It's been nearly one year since Reserve Management, advisor to The Reserve family of money funds and the Hallmark family of funds, first revealed it had inadvertently allowed both the investment advisory and 12b-1 distribution contracts on the majority of its mutual funds to lapse, in some cases since 1997 (see MME 3/13/06).

Now, 11 months after that discovery, the firm has filed a follow-up proxy statement with the Securities and Exchange Commission that contains some unanticipated surprises.

This proxy outlines what happened and alludes to the millions of dollars in past management and distribution fees that the advisor pocketed despite those necessary legal contracts not being in effect. But it also, rather surprisingly, asks investors to approve an increase in both the investment management and 12b-1 fees for the funds. Moreover, the proxy announces Reserve's intention to liquidate or sell all of the Hallmark funds, and proposes a new slate of seven independent trustees.

The firm is asking investors to approve a new comprehensive management fee on each non-Hallmark fund, which Reserve wants to increase by one basis point. In addition, the comprehensive fee will no longer cover the costs of each fund's chief compliance officer nor the counsel to the independent trustees, as it had previously. Those costs will be charged to the funds themselves, not the advisor.

The proxy also asks investors to approve Reserve's retention of the past management fees it earned, even though a technicality rendered those management fee renewals void. The exact amount of the collective management fees paid to Reserve across all of the funds over the period has still not yet been made public.

What has been detailed in the newly filed proxy is the millions of dollars in 12b-1 fees alone that investors paid although the funds' distribution contracts have not been properly renewed by the funds' board of trustees. Those fees tally into the multiple millions of dollars, and once again Reserve is asking investors to allow it to keep those previous fees. Moreover, going forward, Reserve is asking shareholders to bless an increase in the 12b-1 fees from 20 basis points to 25 basis points.

Reserve officials declined to comment.

"It looks like they are trying to kill two birds with one stone by asking for the fee increases in this proxy, but it adds insult to injury," said Roy Weitz, the Tarzana, Calif-based publisher of "This is the definition of chutzpahsaying, We screwed up, but pay us more,'" he added. Moreover, it took Reserve almost one year to alert investors to problems after it discovered the lapse, and then one more year to issue this proxy, Weitz noted. "Maybe they thought, If we don't get shareholders' approval [for the new contracts and retention of past fees], at least it bought us two years of time," he said.

In March 2005, the firm first discovered that two trustees who had previously been classified as independent were, in fact, not independent, according to legal specifications that Reserve did not elaborate on.

Rendering those two trustees not independent changed the composition of the board. Since a majority of a mutual fund board's independent mutual fund trustees are required to periodically consider and potentially approve and renew management contracts and distribution plans, the vote of less than a majority of independent trustees rendered those previously approved contracts null.

There are bright-line rules to determine the independence of fund trustees, said industry insiders, including whether a trustee has a "material business relationship" with anyone or a company involved with the fund. Where a trustee's independence is uncertain, there are processes fund groups can follow to garner further guidance from the SEC.

But it's up to fund groups and boards themselves, who often use annual trustee questionnaires to determine continued independence. "You've got to police whether your trustees are independent. If you don't meet the requisite requirement, there are serious consequences," said one former SEC staff member.

The proxy also reveals that its sub-advised family of Hallmark Funds-the first of which Reserve acquired in October 2004 from Trainer, Wortham of New York and has since broadened out by acquiring other funds and folding them into the Hallmark family-has been seriously bleeding money. Assets have shrunk by as much as 80% for the hardest-hit funds.

While Reserve takes no direct blame for allowing assets to decline to less than $25 million, it acknowledges troubles. "Because of their size, the [Hallmark] funds have been unable to absorb all of their expenses and offer a competitive return," the proxy noted. "None of the funds has the outstanding performance necessary for funds of this size to successfully compete for new assets with larger, more established funds." Consequently, Reserve is expecting to liquidate seven of the eight funds.

The Hallmark Small-Cap Growth Fund, the largest of the Hallmark Funds, is being sold to its sub-advisor, Roanoke Asset Management of New York. "We're excited to assume the management and operation of the fund no later than June 1," confirmed Chris Vroom, a partner at the firm, which has been the sub-advisor to the fund since its inception. "By having the ability to market the fund directly, we will have the ability to highlight the long-term performance and short-term prospects," he added. He declined to disclose the monetary agreement with Reserve.

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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