Reserve's Proxy Reveals Multiple Problems: Trustees' Independence Nixed, Contracts Lapsed
March 13, 2006
Reserve Management of New York, advisor to both The Reserve and the Hallmark Series of Funds, filed a preliminary proxy late last month that reveals a slew of problems that the firm is grappling with, some of which could raise regulatory ire and prove to be quite costly.
The firm's current challenges include multiple funds' advisory and sub-advisory management contracts and 12b-1 distribution fee agreements that were improperly authorized, internal control deficiencies, an auditor's resignation and a convertible securities fund that still has yet to file its June 2005 financial report and remains in limbo.
Right now, it appears that the most serious of Reserve's problems center around lapses in the management and sub-advisory agreements and 12b-1 fees on a baker's dozen of Reserve's funds. The termination of these contracts traces back several years.
According to the proxy filed on Feb. 24, two of the independent trustees who had sat for years on Reserve's board of directors and who had along with other independent trustees regularly approved management and distribution contracts between Reserve and its mutual funds, were not really independent under the letter of the law. That change in legal status for those two trustees from independent to non-independent has far-reaching implications including making null and void all of the advisory and distribution contracts on the funds those trustees had presided over.
Under the '40 Act, approval of a mutual fund's advisory contract, any sub-advisory contracts and 12b-1 distribution fees must be formally and periodically approved by a majority of the fund's independent trustees. In addition, in order for a fund to rely on certain regulatory exemptive rules, its board must be comprised of a majority of independent trustees.
In cases where a fund's independent director is later judged to not be fully independent, that shift in independent board members from majority to less than majority can cause contract approvals to become void.
According to the proxy, it was in early 2005 when Reserve discovered that two of its trustees weren't, in fact, independent. "In the course of preparing documents for a new fund, management became aware that two trustees it believed qualified as independent trustees, based on advice from prior outside counsel, were, in fact, not independent. Both of these persons were directors of different companies that sold shares of one or more Reserve funds and, as a result, were technically interested persons' of the trusts," the proxy explained.
That discovery prompted Reserve's executives to determine its legal ramifications, which are that many management and distribution contracts were not properly approved.
However, in a statement to Money Management Executive, executives at Reserve didn't cite preparation for a new fund as the reason for the discovery, but said it "came about as a result of an internal, annual due diligence review conducted in 2005." Moreover, the executives reiterated that "the past determinations were based on incorrect advice from prior legal counsel."
It isn't clear who that prior legal counsel was. A review of Reserve's SEC filings over the past few years does not readily reveal which outside law firm had been counseling its funds. However, a footnote in a Hallmark filing said Dechert was its outside counsel until October 2004, when Reserve's in-house counsel took over.
In a statement released to Money Management Executive, Dechert said that "without retrieving and reviewing our files from 2000, we cannot respond to your question [but] we did not generally advise these funds." However, a Dechert spokeswoman said the firm did some project work for Reserve.
In its statement, Reserve noted that the two trustees whose independence was questioned stepped down last March. In addition, two other independent trustees also resigned, and then, two months later, a fifth independent trustee left. But SEC filings at the time of these resignations made no mention of the independence issue at all. Rather, one filing simply said that trustees had resigned due to new SEC board independence requirements.
Adding to Reserve's problems is an admission in the proxy that for two of the group's single state municipal money market funds, the fund advisor's review subsequently determined that formal board approval of a comprehensive investment management fee was not properly made in accordance with regulations, and that for certain other funds or share classes, approval of a recent change to a comprehensive management fee was never actually approved by the board of directors.
To right these wrongs, Reserve is now asking for shareholder approval of new and virtually identical management contracts, 12b-1 distribution agreements and sub-advisory contracts for each of the Hallmark funds.