Fed. Sec. L. Rep. P 95,768mildred Galfand, on Behalf of Herself and on Behalf Ofamerican Investors Fund, Inc., Plaintiff-appelleeand Cross-appellant, v. Chestnutt Corporation, Defendant-appellant,andamerican Investors Fund, Inc., Nominal Defendant, 545 F.2d 807 (2d Cir. 1976)

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),¹  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.

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.² 

This policy was devised by Mr. Chestnutt, who managed the Fund's investments through his control of the investment adviser, appellant Chestnutt Corporation.³  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.⁴  In return, Chestnutt Corporation received quarterly reimbursement of its expenses and a fee calculated as follows:

The fee was subject, however, to an "expense ratio limitation".⁵  Total charges to the Fund, including the fee, but excluding interest and taxes, could not exceed 1% of the value of the Fund's average monthly net assets for any year. Chestnutt Corporation's successful effort to increase this expense ratio limitation to 1 1/2% spawned the current litigation.

Prior to 1973, Chestnutt Corporation's fee was not seriously threatened by the expense ratio limitation. But by May of that year a general deterioration of securities prices had resulted in a sharp decline in the value of the Fund's assets.⁶  Inflation simultaneously was causing a rapid increase in the adviser's expenses. In an effort to limit rising costs, Chestnutt Corporation initiated a program of redemptions designed to eliminate shareholder accounts too small to justify service costs. The economies thus achieved, however, caused still greater reduction in the Fund's net asset value. This ominous conjunction of factors led Mr. Chestnutt to believe that, under the 1% expense ratio limitation provided by the two-year advisory contract in force since September 1, 1972, Chestnutt Corporation would be required to begin paying rebates to the Fund within two years.

To forestall this eventuality, Mr. Chestnutt decided to increase the expense ratio limitation to 1 1/2%. Acquiescence of the AIF Board of Directors was not difficult to obtain. Chestnutt first proposed revision of the advisory contract at the May 21, 1973, Board meeting. The measure was approved without any difficulty at the next meeting, on June 5. The directors of the Fund gave the proposal cursory scrutiny at best. Mr. Chestnutt at no time gave any indication that by this action, the Fund was foregoing a possible rebate in 1973; nor did he present any evidence to support his gloomy assertions that current trends threatened the financial viability of the investment adviser.⁷  It is clear from the record that Mr. Chestnutt's personal domination was such that the directors never considered for a moment opposing his suggestion.

Having secured the Board's consent, Mr. Chestnutt sought shareholder ratification of the proposed increase in the expense ratio limitation. The next Annual Meeting was scheduled for July 17, 1973. On June 21 proxy materials were mailed to the Fund's security holders. The materials justified the contract revision as one resulting from "cost increases over which neither the Fund nor the Adviser can exercise control," ignoring entirely the decline in the Fund's net asset value, an equally prominent factor in the "squeeze" on Chestnutt Corporation's profits. The proxy statement added, moreover, that "no higher costs would have been incurred by the Fund had the proposed new agreement been in effect in 1972," although Chestnutt knew the amended contract was likely to increase the ultimate compensation due the investment adviser in 1973.

Despite the effort of appellee Mildred Galfand, suing derivatively on behalf of the Fund, to secure a preliminary injunction,⁸  the Annual Meeting was held as scheduled on July 17 and the new advisory contract was ratified by a wide margin. The modification in the expense ratio took effect on September 1, 1973. Galfand, meanwhile, continued to pursue her remedy at law. A change in venue from the Eastern District of Pennsylvania to the Southern District of New York was subsequently granted, Galfand v. Chestnutt, 363 F. Supp. 296 (E.D. Pa. 1973), and on July 23, 1975, Judge Brieant, after a trial without a jury, found that Chestnutt Corporation breached its fiduciary duty to AIF in securing the expense ratio increase and made false and misleading statements in the proxy materials to obtain shareholder approval of the revamped advisory agreement, in violation of 15 U.S.C. § 80a-20(a) and Rule 14a-9, 17 C.F.R. § 240.14a-9 (1976).⁹ 

Congress, in imposing a fiduciary obligation on investment advisers, plainly intended that their conduct be governed by the traditional rule of undivided loyalty implicit in the fiduciary bond.¹⁰  It is axiomatic, therefore, that a self-dealing fiduciary owes a duty of full disclosure to the beneficiary of his trust. Former Chief Judge Friendly stated the principle succinctly:

under the scheme of the Investment Company Act an investment adviser is "under a duty of full disclosure of information to . . . unaffiliated directors in every area where there was even a possible conflict of interest between their interests and the interests of the fund" a situation which occurs much more frequently in the relations between a mutual fund and its investment adviser than in ordinary business corporations . . .

Fogel v. Chestnutt, 533 F.2d 731, 745 (2d Cir. 1975), cert. denied, --- U.S. ----, 97 S. Ct. 77, 50 L. Ed. 2d 86 (1976), (citing Moses v. Burgin, 445 F.2d 369, 376 (1st Cir.), cert. denied, 404 U.S. 994, 92 S. Ct. 532, 30 L. Ed. 2d 547 (1971)).¹¹  Moreover, even where a fiduciary has made full disclosure, it is the duty of a federal court to subject the transaction to rigorous scrutiny for fairness. See Pepper v. Litton, 308 U.S. 295, 306-07, 60 S. Ct. 238, 84 L. Ed. 281 (1939).¹²  We believe it is clear that, in applying these standards, Chestnutt's conduct in obtaining approval of the contract modification must be found to have fallen far short of the elevated norm Congress expected.

A thorough search of the record reveals no evidence that Chestnutt, in discussing the issue with the AIF directors, made any reference to the fact or even suggested that the Fund would lose a rebate if the expense ratio were raised to 1 1/2% of average monthly net assets. And, although the financial soundness of the investment adviser is of proper concern to a mutual fund, Chestnutt failed to support his Cassandran prophecies of possible bankruptcy with financial statements or corroborating figures. Had he supplied the AIF Board of Directors with data more recent than the 1972 annual report, it would have been apparent that Chestnutt Corporation had ample assets¹³  and substantial income despite recent unfavorable trends. Chestnutt appears to have ignored completely his duty to promote responsible directorial judgment by supplying information sufficient to enable the Fund's Board to evaluate the new contract "with an eye eager to discern . . . rather than shut against" the interests of AIF. Fogel v. Chestnutt, supra at 749. His influence with the Fund's directors can hardly be questioned. The result of this dereliction was a patently one-sided revision of the advisory contract which placed the entire burden of rising costs and a falling market on the Fund, whose financial condition was not accorded even a passing concern.

Chestnutt asserts that to upset the advisory contract approved by the shareholders is tantamount to judicial meddling with corporate democracy. The irony of such an argument will become apparent after examination of the proxy materials, particularly when scrutinized in the light of the rules promulgated by the Securities and Exchange Commission to assure fair corporate suffrage by accurate explanation to the shareholder of issues upon which his vote is sought. See Mills v. Electric Auto-Lite Co., 396 U.S. 375, 381, 90 S. Ct. 616, 24 L. Ed. 2d 593 (1970).

We set out in full the relevant paragraph of the proxy statement purporting to advise AIF security holders of the rationale for the proposed increase in the expense ratio limitation:

As a result of cost increases over which neither the Fund nor the Adviser can exercise control, the Fund and the Adviser have determined that the 1% annual expense ratio limitation in the current Investment Advisory Agreement shall be increased to 1 1/2%. No increase in the fees paid or payable to the Adviser is proposed. The aggregate annual operating costs, including the fee of the Adviser, will be limited to 1 1/2% of average monthly net assets in the contract. Heretofore, the Advisory contract required the Adviser to reimburse the Fund to the extent that total annual expenses (exclusive of interest and taxes) exceeded 1% of average monthly net assets. Under the new Agreement, no reimbursement from the Adviser would be required unless and until total annual expenses of the Fund (again, excluding interest and taxes) exceeded 1 1/2% of average monthly net assets. The Investment Advisory fee schedule would not be changed under the new agreement; however, the higher allowable expense ratio limitation would benefit the Adviser by reducing the risk that some or all of the advisory fee would have to be reimbursed to the Fund due to an increase in rates for other expenses or changes in the average account size of American Investors Fund shareholders. No higher fees or costs would have been incurred by the Fund had the new Agreement been in effect in 1972.

Judge Brieant found the italicized portions of this proxy statement false and misleading under Rule 14a-9.¹⁴  The district judge determined that the shareholders should have been informed that the new expense ratio was sought to avoid penalizing the adviser not only for cost increases beyond its control but also for depreciation of the Fund's net assets. In addition, according to Judge Brieant, the security holders should have been told that a refund might be due in 1973 if the 1% expense ratio term had remained in force for the duration of the old contract.¹⁵ 

But the appellants argue vigorously that these findings are infirm because Judge Brieant, lacking the guidance of the Supreme Court's opinion in TSC Industries v. Northway, 426 U.S. 438, 96 S. Ct. 2126, 48 L. Ed. 2d 757 (1976), evaluated the materiality of the omitted facts under an erroneous standard. It is true, of course, that the test applied below omissions are material if "a reasonable investor might have considered them" so was repudiated in TSC Industries. The correct formulation was enunciated by the Supreme Court thus:

(An) omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote . . . Put another way, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available. Id. at 449, 96 S. Ct. at 2133, 48 L. Ed. 2d at 766.

We are of the view that even under the TSC Industries test, the proxy statement here was materially misleading.

In so holding, we have the benefit of Judge Brieant's careful appraisal of the key paragraph in the proxy statement. This paragraph deceptively stated Chestnutt's avowed reason for fearing the possibility of a future rebate by omitting to mention the primary component of the rebate formula declining Fund assets a subject of considerable interest to shareholders who were being asked effectively to increase the fee of their investment adviser. And the adversion to the absence of a rebate in 1972 if the 1 1/2% limitation had been in effect, without any indication whatever that a refund was even a remote possibility, under any set of circumstances, in 1973 and 1974, was a misleading half-truth. Chestnutt does not seriously dispute the finding that he and the fund directors believed a rebate possible. Indeed, this belief was precisely the reason they desired the expense ratio increase. By presenting some negative factors, the inclusion of these omitted facts certainly would have significantly altered the "total mix" of information made available to voting shareholders. Accordingly, since we find that shareholder approval for the revised advisory contract was secured by means of a materially misleading proxy statement, we affirm the district court's order rescinding the new agreement, 15 U.S.C. § 80a-46(b).

There remains the issue of damages for us to deal with. There is no dispute regarding Judge Brieant's finding that in 1973 Chestnutt Corporation was unjustly enriched under the voided contract by $18,330. The controversy revolves around the appropriate figure for 1974, when the challenged advisory contract was superseded on September 1 by a new one whose validity is not here in question. In light of the maze of figures presented by both sides at this appellate stage, we believe that a proper determination of damages must be based upon a clearer, more certain record. Accordingly, we remand for a recalculation of 1974 damages by the district judge. We are able, however, to provide some guidance on the method of computation. The court should include all expenses for July and August, 1974, in calculating the rebate. Moreover, we believe that the advisory fee for those two months should be included in the damage formula. Although the payment due is apparently measured by the value of the Fund's assets at the end of the quarter (i. e. October 1), the fee represented services rendered daily during July and August. We note that the parties contemplated such proration of expenses in their advisory contract:

P 9. For the quarter and the year in which this agreement terminates, there shall be an appropriate proration in the basis of the number of days that this Agreement is in effect during the quarter and the year respectively . . .

This merely treats the advisory fee as an accrued expense of the Fund.

The judgment is affirmed as modified by a recomputation of the damages on remand.