STATEMENT OF ADDITIONAL INFORMATION
Badgley Funds, Inc.
BADGLEY GROWTH FUND
BADGLEY BALANCED FUND
P.O. Box 701
Milwaukee, Wisconsin 53201-0701
1-877-BADGLEY
www.badgleyfunds.com
This Statement of Additional Information is not a prospectus
and should be read in conjunction with the Prospectus of the
Badgley Growth Fund (the "Growth Fund") and the Badgley Balanced
Fund (the "Balanced Fund"), dated September 28, 1999. The Growth
Fund and the Balanced Fund are each a series of the Badgley
Funds, Inc. (the "Corporation").
A copy of the Prospectus is available without charge upon
request to the above-noted address, toll-free telephone number or
website.
The Funds' audited financial statements for the period June
25, 1998 to May 31, 1999, are incorporated herein by reference to
the Funds' Annual Report, which is available without charge upon
request to the above-noted address, toll-free telephone number or
website.
This Statement of Additional Information is dated September 28, 1999,
as supplemented December 9, 1999.
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TABLE OF CONTENTS
Page No.
FUND ORGANIZATION 3
INVESTMENT RESTRICTIONS 3
IMPLEMENTATION OF INVESTMENT OBJECTIVES 4
DIRECTORS AND OFFICERS 21
PRINCIPAL SHAREHOLDERS 23
INVESTMENT ADVISER 23
FUND TRANSACTIONS AND BROKERAGE 24
CUSTODIAN 25
TRANSFER AGENT AND DIVIDEND-DISBURSING AGENT 25
ADMINISTRATOR 26
DISTRIBUTOR AND PLAN OF DISTRIBUTION 26
PURCHASE, REDEMPTION, EXCHANGE AND PRICING OF SHARES 28
TAXATION OF THE FUNDS 31
PERFORMANCE INFORMATION 31
ADDITIONAL INFORMATION 33
INDEPENDENT ACCOUNTANTS 33
FINANCIAL STATEMENTS 33
APPENDIX A-1
In deciding whether to invest in the Funds, you should rely
on the information in this Statement of Additional Information
and related Prospectus. The Funds have not authorized others to
provide additional information. The Funds have not authorized
the use of this Statement of Additional Information in any state
or jurisdiction in which such offering may not legally be made.
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FUND ORGANIZATION
The Corporation is an open-end, diversified, management
investment company, commonly referred to as a mutual fund. Each
Fund is a series of common stock of the Corporation, a Maryland
company incorporated on April 28, 1998. The Corporation is
authorized to issue shares of common stock in series and classes.
Each share of common stock of each Fund is entitled to one vote,
and each share is entitled to participate equally in dividends
and capital gains distributions by the respective series and in
the individual assets of the respective Fund in the event of
liquidation. Each Fund bears its own expenses and the
shareholders of each Fund have exclusive voting rights on matters
pertaining to the Fund's Rule 12b-1 plan. No certificates will
be issued for shares held in your account. You will, however,
have full shareholder rights. Generally, the Corporation will
not hold annual shareholders' meetings unless required by the
1940 Act or Maryland law. Shareholders have certain rights,
including the right to call an annual meeting upon a vote of 10%
of the Corporation's outstanding shares for the purpose of voting
to remove one or more directors or to transact any other
business. The 1940 Act requires the Corporation to assist the
shareholders in calling such a meeting.
INVESTMENT RESTRICTIONS
The investment objective of the Growth Fund is to seek long-
term capital appreciation. The investment objective of the
Balanced Fund is to seek long-term capital appreciation and
income (i.e., risk-adjusted total return). The following are the
Funds' fundamental investment restrictions which cannot be
changed without the approval of a majority of a Fund's
outstanding voting securities. As used herein, a "majority of a
Fund's outstanding voting securities" means the lesser of (i) 67%
of the shares of common stock of the Fund represented at a
meeting at which more than 50% of the outstanding shares are
present, or (ii) more than 50% of the outstanding shares of
common stock of the Fund.
Each Fund:
1. May not with respect to 75% of its total assets, purchase
the securities of any issuer (except securities issued or
guaranteed by the U.S. government or its agencies or
instrumentalities) if, as a result, (i) more than 5% of the
Fund's total assets would be invested in the securities of
that issuer, or (ii) the Fund would hold more than 10% of
the outstanding voting securities of that issuer.
2. May (i) borrow money from banks for temporary or emergency
purposes (but not for leveraging or the purchase of
investments) and (ii) make other investments or engage in
other transactions permissible under the Investment Company
Act of 1940, as amended (the "1940 Act"), which may involve
a borrowing, including borrowing through reverse repurchase
agreements, provided that the combination of (i) and (ii)
shall not exceed 33 1/3% of the value of the Fund's total
assets (including the amount borrowed), less the Fund's
liabilities (other than borrowings). If the amount borrowed
at any time exceeds 33 1/3% of the Fund's total assets, the
Fund will, within three days thereafter (not including
Sundays, holidays and any longer permissible period), reduce
the amount of the borrowings such that the borrowings do not
exceed 33 1/3% of the Fund's total assets. Each Fund may
also borrow money from other persons to the extent permitted
by applicable law.
3. May not issue senior securities, except as permitted under
the 1940 Act.
4. May not act as an underwriter of another issuer's
securities, except to the extent that the Fund may be deemed
to be an underwriter within the meaning of the Securities
Act of 1933, as amended (the "Securities Act"), in
connection with the purchase and sale of portfolio
securities.
5. May not purchase or sell physical commodities unless
acquired as a result of ownership of securities or other
instruments (but this shall not prevent the Fund from
purchasing or selling options, futures contracts, or other
derivative instruments, or from investing in securities or
other instruments backed by physical commodities).
6. May not make loans if, as a result, more than 33 1/3% of the
Fund's total assets would be lent to other persons, except
through (i) purchases of debt securities or other debt
instruments, or (ii) engaging in repurchase agreements.
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7. May not purchase the securities of any issuer if, as a
result, more than 25% of the Fund's total assets would be
invested in the securities of issuers, the principal
business activities of which are in the same industry.
8. May not purchase or sell real estate unless acquired as a
result of ownership of securities or other instruments (but
this shall not prohibit the Fund from purchasing or selling
securities or other instruments backed by real estate or of
issuers engaged in real estate activities).
The following are each Fund's non-fundamental operating
policies which may be changed by the Board of Directors without
shareholder approval.
Each Fund may not:
1. Sell securities short, unless the Fund owns or has the right
to obtain securities equivalent in kind and amount to the
securities sold short, or unless it covers such short sale
as required by the current rules and positions of the
Securities and Exchange Commission (the "SEC") or its staff,
and provided that transactions in options, futures
contracts, options on futures contracts, or other derivative
instruments are not deemed to constitute selling securities
short.
2. Purchase securities on margin, except that the Fund may
obtain such short-term credits as are necessary for the
clearance of transactions; and provided that margin deposits
in connection with futures contracts, options on futures
contracts, or other derivative instruments shall not
constitute purchasing securities on margin.
3. Invest in illiquid securities if, as a result of such
investment, more than 10% of its net assets would be
invested in illiquid securities.
4. Purchase securities of other investment companies except in
compliance with the 1940 Act and applicable state law.
5. Engage in futures or options on futures transactions which
are impermissible pursuant to Rule 4.5 under the Commodity
Exchange Act (the "CEA") and, in accordance with Rule 4.5,
will use futures or options on futures transactions solely
for bona fide hedging transactions (within the meaning of
the CEA), provided, however, that the Fund may, in addition
to bona fide hedging transactions, use futures and options
on futures transactions if the aggregate initial margin and
premiums required to establish such positions, less the
amount by which any such options positions are in the money
(within the meaning of the CEA), do not exceed 5% of the
Fund's net assets.
6. Make any loans, except through (i) purchases of debt
securities or other debt instruments, or (ii) engaging in
repurchase agreements.
7. Borrow money except from banks or through reverse repurchase
agreements or mortgage dollar rolls, and will not purchase
securities when bank borrowings exceed 5% of its total
assets.
Except for the fundamental investment limitations listed
above and each Fund's investment objective, the Funds' other
investment policies are not fundamental and may be changed with
approval of the Corporation's Board of Directors. Unless noted
otherwise, if a percentage restriction is adhered to at the time
of investment, a later increase or decrease in percentage
resulting from a change in the Fund's assets (i.e., due to cash
inflows or redemptions) or in market value of the investment or
the Fund's assets will not constitute a violation of that
restriction.
IMPLEMENTATION OF INVESTMENT OBJECTIVES
The following information supplements the discussion of the
Funds' investment objectives and strategies described in the
Prospectus under the captions "Investment Objectives" and "How
the Funds Invest."
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Illiquid Securities
Each Fund may invest up to 10% of its respective net assets
in illiquid securities (i.e., securities that are not readily
marketable). For purposes of this restriction, illiquid
securities include, but are not limited to, restricted securities
(securities the disposition of which is restricted under the
federal securities laws), repurchase agreements with maturities
in excess of seven days, and other securities that are not
readily marketable. The Board of Directors of the Corporation,
or its delegate, has the ultimate authority to determine, to the
extent permissible under the federal securities laws, which
securities are liquid or illiquid for purposes of this 10%
limitation. Certain securities exempt from registration or
issued in transactions exempt from registration under the
Securities Act, such as securities that may be resold to
institutional investors under Rule 144A under the Securities Act,
may be considered liquid under guidelines adopted by the Board of
Directors. Each Fund may invest up to 5% of its respective net
assets in such securities. However, investing in securities
which may be resold pursuant to Rule 144A under the Securities
Act could have the effect of increasing the level of a Fund's
illiquidity to the extent that institutional investors become,
for a time, uninterested in purchasing such securities.
The Board of Directors has delegated to the Adviser the day-
to-day determination of the liquidity of any security, although
it has retained oversight and ultimate responsibility for such
determinations. Although no definitive liquidity criteria are
used, the Board of Directors has directed the Adviser to look to
such factors as (i) the nature of the market for a security
(including the institutional private resale market), (ii) the
terms of certain securities or other instruments allowing for the
disposition to a third party or the issuer thereof (e.g., certain
repurchase obligations and demand instruments), (iii) the
availability of market quotations (e.g., for securities quoted in
the PORTAL system), and (iv) other permissible relevant factors.
Restricted securities may be sold only in privately
negotiated transactions or in a public offering with respect to
which a registration statement is in effect under the Securities
Act. Where registration is required, a Fund may be obligated to
pay all or part of the registration expenses and a considerable
period may elapse between the time of the decision to sell and
the time the Fund may be permitted to sell a security under an
effective registration statement. If, during such a period,
adverse market conditions were to develop, the Fund might obtain
a less favorable price than that which prevailed when it decided
to sell. Restricted securities will be priced at fair value as
determined in good faith by the Board of Directors. If, through
the appreciation of restricted securities or the depreciation of
unrestricted securities, a Fund should be in a position where
more than 10% of the value of its net assets are invested in
illiquid securities, including restricted securities which are
not readily marketable (except for Rule 144A securities deemed to
be liquid by the Adviser), the affected Fund will take such steps
as is deemed advisable, if any, to protect liquidity.
Fixed Income Securities
Fixed Income Securities in General. The Balanced Fund may
invest a portion of its assets in a wide variety of fixed income
securities, including bonds and other debt securities and non-
convertible preferred stocks. Each Fund may hold a limited
portion of its assets (generally not to exceed 15% of its total
assets) in short-term money market securities. See "Temporary
Strategies."
Changes in market interest rates affect the value of fixed
income securities. If interest rates increase, the value of
fixed income securities generally decrease. Similarly, if
interest rates decrease, the value of fixed income securities
generally increase. Shares in the Balanced Fund are likely to
fluctuate in a similar manner. In general, the longer the
remaining maturity of a fixed income security, the greater its
fluctuations in value based on interest rate changes. Longer-
term fixed income securities generally pay a higher interest
rate. The Balanced Fund invests in fixed income securities of
varying maturities.
Changes in the credit quality of the issuer also affect the
value of fixed income securities. Lower-rated fixed income
securities generally pay a higher interest rate. Although the
Balanced Fund only invests in investment grade debt securities,
the value of these securities may decrease due to changes in
ratings over time.
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Types of Fixed Income Securities. The Balanced Fund may
invest in the following types of fixed income securities:
Corporate debt securities, including bonds, debentures and notes;
U.S. government securities;
Mortgage and asset-backed securities;
Preferred stocks;
Convertible securities;
Commercial paper (including variable amount master demand notes);
Bank obligations, such as certificates of deposit,
banker's acceptances and time deposits of domestic and
foreign banks, domestic savings association and their
subsidiaries and branches (in amounts in excess of the
current $100,000 per account insurance coverage
provided by the Federal Deposit Insurance Corporation);
and
Repurchase agreements.
Ratings. The Balanced Fund will limit investments in fixed
income securities to those that are rated at the time of purchase
as at least investment grade by at least one national rating
organization, such as S&P or Moody's, or, if unrated, are
determined to be of equivalent quality by the Adviser. Within
the investment grade categories, the Balanced Fund will limit its
purchases to the following criteria:
U.S. government securities;
Bonds or bank obligations rated in one of the three
highest categories (e.g., A- or higher by S&P);
Short-term notes rated in one of the two highest
categories (e.g., SP-2 or higher by S&P);
Commercial paper or short-term bank obligations rated
in one of the three highest categories (e.g., A-3 or
higher by S&P); and
Repurchase agreements involving investment grade fixed
income securities.
Investment grade fixed income securities are generally believed
to have a lower degree of credit risk. If a security's rating
falls below the above criteria, the Adviser will determine what
action, if any, should be taken to ensure compliance with the
Balanced Fund's investment objective and to ensure that the
Balanced Fund will at no time have 5% or more of its net assets
invested in non-investment grade debt securities. Additional
information concerning securities ratings is contained in the
Appendix.
Government Securities. U.S. government securities are
issued or guaranteed by the U.S. government or its agencies or
instrumentalities. These securities may have different levels of
government backing. U.S. Treasury obligations, such as Treasury
bills, notes, and bonds are backed by the full faith and credit
of the U.S. Treasury. Some U.S. government agency securities are
also backed by the full faith and credit of the U.S. Treasury,
such as securities issued by the Government National Mortgage
Association (GNMA). Other U.S. government securities may be
backed by the right of the agency to borrow from the U.S.
Treasury, such as securities issued by the Federal Home Loan
Bank, or may be backed only by the credit of the agency. The
U.S. government and its agencies and instrumentalities only
guarantee the payment of principal and interest and not the
market value of the securities. The market value of U.S.
government securities will fluctuate based on interest rate
changes and other market factors.
Mortgage- and Asset-Backed Securities. Mortgage-backed
securities represent direct or indirect participations in, or are
secured by and payable from, mortgage loans secured by real
property, and include single- and
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multi-class pass-through
securities and collateralized mortgage obligations. Such
securities may be issued or guaranteed by U.S. government
agencies or instrumentalities, such as the Government National
Mortgage Association and the Federal National Mortgage
Association, or by private issuers, generally originators and
investors in mortgage loans, including savings associations,
mortgage bankers, commercial banks, investment bankers, and
special purpose entities (collectively, "private lenders").
Mortgage-backed securities issued by private lenders may be
supported by pools of mortgage loans or other mortgage-backed
securities that are guaranteed, directly or indirectly, by the
U.S. government or one of its agencies or instrumentalities, or
they may be issued without any governmental guarantee of the
underlying mortgage assets but with some form of non-governmental
credit enhancement.
Asset-backed securities have structural characteristics
similar to mortgage-backed securities. Asset-backed debt
obligations represent direct or indirect participations in, or
are secured by and payable from, assets such as motor vehicle
installment sales contracts, other installment loan contracts,
home equity loans, leases of various types of property, and
receivables from credit card or other revolving credit
arrangements. The credit quality of most asset-backed securities
depends primarily on the credit quality of the assets underlying
such securities, how well the entity issuing the security is
insulated from the credit risk of the originator or any other
affiliated entities, and the amount and quality of any credit
enhancement of the securities. Payments or distributions of
principal and interest on asset-backed debt obligations may be
supported by non-governmental credit enhancements including
letters of credit, reserve funds, overcollateralization, and
guarantees by third parties. The market for privately issued
asset-backed debt obligations is smaller and less liquid than the
market for government sponsored mortgage-backed securities.
The rate of principal payment on mortgage- and asset-backed
securities generally depends on the rate of principal payments
received on the underlying assets which in turn may be effected
by a variety of economic and other factors. As a result, the
yield on any mortgage- and asset-backed security is difficult to
predict with precision and actual yield to maturity may be more
or less than the anticipated yield to maturity. The yield
characteristics of mortgage- and asset-backed securities differ
from those of traditional debt securities. Among the principal
differences are that interest and principal payments are made
more frequently on mortgage- and asset-backed securities, usually
monthly, and that principal may be prepaid at any time because
the underlying mortgage loans or other assets generally may be
prepaid at any time. As a result, if the Balanced Fund purchases
these securities at a premium, a prepayment rate that is faster
than expected will reduce yield to maturity, while a prepayment
rate that is slower than expected will have the opposite effect
of increasing the yield to maturity. Conversely, if the Balanced
Fund purchases these securities at a discount, a prepayment rate
that is faster than expected will increase yield to maturity,
while a prepayment rate that is slower than expected will reduce
yield to maturity. Accelerated prepayments on securities
purchased by the Balanced Fund at a premium also impose a risk of
loss of principal because the premium may not have been fully
amortized at the time the principal is prepaid in full. In
addition, prepayments typically occur when interest rates are
declining. As a result, any debt securities purchased by the
Balanced Fund with such prepayment proceeds will likely be at a
lower interest rate than the original investment.
While many mortgage- and asset-backed securities are issued
with only one class of security, many are issued in more than one
class, each with different payment terms. Multiple class
mortgage- and asset-backed securities are issued for two main
reasons. First, multiple classes may be used as a method of
providing credit support. This is accomplished typically through
creation of one or more classes whose right to payments on the
security is made subordinate to the right to such payments of the
remaining class or classes. Second, multiple classes may permit
the issuance of securities with payment terms, interest rates, or
other characteristics differing both from those of each other and
from those of the underlying assets. Examples include so-called
"strips" (mortgage- and asset-backed securities entitling the
holder to disproportionate interests with respect to the
allocation of interest and principal of the assets backing the
security), and securities with class or classes having
characteristics which mimic the characteristics of non-mortgage-
or asset-backed securities, such as floating interest rates
(i.e., interest rates which adjust as a specified benchmark
changes) or scheduled amortization of principal.
Mortgage- and asset-backed securities backed by assets,
other than as described above, or in which the payment streams on
the underlying assets are allocated in a manner different than
those described above may be issued in the future. The Balanced
Fund may invest in such securities if such investment is
otherwise consistent with its investment objectives, policies and
restrictions.
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Convertible Securities. Each Fund may invest in convertible
securities, which are bonds, debentures, notes, preferred stocks,
or other securities that may be converted into or exchanged for a
specified amount of common stock of the same or a different
issuer within a particular period of time at a specified price or
formula. A convertible security entitles the holder to receive
interest normally paid or accrued on debt or the dividend paid on
preferred stock until the convertible security matures or is
redeemed, converted, or exchanged. Convertible securities have
unique investment characteristics in that they generally (i) have
higher yields than common stocks, but lower yields than
comparable non-convertible securities, (ii) are less subject to
fluctuation in value than the underlying stock since they have
fixed income characteristics, and (iii) provide the potential for
capital appreciation if the market price of the underlying common
stock increases. A convertible security may be subject to
redemption at the option of the issuer at a price established in
the convertible security's governing instrument. If a
convertible security held by a Fund is called for redemption, the
Fund will be required to permit the issuer to redeem the
security, convert it into the underlying common stock, or sell it
to a third party. The Adviser will limit investments in
convertible debt securities to those that are rated at the time
of purchase as investment grade by at least one national rating
organization, such as S&P or Moody's, or, if unrated, are
determined to be of equivalent quality by the Adviser. With
respect to the Balanced Fund's investments in convertible
securities, the Balanced Fund will only include that portion of
convertible senior securities with fixed income characteristics
in computing whether the Balanced Fund has at least 25% of its
total assets in fixed income convertible securities.
Variable- or Floating-Rate Securities. The Balanced Fund
may invest in securities which offer a variable- or floating-rate
of interest. Variable-rate securities provide for automatic
establishment of a new interest rate at fixed intervals (e.g.,
daily, monthly, semi-annually, etc.). Floating-rate securities
generally provide for automatic adjustment of the interest rate
whenever some specified interest rate index changes. The
interest rate on variable- or floating-rate securities is
ordinarily determined by reference to or is a percentage of a
bank's prime rate, the 90-day U.S. Treasury bill rate, the rate
of return on commercial paper or bank certificates of deposit, an
index of short-term interest rates, or some other objective
measure.
Variable- or floating-rate securities frequently include a
demand feature entitling the holder to sell the securities to the
issuer at par. In many cases, the demand feature can be
exercised at any time on seven days notice, in other cases, the
demand feature is exercisable at any time on 30 days notice or on
similar notice at intervals of not more than one year. Some
securities which do not have variable or floating interest rates
may be accompanied by puts producing similar results and price
characteristics.
Variable-rate demand notes include master demand notes which
are obligations that permit the Balanced Fund to invest
fluctuating amounts, which may change daily without penalty,
pursuant to direct arrangements between the Balanced Fund, as
lender, and the borrower. The interest rates on these notes
fluctuate from time to time. The issuer of such obligations
normally has a corresponding right, after a given period, to
prepay in its discretion the outstanding principal amount of the
obligations plus accrued interest upon a specified number of
days' notice to the holders of such obligations. The interest
rate on a floating-rate demand obligation is based on a known
lending rate, such as a bank's prime rate, and is adjusted
automatically each time such rate is adjusted. The interest rate
on a variable-rate demand obligation is adjusted automatically at
specified intervals. Frequently, such obligations are secured by
letters of credit or other credit support arrangements provided
by banks. Because these obligations are direct lending
arrangements between the lender and borrower, it is not
contemplated that such instruments will generally be traded.
There generally is not an established secondary market for these
obligations, although they are redeemable at face value.
Accordingly, where the obligations are not secured by letters of
credit or other credit support arrangements, the Balanced Fund's
right to redeem is dependent on the ability of the borrower to
pay principal and interest on demand. Such obligations
frequently are not rated by credit rating agencies and, if not so
rated, the Balanced Fund may invest in them only if the Adviser
determines that at the time of investment other obligations are
of comparable quality to the other obligations in which the
Balanced Fund may invest.
The Balanced Fund will not invest more than 10% of its net
assets in variable- and floating-rate demand obligations that are
not readily marketable (a variable- or floating-rate demand
obligation that may be disposed of on not more than seven days
notice will be deemed readily marketable and will not be subject
to this limitation). See "Investment Policies and Techniques --
Illiquid Securities" and "Investment Restrictions." In addition,
each variable- and floating-rate obligation must meet the credit
quality requirements applicable to all the Balanced Fund's
investments
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at the time of purchase. When determining whether
such an obligation meets the Balanced Fund's credit quality
requirements, the Balanced Fund may look to the credit quality of
the financial guarantor providing a letter of credit or other
credit support arrangement. The Growth Fund may invest in such
securities as described under "Temporary Strategies."
Repurchase Agreements. The Funds may enter into repurchase
agreements with certain banks or non-bank dealers. In a
repurchase agreement, a Fund buys a security at one price, and at
the time of sale, the seller agrees to repurchase the obligation
at a mutually agreed upon time and price (usually within seven
days). The repurchase agreement, thereby, determines the yield
during the purchaser's holding period, while the seller's
obligation to repurchase is secured by the value of the
underlying security. The Adviser will monitor, on an ongoing
basis, the value of the underlying securities to ensure that the
value always equals or exceeds the repurchase price plus accrued
interest. Repurchase agreements could involve certain risks in
the event of a default or insolvency of the other party to the
agreement, including possible delays or restrictions upon a
Fund's ability to dispose of the underlying securities. Although
no definitive creditworthiness criteria are used, the Adviser
reviews the creditworthiness of the banks and non-bank dealers
with which the Funds enter into repurchase agreements to evaluate
those risks.
Reverse Repurchase Agreements
The Funds may, with respect to up to 5% of its net assets,
engage in reverse repurchase agreements. In a reverse repurchase
agreement, a Fund would sell a security and enter into an
agreement to repurchase the security at a specified future date
and price. A Fund generally retains the right to interest and
principal payments on the security. Since a Fund receives cash
upon entering into a reverse repurchase agreement, it may be
considered a borrowing. When required by guidelines of the SEC,
the Fund will set aside permissible liquid assets in a segregated
account to secure its obligations to repurchase the security.
Temporary Strategies
Prior to investing the proceeds from sale of Fund shares and
to meet ordinary daily cash needs, the Adviser may hold cash
and/or invest all or a portion of the Fund's assets in money
market instruments, which are short-term fixed income securities
issued by private and governmental institutions and may include
commercial paper, short-term U.S. government securities,
repurchase agreements, banker's acceptances, certificates of
deposit, time deposits and other short-term fixed-income
securities. All money market instruments will be rated
investment-grade.
Derivative Instruments
In General. Although it does not currently intend to engage
in derivative transactions, each Fund may invest up to 5% of its
respective net assets in derivative instruments. Derivative
instruments may be used for any lawful purpose consistent with a
Fund's investment objective such as hedging or managing risk, but
not for speculation. Derivative instruments are commonly defined
to include securities or contracts whose value depend on (or
"derive" from) the value of one or more other assets, such as
securities, currencies, or commodities. These "other assets" are
commonly referred to as "underlying assets."
A derivative instrument generally consists of, is based
upon, or exhibits characteristics similar to options or forward
contracts. Options and forward contracts are considered to be
the basic "building blocks" of derivatives. For example, forward-
based derivatives include forward contracts, swap contracts, as
well as exchange-traded futures. Option-based derivatives
include privately negotiated, over-the-counter (OTC) options
(including caps, floors, collars, and options on forward and swap
contracts) and exchange-traded options on futures. Diverse types
of derivatives may be created by combining options or forward
contracts in different ways, and by applying these structures to
a wide range of underlying assets.
An option is a contract in which the "holder" (the buyer)
pays a certain amount (the "premium") to the "writer" (the
seller) to obtain the right, but not the obligation, to buy from
the writer (in a "call") or sell to the writer (in a "put") a
specific asset at an agreed upon price at or before a certain
time. The holder pays the premium at inception and has no
further financial obligation. The holder of an option-based
derivative generally will benefit from favorable movements in the
price of the underlying asset but is not exposed to corresponding
losses due to adverse movements in
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the value of the underlying
asset. The writer of an option-based derivative generally will
receive fees or premiums but generally is exposed to losses due
to changes in the value of the underlying asset.
A forward is a sales contract between a buyer (holding the
"long" position) and a seller (holding the "short" position) for
an asset with delivery deferred until a future date. The buyer
agrees to pay a fixed price at the agreed future date and the
seller agrees to deliver the asset. The seller hopes that the
market price on the delivery date is less than the agreed upon
price, while the buyer hopes for the contrary. The change in
value of a forward-based derivative generally is roughly
proportional to the change in value of the underlying asset.
Hedging. A Fund may use derivative instruments to protect
against possible adverse changes in the market value of
securities held in, or are anticipated to be held in, the Fund's
portfolio. Derivatives may also be used by a Fund to "lock-in"
its realized but unrecognized gains in the value of its portfolio
securities. Hedging strategies, if successful, can reduce the
risk of loss by wholly or partially offsetting the negative
effect of unfavorable price movements in the investments being
hedged. However, hedging strategies can also reduce the
opportunity for gain by offsetting the positive effect of
favorable price movements in the hedged investments.
Managing Risk. A Fund may also use derivative instruments
to manage the risks of the Fund's portfolio. Risk management
strategies include, but are not limited to, facilitating the sale
of portfolio securities, managing the effective maturity or
duration of debt obligations in a Fund's portfolio, establishing
a position in the derivatives markets as a substitute for buying
or selling certain securities, or creating or altering exposure
to certain asset classes, such as equity, debt, and foreign
securities. The use of derivative instruments may provide a less
expensive, more expedient or more specifically focused way for a
Fund to invest than "traditional" securities (i.e., stocks or
bonds) would.
Exchange or OTC Derivatives. Derivative instruments may be
exchange-traded or traded in OTC transactions between private
parties. Exchange-traded derivatives are standardized options
and futures contracts traded in an auction on the floor of a
regulated exchange. Exchange contracts are generally liquid.
The exchange clearinghouse is the counterparty of every contract.
Thus, each holder of an exchange contract bears the credit risk
of the clearinghouse (and has the benefit of its financial
strength) rather than that of a particular counterparty. Over-
the-counter transactions are subject to additional risks, such as
the credit risk of the counterparty to the instrument, and are
less liquid than exchange-traded derivatives since they often can
only be closed out with the other party to the transaction.
Risks and Special Considerations. The use of derivative
instruments involves risks and special considerations as
described below. Risks pertaining to particular derivative
instruments are described in the sections that follow.
(1) Market Risk. The primary risk of derivatives is the
same as the risk of the underlying assets; namely, that the value
of the underlying asset may go up or down. Adverse movements in
the value of an underlying asset can expose a Fund to losses.
Derivative instruments may include elements of leverage and,
accordingly, the fluctuation of the value of the derivative
instrument in relation to the underlying asset may be magnified.
The successful use of derivative instruments depends upon a
variety of factors, particularly the Adviser's ability to predict
movements of the securities, currencies, and commodities markets,
which requires different skills than predicting changes in the
prices of individual securities. There can be no assurance that
any particular strategy adopted will succeed. A decision to
engage in a derivative transaction will reflect the Adviser's
judgment that the derivative transaction will provide value to
the Fund and its shareholders and is consistent with the Fund's
objectives, investment limitations, and operating policies. In
making such a judgment, the Adviser will analyze the benefits and
risks of the derivative transaction and weigh them in the context
of the Fund's entire portfolio and investment objective.
(2) Credit Risk. A Fund will be subject to the risk that a
loss may be sustained by the Fund as a result of the failure of a
counterparty to comply with the terms of a derivative instrument.
The counterparty risk for exchange-traded derivative instruments
is generally less than for privately-negotiated or OTC derivative
instruments, since generally a clearing agency, which is the
issuer or counterparty to each exchange-traded instrument,
provides a guarantee of performance. For privately-negotiated
instruments, there is no similar clearing agency guarantee. In
all transactions, a Fund will bear the risk that the counterparty
will default, and this could result in a loss of the expected
benefit of the derivative transaction and possibly other losses
to the Fund. A Fund will enter into transactions in
<PAGE>
derivative instruments only with counterparties that the Adviser
reasonably believes are capable of performing under the contract.
(3) Correlation Risk. When a derivative transaction is
used to completely hedge another position, changes in the market
value of the combined position (the derivative instrument plus
the position being hedged) result from an imperfect correlation
between the price movements of the two instruments. With a
perfect hedge, the value of the combined position remains
unchanged for any change in the price of the underlying asset.
With an imperfect hedge, the value of the derivative instrument
and its hedge are not perfectly correlated. Correlation risk is
the risk that there might be imperfect correlation, or even no
correlation, between price movements of an instrument and price
movements of investments being hedged. For example, if the value
of a derivative instrument used in a short hedge (such as writing
a call option, buying a put option, or selling a futures
contract) increased by less than the decline in value of the
hedged investments, the hedge would not be perfectly correlated.
Such a lack of correlation might occur due to factors unrelated
to the value of the investments being hedged, such as speculative
or other pressures on the markets in which these instruments are
traded. The effectiveness of hedges using instruments on indices
will depend, in part, on the degree of correlation between price
movements in the index and price movements in the investments
being hedged.
(4) Liquidity Risk. Derivatives are also subject to
liquidity risk. Liquidity risk is the risk that a derivative
instrument cannot be sold, closed out, or replaced quickly at or
very close to its fundamental value. Generally, exchange
contracts are very liquid because the exchange clearinghouse is
the counterparty of every contract. OTC transactions are less
liquid than exchange-traded derivatives since they often can only
be closed out with the other party to the transaction. A Fund
might be required by applicable regulatory requirement to
maintain assets as "cover," maintain segregated accounts, and/or
make margin payments when it takes positions in derivative
instruments involving obligations to third parties (i.e.,
instruments other than purchased options). If a Fund is unable
to close out its positions in such instruments, it might be
required to continue to maintain such assets or accounts or make
such payments until the position expired, matured, or is closed
out. The requirements might impair a Fund's ability to sell a
portfolio security or make an investment at a time when it would
otherwise be favorable to do so, or require that the Fund sell a
portfolio security at a disadvantageous time. A Fund's ability
to sell or close out a position in an instrument prior to
expiration or maturity depends on the existence of a liquid
secondary market or, in the absence of such a market, the ability
and willingness of the counterparty to enter into a transaction
closing out the position. Therefore, there is no assurance that
any derivatives position can be sold or closed out at a time and
price that is favorable to a Fund.
(5) Legal Risk. Legal risk is the risk of loss caused by
the legal unenforceability of a party's obligations under the
derivative. While a party seeking price certainty agrees to
surrender the potential upside in exchange for downside
protection, the party taking the risk is looking for a positive
payoff. Despite this voluntary assumption of risk, a
counterparty that has lost money in a derivative transaction may
try to avoid payment by exploiting various legal uncertainties
about certain derivative products.
(6) Systemic or "Interconnection" Risk. Interconnection
risk is the risk that a disruption in the financial markets will
cause difficulties for all market participants. In other words,
a disruption in one market will spill over into other markets,
perhaps creating a chain reaction. Much of the OTC derivatives
market takes place among the OTC dealers themselves, thus
creating a large interconnected web of financial obligations.
This interconnectedness raises the possibility that a default by
one large dealer could create losses for other dealers and
destabilize the entire market for OTC derivative instruments.
General Limitations. The use of derivative instruments is
subject to applicable regulations of the SEC, the several options
and futures exchanges upon which they may be traded, and the
Commodity Futures Trading Commission ("CFTC").
The Corporation has filed a notice of eligibility for
exclusion from the definition of the term "commodity pool
operator" with the CFTC and the National Futures Association,
which regulate trading in the futures markets. In accordance
with Rule 4.5 of the regulations under the CEA, the notice of
eligibility for the Funds includes representations that each Fund
will use futures contracts and related options solely for bona
fide hedging purposes within the meaning of CFTC regulations,
provided that a Fund may hold other positions in futures
contracts and related options that do not qualify as a bona fide
hedging position if the aggregate initial margin deposits and
premiums
<PAGE>
required to establish these positions, less the amount
by which any such futures contracts and related options positions
are "in the money," do not exceed 5% of the Fund's net assets.
To the extent the Fund were to engage in derivative transactions,
it will limit such transactions to no more than 5% of its net
assets.
The SEC has identified certain trading practices involving
derivative instruments that involve the potential for leveraging
a Fund's assets in a manner that raises issues under the 1940
Act. In order to limit the potential for the leveraging of a
Fund's assets, as defined under the 1940 Act, the SEC has stated
that a Fund may use coverage or the segregation of a Fund's
assets. The Funds will also set aside permissible liquid assets
in a segregated custodial account if required to do so by SEC and
CFTC regulations. Assets used as cover or held in a segregated
account cannot be sold while the derivative position is open,
unless they are replaced with similar assets. As a result, the
commitment of a large portion of a Fund's assets to segregated
accounts could impede portfolio management or the Fund's ability
to meet redemption requests or other current obligations.
In some cases a Fund may be required to maintain or limit
exposure to a specified percentage of its assets to a particular
asset class. In such cases, when a Fund uses a derivative
instrument to increase or decrease exposure to an asset class and
is required by applicable SEC guidelines to set aside liquid
assets in a segregated account to secure its obligations under
the derivative instruments, the Adviser may, where reasonable in
light of the circumstances, measure compliance with the
applicable percentage by reference to the nature of the economic
exposure created through the use of the derivative instrument and
not by reference to the nature of the exposure arising from the
assets set aside in the segregated account (unless another
interpretation is specified by applicable regulatory
requirements).
Options. A Fund may use options for any lawful purpose
consistent with the Fund's investment objective such as hedging
or managing risk but not for speculation. An option is a
contract in which the "holder" (the buyer) pays a certain amount
(the "premium") to the "writer" (the seller) to obtain the right,
but not the obligation, to buy from the writer (in a "call") or
sell to the writer (in a "put") a specific asset at an agreed
upon price (the "strike price" or "exercise price") at or before
a certain time (the "expiration date"). The holder pays the
premium at inception and has no further financial obligation.
The holder of an option will benefit from favorable movements in
the price of the underlying asset but is not exposed to
corresponding losses due to adverse movements in the value of the
underlying asset. The writer of an option will receive fees or
premiums but is exposed to losses due to changes in the value of
the underlying asset. A Fund may purchase (buy) or write (sell)
put and call options on assets, such as securities, currencies,
commodities, and indices of debt and equity securities
("underlying assets") and enter into closing transactions with
respect to such options to terminate an existing position.
Options used by the Funds may include European, American, and
Bermuda style options. If an option is exercisable only at
maturity, it is a "European" option; if it is also exercisable
prior to maturity, it is an "American" option. If it is
exercisable only at certain times, it is a "Bermuda" option.
Each Fund may purchase (buy) and write (sell) put and call
options and enter into closing transactions with respect to such
options to terminate an existing position. The purchase of call
options serves as a long hedge, and the purchase of put options
serves as a short hedge. Writing put or call options can enable
a Fund to enhance income by reason of the premiums paid by the
purchaser of such options. Writing call options serves as a
limited short hedge because declines in the value of the hedged
investment would be offset to the extent of the premium received
for writing the option. However, if the security appreciates to
a price higher than the exercise price of the call option, it can
be expected that the option will be exercised and the Fund will
be obligated to sell the security at less than its market value
or will be obligated to purchase the security at a price greater
than that at which the security must be sold under the option.
All or a portion of any assets used as cover for OTC options
written by a Fund would be considered illiquid to the extent
described under "Investment Policies and Techniques Illiquid
Securities." Writing put options serves as a limited long hedge
because increases in the value of the hedged investment would be
offset to the extent of the premium received for writing the
option. However, if the security depreciates to a price lower
than the exercise price of the put option, it can be expected
that the put option will be exercised and the Fund will be
obligated to purchase the security at more than its market value.
The value of an option position will reflect, among other
things, the historical price volatility of the underlying
investment, the current market value of the underlying
investment, the time remaining until expiration, the relationship
of the exercise price to the market price of the underlying
investment, and general market conditions.
<PAGE>
A Fund may effectively terminate its right or obligation
under an option by entering into a closing transaction. For
example, a Fund may terminate its obligation under a call or put
option that it had written by purchasing an identical call or put
option; this is known as a closing purchase transaction.
Conversely, a Fund may terminate a position in a put or call
option it had purchased by writing an identical put or call
option; this is known as a closing sale transaction. Closing
transactions permit a Fund to realize the profit or limit the
loss on an option position prior to its exercise or expiration.
The Funds may purchase or write both exchange-traded and OTC
options. Exchange-traded options are issued by a clearing
organization affiliated with the exchange on which the option is
listed that, in effect, guarantees completion of every exchange-
traded option transaction. In contrast, OTC options are
contracts between a Fund and the other party to the transaction
("counterparty") (usually a securities dealer or a bank) with no
clearing organization guarantee. Thus, when a Fund purchases or
writes an OTC option, it relies on the counterparty to make or
take delivery of the underlying investment upon exercise of the
option. Failure by the counterparty to do so would result in the
loss of any premium paid by the Fund as well as the loss of any
expected benefit of the transaction.
A Fund's ability to establish and close out positions in
exchange-listed options depends on the existence of a liquid
market. Each Fund intends to purchase or write only those
exchange-traded options for which there appears to be a liquid
secondary market. However, there can be no assurance that such a
market will exist at any particular time. Closing transactions
can be made for OTC options only by negotiating directly with the
counterparty, or by a transaction in the secondary market if any
such market exists. Although each Fund will enter into OTC
options only with counterparties that are expected to be capable
of entering into closing transactions with the Funds, there is no
assurance that the Funds will in fact be able to close out an OTC
option at a favorable price prior to expiration. In the event of
insolvency of the counterparty, a Fund might be unable to close
out an OTC option position at any time prior to its expiration.
If a Fund were unable to effect a closing transaction for an
option it had purchased, it would have to exercise the option to
realize any profit.
The Funds may engage in options transactions on indices in
much the same manner as the options on securities discussed
above, except the index options may serve as a hedge against
overall fluctuations in the securities market in general.
The writing and purchasing of options is a highly
specialized activity that involves investment techniques and
risks different from those associated with ordinary portfolio
securities transactions. Imperfect correlation between the
options and securities markets may detract from the effectiveness
of attempted hedging.
Spread Transactions. A Fund may use spread transactions for
any lawful purpose consistent with the Fund's investment
objective such as hedging or managing risk, but not for
speculation. A Fund may purchase covered spread options from
securities dealers. Such covered spread options are not
presently exchange-listed or exchange-traded. The purchase of a
spread option gives a Fund the right to put, or sell, a security
that it owns at a fixed dollar spread or fixed yield spread in
relationship to another security that the Fund does not own, but
which is used as a benchmark. The risk to a Fund in purchasing
covered spread options is the cost of the premium paid for the
spread option and any transaction costs. In addition, there is
no assurance that closing transactions will be available. The
purchase of spread options will be used to protect a Fund against
adverse changes in prevailing credit quality spreads, i.e., the
yield spread between high quality and lower quality securities.
Such protection is only provided during the life of the spread
option.
Futures Contracts. A Fund may use futures contracts for any
lawful purpose consistent with the Fund's investment objective
such as hedging and managing risk but not for speculation. A
Fund may enter into futures contracts, including interest rate,
index, and currency futures. Each Fund may also purchase put and
call options, and write covered put and call options, on futures
in which it is allowed to invest. The purchase of futures or
call options thereon can serve as a long hedge, and the sale of
futures or the purchase of put options thereon can serve as a
short hedge. Writing covered call options on futures contracts
can serve as a limited short hedge, and writing covered put
options on futures contracts can serve as a limited long hedge,
using a strategy similar to that used for writing covered options
in securities. The Funds' hedging may include purchases of
futures as an offset against the effect of expected increases in
currency exchange rates and securities prices and sales of
futures as an offset against the effect of expected declines in
currency exchange rates and securities prices.
<PAGE>
To the extent required by regulatory authorities, the Funds
may enter into futures contracts that are traded on national
futures exchanges and are standardized as to maturity date and
underlying financial instrument. Futures exchanges and trading
are regulated under the CEA by the CFTC. Although techniques
other than sales and purchases of futures contracts could be used
to reduce a Fund's exposure to market, currency, or interest rate
fluctuations, a Fund may be able to hedge its exposure more
effectively and perhaps at a lower cost through using futures
contracts.
An interest rate futures contract provides for the future
sale by one party and purchase by another party of a specified
amount of a specific financial instrument (e.g., debt security)
or currency for a specified price at a designated date, time, and
place. An index futures contract is an agreement pursuant to
which the parties agree to take or make delivery of an amount of
cash equal to the difference between the value of the index at
the close of the last trading day of the contract and the price
at which the index futures contract was originally written.
Transaction costs are incurred when a futures contract is bought
or sold and margin deposits must be maintained. A futures
contract may be satisfied by delivery or purchase, as the case
may be, of the instrument or the currency or by payment of the
change in the cash value of the index. More commonly, futures
contracts are closed out prior to delivery by entering into an
offsetting transaction in a matching futures contract. Although
the value of an index might be a function of the value of certain
specified securities, no physical delivery of those securities is
made. If the offsetting purchase price is less than the original
sale price, a Fund realizes a gain; if it is more, a Fund
realizes a loss. Conversely, if the offsetting sale price is
more than the original purchase price, a Fund realizes a gain; if
it is less, a Fund realizes a loss. The transaction costs must
also be included in these calculations. There can be no
assurance, however, that a Fund will be able to enter into an
offsetting transaction with respect to a particular futures
contract at a particular time. If a Fund is not able to enter
into an offsetting transaction, the Fund will continue to be
required to maintain the margin deposits on the futures contract.
No price is paid by a Fund upon entering into a futures
contract. Instead, at the inception of a futures contract, a
Fund is required to deposit in a segregated account with its
custodian, in the name of the futures broker through whom the
transaction was effected, "initial margin," consisting of cash,
U.S. government securities or other liquid, high-grade debt
obligations, in an amount generally equal to 10% or less of the
contract value. Margin must also be deposited when writing a
call or put option on a futures contract, in accordance with
applicable exchange rules. Unlike margin in securities
transaction, initial margin on futures contracts does not
represent a borrowing, but rather is in the nature of a
performance bond or good-faith deposit that is returned to a Fund
at the termination of the transaction if all contractual
obligations have been satisfied. Under certain circumstances,
such as periods of high volatility, a Fund may be required by an
exchange to increase the level of its initial margin payment, and
initial margin requirements might be increased generally in the
future by regulatory action.
Subsequent "variation margin" payments are made to and from
the futures broker daily as the value of the futures position
varies, a process known as "marking to market." Variation margin
does not involve borrowing, but rather represents a daily
settlement of a Fund's obligations to or from a futures broker.
When a Fund purchases an option on a future, the premium paid
plus transaction costs is all that is at risk. In contrast, when
a Fund purchases or sells a futures contract or writes a call or
put option thereon, it is subject to daily variation margin calls
that could be substantial in the event of adverse price
movements. If a Fund has insufficient cash to meet daily
variation margin requirements, it might need to sell securities
at a time when such sales are disadvantageous. Purchasers and
sellers of futures positions and options on futures can enter
into offsetting closing transactions by selling or purchasing,
respectively, an instrument identical to the instrument held or
written. Positions in futures and options on futures may be
closed only on an exchange or board of trade that provides a
secondary market. The Funds intend to enter into futures
transactions only on exchanges or boards of trade where there
appears to be a liquid secondary market. However, there can be
no assurance that such a market will exist for a particular
contract at a particular time.
Under certain circumstances, futures exchanges may establish
daily limits on the amount that the price of a future or option
on a futures contract can vary from the previous day's settlement
price; once that limit is reached, no trades may be made that day
at a price beyond the limit. Daily price limits do not limit
potential losses because prices could move to the daily limit for
several consecutive days with little or no trading, thereby
preventing liquidation of unfavorable positions.
<PAGE>
If a Fund were unable to liquidate a futures or option on a
futures contract position due to the absence of a liquid
secondary market or the imposition of price limits, it could
incur substantial losses. The Fund would continue to be subject
to market risk with respect to the position. In addition, except
in the case of purchased options, the Fund would continue to be
required to make daily variation margin payments and might be
required to maintain the position being hedged by the future or
option or to maintain certain liquid securities in a segregated
account.
Certain characteristics of the futures market might increase
the risk that movements in the prices of futures contracts or
options on futures contracts might not correlate perfectly with
movements in the prices of the investments being hedged. For
example, all participants in the futures and options on futures
contracts markets are subject to daily variation margin calls and
might be compelled to liquidate futures or options on futures
contracts positions whose prices are moving unfavorably to avoid
being subject to further calls. These liquidations could
increase the price volatility of the instruments and distort the
normal price relationship between the futures or options and the
investments being hedged. Also, because initial margin deposit
requirements in the futures markets are less onerous than margin
requirements in the securities markets, there might be increased
participation by speculators in the future markets. This
participation also might cause temporary price distortions. In
addition, activities of large traders in both the futures and
securities markets involving arbitrage, "program trading," and
other investment strategies might result in temporary price
distortions.
Foreign Currencies. The Funds may purchase and sell foreign
currency on a spot basis, and may use currency-related
derivatives instruments such as options on foreign currencies,
futures on foreign currencies, options on futures on foreign
currencies and forward currency contracts (i.e., an obligation to
purchase or sell a specific currency at a specified future date,
which may be any fixed number of days from the contract date
agreed upon by the parties, at a price set at the time the
contract is entered into). The Funds may use these instruments
for hedging or any other lawful purpose consistent with their
respective investment objectives, including transaction hedging,
anticipatory hedging, cross hedging, proxy hedging, and position
hedging. The Funds' use of currency-related derivative
instruments will be directly related to a Fund's current or
anticipated portfolio securities, and the Funds may engage in
transactions in currency-related derivative instruments as a
means to protect against some or all of the effects of adverse
changes in foreign currency exchange rates on their portfolio
investments. In general, if the currency in which a portfolio
investment is denominated appreciates against the U.S. dollar,
the dollar value of the security will increase. Conversely, a
decline in the exchange rate of the currency would adversely
effect the value of the portfolio investment expressed in U.S.
dollars.
For example, a Fund might use currency-related derivative
instruments to "lock in" a U.S. dollar price for a portfolio
investment, thereby enabling the Fund to protect itself against a
possible loss resulting from an adverse change in the
relationship between the U.S. dollar and the subject foreign
currency during the period between the date the security is
purchased or sold and the date on which payment is made or
received. A Fund also might use currency-related derivative
instruments when the Adviser believes that one currency may
experience a substantial movement against another currency,
including the U.S. dollar, and it may use currency-related
derivative instruments to sell or buy the amount of the former
foreign currency, approximating the value of some or all of the
Fund's portfolio securities denominated in such foreign currency.
Alternatively, where appropriate, a Fund may use currency-related
derivative instruments to hedge all or part of its foreign
currency exposure through the use of a basket of currencies or a
proxy currency where such currency or currencies act as an
effective proxy for other currencies. The use of this basket
hedging technique may be more efficient and economical than using
separate currency-related derivative instruments for each
currency exposure held by the Fund. Furthermore, currency-
related derivative instruments may be used for short hedges --
for example, a Fund may sell a forward currency contract to lock
in the U.S. dollar equivalent of the proceeds from the
anticipated sale of a security denominated in a foreign currency.
In addition, a Fund may use a currency-related derivative
instrument to shift exposure to foreign currency fluctuations
from one foreign country to another foreign country where the
Adviser believes that the foreign currency exposure purchased
will appreciate relative to the U.S. dollar and thus better
protect the Fund against the expected decline in the foreign
currency exposure sold. For example, if a Fund owns securities
denominated in a foreign currency and the Adviser believes that
currency will decline, it might enter into a forward contract to
sell an appropriate amount of the first foreign currency, with
payment to be made in a second foreign currency that the Adviser
believes would better protect the Fund against the decline in the
first security than would a U.S. dollar exposure. Hedging
<PAGE>
transactions that use two foreign currencies are sometimes
referred to as "cross hedges." The effective use of currency-
related derivative instruments by a Fund in a cross hedge is
dependent upon a correlation between price movements of the two
currency instruments and the underlying security involved, and
the use of two currencies magnifies the risk that movements in
the price of one instrument may not correlate or may correlate
unfavorably with the foreign currency being hedged. Such a lack
of correlation might occur due to factors unrelated to the value
of the currency instruments used or investments being hedged,
such as speculative or other pressures on the markets in which
these instruments are traded.
A Fund also might seek to hedge against changes in the value
of a particular currency when no hedging instruments on that
currency are available or such hedging instruments are more
expensive than certain other hedging instruments. In such cases,
the Fund may hedge against price movements in that currency by
entering into transactions using currency-related derivative
instruments on another foreign currency or a basket of
currencies, the values of which the Adviser believes will have a
high degree of positive correlation to the value of the currency
being hedged. The risk that movements in the price of the
hedging instrument will not correlate perfectly with movements in
the price of the currency being hedged is magnified when this
strategy is used.
The use of currency-related derivative instruments by a Fund
involves a number of risks. The value of currency-related
derivative instruments depends on the value of the underlying
currency relative to the U.S. dollar. Because foreign currency
transactions occurring in the interbank market might involve
substantially larger amounts than those involved in the use of
such derivative instruments, a Fund could be disadvantaged by
having to deal in the odd lot market (generally consisting of
transactions of less than $1 million) for the underlying foreign
currencies at prices that are less favorable than for round lots
(generally consisting of transactions of greater than $1
million).
There is no systematic reporting of last sale information
for currencies or any regulatory requirement that quotations
available through dealers or other market sources be firm or
revised on a timely basis. Quotation information generally is
representative of very large transactions in the interbank market
and thus might not reflect odd-lot transactions where rates might
be less favorable. The interbank market in foreign currencies is
a global, round-the-clock market. To the extent the U.S. options
or futures markets are closed while the markets for the
underlying currencies remain open, significant price and rate
movements might take place in the underlying markets that cannot
be reflected in the markets for the derivative instruments until
they re-open.
Settlement of transactions in currency-related derivative
instruments might be required to take place within the country
issuing the underlying currency. Thus, a Fund might be required
to accept or make delivery of the underlying foreign currency in
accordance with any U.S. or foreign regulations regarding the
maintenance of foreign banking arrangements by U.S. residents and
might be required to pay any fees, taxes and charges associated
with such delivery assessed in the issuing country.
When a Fund engages in a transaction in a currency-related
derivative instrument, it relies on the counterparty to make or
take delivery of the underlying currency at the maturity of the
contract or otherwise complete the contract. In other words, the
Fund will be subject to the risk that it may sustain a loss as a
result of the failure of the counterparty to comply with the
terms of the transaction. The counterparty risk for exchange-
traded instruments is generally less than for privately-
negotiated or OTC currency instruments, since generally a
clearing agency, which is the issuer or counterparty to each
instrument, provides a guarantee of performance. For privately-
negotiated instruments, there is no similar clearing agency
guarantee. In all transactions, the Fund will bear the risk that
the counterparty will default, and this could result in a loss of
the expected benefit of the transaction and possibly other losses
to the Fund. The Funds will enter into transactions in currency-
related derivative instruments only with counterparties that the
Adviser reasonably believes are capable of performing under the
contract.
Purchasers and sellers of currency-related derivative
instruments may enter into offsetting closing transactions by
selling or purchasing, respectively, an instrument identical to
the instrument purchased or sold. Secondary markets generally do
not exist for forward currency contracts, with the result that
closing transactions generally can be made for forward currency
contracts only by negotiating directly with the counterparty.
Thus, there can be no assurance that a Fund will, in fact, be
able to close out a forward currency contract (or any other
currency-related derivative instrument) at a time and price
favorable to the Fund. In addition, in the event of insolvency
of the counterparty, a Fund might be unable to close out a
forward currency contract at any time prior to maturity. In the
case of an exchange-traded
<PAGE>
instrument, a Fund will be able to
close the position out only on an exchange which provides a
market for the instruments. The ability to establish and close
out positions on an exchange is subject to the maintenance of a
liquid market, and there can be no assurance that a liquid market
will exist for any instrument at any specific time. In the case
of a privately-negotiated instrument, a Fund will be able to
realize the value of the instrument only by entering into a
closing transaction with the issuer or finding a third party
buyer for the instrument. While the Funds will enter into
privately-negotiated transactions only with entities who are
expected to be capable of entering into a closing transaction,
there can be no assurance that the Funds will, in fact, be able
to enter into such closing transactions.
The precise matching of currency-related derivative
instrument amounts and the value of the portfolio securities
involved generally will not be possible because the value of such
securities, measured in the foreign currency, will change after
the currency-related derivative instrument position has been
established. Thus, a Fund might need to purchase or sell foreign
currencies in the spot (cash) market. The projection of short-
term currency market movements is extremely difficult, and the
successful execution of a short-term hedging strategy is highly
uncertain.
Permissible foreign currency options will include options
traded primarily in the OTC market. Although options on foreign
currencies are traded primarily in the OTC market, the Funds will
normally purchase or sell OTC options on foreign currency only
when the Adviser reasonably believes a liquid secondary market
will exist for a particular option at any specific time.
There will be a cost to the Funds of engaging in
transactions in currency-related derivative instruments that will
vary with factors such as the contract or currency involved, the
length of the contract period and the market conditions then
prevailing. A Fund using these instruments may have to pay a fee
or commission or, in cases where the instruments are entered into
on a principal basis, foreign exchange dealers or other
counterparties will realize a profit based on the difference
("spread") between the prices at which they are buying and
selling various currencies. Thus, for example, a dealer may
offer to sell a foreign currency to a Fund at one rate, while
offering a lesser rate of exchange should the Fund desire to
resell that currency to the dealer.
When required by the SEC guidelines, the Funds will set
aside permissible liquid assets in segregated accounts or
otherwise cover their respective potential obligations under
currency-related derivatives instruments. To the extent a Fund's
assets are so set aside, they cannot be sold while the
corresponding currency position is open, unless they are replaced
with similar assets. As a result, if a large portion of a Fund's
assets are so set aside, this could impede portfolio management
or the Fund's ability to meet redemption requests or other
current obligations.
The Adviser's decision to engage in a transaction in a
particular currency-related derivative instrument will reflect
the Adviser's judgment that the transaction will provide value to
the Fund and its shareholders and is consistent with the Fund's
objectives and policies. In making such a judgment, the Adviser
will analyze the benefits and risks of the transaction and weigh
them in the context of the Fund's entire portfolio and
objectives. The effectiveness of any transaction in a currency-
related derivative instrument is dependent on a variety of
factors, including the Adviser's skill in analyzing and
predicting currency values and upon a correlation between price
movements of the currency instrument and the underlying security.
There might be imperfect correlation, or even no correlation,
between price movements of an instrument and price movements of
investments being hedged. Such a lack of correlation might occur
due to factors unrelated to the value of the investments being
hedged, such as speculative or other pressures on the markets in
which these instruments are traded. In addition, a Fund's use of
currency-related derivative instruments is always subject to the
risk that the currency in question could be devalued by the
foreign government. In such a case, any long currency positions
would decline in value and could adversely affect any hedging
position maintained by the Fund.
The Funds' dealing in currency-related derivative
instruments will generally be limited to the transactions
described above. However, the Funds reserve the right to use
currency-related derivatives instruments for different purposes
and under different circumstances. Of course, the Funds are not
required to use currency-related derivatives instruments and will
not do so unless deemed appropriate by the Adviser. It should
also be realized that use of these instruments does not
eliminate, or protect against, price movements in the Funds'
securities that are attributable to other (i.e., non-currency
related) causes. Moreover, while the use of currency-related
derivatives instruments may reduce the risk of loss due to a
decline in the value of a hedged currency, at the same time the
use of these instruments tends to limit any potential gain which
may result from an increase in the value of that currency.
<PAGE>
Swap Agreements. The Funds may enter into interest rate,
securities index, commodity, or security and currency exchange
rate swap agreements for any lawful purpose consistent with each
Fund's investment objective, such as for the purpose of
attempting to obtain or preserve a particular desired return or
spread at a lower cost to the Fund than if the Fund had invested
directly in an instrument that yielded that desired return or
spread. The Funds may also enter into swaps in order to protect
against an increase in the price of, or the currency exchange
rate applicable to, securities that the particular Fund
anticipates purchasing at a later date. Swap agreements are two-
party contracts entered into primarily by institutional investors
for periods ranging from a few weeks to several years. In a
standard "swap" transaction, two parties agree to exchange the
returns (or differentials in rates of return) earned or realized
on particular predetermined investments or instruments. The
gross returns to be exchanged or "swapped" between the parties
are calculated with respect to a "notional amount," i.e., the
return on or increase in value of a particular dollar amount
invested at a particular interest rate, in a particular foreign
currency, or in a "basket" of securities representing a
particular index. Swap agreements may include interest rate
caps, under which, in return for a premium, one party agrees to
make payments to the other to the extent that interest rates
exceed a specified rate, or "cap;" interest rate floors, under
which, in return for a premium, one party agrees to make payments
to the other to the extent that interest rates fall below a
specified level, or "floor;" and interest rate collars, under
which a party sells a cap and purchases a floor, or vice versa,
in an attempt to protect itself against interest rate movements
exceeding given minimum or maximum levels.
The "notional amount" of the swap agreement is the agreed
upon basis for calculating the obligations that the parties to a
swap agreement have agreed to exchange. Under most swap
agreements entered into by a Fund, the obligations of the parties
would be exchanged on a "net basis." Consequently, a Fund's
obligation (or rights) under a swap agreement will generally be
equal only to the net amount to be paid or received under the
agreement based on the relative values of the positions held by
each party to the agreement (the "net amount"). A Fund's
obligation under a swap agreement will be accrued daily (offset
against amounts owed to the Fund) and any accrued but unpaid net
amounts owed to a swap counterparty will be covered by the
maintenance of a segregated account generally consisting of
liquid assets.
Whether a Fund's use of swap agreements will be successful
in furthering its investment objective will depend, in part, on
the Adviser's ability to predict correctly whether certain types
of investments are likely to produce greater returns than other
investments. Swap agreements may be considered to be illiquid.
Moreover, a Fund bears the risk of loss of the amount expected to
be received under a swap agreement in the event of the default or
bankruptcy of a swap agreement counterparty. Certain
restrictions imposed on the Funds by the Internal Revenue Code
may limit the Funds' ability to use swap agreements. The swaps
market is largely unregulated.
The Funds will enter swap agreements only with
counterparties that the Adviser reasonably believes are capable
of performing under the swap agreements. If there is a default
by the other party to such a transaction, a Fund will have to
rely on its contractual remedies (which may be limited by
bankruptcy, insolvency or similar laws) pursuant to the
agreements related to the transaction.
Additional Derivative Instruments and Strategies. In
addition to the derivative instruments and strategies described
above, the Adviser expects to discover additional derivative
instruments and other hedging or risk management techniques. The
Adviser may utilize these new derivative instruments and
techniques to the extent that they are consistent with a Fund's
investment objective and permitted by the Fund's investment
limitations, operating policies, and applicable regulatory
authorities.
Depositary Receipts
Each Fund may invest up to 15% of its net assets in foreign
securities by purchasing depositary receipts, including American
Depositary Receipts ("ADRs") and European Depositary Receipts
("EDRs") or other securities convertible into securities or
issuers based in foreign countries. These securities may not
necessarily be denominated in the same currency as the securities
into which they may be converted. Generally, ADRs, in registered
form, are denominated in U.S. dollars and are designed for use in
the U.S. securities markets, while EDRs, in bearer form, may be
denominated in other currencies and are designed for use in
European securities markets. ADRs are receipts typically issued
by a U.S. Bank or trust company evidencing ownership of the
underlying securities. EDRs are European receipts evidencing a
similar arrangement. For purposes of a Fund's investment
policies, ADRs and EDRs
<PAGE>
are deemed to have the same
classification as the underlying securities they represent.
Thus, an ADR or EDR representing ownership of common stock will
be treated as common stock.
ADR facilities may be established as either "unsponsored" or
"sponsored." While ADRs issued under these two types of
facilities are in some respects similar, there are distinctions
between them relating to the rights and obligations of ADR
holders and the practices of market participants. For example, a
non-sponsored depositary may not provide the same shareholder
information that a sponsored depositary is required to provide
under its contractual arrangements with the issuer, including
reliable financial statements. Under the terms of most sponsored
arrangements, depositories agree to distribute notices of
shareholder meetings and voting instructions, and to provide
shareholder communications and other information to the ADR
holders at the request of the issuer of the deposited securities.
Investments in securities of foreign issuers involve risks
which are in addition to the usual risks inherent in domestic
investments. In many countries there is less publicly available
information about issuers than is available in the reports and
ratings published about companies in the United States.
Additionally, foreign countries are not subject to uniform
accounting, auditing and financial reporting standards. Other
risks inherent in foreign investments include expropriation;
confiscatory taxation; withholding taxes on dividends or
interest; less extensive regulation of foreign brokers,
securities markets, and issuers; costs incurred in conversions
between currencies; possible delays in settlement in foreign
securities markets; limitations on the use or transfer of assets
(including suspension of the ability to transfer currency from a
given country); the difficulty of enforcing obligations in other
countries; diplomatic developments; and political or social
instability. Foreign economies may differ favorably or
unfavorably from the U.S. economy in various respects and many
foreign securities are less liquid and their prices are more
volatile than comparable U.S. securities. From time to time
foreign securities may be difficult to liquidate rapidly without
adverse price effects. Certain costs attributable to foreign
investing, such as custody charges and brokerage costs, may be
higher than those attributable to domestic investment. The value
of a Fund's assets denominated in foreign currencies will
increase or decrease in response to fluctuations in the value of
those foreign currencies relative to the U.S. dollar. Currency
exchange rates can be volatile at times in response to supply and
demand in the currency exchange markets, international balances
of payments, governmental intervention, speculation and other
political and economic conditions.
Foreign Investment Companies
The Funds may invest, to a limited extent, in foreign
investment companies. Some of the countries in which the Funds
invest may not permit direct investment by outside investors.
Investments in such countries may only be permitted through
foreign government-approved or -authorized investment vehicles,
which may include other investment companies. In addition, it
may be less expensive and more expedient for a Fund to invest in
a foreign investment company in a country which permits direct
foreign investment. Investing through such vehicles may involve
frequent or layered fees or expenses and may also be subject to
limitation under the 1940 Act. Under the 1940 Act, a Fund may
invest up to 10% of its total assets in shares of other
investment companies and up to 5% of its total assets in any one
investment company as long as the investment does not represent
more than 3% of the voting stock of the acquired investment
company. The Funds do not intend to invest in such investment
companies unless, in the judgment of the Adviser, the potential
benefits of such investments justify the payment of any
associated fees and expenses.
High-Yield (High-Risk) Securities
In General. The Balanced Fund will invest in fixed income
securities rated at the time of purchase as at lease investment
grade by at least one nationally recognized statistical rating
organization ("NRSROs"), such as S&P or Moody's. If a security's
rating falls below the ratings criteria set forth in the
Prospectus, the Adviser will determine what action, if any,
should be taken to ensure compliance with the Balanced Fund's
investment objective and to ensure that the Balanced Fund will at
no time have 5% or more of its net assets invested in non-
investment grade debt securities. Non-investment grade debt
obligations ("lower-quality securities") include (1) bonds rated
as low as C by S&P, Moody's and comparable ratings of other
NRSROs; (2) commercial paper rated as low as C by S&P, Not Prime
by Moody's and comparable ratings of other NRSROs; and (3)
unrated debt obligations of comparable quality. Lower-quality
securities, while generally offering higher yields than
investment grade securities with similar maturities, involve
greater risks, including the possibility of default or
bankruptcy. They are regarded as predominantly speculative with
respect to the issuer's capacity to pay interest and repay
principal. The special risk considerations in
<PAGE>
connection with investments in these securities are discussed below.
Refer to the Appendix for a description of the securities ratings.
Effect of Interest Rates and Economic Changes. The lower-
quality and comparable unrated security market is relatively new
and its growth has paralleled a long economic expansion. As a
result, it is not clear how this market may withstand a prolonged
recession or economic downturn. Such conditions could severely
disrupt the market for and adversely affect the value of such
securities.
All interest-bearing securities typically experience
appreciation when interest rates decline and depreciation when
interest rates rise. The market value of lower-quality and
comparable unrated securities tend to reflect individual
corporate developments to a greater extent than do higher rated
securities. As a result, they generally involve more credit
risks than securities in the higher-rated categories. During an
economic downturn or a sustained period of rising interest rates,
highly leveraged issuers of lower-quality and comparable unrated
securities may experience financial stress and may not have
sufficient revenues to meet their payment obligations. The
issuer's ability to service its debt obligations may also be
adversely affected by specific corporate developments, the
issuer's inability to meet specific projected business forecasts
or the unavailability of additional financing. The risk of loss
due to default by an issuer of these securities is significantly
greater than issuers of higher-rated securities because such
securities are generally unsecured and are often subordinated to
other creditors. Further, if the issuer of a lower-quality or
comparable unrated security defaulted, the Balanced Fund might
incur additional expenses to seek recovery. Periods of economic
uncertainty and changes would also generally result in increased
volatility in the market prices of these securities and thus in
the Balanced Fund's net asset value.
As previously stated, the value of a lower-quality or
comparable unrated security will decrease in a rising interest
rate market and accordingly, so will the Balanced Fund's net
asset value. If the Balanced Fund experiences unexpected net
redemptions in such a market, it may be forced to liquidate a
portion of its portfolio securities without regard to their
investment merits. Due to the limited liquidity of lower-quality
and comparable unrated securities (discussed below), the Balanced
Fund may be forced to liquidate these securities as a substantial
discount. Any such liquidation would force the Balanced Fund to
sell the more liquid portion of its portfolio.
Payment Expectations. Lower-quality and comparable unrated
securities typically contain redemption, call or prepayment
provisions which permit the issuer of such securities containing
such provisions to, at its discretion, redeem the securities.
During periods of falling interest rates, issuers of these
securities are likely to redeem or prepay the securities and
refinance them with debt securities with a lower interest rate.
To the extent an issuer is able to refinance the securities, or
otherwise redeem them, the Balanced Fund may have to replace the
securities with a lower yielding security, which would result in
a lower return for the Balanced Fund.
Credit Ratings. Credit ratings issued by credit rating
agencies are designed to evaluate the safety of principal and
interest payments of rated securities. They do not, however,
evaluate the market value risk of lower-quality securities and,
therefore, may not fully reflect the true risks of an investment.
In addition, credit rating agencies may or may not make timely
changes in a rating to reflect changes in the economy or in the
condition of the issuer that affect the market value of the
security. Consequently, credit ratings are used only as a
preliminary indicator of investment quality. Investments in
lower-quality and comparable unrated obligations will be more
dependent on the Adviser's credit analysis than would be the case
with investments in investment-grade debt obligations. The
Adviser employs its own credit research and analysis, which
includes a study of existing debt, capital structure, ability to
service debt and to pay dividends, the issuer's sensitivity to
economic conditions, its operating history and the current trend
of earnings. The Adviser continually monitors the investments in
the Balanced Fund's portfolio and carefully evaluates whether to
dispose of or to retain lower-quality and comparable unrated
securities whose credit ratings or credit quality may have
changed.
Liquidity and Valuation. The Balanced Fund may have
difficulty disposing of certain lower-quality and comparable
unrated securities because there may be a thin trading market for
such securities. Because not all dealers maintain markets in all
lower-quality and comparable unrated securities, there is no
established retail secondary market for many of these securities.
The Balanced Fund anticipates that such securities could be sold
only to a limited number of dealers or institutional investors.
To the extent a secondary trading market does exist, it is
generally not as liquid as the secondary market for higher-rated
securities. The lack of a liquid secondary market may have an
adverse impact on
<PAGE>
the market price of the security. As a result,
the Balanced Fund's asset value and ability to dispose of
particular securities, when necessary to meet the Balanced Fund's
liquidity needs or in response to a specific economic event, may
be impacted. The lack of a liquid secondary market for certain
securities may also make it more difficult for the Balanced Fund
to obtain accurate market quotations for purposes of valuing the
Balanced Fund's portfolio. Market quotations are generally
available on many lower-quality and comparable unrated issues
only from a limited number of dealers and may not necessarily
represent firm bids of such dealers or prices for actual sales.
During periods of thin trading, the spread between bid and asked
prices is likely to increase significantly. In addition, adverse
publicity and investor perceptions, whether or not based on
fundamental analysis, may decrease the values and liquidity of
lower-quality and comparable unrated securities, especially in a
thinly traded market.
Legislation. Legislation may be adopted, from time to time,
designed to limit the use of certain lower-quality and comparable
unrated securities by certain issuers. It is anticipated that if
additional legislation is enacted or proposed, it could have a
material affect on the value of these securities and the
existence of a secondary trading market for the securities.
Warrants
Each Fund may invest in warrants, valued at the lower of
cost or market value, if, after giving effect thereto, not more
than 5% of its net assets will be invested in warrants other than
warrants acquired in units or attached to other securities.
Warrants are options to purchase equity securities at a specific
price for a specific period of time. They do not represent
ownership of the securities but only the right to buy them.
Investing in warrants is purely speculative in that they have no
voting rights, pay no dividends and have no rights with respect
to the assets of the corporation issuing them. In addition, the
value of a warrant does not necessarily change with the value of
the underlying securities, and a warrant ceases to have value if
it is not exercised prior to its expiration date.
Short Sales Against the Box
Each Fund may sell securities short against the box to hedge
unrealized gains on portfolio securities. Selling securities
short against the box involves selling a security that a Fund
owns or has the right to acquire, for delivery at a specified
date in the future. If a Fund sells securities short against the
box, it may protect unrealized gains, but will lose the
opportunity to profit on such securities if the price rises.
DIRECTORS AND OFFICERS
Under the laws of the State of Maryland, the Board of
Directors of the Corporation is responsible for managing its
business and affairs. The directors and officers of the
Corporation, together with information as to their principal
business occupations during the last five years, and other
information, are shown below. Each director who is deemed an
"interested person," as defined in the 1940 Act, is indicated by
an asterisk.
*J. Kevin Callaghan, a Director and Co-Chairman of the
Corporation.
Mr. Callaghan, 41 years old, received a Bachelor of Arts
degree in economics and finance from the University of Puget
Sound in 1981. Mr. Callaghan has been with the Adviser since
1983 and is currently a portfolio manager with the Adviser.
*Steven C. Phelps, a Director and Co-Chairman of the
Corporation.
Mr. Phelps, 38 years old, graduated magna cum laude from
Williams College in 1983 with a degree in political economy and
was awarded a Fulbright Scholarship at the University of
Frankfurt, Germany. Mr. Phelps joined the Adviser in 1986 after
working for two years with PACCAR, Inc. as an analyst in the
treasury department of the finance subsidiary and as an
independent researcher in the field of transportation economics.
Mr. Phelps is a Chartered Financial Analyst and a Chartered
Investment Counselor.
<PAGE>
Frank S. Bayley, a Director of the Corporation since June 1998.
Mr. Bayley, 60 years old, earned a Bachelor of Arts degree
and a law degree from Harvard University. Mr. Bayley has been a
partner with the law firm of Baker & McKenzie since 1986. Mr.
Bayley serves as director and co-chairman of C. D. Stimson
Company, a private investment company. In addition, Mr. Bayley
has been a Trustee of AIM Global Mutual Funds (formerly GT Global
Mutual Funds) since 1985.
Madelyn B. Smith, a Director of the Corporation since June 1998.
Ms. Smith, 68 years old, received a Bachelor of Arts degree
from the University of Puget Sound in 1970. Prior to retiring,
Ms. Smith worked as an analyst and portfolio manager with the
Frank Russell Company from 1971 to 1997.
Graham S. Anderson, a Director of the Corporation since July 1999.
Mr. Anderson, 66 years old, received a Bachelor of Arts from
the University of Washington. Mr. Anderson has served as a
director of Tully's Coffee Co. since 1992. From 1987 until 1994,
Mr. Anderson served as the Chairman and Chief Executive Officer
of Pettit-Morry Co., an insurance broker, and prior thereto
served as President and Chief Executive Officer of Pettit-Morry
Co. In addition, Mr. Anderson served as a director of Marker
International, a ski equipment manufacturer, from 1985 to 1999,
director of Commerce Bank Corporation from 1991 to 1999, director
of Gray's Harbor Paper Company from 1992 to 1998 and director of
Acordia Northwest, Inc., the successor to Pettit-Morry Co., until
1998. Mr. Anderson was also the Chairman of the National
Association of Insurance Brokers and Alberg Holding Co.
Otis P. Heald III (Tres), President of the Corporation.
Mr. Heald, 34 years old, earned a Bachelor of Science degree
in finance and real estate from San Francisco State University in
1989 and a Master's of Business Administration in finance from
the University of Southern California in 1995. Prior to joining
the Adviser as a portfolio manager in 1996, Mr. Heald was a
portfolio manager and securities analyst at Wells Fargo/First
Interstate Capital Management. Mr. Heald worked as a credit
analyst and commercial lender for four years before entering the
investment management industry. Mr. Heald is a Chartered
Financial Analyst.
Lisa P. Guzman, Treasurer and Secretary of the Corporation.
Ms. Guzman, 44 years old, graduated with honors from the
University of Washington in 1977 with a Bachelor of Arts degree
and from the University of Puget Sound in 1983 with a Master's of
Business Administration. Prior to joining the Adviser in 1990,
Ms. Guzman worked for 12 years at PACCAR, Inc., the last four
years as cash manager of its finance subsidiary.
The address for Messrs. Callaghan, Phelps and Heald and Ms.
Guzman is Badgley, Phelps and Bell, Inc., 1420 Fifth Avenue,
Suite 4400, Seattle, Washington, 98101. The address for Mr.
Bayley is Baker & McKenzie, Two Embarcadero Center, 24th Floor,
San Francisco, California 94111. The address for Ms. Smith is 9
Forest Glen Drive SW, Tacoma, Washington 98498. The address for
Mr. Anderson is Graco Investments Inc., 520 Pike Street, 20th
Floor, Seattle, Washington 98101.
As of August 31, 1999, officers and directors of the
Corporation beneficially owned 9.9% of the Growth Fund's then
outstanding shares and 3.5% of the Balanced Fund's then
outstanding shares. Directors and officers of the Corporation
who are also officers, directors, employees, or shareholders of
the Adviser do not receive any compensation from any of the Funds
for serving as directors or officers.
The following table provides information relating to
compensation paid to directors of the Corporation for their
services as such for the period June 25, 1998 to May 31, 1999:
<PAGE>
Name Cash Other
Compensation(1) Compensation Total
J. Kevin Callaghan $ 0 $0 $ 0
Steven C. Phelps $ 0 $0 $ 0
Frank S. Bayley $1,000 $0 $1,000
Madelyn B. Smith $1,000 $0 $1,000
Graham S. Anderson(2) $ 0 $0 $ 0
All directors as a $2,000 $0 $2,000
group (5 persons)
____________________
(1) Each director who is not deemed an "interested person" as
defined in the 1940 Act, receives $250 for each Board of
Directors meeting attended by such person and reasonable expenses
incurred in connection therewith. The Board held four meetings
during fiscal 1999.
(2) Mr. Anderson was elected to the Board of Directors in July
1999. Accordingly, he did not receive any compensation from any
of the Funds during fiscal 1999.
PRINCIPAL SHAREHOLDERS
As of August 31, 1999, the following persons owned of record
or are known by the Corporation to own of record or beneficially
5% or more of the outstanding shares of each Fund:
Name and Address Fund No. Shares Percentage
Charles Schwab & Co. Growth 172,882 25.4%
Special Custody Account for the Balanced 772,801 45.0%
Exclusive Benefit of Customers
101 Montgomery Street
San Francisco, CA 94104-4122
Montevilla Farm Limited Partnership Growth 34,695 5.1%
P.O. Box 1863
Bellevue, WA 98009-1863
Based on the foregoing, as of August 31, 1999, the
Corporation was not aware of any one security holder beneficially
owning 25% or more of a Fund's voting securities.
INVESTMENT ADVISER
Badgley, Phelps and Bell, Inc. (the "Adviser") is the
investment adviser to the Funds. The Adviser is controlled by
several of its officers and directors.
The investment advisory agreement between the Corporation
and the Adviser dated as of June 23, 1998 (the "Advisory
Agreement") has an initial term of two years and thereafter is
required to be approved annually by the Board of Directors of the
Corporation or by vote of a majority of each of the Fund's
outstanding voting securities (as defined in the 1940 Act). Each
annual renewal must also be approved by the vote of a majority of
the Corporation's directors who are not parties to the Advisory
Agreement or interested persons of any such party, cast in person
at a meeting called for the purpose of voting on such approval.
The Advisory Agreement was approved by the Board of Directors,
including a majority of the disinterested directors on June 23,
1998 and by the initial shareholders of each Fund on
<PAGE>
June 23, 1998. The Advisory Agreement is terminable without penalty,
on 60 days' written notice by the Board of Directors of the
Corporation, by vote of a majority of each of the Fund's
outstanding voting securities or by the Adviser, and will
terminate automatically in the event of its assignment.
Under the terms of the Advisory Agreement, the Adviser
manages the Funds' investments and business affairs, subject to
the supervision of the Corporation's Board of Directors. At its
expense, the Adviser provides office space and all necessary
office facilities, equipment and personnel for managing the
investments of the Funds. As compensation for its services, the
Growth Fund pays the Adviser an annual management fee of 1.00% of
its average daily net assets, and the Balanced Fund pays the
Adviser an annual management fee of 0.90% of its average daily
net assets. The advisory fee is accrued daily and paid monthly.
The organizational expenses of each Fund were advanced by the
Adviser and will be reimbursed by the Funds over a period of not
more than 60 months.
For the fiscal year ended May 31, 1999, the Adviser waived
its management fee and reimbursed the Funds' other expenses so
that the Growth Fund's total operating expenses (on an annual
basis) did not exceed 1.50% of its average daily net assets and
that the Balanced Fund's total operating expenses (on an annual
basis) did not exceed 1.30% of its average daily net assets. The
Adviser has contractually agreed that until September 30, 2000,
the Adviser will continue to waive its management fee and/or
reimburse the Fund's operating expenses to the extent necessary
to ensure that (i) the total operating expenses (on an annual
basis) for the Growth Fund do not exceed 1.50% of average daily
net assets, and (ii) the total operating expenses (on an annual
basis) for the Balanced Fund do not exceed 1.30% of the average
daily net assets. After such date, the Adviser may from time to
time voluntarily waive all or a portion of its fee and/or absorb
expenses for the Funds. Any waiver of fees or absorption of
expenses will be made on a monthly basis and, with respect to the
latter, will be paid to the Funds by reduction of the Adviser's
fee. Any such waiver/absorption is subject to later adjustment
during the term of the Advisory Agreement to allow Adviser to
recoup amounts waived/absorbed to the extend actual fees and
expenses for a period are less than the expense limitation caps,
provided, however, that, the Adviser shall only be entitled to
recoup such amounts for a maximum period of three years from the
date such amount was waived or reimbursed. For the period June
25, 1998 to May 31, 1999, the Funds did not pay a management fee
to the Adviser because the Adviser waived its entire management
fee. If the Adviser had not agreed to waive its management fee,
the Adviser would have received $31,437 and $53,223 from the
Growth Fund and Balanced Fund, respectively, for its investment
advisory services.
For more information on the Adviser, see the Adviser's
website at http://www.badgley.com. Information contained in the
Adviser's website is not deemed to be a part of the Funds'
Prospectus or this Statement of Additional Information.
FUND TRANSACTIONS AND BROKERAGE
Under the Advisory Agreement, the Adviser, in its capacity
as portfolio manager, is responsible for decisions to buy and
sell securities for the Funds and for the placement of the Funds'
securities business, the negotiation of the commissions to be
paid on such transactions and the allocation of portfolio
brokerage business. The Adviser seeks to obtain the best
execution at the best security price available with respect to
each transaction. The best price to the Funds means the best net
price without regard to the mix between purchase or sale price
and commission, if any. While the Adviser seeks reasonably
competitive commission rates, the Funds do not necessarily pay
the lowest available commission. Brokerage will not be allocated
based on the sale of a Fund's shares.
The Adviser has adopted procedures that provide generally
for the Adviser to seek to batch orders for the purchase or sale
of the same security for the Funds and other advisory accounts
(collectively, "accounts"). The Adviser will batch orders when
it deems it to be appropriate and in the best interest of the
accounts. When a batched order is filled in its entirety, each
participating account will participate at the average share price
for the batched order on the same business day, and transaction
costs will be shared pro rata based on each account's
participation in the batched order. When a batched order is only
partially filled, the securities purchased will be allocated on a
pro rata basis to each account participating in the batched order
based upon the initial amount requested for the account, subject
to certain exceptions, and each participating account will
participate at the average share price for the batched order on
the same business day. With respect to that portion of the order
not filled, the Adviser will reevaluate whether to place another
order and on what terms for the same securities or whether an
order should be placed for different securities.
<PAGE>
Section 28(e) of the Securities Exchange Act of 1934, as
amended, ("Section 28(e)"), permits an investment adviser, under
certain circumstances, to cause an account to pay a broker or
dealer who supplies brokerage and research services a commission
for effecting a transaction in excess of the amount of commission
another broker or dealer would have charged for effecting the
transaction. Brokerage and research services include (a)
furnishing advice as to the value of securities, the advisability
of investing, purchasing or selling securities and the
availability of securities or purchasers or sellers of
securities; (b) furnishing analyses and reports concerning
issuers, industries, securities, economic factors and trends,
portfolio strategy and the performance of accounts; and (c)
effecting securities transactions and performing functions
incidental thereto (such as clearance, settlement, and custody).
In selecting brokers or dealers, the Adviser considers
investment and market information and other research, such as
economic, securities and performance measurement research
provided by such brokers or dealers and the quality and
reliability of brokerage services, including execution
capability, performance and financial responsibility.
Accordingly, the commissions charged by any such broker or dealer
may be greater than the amount another firm might charge if the
Adviser determines in good faith that the amount of such
commissions is reasonable in relation to the value of the
research information and brokerage services provided by such
broker or dealer to the Funds. The Adviser believes that the
research information received in this manner provides the Funds
with benefits by supplementing the research otherwise available
to the Funds. Such higher commissions will not be paid by the
Funds unless (a) the Adviser determines in good faith that the
amount is reasonable in relation to the services in terms of the
particular transaction or in terms of the Adviser's overall
responsibilities with respect to the accounts, including the
Funds, as to which it exercises investment discretion; (b) such
payment is made in compliance with the provisions of Section
28(e) and other applicable state and federal laws; and (c) in the
opinion of the Adviser, the total commissions paid by the Funds
will be reasonable in relation to the benefits to the Funds over
the long term.
The aggregate amount of brokerage commissions paid by the
Growth Fund and the Balanced Fund for the period June 25, 1998 to
May 31, 1999 were $8,180 and $10,395, respectively. For the
period June 25, 1998 to May 31, 1999, the Funds did not pay
brokerage commissions with respect to transactions for which
research services were provided. During the period June 25, 1998
to May 31, 1999, the Funds did not acquire any stock of their
regular brokers or dealers.
The Adviser places portfolio transactions for other advisory
accounts managed by the Adviser. Research services furnished by
firms through which the Funds effect their securities
transactions may be used by the Adviser in servicing all of its
accounts; not all of such services may be used by the Adviser in
connection with the Funds. The Adviser believes it is not
possible to measure separately the benefits from research
services to each of the accounts (including the Funds) managed by
it. Because the volume and nature of the trading activities of
the accounts are not uniform, the amount of commissions in excess
of those charged by another broker paid by each account for
brokerage and research services will vary. However, the Adviser
believes such costs to the Funds will not be disproportionate to
the benefits received by the Funds on a continuing basis. The
Adviser seeks to allocate portfolio transactions equitably
whenever concurrent decisions are made to purchase or sell
securities by the Funds and another advisory account. In some
cases, this procedure could have an adverse effect on the price
or the amount of securities available to the Funds. In making
such allocations between a Fund and other advisory accounts, the
main factors considered by the Adviser are the respective
investment objectives, the relative size of portfolio holdings of
the same or comparable securities, the availability of cash for
investment and the size of investment commitments generally held.
CUSTODIAN
As custodian of the Funds' assets, Firstar Bank Milwaukee,
N.A. ("Firstar Bank"), 777 East Wisconsin Avenue, Milwaukee,
Wisconsin 53202, has custody of all securities and cash of each
Fund, delivers and receives payment for portfolio securities
sold, receives and pays for portfolio securities purchased,
collects income from investments and performs other duties, all
as directed by the officers of the Corporation.
TRANSFER AGENT AND DIVIDEND-DISBURSING AGENT
Firstar Mutual Fund Services, LLC ("Firstar"), Third Floor,
615 East Michigan Street, Milwaukee, Wisconsin 53202, acts as
transfer agent and dividend-disbursing agent for the Funds.
Firstar is compensated based on an annual fee per open account of
$14 (subject to a minimum annual fee of $16,250 per Fund) plus
out-of-pocket expenses, such
<PAGE>
as postage and printing expenses in
connection with shareholder communications. Firstar also
receives an annual fee per closed account of $14.
From time to time, the Corporation, on behalf of the Funds,
directly or indirectly through arrangements with the Adviser, the
Distributor (as defined below) or Firstar, may pay amounts to
third parties that provide transfer agent type services and other
administrative services relating to the Funds to persons who
beneficially have interests in a Fund, such as participants in
401(k) plans. These services may include, among other things,
sub-accounting services, transfer agent type activities,
answering inquiries relating to the Funds, transmitting proxy
statements, annual reports, updated prospectuses, other
communications regarding the Funds and related services as Funds
or beneficial owners may reasonably request. In such cases, the
Funds will not pay fees based on the number of beneficial owners
at a rate that is greater than the rate the Funds are currently
paying Firstar for providing these services to the Funds'
shareholders (i.e., $14 per account plus expenses).
ADMINISTRATOR
Pursuant to a Fund Administration Servicing Agreement and a
Fund Accounting Servicing Agreement, Firstar also performs
accounting and certain compliance and tax reporting functions for
the Corporation. For these services, Firstar receives from the
Corporation out-of-pocket expenses plus the following aggregate
annual fees, computed daily and payable monthly, based on each
Fund's aggregate average net assets:
Administrative Services Fees
First $200 million of average net assets .06 of 1%*
Next $500 million of average net assets .05 of 1%
Average net assets in excess of$700 million .03 of 1%
_____________________________
* Subject to a minimum fee of $30,000 per Fund.
Accounting Services Fees
Growth Fund Balanced Fund
First $40 million of average net assets $22,000 $23,500
Next $200 million of average net assets .01 of 1% .015 of 1%
Average net assets in excess of $240 million .005 of 1% .01 of 1%
For the period June 25, 1998 to May 31, 1999, Firstar
received $27,501 and $27,501 from the Growth Fund and the
Balanced Fund, respectively, under the Fund Administration
Servicing Agreement, and $21,996 and $23,382 from the Growth Fund
and the Balanced Fund, respectively, under the Fund Accounting
Servicing Agreement.
DISTRIBUTOR AND PLAN OF DISTRIBUTION
Distributor
Under a distribution agreement dated June 23, 1998 (the
"Distribution Agreement"), Rafferty Capital Markets, Inc. (the
"Distributor"), 1311 Mamaroneck Avenue, White Plains, New York
10605, acts as principal distributor of the Funds' shares. The
Distribution Agreement provides that the Distributor will use its
best efforts to distribute the Funds' shares, which shares are
offered for sale by the Funds continuously at net asset value per
share without the imposition of a sales charge. Pursuant to the
terms of the Distribution Agreement, the Distributor receives
from the Corporation out-of-pocket expenses plus an annual fee
equal to the greater of (i) $18,000 or (ii) .01% of each Fund's
net assets, computed daily and payable monthly. All or a portion
of the distribution and shareholder servicing fee may be used by
the Distributor to pay such expenses under the distribution and
shareholder servicing plan discussed below.
<PAGE>
Distribution and Shareholder Servicing Plan
The Corporation, on behalf of the Funds, has adopted a plan
pursuant to Rule 12b-1 under the 1940 Act (the "12b-1 Plan"),
which requires it to pay the Distributor, in its capacity as the
principal distributor of Fund shares, a distribution and
shareholder servicing fee of 0.25% per annum of each Fund's
average daily net assets. Under the terms of the 12b-1 Plan, the
Distributor is authorized to, in turn, pay all or a portion of
this fee to any securities dealer, financial institution or any
other person (the "Recipient") who renders assistance in
distributing or promoting the sale of Fund shares, or who
provides certain shareholder services to Fund shareholders,
pursuant to a written agreement (the "Related Agreement").
Payments under the 12b-1 Plan are based upon a percentage of
average daily net assets attributable to each Fund regardless of
the amounts actually paid or expenses actually incurred by the
Distributor, however, in no event, may such payments exceed the
maximum allowable fee. It is, therefore, possible that the
Distributor may realize a profit in a particular year as a result
of these payments. The 12b-1 Plan has the effect of increasing
the Fund's expenses from what they would otherwise be. The Board
of Directors reviews each Fund's distribution and shareholder
servicing fee payments in connection with their determination as
to the continuance of the 12b-1 Plan.
The 12b-1 Plan, including a form of the Related Agreement,
has been unanimously approved by a majority of the Board of
Directors of the Corporation, and of the members of the Board who
are not "interested persons" of the Corporation as defined in the
1940 Act and who have no direct or indirect financial interest in
the operation of the 12b-1 Plan or any related agreements (the
"Disinterested Directors") voting separately. The 12b-1 Plan,
and any Related Agreement which is entered into, will continue in
effect for a period of more than one year only so long as its
continuance is specifically approved at least annually by a vote
of a majority of the Corporation's Board of Directors and of the
Disinterested Directors, cast in person at a meeting called for
the purpose of voting on the 12b-1 Plan or the Related Agreement,
as applicable. In addition, the 12b-1 Plan and any Related
Agreement may be terminated with respect to either or both Funds
at any time, without penalty, by vote of a majority of the
outstanding voting securities of the applicable Fund, or by vote
of a majority of Disinterested Directors (on not more than 60
days' written notice in the case of the Related Agreement only).
Payment of the distribution and shareholder servicing fee is to
be made monthly. The Distributor will provide reports to the
Board of Directors of the Corporation of all recipients of
payments made (and the purposes for which amounts were paid)
pursuant to the 12b-1 Plan.
Interests of Certain Persons
With the exception of the Adviser, in its capacity as the
Funds' investment adviser, and the Distributor, in its capacity
as principal underwriter of Fund shares, no "interested person"
of the Funds, as defined in the 1940 Act, and no director of the
Corporation who is not an "interested person" has or had a direct
or indirect financial interest in the 12b-1 Plan or any Related
Agreement.
Anticipated Benefits to the Funds
The Board of Directors considered various factors in
connection with its decision to approve the 12b-1 Plan,
including: (a) the nature and causes of the circumstances which
make implementation of the 12b-1 Plan necessary and appropriate;
(b) the way in which the 12b-1 Plan would address those
circumstances, including the nature and potential amount of
expenditures; (c) the nature of the anticipated benefits; (d) the
merits of possible alternative plans or pricing structures; (e)
the relationship of the 12b-1 Plan to other distribution efforts
of the Funds; and (f) the possible benefits of the 12b-1 Plan to
any other person relative to those of the Funds.
Based upon its review of the foregoing factors and the
material presented to it, and in light of its fiduciary duties
under relevant state law and the 1940 Act, the Board of Directors
determined, in the exercise of its business judgment, that the
12b-1 Plan was reasonably likely to benefit the Funds and their
respective shareholders in at least one or several potential
ways. Specifically, the Board concluded that the Distributor and
any Recipients operating under Related Agreements would have
little or no incentive to incur promotional expenses on behalf of
a Fund if a 12b-1 Plan were not in place to reimburse them, thus
making the adoption of such 12b-1 Plan important to the initial
success and thereafter, continued viability of the Funds. In
addition, the Board determined that the payment of distribution
fees to these persons should motivate them to provide an enhanced
level of service to Fund shareholders, which would, of course,
benefit such shareholders. Finally, the adoption of the 12b-1
Plan would help to increase net
<PAGE>
assets under management in a
relatively short amount of time, given the marketing efforts on
the part of the Distributor and Recipients to sell Fund shares,
which should result in certain economies of scale.
While there is no assurance that the expenditure of Fund
assets to finance distribution of Fund shares will have the
anticipated results, the Board of Directors believes there is a
reasonable likelihood that one or more of such benefits will
result, and since the Board will be in a position to monitor the
distribution and shareholder servicing expenses of the Funds, it
will be able to evaluate the benefit of such expenditures in
deciding whether to continue the 12b-1 Plan.
Amounts Incurred Under the Plan
For the period June 25, 1998 to May 31, 1999, pursuant to
the terms of the 12b-1 Plan, the Growth Fund expensed $7,859,
representing 0.25% per annum of its average daily net assets. Of
this amount, $704.32 was spent on advertising, $84.58 on printing
and mailing prospectuses to other than current shareholders and
$5,589.82 was spent on compensation to broker-dealers. The
Distributor received $5,147.16 of the amounts incurred under the
12b-1 Plan with respect to the Growth Fund. For the same period,
pursuant to the terms of the 12b-1 Plan, the Balanced Fund
expensed $14,784, representing 0.25% per annum of its average
daily net assets. Of this amount, $1,721.87 was spent on
advertising, $69.66 on printing and mailing to other than current
shareholders and $6,067.27 was spent on compensation to broker-
dealers. The Distributor received $11,040.84 of the amounts
incurred under the 12b-1 Plan with respect to the Balanced Fund.
PURCHASE, REDEMPTION, EXCHANGE AND PRICING OF SHARES
Financial Intermediaries
If you purchase or redeem shares of a Fund through a
financial intermediary (such as a broker-dealer), certain
features of the Fund relating to such transactions may not be
available or may be modified. In addition, certain operational
policies of a Fund, including those related to settlement and
dividend accrual, may vary from those applicable to direct
shareholders of a Fund and may vary among intermediaries. You
should consult your financial intermediary for more information
regarding these matters. Refer to "Transfer Agent and Dividend-
Disbursing Agent" for information regarding certain fees paid by
the Corporation to financial intermediaries. In addition,
financial intermediaries may receive compensation pursuant to the
12b-1 Plan under a Related Agreement and may receive additional
compensation in excess of such amounts from the Adviser. Certain
financial intermediaries may charge you an advisory, transaction
or other fee for their services. You will not be charged for
such fees if you purchase or redeem your Fund shares directly
from a Fund without the intervention of a financial intermediary.
Automatic Investment Plan
The Automatic Investment Plan ("AIP") allows you to make
regular systematic investments in one or more of the Funds from
your bank checking or NOW account. The minimum initial
investment for investors using the AIP is $10,000 with a monthly
minimum investment of $250. To establish the AIP, complete the
appropriate section in the shareholder application. Under
certain circumstances (such as discontinuation of the AIP before
a Fund's minimum initial investment is reached), the Corporation
reserves the right to close the investor's account. Prior to
closing any account for failure to reach the minimum initial
investment, the Corporation will give the investor written notice
and 60 days in which to reinstate the AIP or otherwise reach the
minimum initial investment. You should consider your financial
ability to continue in the AIP until the minimum initial
investment amount is met because the Corporation has the right to
close an investor's account for failure to reach the minimum
initial investment. Such closing may occur in periods of
declining share prices.
Under the AIP, you may choose to make monthly investments on
the days of your choosing (or the next business day thereafter)
from your financial institution in amounts of $250 or more.
There is no service fee for participating in the AIP. However, a
service fee of $20 will be deducted from your Fund account for
any AIP purchase that does not clear due to insufficient funds
or, if prior to notifying the Corporation in writing or by
telephone of your intention to terminate the plan, you close your
bank account or in any manner prevent withdrawal of funds from
the designated checking or NOW account. You can set up the AIP
with any financial institution that is a member of ACH.
<PAGE>
The AIP is a method of using dollar cost averaging which is
an investment strategy that involves investing a fixed amount of
money at a regular time interval. However, a program of regular
investment cannot ensure a profit or protect against a loss from
declining markets. By always investing the same amount, you will
be purchasing more shares when the price is low and fewer shares
when the price is high. Since such a program involves continuous
investment regardless of fluctuating share values, you should
consider your financial ability to continue the program through
periods of low share price levels.
Individual Retirement Accounts
In addition to purchasing Fund shares as described in the
Prospectus under "How to Purchase Shares," individuals may
establish their own tax-sheltered IRAs. The Funds offer two
types of IRAs, including the Traditional IRA, that can be adopted
by executing the appropriate Internal Revenue Service ("IRS")
Form.
Traditional IRA. In a Traditional IRA, amounts contributed
to the IRA may be tax deductible at the time of contribution
depending on whether the investor is an "active participant" in
an employer-sponsored retirement plan and the investor's income.
Distributions from a Traditional IRA will be taxed at
distribution except to the extent that the distribution
represents a return of the investor's own contributions for which
the investor did not claim (or was not eligible to claim) a
deduction. Distributions prior to age 59-1/2 may be subject to
an additional 10% tax applicable to certain premature
distributions. Distributions must commence by April 1 following
the calendar year in which the investor attains age 70-1/2.
Failure to begin distributions by this date (or distributions
that do not equal certain minimum thresholds) may result in
adverse tax consequences.
Roth IRA. In a Roth IRA (sometimes known as the American
Dream IRA), amounts contributed to the IRA are taxed at the time
of contribution, but distributions from the IRA are not subject
to tax if the investor has held the IRA for certain minimum
periods of time (generally, until age 59-1/2). Investors whose
income exceeds certain limits are ineligible to contribute to a
Roth IRA. Distributions that do not satisfy the requirements for
tax-free withdrawal are subject to income taxes (and possibly
penalty taxes) to the extent that the distribution exceeds the
investor's contributions to the IRA. The minimum distribution
rules applicable to Traditional IRAs do not apply during the
lifetime of the investor. Following the death of the investor,
certain minimum distribution rules apply.
For Traditional and Roth IRAs, the maximum annual
contribution generally is equal to the lesser of $2,000 or 100%
of the investor's compensation (earned income). An individual
may also contribute to a Traditional IRA or Roth IRA on behalf of
his or her spouse provided that the individual has sufficient
compensation (earned income). Contributions to a Traditional IRA
reduce the allowable contributions under a Roth IRA, and
contributions to a Roth IRA reduce the allowable contribution to
a Traditional IRA.
Simplified Employee Pension Plan. A Traditional IRA may
also be used in conjunction with a Simplified Employee Pension
Plan ("SEP-IRA"). A SEP-IRA is established through execution of
Form 5305-SEP together with a Traditional IRA established for
each eligible employee. Generally, a SEP-IRA allows an employer
(including a self-employed individual) to purchase shares with
tax deductible contributions not exceeding annually for any one
participant 15% of compensation (disregarding for this purpose
compensation in excess of $160,000 per year). The $160,000
compensation limit applies for 1999 and is adjusted periodically
for cost of living increases. A number of special rules apply to
SEP Plans, including a requirement that contributions generally
be made on behalf of all employees of the employer (including for
this purpose a sole proprietorship or partnership) who satisfy
certain minimum participation requirements.
SIMPLE IRA. An IRA may also be used in connection with a
SIMPLE Plan established by the investor's employer (or by a self-
employed individual). When this is done, the IRA is known as a
SIMPLE IRA, although it is similar to a Traditional IRA with the
exceptions described below. Under a SIMPLE Plan, the investor
may elect to have his or her employer make salary reduction
contributions of up to $6,000 per year to the SIMPLE IRA. The
$6,000 limit applies for 1999 and is adjusted periodically for
cost of living increases. In addition, the employer will
contribute certain amounts to the investor's SIMPLE IRA, either
as a matching contribution to those participants who make salary
reduction contributions or as a non-elective contribution to all
eligible participants whether or not making salary reduction
contributions. A number of special rules apply to SIMPLE Plans,
including (1) a SIMPLE
<PAGE>
Plan generally is available only to
employers with fewer than 100 employees; (2) contributions must
be made on behalf of all employees of the employer (other than
bargaining unit employees) who satisfy certain minimum
participation requirements; (3) contributions are made to a
special SIMPLE IRA that is separate and apart from the other IRAs
of employees; (4) the distribution excise tax (if otherwise
applicable) is increased to 25% on withdrawals during the first
two years of participation in a SIMPLE IRA; and (5) amounts
withdrawn during the first two years of participation may be
rolled over tax-free only into another SIMPLE IRA (and not to a
Traditional IRA or to a Roth IRA). A SIMPLE IRA is established
by executing Form 5304-SIMPLE together with an IRA established
for each eligible employee.
Under current IRS regulations, all IRA applicants must be
furnished a disclosure statement containing information specified
by the IRS. Applicants generally have the right to revoke their
account within seven days after receiving the disclosure
statement and obtain a full refund of their contributions. The
custodian may, in its discretion, hold the initial contribution
uninvested until the expiration of the seven-day revocation
period. The Custodian does not anticipate that it will exercise
its discretion but reserves the right to do so.
Systematic Withdrawal Plan
You may set up automatic withdrawals from your account at
regular intervals. To begin distributions, you must have an
initial balance of $10,000 in your account and withdraw at least
$250 per payment. To establish the systematic withdrawal plan
("SWP"), you must complete the appropriate section in the
shareholder application. Redemptions will take place on a
monthly, quarterly, semi-annual or annual basis (or the following
business day) as indicated on your shareholder application. You
may vary the amount or frequency of withdrawal payments or
temporarily discontinue them by calling 1-877-BADGLEY (1-877-223-
4539). Depending upon the size of the account and the
withdrawals requested (and fluctuations in the net asset value of
the shares redeemed), redemptions for the purpose of satisfying
such withdrawals may reduce or even exhaust your account. If the
amount remaining in your account is not sufficient to meet a plan
payment, the remaining amount will be redeemed and the SWP will
be terminated.
Exchange Privilege
Fund to Fund Exchange. You may exchange your shares in a
Fund for shares in any other Fund of the Corporation at any time
by written request or by telephone exchange if you have
authorized this privilege in the shareholder application.
Exchange requests are available for exchanges of $1,000 or more.
The value of the shares to be exchanged and the price of the
shares being purchased will be the net asset value next
determined after receipt of instructions for exchange. No sales
charge is imposed on exchanges between Funds; however, a $5
service fee will be charged for each telephone exchange request
(no charge is imposed with respect to written exchange requests).
Exchange requests should be directed to the following address:
By Mail In Person or By Overnight Mail
Firstar Mutual Fund Services, LLC Firstar Mutual Fund Services, LLC
P.O. Box 701 Third Floor
Milwaukee, Wisconsin 53201-0701 615 East Michigan Street
Milwaukee, Wisconsin 53202
To effect a telephone exchange, you may call 1-877-BADGLEY
(1-877-223-4539). Exchange requests may be subject to
limitations, including those relating to frequency, that may be
established from time to time to ensure that such exchanges are
not disadvantageous to the Funds or their investors. The
Corporation reserves the right to modify or terminate the
exchange privilege upon 60 days' written notice to each
shareholder prior to the modification or termination taking
effect. The exchange privilege is only available in states where
the securities are registered.
Money Market Exchange. As a service to our shareholders,
the Corporation has established a program whereby our
shareholders can exchange shares of any one of the Funds for
shares of the Firstar Money Market Funds (the "Firstar Funds").
Exchange requests are available for exchanges of $1,000 or more.
The Firstar Funds are no-load money market funds managed by an
affiliate of Firstar. The Firstar Funds are unrelated to the
Corporation or any of the
<PAGE>
Funds. However, the Distributor may be
compensated by the Firstar Funds for servicing and related
services provided in connection with exchanges made by
shareholders of the Funds. This exchange privilege is a
convenient way to buy shares in money market funds in order to
respond to changes in your goals or in market conditions. Before
exchanging into the Firstar Funds, please read the applicable
prospectus, which may be obtained by calling 1-877-BADGLEY (1-877-
223-4539). As noted above, there is no charge for written
exchange requests. Firstar will, however, charge a $5.00 fee for
each exchange transaction that is executed via the telephone.
An exchange from one Fund to another, including the Firstar
Funds, is treated the same as an ordinary sale and purchase for
federal income tax purposes and you will realize a capital gain
or loss. An exchange is not a tax-free transaction.
Pricing of Shares
Shares of the Funds are sold on a continual basis at the net
asset value per share next computed following receipt of an order
in proper form by a dealer, the Distributor or Firstar, the
Funds' transfer agent.
The net asset value per share is determined as of the close
of trading (generally 4:00 p.m. Eastern Standard Time) on each
day the New York Stock Exchange (the "NYSE") is open for
business. Purchase orders received or shares tendered for
redemption on a day the NYSE is open for trading, prior to the
close of trading on that day, will be valued as of the close of
trading on that day. Applications for purchase of shares and
requests for redemption of shares received after the close of
trading on the NYSE will be valued as of the close of trading on
the next day the NYSE is open. The net asset value is calculated
by taking the value of a Fund's total assets, including interest
or dividends accrued, but not yet collected, less all
liabilities, and dividing by the total number of shares
outstanding. The result, rounded to the nearest cent, is the net
asset value per share.
In determining the net asset value, expenses are accrued and
applied daily and securities and other assets for which market
quotations are available are valued at market value. Common
stocks and other equity-type securities are valued at the last
sales price on the national securities exchange or NASDAQ on
which such securities are primarily traded; however, securities
traded on a national securities exchange or NASDAQ for which
there were no transactions on a given day, and securities not
listed on a national securities exchange or NASDAQ, are valued at
the average of the most recent bid and asked prices. Fixed
income securities are valued by a pricing service that utilizes
electronic data processing techniques to determine values for
normal institutional-sized trading units of fixed income
securities without regard to sale or bid prices when such values
are believed to more accurately reflect the fair market value of
such securities; otherwise, actual sale or bid prices are used.
The Board of Directors may approve the use of pricing services to
assist the Funds in the determination of net asset value. Fixed
income securities having remaining maturities of 60 days or less
when purchased are generally valued by the amortized cost method.
Under this method of valuation, a security is initially valued at
its acquisition cost and, thereafter, amortization of any
discount or premium is assumed each day, regardless of the impact
of fluctuating interest rates on the market value of the
security.
TAXATION OF THE FUNDS
Each Fund intends to qualify annually as a "regulated
investment company" under Subchapter M of the Code, and, if so
qualified, will not be liable for federal income taxes to the
extent earnings are distributed to shareholders on a timely
basis. In the event a Fund fails to qualify as a "regulated
investment company," it will be treated as a regular corporation
for federal income tax purposes. Accordingly, the Fund would be
subject to federal income taxes and any distributions that it
makes would be taxable and non-deductible by the Fund. This
would increase the cost of investing in the Fund for shareholders
and would make it more economical for shareholders to invest
directly in securities held by the Fund instead of investing
indirectly in such securities through the Fund.
PERFORMANCE INFORMATION
The Funds' historical performance or return may be shown in
the form of various performance figures. The Funds' performance
figures are based upon historical results and are not necessarily
representative of future performance. Factors affecting the
Funds' performance include general market conditions, operating
expenses, and investment management.
<PAGE>
Total Return
The average annual total return of each Fund is computed by
finding the average annual compounded rates of return over the
periods that would equate the initial amount invested to the
ending redeemable value, according to the following formula:
P(1+T)n = ERV
P = a hypothetical initial payment of $1,000.
T = average annual total return.
n = number of years.
ERV = ending redeemable value of a hypothetical
$1,000 payment made at the beginning of the
stated periods at the end of the stated
periods.
Performance for a specific period is calculated by first taking
an investment (assumed to be $1,000) ("initial investment") in a
Fund's shares on the first day of the period and computing the
"ending value" of that investment at the end of the period. The
total return percentage is then determined by subtracting the
initial investment from the ending value and dividing the
remainder by the initial investment and expressing the result as
a percentage. The calculation assumes that all income and
capital gains dividends paid by a Fund have been reinvested at
the net asset value of the Fund on the reinvestment dates during
the period. Total return may also be shown as the increased
dollar value of the hypothetical investment over the period.
Cumulative total return represents the simple change in
value of an investment over a stated period and may be quoted as
a percentage or as a dollar amount. Total returns may be broken
down into their components of income and capital (including
capital gains and changes in share price) in order to illustrate
the relationship between these factors and their contributions to
total return.
The total returns for the Growth Fund and the Balanced Fund
for the period June 25, 1998 to May 31, 1999 were 14.65% and
8.66%, respectively.
Yield
Yield is computed in accordance with a standardized method
prescribed by rules of the SEC. Under that method, the current
yield quotation for a Fund is based on a one-month or 30-day
period. The yield is computed by dividing the net investment
income per share earned during the 30-day or one-month period by
the maximum offering price per share on the last day of the
period, according to the following formula:
YIELD = 2[(ab/cd + 1)6 - 1]
Where: a = dividends and interest earned during the period.
b = expenses accrued for the period (net of reimbursements).
c = the average daily number of shares
outstanding during the period that were entitled to
receive dividends.
d = the maximum offering price per share on
the last day of the period.
Comparisons
From time to time, in marketing and other Fund literature,
the Funds' performance may be compared to the performance of
other mutual funds in general or to the performance of particular
types of mutual funds with similar investment goals, as tracked
by independent organizations. Among these organizations, Lipper
Analytical Services, Inc. ("Lipper"), a widely used independent
research firm which ranks mutual funds by overall performance,
investment objectives, and assets, may be cited. Lipper
performance figures are based on changes in net asset value, with all
<PAGE>
income and capital gains dividends reinvested. Such
calculations do not include the effect of any sales charges
imposed by other funds. The Funds will be compared to Lipper's
appropriate fund category, that is, by fund objective and
portfolio holdings.
The Funds' performance may also be compared to the
performance of other mutual funds by Morningstar, Inc.
("Morningstar"), which ranks funds on the basis of historical
risk and total return. Morningstar's rankings range from five
stars (highest) to one star (lowest) and represent Morningstar's
assessment of the historical risk level and total return of a
fund as a weighted average for 3, 5 and 10 year periods.
Rankings are not absolute or necessarily predictive of future
performance.
Evaluations of Fund performance made by independent sources
may also be used in advertisements concerning the Funds,
including reprints of or selections from, editorials or articles
about the Funds. Sources for Fund performance and articles about
the Funds may include publications such as Money, Forbes,
Kiplinger's, Financial World, Business Week, U.S. News and World
Report, the Wall Street Journal, Barron's and a variety of
investment newsletters.
The Funds may compare their performance to a wide variety of
indices and measures of inflation including the Standard & Poor's
Index of 500 Stocks, the NASDAQ Over-the-Counter Composite Index,
the Russell 2500 Index and the Lehman Aggregate Bond Index.
There are differences and similarities between the investments
that the Funds may purchase for their respective portfolios and
the investments measured by these indices.
ADDITIONAL INFORMATION
From time to time, in marketing and other Fund literature,
the Funds may quote founders, officers, directors and other
employees of the Adviser, such as a quote from Charles H. Badgley
who said, "Success in any endeavor is best achieved when goals
are defined and strategy is well planned. This is especially
true with money management." In addition, the Funds may state
that they have been selected as an option for purchase through
Charles Schwab's Institutional "One Source" service, which allows
Charles Schwab institutional investors, including financial
planners and investment advisers, to access information
concerning and to purchase shares in the Funds.
From time to time, the Funds may waive their minimum initial
investments. The Funds anticipate lowering the minimum from
$25,000 to $10,000 for estate planning purposes during December
1999 and January 2000. The Funds plan to send materials
promoting the reduction in the minimum initial investment to
current and prospective shareholders. These sales materials will
advise investors to consult their tax advisers.
INDEPENDENT ACCOUNTANTS
PricewaterhouseCoopers LLP, 100 East Wisconsin Avenue, Suite
1500, Milwaukee, Wisconsin 53202, independent accountants for the
Funds, audit and report on the Funds' financial statements.
FINANCIAL STATEMENTS
The following audited financial statements of each of the
Funds are incorporated herein by reference to the Funds' Annual
Report for the period June 25, 1998 to May 31, 1999, as filed
with the Securities and Exchange Commission on August 3, 1999:
(a) Report of Independent Accountants.
(b) Schedule of Investments as of May 31, 1999.
(c) Statement of Assets and Liabilities as of May 31, 1999.
(d) Statement of Operations for the period June 25, 1998 to
May 31, 1999.
(e) Statement of Changes in Net Assets for the period June 25,1998
to May 31, 1999.
<PAGE>
(f) Financial Highlights for the period June 25, 1998 to
May 31, 1999.
(g) Notes to the Financial Statements.
<PAGE>
APPENDIX
SHORT-TERM RATINGS
Standard & Poor's Short-Term Debt Credit Ratings
A Standard & Poor's credit rating is a current opinion of
the creditworthiness of an obligor with respect to a specific
financial obligation, a specific class of financial obligations
or a specific financial program. It takes into consideration the
creditworthiness of guarantors, insurers or other forms of credit
enhancement on the obligation and takes into account the currency
in which the obligation is denominated. The credit rating is not
a recommendation to purchase, sell or hold a financial
obligation, inasmuch as it does not comment as to market price or
suitability for a particular investor.
Credit ratings are based on current information furnished by
the obligors or obtained by Standard & Poor's from other sources
it considers reliable. Standard & Poor's does not perform an
audit in connection with any credit rating and may, on occasion,
rely on unaudited financial information. Credit ratings may be
changed, suspended or withdrawn as a result of changes in, or
unavailability of, such information, or based on other
circumstances.
Short-term ratings are generally assigned to those
obligations considered short-term in the relevant market. In the
U.S., for example, that means obligations with an original
maturity of no more than 365 days-including commercial paper.
Short-term ratings are also used to indicate the creditworthiness
of an obligor with respect to put features on long-term
obligations. The result is a dual rating, in which the short-
term rating addresses the put feature, in addition to the usual
long-term rating.
Ratings are graded into several categories, ranging from `A-
1' for the highest quality obligations to `D' for the lowest.
These categories are as follows:
A-1 A short-term obligation rated `A-1' is rated in the
highest category by Standard & Poor's. The obligor's
capacity to meet its financial commitment on the
obligation is strong. Within this category, certain
obligations are designated with a plus sign (+). This
indicates that the obligor's capacity to meet its
financial commitment on these obligations is extremely
strong.
A-2 A short-term obligation rated `A-2' is somewhat more
susceptible to the adverse effects of changes in
circumstances and economic conditions than obligations
in higher rating categories. However, the obligor's
capacity to meet its financial commitment on the
obligation is satisfactory.
A-3 A short-term obligation rated `A-3' exhibits adequate
protection parameters. However, adverse economic
conditions or changing circumstances are more likely to
lead to a weakened capacity of the obligor to meet its
financial commitment on the obligation.
B A short-term obligation rated `B' is regarded as having
significant speculative characteristics. The obligor
currently has the capacity to meet its financial
commitment on the obligation; however, it faces major
ongoing uncertainties which could lead to the obligor's
inadequate capacity to meet its financial commitment on
the obligation.
C A short-term obligation rated `C' is currently
vulnerable to nonpayment and is dependent upon
favorable business, financial and economic conditions
for the obligor to meet its financial commitment on the
obligation.
D A short-term obligation rated `D' is in payment
default. The `D' rating category is used when payments
on an obligation are not made on the date due even if
the applicable grace period has not expired, unless
Standard & Poor's believes that such payments will be
made during such grace period. The `D' rating also
will be used upon the filing of a bankruptcy petition
or the taking of a similar action if payments on an
obligation are jeopardized.
<PAGE>
Moody's Short-Term Debt Ratings
Moody's short-term debt ratings are opinions of the ability
of issuers to repay punctually senior debt obligations. These
obligations have an original maturity not exceeding one year,
unless explicitly noted. Moody's ratings are opinions, not
recommendations to buy or sell, and their accuracy is not
guaranteed.
Moody's employs the following three designations, all judged
to be investment grade, to indicate the relative repayment
ability of rated issuers:
PRIME-1 Issuers rated `Prime-1' (or supporting institutions)
have a superior ability for repayment of senior short-
term debt obligations. Prime-1 repaying ability will
often be evidenced by many of the following
characteristics:
* Leading market positions in well-established industries.
* High rates of return on funds employed.
* Conservative capitalization structure with moderate reliance
on debt and ample asset protection.
* Broad margins in earnings coverage of fixed financial
charges and high internal cash generation.
* Well-established access to a range of financial markets and
assured sources of alternate liquidity.
PRIME-2 Issuers rated `Prime-2' (or supporting institutions)
have a strong ability for repayment of senior short-
term debt obligations. This will normally be evidenced
by many of the characteristics cited above, but to a
lesser degree. Earnings trends and coverage ratios,
while sound, may be more subject to variation.
Capitalization characteristics, while still
appropriate, may be more affected by external
conditions. Ample alternate liquidity is maintained.
PRIME-3 Issuers rated `Prime-3' (or supporting institutions)
have an acceptable ability for repayment of senior
short-term obligations. The effect of industry
characteristics and market compositions may be more
pronounced. Variability in earnings and profitability
may result in changes in the level of debt protection
measurements and may require relatively high financial
leverage. Adequate alternate liquidity is maintained.
NOT PRIME Issuers rated `Not Prime' do not fall within any of the
Prime rating categories.
Fitch IBCA International Short-Term Debt Credit Ratings
Fitch IBCA's international debt credit ratings are applied
to the spectrum of corporate, structured and public finance.
They cover sovereign (including supranational and subnational),
financial, bank, insurance and other corporate entities and the
securities they issue, as well as municipal and other public
finance entities, securities backed by receivables or other
financial assets and counterparties. When applied to an entity,
these short-term ratings assess its general creditworthiness on a
senior basis. When applied to specific issues and programs,
these ratings take into account the relative preferential
position of the holder of the security and reflect the terms,
conditions and covenants attaching to that security.
International credit ratings assess the capacity to meet
foreign currency or local currency commitments. Both "foreign
currency" and "local currency" ratings are internationally
comparable assessments. The local currency rating measures the
probability of payment within the relevant sovereign state's
currency and jurisdiction and therefore, unlike the foreign
currency rating, does not take account of the possibility of
foreign exchange controls limiting transfer into foreign
currency.
A short-term rating has a time horizon of less than 12
months for most obligations, or up to three years for U.S. public
finance securities, and thus places greater emphasis on the
liquidity necessary to meet financial commitments in a timely
manner.
<PAGE>
F-1 Highest credit quality. Indicates the strongest
capacity for timely payment of financial commitments;
may have an added "+" to denote any exceptionally
strong credit feature.
F-2 Good credit quality. A satisfactory capacity for
timely payment of financial commitments, but the margin
of safety is not as great as in the case of the higher
ratings.
F-3 Fair credit quality. The capacity for timely payment
of financial commitments is adequate; however, near
term adverse changes could result in a reduction to non-
investment grade.
B Speculative. Minimal capacity for timely payment of
financial commitments, plus vulnerability to near term
adverse changes in financial and economic conditions.
C High default risk. Default is a real possibility.
Capacity for meeting financial commitments is solely
reliant upon a sustained, favorable business and
economic environment.
D Default. Denotes actual or imminent payment default.
Duff & Phelps, Inc. Short-Term Debt Ratings
Duff & Phelps Credit Ratings' short-term debt ratings are
consistent with the rating criteria used by money market
participants. The ratings apply to all obligations with
maturities of under one year, including commercial paper, the
uninsured portion of certificates of deposit, unsecured bank
loans, master notes, bankers acceptances, irrevocable letters of
credit and current maturities of long-term debt. Asset-backed
commercial paper is also rated according to this scale.
Emphasis is placed on liquidity which is defined as not only
cash from operations, but also access to alternative sources of
funds including trade credit, bank lines and the capital markets.
An important consideration is the level of an obligor's reliance
on short-term funds on an ongoing basis.
The distinguishing feature of Duff & Phelps Credit Ratings'
short-term debt ratings is the refinement of the traditional `1'
category. The majority of short-term debt issuers carry the
highest rating, yet quality differences exist within that tier.
As a consequence, Duff & Phelps Credit Rating has incorporated
gradations of `1+' (one plus) and `1-` (one minus) to assist
investors in recognizing those differences.
These ratings are recognized by the SEC for broker-dealer
requirements, specifically capital computation guidelines. These
ratings meet Department of Labor ERISA guidelines governing
pension and profit sharing investments. State regulators also
recognize the ratings of Duff & Phelps Credit Rating for
insurance company investment portfolios.
Rating Scale: Definition
High Grade
D-1+ Highest certainty of timely payment. Short-term
liquidity, including internal operating factors and/or
access to alternative sources of funds, is outstanding,
and safety is just below risk-free U.S. Treasury short-
term obligations.
D-1 Very high certainty of timely payment. Liquidity
factors are excellent and supported by good fundamental
protection factors. Risk factors are minor.
D-1- High certainty of timely payment. Liquidity factors
are strong and supported by good fundamental protection
factors. Risk factors are very small.
<PAGE>
Good Grade
D-2 Good certainty of timely payment. Liquidity factors
and company fundamentals are sound. Although ongoing
funding needs may enlarge total financing requirements,
access to capital markets is good. Risk factors are
small.
Satisfactory Grade
D-3 Satisfactory liquidity and other protection factors
qualify issue as to investment grade. Risk factors are
larger and subject to more variation. Nevertheless,
timely payment is expected.
Non-investment Grade
D-4 Speculative investment characteristics. Liquidity is
not sufficient to insure against disruption in debt
service. Operating factors and market access may be
subject to a high degree of variation.
Default
D-5 Issuer failed to meet scheduled principal and/or
interest payments.
LONG-TERM RATINGS
Standard & Poor's Long-Term Debt Credit Ratings
A Standard & Poor's credit rating is a current opinion of
the creditworthiness of an obligor with respect to a specific
financial obligation, a specific class of financial obligations
or a specific financial program. It takes into consideration the
creditworthiness of guarantors, insurers or other forms of credit
enhancement on the obligation and takes into account the currency
in which the obligation is denominated. The credit rating is not
a recommendation to purchase, sell or hold a financial
obligation, inasmuch as it does not comment as to market price or
suitability for a particular investor.
Credit ratings are based on current information furnished by
the obligors or obtained by Standard & Poor's from other sources
it considers reliable. Standard & Poor's does not perform an
audit in connection with any credit rating and may, on occasion,
rely on unaudited financial information. Credit ratings may be
changed, suspended or withdrawn as a result of changes in, or
unavailability of, such information, or based on other
circumstances.
Credit ratings are based, in varying degrees, on the
following considerations: (1) likelihood of payment-capacity
and willingness of the obligor to meet its financial commitment
on an obligation in accordance with the terms of the obligation;
(2) nature of and provisions of the obligation; and (3)
protection afforded by, and relative position of, the obligation
in the event of bankruptcy, reorganization or other arrangement
under the laws of bankruptcy and other laws affecting creditors'
rights.
The rating definitions are expressed in terms of default
risk. As such, they pertain to senior obligations of an entity.
Junior obligations are typically rated lower than senior
obligations, to reflect the lower priority in bankruptcy. (Such
differentiation applies when an entity has both senior and
subordinated obligations, secured and unsecured obligations, or
operating company and holding company obligations.) Accordingly,
in the case of junior debt, the rating may not conform exactly
with the category definition.
AAA An obligation rated `AAA' has the highest rating
assigned by Standard & Poor's. The obligor's capacity
to meet its financial commitment on the obligation is
EXTREMELY STRONG.
AA An obligation rated `AA' differs from the highest rated
obligations only in small degree. The obligor's
capacity to meet its financial commitment on the
obligation is VERY STRONG.
<PAGE>
A An obligation rated `A' is somewhat more susceptible to
the adverse effects of changes in circumstances and
economic conditions than obligations in higher rated
categories. However, the obligor's capacity to meet
its financial commitment on the obligation is still
STRONG.
BBB An obligation rated `BBB' exhibits ADEQUATE protection
parameters. However, adverse economic conditions or
changing circumstances are more likely to lead to a
weakened capacity of the obligor to meet its financial
commitment on the obligation.
Obligations rated `BB', `B', `CCC, `CC', and `C' are
regarded as having significant speculative characteristics. `BB'
indicates the least degree of speculation and `C' the highest.
While such obligations will likely have some quality and
protective characteristics, these may be outweighed by large
uncertainties or major exposures to adverse conditions.
BB An obligation rated `BB' is LESS VULNERABLE to
nonpayment than other speculative issues. However, it
faces major ongoing uncertainties or exposure to
adverse business, financial or economic conditions
which could lead to the obligor's inadequate capacity
to meet its financial commitment on the obligation.
B An obligation rated `B' is MORE VULNERABLE to
nonpayment than obligations rated `BB', but the obligor
currently has the capacity to meet its financial
commitment on the obligation. Adverse business,
financial or economic conditions will likely impair the
obligor's capacity or willingness to meet its financial
commitment on the obligation.
CCC An obligation rated `CCC' is CURRENTLY VULNERABLE to
nonpayment, and is dependent upon favorable business,
financial and economic conditions for the obligor to
meet its financial commitment on the obligation. In
the event of adverse business, financial or economic
conditions, the obligor is not likely to have the
capacity to meet its financial commitment on the
obligation.
CC An obligation rated `CC' is CURRENTLY HIGHLY VULNERABLE
to nonpayment.
C The `C' rating may be used to cover a situation where a
bankruptcy petition has been filed or similar action
has been taken, but payments on this obligation are
being continued.
D An obligation rated `D' is in payment default. The `D'
rating category is used when payments on an obligation
are not made on the date due even if the applicable
grace period has not expired, unless Standard & Poor's
believes that such payments will be made during such
grace period. The `D' rating also will be used upon
the filing of a bankruptcy petition or the taking of a
similar action if payments on an obligation are
jeopardized.
Plus (+) or minus (-): The ratings from `AA' to `CCC' may
be modified by the addition of a plus or minus sign to show
relative standing within the major rating categories.
Moody's Long-Term Debt Ratings
Aaa Bonds which are rated `Aaa' are judged to be of the
best quality. They carry the smallest degree of
investment risk and are generally referred to as "gilt
edged." Interest payments are protected by a large or
by an exceptionally stable margin and principal is
secure. While the various protective elements are
likely to change, such changes as can be visualized are
most unlikely to impair the fundamentally strong
position of such issues.
Aa Bonds which are rated `Aa' are judged to be of high
quality by all standards. Together with the Aaa group
they comprise what are generally known as high-grade
bonds. They are rated lower than the best bonds
because margins of protection may not be as large as in
Aaa securities or fluctuation of protective elements
may be of greater amplitude or there may be other
elements present which make the long-term risk appear
somewhat larger than Aaa securities.
<PAGE>
A Bonds which are rated `A' possess many favorable
investment attributes and are to be considered as upper-
medium-grade obligations. Factors giving security to
principal and interest are considered adequate, but
elements may be present which suggest a susceptibility
to impairment some time in the future.
Baa Bonds which are rated `Baa' are considered as medium-
grade obligations (i.e., they are neither highly
protected nor poorly secured). Interest payments and
principal security appear adequate for the present but
certain protective elements may be lacking or may be
characteristically unreliable over any great length of
time. Such bonds lack outstanding investment
characteristics and in fact have speculative
characteristics as well.
Ba Bonds which are rated `Ba' are judged to have
speculative elements; their future cannot be considered
as well-assured. Often the protection of interest and
principal payments may be very moderate, and thereby
not well safeguarded during both good and bad times
over the future. Uncertainty of position characterizes
bonds in this class.
B Bonds which are rated `B' generally lack
characteristics of the desirable investment. Assurance
of interest and principal payments or of maintenance of
other terms of the contract over any long period of
time may be small.
Caa Bonds which are rated `Caa' are of poor standing. Such
issues may be in default or there may be present
elements of danger with respect to principal or
interest.
Ca Bonds which are rated `Ca' represent obligations which
are speculative in a high degree. Such issues are
often in default or have other marked shortcomings.
C Bonds which are rated `C' are the lowest rated class of
bonds, and issues so rated can be regarded as having
extremely poor prospects of ever attaining any real
investment standing.
Moody's applies numerical modifiers 1, 2 and 3 in each
generic rating classification from `Aa' through `B.' The
modifier 1 indicates that the obligation ranks in the higher end
of its generic rating category; the modifier 2 indicates a mid-
range ranking; and the modifier 3 indicates a ranking in the
lower end of that generic rating category.
Fitch IBCA International Long-Term Debt Credit Ratings
Fitch IBCA's international debt credit ratings are applied
to the spectrum of corporate, structured and public finance.
They cover sovereign (including supranational and subnational),
financial, bank, insurance and other corporate entities and the
securities they issue, as well as municipal and other public
finance entities, securities backed by receivables or other
financial assets and counterparties. When applied to an entity,
these long-term ratings assess its general creditworthiness on a
senior basis. When applied to specific issues and programs,
these ratings take into account the relative preferential
position of the holder of the security and reflect the terms,
conditions and covenants attaching to that security.
International credit ratings assess the capacity to meet
foreign currency or local currency commitments. Both "foreign
currency" and "local currency" ratings are internationally
comparable assessments. The local currency rating measures the
probability of payment within the relevant sovereign state's
currency and jurisdiction and therefore, unlike the foreign
currency rating, does not take account of the possibility of
foreign exchange controls limiting transfer into foreign
currency.
Investment Grade
AAA Highest credit quality. `AAA' ratings denote the
lowest expectation of credit risk. They are
assigned only in case of exceptionally strong
capacity for timely payment of financial
commitments. This capacity is highly unlikely to
be adversely affected by foreseeable events.
<PAGE>
AA Very high credit quality. `AA' ratings denote a
very low expectation of credit risk. They
indicate very strong capacity for timely payment
of financial commitments. This capacity is not
significantly vulnerable to foreseeable events.
A High credit quality. `A' ratings denote a low
expectation of credit risk. The capacity for
timely payment of financial commitments is
considered strong. This capacity may,
nevertheless, be more vulnerable to changes in
circumstances or in economic conditions than is
the case for higher ratings.
BBB Good credit quality. `BBB' ratings indicate that
there is currently a low expectation of credit
risk. The capacity for timely payment of
financial commitments is considered adequate, but
adverse changes in circumstances and in economic
conditions are more likely to impair this
capacity. This is the lowest investment grade
category.
Speculative Grade
BB Speculative. `BB' ratings indicate that there is
a possibility of credit risk developing,
particularly as the result of adverse economic
change over time; however, business or financial
alternatives may be available to allow financial
commitments to be met.
B Highly speculative. `B' ratings indicate that
significant credit risk is present, but a limited
margin of safety remains. Financial commitments
are currently being met; however, capacity for
continued payment is contingent upon a sustained,
favorable business and economic environment.
CCC, CC, High default risk. Default is a real
C possibility. Capacity for meeting financial
commitments is solely reliant upon sustained,
favorable business or economic developments. A
`CC' rating indicates that default of some kind
appears probable. `C' ratings signal imminent
default.
DDD, DD Default. Securities are not meeting current
and D obligations and are extremely speculative. `DDD'
designates the highest potential for recovery of
amounts outstanding on any securities involved.
For U.S. corporates, for example, `DD' indicates
expected recovery of 50% - 90% of such
outstandings, and `D' the lowest recovery
potential, i.e. below 50%.
Duff & Phelps, Inc. Long-Term Debt Ratings
These ratings represent a summary opinion of the issuer's
long-term fundamental quality. Rating determination is based on
qualitative and quantitative factors which may vary according to
the basic economic and financial characteristics of each industry
and each issuer. Important considerations are vulnerability to
economic cycles as well as risks related to such factors as
competition, government action, regulation, technological
obsolescence, demand shifts, cost structure and management depth
and expertise. The projected viability of the obligor at the
trough of the cycle is a critical determination.
Each rating also takes into account the legal form of the
security (e.g., first mortgage bonds, subordinated debt,
preferred stock, etc.). The extent of rating dispersion among
the various classes of securities is determined by several
factors including relative weightings of the different security
classes in the capital structure, the overall credit strength of
the issuer and the nature of covenant protection.
The Credit Rating Committee formally reviews all ratings
once per quarter (more frequently, if necessary). Ratings of
`BBB-` and higher fall within the definition of investment grade
securities, as defined by bank and insurance supervisory
authorities. Structured finance issues, including real estate,
asset-backed and mortgage-backed financings, use this same rating
scale. Duff & Phelps Credit Rating claims paying ability ratings
of insurance companies use the same scale with minor modification
in the definitions. Thus, an investor can compare the credit
quality of investment alternatives across industries and
structural types. A "Cash Flow Rating" (as noted for specific
ratings) addresses the
<PAGE>
likelihood that aggregate principal and
interest will equal or exceed the rated amount under appropriate
stress conditions.
Rating Scale Definition
AAA Highest credit quality. The risk factors are
negligible, being only slightly more
than for risk-free U.S. Treasury debt.
AA+ High credit quality. Protection factors are strong.
AA Risk is modest but may vary slightly
AA- from time to time because of economic conditions.
A+ Protection factors are average but adequate. However,
A risk factors are more
A- variable and greater in periods of economic stress.
BBB+ Below-average protection factors but still considered
BBB sufficient for prudent investment. Considerable
BBB- variability in risk during economic cycles.
BB+ Below investment grade but deemed likely to meet
BB obligations when due. Present or prospective
BB- financial protection factors fluctuate according to
industry conditions or company fortunes. Overall
quality may move up or down frequently within this category.
B+ Below investment grade and possessing risk that
B obligations will not be met when due. Financial
B- protection factors will fluctuate widely according to
economic cycles, industry conditions and/or company
fortunes. Potential exists for frequent changes in the
rating within this category or into a higher
or lower rating grade.
CCC Well below investment grade securities. Considerable
uncertainty exists as to timely payment
of principal, interest or preferred dividends.
Protection factors are narrow and risk can be
substantial with unfavorable
economic/industry conditions, and/or with unfavorable
company developments.
DD Defaulted debt obligations. Issuer failed to meet
scheduled principal and/or interest payments.
DP Preferred stock with dividend arrearages.
