It seems Reserve Management, the New York firm that advises the Reserve Funds and the Hallmark Funds, has had more than one headache to deal with lately.

On February 24, the company filed a proxy statement with regard to an upcoming special shareholders meeting. In it, Reserve outlined difficulties relating to a misclassification of at least two former members of its Board of Trustees, and explained how this, and another procedural error, rendered invalid several of its management, sub-investment management, and distribution contracts.

Under Section 15 of the Investment Company Act of 1940, any investment management agreements a company makes must be approved by shareholders, as well as by a majority of independent trustees, or trustees who are not "interested persons" of the fund. Following an initial two-year period, the agreements must be renewed annually by a board majority, including a majority of independent trustees. Otherwise, the agreements lapse automatically. Under rule 12b-1, the board must contain a majority of independent trustees to approve and renew distribution and related contracts.

According to Reserve's statement, company executives believed their board of trustees to be in compliance with the above stipulations. However, while preparing documents for a new fund in early 2005, Reserve's management discovered that two members of the board were directors of companies that sold shares of one or more Reserve funds, meaning they never should have been considered independent and disinterested trustees.

Upon investigations conducted with the assistance of counsel, Reserve determined that the "comprehensive fee" investment management agreements related to two funds, the Louisiana Municipal Money-Market Fund and the Minnesota Municipal Money-Market Fund, were never properly approved under Section 15's regulations. It also found that, "for certain other Funds or share classes," the board never formally approved changes to the comprehensive management fee.

Management found that board composition for the Hallmark Funds over the period from March 22, 2000 to March 22, 2005 meant that sub-investment and distribution agreements for those funds had lapsed.

The two trustees initially identified as non-independent stepped down in March 2005. Three other independent trustees stepped down between that time and May 2005, for reasons that are unclear.

Through the special shareholder meeting heralded by the proxy statement, Reserve hopes to win approval for new management, sub-advisory and distribution contracts that would replicate the provisions of the lapsed contracts, thus rescuing the agreements from limbo. Reserve also wants its shareholders to allow it to keep unspecified fees paid under terms of the lapsed contracts, and to appoint new trustees to an expanded board without first soliciting votes from shareholders.

Even if this vote can resolve the lapsed contract issue, however, Reserve may not enjoy plain sailing. The Hallmark Convertible Securities Fund, which is subadvised by Froley Revy Investment Co. and was closed to new investments last October, repeatedly delayed filing its financial reports last year. Also last fall, PricewaterhouseCoopers, after filing documents referring to that fund's failure "to identify and collect amounts due to the fund," stepped down as Reserve's auditor after fifteen years.

Representatives from Reserve Management were unable to respond to this story by press time. 

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