 291 (E.D.Pa. 1973)]. The evidence presented in support of plaintiff's motion was limited (see 363 F. Supp. p. 293); on the basis of the sparse record before him Judge Broderick held (363 F. Supp. p. 296):

 
"The Court, therefore, concludes that the plaintiff has not established the first prerequisite for the issuance of a preliminary injunction -- a reasonable probability of eventual success on the merits."

 Subsequently, Judge Broderick granted defendants' motion for change of venue to this Court. [Decision reported at 363 F. Supp. 296.]

 On June 21, 1973, proxy solicitation materials for the annual shareholders' meeting on July 17, 1973 were mailed by management to AIF's shareholders. Proxies were solicited and shareholder approval sought, inter alia, for a new contract between the Fund and its investment adviser, Chestnutt Corporation. The new contract was intended to replace a prior contract dated as of September 1, 1972 (Ex. 4, hereinafter referred to as the "old agreement"), which had not yet expired. The Fund and its adviser had an established custom and practice of executing two year agreements which were replaced annually, a year prior to the expiration date.

 The adviser's fees were unchanged by the new agreement. The only change proposed was an increase in the "expense ratio limitation" from 1% to 1 1/2%. Under paragraph 9 of the old agreement, the adviser was required to reimburse the Fund, up to the amount of its fee for the year, to the extent certain expenses, together with the fee, exceeded 1% of the Fund's average monthly net assets (see paragraph 9, quoted in full, infra, p. 1330).

 Plaintiff claims Mr. Chestnutt influenced the other Fund directors improperly to have the expense ratio increased to 1 1/2%, and did so solely for the benefit of the adviser and contrary to the interests of the Fund, to forestall an anticipated rebate of the fee during the year 1973, all in violation of 15 U.S.C. § 80a-35(b). *fn1"

 Plaintiff also claims defendants made false and misleading statements in the proxy materials to obtain shareholder approval of the change, in violation of 15 U.S.C. § 80a-20(a) *fn2" and Rule 14a-9 *fn3" [17 C.F.R. § 240.14a-9].

 The proxy materials (Ex. 1) state that the expense ratio limitation increase was sought because of rising costs, which neither the Fund nor its adviser could control. Plaintiff claims this is false. The proxy materials also state that no rebate would have been due the Fund had the 1 1/2% expense ratio limitation been in effect in 1972. Plaintiff claims this statement is incomplete and misleading. With the market value of net assets declining and an expense ratio limitation of 1% of the Fund's net asset value, the Fund most likely would have been entitled to a refund of a portion of the adviser's fees for 1973. Plaintiff contends the shareholders should have been told a change to a 1 1/2% limitation would result in a loss of that foreseeable refund.

 The AIF annual meeting was held as scheduled on July 17, 1973 and the proposed new contract (Ex. 1) was approved by the Fund's shareholders.

 On July 25, 1974, this Court granted defendants' motion to dismiss, as moot, the original complaint seeking equitable relief. Leave to file an amended complaint was granted plaintiff upon posting a $1,000.00 bond, pursuant to Local Rule 2 of the Civil Rules of this Court. Bond was posted, and an amended complaint was filed on August 14, 1974. The amended complaint makes the same allegations and seeks judgment voiding the new advisory agreement, requiring defendants to account for and pay over to AIF any rebate which would have been due had the expense ratio limitation of 1% remained in effect for 1973.

 Trial of this action commenced on February 18, 1975 before the Court without a jury.

 Factual Background of the Dispute.

 AIF was formed by George Chestnutt in 1957. Since its inception, Chestnutt Corporation or its predecessors (all controlled by Mr. Chestnutt) served as adviser to the Fund, providing research and guidance in the administration of the Fund's assets, office space, and related office expenses, executive salaries and promotional costs. *fn4"

 Mr. Chestnutt was one of the first investment advisers to develop a theory of investment strategy based on keeping complex statistical records or charts showing historical price and volume fluctuations, and relative performance of individual stocks and stocks of selected industry groups. Since 1946, Mr. Chestnutt has edited and published a weekly technical stock market letter, "American Investors Service."

 Mr. Chestnutt and many respected investors believe that market trends can be predicted by analysis of statistics and charts showing trends with respect to price fluctuations of individual stocks, stocks in industry groups, and the stock market in general. Chestnutt Corporation furnishes the Fund with "continuing analysis of the action of over 1,000 issues by means of daily charts supplemented by a weekly computer analysis of relative market performance," and correlations of "economic findings with technical studies in the fields of money, credit availability and banking statistics." (Ex. 1, p.4).

 The Fund was organized on the theory that, unlike other funds, it would provide an opportunity to participate in a portfolio administered in accordance with the general theories expounded by the Chartists, and Mr. Chestnutt's theories in particular. This method or practice required extensive administrative overhead. At one time, Chestnutt Corporation employed 110 people to administer this Fund and its other accounts. By the end of 1974, the staff had been cut to approximately 37. (Tr. p.69).

 The preparation of charts and computer analyses makes the service provided by Chestnutt Corporation expensive, but the Fund's shares were sold and bought upon the representation that this unique investment strategy would be pursued by the Fund's manager. Although Chestnutt's methods may not have been particularly successful in recent years, they remain respectable, and enjoy acceptance among knowledgeable investors.

 As an open-end no-load investment company, the Fund may have a board of directors "all the members of which, except one, are interested persons of the investment adviser" [15 U.S.C. § 80a-10(d)]. At the time of the events in suit, AIF's board consisted of eight members, three of whom were not "interested persons". The other five, including Mr. Chestnutt, were all affiliated in some fashion with Chestnutt Corporation.

 Each contract between the Fund and the adviser was for a term of two years, but was submitted to the shareholders for approval annually as is required by the Act, and its terms were in compliance with the Act (15 U.S.C. § 80a-15). The annual fee received by Chestnutt Corporation was computed as a percentage of the net assets of the Fund.

 The 1% expense ratio limitation was added to the contract renewed some years prior to the events in suit at the instance of state regulatory commissions, notably in California, where the Fund sold shares.

 The investment performance of the Fund over the years had been relatively unsuccessful compared with other funds. *fn5" Fund assets had declined in market value from $220,000,000.00 in September 1972 to less than $150,000,000.00 in May 1973. Expenses had been increasing due primarily to inflation. In 1970 the Fund instituted a minimum investment requirement of $400.00. Prior thereto, it had required no minimum investment. As a consequence, it had a large proportion of small accounts, and thus its administrative expenses of the sort which are directly related to the number of accounts (shareholders) were high, compared with funds which had few small shareholders.

 Violation of Fiduciary Duty.

 In 1972 and early 1973, AIF, like other funds, was suffering from a decline in the total market value of its assets, caused by shareholder redemptions and a general drop in market prices of securities. In May 1973, it appeared likely that unfavorable market conditions would continue, and the adviser's total fee would therefore decline with the asset value of the Fund. It also appeared likely that expenses of the Fund would increase with the foreseeable result that Chestnutt Corporation would then be required to refund some part of its fee to the Fund in compliance with the 1% expense ratio limitation contained in the advisory contract dated September 1, 1972 then in effect. Mr. Chestnutt thought this eventuality likely within a year or two (Deposition of George Chestnutt, June 4, 1974, p.14).

 The Board of Directors of AIF had frequently considered its rising expenses but had never considered increasing the expense ratio limitation until the matter was brought up by Mr. Chestnutt at a board meeting on May 21, 1973. Messrs. Cram and Lee, attorneys for the Fund and for Chestnutt Corporation, were asked to make inquiries of those securities commissioners of the states requiring an expense ratio limitation, and to report to the board at its next meeting.

 At the next meeting of the board on June 5, 1973, the proposed increase was approved, to be implemented in a new contract to be submitted at the July meeting, and dated as of September 1, 1973. Eugene Ulrich, a disinterested director of the Fund distributed to the directors on June 5th a table (Ex. 14) listing twenty funds having assets over $100,000,000.00, their number of shareholders, turnover rate, percent of expenses, and management fees. This tabulation submitted by Ulrich was the only information the directors had before them when they were discussing the advisability of increasing the expense ratio. No further information was requested by the directors and none was offered by Chestnutt Corporation.

 Mr. Ulrich's initiative in furnishing this information is insufficient to fulfill the requirements of 15 U.S.C. § 80a-15(c):

 
". . . It shall be the duty of the directors of a registered investment company to request and evaluate, and the duty of an investment adviser to such company to furnish, such information as may reasonably be necessary to evaluate the terms of any contract whereby a person ...

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