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January 16, 2009 12:44 PM

Dechert, K&L Gates Sued for Malpractice

Posted by Nate Raymond

Money market fund Reserve Management Co. Inc. on Tuesday accused Dechert and K&L Gates of failing to advise it four years ago that two members of its board weren't independent, opening the fund up to scrutiny from the Securities and Exchange Commission.

Reserve says it spent $4 million in professional and other fees trying to avoid an SEC action over having an improperly composed board. Such an action could have cost Reserve "hundreds of millions of dollars" in disgorged profits and fines, the complaint says. Reserve filed the malpractice suit in D.C. Superior Court against the two firms; it is seeking compensatory damages and repayment of fees. (Download the complaint.)

Reserve is represented by Matias Dorta of Tew Cardenas in Miami.

In a statement, Dechert said "this matter has no merit and we intend to defend it vigorously." The firm has not yet retained counsel, the spokeswoman said. A spokesman for K&L Gates declined to comment.

The malpractice suit appears unrelated to recent controversies surrounding Reserve, which has come under scrutiny since it broke-the-buck following Lehman Brothers filing for bankruptcy. The SEC staff has recommending suing Reserve, and on Tuesday, Massachusetts's secretary of the commonwealth sued Reserve for fraud.

In its complaint, Reserve says it turned to Dechert from 1997 to 2002 to advise the company and its funds on compliance and regulatory matters. K&L Gates did the same from 2003 to 2005.

Reserve says both firms would have been responsible for advising the company and funds on the Investment Company Act of 1940. The act regulates how many independent directors a mutual fund's board contains. It also defines who is an "interested person" and limits how many can be on a board.

Under the act, independent directors had to comprise at least 40 percent of a board, the complaint says. But in 1997, the same year Reserve retained Dechert, the SEC adopted more stringent rules, requiring that independent directors make up a majority of the board.

Dechert billed Reserve for advice it gave on securities, and helped the fund prepare and submit an application to the SEC that Reserve says lead to the agency's order in 1997, according to the complaint. Then-Dechert partner Paul Roye is listed in filings by Reserve with the SEC during that period.

Billing records show that Dechert advised Reserve on the composition of its board and what constituted an interested person, according to the complaint. Yet Dechert did not advise, as later counsel would, that two members of the board deemed then as independent would actually be considered interested parties, the complaint says.

The complaint does not name the two trustees. "Trustee 1" was a member of the board of directors of a "major investment bank" that received "significant" revenue from Reserve from 1999 to 2005. The other, "Trustee 2," joined the board in 2002 and also was a director of a trust company, of which Trustee 2 owned 2 percent.

Documents filed by Reserve with the SEC in 2004 say that only two "independent" trustees held outside board memberships. St. John's University president Rev. Donald Harrington, who had been on the board since 1987, was a director at investment bank Bear Stearns. Patrick Foye, who joined the board in 2001 according to the filing, was a director at the Philadelphia Trust Company. Harrington and Foye resigned from Reserve's board in 2005.

Reserve claims that when K&L Gates' predecessor Kirkpatrick & Lockhart took over from Dechert, it too failed to advise that the two board members weren't independent. K&L Gates failed to give that advice despite discussion during a June 2003 board meeting that one trustee worked at a bank and another owned 2 percent of a trust company.

In 2005 Reserve retained new counsel, which goes unnamed in the complaint. This time, Reserve's counsel did bring to the company's attention the composition issue.

That had broad implications, Reserve says, as it meant from 1997 to 2005 it had operated without a majority independent board of trustees.  Certain plans and agreements Reserve entered into either lapsed or now were deemed improperly approved, the complaint says. The two board members resigned, and Reserve's board of directors hired independent counsel.

Reserve also disclosed the problem to the SEC "preemptively and on its own initiative." The SEC at one point threatened sanctions, the complaint says, including disgorging all of the fund's profits from 1997 to 2005.

Thanks to Reserve's "swift response and good-faith mitigation of this matter," the company avoided losses that could have numbered in the hundreds of millions of dollars. The cleanup process cost Reserve $4 million, it says. Reserve now wants Dechert and K&L Gates to refund it those costs, plus damages.

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