I think, however, it is very important to adopt the enlarged definition of interested persons and then make it applicable in sections 10 and 15.

Now, on the question of ratification by the shareholders, I confess to being somewhat cynical on this. I rather think that shareholder ratification in 99 out of a 100 instances can be had for the asking. I think that this is particularly true in corporate organizations where the shareholders are very widely scattered as, of course, they are in most instances in mutual funds.

I am glad that the ratification provision does not have the complete effect of approving the transaction, that it doesn't eliminate the requirement that it still be reasonable.

I would now like to say a few words on section 36 which, of course, is also in the general area of breach of duty. Section 36 will be amended by deleting some of the pejorative language like "gross breach of duty" and "gross breach of trust" and so forth. Although I think it is excellent to get rid of this type of language, one problem I have is the introduction of the phrase, "involving personal misconduct," into the language. I am very fearful of what this may do.

I suggest an illustration that might point this up. Suppose, for example, we have one director who has, by hypothesis, engaged in personal misconduct, looting or whatever it may be. Two other directors have been simply very supine and indifferent to what is going on; perhaps they have been very irregular in attending meetings and this type of thing. The question may arise whether they have engaged in misconduct? Arguably they may not have. I would hope the courts would say they have. I believe that the inclusion of this phrase could have some unfortunate and unintended repercussions in the statute and that it could go a long way in the direction of returning section 36 to being the virtually useless provision that it is under the present statute. Finally, I would like to comment on SEC intervention in private actions under the 1940 act: This is section 44. I think that it is very desirable for the SEC to have the opportunity in the public interest to step in and to offer to the courts its expertise in building up a sound body of law. I think the SEC is the one that is preeminently able to do it, and if Congress adopts the reasonableness criteria, it is very important to permit the SEC to be able to come into the case and present its position.

I would like to just add one further point. This is quite technical, but under section 10 of the bill which would amend section 33, I notice that there is an obligation to file papers with the SEC where the defendant is an affiliated person. I would suggest that, in harmony with the approach being taken in this bill, it would be desirable to give the SEC the opportunity to have papers filed in any action which name the interested person as defendant, and not merely limit it to an action against an affiliated person.

In short, I have limited my presentation to a cluster of topics involving essentially the fiduciary duty principle, and I think that there is certainly room for disagreement on a few points. I think, fundamentally, S. 34 is very sound on this point. Time and experience may show that it is desirable, perhaps, to tighten these up in some ways, but it is a good beginning, and I think it is actually something more than a

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good beginning. I think it is an important step in needed regulation in the public interest.

Senator PROXMIRE. Thank you very much, Professor Folk. That is reassuring. We have just heard from Dr. Wallich that he apparently feels the reasonableness provision is all right. He thinks it is a step in the right direction, but a very limited step, and only a step in a journey of a thousand miles. You seem to think it would be-you imply at least that it wil have substantial effect. On what do you base this?

Mr. FOLK. I don't know how substantial the effect.

Senator PROXMIRE. Let me say what I am talking about, substantial effect in terms of providing an opportunity to have a rational limitation of the fees, of the advisory fees, so they won't be excessive.

Mr. FOLK. I think to the extent that a case-by-case development of the law will achieve a rational limitation, this should do it. I am still inclined to have a good deal of faith in the judicial process in this area. I believe it would be desirable to pursue it in this fashion until it appears to be really ineffective, that the courts are unable to take the necessary steps.

I would, if it were to be strengthened, I would suggest the strengthening would best lie within the present context, and that would be to switch the burden of proof over to the investment company to establish reasonableness. I believe that would be perhaps a most effective move, assuming that the matter is kept within the context of the courts.

It seems to me the alternative would be to go to a public utility fee type regulation by the SEC, and I question whether that is really practical, really a practical consideration, leaving aside any points about desirability.

Senator PROXMIRE. This is the other alternative; if the industry insists that its fees are reasonable and they oppose this provision in the bill in spite of that, and you think the other alternative to something of this kind would be a public utility regulation?

Mr. FOLK. I don't really see any middle ground here. I don't quite see how the mechanism of the market is going to be very effective in this particular area. I don't myself see alternatives.

Senator PROXMIRE. The industry's main objection to this provision, as I understand it, they are afraid of harassing suits that would be time consuming, expensive, and serve little purpose except publicity for the people bringing them. That is their view. Do you feel this is valid argument.

Mr. FOLK. No, sir; I do not. I think that this is an objection that has been raised ever since the shareholder derivative suit was recognized by the courts. Management has always said that it provides the occasion for harassment. It is certainly true that we have suits that are harassing in nature, but I do not think that the courts, at least in recent years, have had very much difficulty in dealing with this particular problem.

The great evil of course would be the private buy-out, the settlement under the table with the shareholder. I should suppose that our Federal courts, particularly since settlements must be approved, our Federal courts would keep a close eye on this.

I do not think that is really an objection.

Senator PROXMIRE. Anyway, we have no record to date under the present law of any suit succeeding in reducing a fee, do we?

Mr. FOLK. I think the overall effect of the litigation, particularly some of the litigation that did occur in Delaware, did have some salutary effect in reducing the level of fees. I might point out that it wasn't so much a litigated decision, but it was a dictum by former Chancellor Seitz in Saxe against Brady in which he gave a rather distinct hint that, given the increasing size of mutual funds, a fixed and inflexible. fee level was approaching the point of unreasonableness. I think this was a very strong hint from an extraordinarily able judge to the effect that the courts were about fed up with it. I think this prompted a good many settlements.

Senator PROXMIRE. Let me just ask, you referred to personal misconduct as a phrase which you said that might be unfortunate, and you suggested its elimination, as I understand it?

Mr. FOLK. I do, yes, sir.

Senator PROXMIRE. Do you feel we should just eliminate it without substituting any other criteria or any other provision?

Mr. FOLK. I don't think it is necessary to do that. I think that this leaves the matter open for the courts to consider all types of fiduciary breaches of duty. I do not think, as is indicated in the analysis of S. 34, I don't think this necessarily opens up the way for the threat of restructuring the mutual fund industry. As a matter of fact, one of the premises of the bill is, at least as to the externally managed fund, that the structure remains intact. Congress is being asked to approve such legislation which would regulate within that context.

Senator PROXMIRE. Senator McIntyre.

Senator MCINTYRE. Professor Folk, I haven't had a chance to read your statement, but you can be sure I will look it over very carefully. Mr. FOLK. I apologize for not being able to get it to the committee

sooner.

Senator MCINTYRE. I can just surmise that it is going to make good reading as far as I am concerned, because it looks as if it goes into this thing in a little bit more detail, and I am delighted.

This breach of fiduciary duty, what would we need to modify or add to or amend this? Isn't this pretty common? There must be an awful lot of cases on this.

Mr. FOLK. There are.

Senator MCINTYRE. What do we need this "personal misconduct" for?

Mr. FOLK. I agree. I think it should be eliminated. I think it is going to have a restrictive hampering effect upon the courts. Remember section 36 is not just open for every Tom, Dick, and Harry to get into the act. This is for the SEC to seek relief. I think we can assume that they will proceed in an appropriate fashion here.

Senator MCINTYRE. I think you have also made an interesting point in your comments about the word "misconduct" that some lawyer could well argue that because his man sat there and drew his salary and got his director's fee and went home and didn't open his big mouth, that he wasn't guilty of misconduct. That lends a further complication that I didn't see.

Mr. FOLK. I think at the very least it is going to require judicial determination in some areas to see exactly what will be the limits of section 36. Hopefully section 36, stripped of what I call the pejorative adjectives, could become a very effective weapon for dealing with

breaches of duty. I think this goes forward, the statute goes forward say six steps and backs up three and a half steps by this language.

Senator MCINTYRE. The industry speaks about harassing lawsuits, and certainly I can well imagine these are and can be of a nuisance type and variety, requiring the presence of important members of the firm to be tied up in court. However, on the other side, it does-it is one little bit of policing that goes on regardless of whether Congress acts or not.

You have indicated to the committee that a particular stockholder who feels very strongly about this issue, that he has a long, hard road to go before he finally gets to court; is that right?

Mr. FOLK. That is correct, sir. Generally he does.

Senator MCINTYRE. I would like to ask you, in this S. 34, I believe it is, I guess it is in S. 296, too, have we added an additional burden to this claimant by indicating that he cannot take any action on his own until 6 months have elapsed unless the SEC has given some sort of approval or some sort of intervention to his claim?

What is going to be the position of the suitholder who comes into court and the judge finds that the SEC has just remained apathetic? Mr. FOLK. The argument that you are concerned with is somebody will say since the SEC has not acted that the shareholder is not able to do so. Is that the argument?

Senator MCINTYRE. I was thinking suppose I was the judge, I had read this law and I am going to be called upon, as the industry says, this layman is now going to be called upon to determine what is reasonable here in the final analysis. I say apparently the SEC did not think too much of this claim. Isn't that going to cause me to look a little less fairly and equitably upon the cause?

Mr. FOLK. I rather think it would not have that effect. I think a fairminded judge would not be that much concerned about the fact that the SEC for reasons of internal allocation of funds and scarce resources had chosen not to take action here. I know in some areas the SEC has been asked to intervene or at least to present a brief amicus curiae, for instance, in cases arising under section 16(b) of the Securities and Exchange Act of 1934, and I know the Second Circuit has. sometime lamented the SEC's failure to come in and present its views, but has not in any way felt that this was a suggestion that the SEC thought ill of the plaintiff's case.

I believe the plaintiff has difficult problems in any derivative problems, but I rather think this is not too much of a difficulty.

Senator MCINTYRE. You have made a suggestion here this morning that I am wondering about, and that is you say you think we are really wrong in putting the burden of proof on the claimant, that the burden of proof should be upon the defendant or the particular industry that is being sued. Does that alter the law today? Are we altering the law today? Are we putting the burden where it isn't in the courts today? Mr. FOLK. This goes back, of course, to the restrictive interpretations that I indicated the section would get rid of. For example, in Saxe v. Brady, the court said at least after ratification had occurred, that it had not only shifted the burden of proof over to the plaintiff but it increased his burden quite measurably, the quantum of proof that he had to submit. So, at least where ratification is had, and I suspect many corporate lawyers make a point of getting ratification, since it

isn't all that difficult, that they certainly in the present law would want ratification.

Senator MCINTYRE. That is stockholder ratification?

Mr. FOLK. That would be stockholder ratification. The statute, of course, says, as I read it on page 79 of the comparative print "The presumption of reasonableness occurs only if it has been approved or ratified by the shareholders and by the vote of a majority of disinterested directors."

It seems to me that is very important. That at least does limit the presumption of reasonableness. As it stands right here (and I assume the word "and" is intentional, and not a misprint for "or"), as it stands right here the statute accords the presumption of reasonableness if it has had shareholder ratification and approval by disinterested direc

tors.

I hope that "and" won't get lost, because if it switches to "or," then shareholder ratification would give rise to a presumption of reasonableness, and I think this would be almost as bad as the existing situation.

Senator MCINTYRE. In your introductory remarks I thought you made reference to the fact that certain State laws are falling into, not falling but moving into an area of business judgment. It seems to me that the industry is trying to tell us that where they have stockholder ratification, where they have directors supervising their deliberations and coming into a conclusion that a certain management fee is fair and reasonable, that they should be treated in the same fashion as a private business corporation.

Mr. FOLK. I think the difference lies in the fact that this isn't the ordinary business corporation. This is a type of corporation engaging in a form and type of activity of great significance to the public interest and of great significance to the individual shareholders.

As I say, I am really quite cynical on ratification in corporations of any size. I think absent a proxy fight that seeks to raise the question, ratification would destroy the effectiveness of the proposed standard.

Senator MCINTYRE. Does that cynicism of yours extend to the socalled unaffiliated director? Not meaning to impugn the character, integrity, honesty, and outstanding characteristics of all of them whoever they may be.

Mr. FOLK. May I soften my language a little bit in that context and say that my scepticism would extend to the affiliated director. However, I think if Congress does adopt the definition in the bill of an "interested director," we will have a substantial step forward.

I think it is perfectly possible that a director may not be interested within the bill and still in very subtle ways be beholden to the investment adviser or others who really dominate the fund.

If it is felt that we need still more genuinely disinterested directors, perhaps what is necessary is to have a specific statutory provision that a full majority, an absolute majority of the directors, shall be disinterested.

Senator MCINTYRE. I wonder if perhaps that if some section of the law spelled out very clearly that if you are going to accept a disinterested, unaffiliated directorship, that you had better be aware of the fact that as a director, unaffiliated or not, that you be required to live