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Galfand v. Chestnutt Corp.

decided as amended: November 4, 1976.

MILDRED GALFAND, ON BEHALF OF HERSELF AND ON BEHALF OF AMERICAN INVESTORS FUND, INC., PLAINTIFF-APPELLEE AND CROSS-APPELLANT,
v.
CHESTNUTT CORPORATION, DEFENDANT-APPELLANT, AND AMERICAN INVESTORS FUND, INC., NOMINAL DEFENDANT



Appeal from a judgment of $76,672 entered in the United States District Court for the Southern District of New York, Charles L. Brieant, Judge, in favor of a shareholder, suing on behalf of a mutual fund, against the fund's investment adviser for breach of fiduciary duty, 15 U.S.C. § 80a-35(b), and issuance of a false and misleading proxy statement, 15 U.S.C. § 80a-20(a) and S.E.C. Rule 14a-9. Cross-appeal by plaintiff below for increase of damage award.

Kaufman, Chief Judge, Mansfield and Meskill, Circuit Judges.

Author: Kaufman

Kaufman, Chief Judge:

The relationship between investment advisers and mutual funds is fraught with potential conflicts of interest. The typical fund ordinarily is only a shell, organized and controlled by a separately owned investment company adviser, which selects its portfolio and administers its daily business. Compensation for these services is determined under an advisory contract, the terms of which are all too often dictated to unwary or negligent fund directors and fund shareholders by the investment adviser.

The vulnerability of mutual fund shareholders to unscrupulous advisers prompted Congress to enact Section 20 of the Investment Company Amendments Act of 1970, 15 U.S.C. § 80a-35(b),*fn1 imposing a fiduciary duty on the investment adviser with respect to its receipt of compensation for services rendered to the fund. We are called upon to consider whether, in securing a mid-term modification of its advisory contract with American Investors Fund, Inc. (AIF), Chestnutt Corporation observed its duty of uncompromising fidelity to the interests of AIF security owners. In addition, we are required to decide whether the proxy statement sent to AIF shareholders contained material misstatements or omissions in violation of 15 U.S.C. § 80a-20(a) and the Security and Exchange Commission's Rule 14a-9. We hold that Chestnutt Corporation abused its position of trust by acquiring from the mutual fund, without full disclosure to the AIF Board of Directors, a patently one-sided revision of the advisory contract and that it subsequently violated Rule 14a-9 in obtaining shareholder ratification of the new contract on the basis of a misleading proxy statement. Accordingly, we affirm the judgment of the district court. We also remand, for the reasons hereinafter set forth, for a recalculation of damages.

I.

A brief recitation of the facts will facilitate understanding the legal issues presented for review. AIF was founded in 1957 by George A. Chestnutt, Jr., who became and remains both a Director and President of the Fund. Like other mutual funds, AIF provided small investors an opportunity to pool their venture capital to obtain the benefits of professional financial advice and diversification at a relatively modest cost. The Fund was unusual, however, in that it offered its security holders an investment strategy inspired by the principles of what was characterized as Chartism.*fn2

This policy was devised by Mr. Chestnutt, who managed the Fund's investments through his control of the investment adviser, appellant Chestnutt Corporation.*fn3 The adviser, in addition to supervising the Fund's portfolio, furnished office space and clerical personnel, and paid both the salaries of the Fund's executives and all promotional expenses relating to Fund sales.*fn4 In return, Chestnutt Corporation received quarterly reimbursement of its expenses and a fee calculated as follows:

Quarterly Equivalent Net Assets

Rate Annual Rate of the Fund

0.2% 0.8% on the next $50 million

0.15% 0.6% on the next $50 million

0.1% 0.4% on the next $200 million

0.0875% 0.35% on the ...


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