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HERZOG v. RUSSELL

December 17, 1979

ALVIN HERZOG, Plaintiff, against PHILIP A. RUSSELL, HARRIS J. ASHTON, CHARLES B. JOHNSON, EDMUND H. KERR, EDWIN C. McDONALD, FRANKLIN DISTRIBUTORS, INC. and FRANKLIN CUSTODIAN FUNDS, INC., Defendants.


The opinion of the court was delivered by: SIFTON

MEMORANDUM DECISION

A trial in the above action was held in April 1979. The following constitutes the Court's findings of fact and conclusions of law pursuant to Fed.R.Civ.P. 52(a).

 This is a derivative action brought by Alvin Herzog, a shareholder since August 18, 1969, of defendant, Franklin Custodian Funds, Inc. (the "Fund"), on behalf of and for the benefit of the Fund. The action was begun in 1971. The named defendants are the Fund, five of its directors, and Franklin Distributors, Inc. ("Distributors"). The case against one of the directors, Edmund H. Kerr, was dismissed by this Court on September 25, 1978, for lack of prosecution. Defendant McDonald was never served and did not appear at trial.

 The Fund is a registered investment company of the "mutual fund" type which sells shares to the public. Distributors was owned and controlled by defendant, Charles B. Johnson ("Johnson"), a director of the Fund, and by Rupert H. Johnson. Distributors acted pursuant to contract as investment advisor and principal distributor of the Fund's shares.

 The complaint sets forth four distinct claims in a single cause of action alleging (1) that the Agreement between the Fund and Distributors provided for an excessive management fee, (2) that Distributors derived benefits at the expense of the Fund through techniques known as "give ups" and "reciprocals," caused the Fund to pay higher than necessary brokerage commissions and to neglect opportunities to trade in the "third market," and failed to recapture brokerage commissions for the benefit of the Fund by organizing its own brokerage subsidiary, (3) that restricted securities were given an excessive valuation resulting in excessive management fees and excessive share redemption payments, and (4) the Fund is entitled to an accounting for all profits derived by defendants from a public offering of 19% of the stock of Franklin Resources, Inc. ("Resources"), the corporate parent of Distributors. Plaintiff's claims for excessive management fees and for improper valuation of restricted securities were withdrawn prior to trial.

 Leave to file an amended complaint was granted by this Court in a Memorandum Decision and Order dated April 19, 1978, but the order granting such leave was never complied with. Plaintiff, instead, attempted to serve and file an amended and supplemental complaint differing substantially from that for which permission had been sought. On October 6, 1978, in a further Memorandum and Order, this Court indicated that amendment of the complaint to conform to proof offered during trial would be allowed with regard to claims based on the following issues:

 1. Whether defendants violated applicable provisions of the statutes and regulations referred to in the complaint by failing to disclose to stockholders and independent directors of the Fund that there were opportunities for the recapture of brokerage commissions which the Board of Directors of the Fund had not pursued.

 2. Whether defendants violated applicable provisions of the statutes and regulations referred to in the complaint by failing to disclose to the stockholders of the Fund an assignment of the investment advisory agreement between the Fund and Distributors as a consequence of an alleged transfer of control in Distributors said to have resulted from the following transactions: the pre-December 1969 private placement of stock of Distributors by certain defendants; the December 1969 acquisition of Distributors by Resources; and the 1971 distribution of stock of Resources to the public.

 The potential inclusion of such proxy rule issues by the Order of this Court was without prejudice to litigation concerning the relation back of the claims asserted by such amendment under Fed.R.Civ.P. 15(c) for purposes of defenses based on limitations and laches. Defendants contend that the new issues sought to be raised by amendment were not part of the transaction or occurrence attempted to be set forth in the original pleading and must be considered to have been introduced into the case by the Order of October 13, 1978. As such, defendants contend that these issues are barred by laches.

 Because the Court finds no basis for liability on either of the claims set forth above, it need not decide the issue of whether the claims should relate back to the date of the original complaint.

 This case presents questions examined before in this Circuit concerning the duties of investment advisor and mutual fund with respect to recapture of brokerage commissions earned on transactions in the Fund's portfolio for the benefit of the fund. The applicable legal principles in this Circuit are laid down in Tannenbaum v. Zeller, 552 F.2d 402 (2d Cir. 1977), and Fogel v. Chestnutt, 533 F.2d 731 (2d Cir. 1975), cert. denied, 429 U.S. 824, 97 S. Ct. 77, 50 L. Ed. 2d 86 (1976), which approved with qualifications the landmark decision in Moses v. Burgin, 445 F.2d 369 (1st Cir.), cert. denied, 404 U.S. 994, 92 S. Ct. 532, 30 L. Ed. 2d 547 (1971), the first Court of Appeals decision dealing with the recapture problem.

 The background of the recapture problem is set forth in the opinions in Fogel, supra, and Tannenbaum, supra, and will not be repeated here. The cause of the problem was eliminated by the Securities Act Amendments of 1975, Pub.L. No. 94-29, 89 Stat. 97, which forbade exchange transactions for one's own account or that of an associate and eliminated the imposition of fixed commission rates by securities exchanges. See Tannenbaum v. Zeller, supra, 552 F.2d at 409.

 FIDUCIARY DUTY

 Plaintiff contends that the failure to recapture brokerage commissions violated defendants' fiduciary duty to Fund. *fn1"

 Although plaintiff referred to customer directed give-ups in his pretrial papers and at trial as an available method of recapture, such practices were prohibited by the SEC prior to the time that plaintiff became a shareholder of the Fund and, thus, were not an available method of recapture during the period in question. Investment Company Act, Rel.No.5554 (Dec. 3, 1968).

 The evidence at trial focused on two specific recapture methods which plaintiff alleges continued to be available to the Fund during the relevant period. These are preferred rate non-membership on the Pacific Coast Stock Exchange ("PCE") *fn2" and affiliated membership on the Philadelphia-Baltimore-Washington Exchange ("PBW").

 In Tannenbaum v. Zeller, supra, the Second Circuit held that a decision to forego recapture did not violate the fiduciary obligations of the Fund's adviser or directors under section 36 of the Investment Company Act, 15 U.S.C. § 80a-1 et seq. (the "Act"), "if the independent directors (1) were not dominated or unduly influenced by the investment adviser; (2) were fully informed by the adviser and interested directors of the possibility of recapture and the alternative uses of brokerage; and (3) fully aware of this information reached a reasonable business decision to forego recapture after ...


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