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The Reserve Fund’s recent announcement that it is setting aside $3.5 billion of investors’ funds to cover legal costs and damages related to pending litigation could have important consequences for investors in its money market accounts. Anyone with Reserve Fund exposure, especially those who submitted redemption requests while the Reserve Fund’s net asset value was $1 per share, should get in line now.

Over the last year, the Reserve Primary Fund’s “breaking the buck” (i.e., net asset value declining below $1 per share) as a result of exposure to Lehman Brothers Holdings, Inc. debt has resulted in dozens of suits by investors to recover their investments. These suits started after the Primary Fund failed to honor billions of dollars of redemption requests submitted on and after the day of Lehman’s bankruptcy filing. The Primary Fund has commenced interim distributions on a pro rata basis, but certain investors are seeking to recoup their full investments because they submitted redemption requests before share prices dropped below par.

The Reserve Fund has now set aside billions to pay these damages. Investors in the Primary Fund should evaluate their claims to determine whether they might ultimately receive more than the expected pro rata distributions.

Background: The Primary Fund Breaks the Buck

The Primary Fund is one of a series of money market funds comprising the Reserve Fund, whose president co-founded the first money market fund in the early 1970s. Money market funds traditionally have served cautious investors seeking to preserve their principal while also earning interest. Normally, money market funds maintain a net asset value (NAV) of at least $1 per share, meaning investors redeeming shares will recoup their principal at 100 cents on the dollar, along with profits earned by the fund on its investments.

It is almost unheard of for a money market fund’s NAV to drop below $1—an event described as “breaking the buck.” This phenomenon has happened only twice: once in 1994 with a relatively small fund, and again in September 2008 with the Reserve Primary Fund.

On September 15, 2008, the day Lehman filed for Chapter 11 bankruptcy protection, a number of investors decided to redeem all or some of their Primary Fund shares. The events of the next 48 hours would set the Primary Fund on a fast track toward liquidation and litigation.

When redemption requests began pouring into the Primary Fund on September 15, it honored some, but not all. That afternoon, the Primary Fund announced that, due to its small exposure to Lehman debt holdings, the Fund’s NAV would not be negatively impacted. However, the next day, the Primary Fund announced that its holdings of Lehman debt securities had been valued at zero effective as of 4 p.m. September 16. The statement informed investors that redemption requests submitted before 3 p.m. on September 16 would be honored at $1 per share. Thereafter, redemption requests would be honored at the reduced NAV of $0.97 per share. Not surprisingly, this set off a flurry of redemption requests before 3:00 p.m. These requests were not honored at $1 per share.

By late September, the Reserve Fund’s Board of Trustees had decided to liquidate the assets in the Primary Fund and make pro rata distributions to investors. The first round of distributions, totaling $26 billion, took place in late October. Then, in late November, the Reserve Fund announced that it had miscalculated the Primary Fund’s NAV on September 16; the proper value per share from 11 a.m. to 4 p.m. was $0.99, not $1. In the meantime, numerous investors started filing lawsuits.

Liquidation Plan and Special Reserve

In response to the lawsuits, the Reserve Fund’s liquidation plan calls for the retention of a “Special Reserve,” comprised of investors’ money in the Primary Fund, to cover legal and accounting fees associated with defending the Primary Fund against civil suits and paying damages resulting from these suits. On February 26, 2009, the Primary Fund announced that $3.5 billion would be set aside in the Special Reserve, noting that up to $100 million of that total might be devoted to the Primary Fund’s legal expenses.

The liquidation plan also calls for a series of interim distributions to all investors on a pro rata basis, regardless of when investors submitted their redemption requests. In other words, investors who submitted redemption requests on September 15 (when the NAV was properly calculated at $1) and investors who submitted redemption requests after 11 a.m. on September 16 (when the NAV was $0.99 or $0.97) would receive the same pro rata distributions. The February 26, 2009 announcement sets the interim pro rata distributions at up to $0.9172 per share.

Litigation against the Reserve Fund

Investors have initiated more than 30 law suits against the Reserve Fund, the Primary Fund and related entities, asserting various claims to damages ranging from breach of contract under the Primary Fund’s prospectus to securities fraud. State securities regulators in Colorado and Massachusetts have filed suit as well.

The private actions fall into two broad categories:

(1) Institutional investors who submitted redemption requests while the NAV was properly calculated at $1 per share. These investors assert that, pursuant to the prospectus, they are entitled to a full return of their investments at $1 per share because they properly submitted redemption requests before the Primary Fund broke the buck. The Primary Fund did not honor approximately $21.1 billion in redemption orders falling into this category.

(2) Individual and class actions brought by investors who submitted redemption requests after the NAV was calculated below $1 per share.

The Judicial Panel on Multi-District Litigation recently granted the Primary Fund’s request to hold consolidated pretrial proceedings in the United States District Court for the Southern District of New York for all actions that have been filed in federal courts in various jurisdictions. A number of investors have filed suit in state court in New York and elsewhere. The Primary Fund has sought removal of all or most of those actions to federal court, but the investors’ motions to remand are pending.

Should You File Suit?

Given that the Reserve Fund has set aside $3.5 billion for litigation expenses and damages, now is the time for investors in the Fund who have not yet filed suit to consider whether they should do so. As noted above, based on the timing of their redemption requests, investors may have a strong basis to recover significantly more than the current pro rata distribution of $0.9172 per share. For example, investors who submitted redemption requests when the NAV was properly calculated at $1 per share may be entitled to recoup their investments at par value. Those are the investors who should consider filing an individual action. Investors who join an ongoing class action or simply wait for interim distributions under the liquidation plan may receive pro rata distributions at below $1 per share.

In addition, investors contemplating filing a complaint must carefully analyze and decide the proper jurisdiction and venue for their law suit, which Reserve Fund entities are proper parties and what claims to assert. Whether an action belongs in federal or state court could turn on the nature of the claims contained in the complaint. Moreover, as noted earlier, pre-trial proceedings for federal actions have been consolidated in a New York federal court. Trial and other proceedings, however, are expected to proceed in the federal jurisdiction where the action was initiated.