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TANNENBAUM v. ZELLER

July 30, 1975

Susan Tannenbaum, Plaintiff,
v.
Robert G. Zeller, et al., Defendants


Carter, District Judge.


The opinion of the court was delivered by: CARTER

CARTER, District Judge:

I.

 This is a derivative action brought pursuant to Section 44 of the Investment Company Act of 1940, as amended (15 U.S.C. § 80a-43); Section 27 of the Securities Exchange Act of 1934 (15 U.S.C. § 78aa); and Section 22 of the Securities Act of 1933 (15 U.S.C. § 77v). Plaintiff, who has been a shareholder of record of the Chemical Fund (Fund) continuously since at least 1965, sues on behalf of the Fund.

 The latter, a Delaware corporation, is an open end "mutual fund" registered with the Securities and Exchange Commission under the Investment Company Act. The Fund's principal activity is its varied investments in the chemical process industry. On December 31, 1965, the net total assets of the Fund were $433,849,751, and as of December 31, 1973, these assets had registered a more than 100% growth totaling $897,333,945. While the net total assets at the time of trial in 1974 were down to approximately 706 million dollars, a reflection of the general downward economic trend in this country, the Fund's performance still compared favorably with like investment operations.

 The Fund's manager and distributor of shares, pursuant to written contracts, is F. Eberstadt & Co., Managers & Distributors, Inc. (M & D), also a Delaware corporation. M & D is a subsidiary of F. Eberstadt & Co., Inc., a brokerage house founded by the late F. Eberstadt, who also served on the board of the Fund. M & D provides staff, offices, advice and recommendations to the Fund and manages and supervises the business and affairs of the Fund, subject to the latter's Board of Directors, a majority of whom are disinterested or unaffiliated directors; that is, having no association with F. Eberstadt & Co. or M & D, within the meaning of Sections 2(a)(3), 2(a)(19), 10(a) and 10(b), of the Investment Company Act, 15 U.S.C. §§ 80a2(a)(3), 80a2(a)(19), 80a10(a), and 80a10(b). The management agreement and the distribution agreement obligate M & D to provide all statistical and research services at M & D's expense and to pay for the sale and distribution of Fund shares.

 The unaffiliated or disinterested Fund directors are men of repute in academia, business and the professions. Among them are Dr. James S. Coles, director since 1968, currently President of Research Corporation, a foundation for the advancement of science, and before that President of Bowdoin College; Burt N. Dorsett, director since 1966, currently Vice President and Senior Investment Officer for College Retirement Equities Fund, and former Vice President for Investments at the University of Rochester; Alfred E. Driscoll, director since 1957, currently Chairman of the New Jersey Turnpike Authority and former governor of New Jersey; Dr. Bertrand Fox, director since 1970, recently retired Professor of Investment Banking at Harvard University Graduate School of Business Administration; Dr. Roger F. Murray, director since 1959, Professor of Banking and Finance at the Columbia University Graduate School of Business, formerly Vice President, responsible for portfolio management at Bankers Trust Co., and at one time manager of the investment portfolio of the Teachers Insurance and Annuity Association & College Retirement Equities Fund; Whitman Hobbs, director since 1972, John N. Martin, Franz Schneider, long time director, and Julian Avery, director until 1968, holding responsible positions in various corporate business institutions; Dr. Howard Rusk, director since 1962, well-known authority on rehabilitation and other medical questions; Leroy Marek, director from 1959-1973, a consultant on scientific problems and issues; and James J. Minot, director from 1968-1970, senior partner in Paine, Webber, Jackson & Curtis, Inc.

 The parent company, Eberstadt (formerly a partnership), until 1972 owned all the capital stock of M & D, and since that time has held 75% of M & D's stock. Eberstadt since 1962 has been a member of the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) and continuously since 1970, a member or associate member of the American Stock Exchange (AMEX). Robert Zeller, the only individual defendant served, is Vice Chairman of the Fund's Board and of M & D's Board. Prior to the incorporation of Eberstadt, Zeller was a partner in the firm. Since its incorporation he has been chairman of its Board and its chief executive officer.

 Prior to 1971, the constitution and rules of the New York Stock Exchange required all members to charge at least a prescribed minimum commission on all transactions without regard to size or profitability. Moreover, the Exchange had always and continues to prohibit any direct rebate to a customer of any part of a commission earned by a member in the execution of a transaction, i.e., the consummation of a trade on the exchange. The costs of executing large orders, however, were not proportionately higher than the execution costs of small orders. But for the minimum commission regulation, broker-dealer firm members of NYSE in competing for business would have been willing to reduce their commissions based on quantity discounts to the customer. The unavailability of this form of discount led to a widespread practice in the mutual fund industry of customer directed "give-ups." Thus prior to December 5, 1968, it was common practice, custom and usage for a mutual fund through its manager to direct executing brokers on the NYSE and other national securities exchanges to "give-up" part of their commission to other exchange members who had no part in the execution of the transaction. *fn1" The "give-up" was normally directed to a non-executing broker but one who had sold the shares of the mutual fund to the public and/or who had provided useful research and statistical information. For the years 1965 through 1973, the Fund paid gross commissions to M & D, a portion of which M & D paid to nonaffiliated dealers, in the amounts indicated below: SALES CHARGE NET AMT. RECEIVED BY AMT. ALLOWED RETAINED YEAR M & D TO DEALERS BY M & D 1965 $ 1,678,130 $1,443,784 $ 234,346 1966 2,126,476 1,676,727 449,749 1967 1,599,478 1,236,823 362,655 1968 1,440,831 1,118,046 322,785 1969 1,328,119 1,034,212 293,907 1970 2,098,752 1,619,762 478,990 1971 3,166,064 2,433,832 732,232 1972 6,334,902 4,885,042 1,479,860 1973 10,751,197 8,251,184 2,500,013 Between 1965 and 1973, the Fund paid brokerage commissions for the execution of purchases and sales of securities on behalf of the Fund on the NYSE, on which 80% of the portfolio transactions were executed, the AMEX and regional securities exchanges in the following amounts: YEAR AMOUNT 1965 $ 339,860 1966 447,653 1967 617,787 1968 501,604 1969 472,757 1970 651,596 1971 920,767 1972 939,660 1973 1,291,735 From January 1, 1965 through December 5, 1968, brokers who executed transactions were directed by the Fund through M & D to "give-up" a portion of their commissions to brokers and dealers who performed no services in the execution of these transactions. The "give-ups" were awarded to these non-executing brokers and dealers for services rendered in the selling of Fund shares and in providing statistical or research services without making any charge therefor. The "give-ups" constituted a substantial portion of the execution commission which, as previously suggested, executing brokers and dealers willingly shared because the low cost of execution was more than adequately met by the minimum commissions specified. These "give-ups" from 1965 to 1968 exceeded the following amounts: YEAR AMOUNT 1965 $ 81,686 1966 136,200 1967 214,600 1968 246,600 From January 1, 1965, through July 15, 1973, one of the basis on which brokers and dealers were chosen as executing brokers or dealers to handle a portfolio transaction for the Fund was to reward them for the sale of Fund shares. During the years 1965-1970, commissions paid by the Fund when the sale of Fund's shares was a criterion for selection of an executing broker were as follows: YEAR AMOUNT 1965 $271,910 1966 379,752 1967 510,346 1968 430,150 1969 363,036 1970 462,613 During that period and to date another basis for the selection of executing brokers was to compensate them for providing statistical and research services to the Fund through M & D. The commissions paid in connection with such transactions were as follows: YEAR AMOUNT 1965 $40,977 1966 42,900 1967 61,000 1968 45,967 1969 46,454 1970 91,662

 These allocations are known as reciprocal brokerage, and approximately 98% of the Fund's portfolio transactions were allocated on this basis. After July 15, 1973, pursuant to a rule adopted by the NASD, the sale of Fund shares could no longer be a criterion for selection or non-selection of an executing broker or dealer.

 While direct customer rebates were prohibited by the NYSE and AMEX and certain regional securities exchanges, a member firm serving as an investment advisor was not prohibited from crediting against its investment advisory fee some portion of the commission it earned from execution of portfolio transactions for the investment advisory client. Thus, M & D would have been permitted to credit against its management fee from the Fund some portion of any brokerage commission earned by Eberstadt in the execution of the Fund's portfolio transactions; and before "give-ups" were abolished, it would have been possible for Eberstadt to have received "give-ups" from other member firms who acted as executing brokers for the Fund and for such "give-ups" to be credited against the Fund's management fee. That fee, while based on a percentage lower than most in the industry, was not insubstantial as the management fees between 1965 and 1969 listed below indicate: YEAR AMOUNT 1965 $ 1,160,563 1966 1,268,590 1967 1,428,228 1968 1,505,231 1969 1,521,868 On March 20, 1970, and on March 14, 1971, the formula for computation of the management fee was revised, and the fees in the years since have been as follows: YEAR AMOUNT 1970 $1,662,203 1971 2,247,468 1972 3,097,640 1973 3,361,470

 "Give-ups" were abolished by a rule of the NYSE effective December 5, 1968. Recapture of commissions or a portion thereof, however, was permissible in other respects until adoption of Article IX, Section 7(k) of the Constitution of the NYSE on January 29, 1973, and of the present Rule 318 of the NYSE on February 1, 1973. Similar rules have now been adopted by the AMEX and various regional exchanges.

 The plaintiff's basic contention is that from January 1, 1965, until December 5, 1968, when "give-ups" were prohibited by NYSE rules, and up to the present when recapture of excess commissions was available, defendants were required to use the Fund-directed "give-ups" and the recapture of excess commissions for the benefit of the Fund; that prior to December 14, 1970, the use of excess commissions to discharge M & D obligations under its management and distribution agreements with the Fund violated §§ 36 and 1(b)(2) of the Investment Company Act (15 U.S.C. §§ 80a-35 and 80a-1(b)(2)), entitling plaintiff to recover on behalf of the Fund; and that such use of excess commissions after December 15, 1970, violated §§ 36(a) and 1(b)(2) of the Investment Company Act (15 U.S.C. §§ 80a-35(a) and 80a-1(b)(2)), entitling plaintiff to recover damages on behalf of the Fund; and that such use from January 1, 1965, to the present constituted a breach of fiduciary duty at common law entitling plaintiff to recover damages on behalf of the Fund.

 II.

 Plaintiff's chief reliance is on Moses v. Burgin, 445 F.2d 369 (1st Cir.), cert. denied sub nom. Johnson v. Moses, 404 U.S. 994, 30 L. Ed. 2d 547, 92 S. Ct. 532 (1971). Before proceeding further a few threshold observations may be helpful. Plaintiff may be correct in her view that the basic thrust of Burgin is that the management of a mutual fund is obligated to use all proper means to secure excess brokerage commissions for the benefit of the fund. However, application of that principle to this case will not necessarily result a fortiori, as plaintiff seems to suggest, in a conclusion that failure of M & D to direct ...


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