Summary
declining to dismiss a Section 36(b) claim because it is "impossible to say, as a matter of law, that a net adviser fee equal to 42.3% of a fund's total investment income in a given year, where such fund by any objective standard performed poorly in that year, is not disproportionately large enough to bear an unreasonable relationship to the services rendered by that adviser"
Summary of this case from Krantz v. Fidelity Management Research Co.Opinion
98 Civ. 3725 (RWS)
January 19, 2000
WECHSLER HARWOOD HALEBIAN FEFFER, New York (JOEL C. FEFFER, ESQ. JEFFREY M. HABER, ESQ. of Counsel), Attorney for Plaintiff.
WILLKIE FARR GALLAGHER, New York, (LAWRENCE O. KAMIN, ESQ., ISKAH C. SINGH, ESQ., MARCIA TAVARES MAACK, ESQ. of Counsel), Attorney for Defendant.
OPINION
Defendant BEA Associates ("BEA") has moved to dismiss the complaint of plaintiff Robert Strougo ("Strougo") pursuant to Rules 12(b)(6), 12(b)(7), and 23.1, Fed.R.Civ.P., for failure to state a claim, failure to join a necessary party, and failure to meet the demand requirement in a shareholder derivative suit, respectively. For the reasons set forth below, the motion is granted in part and denied in part.
The Parties
Plaintiff Strougo is a shareholder of the Brazilian Equity Fund, Inc. (the "Fund") having purchased 1,000 shares of the Fund's stock on January 11, 1993. Strougo continues to hold shares of the Fund.
The Fund is a non-diversified, publicly traded, closed-end investment company registered under the Investment Company Act of 1940, as amended, 15 U.S.C. § 80a-47(a) (the "ICA"), and incorporated under the laws of Maryland, that invests primarily in the equity securities of Brazilian companies. The Fund's shares are traded on the New York Stock Exchange.
Defendant BEA serves as investment adviser to the Fund and manages the Fund's operations and investments. Its principal executive offices are located at 153 East 53rd Street, New York, New York 10022. On January 12, 1999, BEA changed its name to Credit Suisse Asset Management, reflecting a change of ownership and control.
Prior Proceedings
Strougo filed the complaint (the "Original Complaint") in this action on May 21, 1998, alleging a violation of ICA § 36(b). BEA filed a motion to dismiss on August 17, 1998, submissions for which were received through February 22, 1999. This Court granted the motion and dismissed the action on March 18, 1999. See Strougo v. BEA Assoc., No. 98 Civ. 3725 (RWS), 1999 WL 147737 (S.D.N.Y. Mar. 18, 1999) (hereinafter "Strougo I").
On April 2, 1999, Strougo filed an amended complaint (the "Amended Complaint"). On July 6, 1999, BEA filed the instant motion. Submissions were received through October 20, 1999, at which point oral argument was heard.
Facts
On a motion to dismiss under Rule 12(b)(6), the facts alleged in the complaint are presumed to be true, and all factual inferences are drawn in the plaintiff's favor. See Mills v. Polar Molecular Corp., 12 F.3d 1170, 1174 (2d Cir. 1993). Accordingly, the facts presented here are drawn from the allegations of the Amended Complaint and do not constitute findings of fact by the Court.
BEA manages the Fund's operations subject to the governance of an eight-member board of directors (the "Board"). At the time the Original Complaint was filed, Board members Emilio Bassini ("Bassini"), Richard Watt, and Daniel Sigg were BEA employees. Board members Dr. Enrique Arzac, James J. Cattano, Peter A. Gordon, George W. Landau, and Martin M. Torino were not BEA employees, but served on the boards of numerous BEA-advised funds for which they received the following compensation during the Fund's fiscal year ended March 31, 1998:
Compensation From Director Number of BEA Funds All BEA Funds
Dr. Enrique Arzac 10 $94,500
James J. Cattano 7 $54,500
Peter A. Gordon 5 $45,500
George W. Landau 6 $55,000
Martin M. Torino 5 $46,000
The aggregate compensation ($295,500) received by the five directors whose compensation is listed in the table above (the "Non-Employee Directors") during the Fund's fiscal year ended March 31, 1998 was 9.4% higher than the aggregate compensation received by the same individuals for serving on the same number of BEA boards during the Fund's preceding fiscal year. Each of the five directors holds a full-time employment position not related to work for BEA.
The Board has no separate nominating committee comprised exclusively of the Non-Employee Directors. The Fund has a "staggered" or "classified" board of directors. The Fund's by-laws require that the holders of at least 25% of all outstanding shares request a special shareholder meeting.
The Non-Employee Directors have taken no action to replace BEA or lower its fees, notwithstanding the performance of the Fund, which, when measured against comparable funds, is alleged to have been poor.
The Fund pays to each of its Non-Employee Directors an annual fee of $5,000 plus $500 for each board meeting attended. In addition, the Fund reimburses its Non-Employee Directors for travel and out-of-pocket expenses incurred in conjunction with board meetings. Such compensation is greater than the collective investment the Non-Employee Directors have in the Fund — 2,332 shares, or 0.035 percent of the Fund's outstanding shares.
On March 17, 1998, the Non-Employee Directors notified the Securities and Exchange Commission ("SEC") of their intent to exclude from the Fund's 1998 proxy statement a shareholder proposal to terminate the advisory agreement with BEA and solicit competitive proposals for a new investment adviser. The Non-Employee Directors requested assurance from the SEC that it would take no action if the Fund excluded the proposal from its proxy solicitation materials.
On May 8, 1998, the SEC ruled that it could not provide the Non-Employee Directors with the assurance that it would not seek enforcement action with regard to the board's decision to exclude the shareholder proposal.
The Non-Employee Directors acted to "thwart" this shareholder initiative. In addition, the Non-Employee Directors, acting on behalf of BEA, ignored BEA's "abysmal" performance and permitted the expenditure of Fund assets to finance their campaign to deprive the Fund's shareholders of their right to vote.
As compensation for its advisory services, BEA receives from the Fund an annual fee, calculated weekly and paid quarterly, equal to 1.35 percent of the first $100 million of the Fund's average weekly net assets and 1.05 percent of the Fund's average weekly net assets in excess of $100 million. BEA has waived its portion of the advisory fee previously payable to former sub-advisors, equal to an annual rate of 0.35 percent of the Fund's average weekly net assets. The complaint alleges that such fee is higher than those paid by most U.S. investment companies.
Of eighty-five world equity funds whose total expenses were reported in The Wall Street Journal on December 31, 1998, eighteen, or 21%, had a higher expense ratio than the Fund. Of the remaining sixty-seven world equity funds, the Fund reported the worst one-year market return — a loss of 53.5% The Fund's return (based on net asset value and assuming reinvestment of dividends and distributions) for the year ended March 31, 1998 was minus 6.6% The Morgan Stanley Capital International Brazil Index rose by 12.6% during the same period. During the Fund's 1998 and 1997 fiscal years, BEA's net fees equaled 42.3% and 46.0%, respectively, of the Fund's total investment income.
Discussion
Strougo's Amended Complaint alleges causes of action under §§ 36(a) (b) of the ICA. Defendant's motion seeks dismissal of both causes of action.
I. Legal Standards
In deciding the merits of a motion to dismiss for failure to state a claim, all material allegations composing the factual predicate of the action are taken as true, for the court's task is to "assess the legal feasibility of the complaint, not assay the weight of the evidence which might be offered in support thereof." Ryder Energy Distribution Corp. v. Merrill Lynch Commodities Inc., 748 F.2d 774, 779 (2d Cir. 1984) (quoting Geisler v. Petrocelli, 616 F.2d 636, 639 (2d Cir. 1980)). Thus, where a plaintiff can prove no set of facts in support of his or her claim which would warrant relief, the motion to dismiss must be granted. See H.J. Inc. v. Northwestern Bell Tel. Co., 492 U.S. 229, 249-50 (1989).
II. The § 36(a) Cause of Action Will Be Dismissed
BEA objects to the § 36(a) cause of action on three grounds: (a) failure to name the Fund as a defendant; (b) failure to make pre-suit demand on the Board; and (c) failure to state a claim. These objections will be addressed in turn.
A. The Fund Is A Necessary Party
Under Rule 19(b), Fed.R.Civ.P., indispensable parties must be joined in a lawsuit; otherwise, the action is subject to dismissal under Rule 12(b)(7). As a general rule, in a derivative suit the corporation on whose behalf the suit is brought is an indispensable party. See, e.g., Ross v. Bernhard, 396 U.S. 531, 538 (1970).
Strougo contends that the general rule should not apply in a case involving a registered investment company, which often has no employees of its own and is managed entirely by principals and employees of the investment adviser. While there may be some merit to this view, Strougo cites no cases or other authority in support of his position. Strougo's reasoning, alone, does not support carving out an exception to the well-established rule that a corporation is an indispensable party in a derivative suit. Accordingly, the § 36(a) claim will be dismissed without prejudice for failure to join the Fund as a defendant. Strougo will, however, be permitted to amend his complaint once again in order to join the Fund as a defendant. In anticipation that Strougo will take this step, the Court will move on to consider BEA's other reasons for seeking dismissal of the § 36(a) claim.
B. Strougo Is Not Required To Make Pre-Suit Demand on the Board
Strougo's original complaint was dismissed on the ground that it did not state a cause of action under ICA § 36(b). See Strougo I, 1999 WL 147737, at *2-*5. The opinion indicated that the allegations would more likely present a claim under § 36(a). See id. at *4.
The Amended Complaint states the § 36(a) claim in addition to alleging additional facts which Strougo contends meet the pleading requirement for a § 36(b) claim and which will be addressed below. The § 36(a) claim is brought as a shareholder derivative claim, thereby triggering the demand requirements of Rule 23.1, Fed.R.Civ.P. The Amended Complaint alleges demand futility because the five Non-Employee Directors are controlled and dominated by the Board, which participated or acquiesced in the allegedly wrongful acts in violation of the ICA and the fiduciary duties of the Board.
Subsequent to the filing of the Original Complaint, but prior to the filing of the Amended Complaint, the Board's composition changed: Robert J. McGuire ("McGuire") and Miklos A. Vasarhelyi ("Vasarhelyi") became directors. According to an affidavit of Lawrence O. Kamin, counsel for BEA, McGuire and Vasarhelyi do not serve on any other BEA-advised funds and receive no compensation from BEA beyond their compensation for services to the Fund.
Under Maryland law, which governs here, "demand should not be excused `so long as there are two directors whose involvement in the facts underlying the claim is not so great as to call into question their compliance with the standard of conduct of Section 2-405.1' of the Maryland Corporations and Associations Code." Strougo v. Scudder, Stevens Clark, Inc., 964 F. Supp. 783, 795 (S.D.N.Y. 1997) (hereinafter "Scudder") (quoting Hanks, Maryland Corporation Law, § 7.21[c] at 269 (1994-1 Supp.). BEA contends that because the Amended Complaint was filed after McGuire and Vasarhelyi joined the Board, demand should have been made with respect to the § 36(a) claim. Strougo, by contrast, contends that the demand requirement should be assessed as of the date of the filing of the Original Complaint.
There is no guidance on this question in the Maryland statutes, nor has it been considered by the Maryland courts. In this circuit, the sole authority is Brody v. Chemical Bank, 517 F.2d 932 (2d Cir. 1975). Brody held that where the composition of a board of directors had changed since the initial filing date of an action, an amended complaint filed after the date when the board changed should have alleged demand on the new board, not on the board in office at the time the action was originally commenced. See id. at 934. However, Brody appears to have relied exclusively on federal law in reaching this conclusion. See id. The Supreme Court has subsequently held that when considering the demand futility exception of Rule 23.1 in an action brought pursuant to the ICA, a court must "apply the demand futility exception as it is defined by the law of the State of incorporation." Kamen v. Kemper Financial Servs., Inc., 500 U.S. 90, 108-09 (1991). Since the Kamen decision, Brody has not been cited for the proposition stated above, and thus no longer appears to be controlling.
The Delaware Chancery Court reached a different conclusion in Harris v. Carter, 582 A.2d 222 (Del.Ch. 1990). Harris involved procedural circumstances similar to those at hand here. The Harris plaintiff originally filed a non-derivative claim. An amended complaint asserted a derivative claim under substantially the same allegations, alleging that demand was futile under the board that was in place at the time the original complaint was filed. The board had changed composition between the time of the filing of the original and that of the amended complaint, and the defendants maintained that the demand requirement should have been assessed as of the time of the filing of the amended complaint. See id. at 224-25.
In holding that demand futility should be assessed as of the time of the filing of the original complaint with respect to claims the allegations of which are raised both in the original complaint and in an amended complaint, the Harris court reasoned that,
[w]hen a board is comprised of new directors who are under no personal conflict with respect to prosecution of a pending derivative claim, the board may cause the corporation to act in a number of ways with respect to that litigation. It may move the court to take control dof the litigation by being realigned as a party plaintiff. Or the board may, after deliberation on the matter, move to dismiss the case as not, in the board's business judgment, in the corporation's best interest. If the new board is independent and acts in an informed way in good faith its judgment ought ordinarily be respected by the court. Finally, the board may, through a formal understanding or by simply failing to act, allow the representative plaintiff and his counsel to carry the litigation forward.
Id. at 230-31 (citations omitted).
The holdings of the Delaware Court of Chancery are not, of course, binding on this court. Yet the reasoning of the Harris court is persuasive. Moreover, the Court of Chancery has a well-recognized expertise in the field of state corporation law.
Of course, the reasoning of the Harris court assumes that the corporation is involved in the action, which will not be the case here until (and unless) Strougo amends the complaint to add the Fund as a party — thus providing another reason for requiring joinder not mentioned in subsection A above.
For these reasons, Strougo's allegations of demand futility will be considered as of the date of the filing of his original complaint. In a related action, Strougo v. Bassini, 1 F. Supp.2d 268 (S.D.N.Y. 1998) (hereinafter "Bassini"), this Court held that due to the multiple directorships held by the five non-employee Board members (Arzac, Cattano, Gordon, Landau, and Torino), demand was excused. See id. at 273-74. BEA maintains, however, that a Maryland statute enacted on October 1, 1998 (after the date of the Bassini decision) and retroactive to actions filed after January 1, 1998, mandates a change in the result here. See Md. Code Ann., [Corporations and Associations], § 2-405.3 (1998). The Maryland statute states that "[a] director of a corporation who with respect to the corporation is not an interested person, as defined by the [ICA], shall be deemed to be independent and disinterested when making any determination or taking any action as a director." Id. § 2-405.3(b). As paragraph 14 of the Amended Complaint spells out, the ICA defines an "interested person" as "any affiliated person." 15 U.S.C. § 80a-2(a)(19) (A)(i). An "affiliated person," in turn, is defined to include "any person directly or indirectly . . . controlled by . . . such other person." Id. § 80a-2(a)(3)(C).
Finally, "control" is defined as "the power to exercise a controlling influence over the management or policies of a company." Id. § 80a-2(a)(9).
This question of control is substantially the same question resolved in Bassini, where this Court, in holding that the Non-Employee Directors were "interested" within the meaning of the ICA, stated that "well-compensated service on multiple boards of funds managed by a single fund adviser can, in some circumstances, be indistinguishable in all relevant respects from employment by the fund manager, which admittedly renders a director interested." Bassini, 1 F. Supp.2d at 273 (quoting Strougo v. Scudder, Stevens Clark, Inc., No. 96 Civ. 2136 (RWS), 1997 WL 473566, at *5 (S.D.N.Y. Aug. 18, 1997)).
BEA points out that the ICA definition of "control" presumes that a natural person is not a control person. See 15 U.S.C. § 80a-2(a)(9). The next sentence of the definition, however, states that "any such presumption may be rebutted by evidence." Id. In a motion to dismiss on the pleadings, the task is not to weigh the evidence. The Amended Complaint alleges facts sufficient to maintain a cause of action predicated on BEA's control over the Non-Employee Directors.
In any event, the ICA not only defines an "affiliated person" as a "controlled person," but also as any "employee." Id. § 80a-2(a)(3)(D). Bassini, relying on Scudder, explicitly found that the Non-Employee Directors could not be distinguished from employees for the purpose of determining whether they were affiliated. While Scudder and Bassini did not, therefore, explicitly identify which subcategory listed under the ICA definition of "affiliated person" the directors in question fell into, it was either (C), or (D), or both. Thus, the Maryland statute does not require a decision contrary to the one reached in Bassini, which is controlling here. For the reasons stated in Bassini and Scudder, Strougo is found to have alleged sufficient facts to satisfy the demand futility requirement of Rule 23.1.
C. Strougo Has Stated A Valid Claim for Breach of Fiduciary Duty Under § 36(a)
BEA also contends that Strougo has not brought a valid breach of fiduciary claim under § 36(a). However, this contention was based on the assumption that Strougo has not adequately pled that the Non-Employee Directors are "interested," a point rejected above.
BEA also maintains that the § 36(a) claim does not allege personal misconduct, because the misconduct is addressed solely to BEA, the investment adviser. This precise argument, however, was previously rejected by this Court. See Scudder, 964 F. Supp. at 798-801. BEA has not offered any reasoning or cited any authorities suggesting that the Scudder holding should be abandoned.
III. The § 36(b) Claim Will Not Be Dismissed
The legal standard for an excessive fee claim under § 36(b) is "whether the fee schedule represents a charge within the range of what would have been negotiated at arm's-length in the light of all of the surrounding circumstances." Gartenberg v. Merrill Lynch Asset Management Inc., 694 F.2d 923, 928 (2d Cir. 1982). To violate § 36(b), "the adviser-manager must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered." Id.
Gartenberg identified six factors to weigh in determining whether fees charged by the investment adviser were disproportionate to the services rendered: "(a) the nature and quality of services provided to fund shareholders; (b) the profitability of the fund to the adviser-manager; (c) fall-out benefits; (d) economies of scale; (e) comparative fee structures; and (f) the independence and conscientiousness of the trustees." Brinsk v. Fund Asset Management, Inc., 875 F.2d 404, 409 (2d Cir. 1989) (citing Gartenberg, 694 F.2d at 929-30).
In the Amended Complaint, Strougo alleges (i) that BEA's advisory fee was twice the amount of the average advisory fee in the 1960s; (ii) that, of 85 world equity funds, only 18, or 21%, had a higher expense ratio than the Fund and of the 67 remaining funds, the Fund reported the worst one-year market return: a loss of 53.5%; (iii) that it only provides services for which it receives compensation; (iv) that it operates to benefit the adviser rather than the shareholder; and (v) that during the 1998 and 1997 fiscal years, BEA's net fees equaled 42.3% and 46.0% of the Fund's total investment income.
BEA contends that these allegations are insufficient to state a § 36(b) claim under the Gartenberg test. Yet Gartenberg is a post-trial decision in which the evidence can be weighed against the six-factor test. The pleading standards under the federal rules — absent a heightened requirement such as exists for pleading fraud under Rule 9(b) — do not contemplate pleadings sufficiently detailed to enable a court to make a determination on a 12(b)(6) motion as to whether the six Gartenberg factors were met. Rather, the inquiry at this stage should be whether the Amended Complaint alleges sufficient facts to make out a claim under the more general Gartenberg formulation that "the adviser-manager must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered." Id. at 928. And, under this formulation, it is impossible to say, as a matter of law, that a net adviser fee equal to 42.3% of a fund's total investment income in a given year, when such fund by any objective standard performed poorly in that year, is not disproportionately large enough to bear an unreasonable relationship to the services rendered by that adviser. The allegations in the Amended Complaint suffice to state a claim under § 36(b).
Conclusion
For the reasons set forth above, Strougo's § 36(a) claim will be dismissed without prejudice for failure to join the Fund as a necessary party. Strougo is given leave to file a second amended complaint within twenty (20) days to add the Fund as a defendant. Strougo's § 36(b) claim stands.
It is so ordered.