Lasker v. BurksLasker v. Burks
- Reporters:
- Before:
- Lumbard, Oakes, Meskill
This appeal by two mutual fund shareholders raises an important question of first impression: can minority directors of a registered mutual fund, who were nominated by the majority directors of the fund to be ” independent” directors pursuant to the requirements of the Investment Company Act,
Howard Lasker and Irving Goldberg commenced this derivative action in February, 1973, against individuals who had been directors of Fundamental Investors, Inc. (the Fund), an open-end investment company1 registered under the Investment Company Act,
It is undisputed that Anchor never made any independent investigation of Penn Central‘s financial situation before the Fund‘s purchase of the notes. Moreover, although repоrts of Penn Central‘s operations in early 1970 showed mounting losses, it was not until May that the Fund officers made any attempt to resell any part of the notes to Goldman, Sachs, or otherwise to realize on the investment. On June 21, 1970, Penn Central filed a petition for reorganization which is still in process in the Eastern District of Pennsylvania. Consequently, the Fund‘s Penn Central notes were not paid at maturity.
In November 1970, the Fund, joined by three other noteholders,2 sued Goldman, Sachs in the Southern District of New York for recovery of their losses arising from their purchases of Penn Central notes. In July 1973, then District Judge Gurfein stayed the instant action, which had been commenced five months earlier, pending resolution of the suit against Goldman, Sachs. That suit was settled on behalf of the Fund in July 1974. Under the settlement, Goldman, Sachs took back the Fund‘s Penn Central notes, paid the Fund $5,250,000, and assigned to the Fund a 73.75 percent interest in the proceeds of the notes in the reorganization proсeedings. The Fund‘s co-plaintiffs did not settle, and the jury rendered verdicts in their favor against Goldman, Sachs for the full amount of their claims.3
On July 24, 1974, the Fund‘s board of directors met and discussed the pending Lasker case. They decided that five of the statutorily disinterested directors, none of whom were involved in the derivative aсtion,4 should decide what action should be taken regarding the Lasker case, and act accordingly on behalf of the entire board.5 This procedure had been discussed prior to the July board meeting by the defendant John R. Haire, president of the Fund and chairman of Anchor‘s board of directors, and Roger Wickers, an officer of both the Fund and Anchor. Upon Haire‘s instruction, Wickers had ascertained that Stanley H. Fuld, former chief judge of the New York Court of Appeals, would be available to serve as special counsel. The minority directors agreed to consider what should be done about the Laskеr case, and instructed Wickers to retain Judge Fuld to advise them.
Judge Fuld, in his report of December 5, 1974, supplemented on December 18, 1974, concluded, on the basis of the information furnished to him, that neither Anchor nor the Fund directors would be found liable under federal or state law. At the same time, Judge Fuld pointed out the аbsence of legal authority on whether a mutual fund‘s investment adviser is required to conduct independent research regarding its investment recommendations. He further cautioned that it was “impossible to predict . . . what a trier of fact will find, particularly in complex circumstances.” After considering the special counsel‘s reports, on January 6, 1975, the minority directors instructed counsel for the Fund to seek dismissal of the Lasker action on the ground that it was their business judgment that further prosecution of the action would not be in the best interests of the Fund.
Judge Werker, in passing on the motion to dismiss, held that the minority directors, in the exerсise of their business judgment, had the power to bar further prosecution of the case, provided they were truly disinterested and independent. As a factual issue had been raised regarding whether the minority directors were independent and disinterested, he granted discovery on that issue. Lasker v. Burks, 404 F.Supp. 1172 (S.D.N.Y.1975). After such discovery, the motion to dismiss was renewed and granted by Judge Werker on January 7, 1977. In his second opinion, 426 F.Supp. 844 (S.D.N.Y.1977), Judge Werker found no factual support for the conclusion that the minority directors had not acted independently. In accordance with his earlier opinion, he dismissed the complaint.
From what this record discloses regarding thе Fund‘s investment in Penn Central notes on Anchor‘s advice, we cannot say that, following a trial on the merits, the defendants would be found free from liability for the Fund‘s losses. We see nothing in the findings of Congress, the legislation regulating investment companies and their advisers, or in the decisions of the courts which suggests that under such circumstances disinterested directors, such as the five who acted here, have the power to terminate litigation brought by mutual fund stockholders against the fund‘s investment adviser and its majority directors for breach of their fiduciary duties. On the contrary, the findings of Congress, the statutory scheme, and the relevant case law pеrsuade us that the statutorily disinterested directors of a registered investment company were never meant to have the final word in determining whether it is in the best interest of a mutual fund to press claims against their co-directors, and the adviser with which those directors are affiliated, for breach of fiduciary duties.
In rеsponse to disclosure of grave abuses in the management of investment companies, Congress in 1940 enacted the Investment Company Act (ICA),
Thе ICA provides that no more than 60% Of a registered company‘s board of directors can be “interested persons” affiliated with the investment adviser.8 Moreover, it gives the statutorily disinterested directors, usually referred to as “independent directors,” certain powers to supervise management and auditing аrrangements.9 Thus, section 15(c) of the ICA,
Congress has not been satisfied, moreover, that the presence of disinterested directors who observe their duties will be sufficient protection to the stockholders, as it has specifically provided in section 36(b) that shareholders may sue derivatively to recover exсessive fees paid to the adviser and the principal underwriter. See
We have been sensitive to the need for protection of the public interest in accordance with the views of Congress. Thus, in Galfand v. Chestnutt, 545 F.2d 807 (2d Cir. 1976), we found that the investment adviser had abused its position of trust by securing a favorable modification of its advisory contract without fully disсlosing to the fund‘s directors the ramifications of the changes. Writing for the panel, Chief Judge Kaufman observed that, “(t)he 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.” Id. at 808. See also Tannenbaum v. Zeller, 552 F.2d 402 (2d Cir. 1977).
Moreover, in many instances where no specific authority is granted by statute the courts have inferred that stockholders may bring suit. See, e. g., Abrahamson v. Fleschner, --- F.2d ---- at ---- (2d Cir. Feb. 25, 1977) and cases cited therein. It would surely be anomalous to hold that the statutоrily disinterested directors could determine not to pursue litigation against their co-directors for liability which may amount to many millions of dollars, and foreclose the stockholders from continuing such litigation, while at the same time stockholders by statute are empowered to recover excess fees paid the adviser and underwriter.
In the ordinary routine of running an investment trust, the disinterested directors must constantly deal with interested directors in a spirit of accommodation. Indeed, they are compelled for the most part to rely on the information and expert advice provided by the adviser and the mаjority directors.11 The continued service of the statutorily disinterested directors, for which in this case they were paid from $11,000 to $13,000 per annum,12 depends almost entirely on the establishment of satisfactory working arrangements between them and the majority responsible for their selection. It is asking too much of human nаture to expect that the disinterested directors will view with the necessary objectivity the actions of their colleagues in a situation where an adverse decision would be likely to result in considerable expense and liability for the individuals concerned.13 Correspondingly, it cannot be expectеd that the public or the Fund‘s stockholders would believe that these five statutorily disinterested directors could act with that impartiality and objectivity which the public interest requires. It follows that disinterested directors of an investment company do not have the power to foreclose the continuation of nonfrivolous litigation brought by shareholders against majority directors for breach of their fiduciary duties. Of course here we do not reach the question of whether a court should defer to the decision of statutorily disinterested directors of an investment company to terminate a shareholder derivativе suit which the court finds to be frivolous.
Our conclusion makes it unnecessary to consider the findings of the district court that the disinterested directors were sufficiently independent to determine that the litigation be ended.14 We have no doubt that the five minority directors acted in good faith in all that they did.
Reversed and remanded for further proceedings.