## Facts

- American Investors Fund, Inc. (AIF) was a registered mutual fund whose operations and portfolio management were handled by its investment adviser, Chestnutt Corporation.
- Under the original advisory contract, Chestnutt’s fee included a breakpoint/rebate feature that required Chestnutt to rebate fees to AIF when fund assets declined below specified levels.
- As AIF’s assets depreciated, the rebate feature became more likely to reduce Chestnutt’s compensation.
- Chestnutt sought a mid-term revision of the advisory contract to eliminate or substantially alter the rebate mechanism, increasing or stabilizing its compensation.
- AIF’s board, including independent directors, approved the revised advisory contract after Chestnutt presented the proposal.
- The courts found Chestnutt did not provide the board full and candid information about the economic effect of the change, the self-interested reasons for the request, and potential consequences under the existing contract.
- A proxy statement was issued to shareholders to obtain ratification of the revised contract; it failed to clearly disclose the loss of the existing rebate, the role of fund depreciation in motivating the change, and that Chestnutt might owe a refund under the existing contract if the change were not approved.
- A shareholder, Mildred Galfand, sued derivatively alleging breach of fiduciary duty regarding compensation under Investment Company Act (ICA) § 36(b) and misleading proxy solicitation under ICA § 20(a) and SEC Rule 14a-9.

## Issues

1. Whether Chestnutt breached its fiduciary duty under ICA § 36(b) by procuring a mid-term advisory fee revision favorable to itself without full disclosure to AIF’s independent directors.
2. Whether the proxy statement soliciting shareholder approval contained materially misleading statements or omissions in violation of ICA § 20(a) and SEC Rule 14a-9, applying the materiality standard articulated in TSC Industries, Inc. v. Northway, Inc.
3. What remedy and damages measure should apply if liability is established.

## Decision

- The Second Circuit affirmed the finding that Chestnutt breached its ICA § 36(b) fiduciary duty by obtaining a one-sided compensation revision without full disclosure to unaffiliated directors.
- The court affirmed the finding that the proxy solicitation violated Rule 14a-9 because the proxy statement contained material omissions and misleading characterizations about the fee change and Chestnutt’s self-interest.
- The court affirmed rescission of the revised advisory contract.
- The court remanded for recalculation of damages consistent with § 36(b), focusing on compensation received in connection with the breach.

## Legal Principles

- ICA § 36(b) imposes a fiduciary duty on investment advisers with respect to compensation received from a mutual fund; when advisers seek changes to their own compensation, they must act with strict loyalty to fund shareholders.
- Because of the structural conflicts in the adviser–mutual fund relationship, advisers owe unaffiliated directors a duty of full disclosure in any area of possible conflict, including complete candor about the economic impact of compensation changes.
- Rule 14a-9 prohibits proxy solicitations containing materially false or misleading statements or omitting material facts necessary to make statements not misleading.
- Under the TSC Industries materiality standard, an omitted or misstated fact is material if there is a substantial likelihood a reasonable shareholder would consider it important in voting, such that it would significantly alter the total mix of available information.
- Remedies may include rescission of an improperly obtained advisory contract and monetary recovery tied to the compensation differential attributable to the wrongful conduct.

## Conclusion

The court held that an investment adviser violates ICA § 36(b) when it secures a mid-term fee increase through incomplete disclosure to independent directors, and it violates Rule 14a-9 when shareholders are asked to ratify the change using a proxy statement that omits or obscures information a reasonable shareholder would view as important; rescission was affirmed and damages were remanded for recalculation tied to improper compensation received.


Galfand v. Chestnutt Corp., 545 F.2d 807 (2d Cir. 1976)