interest in a fund's advisor-underwriter, it is clear that decisions which must be made by unaffiliated directors are being made by interested directors. Indeed, since the advisor normally is in a position to secure the election of all the directors of the fund, it would be fatuous to suppose that one holding such control will knowingly place on the fund's board persons who will be other than kindly disposed to the advisor's interests. This is not to suggest that unaffiliated directors breach their duty. It is to declare emphatically that many such unaffiliated directors are in a posture of unavoidable conflict of interests, even though they do their best to resolve those conflicts as decent and honorable men. But the very existence of such conflicts deflects the main thrust of the Act: that a certain percentage of directors will be the disinterested, dispassionate protectors of the interests of the fund shareholders especially when the critical question of the advisory contract is to be voted upon. One need not suppose that an unaffiliated director is necessarily subservient to the advisor. However, his delicate position of subtle dependence will dispose him to resolve doubts in favor of the advisor, to stress in his own mind the quality of services actually rendered rather than investigate the possibilities of improvement, to silence nagging doubts that the compensation formula may be producing excessive compensation as fund assets grow, to soften the probing question or forego the extra hours of independent inquiry into comparative statistics and information, or to ignore suspicions as to the propriety of sales practices under the fund underwriter's auspices.

Congress in 1940 no doubt believed that unaffiliated directors would pursue such efforts on behalf of the fund and doubtlessly in some measure these expectations have been fulfilled. But the fact of mere partial fulfillment is disquieting, and the failure has occurred in crucial areas of fund operation. For example, almost none of the externally managed funds took steps to reduce compensation under the classic one-half of 1% of net assets formula, until pressure was generated by the Wharton School Report and, more tangibly, the numerous shareholder derivative suits challenging operation of the formula. It could reasonably be supposed that truly disinterested fund directors would have anticipated the undue swelling of compensation under a rigid formula and would have urged reduction of compensation so that the advisor would pass on to the fund shareholders some of the economies of sale. As Chancellor Seitz stated in Saxe v. Brady, 40 Del. Ch. 474, 497-98, 184 A.2d 602, 616-17 (Del.Ch. 1962), “it is not to be assumed that an independent board would wait until the fees paid under the management contract warranted a finding of waste before attempting to negotiate a better deal," for "ideally a truly independent and active board would be expected to be alert to the factors" bearing on the reasonableness of compensation. In this case, Chancellor Seitz assumed without deciding that "an independent board was not present" despite the requisite number of unaffiliated directors.

The bill's provisions would go far towards correcting these deficiencies in the original act. Section 10(a) would be revised so that no more than 60% of the board will be "interested persons." This substantially enlarges the corresponding prohibition in original 10(a) which barred a like percentage of persons who are investment advisors or "affiliated persons" of the adviser. The enlargement derives from the much broadened definition of "interested person" in Section 2(a) (19). Similarly, the prohibitions of Section 10(b) are reframed in terms of "interested" persons rather than "affiliated" persons as in the original act.

Most significant is the effect on Section 15 (c) which presently requires approval of the advisory contract by "a majority of the directors who are not parties to such contract or agreement or affiliated persons of any such party" (unless ratified by the shareholders). The new provision would require approval by a majority who are neither parties to the contract nor "interested persons of any such party." It would add three additional safeguards.

First, ratification by shareholders is deleted-quite properly, I believe, because it has been a convenient northwest passage around the existing statutory requirement of approval by a majority of non-affiliated directors. Indeed, ratification even with full disclosure, is hardly any safeguard at all, because it can be so easily obtained from shareholders who have little interest in what they are being asked to vote on if, indeed, they understand what they are doing let alone its legal significance.

Secondly, the directors must vote on the advisory contract "in person at a meeting called for the purpose of voting on such approval." This insures that each disinterested director will have specific notice of the purpose of the meeting.

Presence at the meeting at least creates a forum for a free exchange of views and ideas, whether or not the exchange is productive.

Thirdly, all directors would have a specific duty in this context to "request and evaluate" information "reasonably necessary to determine the reasonableness of compensation." The advisor has a correlative statutory duty to provide such information. The first part of this provision probably only declares existing law, for directors always have a duty, when voting on compensation, to consider its reasonableness. However, the statutory declaration should bring home this duty much more sharply to all directors and stand as a continuing reminder when the common-law duty may be forgotten. After all, most corporate directors are not lawyers; a specific statutory statement is apt to be quite meaningful to them.

The definition in Section 2(a) (19) of "interested person" is more inclusive than the older term "affiliated person," and it quite properly is divided between interested persons in respect of an investment company and an investment advisor or underwriter.

(A) Both parts of the definition include affiliated persons and any "member of the immediate family" of a natural person who is an "affiliated person." This would cover the example, supra p. 15 of the son of the founder and control stockholder of the adviser, who under present law may be an "unaffiliated" director.

(B) When used with respect to an investment company, the term includes "any interested person of any investment adviser of or principal underwriter" of the investment company. This is especially important as a device to keep the investment company's board from being packed with technically unaffiliated, but substantially interested, persons linked to the investment advisor or principal underwriter.

(C) When used with respect to an investment company, the term includes persons who have recently acted as legal counsel for the company or for the investment advisor or principal underwriter. This would cover the situation, noted supra p. 15, of the advisor's attorney who may at present be an unaffiliated director of the investment company.

(D) In both parts of the definition, the term includes persons whom the SEC has determined to be interested by virtue of material business or professional relationships with the investment company or its advisor or principal underwriter.

2. Enforcement of breaches of duty

Section 36 of the 1940 Act authorizes the SEC to proceed against certain persons for "gross misconduct or gross abuse of trust" towards an investment company. This provision has been ineffective. For one thing, the very terms themselves exclude most situations involving ordinary breaches of duty or conflict of interests. The adjective "gross" connotes something much more serious, perhaps bordering on the criminal. Secondly, when the SEC has used this provision to challenge certain types of duty breach, it has been unsuccessful precisely because the activity complained of lacked the degree of turpitude suggested by the language of Section 36. See SEC v. Insurance Securities, Inc., 254 F. 2d 642 (9th Cir. 1958). Compare Aldred Inv. Trust v. SEC, 151 F.2d 254 (1st Cir. 1945). Finally, the SEC has been reluctant to use this section to stigmatize conduct, which may well be questionable, with the pejorative terms "gross misconduct or gross abuse of trust," apart from the fact that the conduct may not itself be so "gross" as all that.

Because the present Act lacks any general provision for the SEC to challenge breaches of duty-and, indeed, the very presence of Section 36 may be interpreted adversely to implying other and wider enforcement powers in the statute-most of the important litigation has been instituted by private parties in state courts. This is most obviously true of the cases attacking the advisory fee; and, as indicated earlier, the courts unfortunately invoked state law restrictions which proved to be inappropriate to the difficult and subtle problems in the litigation, although outstanding judges, such as former Chancellor Seitz in Delaware, recognized the anomaly.

Quite clearly, the statute should give the SEC standing to invoke court aid in situations not now encompassed by the narrow terms "gross misconduct or gross abuse of trust." Section 20 of the Investment Company Amendments (Committee Print pp. 102-03) would permit an action if certain persons have or will engage "in any act or practice constituting a breach of fiduciary duty" to the fund. This includes the offenses covered by existing language, but the merit of

the proposed revision is that it will permit challenge of many other types of duty breach or interest conflicts. Both in the existing law and under the proposed language, the same persons will be covered: officers, directors, investment advisors, depositors, and principal underwriters.

It is regrettable that S. 34 has seemingly limited the possible scope of the corrective provisions of section 36 by introducing the restrictive phrase "involving personal misconduct" to modify actions for "breach of fiduciary duty." The phrase is by no means certain as to scope, but it would likely limit needed relief to situations where directors and others have engaged in some clearcut personal impropriety. Since there may still be interested persons on boards of investment companies, one wonders whether their activities will be substantially immunized from injunctive relief, unless it descends to the level of "personal misconduct."

One illustration of this would be an action against directors A and B for allowing director C to engage in serious misconduct, although A and B were not parties to a conspiracy nor did they benefit from C's action. But it may be questioned whether, within the meaning of the phrase, A and B, by remaining silent, have engaged in "personal misconduct." And yet relief against supinely indifferent directors such as A and B may be at least as important as relief against the evildoing director C. I believe that the introduction of this seemingly innocuous limiting phrase is apt to have unintended repercussions in effectuating the cbjective of enlarging section 36. More exactly, it may keep section 36 from going much beyond present law. Ultimately, the difference between old and new is that the misconduct must now be "personal" rather than "gross." I doubt that the deletion of the perjorative adjective "gross" does much to enlarge a potentially useful and needed provision of the statute, and I urge deletion of the limiting phrase "involving personal misconduct." The fact that this phrase is deleted does not mean that section 36, as amended, would necessarily be opened up for the SEC to seek "a general revision of the practices or structures of the investment company industry." See Committee Print at p. 22.

3. SEC intervention in certain private actions under the Investment Company Act of 1940

Section 22 of the Investment Company Amendments of 1969 would amend Section 44 of the 1940 Act by adding a provision authorizing the SEC to intervene as a party in any action seeking to enforce the standard of reasonableness (new Section 15(d)) which would govern the compensation charged to a fund by its investment advisor or principal underwriter. See Committee Print, pp. 51-52. This provision is desirable. Involved is a novel and important statutory provision The SEC expertise on these topics would be of material aid to courts in developing a sound body of case law, since the SEC could thus bring to bear its accumulation of data and information demonstrating the need for enactment of the substantive provision. Intervention is particularly needed in management fee cases if there is a presumption of reasonableness of a particular fee which then puts the burden of proof on the plaintiff to show unreasonableness. Since this is a heavy burden to be carried by a private party, the balance in favor of the fund and its advisor-underwriters, would be slightly redressed if the objector has the material support of the SEC. Accordingly, I favor enactment of the changes in Section 44 of the 1940 Act (as provided for in Section 22 of the Amendments).

Senator PROXMIRE. Our next witness is Mr. Abraham L. Pomerantz, attorney, New York, a man who has been before this committee before, and it is always a delight and a pleasure to have you, Mr. Pomerantz. You are an unusual, outspoken, and very able and intelligent man, and also a smashing success.

STATEMENT OF ABRAHAM L. POMERANTZ, ATTORNEY,
NEW YORK, N.Y.

Mr. POMERANTZ. Thank you for all those accolades.

Senator PROXMIRE. We have read about the great work you have done in this area, and we are happy to have you. You have a brief statement. You can handle it in any way you wish.

(The prepared statement of Mr. Pomerantz may be found at p. 177.) Mr. POMERANTZ. Yes.

I would appreciate if you would interrupt me if I go along too long or at any point you would want to put a question.

Perhaps touched off by Senator McIntyre's line of questions of the last witness as to why mutual funds should have different treatment or why the courts should have a different view of ratification in a mutual fund case from the view we would take of an ordinary industrial corporation and kindred searching questions asked by Senator McIntyre, it would be well to ask a rather primitive question to put this present bill in proper focus. That is, why has Congress seen fit to make the investment company, the mutual fund, the subject, or if you wish, the object of special attention rather than General Motors or steel or rail companies? I think the answer lies in the fact, as is stated in the preamble of the Investment Company Act, that mutual funds, unique of all corporate creatures in America, are just rife with conflict of interest. All companies have some amount of it, some amount of duality, but conflict of interest is a very specific affliction of the mutual fund, because the very men who sit on the boards of the fund and in an active managerial way are forsworn as directors to be faithful and loyal to the interest of the fund with particular reference I might say to the need to protect the fund from the overreaching of the investment adviser or manager, these same directors are also managers and in large part owners of the investment advisory and managerial company.

So, sitting as directors, their loyalty belongs to the fund. Sitting as investment advisors, self-interest being what it is, it can be assumed that they are going to keep an eye on the rather economically important matter of being re-elected or reappointed investment advisor and getting the largest fees that they can get.

So, you have a built conflict of extraordinary proportions, and the records of my litigations and the records before you show that these men have not been modest or temporate in fixing the amounts of their fees.

Now, you can do all kinds of tricks with statistics. You can say, as I have heard said here his morning, that it doesn't cost each shareholder very much, and if an advisor, as they have done, makes $10 million to $12 million a year on advisory fees, well, on a per share basis it comes to not very much. Of course, the argument is sociologically and morally deeply unsound. It would be like saying let the president of General Motors take $10 million a share salary because on a per share basis it doesn't hurt very much.

This, I think, is a statistical trick which doesn't fool sophisticated people. Compensation should be reasonable. It is no answer to say the millions insiders get affect the public on a per-share basis very little.

It is because of this conflict that Congress has seen fit in the Investment Company Act to try to purify or dilute the dangers inherent in the situation, and one of the present sections of the Investment Company Act, which I think was well intended, was that the directors of the fund should be made up of about 40 percent of unaffiliated, independent directors.

As you have said, Senator McIntyre, in a rhetorical question, these independent men may be honorable men, and I am sure are, some are very charismatic men, retired Army generals, retired admirals, col

lege professors, but not men who necessarily are really students of investments.

My examination of some of these men shows an almost funny, were it not so sad, ignorance of the matters about which they are supposed to direct. The passage of time inhibits me from referring to some of the perfectly fantastic things that these so-called independent directors did, or more accurately did not do, as the juggernaut of the advisory fee came by year after year only to find these independent men quite passive.

Until I began the series of what the defendants elect to call harassing litigations defendants are always harassed by litigations, they never enjoy them these "independent" men took no steps to reduce the fee or even to discuss the matter.

Again the testimony shows that as in your hypothesis, Senator McIntyre, or was it Senator Proxmire, I forget now, when fees go up from $100 million to $1 billion, and the same one-half of 1 percent meant 10 times the take for the adviser, not in one case is there a record of one independent director-yes, there is one, I will pass over it and come back to it-not one case where an independent director stood up and said isn't it time that we reconsider the advisory fee and scale it down perhaps to three-eighths. For in spite of the tentative answer given by the prior witness, the fact is there is virtually no increase in advisory expense when a fund goes up from $100 million to $1 billion. The same team of experts are going to be there to make decisions, whether they are buying a thousand shares or 10,000 shares of stock. So you have built-in proof of the fact that the unaffiliated, or independent, director requirement just doesn't work. In fact it worked opposite to its intent, because what would happen in many of the cases is defendants would plea as a defense that the board of directors of the fund unanimously voted and each year would revote the same advisory fee to the same adviser. So that what was intended to be a purifying device turned out to be a shield that these directors used in rationalizing retention of their fees.

I pass over quickly, because other witnesses have adverted to it, the similar, conflict between theory and reality in connection with stockholder's ratification. My 45 years at the bar doesn't bring to mind a single case where requested ratification was ever denied by the shareholders, and some of the ratification resolutions put to them were really pretty wild and way out. The reason for this is these same salesmen, Senator Proxmire, who are so good at selling the funds, are equally good at selling the shareholders to send back their proxy vote. Between the proxy solicitors and the inundation of proxy materials, people being what they are, they sign on the dotted line and send their proxies back in.

Here again ratification has been used by defendants as a shield because again the defense argument is if 99 percent of the shareholders vote in favor of it, what is plaintiff kicking about? And that has been used, as Professor Folk said, in Saxe against Brady to dismiss a case in which the chancellor strongly implied he would have given judgment for the plaintiff were it not for the fact of ratification. Now, you Senators are too sophisticated to need to be told that this whole ratification business is a mirage, it is a delusion. It is for these reasons that I think the initial, underscore it, the initial SEC