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GALFAND v. CHESTNUTT

July 13, 1973

Mildred GALFAND, on behalf of herself and on behalf of American Investors Fund, Inc., Plaintiff,
v.
George A. CHESTNUTT, Jr., and Chestnutt Corporation, Defendants, American Investors Fund, Nominal Defendant


Broderick, District Judge.


The opinion of the court was delivered by: BRODERICK

Broderick, District Judge.

 This is a shareholder derivative action filed on July 6, 1973. A hearing was held on July 11, 1973 on plaintiff's request for a preliminary injunction restraining the defendant, American Investors Fund, Inc. (Fund) from conducting its annual meeting scheduled for July 17, 1973 in Greenwich, Connecticut and barring the use of the proxies. The defendant filed on July 11, 1973 a motion to transfer this action to the United States District Court for the Southern District of New York, pursuant to 28 U.S.C. § 1404(a).

 The complaint alleges that defendants George Chestnutt and Chestnutt Corporation, the Fund's investment advisor, have entered into a self-dealing investment advisory agreement which is unfair to the shareholders and that the proxy statements requesting shareholder approval of the agreement conceal the real nature of the proposal.

 The plaintiff claims that the proposed investment advisory contract results from a violation of the fiduciary duty set forth in Section 36(b) of the Investment Company Act, 15 U.S.C. § 80a-35(b). Plaintiff further alleges that as part of the plan the defendant, George A. Chestnutt, Jr., a citizen of Greenwich, Connecticut and President of the Fund and the President of Chestnutt Corporation, utilized his control of the other directors of the Fund by virtue of his 47% ownership of the stock of the Fund to induce the directors to breach their fiduciary duties by accepting the proposed new investment advisory agreement which has been proposed for ratification at the annual meeting on July 17, 1973. The plaintiff alleges that the proxy material is false and misleading in that it states:

 
as a result of cost increases over which neither the fund nor the advisor can exercise control, the FUND and the advisor have determined that the 1% annual expense ratio limitation in the current Advisory Agreement shall be increased to 1 1/2%. (Emphasis added)

 Plaintiff's first contention in support of her motion for a preliminary injunction is that the proxy solicitation material being used to obtain shareholder approval for the proposed modification of the investment advisory agreement violates Rule 14a-9 of the Securities and Exchange Commission in that it falsely states that the change is proposed "as a result of cost increases over which neither the Fund nor the advisor can exercise control." The plaintiff's second ground is that the directors have breached their fiduciary duties in proposing the modification of the agreement imposed by Section 36(b) of the Investment Company Act of 1940, 15 U.S.C. § 80a-35(b), as it is a self-enrichment proposal which is contrary to the best interests of the Fund.

 The only evidence introduced by the plaintiff in support of the preliminary injunction motion is the deposition of the defendant, George Chestnutt, Jr., the Fund's April 30, 1973 prospectus, the Fund's proxy statement for the July 17, 1973 meeting, and the annual report of the Fund.

 The Fund's proxy solicitation statement for the July 17, 1973 annual meeting provides as follows, in pertinent part:

 
APPROVAL OF THE TERMS OF NEW ADVISORY AGREEMENT
 
As a result of cost increases over which neither the Fund nor the Adviser can exercise control, the Fund and the Adviser have determined that the 1% annual expense ratio limitation in the current Investment Advisory Agreement shall be increased to 1 1/2% of average monthly net assets in the contract. Heretofore, the Advisory Contract required the Adviser to reimburse the Fund to the extent that total annual expenses (exclusive of interest and taxes) exceeded 1% of average monthly net assets. Under the new agreement, no reimbursement from the Adviser would be required unless and until total annual expenses of the Fund (again, including interest and taxes) exceeded 1 1/2% of average monthly net assets. The Investment Advisory fee schedule would not be changed under the new agreement; however, the higher allowable expense ratio limitation would benefit the Adviser by reducing the risk that some or all of the advisory fee would have to be reimbursed to the Fund due to an increase in rates for other expenses or changes in the average account size of American Investors Fund shareholders. No higher fees or costs would have been incurred by the Fund had the proposed new Agreement been in effect in 1972.
 
The contract provides that the total expenses of the Fund (exclusive of interest and taxes but including the advisory fee) shall not be more than 1 1/2% of the average monthly net assets of the Fund. The Board of Directors of the Fund has agreed, however, that should the Fund register its shares for sale in states which impose a more stringent expense limitation, the Adviser will reimburse the Fund for expenses above the limitation imposed by such states. The Board of Directors of the Fund and the Adviser contemplate making undertakings to certain states in which Fund sales are being made, which undertakings would require the Adviser to reimburse the Fund to the extent that total expenses of the Fund (exclusive of interest and taxes) exceed 1 1/2% of the first $30 million and 1% of the excess over $30 million. However, no assurance can be given that the annual expense ratio will in fact be at a level less than 1 1/2% of average monthly net assets.

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