Burks v. Lasker

PETITIONER:Burks
RESPONDENT:Lasker
LOCATION:Monroe County Courthouse

DOCKET NO.: 77-1724
DECIDED BY: Burger Court (1975-1981)
LOWER COURT: United States Court of Appeals for the Second Circuit

CITATION: 441 US 471 (1979)
ARGUED: Jan 17, 1979
DECIDED: May 14, 1979

ADVOCATES:
Daniel A. Pollack – for petitioners
Joseph H. Einstein – for respondents
Ralph C. Ferrara – for the Securities and Exchange Commission, Washington, D

Facts of the case

Question

Audio Transcription for Oral Argument – January 17, 1979 in Burks v. Lasker

Warren E. Burger:

We’ll hear arguments next in Burks against Lasker.

Mr. Pollack you may proceed whenever you are ready.

Daniel A. Pollack:

Mr. Chief Justice and then may it please the Court.

The central issue in this case may be stated as follows.

Does the Investment Company Act of 1940 deprive the disinterested directors of the mutual fund of their power to terminate a stockholders’ derivate action, which those directors in good faith have concluded is contrary to the best interests of the fund and its shareholders?

The District Court held that the disinterested directors in the exercise of their good faith business judgment have the power to terminate such an action.

The Court of Appeals held that as a matter of law, the directors have no such power irrespective of the fact that they acted in good faith.

Certain subsidiary issues are also raised in this case and they will emerge in my later discussion of the plaintiffs point in this case.

The facts are set forth chronologically in our main brief, the white covered brief that pages 4 through 19.

In the interest of moving promptly to the central legal issue in this case I will simply summarize the highlights at this point.

In November 1969, Fundamental Investors, the mutual fund involved in this case, purchased $20 million of the commercial paper of Penn Central.

The commercial paper of Penn Central was rated, prime, the highest rating by NCO, a subsidiary of Dun & Bradstreet which is the foremost independent rating agency in the United States.

In June 1970, Penn Central filed for reorganization and defaulted on the notes.

Numerous people were caught in the default as well as Fundamental Investors, banks, trust companies, charities, universities many other sophisticated and able investors.

In November 1970, the Board of Directors of Fundamental authorized a lawsuit against Goldman Sachs, the dealer which had sold the paper.

That suit proceeded vigorously for several years as part of a multi-district proceeding.

In February 1973, three years after the purchase, two stockholders holding very minimal shares filed a derivate action against Anchor Corporation, the investment advisor to Fundamental, and against the Directors of Fundamental at the time of the purchase, that is to say the 1969 directors.

That action was stayed by Judge Gurfein, pending resolution of the claims of Fundamental Investors against Goldman Sachs.

In July 1974, on the eve of trail of the action between Fundamental and Goldman Sachs there was a settlement pursuant on to which Fundamental was paid five million two hundred fifty thousand dollars in cash and also the balance of their claim in the notes of Penn Central and reorganization.

The board of directors —

Potter Stewart:

Has the value of those yet been ascertained?

Daniel A. Pollack:

The exact value is not a matter of record, Your Honor.

However, I believe that the card indication is that the additional paper may be worth as much as $3 million or $4 million.

The Board of Directors of Fundamental promptly convened and determined that it would review the Lasker action, that is to say the derivative action, and that the five disinterested Directors among them who were not defendants in the Lasker action, who had not been Directors at the time of purchase and who were not affiliated in any way with Anchor, would constituting quorum, determine what posture the fund should take with respect to that action.

Those five disinterested Directors there upon retained independent special counsel, former Chief Judge of the State of New York, Stanley H. Fuld and they instructed him to prepare a comprehensive memorandum and report on the subject.

Judge Fuld studied the matter for several months and in December issued a report to the disinterested directors, in which he concluded that neither Anchor nor any of the fund directors had violated any law or any contractual or other obligation to Fundamental Investors.

The disinterested directors then deliberated the matter among themselves in a serious of special meetings.

They interrogated people in the fund, they interrogated people from Anchor, they questioned Judge Fuld, they communicated extensively and among themselves they had no contact with anyone from Anchor.

In early January 1975, those five disinterested directors put the matter to a vote and unanimously determined that the maintenance of these derivative action against the advisor and the directors was contrary to the best interests of the fund and they determined that they would move to dismiss the suit.

The motion to dismiss was filed.

Daniel A. Pollack:

Judge Walker said that the disinterested directors acting for the Board had the power to determine in the good faith exercise of their business judgment, that this suit should be terminated.

Warren E. Burger:

This action was taken by a quorum, a lawful quorum of the Board, was it not?

Daniel A. Pollack:

Yes, it was Mr. Chief Justice and in that respect the plaintiffs at the time of motion to dismiss before Judge Walker, questioned the independence of these interested directors and Judge Walker promptly ordered discovery on the subject.

There was extensive discovery, spanning several months.

Over thousand pages of testimony was taken.

There were several document productions.

The motion was then renewed and Judge Walker found that there was no basis, no factual basis to question the independence of these directors and he granted the motion to dismiss.

Thereafter the Court of Appeals reversed and they held that as a matter of law, irrespective of whether the directors had acted in good faith, they were deprived by the Investment Company Act of the power to make such a decision on behalf of the fund.

In effect, the Court of Appeals, although it didn’t use these words, said that the disinterested directors couldn’t be trusted.

I turn to the legal analysis at this point.

The starting point of the legal analysis is Delaware Corporation Law, Section 141A.

The Court will find that reproduced in the addendum to our main brief, the white covered brief.

The language of 141A says just this “The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a Board of Directors.”

Fundamental is a Delaware Corporation.

It fits squarely within that provision and we believe that the directors of Fundamental as a Delaware Corporation had and have the power to mange the affairs of the corporation.

This Court has long held in a line of cases is going back 75 to 100 years that that power includes the power to determine whether or not claims shall be prosecuted on behalf of the corporation.

This Court in the Corbus and United Copper cases which are the two seminal cases following (Inaudible) said as follows and I quote two sentences from Corbus “A court of equity may not me called upon at the appeal of any single stockholder to compel the directors of the corporation to enforce every right which it may posses, irrespective of other considerations.

It is not a trifling thing for a stockholder to attempt to coerce the directors of a corporation to act which their judgment does not approve or to substitute his judgment for theirs.”

And that states the business judgment Rule as it as been enunciated by this Court.

We turn to the second point on the legal analysis.

Potter Stewart:

If all of the directors were directors at the time of the alleged erroneous action, negligent or wrongful action on the part of the corporation and the derivative shareholders sued them all and then he could in fact do exactly that —

Daniel A. Pollack:

Arguably that is so Mr. Justice Stewart.

Potter Stewart:

[Voice Overlap] derivative suits then —

Daniel A. Pollack:

Arguably that is so Mr. Justice Stewart, but that does not deal with the case such as here where there is a quorum that can pass on the matter.

Potter Stewart:

That language is a little broader than facts of life, isn’t it?

Daniel A. Pollack:

I pass on that one Your Honor.

Potter Stewart:

Well, are you suggesting that what you read from is the Federal Rule?

Daniel A. Pollack:

No I’m suggesting that that is the Rule of this Court which has been applied through the years and has guarded the interpretation in lower courts.

Byron R. White:

Where would this Court get Rule like that?

Daniel A. Pollack:

This Court was faced with the question, it is a pre-early case agreed, but it was faced with a question as to the powers of directors as a matter of General Corporate Law.

Byron R. White:

Because I would take it, you probably don’t agree with the United States’ amicus brief in this case?

Daniel A. Pollack:

With the United States Your Honor?

We agree with some aspects of their brief insofar as they say that the Investment Company Act is the source of power and governs —

Byron R. White:

But you wouldn’t —

Daniel A. Pollack:

We do not agree.

Byron R. White:

You wouldn’t think there is any room for a Federal Rule in this case at all?

Daniel A. Pollack:

We can well understand the argument for a Federal Rule in this case Your Honor.

Byron R. White:

But now, how about, do you agree with the United States or not?

Daniel A. Pollack:

Our first choice and the logical point of departure is that this is matter of State Law and we hold to that proposition.

Byron R. White:

That’s what I want to know.

So you don’t think there is any room for a Federal Rule in this case?

Daniel A. Pollack:

No, that is not so Mr. Justice White.

What I say is that as a principle or starting point we say the State Law governs.

However, we recognize that under the Investment Company Act this Court could say that the policies of the Act are so important that it will be taken out of the hands of the states for regulatory purposes.

I recognize that that is the first of foot note 11 by Your Honor in the Santa Fe opinion and we are content to live with the either side of that equation.

We think the more orderly way to decide it is as a matter of State Law.

However, we are also willing to have the matter decided as a matter of Federal Law within the policies of the Investment Company Act.

Potter Stewart:

I thought your argument and may be I’m just seeing the same thing in another way or maybe misunderstand your argument, was that, this is a matter of Delaware law where this place — this company was incorporated.

Daniel A. Pollack:

Yes.

Potter Stewart:

Until and unless there is something in the Investment Company Act of 1940 or the Investment Advisers Act or somewhere else in Federal law that tell us that Delaware law shall not control?

Daniel A. Pollack:

That is exactly my argument Mr. Justice Stewart.

Potter Stewart:

And upon your examination of the Federal laws, you find that there is nothing there to supersede Delaware law?

Daniel A. Pollack:

That is our position Your Honor.

Byron R. White:

So you disagree with United States then?

Daniel A. Pollack:

Well I think.

Byron R. White:

I mean that’s, your first preference is —

Daniel A. Pollack:

Our first preference is United State law.

Potter Stewart:

As matter of argument you just don’t agree with it?

Daniel A. Pollack:

Correct but we believe that even under their argument —

Byron R. White:

Yes, I understand.

Potter Stewart:

We come out the same way —

Daniel A. Pollack:

— we come out the same way that directors do have the power under the Investment Company Act.

Byron R. White:

Disinterested directors?

Daniel A. Pollack:

The disinterested directors, absolutely Your Honor.

I turn now to the point of the Court of Appeals.

The starting point was Delaware law.

The Court of Appeals said that the — under the Investment Company Act the disinterested directors were deprived of their power.

We believe that this is a misconstruction of the Act, the legislative history of the Act and the cases under the Act.

As regards the act itself first, I point out to the Court that nowhere does it expressly preferred to remove this power from the disinterested directors.

Next I point out as the SEC has said in its brief, that when Congress meant to remove such power it did so expressly, for example in section 36 B.

Further more a reading of the act and its structure indicates clearly that Congress placed great trust in this people and did not have the same jaundice view of the disinterested directors that was held by the Court of Appeals here.

Section 10 provides that 40% of all directors of mutual fund must be disinterested.

Section 15 provides that these are the directors, these disinterested directors who must pass upon and approve the very sensitive issue of the contract, the advisory contract between the fund and the advisor.

We do not believe that Congress would have vested that power in the directors had they believed that the Court of Appeals did that they were not to be trusted.

Potter Stewart:

This statutory requirement of 40% disinterested directors came into the Act in the 19, what 70 amendment?

Daniel A. Pollack:

I don’t have the answer to that immediately Your Honor.

I believe to that proceeded it, but the disinterested director category came in the 1970 amendment.

Potter Stewart:

This formally on affiliated.

Daniel A. Pollack:

Correct and I believe that the 40% requirement preceded the 1970 amendments I would – that

Potter Stewart:

When did these directors — these directors where not directors at the time of the purchase of the Penn Central.

Daniel A. Pollack:

That is correct Your Honor that is correct none of these five are on the board of that time.

One came on a 1971, one in 1972, and two 1973 and one in 1974.

Potter Stewart:

And there is no question is there that they meet the at least the statuary definition of being disinterested directors.

Daniel A. Pollack:

No question Your Honor that they meet not only that the statuary definition —

Potter Stewart:

In fact the word is —

Daniel A. Pollack:

— Judge Walker did in fact find that they were disinterested.

Potter Stewart:

— keeps telling what.

Daniel A. Pollack:

Yes, I have addressed myself to the Act.

I pass now to the legislative of history.

In the 1970 amendments, Congress added a new section to A19 in that section which created the new category of disinterested directors they sought to remedy the criticism of the prior category of unaffiliated directors.

Daniel A. Pollack:

And they filtered the new definition of the disinterested directors which was a far most stringent one to qualify through the Act in Section 10, Section 15, Section 32.

We believe as the Senate Report 91 184 shows and we have quoted that in our brief that Congress believed that in so doing it had created the necessary simuse in these directors to fulfill the functions of passing on matters that involved the advisor.

Finally the cases under the Act.

There are three cases which we believe to be relevant.

We recognized that they are in some respects distinguishable.

Tannenbaum, Fogo and Kaufman, the logic of them is not distinguishable.

In each of those three cases the Court of Appeals in two cases for the Second Circuit in the one case for the First Circuit clearly indicate that there is a business judgment Rule applicable to mutual funds.

We do not believe that the plaintiffs have come up with a single case or that the Court of Appeals came up with the single case which shows in any way that the Investment Company Act deprived the disinterested directors of there business judgment powers.

In that regard we are pleased of course by the position of the government in this case because the SEC in a rare display of support for the defendant has said as its central thesis and supporting our central thesis of power in the disinterested directors here and I quote from there brief, “although Congress could have prohibited the disinterested directors from exercising business judgment in the circumstances of this case, it did not do so.”

Warren E. Burger:

Whose quote is that?

Daniel A. Pollack:

That’s from the SEC brief at page 21 Your Honor.

So the SEC thus supports the fundamental premise on which our position is based.

Not only that they go on to recognize which that which is the fact and that is that the business judgment Rule is itself an important shareholder protection device.

The Rule of the Court of Appeals here would wipe that away in a context to mutual funds.

Potter Stewart:

But the SEC both does and doesn’t support your theory from what you have quoted it would seem to follow that where it is in the discretion, the unreviewable discretion of the independent disinterested directors or majority of quorum to make decisions on the behalf of the corporation.

But then the SEC says what here from the note, I know but in this kind of case since it’s a mutual company it’s incumbent upon the district to look at the fundamental fairness and rectitude of the decision.

Daniel A. Pollack:

Mr. Justice Stewart the SEC has a three-prong test.

The directors have to be independent.

They have to be informed and the judgment must be reasonable.

They acknowledge in there brief I believe that the first two prongs of the test are meet —

Potter Stewart:

— in this case?

Daniel A. Pollack:

In this case.

Potter Stewart:

So then it’s incumbent upon the district judge to see if it was a reasonable decision?

Daniel A. Pollack:

Correct and I would address myself to the issue of reasonableness.

Potter Stewart:

It would seem to follow of what you are quoting to us that it’s not incumbent at all on anybody, if the directors have the power?

Daniel A. Pollack:

I believe that classically under the business judgment Rule as it has been formulated in the cases in this Court that is so.

We do believe however that even if the SEC tests were to be adopted that we meet that test.

We believe that as to reasonableness that’s perfectly implicit.

Judge Walker would not have dismissed this case we believe if he believed that the decision was unreasonable.

Further more —

Potter Stewart:

It seems to me, it seems to me that a judge who was persuaded by your argument, that this is in within the unreviewable power of disinterested directors to make the decision, would have dismissed the case even if he or might well have dismissed the case would have even if he had thought that this decision might have been very unreasonable decision?

Daniel A. Pollack:

Mr. Justice Stewart arguably, arguably that is so, but I would call Your Honor’s attention to the Kramer case where they formulated a little differently from the SEC.

They say that the judgment must be made in exercise of — business judgment must be made in good faith.

Implicit in that is that they be independent and informed and that the judgment not be so unreasonable as to fall outside the bounds of sound discretion, in other words they speak in effect of a zone of reasonableness or the bounds of soundness —

Potter Stewart:

It seems to me the logic of your argument and indeed the logic of the language of the SEC brief that’s quoted to us, leads to a conclusion that would exclude any oversight by a — by a Federal Judge of whether or not the decision was reasonable, however —

Daniel A. Pollack:

Judge Walker also did point out in his opinion expressly that he found that this was a reasoned decision.

In footnote 16 of their brief the SEC equates a reasoned determination with reasonableness.

I think that before I sit down for this at this point in time I would like to address briefly the two subsidy area issues raised by the plaintiffs.

They raise the question as to whether a minority of the full board can take this action.

We believe that has no legal force.

The question is, is there a quorum.

Section 141A of Delaware Law is quite clear on the subject that a quorum, albeit a minority of the board, has the power to transact the business of the corporation.

Warren E. Burger:

In that sense would you say it’s analogous to the law which permits six members of this Court to sit as a quorum and if six members are here for although minority less than majority of the full court and make a binding holding of the Court?

Daniel A. Pollack:

I pondered that very analogy Your Honor under 28 U.S.C 1, which I reviewed the other evening.

I think there is a distinction and I think perhaps Mr. Justice Marshall did put his finger on it.

The difference is while it is a minority of the full board that’s acting; the quorum itself in the case of the Court cannot be a minority because I believe your quorum will be six, out of nine.

Warren E. Burger:

Six but a four, if those six decides something isn’t that holding in this Court?

Daniel A. Pollack:

Yes it is Your Honor, but if the quorum —

Warren E. Burger:

It may be regarded as less significant at sometime in the future when on the context to that particular decision it makes the law of the case?

Daniel A. Pollack:

Absolutely, no question about that Your Honor and the concept of quorum is embedded in corporate law in this county for many, many years.

Potter Stewart:

And what does the Delaware Law provides again?

Daniel A. Pollack:

Delaware Law 141 A, I believe provides that a quorum can transact the business of the board and it may be a minority.

Potter Stewart:

But does it say.

Daniel A. Pollack:

Up to one it can be as little as one third if the by laws so permit and in the case of fundamental the by laws had a one third quorum.

So that four of the eleven —

Potter Stewart:

By laws say with the minimum of one-third.

Daniel A. Pollack:

Exactly actually the five here where more than a quorum, four would have been a quorum, five actually acted.

The other point that I wish to address before I sit down at this point is their concept that once a derivative action is validly commenced under Rule 23.1, it can never be terminated.

In effect what they say is if you put the key in the lock, it’s once and you once get the door open, you throw away the key.

Obviously that makes no sense at all because the directors are the ones charged with the oversight of the business of the corporation and they must have continuing power to review the matters of the corporation and determine on a continuing basis what is in the best interest of the corporation.

Daniel A. Pollack:

We believe that the demand requirement is a procedural requirement which speaks only as of the time of the institution of the suit.

It does not and cannot for evermore strict the directors of their power to act for the corporation and vest control of the corporate destiny in a single stockholder.

Thank you, Mr. Chief Justice.

Warren E. Burger:

Mr. Ferrara.

Ralph C. Ferrara:

Mr. Chief Justice, and may it please the Court.

The Securities and Exchange Commission believes that an understanding of the relationships between State and Federal Law as they impact upon the governance of investment companies is critical to a resolution of the issues presented in this case.

First, we agree with the petitioners that corporate directors and not federal judges should be given the fullest opportunity under State Law and under the Investment Company Act of 1940 to manage the business affairs of investment companies.

On the other hand, we agree with the respondents and the Court of Appeals that the Investment Company Act of 1940 superimposes upon basic State Law provisions, a pervasive array of federal controls, controls which we believe create federal standards to assure that the operation of the Act will not be frustrated by the possible laxity of the law of an individual state.

Now, the proper reconciliation of both the State and Federal interests, we believe, would be to prohibit as a matter of Federal Law that as interested directors of an investment company from terminating even non frivolous derivative litigation nor however would that law or would that reconciliation embrace the most recent State Court formulation of the Delaware Business Judgment Rule as the sole standard by which to judge directorial action.

Rather we believe that the State and the Federal interests can be balanced by according full discretion to the directors’ judgments so long as they are independent, they are fully informed and they act reasonably.

Potter Stewart:

Mr. Ferrara you find this Federal limitation and requirement in fiduciary obligations imposed by the 1940 Act and in the general purpose of Congress, is that correct?

Ralph C. Ferrara:

That goes to the heart of our authority, Mr. Justice Stewart.

Potter Stewart:

It says to be found somewhere – [Voice Overlap]

Ralph C. Ferrara:

It doesn’t and I think that.

I think that -– that Section 36 A of the Investment Company Act, the fiduciary standard, the provision of the Act that imposes upon disinterested directors of an investment company, the responsibility to not breach fiduciary duties is the heart of our argument, but around that argument is a regulatory statute, a Federal Regulatory Statute which super imposes an array of controls upon the composition of the Board of Directors, how directors are selected, the manner in which —

Potter Stewart:

Your claim that any of those provisions were violated in this case, is there?

Ralph C. Ferrara:

No, we don’t, but we do say that surrounding Section 36 A there are those other —

Potter Stewart:

The numbers, you find it in the numbers–

Ralph C. Ferrara:

That’s correct sir.

Warren E. Burger:

But no problem about any of those things in this case on basis of the majority? There is full compliance whether or whether they are applicable or not?

Ralph C. Ferrara:

We recall Mr. Justice that Section 36 A of the Act, the general fiduciary standard prescribes breaches of fiduciary duty involving personal misconduct and the House and the Senate at the time they enacted those provisions in 1970 said —

Warren E. Burger:

You wouldn’t need — you wouldn’t need to the Congress to tell a State Court that, would you?

Ralph C. Ferrara:

Well, you might.

See unfortunately the court of a — the District Court Judge in this case found that all State Law would require is that the directors be independent and act in good faith.

The Congress is required in the Investment Company Act of 1940 that there be an additional ingredient, that is that their decisions be reasonable, that additional ingredient finds its heart in Section 36 A, as I said a moment ago in the House and Senate reports that a company, the enactment of that section where they provided in these words that 36 A proscribed non-feasance of duty and abdication of responsibility.

Abdication of responsibility, those words go far beyond we think that typical fraud statute that’s found in one of the Federal Securities Laws.

They expand upon notions of fiduciary duty as found even in Delaware Law.

Now does that mean that Delaware Law has to be displaced by a Federal Standard, no.

But does it mean that when the Delaware Statute or Idaho Statute or an Ohio Statue says that directors shall be a court of the business judgment Rule in the Courts of that State say that the business judgment Rule only needs to be tested against the independence and good faith standard, that if it’s an investment company an additional standard needs to be employed, we think the Investment Company Act says that we think the court say that’s how you interpret the Investment Company Act.

John Paul Stevens:

Mr. Ferrara there are so many statutory provisions I may get them mixed up, but Section 36 A is Section 88 A-35 of — that’s a same one in which authorizes the commission to bring certain kinds of litigation?

Ralph C. Ferrara:

It does indeed.

John Paul Stevens:

Does it have anything to do with private litigation?

Ralph C. Ferrara:

Well, the issues that you’re implicitly raising Mr. Justice Stevens is whether there is an implied Right of Action under Section 36 A of the Investment Company Act.

That’s an issue that is specifically not in this case, however the courts have found that notwithstanding the language of the Statue that the commission may bring an action to enjoin, but there is a private Right of Action under 36.

As a matter of fact the courts have rather consistently held that position although again that is not an issue in this case.

It’s not been raised by the —

John Paul Stevens:

But you are really going one step beyond that.

What you’re in fact saying is not only does 36 A authorizes the United – the SEC to bring in action, it also implicitly authorizes a private action and beyond that it places certain restrictions on the power of independent directors to settle such an action after it’s been brought.

Ralph C. Ferrara:

Mr. Justice Stevens I’m sure that the day is going to come when myself or one of my successors are going to be here arguing the case that 36 A creates an implied Right of Action for private litigants under the federal — under the Investment Company Act.

We don’t have to take that decision now.

Nor we — nor does this case involves the commission’s power to bring an adjunctive action under 36A.

All it does say is that whoever has the right to bring the action, the private party or the commission, the standard upon which the action has to be based is a breach of fiduciary duty, this recall, this is not this is not a —

John Paul Stevens:

Granting all that, where is anything about who can settle such an action, place any limitations on the power to settle such an action.

I’m assuming for purposes of our decision just the same assumption you make there is a private, we’ll assume there is a private remedy.

We are not talking about whether there is a private remedy we’re talking about who can cut off the private remedy and what in the Statute says anything about that?

Ralph C. Ferrara:

Nothing in the Statute quite correct.

Potter Stewart:

This isn’t right of a private remedy, it’s a derivative law suit brought on behalf of the corporation?

Ralph C. Ferrara:

It is indeed and the posture —

Potter Stewart:

Under no authority of the Investment Company Act of 1940, but under quite different authorization?

Ralph C. Ferrara:

Well, the allegations containing violation of the Investment Company Act 1940 and the Advisors Act, two federal claims.

Now you are quite correct procedurally this case involves the disposition of the derivative action and in the context where a Federal District Court Judge was being asked in a contested claim in a voluntary dismissal whether the action should be dismissed and the Federal District Court Judge was faced with the situation of whether to dismiss the action over the objections of the plaintiffs who had instituted the action.

In that context the Federal District Court Judge was forced to sort out the basis upon which he dismissed the action and he did that by we think reference to both State Law standards, the Delaware Law, independence in good faith and by reference to the federal standards.

I quite frankly think that if Tannenbaum against Zeller, the case that we cite is authority for the three-prong test that we urge in our brief had been decided at the time this District Court Judge had before him the dismissal of this action that his conduct in the action may have been a little different and his decision may have read slightly differently.

I’m not sure that the result would have changed, but that’s not our job.

John Paul Stevens:

You say findings unreasonable —

Ralph C. Ferrara:

I’m sorry.

John Paul Stevens:

You say he then would have made findings on the reasonableness of —

Ralph C. Ferrara:

I think he would have we’re not —

John Paul Stevens:

We are still get the thing just, I don’t mean to take up too much time, but he could have acted just on the basis of State Law.

Now, the other side says well you can’t do that because the Federal Statute restricts you power that, the Independent Directors’ power to settle.

John Paul Stevens:

I would normally look to some provision in the Federal statute that describes the powers and duties of Independent Directors rather than something that give somebody cause of action.

Ralph C. Ferrara:

But the Investment Company Act of 1940 clearly details that not only prescribes the duties of Independent Directors are, but says that you can’t even have Board of Directors unless 40% of them disinterested and then says —

John Paul Stevens:

Right, but is there anything that says those directors can’t settle a lawsuit, that’s the problem?

Ralph C. Ferrara:

No, the question is not whether not they cancel the lawsuit, but whether in the process of settling the lawsuit they breached their fiduciary duties to the shareholders of the fund.

They are direct — a disinterested director or any director of an investment company simply can’t without reference to any standard, without reference to any standard dismiss a lawsuit.

Byron R. White:

Where is the standard in the federal statute?

Ralph C. Ferrara:

The standard in the Section 36 A because all of the directors–

Byron R. White:

Can you read it, can you read it —

Ralph C. Ferrara:

Section 36A prescribes breaches of fiduciary duty based upon–

Byron R. White:

Breach of fiduciary duty.

Ralph C. Ferrara:

Well, the statute doesn’t say what a breach of fiduciary duty it is, but the Congress and both the House and the Senate reports when they passed that Statute said what they thought it met.

Byron R. White:

Well, I think — I don’t still don’t think you have answered Mr. Justice Stevens that where is a — what specifically in the Statue forbids or forbids a settlement unless you go through this ritual.

Ralph C. Ferrara:

Let me, let me try once again.

Byron R. White:

Because you know there is a question, just how specific must a Federal law be and in Cort against Ash the court said and I’m for sure you must be quite familiar with that statement in Cort against Ash that —

Ralph C. Ferrara:

Indeed I am sir.

Byron R. White:

— that except where Federal law expressly requires certain responsibilities and directives with respect to it the state law will govern internal affairs of corporation.

Ralph C. Ferrara:

You have raised two questions.

Let me try to respond to your first question which is also Mr. Justice Stevens’ question.

Byron R. White:

You can respond to Justice Stevens’ question first.

Ralph C. Ferrara:

Alright.

First the Investment Company Act clearly defines the composition of a Board of Directors, 40% must be disinterested.

Now in all actions taken by those directors, dismissals of lawsuits, purchases of securities whatever the directorial action called for, those directors’ conduct is guided by Section 36(a).

Section 36(a) says that in whatever the Director is doing, dismissing a lawsuit or otherwise that Director cannot breach a fiduciary duty.

The house in the Senate say, what a fiduciary duty is?

And that is nonfeasance of duty or abdication of responsibility.

Consequently, in deciding whether the directors lived up to their responsibilities under Section 36(a) and in this case one has to determine whether they abdicated their responsibility or engaged in nonfeasance.

Now returning —

Potter Stewart:

Directors always have fiduciaries vis-à-vis the shareholders, there is nothing —

Ralph C. Ferrara:

But you know always — you are quiet right Mr. Justice Stewart all directors are fiduciaries but here because of Section 36(a) I suppose you would say investment company directors are super fiduciaries, particularly disinterested directors, because there is no other Federal statute, not the Securities Act, not the Securities Exchange Act, not the Public Utility Holding Company Act of 1934, 35 I’m sorry, no other Federal statute has express provision that says that these directors have to have a fiduciary duty.

Recall, this is not Green against Santa Fe, and getting back to the question of it, this is not Green against Santa Fe, this is not a Section 10(b)(5) that involves fraud, deception or manipulation, this is a Section 36(a) that talks in terms of Breaches of Fiduciary duty.

Ralph C. Ferrara:

Now returning to the question about Cort against Ash and Green and Santa Fe, clearly the court in those cases said that State law is not going to be displaced unless there is a Federal statute, which expressly calls for that.

This case is not Green and Santa Fe, it doesn’t involve Section 10(b) what this Court found be a disclosure based statute, but rather 36(a) and we are not trying to displace the entirety of State law.

All we are suggesting, I’m sorry.

Byron R. White:

Certainly you are putting quiet a gloss on it.

Ralph C. Ferrara:

A very modest gloss I would suggest.

Once you have determined that State law requires independence and good faith we think that asking that —

Byron R. White:

I don’t know, some Federal judge will think it’s a very mild veracity as to sit down and decide whether the judgment is reasonable.

Ralph C. Ferrara:

We are not asking that he substitute his judgment for that of the directors.

Byron R. White:

You are asking to do something that he wouldn’t have to do under State law.

Ralph C. Ferrara:

We are asking —

Warren E. Burger:

Well now since you emphasize that section so much and what the Congress intended, it’s certainly not unimportant and this is in your own brief of page 21, the statement from the legislative history that it is not intended by the statute to shift the responsibility from managing an investment company in the best interest of the shareholders from the directors of such company to the judiciary.

Ralph C. Ferrara:

Clearly.

Warren E. Burger:

Now that have to thins out this gloss a little bit, doesn’t it?

Ralph C. Ferrara:

Mr. Chief Justice, it does thin it out a little bit and that’s exactly why we can’t be here fully supporting the Court of Appeals.

The Court of Appeals we think went too far and would have substituted the Federal judiciary for the disinterested directors.

We are saying that that Federal District Court Judge should not substitute his own judgment for that of the directors, but only in reviewing this action that he determine whether the directors acted reasonably in the same process that he has to decide whether they were independent and acting with faith.

Warren E. Burger:

You are making the District Judge a super Director, you spoke of a super fiduciary, you are making him a super, super fiduciary.

Ralph C. Ferrara:

Mr. Chief Justice if the impression left by our brief is that we are asking a Federal District Court Judge to become a Director of an investment company then our brief reads incorrectly.

We are not asking that.

Byron R. White:

But you must concede that just under your formulation a District Judge could conclude this is an unreasonable decision by the directors and set it aside?

Ralph C. Ferrara:

The District Court Judge could, the District Court Judge could consistent with, actually a line of authority that stretches back to 1917 in this Court’s case and in —

Byron R. White:

That, that’s a bootstrap, that’s a bootstrap —

Ralph C. Ferrara:

The District Court judges all the time and in different kinds of context have to determine whether or not conduct is reasonable.

At the time a District Court Judge is doing that he doesn’t always substitute his judgment.

Byron R. White:

So you are saying, yes a District Judge can under your formulation set it aside as unreasonable?

Ralph C. Ferrara:

Absolutely, but —

Byron R. White:

You just say he always could.

Ralph C. Ferrara:

No, no —

Byron R. White:

Don’t you say on your formulations he may set it aside.

Ralph C. Ferrara:

I absolutely agree that a District Court Judge may set upside directors — directorial action as unreasonable.

Ralph C. Ferrara:

But I don’t say that, I mean —

Byron R. White:

Even now a State Court wouldn’t?

Ralph C. Ferrara:

The State court would have never reached the question, because the State court never considered the question; they considered something else slightly different.

Byron R. White:

The State court would find the directors’ action to be quiet consistent and would not set it aside and you suggest that under your formulation a Federal court could.

Ralph C. Ferrara:

No I say that if the State court viewed reasonableness as a criteria of its review then it could set it aside.

The Federal judge in setting aside, empowering the Federal judge to set aside directorial action as unreasonable though again I suggest, I submit, I emphasize does not need that the Judge has to substitute his judgment.

All that means is that as in a dozen other different contexts that Federal District Court judges face, he has to pass upon the fundamental reasonableness of the transaction.

Warren E. Burger:

It looks like just one of them, we had one this morning.

We know that that’s quite right in other context judges do.

But they usually can trace the exercise of their review to some specific source that is the Fourth Amendment, the reasonableness of a search.

Can you suggest any places where the judge does this without being able to trace it to some specific authority?

Ralph C. Ferrara:

A court I believe in passing upon a judgment notwithstanding the verdict, passing upon a directed verdict–

Warren E. Burger:

Other person should take the first one?

Ralph C. Ferrara:

Yes, I believe that.

Warren E. Burger:

On judgment NOV?

Ralph C. Ferrara:

That’s correct.

Doesn’t a judge at that point Mr. Chief Justice have to weigh whether or not it would be unreasonable —

Warren E. Burger:

Now you’ve raised the question of whether or not the evidence supports the verdict?

Ralph C. Ferrara:

That’s correct in the minds of the, in the minds of a reasonable juror, isn’t that a standard that’s incorporated under the case law?

It’s not in the Federal Rule but under the case law?

Warren E. Burger:

That’s a weighing of evidence and not a weighing of the reasonableness I submit to you.

Well, we’ve exploited.

So thank you —

Lewis F. Powell, Jr.:

Mr. Ferrara.

Ralph C. Ferrara:

Yes sir.

Lewis F. Powell, Jr.:

I like to ask you a couple of questions.

Let’s assume that we agreed with the position of the Commission, remanded the case for the application your your three-part test, the third part of which has been the subject of a good deal of discussion, what do you think the District Court would do in the way of determining whether or not the independent directors had exercised a reasonable judgment in our Court to say that the District Judge had a very substantial amount of information before him.

Do you think he could act on that information, Judge Fuld report the discussions of the independent directors with independent experts or do you think you have to have another full blown trial, an evidentiary trial?

Ralph C. Ferrara:

It’s a very difficult question, but let me try to respond it in two levels.

First it is hotly contested in this case whether or not the Judge allowed a sufficient amount of discovery to go forward to pass upon the question of the independence and good faith of the directors.

Ralph C. Ferrara:

The judge we think —

Lewis F. Powell, Jr.:

That’s a question separate from reasonableness —

Ralph C. Ferrara:

I know it is but you asked I think two questions; one what would the District Court Judge have to do in terms of the record and two what we have to do in terms of satisfying the reasonableness standard.

In terms of the record the first determination you’d have to make is whether or not there was a sufficient record before him to pass upon the reasonableness of the directors’ actions.

I think that there are two views on that.

The respondents would urge — I’m sorry the petitioners would urge that the District Court Judge too closely circumscribed their ability to seek discovery on the question of the merits of the action.

I believe that a District Court Judge in looking at the discovery that was permitted may find that adequate discovery was had, but the District Court Judge in his sound discretion would have to determine that.

I do not see and I think it would be wrong to say that a District Court Judge would have to conduct there after a full trial on the merits.

There should still be of a proceeding that is within the sound discretion of the District Court Judge to tailor.

Now, the one, but there is nothing magic in elocution of reasonableness.

We didn’t go through the opinion as did the responders.

Lewis F. Powell, Jr.:

I would like to interrupt you here a minute.

If you got to try this case on the merits —

Ralph C. Ferrara:

No.

Lewis F. Powell, Jr.:

Well wait a minute, the question would be in very summary terms whether or not the management had exercised the degree of care required of management in purchasing the Penn Central Commercial Paper.

Do you agree with that so far?

Ralph C. Ferrara:

I agree that’s — under the state law claim, it’s correct.

Lewis F. Powell, Jr.:

That’s right.

Well in other words whether or not there was a fat chance to win the case —

Ralph C. Ferrara:

That’s correct.

Lewis F. Powell, Jr.:

— might have a bearing on whether the independent directors exercised —

Ralph C. Ferrara:

That’s right.

Lewis F. Powell, Jr.:

— a reasonable judgment.

Is it your suggestion that the District Court would have to make a judgment himself as to whether there was a fat chance to win the case?

If so, wouldn’t he have to try almost a full blown trial?

Ralph C. Ferrara:

The ‘if so’ is no.

The second question is no, but let me get to the first.

That first question goes to the heart of our concern with the District Court’s opinion.

The District Court judge while purporting to evaluate good faith in independence and as I say there is no magic to finding the word ‘reasonable’ in the opinion, but purporting to focus on good faith in independence specifically said that he wasn’t going to concern himself one with the merits of the action.

He said he wasn’t even going to let the merits of the action color his decision.

Lewis F. Powell, Jr.:

But you think he must look in to the merits?

Ralph C. Ferrara:

We think that he at least, at least has to a look at the merits.

I mean he at least has to consider whether in view of what the apparent merits of the action are, under any formulation the Tannenbaum test, the Kaufmann test, the Cramer test, the (Inaudible) test whatever formulation of all our three-prong test test you want to use, then he has to pass on reasonables.

If this Court, if this District Court judge some place in his opinion had said and in addition to looking at whether or not these directors were independent and whether or not they had all this information the judge Fuld produced for us, we also gave some considerations to the merits of this action as they were expatiated on in judge Fuld’s memo, I think we would have a different case.

But he specifically in at least two different places said, “I’m going to consider the merits of this action and they’re not going to color my judgment.”

That’s his words, they’re not going to color.

Potter Stewart:

That would have been exactly what he should have said had Delaware law exclusively applied, you’d agree with it?

Ralph C. Ferrara:

Had it — it depends upon how you view the good faith requirement of Delaware law.

I’m not even sure under Delaware law that if a District Court judge is asked to pass upon the good faith of disinterested directors or independent directors of the non (Inaudible) company, he disregards the merits completely that he can met that good faith standard but that’s not an issue in this case.

Remember —

Potter Stewart:

No it is an issue in this case.

Ralph C. Ferrara:

It’s an issue —

Potter Stewart:

It’s very much an issue in this case.

Ralph C. Ferrara:

Would — it’s an issue in this case only to the extent that you have to try to —

Potter Stewart:

If Delaware law exclusively applies to this case then it’s a very important to know what Delaware law is.

Ralph C. Ferrara:

It is and under Delaware law, well I have not researched the Delaware cases, we would submit that within the notion of good faith under Delaware law there has to be some consideration given to the merits.

Not a full trial, not what Mr. Justice Powell is concerned with —

Potter Stewart:

Was there any claim here that the direct — that these disinterested directors acted in bad faith?

Ralph C. Ferrara:

As a matter of fact the District Court judge found they acted in good faith.

Potter Stewart:

Exactly.

Ralph C. Ferrara:

But he did that without —

Potter Stewart:

And isn’t that the test to Delaware law?

Ralph C. Ferrara:

The Delaware law test is good faith but how?

Potter Stewart:

Exactly.

Ralph C. Ferrara:

The issue is whether in determining that they acted in good faith, you can make that determination completely divorced at the merits of the actions and irrespective of whether you’ve —

Potter Stewart:

They could be very badly mistaken but still be in complete good faith and wholly disinterested?

Ralph C. Ferrara:

If they are very badly —

Potter Stewart:

— but at the same time make what somebody else would think would be an unreasonable decision?

Ralph C. Ferrara:

When you put it that way though, this is the box that we get in.

If let’s say, it is —

Potter Stewart:

Your box I don’t know anything else here. [Laughter]

Ralph C. Ferrara:

I’m sorry you are right the box that I get into, is that when you are dealing with an investment company and the disinterested directors of an investment company, unfortunately you may have to go that one extra step because of 36(a) it prescribes unreasonable conduct.

Potter Stewart:

That’s your claim that the penumbras of the 1940 Act put some limitation on what would ordinarily be as the provisions of state law.

If you are mistaken, then it’s I submit it’s quite important and not at all irrelevant to know what the state law is.

Ralph C. Ferrara:

Absolutely and again on the penumbra of question I agree there is a variety of sections which impact upon this, but penumbra doesn’t, I don’t think appropriately categorized, I’m sorry characterize 36(a) that talks in terms, at least in the House and Senate reports of unreasonableness.

John Paul Stevens:

This much is clear is it not Mr. Ferrara that if your super fiduciary theory is correct and these directors have found to have acted unreasonably under 36(a) they would be personally liable to damages?

Ralph C. Ferrara:

They might be.

It’s a — Mr. Justice Stevens it’s a very — recall, you know there’s — that famous, I guess famous in the private bar and the government bar footnote 11 to this Court’s opinion in Green against Santa Fe and that footnote in distinguishing or explaining what this Court perceived the reach of Rule 10(b) 5 and Section 10(b) was, you said this is a lot different than Section 206 of the Investment Advisors Act.

You said there this is what, these are words of this Court, you said there federal fiduciary principles were being applied and Section 206 of the Advisors Act although the companion statute of the Investment Company Act says nothing about fiduciary duties.

I mean this is hardcore federal fiduciary principles in Section 36(a).

Thank you very much I’m sorry for the —

Warren E. Burger:

Mr. Einstein.

I want to relieve your anxiety.

We will not charge Mr. Ferrara’s overtime to you because we were largely responsible for it.

Joseph H. Einstein:

Thank you, Your Honor.

I wasn’t least bit worried.

Mr. Chief Justice, may it please the Court.

Late in 1969 the mutual fund here purchased $20 million worth of Penn Central notes.

The record clearly establishes that it entered into this purchase at the suggestion of its advisor Anchor Corporation in a situation where there was absolutely no investigation whatsoever conducted as to the propriety of this $20 million investment.

This occurred even though Anchor was at the time receiving some $4 million per year for allegedly managing the portfolio of this investment fund.

Now in buying the notes not only did Anchor fail to conduct any investigation, but it failed over the next six or seven months to be aware of the increasing storm signs and warnings as to the dismal failing condition of Penn Central and failed to even execute a buyout or a sellout of the notes when it might have.

Moreover there was an internal guideline in the fund, which said that the fund should not purchase commercial paper of this nature unless it had a commitment that it could sell it, the so called buyback commitment.

Now in the reply brief, my adversary has said that we have misleadingly asserted that this buyback provision was violated because Anchor believed that it had such an understanding.

Yet Judge Fuld disagreed.

He stated at page 113 of the appendix, accordingly it appears that there was not and that Anchor did not believe there was an illegal binding agreement by Goldman Sachs to repurchase Penn Central paper.

Therefore, I think the case comes before Your Honors in the situation where you have, in my judgment and in the judgment of the Court of Appeals, a rather strong showing of breach of fiduciary duty and gross abuse of trust in violation of the 1940 act by Anchor and by the directors at that time of the mutual fund.

Warren E. Burger:

You are suggesting that this was negligence that was so gross as to arise to the level of the breach of trust.

Joseph H. Einstein:

Yes I do Your Honor.

I think —

Warren E. Burger:

In other words it was utterly stupid to do what they did or failed to do —

Joseph H. Einstein:

I think it goes even beyond stupidity.

Potter Stewart:

And that was the basis of your derivative shareholders —

Joseph H. Einstein:

That is absolutely right Your Honor.

Potter Stewart:

Which really — only tangentially is — it bears an issue here.

Joseph H. Einstein:

Well as I’ll come to in a moment I do think that the merits of the action do very much bear on the issue here.

Now as the court is aware there was this lawsuit brought by the Fund against Goldman Sachs alleging fraud and misrepresentation at the time of the purchase.

Now that suit was settled for slightly over 25% of the loss and I must advise the Court that one of the reasons that motivated the Fund to settle was because it had a sophisticated advisor and it was worried that if it pressed a litigation the effect of its having an allegedly sophisticated advisor might militate against recovery.

Now even if you take the $5 million that’s been recovered and you ascribe whatever value you want to these pieces of paper that have been issued to the Fund as additional settlement value, there is still a shortfall here of $10 million, $12 million, $15 million, which we believe should be recouped from Anchor and from the defendant directors.

Now after the action against Goldman Sachs was settled the motion which leads us to this Court today was interposed by the defendants.

Now it’s significant to note that shortly after the Penn Central collapse the Board of Directors of the fund determined to sue Goldman Sachs.

They also determined to hold in abeyance any other action against anyone else.

Now, over the years between that time in 1970 and 1974 when a dismissal motion was interposed, the fund board of directors did change and composed a five-member minority of the board who are independent and unaffiliated with Anchor.

It was these minority directors who ultimately determined to seek dismissal of this action.

Now, initially when the motion was made in the District Court, the District Court permitted discovery and it appears on page 20 of the appendix on a very, very limited claim. He permitted discovery to pursue the relationship of the minority directors and the qualifications committee to determine whether the minority directors were disinterested or independent.

That was the sole scope of the discovery allowed in this action.

Now, it’s significant to note that the discovery permitted did not include any discovery on the merits, did not include any discovery on the nature and content of the disclosures made to Judge Fuld and I think that’s a significant area.

Because the disinterested minority directors could only act based upon information filtered to them through Judge Fuld through their special counsel.

The disclosures being made to special counsel with the disclosures of the defendant directors and Anchor Corporation made not under oath but in informal discussions.

Now, I think it was important for the District Judge to have had and he could not have had in this case an indication of whether the full mix of available information was supplied to Judge Fuld and through him to the minority independent directors.

John Paul Stevens:

Now why would that be important, I just don’t understand you, what issue would that been relevant?

Joseph H. Einstein:

That would go to the reasonableness Mr. Justice Stevens of the dismissal of the action, and I submit to you as a principle thesis here and one that has been overlooked and not mentioned up till now that this case is governed very much by Rule 23.1 promulgated by this Court.

John Paul Stevens:

But Mr. Einstein if I understand that the SEC’s position is there was full — they do not challenge the fully informed character of the independent directors’ decision?

Joseph H. Einstein:

I don’t see how anybody on this record can assert with all deference to the SEC that the directors were fully informed.

There’s nothing in this record which will disclose what information was given to the director and what information may have been withheld.

John Paul Stevens:

Is it not quite clear that the restriction on discovery of which you complain would be more pertinent to the question of full information, than to the question of reasonable information, wouldn’t it?

Perhaps its relevant to both?

Joseph H. Einstein:

I think it’s relevant to both and I think the question of merits also is relevant because a decision to dismiss a case that has a weak merit might be supportable on very slim business judgment rules whereas if the case has strong merit you would need more to support dismissal.

John Paul Stevens:

It would seem to me maybe I miss something that, that if we were persuaded and I don’t know whether we should be or not, that the SEC is correct in saying the independent directors were fully informed, then we shouldn’t test reasonableness by their failure to get more information?

Joseph H. Einstein:

If they were fully informed, they were fully informed.

I just submit to Your Honor that this record clearly demonstrates — is silent on that issue and indeed we believe that they were not fully informed.

Lewis F. Powell, Jr.:

Did the District Judge make a finding on that point?

Joseph H. Einstein:

I don’t believe he did Your Honor.

The District Judge opinion really proceeds strictly on the authority of the majority — of the minority quorum to bring about this business.

Lewis F. Powell, Jr.:

He did find they were independent?

Joseph H. Einstein:

Yes Your Honor he did, and that finding was in affect overruled by the Second Circuit both I believe on the facts and on the law.

Lewis F. Powell, Jr.:

He also found that they acted in good faith?

Joseph H. Einstein:

Yes, Your Honor.

Lewis F. Powell, Jr.:

As I read the Second Circuit it didn’t overrule of finding a fact.

It merely questioned whether anyone could be an independent director at anytime on any circumstances?

Potter Stewart:

Or all these directors had any power to do what they did?

Joseph H. Einstein:

Second Circuit Your Honor, the opinion I find somewhat ambivalent on this issue because if you look at pages A46 and 47 of the appendix where the opinion appears, Second Circuit clearly discusses the fact that these directors serve not only as directors on this fund’s board but on a number of other boards where funds are managed by Anchor and received $11,000 to $13,000 per annum compensation.

Warren E. Burger:

We’ll resume there at 1 o’clock.

Joseph H. Einstein:

Thank you, Your Honor.

Which says at page 263 of 244 US, courts interfere seldom to control such discretion intra vires the corporation except where the directors are guilty of misconduct equivalent to breach of trust or where they stand in a dual relation which prevents an unprejudiced exercise of judgment.

Now under those standards, I think it’s very clear that this minority of the Board could not act and the Board could not act.

Potter Stewart:

What you’re saying would lead me to believe that you, if you want to you can file another derivative suit on behalf of the corporation grounded upon the wrongful action of these directors in making this business decision to settle this lawsuit.

Joseph H. Einstein:

I don’t think that —

Potter Stewart:

That’s where your claims would be appropriately tested out, isn’t?

Joseph H. Einstein:

No, I think my claims can be properly tested out in the District Court which has a —

Potter Stewart:

No it would be in the District Court.

Joseph H. Einstein:

No, on this action after all we are now six years since this action was filed and still in the preliminary procedures without ever having an answer filed or any discovery and I think that the claims can be tested out in the District Court, which can easily and under very familiar standards deal with all these questions.

Potter Stewart:

It’s generally the business of directors who are fiduciaries with respect to the shareholders to make these business decisions on behalf of the corporation.

The District Court found that these were disinterested directors both in fact and within the meaning of the Federal Statute that they acted by a majority of the quorum, and that they acted in good faith.

And why is this business decision any different from any other business decision that a directors should — are trusted with making.

Joseph H. Einstein:

Because they seek to exculpate the majority of the board from serious substantiated charges of wrongdoing, that’s why it is different.

They are not —

Potter Stewart:

Their original action was brought on the — for other corporation on behalf of the corporation?

Joseph H. Einstein:

That’s right.

Potter Stewart:

And now these directors are acting on behalf of the corporation.

Joseph H. Einstein:

But they’re seeking to exculpate fellow directors.

Potter Stewart:

Whatever they’re seeking to do, they’re making a business decision for the corporation like any other business decision for the corporation, and if you think that they acted wrongly you can bring another stockholder’s derivative suit.

Joseph H. Einstein:

I think that under the stand —

Potter Stewart:

— on behalf of the corporation against them?

Joseph H. Einstein:

I think that under the Standards of Rule 23.1 I don’t have to go through that procedure that I can present those arguments and have them considered by the District Court.

Potter Stewart:

In Rule 23 against dismissing or compromising that within the court?

Joseph H. Einstein:

That’s correct.

Potter Stewart:

That’s 23.1.

Joseph H. Einstein:

That’s 23.1.

Potter Stewart:

No, it’s 23.1 it follows.

Joseph H. Einstein:

23.1, 23 is class actions, 23.1 is derivative actions.

John Paul Stevens:

The clause 23.1 says, as you need the approval of the District Court.

Joseph H. Einstein:

That’s correct and the case –

John Paul Stevens:

That’s the approval of the District Court.

Joseph H. Einstein:

But the case law first of all requires notice to the stockholders and the case law that has surrounded Rule 23.1 has made it very clear that the court has to consider the propriety of the dismissal of business judgment reasons, the merits of the action to make sure that dismissal is proper.

John Paul Stevens:

And those cases all deal with dismissals by the shareholders who are suing on behalf of the corporation where the evils are quite different and that’s those are evils to which this Rule directed everybody knows that.

Joseph H. Einstein:

With all deference Your Honor, there are a number of cases which we have cited in our brief where a majority of a Board of Directors of a new board that has turned over during the course of a litigation has come into court to seek dismissal of a derivative action and in each of those cases and they are cited at pages 43 through 49, 50 of our brief, in each of those cases where a majority, a new and concededly independent majority came into the corporation, the court conducted a painstaking, extensive hearing to determine whether dismissal was appropriate.

Now, that’s Birnbaum against Birrel decided by Chief Judge Edelstein in the Southern District of New York, decided that Burger against Dyson, Denicke against the Anglo California National Bank, all decided that, and indeed Goodwin against Castleton, a Washington case also reached the same result.

Whereas the courts in all of those cases even where a majority of the board came in and asked for the dismissal refused to simply rubber stamp that dismissal.

They examined the merits of the action.

They examined the business judgment reasons and only then if the court deemed it proper was the derivative action permitted to be dismissed.

Now, I think that’s very different than what occurred here.

Potter Stewart:

Yeah, but in each case as I just reading it, I’m not familiar with it, I read the opinion Birnbaum against Birrel and Burger against Dyson as I read the description in your brief, the shareholder plaintiffs received something too, didn’t they?

Joseph H. Einstein:

Yes, they did and the corporation received something.

In each of those cases there was consideration running to the corporation in connection with the settlement.

Here the corporation receives nothing.

This case is not – is being dismissed without any compensation to the corporation.

I think that heightens the obligation of the court to see that the dismissal is in the best interest of the shareholder.

Byron R. White:

Well, it is — it is apparent then you’re the Rule, you are advancing would certainly I suppose a fortiori or not applied it to compromises.

Joseph H. Einstein:

Yes.

Byron R. White:

If the directors wanted to compromise a suit and wanted to settle it, it could not do, they could not do so over the objection of the plaintiffs even if State Law would given them that power.

Joseph H. Einstein:

I question whether Delaware Law gives the minority power.

Byron R. White:

Yes.

Joseph H. Einstein:

If there was a majority of directors that decide to do it, I think the court would have the obligation to examine the compromise to make sure it was fair and appropriate.

Who is to say that the new board may not have had some kind of an arrangement with the defendants, you never know that.

Warren E. Burger:

Was there not under Delaware Law majority action here by a quorum of the directors.

Joseph H. Einstein:

There was quorum action, it’s a minority, it’s 5 out of a 11 directors.

Warren E. Burger:

But that’s the Law of Delaware, isn’t it?

Joseph H. Einstein:

But the Law of the Delaware says that a minority that a quorum can be a minority.

The Law of Delaware also says that when you bring a derivative action and less and more – I’m sorry and a majority of the board is charged with wrongdoing, you don’t have to make a demand, that’s Federal Law and that’s Delaware Law.

Now, if you don’t have to make a demand where there’s a minority quorum in order to bring a derivative action, do I have — there’s a litigant then every month or every year, when there’s a new election have to make a new demand because maybe the composition of that board has changed or if you follow it to its end, if there’s a minority quorum do you have to make a demand on that minority let it act and then have a threshold litigation on the appropriateness in minority action.

Warren E. Burger:

We don’t have any of those hypotheticals, do we?

Joseph H. Einstein:

But I think that’s where there, that’s where the flaw is in my advisory’s position because Rule 23.1 and the decisions under both Federal and Delaware grant access to the courts that the Federal and State courts whenever a majority of the Board is charged with wrongdoing without the necessity of a demand.

Now, if you’re in court on that theory I don’t see how or why it’s appropriate to have the same minority turn around the next day or the next week or the next month and spin your right back out of court again.

I don’t think Rule 23.1 contemplates it or the Delaware Law contemplates it.

Byron R. White:

Of course in a Federal Court, a derivative action unless there’s some Federal Statute that the State Corporation Law is going to govern it?

Joseph H. Einstein:

That’s correct and the State Corporation Law of Delaware is in effect Rule 23.1 and a decision is under —

Byron R. White:

You wouldn’t think that, you wouldn’t think that — do you think under 23.1, the District Judge could just say, “I’m just not going to approve the settlement because this is just by a majority of a minority quorum?”

Joseph H. Einstein:

I think The District Court — well, I have serious question Your Honor about whether a minority has the standing or the power to bring the question before the board, before the court.

Let’s assume it does.

Byron R. White:

Suppose it does and it’s clear under Delaware Law that it does.

Joseph H. Einstein:

Alright let’s assume that it has —

Byron R. White:

Does a District Court just ignore that and say I’m not even going to consider it?

Joseph H. Einstein:

No, the District Court would have to consider the application and weigh it on the merits, is the dismissal in the best interest of the stockholders.

Is the quorum group independent?

What are the reasons which allegedly support dismissal?

What is the merit of the action?

What are all the relevant factors and then make an informed judgment.

District Courts do this all the time in settling class and derivative actions under Rules 23 and 23.1.

This is nothing new, it is nothing extraordinary; it doesn’t broaden the burdens of obligations with the District Court.

I’m not suggesting as I think some concern was expressed before that an entirely new procedure be created that there need be full discovery as if the case was being prepared to trial on the merits.

Joseph H. Einstein:

All that is required is that the District Judge afford the objecting party an opportunity for reasonable discovery in the discretion of the judge and then pass on these issues.

There have been many cases Your Honor, where District Court have refused settlements because they thought they were unreasonable.

And I think that the District Court has that power and authority.

Now, I would like to pass on to one other matter and that is the fact of the subsequent removal of Anchor as the fund’s advisor because I think that is a matter of great significance in this litigation.

Anchor is no longer the advisor and one of the alleged motivating factors in connection with the action of the minority directors here was that continued litigation would so adversely affect the fund’s relationship with Anchor that that relationship would be destroyed.

Since the relationship no longer exists, I have serious doubt is to whether there is any further basis for dismissal of this action.

Now, I would call the Court’s attention to decisions in McLeod versus General Electric 385 US 533 and Patterson v. Alabama 294 US 600 and I read the citations because they are not in our brief, which clearly indicate that when there is a set of circumstances which has occurred between the time of a decision and a time of a hearing in this Court, this Court can and should look to these additional facts and circumstances in reaching a decision and Korn against Franchard which is reported at 456 F.2d 1206 indicates that where the circumstance is so strong and compelling as I believe this one is that it mandates a different result or I believe in our case it would mandate an affirmance because it undercuts the decision for the reasons for dismissal that the Court can grant the appropriate relief and need not merely remand the case for another look in the lower courts.

Warren E. Burger:

The citations you gave I think some of us were not aware that you’re referring non-cited cases, so give me the Supreme Court cites again.

Joseph H. Einstein:

McLeod versus General Electric 385 US 533, Patterson v. Alabama 294 US 600 and the Second Circuit case is Korn v Franchard 456 F.2nd 1206.

I’ve hadn’t cited these because the issue of this Court’s ability to consider this fact was only raised in my advisory’s reply brief to which I of course hadn’t — I believe Patterson was a criminal case.

I believe so.

Thurgood Marshall:

(Inaudible)

Joseph H. Einstein:

Well, what the case, what those two cases stand for; McLeod is a NLRB Case and Korn v. Franchard is a Class Action Decertification Case.

All of them clearly indicate that where a subsequent fact has occurred after the decision but before the hearing of the appeal the Court can and should look at that subsequent fact and take the appropriate action.

In summary Your Honors, I would submit that the decision of the Second Circuit was clearly correct within the narrow confines of the cases decided by that court.

When you look at the specific facts at bar and consider them in light of the history and purposes of the 1940 Act, we believe that the decision was correct.

We also believe —

Byron R. White:

Didn’t the District Judge I suppose thought he was complying with Rule 23?

Joseph H. Einstein:

The District Judge rejected the position, the Rule 23.1 was applicable.

The question was briefed in the Second Circuit but never reached by the court.

Byron R. White:

You say that Rule 23 has nothing to do with it whatsoever?

Joseph H. Einstein:

That’s correct.

It did not applied and the District Court and the Second Circuit found it unnecessary to reach the question.

Now we also believe Your Honors is that if you do not follow the rationale of the Second Circuit and view the case as one under Rule 23.1 requiring hearing as a prerequisite to dismissal, and when you look at the factors that the Court must consider that on this record, specially given the subsequent termination of the Anchors, the fund’s advisor, there’s no rational or reasonable basis for the dismissal of this action.

The action should be allow to proceed.

The alleged harm which the fund perceived it could suffer by further prosecution to this action, of this action is no longer existent.

William J. Brennan, Jr.:

I don’t understand. If we agreed with you on 23.1 and the District Court refused to apply it, we think he should, why would we send it back (Inaudible)

Joseph H. Einstein:

Because when you look at the factors that Rule 23.1 requires Mr. Justice Brennan, consideration of the merits, the Court of Appeals has found there was merit.

The question of independence, the Court of Appeals question that, and the so called business judgment reasons, the reasonableness of the decision particularly you find that the business judgment reasons no longer exist because of the termination of Anchor.

William J. Brennan, Jr.:

But in the first instance if you’re right as the 23.1 contemplate that the District Court shall make the initial judgment whether the 23.1 has been satisfied?

Joseph H. Einstein:

Yes, but if you send it back to the District Court and the District Court refused against a dismissal and your view of the case today was that it had to be retained, it could not be dismissed, we just have an up and down procedure again without any reason or purpose.

Byron R. White:

We might affirm a judgment we did that — we might not have made in the first instance ourselves just because sometime — it might rest on findings that are clearly erroneous?

Joseph H. Einstein:

That is correct Your Honor, but I think in this case with the removal of Anchor the facts are so clear that they mandate only one result and that is the rationale and teaching of Korn against Franchard which I cited to the Court before.

I see my time is done, thank you Your Honor.

Lewis F. Powell, Jr.:

Do your class still own the shares of —

Joseph H. Einstein:

Yes, Your Honor.

Lewis F. Powell, Jr.:

— in the fund?

How many shares do they own is out of interest?

Joseph H. Einstein:

I think about 200 each Your Honor.

Lewis F. Powell, Jr.:

400 out of how many?

Joseph H. Einstein:

Well, I know there is a 140,000 stockholders of the fund.

It’s quite a large fund.

There are many millions of shares outstanding.

I do not recall the number.

Warren E. Burger:

Mr. Pollack.

Daniel A. Pollack:

Mr. Chief Justice, and again may it please the Court.

Rule 23.1 as relied on by Mr. Einstein has nothing to do with this case.

It involves settlements by plaintiffs and the vice sought to be eradicated there is collusive settlements where a plaintiff drops a suit.

This is not a case of an involuntary dismissal.

This is a case where the matter was litigated on the merits before Judge Walker and he dismissed the case on an involuntary basis.

I want bring the — respectfully bring the attention of the Court back to the central issue in this case.

The Court of Appeals found that as a matter of a law disinterested directors had no power to terminate this stockholders’ derivative action.

I’ve listened carefully to the discussion this morning and I believe the briefs also support the proposition that no one has cited any authority indicating that the Act expressly deprives this power from the directors, that the history of the Act deprives the directors of this power or that the relevant case law under the Act deprives the directors of this power.

Mr. Ferrara has indicated in his brief for the government that the SEC supports the notion that the directors have the power and that the power has not been withdrawn by the Act or what he says is that there should be a remand, but I call to the attention of the Court the final footnote and the brief of the commission.

I believe the microphone may have gone off again.

Warren E. Burger:

No, it’s still functioning.

Daniel A. Pollack:

Thank you Mr. Chief Justice.

Warren E. Burger:

What’s the number of the footnote?

Daniel A. Pollack:

21; Footnote 21 says although we suggest a remand, this Court could determine reasonableness if it wishes because that determination involves only the application of a legal standard to a documentary record.

Now, if this Court can determine reasonableness from this record, surely Judge Walker could and we argue implicitly did make a finding of reasonableness, if this Court should find that, that is necessary.

Daniel A. Pollack:

Therefore we’ll comeback to the proposition that although we believe that State Law governs and that is the test to be applied, that is to say the test of good faith, no matter which of the tests that have been proposed here we believe that we meet that test.

Judge Walker found and I cite this to the Court at 836 that the minority directors carefully evaluated the opinions tendered by both counsels.

They considered the merits, they discussed the facts and circumstances surrounding the purchase and retention of the paper and they communicated extensively among themselves before reaching a decision to seek dismissal of this suit.

I believe that this is precisely the type of directorial conduct that one wishes to encourage.

Thank you very much for your time.

Warren E. Burger:

Thank you gentlemen.

The case is submitted.