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THE SENTINEL FUNDS
SENTINEL HIGH YIELD BOND FUND
PROSPECTUS SUPPLEMENT DATED JUNE 23, 1997 TO PROSPECTUS DATED MARCH 31, 1997
On June 23, 1997, Sentinel Group Funds, Inc. (the "Company") began
offering a new Fund named Sentinel High Yield Bond Fund (the "High Yield
Fund"). This Supplement, which is to be used in conjunction with the
Prospectus for the Sentinel Funds dated March 31, 1997 (the "Prospectus"),
describes the investment objective and policies and other features of the
High Yield Fund.
THE HIGH YIELD FUND MAY INVEST WITHOUT LIMITATION IN LOWER QUALITY DEBT
SECURITIES, SOMETIMES CALLED "JUNK BONDS". INVESTORS IN THE HIGH YIELD FUND
SHOULD CONSIDER THAT THESE SECURITIES CARRY GREATER RISKS, SUCH AS THE RISK OF
DEFAULT, THAN OTHER DEBT SECURITIES. Please refer to the Risk Factors
section below for further information.
SHAREHOLDER TRANSACTION EXPENSES (as a percentage of the offering price)
Class A Shares:
Sales Charge Imposed on Purchases........................ 4.00% maximum(1)
Sales Charge Imposed on Reinvested Dividends............. None
Redemption Fees.......................................... None(2)
Exchange Fees............................................ None
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(1) The complete schedule of sales charges is the same as for the Bond,
Government Securities, Tax-Free Income, New York and Pennsylvania Funds set
forth on page 31 of the Prospectus.
(2) If a shareholder chooses to redeem by means of a wire transfer, a wire
charge not normally in excess of $25.00 will be assessed. In addition, a
deferred sales charge of up to 1% is assessed on certain redemptions of Class
A shares made within two years of purchase, if they were purchased without a
sales load as part of an investment of $1,000,000 or more. See "How to
Purchase Shares -- Class A Shares -- Sales Charges" in the Prospectus.
Class B Shares:
Sales Charge Imposed on Purchases........................ None
Sales Charge Imposed on Reinvested Dividends............. None
Contingent Deferred Sales Charge ("CDSC")................ 4.00% maximum(3)
Exchange Fees............................................ None
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(3) The maximum CDSC is imposed on shares redeemed in the first year after
purchase. For shares held longer than one year, the CDSC declines according
to the schedules and other terms set forth under "How to Redeem Shares --
Class B Shares -- CDSC" in the Prospectus.
ANNUAL FUND OPERATING EXPENSES
The following table sets forth the anticipated annual operating expenses
of the Class A shares and Class B shares of the High Yield Fund for the
remainder of the fiscal year ending November 30, 1997.
CLASS A CLASS B
SHARES SHARES
------- -------
Management Fees 0.75% 0.75%
Rule 12b-1 Fees (includes service fee & distribution fee) 0.20% 0.43%
Other Expenses:
Accounting and Administrative Costs 0.04%(5) 0.04(5)
Other 0.22%(5) 0.14(5)
Total Other Expenses 0.26%(5) 0.18(5)
Total Fund Operating Expenses 1.21% 1.36
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(5) "Other Expenses" are based on estimated amounts for the current fiscal
year.
The following examples illustrate the expenses that an investor would
pay on a $1,000 investment in the High Yield Fund over 1 and 3 year periods
assuming the operating expense ratio as set forth in the table above and a 5%
annual rate of return.
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1 YEAR 3 YEARS
------ -------
Class A shares $52 $77
Class B shares (assuming redemption
at the end of the period) $54 $73
Class B shares (assuming no redemption
at the end of the period) $14 $43
These examples should not be considered a representation of past or future
expenses. Actual expenses may be greater or less than those shown, and the 5%
annual rate used in this example is a hypothetical rate of return. The purpose
of the foregoing examples is to assist the investor in understanding the various
expenses that an investor in the High Yield Fund will bear directly or
indirectly.
INVESTMENT OBJECTIVE AND POLICIES
The High Yield Fund seeks high current income and total return by investing
primarily in lower rated corporate debt securities. There can be no assurance
that the High Yield Bond Fund's objective will be achieved.
The High Yield Fund will normally invest at least 80% of its total
assets in lower rated debt securities. However, when unusual economic
conditions cause a temporary narrowing of yield spread between these
securities and higher rated securities, the High Yield Fund may invest up to
100% of its assets in higher rated securities. The High Yield Fund may
invest in debt securities of any maturity. No more than 25% of the High
Yield Fund's assets will be invested in a single industry, and no more than
5% of assets in a single issuer.
LOWER RATED DEBT SECURITIES. Lower rated debt securities (commonly
referred to as junk bonds) are debt securities which, because of the greater
possibility that the issuers will default, are not investment grade (I.E., are
rated below BBB by Standard & Poor's Ratings Services ("S&P") or below Baa by
Moody's Investors Service, Inc. ("Moody's"), or are unrated but considered by
the High Yield Fund's subadvisor, Keystone Investment Management Company
("Keystone"), to be of comparable credit quality). Because of the increased
risk of default, these securities generally have higher nominal or effective
interest rates than higher quality securities.
The High Yield Fund may purchase bonds in the lowest rating categories
(D for S&P and C for Moody) and comparable unrated securities. However, the
High Yield Fund will only purchase securities rated lower than B- by S&P or
B3 or lower by Moody's if Keystone believes the quality of such securities is
higher than indicated by the rating.
FOR INFORMATION AND ASSISTANCE, call your Financial Advisor or Investor
Services 1-800-282-FUND (3863)
2
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COMMON STOCK. The High Yield Fund may invest up to 20% of total assets in
common stocks, usually as a result of warrants associated with debt instruments
purchased by the High Yield Fund, but also, under certain circumstances, to seek
capital appreciation. The Fund may also invest in debt securities
convertible into common stock.
DEBT SECURITIES. The High Yield Fund may invest in debt securities of any
maturity that pay interest at fixed, floating or adjustable rates. The High
Yield Fund also may invest in debt securities (i) that do not pay interest but,
instead, are issued at a significant discount to their maturity values (referred
to as zero coupon securities), (ii) that pay interest, at the issuer's option,
in additional securities instead of cash (referred to as pay-in-kind securities)
or (iii) pay interest at predetermined rates that increase over time (referred
to as step coupon bonds).
The High Yield Fund, when aggregated with the holdings of other mutual
funds advised by Keystone, will not own more than 20% of the outstanding debt
securities of any issuer.
To the extent the High Yield Fund invests in adjustable or floating rate
securities, the value of such securities is less likely to be adversely
affected by interest rate changes than fixed rate securities. However,
reductions in interest rates also may translate into lower ordinary income
distributions paid by the High Yield Fund. Additionally, although zero
coupon securities, pay-in-kind securities and step coupon bonds may not pay
interest, the High Yield Fund nevertheless must under existing tax laws
accrue and distribute the income deemed to be earned on a current basis, and
therefore may have to sell other investments to raise the cash needed to make
income distributions.
CORPORATE LOANS. The High Yield Fund may invest in corporate loans made by
banks or other financial institutions either at origination or by acquiring
participations in, or assignments of or novations of corporate loans. Certain
corporate loans may not be readily marketable and may be subject to restrictions
on resale; except as described under "Illiquid Securities" below, to the extent
corporate loans are not readily marketable or subject to such restrictions,
those loans would be subject to the High Yield Fund's limitation on illiquid
securities.
The corporate loans in which the High Yield Fund may invest typically
are originated, negotiated and structured by a syndicate of co-lenders, one
or more of whom administers the loan on behalf of the syndicate. The value
of a corporate loan will depend primarily on the creditworthiness of the
borrower. The High Yield Fund will invest in a corporate loan only if, in
Keystone's judgment, the borrower can meet the debt service on such a loan;
however, Keystone has no set minimum credit rating criteria regarding the
borrowers with respect to investments in corporate loans by the High Yield
Fund. Although Keystone will continue to monitor the creditworthiness of the
borrowers of corporate loans in which the High Yield Fund invests, there can
be no assurance that such analysis will disclose factors that will impair the
value of a corporate loan.
FOR INFORMATION AND ASSISTANCE, call your Financial Advisor or Investor
Services 1-800-282-FUND (3863)
3
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ILLIQUID SECURITIES. The High Yield Fund may invest up to 15% of its
net assets in illiquid securities. Illiquid securities are not readily
marketable and include securities that are restricted as to disposition under
the federal securities laws or otherwise. If registration of such securities
under the Securities Act of 1933, as amended (the "Securities Act"), is
required, such registration may not be readily accomplished, and if such
securities may be sold without registration, such resale may be permissible
only in limited quantities. In either event, the inability to sell
securities at the most opportune time may negatively affect the net asset
value of the High Yield Fund.
Notwithstanding the foregoing, the High Yield Fund may purchase certain
restricted securities ("Rule 144A Securities") for which there is a secondary
market of qualified institutional buyers as defined by Rule 144A under the
Securities Act. Rule 144A Securities that are determined to be liquid
securities, either by Keystone pursuant to guidelines approved by the Board
or by the Company's Board of Directors, will not be subject to the High Yield
Fund's limitation on illiquid securities. Such liquid Rule 144A Securities
may become illiquid if qualified institutional buyers are unavailable.
See "Investment Objectives and Policies--Considerations Applicable to the
Fixed Income Funds" in the Statement of Additional Information for additional
information regarding liquidity determinations with respect to Rule 144A
Securities and corporate loans.
FOREIGN INVESTMENTS. The High Yield Fund may invest up to 25% of net
assets in the securities of foreign issuers, provided that all such
securities are denominated in U.S. dollars and are purchased and held by the
High Yield Fund in the United States. Investments in foreign securities have
special risks related to political, economic and legal conditions outside the
U.S. As a result, the prices of foreign securities may fluctuate
substantially more than the prices of securities of issuers based in the U.S.
Special risks associated with foreign securities include the existence of
less liquid markets, the unavailability of reliable information about
issuers, the existence (or potential imposition) of exchange control
regulations and political and economic instability, among others.
TEMPORARY/DEFENSIVE INVESTMENTS. Temporarily available cash may be
invested in short term securities such as certificates of deposit, bankers'
acceptances, commercial paper, Treasury bills, repurchase agreements and U.S.
Government Securities, as defined in the Prospectus. Some or all of the High
Yield Fund's assets also may be invested in such investments during periods
of unusual market conditions.
DERIVATIVES. The High Yield Fund does not expect to invest in futures
and options, or other derivatives contracts during the coming year. However,
if and when derivative securities are developed which permit effective
hedging of a lower quality bond portfolio, the High Yield Fund may, for
hedging purposes only, buy or sell derivative securities contracts which in
the opinion of Keystone will hedge specified risks relating to the High Yield
Fund's portfolio of lower quality bonds. The total market value of such
contracts at the time of the transaction initiating the position will not
exceed 5% of the High Yield Fund's net assets.
"WHEN-ISSUED" SECURITIES. The High Yield Fund also may invest in "when-
issued" securities, as discussed on page 24 of the Prospectus.
RISK FACTORS. Lower rated bonds are generally considered
significantly more speculative and likely to default than higher quality
bonds. Relative to other debt securities, junk bond values tend to be more
volatile because: (i) an economic downturn may affect the ability of issuers
to pay interest and repay principal; and (ii) the secondary market for such
securities may at times be less liquid or their prices may respond more
adversely to negative publicity or investor perceptions, making it more
difficult to value or dispose of the securities. If the market for lower
rated bonds becomes illiquid, the Fund may experience problems in valuing
these securities. The likelihood that these securities will help the High
Yield Fund achieve its investment objective is more dependent on Keystone's
own credit analysis than on ratings. Lower rated bonds are also more
sensitive than other debt securities to adverse issuer-specific developments.
The risk of loss due to default by the issuer of a junk bond is
significantly greater for the holders of junk bonds than for holders of
higher rated securities because such securities may be unsecured and may be
subordinated to other creditors of the issuer. In the event of a default, the
High Yield Fund may incur additional expenses to the extent it is required to
seek recovery or participate in the restructuring of the obligation.
Junk bonds also may have call or redemption features that permit the
issuer to repurchase the securities from the High Yield Fund. If a call is
exercised by the issuer during a period of declining interest rates, the High
Yield Fund would likely be required to replace such called securities with
lower yielding securities, thus decreasing net investment income to the High
Yield Fund. See the Appendix to this Supplement for a description of S&P's
and Moody's ratings of lower rated corporate debt securities.
FOR INFORMATION AND ASSISTANCE, call your Financial Advisor or Investor
Services 1-800-282-FUND (3863)
4
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MANAGEMENT OF THE HIGH YIELD FUND
INVESTMENT ADVISOR. The investment advisor to the High Yield Fund is
Sentinel Advisors Company (the "Advisor"), which also is the investment advisor
to the other Sentinel Funds. Information with respect to the Advisor is set
forth on page 26 of the Prospectus. For its services as investment advisor, the
Advisor receives from the High Yield Fund a fee based on the average daily value
of the net assets of the High Yield Fund in accordance with the following
schedule:
0.75% per annum on the first $100 million of average daily net assets
of the High Yield Fund;
0.70% per annum on the next $100 million of such assets;
0.65% per annum on the next $100 million of such assets; and
0.60% per annum on such assets in excess of $300 million.
SUBADVISOR. The Advisor has entered into a Sub-Investment Advisory
Agreement with Keystone. Pursuant to this agreement, Keystone provides the
Advisor with a continuous investment program consistent with the High Yield
Fund's stated investment objective and policies. Under this arrangement,
Keystone works in cooperation with the Advisor's investment professionals but
has full authority to manage the High Yield Fund's portfolio on a day to day
basis. The Sub-Investment Advisory Agreement provides for a fee from the
Advisor to Keystone equal to one half of the fee paid by the High Yield Fund to
the Advisor, provided that the fee paid by the Advisor to Keystone will always
be at least 0.35% per annum of the average daily net assets of the High Yield
Fund. This agreement became effective June 20, 1997.
Keystone is located at 200 Berkeley Street, Boston, Massachusetts 02116
and is an indirect subsidiary of First Union Corporation, the sixth largest
bank holding company in the United States. First Union is headquartered in
Charlotte, North Carolina. First Union and its subsidiaries provide a broad
range of financial services to individuals and businesses throughout the
United States.
The portfolio manager for the High Yield Fund is Prescott B. Crocker,
Senior Vice President and Group Head of Corporate Fixed Income at Keystone. Mr.
Crocker is a Chartered Financial Analyst, and has been the High Yield Fund's
portfolio manager since its inception on June 20, 1997. Mr. Crocker joined
Keystone in February, 1997. Prior to that he was President of Boston
Security Counselors, the investment management subsidiary of the brokerage
firm Advest Co. Inc. He had joined Boston Security Counselors in November of
1993 as Senior Vice President - Fixed Income, where he managed among others
the Advest Advantage series High Yield Trust. Upon the sale of the Advest
Advantage funds to Northstar Investment Management Co. in July of 1995, Mr.
Crocker joined that company as Fund Manager. He returned to Boston Security
Counselors in August of 1996 as President.
DISTRIBUTION PLANS
The Class A shares of the High Yield Fund participate in the Company's
Class A Distribution Plan. This Plan provides for a fee to the Distributor
of the Sentinel Funds at a maximum annual rate of 0.20% of average daily net
assets of the Class A shares of the High Yield Fund. The Class B shares
participate in the Company's Class B Distribution Plan. This Plan provides
for a fee to the Distributor of the Sentinel Funds at a maximum annual rate
of 1.00% of average daily net assets of the Class B shares of the High Yield
Fund. No such fee will be assessed in respect of seed money shares owned by
National Life Insurance Company, which will result in an overall 12b-1 fee to
the Class B shares of less than 1.00% for so long as National Life Insurance
Company maintains its investment. Additional information on these Distribution
Plans is set forth on pages 28 to 30 of the Prospectus.
Class B shares of the High Yield Fund automatically convert to Class A
shares of the High Yield Fund at the end of the applicable CDSC period in the
same way as the Class B shares of the other Sentinel Funds which offer Class B
shares convert to Class A shares of the same Fund. See page 31 of the
Prospectus.
FOR INFORMATION AND ASSISTANCE, call your Financial Advisor or Investor
Services 1-800-282-FUND (3863)
5
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INITIAL MARKETING INCENTIVES
The Distributor intends to provide the following arrangements for the first
90 days after the introduction of the High Yield Fund. First, the Distributor
will make a payment in addition to the normal dealer reallowance described in
the Prospectus in an amount of 0.25% of investments during the first 90 days of
the High Yield Fund's operation for which a single registered representative is
the registered representative of record, if the amount of such investments
during the first 90 days of the High Yield Fund's operation for which such
registered representative is the registered representative of record is
$1,000,000 or more. Second, all sales of High Yield Fund shares during the
first 90 days of the High Yield Fund's operation will be multiplied by 1.5 for
purposes of determining qualification for the sales contest described on page 33
of the Prospectus.
DIVIDENDS AND CAPITAL GAINS DISTRIBUTIONS
The High Yield Fund pays dividends substantially equivalent to its net
investment income on a monthly basis. Distributions of net realized capital
gains, if any, are paid annually in December. Dividends and capital gains
distributions will be reinvested automatically in shares of the same class of
the High Yield Fund unless investors elect otherwise. See "Shareholder
Services-Distribution Options" on page 44 of the Prospectus.
PERFORMANCE DATA
The High Yield Fund may include average annual total return and yield
information in advertisements or in information distributed to existing or
prospective shareholders in the same manner as the other fixed-income Sentinel
Funds, as described on page 46 of the Prospectus. The High Yield Fund may
compare its performance to the Chase Manhattan Bank Index.
ORGANIZATION OF THE HIGH YIELD FUND
The High Yield Fund is a series of Sentinel Group Funds, Inc., information
on which is presented on page 47 of the Prospectus.
TAXES
With the exception of topics relating to specific Funds, the discussion
under "Taxes" in the Prospectus generally also applies to the High Yield Fund.
OTHER MATTERS
The information presented in the Prospectus under the topics "Custodian",
"How to Purchase Shares", "How to Redeem Shares", "Tax Deferred Retirement
Plans", "Determination of Net Asset Value" and "Shareholder Services" generally
apply to the High Yield Fund in the same way that they apply to the other
Sentinel Funds. The High Yield Fund does not offer the check writing privilege
that is offered with the Class A shares of the other fixed income Sentinel
Funds.
FOR INFORMATION AND ASSISTANCE, call your Financial Advisor or Investor
Services 1-800-282-FUND (3863)
6
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APPENDIX
RATINGS OF HIGH YIELD DEBT SECURITIES
DESCRIPTION OF MOODY'S INVESTORS SERVICE, INC. ("MOODY'S")
CORPORATE RATINGS
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.
NOTE: Moody's applies numerical modifiers 1, 2, and 3 in each generic rating
classification from Aa through B in its corporate bond rating system. The
modifier 1 indicates that the security ranks in the higher end of its generic
rating category; the modifier 2 indicates a mid-range ranking; and the modifier
3 indicates that the issue ranks in the lower end of its generic rating
category.
DESCRIPTION OF STANDARD & POOR'S RATINGS SERVICES ("S&P")
CORPORATE DEBT RATINGS
An S&P corporate rating is a current assessment of the creditworthiness of an
obligor with respect to a specific obligation. This assessment may take into
consideration obligors such as guarantors, insurers, or lessees.
The debt rating is not a recommendation to purchase, sell or hold a security,
inasmuch as it does not comment as to market price or suitability for a
particular investor.
The ratings are based on current information furnished by the issuer or obtained
by S&P from other sources it considers reliable. S&P does not perform an audit
in connection with any rating and may, on occasion, rely on unaudited financial
information. The ratings may be changed, suspended or withdrawn as a result of
changes in, or unavailability of, such information, or for other circumstances.
The ratings are based, in varying degrees, on the following considerations:
I. Likelihood of default capacity and willingness of the obligor as to
the timely payment of interest and repayment of principal in accordance with the
terms of the obligation;
II. Nature of and provisions of the obligation; and
FOR INFORMATION AND ASSISTANCE, call your Financial Advisor or Investor
Services 1-800-282-FUND (3863)
A-1
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III. Protection afforded to, 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.
Debt rated BB, B, CCC, CC and C is regarded, on balance, as having predominantly
speculative characteristics with respect to capacity to pay interest and repay
principal in accordance with the terms of the obligation. BB indicates the
lowest degree of speculation and C the highest degree of speculation. While
such debt will likely have some quality and protective characteristics, these
are outweighed by large uncertainties or major risk exposures to adverse
conditions.
BB--Debt rated BB has less near-term vulnerability to default than other
speculative issues. However, it faces major ongoing uncertainties or exposure
to adverse business, financial or economic conditions which could lead to
inadequate capacity to meet timely interest and principal payments. The BB
rating category is also used for debt subordinated to senior debt that is
assigned an actual or implied BBB- rating.
B--Debt rated B has a greater vulnerability to default but currently has the
capacity to meet interest payments and principal repayments. Adverse business,
financial or economic conditions would likely impair capacity or willingness to
pay interest and repay principal. The B rating category is also used for debt
subordinated to senior debt that is assigned an actual or implied BB or BB-
rating.
CCC--Debt rated CCC has a currently identifiable vulnerability to default, and
is dependent upon favorable business, financial and economic conditions to meet
timely payments of interest and repayment of principal. In the event of adverse
business, financial or economic conditions, it is not likely to have the
capacity to pay interest and repay principal. The CCC rating category is also
used for debt subordinated to senior debt that is assigned an actual or implied
B or B- rating.
CC--The rating CC is typically applied to debt subordinated to senior debt which
is assigned an actual or implied CCC rating.
C--The rating C is typically applied to debt subordinated to senior debt which
is assigned an actual or implied CCC- debt rating. The C rating may be used to
cover a situation where a bankruptcy petition has been filed but debt service
payments are continued.
CI--The rating CI is reserved for income bonds on which no interest is being
paid.
D--Debt rated D is in payment default. The D rating category is also used when
interest payments or principal payments are not made on the date due even if the
applicable grace period has not expired, unless S&P 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 if debt service payments 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 with the major
ratings categories.
Provisional ratings: The letter "p" indicates that the rating is provisional.
A provisional rating assumes the successful completion of the project being
financed by the debt being rated and indicates that payment of debt service
requirements is largely or entirely dependent upon the successful and timely
completion of the project. This rating, however, while addressing credit
quality subsequent to
FOR INFORMATION AND ASSISTANCE, call your Financial Advisor or Investor
Services 1-800-282-FUND (3863)
A-2
<PAGE>
completion of the project, makes no comment on the likelihood of, or risk of
default upon failure of, such completion. The investor should exercise judgment
with respect to such likelihood and risk.
L--The letter "L" indicates that the rating pertains to the principal amount of
those bonds to the extent that the underlying deposit collateral is insured by
the Federal Savings & Loan Insurance Corp. or the Federal Deposit Corp. and
interest is adequately collateralized.
*--Continuance of the rating is contingent upon S&P's receipt of an executed
copy of the escrow agreement or closing documentation confirming investments and
cash flows.
NR--Indicates that no rating has been requested, that there is insufficient
information on which to base a rating or that S&P does not rate a particular
type of obligation as a matter of policy.
Debt Obligations of Issuers outside the United States and its territories are
rated on the same basis as domestic corporate and municipal issues. The ratings
measure the creditworthiness of the obligor but do not take into account
currency exchange and related uncertainties.
Bond Investment Quality Standards: Under present commercial bank regulations
issued by the Comptroller of the Currency, Bonds rated in the top four
categories ("AAA", "AA", "A", "BBB", commonly known as "investment grade"
ratings) are generally regarded as eligible for bank investment. In addition,
the laws of various states governing legal investments may impose certain rating
or other standards for obligations eligible for investment by savings banks,
trust companies, insurance companies and fiduciaries generally.
The ratings are based on current information furnished to S&P by the issuer, and
obtained by S&P from other sources it considers reliable. The ratings may be
changed, suspended, or withdrawn as a result of changes in, or unavailability of
such information.
FOR INFORMATION AND ASSISTANCE, call your Financial Advisor or Investor
Services 1-800-282-FUND (3863)
A-3
<PAGE>
STATEMENT OF ADDITIONAL INFORMATION
JUNE 23, 1997
THE SENTINEL FUNDS
NATIONAL LIFE DRIVE
MONTPELIER, VERMONT 05604
(800) 282-FUND (3863)
Sentinel Common Stock Fund (the "Common Stock Fund")
Sentinel Balanced Fund (the "Balanced Fund")
Sentinel Growth Fund (the "Growth Fund")
Sentinel Small Company Fund (the "Small Company Fund")
Sentinel World Fund (the "World Fund")
Sentinel Bond Fund (the "Bond Fund")
Sentinel Government Securities Fund (the "Government Securities Fund")
Sentinel Short Maturity Government Fund (the "Short Maturity Government Fund")
Sentinel U.S. Treasury Money Market Fund (the "Treasury Fund")
Sentinel Tax-Free Income Fund (the "Tax-Free Income Fund")
Sentinel New York Tax-Free Income Fund (the "New York Fund")
Sentinel Pennsylvania Tax-Free Trust (the "Pennsylvania Fund")
Sentinel High Yield Bond Fund (the "High Yield Fund")
Each of SENTINEL GROUP FUNDS, INC. (the "Company") and the Pennsylvania Fund
is a managed, open-end investment company, which continuously offers its
shares to investors. The Company consists of twelve separate and distinct
funds, ten of which are diversified (the New York Fund being
non-diversified), and the Pennsylvania Fund is a separate, non-diversified
fund. The twelve funds of the Company and the Pennsylvania Fund are
referred to hereinafter collectively as the "Funds", and individually as a
"Fund". The Funds are described in a Prospectus of the Funds dated March 31,
1997 (the "Prospectus"). Each of the Funds has different investment
objectives and risk characteristics.
Sentinel Advisors Company (the "Advisor") acts as the investment advisor to
the Funds. Shares of the Funds are distributed by Sentinel Financial
Services Company ("SFSC"). Both the Advisor and SFSC are partnerships whose
partners are affiliates of National Life Insurance Company ("National Life"),
Provident Mutual Life Insurance Company ("Provident Mutual") and The Penn
Mutual Life Insurance Company ("Penn Mutual").
This Statement of Additional Information is not a Prospectus and should be
read in conjunction with the Prospectus. The Prospectus, which has been
filed with the Securities and Exchange Commission (the "SEC"), can be
obtained upon request and without charge by writing to the Funds at the above
address. This Statement of Additional Information has been incorporated by
reference into the Prospectus.
<PAGE>
TABLE OF CONTENTS
Page
----
The Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Investment Objectives and Policies . . . . . . . . . . . . . . . . . . . . 3
Investment Restrictions. . . . . . . . . . . . . . . . . . . . . . . . . . 14
Management of the Funds. . . . . . . . . . . . . . . . . . . . . . . . . . 15
The Investment Advisory Contracts. . . . . . . . . . . . . . . . . . . . . 20
The Distribution Contracts . . . . . . . . . . . . . . . . . . . . . . . . 22
The Distribution Plans . . . . . . . . . . . . . . . . . . . . . . . . . . 23
The Fund Services Agreements . . . . . . . . . . . . . . . . . . . . . . . 24
Portfolio Transactions and Brokerage Commissions . . . . . . . . . . . . . 25
Portfolio Turnover . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Capitalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
How To Purchase Shares and Reduce Sales Charges. . . . . . . . . . . . . . 28
Issuance of Shares at Net Asset Value. . . . . . . . . . . . . . . . . . . 28
How to Redeem Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Determination of Net Asset Value . . . . . . . . . . . . . . . . . . . . . 29
Computation of Maximum Offering and Redemption Prices. . . . . . . . . . . 30
Dividends and Capital Gains Distributions. . . . . . . . . . . . . . . . . 32
Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Shareholder Services . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Total Return, Yield and Tax-Equivalent Yield Information . . . . . . . . . 39
General Information. . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
Appendix A - Description of Bond Ratings . . . . . . . . . . . . . . . . . 43
Appendix B - Economic Conditions in New York . . . . . . . . . . . . . . . 46
Appendix C - Economic Conditions in Pennsylvania . . . . . . . . . . . . . 54
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THE FUNDS
Originally incorporated in the State of Delaware on December 5, 1933 as
Group Securities, Inc., the Company became a Maryland corporation on February
28, 1973. On November 30, 1973, the Company's name was changed to USLIFE
Funds, Inc. On September 30, 1976, the Company's name was changed to
Sentinel Group Funds, Inc.
On March 31, 1978, Sentinel Bond Fund, Inc. (formerly Sentinel Income
Fund, Inc.) and Sentinel Growth Fund, Inc., both managed, open-end,
diversified investment companies incorporated in Maryland on October 24,
1968, were merged into the Company as separate classes of stock. On March
27, 1986, the Board of Directors created, as a new class of stock of the
Company, the Government Securities Fund. The Board of Directors created the
Tax-Free Income Fund as a new class of the Company's stock on June 14, 1990.
The Pennsylvania Fund is a trust formed under the laws of Pennsylvania in
1986. The Fund became a member of the Sentinel Family of Funds on March 1,
1993. On that date the Advisor and SFSC became the investment advisor and
distributor, respectively, to the Fund. Immediately prior to March 1, 1993,
the investment advisor to the Fund was ProvidentMutual Management Co., Inc.
("PMMC"), and its distributor was ProvidentMutual Financial Services, Inc.,
both of which are affiliates of Provident Mutual.
On March 1, 1993, the Company completed the acquisition of substantially
all of the assets of eight ProvidentMutual Funds, and Sentinel Cash
Management Fund, Inc., ("SCMF") in exchange solely for common stock of the
corresponding Funds of the Company that acquired such assets. In order to
facilitate the acquisitions, on August 13, 1992 the Board of Directors
authorized the creation of three new classes of stock of the Company, namely,
the Small Company, World and Treasury Funds. On the same date, the Investment
Advisory Agreement between the Company and Sentinel Advisors, Inc.,
("Sentinel Advisors"), an indirect wholly-owned subsidiary of National Life,
and the Distribution Agreement between the Company and Equity Services, Inc.
("ESI"), also an indirect wholly-owned subsidiary of National Life,
terminated, and were replaced by the arrangements described in the Prospectus
under "Management of the Funds" and "How to Purchase Shares".
On March 27, 1995, the Company completed the acquisition of substantially
all of the assets of seven funds of The Independence Capital Group of Funds,
Inc., in exchange solely for common stock of the corresponding Funds of the
Company that acquired such assets. In order to facilitate the acquisitions,
on December 15, 1994, the Board of Directors authorized the creation of two
new classes of stock of the Company, namely, the New York and Short Maturity
Government Funds.
On March 14, 1997, the Board of Directors of the Company authorized the
creation of the High Yield Bond Fund as a new series of the Company.
INVESTMENT OBJECTIVES AND POLICIES
The investment objectives and certain fundamental policies of each of the
Funds are set forth in the Prospectus.
GENERAL CONSIDERATIONS
Each Fund's fundamental policies and investment objectives as they affect
each such Fund cannot be changed without the approval of the lesser of (i) 67
percent or more of the voting securities of each such Fund present at a
meeting if the holders of more than 50 percent of the outstanding voting
securities of each such Fund are present or represented by proxy, or (ii)
more than 50 percent of the outstanding voting securities of each such Fund.
With respect
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to the submission of a change in fundamental policy or investment objective
of each such Fund, such matter shall be deemed to have been effectively acted
upon with respect to any such Fund if a majority of the outstanding voting
securities of such Fund vote for the approval of such matters,
notwithstanding (1) that such matter has not been approved by a majority of
the outstanding voting securities of any other Fund affected by such matter
and (2) that such matter has not been approved by a majority of the
outstanding voting securities of the Company. Fundamental policies adopted
with respect to each Fund, except the Pennsylvania Fund and the New York
Fund, provide that no Fund shall concentrate its investments in a particular
industry or group of industries nor will it purchase a security if, as a
result of such purchase, more than 25% of its assets will be invested in a
particular industry.
CONSIDERATIONS APPLICABLE TO THE FIXED-INCOME FUNDS
Each of the Bond Fund, the New York Fund, the Tax-Free Income Fund, and
the fixed income portion of the Balanced Fund may invest up to 5% of its
total assets in debt securities which are rated below "investment grade",
i.e., lower than "Baa" by Moody's Investors Service, Inc. ("Moody's") or
lower than "BBB" by Standard & Poor's Ratings Services ("Standard & Poor's") or
which, in the Advisor's judgment, possess similar credit characteristics.
See Appendix A - "Description of Bond Ratings" for additional information
regarding ratings of debt securities. The Advisor considers the ratings
assigned by Standard & Poor's or Moody's as one of several factors in its
independent credit analysis of issuers. Such securities are considered by
Standard & Poor's and Moody's to have varying degrees of speculative
characteristics. Consequently, although securities rated below investment
grade can be expected to provide higher yields, such securities may be
subject to greater market price fluctuations and risk of loss of principal
than lower yielding, higher rated debt securities. Investments in such
securities will be made only when in the judgment of the Advisor, such
securities provide attractive total return potential relative to the risk of
such securities, as compared to higher quality debt securities. The Funds do
not intend to purchase debt securities that are in default or which the
Advisor believes will be in default.
Each of the Funds to a limited extent may enter into repurchase
agreements with selected banks and broker-dealers under which the Fund
purchases securities issued or guaranteed by the U.S. Government or its
agencies or instrumentalities ("U.S. Government Securities") and agrees to
resell the securities at an agreed upon time and an agreed upon price. The
difference between the amount a Fund pays for securities and the amount it
receives upon resale is interest income to a Fund. Failure of the seller to
repurchase the securities as agreed may result in a loss to a Fund if the
market value of the securities has fallen to less than the repurchase price.
In the event of such a default, a Fund may also experience certain costs and
be delayed or prevented from recovering or liquidating the collateral
securities, which could result in further loss to a Fund. The Funds will use
repurchase agreements as a means of making short-term investments of seven
days or less and in aggregate amounts of not more than 25% of the net assets
of the Fund. All repurchase agreements used by the Funds will provide that
the value of the collateral underlying the repurchase agreement always will
be at least equal to 102% of the repurchase price. The Advisor will monitor
on a continuing basis the creditworthiness of all parties with which it might
enter into repurchase agreements and will enter into repurchase agreements
only if it determines that the credit risk of such a transaction is minimal.
As stated in the Prospectus (as supplemented), the High Yield Fund may
invest in Rule 144A Securities and corporate loans; however, the High Yield
Fund's investment in illiquid securities is limited to 15% of its net assets.
The Bond Fund may not invest in illiquid securities, but may invest Rule 144A
Securities to the extent deemed to be liquid under the policies and procedures
discussed below. In promulgating Rule 144A under the Securities Act, the
Securities and Exchange Commission ("SEC") stated that although the ultimate
responsibility for liquidity determinations rests with a fund's board of
directors, the board may delegate the day-to-day function of determining
liquidity to the investment advisor provided the board retains sufficient
oversight. The Board of Directors of the Company will consider the adoption of
policies and procedures for the Bond Fund and the High Yield Fund for the
purpose of determining whether Rule 144A Securities and, in the case of High
Yield Fund only, corporate loans, in which such Fund proposes to invest are
liquid or illiquid and will consider guidelines under these policies and
procedures pursuant to which the Advisor will make these determinations on an
ongoing basis. In making these determinations, consideration will be given to,
among other things, the frequency of trades and quotes for the investment, the
number of dealers willing to sell the investment and the number of potential
purchasers, dealer undertakings to make a market in the investment, the nature
of the investment and the time needed to dispose of the investment. The Board
of Directors will review periodically purchases and sales of Rule 144A
Securities by the Bond Fund and the High Yield Fund and corporate loans by the
High Yield Fund.
The extent that liquid Rule 144A Securities or corporate loans in which the
Bond Fund or the High Yield Fund invest become illiquid, due to the lack of
sufficient qualified institutional buyers or market or other conditions, the
Advisor, under the supervision of the Board of Directors, will consider
appropriate measures to enable the Bond Fund and the High Yield Fund to maintain
sufficient liquidity for operating purposes and to meet redemption requests.
CONSIDERATIONS APPLICABLE TO THE TAX-EXEMPT FUNDS
As described in the Prospectus, the Tax-Free Income Fund, the
Pennsylvania Fund and the New York Fund (together, the "Tax-Exempt Funds")
may purchase and sell exchange-traded financial futures contracts ("financial
futures contracts") to hedge their portfolios of municipal bonds against
declines in the value of such securities and to hedge against increases in
the cost of securities they intend to purchase. To hedge their portfolios,
the Tax-Exempt
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Funds may take an investment position in a financial futures contract which
will move in the opposite direction from the portfolio position being hedged.
While the use of hedging strategies is intended to moderate capital changes
in portfolio holdings and thereby reduce the volatility of the net asset
value of Fund shares, the Tax-Exempt Funds anticipate that their net asset
values will fluctuate. Set forth below is information concerning financial
futures transactions.
DESCRIPTION OF FINANCIAL FUTURES CONTRACTS. A financial futures contract
is an agreement between two parties to buy and sell a security, or in the
case of an index-based financial futures contract, to make and accept a cash
settlement for a set price on a future date. A majority of transactions in
financial futures contracts, however, do not result in the actual delivery of
the underlying instrument or cash settlement, but are settled through
liquidation, i.e., by entering into an offsetting transaction. Financial
futures contracts have been designed by boards of trade which have been
designated "contracts markets" by the Commodity Futures Trading Commission
(the "CFTC").
The purchase or sale of a financial futures contract differs from the
purchase or sale of a security in that no price or premium is paid or
received. Instead, an amount of cash or securities acceptable to the broker
and the relevant contract market, which varies but is generally about 5% of
the contract amount, must be deposited with the broker. This amount is known
as "initial margin" and represents a "good faith" deposit assuring the
performance of both the purchaser and seller under the financial futures
contract. Subsequent payments to and from the broker, called "variation
margin", are required to be made on a daily basis as the price for the
futures contract fluctuates and makes the long and short positions in the
futures contract more or less valuable, a process known as "mark to the
market". At any time prior to the settlement date of the futures contract,
the position may be closed out by taking an opposite position which will
operate to terminate the position in the futures contract. A final
determination of variation margin is then made, additional cash is required
to be paid to or released by the broker and the position realizes a loss or a
gain. In addition, a nominal commission is paid on each completed sale
transaction.
The Tax-Exempt Funds may deal in financial futures contracts based on a
long-term municipal bond index developed by the Chicago Board of Trade (the
"CBT") and The Bond Buyer (the "Municipal Bond Index"). The Municipal Bond
Index is comprised of 40 tax-exempt municipal revenue bonds and general
obligations bonds. Each bond included in the Municipal Bond Index must be
rated "A" or higher by Moody's or Standard & Poor's and must have a remaining
maturity of 19 years or more. Twice a month new issues satisfying the
eligibility requirements are added to, and an equal number of old issues are
deleted from, the Municipal Bond Index. The value of the Municipal Bond
Index is computed daily according to a formula based on the price of each
bond in the Municipal Bond Index, as evaluated by six dealer-to-dealer
brokers.
The Municipal Bond Index financial futures contract is traded only on the
CBT. Like other contract markets, the CBT assures performance under
financial futures contracts through a clearing corporation, a non-profit
organization managed by the exchange membership which is also responsible for
handling daily accounting of deposits or withdrawals of margin.
The Tax-Exempt Funds may purchase and sell financial futures contracts on
U.S. Government Securities as a hedge against adverse changes in interest
rates as described below. With respect to U.S. Government Securities,
currently there are financial futures contracts based on long-term U.S.
Treasury bonds, U.S. Treasury notes, Government National Mortgage Association
("GNMA") Certificates and three-month U.S. Treasury bills. The Tax-Exempt
Funds may purchase and write call and put options on financial futures
contracts on U.S. Government Securities in connection with their hedging
strategies.
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The Tax-Exempt Funds also may engage in other financial futures contracts
transactions, such as financial futures contracts on other municipal bond
indices which may become available, if the Advisor should determine that
there is normally a sufficient correlation between the prices of such
financial futures contracts and the municipal bonds in which the Tax-Exempt
Funds invest to make such hedging appropriate.
FUTURES STRATEGIES A Tax-Exempt Fund may sell a financial futures
contract (i.e., assume a short position) in anticipation of a decline in the
value of their investments in municipal bonds resulting from an increase in
interest rates or otherwise. The risk of decline could be reduced without
employing futures as a hedge by selling such municipal bonds and either
reinvesting the proceeds in securities with shorter maturities or by holding
assets in cash. This strategy, however, entails increased transaction costs
in the form of dealer spreads and typically would reduce the average yield of
the Funds' portfolio securities as a result of the shortening of maturities.
The sale of financial futures contracts provides an alternative means of
hedging against declines in the value of their investments in municipal
bonds. As such values decline, the value of the Funds' positions in the
financial futures contracts will tend to increase, thus offsetting all or a
portion of the depreciation in the market value of the Funds' municipal bond
investments which are being hedged. While the Tax-Exempt Funds will incur
commission expenses in selling and closing out financial futures contract
positions, commissions on financial futures contract transactions are lower
than transaction costs incurred in the purchase and sale of municipal bonds.
In addition, the ability to trade in the standardized contracts available in
the futures markets may offer a more effective defensive position than a
program to reduce the average maturity of the portfolio securities, due to
the unique and varied credit and technical characteristics of the municipal
debt instruments available to the Funds. Employing futures as a hedge also
may permit the Tax-Exempt Funds to assume a defensive posture without
reducing the yield on their investments beyond any amounts required to engage
in futures trading.
When the Tax-Exempt Funds intend to purchase municipal bonds, they may
purchase financial futures contracts as a hedge against any increase in the
cost of such municipal bonds, resulting from a decrease in interest rates or
otherwise, that may occur before such purchases can be effected. Subject to
the degree of correlation between the municipal bonds and the financial
futures contracts, subsequent increases in the cost of municipal bonds should
be reflected in the value of the futures held by the Tax-Exempt Funds. As
such purchases are made, an equivalent amount of financial futures contracts
will be closed out. Due to changing market conditions and interest rate
forecasts, however, a financial futures contract position may be terminated
without a corresponding purchase of portfolio securities.
CALL OPTIONS ON FINANCIAL FUTURES CONTRACTS The Tax-Exempt Funds also
may purchase and sell exchange-traded call and put options on financial
futures contracts on U.S. Government Securities. The purchase of a call
option on a financial futures contract is analogous to the purchase of a call
option on an individual security. Depending on the pricing of the option
compared to either the financial futures contract on which it is based, or
the price of the underlying debt securities, it may or may not be less risky
than ownership of the financial futures contract or the underlying debt
securities. Like the purchase of a financial futures contract, a Tax-Exempt
Fund will purchase a call option on a financial futures contract to hedge
against a margin advance when it is not fully invested.
The writing of a call option on a financial futures contract constitutes
a partial hedge against declining prices of the securities which are
deliverable upon exercise of the financial futures contract. If the futures
price at expiration is below the exercise price, the Tax-Exempt Fund will
retain the full amount of the option premium which provides a partial hedge
against any decline that may have occurred in the Fund's portfolio holdings.
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PUT OPTIONS ON FINANCIAL FUTURES CONTRACTS The purchase of a put option
on a financial futures contract is analogous to the purchase of a protective
put option on a portfolio security. The Tax-Exempt Funds may purchase put
options on financial futures contracts to hedge the Funds' portfolios against
the risk of rising interest rates.
The writing of a put option on a financial futures contract constitutes a
partial hedge against increasing prices of the securities which are
deliverable upon exercise of the futures contract. If the futures price at
expiration is higher than the exercise price, the Tax-Exempt Funds will
retain the full amount of the option premium which provides a partial hedge
against any increase in the price of municipal bonds which the Funds intend
to purchase.
The writer of an option on a financial futures contract is required to
deposit initial and variation margin pursuant to requirements similar to
those applicable to financial futures contracts. Premiums received from the
writing of an option will be included in initial margin. The writing of an
option on a financial futures contract involves risks similar to those
relating to financial futures contracts.
RESTRICTIONS ON USE OF FUTURES TRANSACTIONS Regulations of the CFTC
applicable to the Tax-Exempt Funds provide that the Tax-Exempt Funds may
purchase and sell financial futures contracts and options thereon either (a)
for bona fide hedging purposes or (b) for non-hedging purposes, provided that
the aggregate initial margins and premiums required to establish positions in
such contracts and options do not exceed 5% of the liquidation value of a
Tax-Exempt Fund's portfolio assets after taking into account any unrealized
profits and losses on such contracts or options. (However, as stated above,
the Tax-Exempt Funds intend to engage in futures and options transactions for
hedging purposes only.) Margin deposits may consist of cash or securities
acceptable to the broker and the relevant contract market.
When the Tax-Exempt Funds purchase a financial futures contract or a call
option with respect thereto or write a put option on a financial futures
contract, an amount of cash, cash equivalents or short-term, high-grade,
fixed-income securities will be deposited in a segregated account with the
Funds' custodian so that the amount so segregated, plus the amount of initial
and variation margin held in the account of their broker, equals the market
value of the financial futures contract, thereby ensuring that the use of
such futures is unleveraged.
RISK FACTORS IN FUTURES AND OPTIONS TRANSACTIONS Investment in financial
futures contracts involves the risk of imperfect correlation between
movements in the price of the financial futures contract and the price of the
security being hedged. The hedge will not be fully effective when there is
imperfect correlation between the movements in the prices of two financial
instruments. For example, if the price of the financial futures contract
moves more than the price of the hedged security, the Tax-Exempt Funds will
experience either a loss or gain on the financial futures contract which is
not completely offset by movements in the price of the hedged securities. To
compensate for imperfect correlations, the Tax-Exempt Funds may purchase or
sell financial futures contracts in a greater dollar amount than the hedged
securities if the volatility of the price of the hedged securities is
historically greater than that of the financial futures contracts.
Conversely, the Tax-Exempt Funds may purchase or sell fewer financial futures
contracts if the volatility of the price of the hedged securities is
historically less than that of the financial futures contracts.
The particular municipal bonds comprising the index underlying the
Municipal Bond Index financial futures contract may vary from the bonds held
by the Tax-Exempt Funds. As a result, each Fund's ability to hedge
effectively all or a portion of the value of its municipal bonds through the
use of such financial futures contracts will depend in part on the degree to
which price movements in the index underlying the financial futures contract
correlate with the price movements of the municipal bonds held by that Fund.
The correlation may be affected by disparities in the average maturity,
ratings, geographic mix or structure of such Fund's
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investments as compared to those comprising the Municipal Bond Index, and
general economic or political factors. In addition, the correlation between
movements in the value of the Municipal Bond Index may be subject to change
over time as additions to and deletions from the Municipal Bond Index alter
its structure. The correlation between financial futures contracts on U.S.
Government Securities and the municipal bonds held by the Tax-Exempt Funds
may be adversely affected by similar factors and the risk of imperfect
correlation between movements in the prices of such financial futures
contracts and the prices of the municipal bonds held by the Tax-Exempt Funds
may be greater.
The Tax-Exempt Funds expect to liquidate a majority of the financial
futures contracts they enter into through offsetting transactions on the
applicable contract market. There can be no assurance, however, that a
liquid secondary market will exist for any particular financial futures
contract at any specific time. Thus, it may not be possible to close out a
financial futures contract position. In the event of adverse price
movements, the Tax-Exempt Funds would continue to be required to make daily
cash payments of variation margin. In such situations, if a Fund has
insufficient cash, it may be required to sell portfolio securities to meet
daily variation margin requirements at a time when it may be disadvantageous
to do so. The inability to close out financial futures contract positions
also could have an adverse impact on a Fund's ability to hedge effectively
its investments in municipal bonds. The Tax-Exempt Funds will enter into a
financial futures contract position only if, in the judgment of the Advisor,
there appears to be an actively traded secondary market for such financial
futures contracts.
The liquidity of a secondary market in a financial futures contract may
be adversely affected by "daily price fluctuation limits" established by
commodity exchanges which limit the amount of fluctuation in a futures
contract price during a single trading day. Once the daily limit has been
reached in the contract, no trades may be entered into at a price beyond the
limit, thus preventing the liquidation of open financial futures contract
positions. Prices have in the past reached or exceeded the daily limit on a
number of consecutive trading days.
The successful use of transactions in futures and related options also
depends on the ability of the Advisor to forecast correctly the direction and
extent of interest rate movements within a given time frame. To the extent
interest rates remain stable during the period in which a financial futures
contract or option is held by the Tax-Exempt Funds or such rates move in a
direction opposite to that anticipated, a Fund may realize a loss on the
hedging transaction which is not fully or partially offset by an increase in
the value of portfolio securities. As a result, a Fund's total return for
such period may be less than if it had not engaged in the hedging transaction.
Because of low initial margin deposits made on the opening of a financial
futures contract position, futures transactions involve substantial leverage.
As a result, relatively small movements in the price of the financial
futures contracts can result in substantial unrealized gains or losses.
Because the Tax-Exempt Funds will engage in the purchase and sale of
financial futures contracts solely for hedging purposes, however, any losses
incurred in connection therewith should, if the hedging strategy is
successful, be offset in whole or in part by increases in the value of
securities held by the Funds or decreases in the price of securities that the
Funds intend to acquire.
The amount of risk the Tax-Exempt Funds assume when they purchase an
option on a financial futures contract is the premium paid for the option
plus related transaction costs. In addition to the correlation risks
discussed above, the purchase of an option on a financial futures contract
also entails the risk that changes in the value of the underlying financial
futures contract will not be fully reflected in the value of the option
purchased.
Municipal Bond Index financial futures contracts only recently have been
approved for trading and therefore have little trading history. It is
possible that trading in such
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financial futures contracts will be less liquid than trading in other futures
contracts. The trading of financial futures contracts also is subject to
certain market risks, such as inadequate trading activity, which could at
times make it difficult or impossible to liquidate existing positions.
TAX-EXEMPT OBLIGATIONS The Tax-Exempt Funds may invest in municipal
obligations that constitute "private activity bonds" under the Internal
Revenue Code of 1986, as amended (the "Code") which could subject holders of
certain private activity bonds to an alternative minimum tax ("AMT"). The
provisions of the Code relating to private activity bonds generally apply to
bonds issued after August 15, 1986, with certain transitional rule
exemptions. Private activity bonds are eligible for purchase by the
Tax-Exempt Funds provided that the interest paid thereon qualifies as exempt
from federal income taxes (and in the case of the New York and Pennsylvania
Funds, New York State and City, and Pennsylvania, personal income taxes,
respectively). It is the position of the SEC and the Funds that municipal
obligations that generate income subject to the AMT should not be counted as
tax-exempt for the purpose of determining whether 80% of a Fund's net assets
are invested in tax-exempt obligations.
Tax-exempt obligations held by the Tax-Exempt Funds generally will
consist of investment grade municipal obligations with maturities of longer
than one year. Long-term obligations normally are subject to greater market
fluctuations as a result of changes in interest rates and market conditions
than are short-term obligations. The two principal classifications of
municipal obligations which may be held by the Tax-Exempt Funds are "general
obligation" bonds and "revenue" bonds. General obligation bonds are secured
by the issuer's pledge of its full faith, credit and taxing power in support
of the payment of principal and interest. Revenue bonds are payable only
from the revenues derived from a particular facility or class of facilities
or, in some cases, from the proceeds of a special excise tax or other
specific revenue source such as the user of the facility being financed.
Tax-exempt private activity bonds (including industrial development bonds)
are in most cases revenue bonds and are not payable from the unrestricted
revenues of the issuer. Consequently, the credit quality of private activity
bonds usually is related directly to the credit standing of the corporate
user of the facility involved. In addition, the Tax-Exempt Funds may invest
in short-term municipal obligations (commonly referred to as municipal
notes). Municipal notes often are used to provide for short-term capital
needs and generally have maturities of one year or less. Municipal notes
include variable and floating rate demand obligations, tax anticipation
notes, revenue anticipation notes, construction loan notes and bond
anticipation notes.
The Pennsylvania Fund will attempt to invest 100% of its assets in
Pennsylvania Obligations (as defined in the Prospectus), and the New York
Fund will attempt to invest 100% of its assets in New York Obligations (as
defined in the Prospectus). As a matter of fundamental policy, the
Pennsylvania and New York Funds, under normal market conditions, will invest
at least 80% of their net assets in tax-exempt Pennsylvania Obligations or
New York Obligations, respectively, in each case which are rated within the
top four rating categories by a nationally recognized statistical rating
organization or, if not rated, which, in the opinion of the Advisor, possess
equivalent investment characteristics. The fourth grade is considered
medium-grade and has speculative characteristics. The Pennsylvania Fund may
invest up to 25% of its assets in securities rated at this fourth grade, and
the New York Fund may invest without limitation in securities rated at this
fourth grade. These bond ratings are described in Appendix A to this
Statement of Additional Information.
During temporary defensive periods when, in the Advisor's opinion,
suitable Pennsylvania or New York Obligations are unavailable, or the Advisor
anticipates an increase in interest rates, the Pennsylvania and New York
Funds may invest not more than 20% of their assets in obligations, the
interest on which is exempt only from federal income taxes (such as
obligations issued by states other than Pennsylvania or New York) or is
exempt only from Pennsylvania or New York personal income taxes (such as
obligations issued or guaranteed by the U.S. Government or its agencies or
instrumentalities). Moreover, under such conditions, all three
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Tax-Exempt Funds may make temporary investments in high-quality obligations,
the interest on which is not exempt from either federal or any state personal
income taxes. Such investments will consist of debt securities (including
commercial paper) of issuers having, at the time of purchase, a quality
rating within the two highest categories of either Standard & Poor's or
Moody's, certificates of deposit, banker's acceptances, or repurchase
agreements.
VARIABLE OR FLOATING RATE NOTES The Tax-Exempt Funds may invest in
variable or floating rate demand obligations, which are securities that
provide for adjustment in their interest rates at intervals ranging from
daily to up to one year based upon prevailing market rates for similar
investments and an adjustment formula that is intended to maintain the market
value of the security at par. These obligations normally have a stated
maturity in excess of one year but permit the holder to demand repayment of
principal plus payment of accrued interest at any time upon a specified
number of days' notice. The Tax-Exempt Funds will have the right to receive
repayment of principal and payment of accrued interest within seven days.
Some notes may be rated by credit rating agencies but unrated notes purchased
by the Funds, in the Advisor's opinion, will be of comparable quality at the
time of purchase to instruments that are rated as high quality. Where
necessary to ensure that an unrated note is of high quality, the Funds will
require that the issuer's obligation to pay the principal of the note be
backed by an unconditional domestic or foreign bank letter or line of credit,
guarantee or commitment to lend. In such a case, the quality of the bank
will be looked to for purposes of satisfying the Funds' quality standards.
In addition, the Advisor will consider that foreign banks are not subject to
the same regulations as are domestic banks and may be involved in different
business activities and have different risks. Although there may be no active
secondary market for a particular instrument, the Funds may, upon notice,
exercise a note's demand feature or resell the note at any time to a third
party. If a significant portion of a Fund's assets were invested in notes of
a single issuer, however, the issuer's ability to meet the demand feature
could affect that Fund's liquidity. Included in the variable and floating
rate demand instruments that the Tax-Exempt Funds may purchase are
participations in municipal obligations purchased from and owned by financial
institutions, primarily banks, the interest on which, in the opinion of
counsel to the issuer, is exempt from federal income taxes and in the case of
the New York and Pennsylvania Funds, New York State and City, and
Pennsylvania, personal income taxes, respectively. In determining average
weighted portfolio maturity, an instrument will be deemed to have a maturity
equal to the longer of the period remaining to the next interest rate
adjustment or the demand notice period.
MUNICIPAL BOND INSURANCE. Certain of the municipal obligations held in
the portfolios of the Tax-Exempt Funds may be insured. Different types of
such insurance include a "New Issue Insurance Policy", a "Mutual Fund
Insurance Policy" or a "Secondary Market Insurance Policy".
A New Issue Insurance Policy is obtained by the issuer of the securities,
and all premiums for such a policy are paid in advance by the issuer. Such
policies are generally used by an issuer to increase the credit rating of a
lower-rated security, and therefore may increase both the purchase price and
the subsequent resale value of a security for a Fund's portfolio. They are
non-cancellable and continue in force as long as the securities are
outstanding and the respective insurers remain in business. Premiums for
issuer insurance are paid in advance by the issuer and are reflected in a
somewhat higher purchase price paid by the Tax-Exempt Funds for these
obligations. The creditworthiness of the issuer will be evaluated in order
to determine its ability to meet its obligations to pay interest and repay
principal. The insurance covers the event that the issuer defaults on an
interest payment or principal repayment; if this occurs, the insurer will be
notified and will make payment to the bondholders. There is, however, no
guarantee that the insurer will meet its obligations. These insurance
policies do not protect bondholders from adverse changes in interest rates.
A Mutual Fund Insurance Policy is used to guarantee specific bonds only
while owned by a mutual fund. If a Fund were to purchase such a policy,
payment of the annual premiums
10
<PAGE>
would reduce such Fund's current yield. The Tax-Exempt Funds have no plans
to purchase a Mutual Fund Insurance Policy at this time.
A Secondary Market Insurance Policy is purchased by an investor
subsequent to a security's issuance and generally insures a particular
security for the remainder of its term. The Tax-Exempt Funds may purchase
securities which already have been insured under a Secondary Market Insurance
Policy by a prior investor, or such Funds may purchase such a policy from a
vendor providing such a service.
OTHER MATTERS SPECIFIC TO THE NEW YORK FUND. The New York Fund is a
non-diversified series of the Company under the Investment Company Act of
1940, as amended (the "1940 Act"). Therefore, the New York Fund could invest
all of its assets in securities of a single issuer. However, as the Fund
intends to comply with Subchapter M of the Code, at least 50% of its total
assets must be comprised of individual issues, each of which represents no
more than 5% of such Fund's total assets and not more than 10% of the
issuer's outstanding voting securities. Those issues which represent more
than 5% of the New York Fund's total assets must be limited in the aggregate
to 50% of such Fund's total assets, provided, however, that no more than 25%
of the Fund's total assets may be invested in any one issuer. For these
purposes, a security is considered to be issued by the governmental entity
(or entities) whose assets or revenues back the security, or with respect to
a private activity bond that is backed only by the assets and revenues of a
non-governmental user, a security is considered to be issued by such
non-governmental user. In accordance with SEC regulations, the guarantor of
a guaranteed security may be considered to be an issuer in connection with
such guarantee. Since investment return on a non-diversified portfolio
typically is dependent upon the performance of a smaller number of securities
relative to the number held in a diversified portfolio, the New York Fund is
more susceptible to economic, political and regulatory developments and the
change in value of any one security will affect the overall value of a
non-diversified portfolio and thereby subject its net asset value per share
to greater fluctuations.
Because the New York Fund invests at least 80% of its assets in New York
Obligations, its net asset value is particularly sensitive to changes in the
economic conditions and governmental policies of the State of New York. See
Appendix B - "Economic Conditions in New York" for additional information
regarding these factors.
OTHER MATTERS SPECIFIC TO THE PENNSYLVANIA FUND. The Pennsylvania Fund
is registered as a non-diversified, open-end investment company under the
1940 Act. Therefore, the Pennsylvania Fund could invest all of its assets in
securities of a single issuer. However, as the Pennsylvania Fund also
intends to comply with Subchapter M of the Code, it must observe the same
diversification restrictions set forth in the preceding section for the New
York Fund. Since investment return on a non-diversified portfolio typically
is dependent upon the performance of a smaller number of securities relative
to the number held in a diversified portfolio, the Pennsylvania Fund is also
more susceptible to economic, political and regulatory developments, and the
change in value of any one security will affect the overall value of a
non-diversified portfolio and thereby subject the Pennsylvania Fund's net
asset value per share to greater fluctuations.
Because the Pennsylvania Fund invests at least 80% of its assets in
Pennsylvania Obligations, its net asset value is particularly sensitive to
changes in the economic conditions and governmental policies of the
Commonwealth of Pennsylvania ("Pennsylvania"). See Appendix C -"Economic
Conditions in Pennsylvania" for additional information regarding these
factors.
The Pennsylvania Fund's portfolio turnover rate generally will not exceed
100%. A portfolio turnover rate of 100% or higher will result in higher
transaction costs, which must be
11
<PAGE>
borne directly by the Pennsylvania Fund and ultimately by its shareholders.
High portfolio turnover may result in the realization of substantial net
capital gains. To the extent net short-term capital gains are realized, any
distributions resulting from such gains are considered ordinary income for
federal income tax purposes. The Fund will, however, comply with the federal
income tax requirement that less then 30% of its gross income be derived from
the sale or other disposition of securities held for less than three months.
In addition, the Pennsylvania Fund does not intend to (i) invest in
securities secured by real estate or interests therein or issued by companies
or investment trusts which invest in real estate or interests therein, or
(ii) invest in securities issued by companies which, together with any
predecessor, have been in continuous operation for fewer than three years.
The Pennsylvania Fund would seek to notify shareholders before changing any
of these policies.
CONSIDERATIONS APPLICABLE TO THE WORLD FUND AND HIGH YIELD BOND FUND
FOREIGN CURRENCY TRANSACTIONS. The value of the assets of the World Fund
as measured in U.S. dollars may be affected favorably or unfavorably by
changes in foreign currency exchange rates and exchange control regulations,
and the Fund may incur costs in connection with conversions between various
currencies.
The Fund will conduct its foreign currency exchange transactions either
on a spot (i.e., cash) basis at the spot rate prevailing in the foreign
currency exchange market or through the use of forward contracts to purchase
or sell foreign currencies. A forward foreign currency exchange contract
involves an obligation by the Fund to purchase or sell a specific amount of
currency at a future date, which may be any fixed number of days from the
date of the contract agreed upon by the parties, at a price set at the time
of the contract. These contracts are transferable in the interbank market
conducted directly between currency traders (usually large commercial banks)
and their customers. A forward contract generally has no deposit
requirements, and no commissions are charged at any stage for trades.
Neither type of foreign currency transaction will eliminate fluctuations in
the prices of the Fund's portfolio securities or prevent loss if the prices
of such securities should decline.
The World Fund may enter into forward foreign currency exchange contracts
only under two circumstances. First, when the Fund enters into a contract
for the purchase or sale of a security denominated in a foreign currency, it
may desire to "lock in" the U.S. dollar price of the security. The Fund will
then enter into a forward contract for the purchase or sale, for a fixed
amount of dollars, of the amount of foreign currency involved in the
underlying securities transactions; in this manner the Fund will be better
able 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 securities are purchased or
sold and the date on which payment is made or received.
Second, when the Advisor or the World Fund Subadvisor (as defined in
the Prospectus) believes that the currency of a particular foreign country
may suffer a substantial decline against the U.S. dollar, the Fund may enter
into a forward contract to sell, for a fixed amount of dollars, the amount of
foreign currency approximating the value of some or all of the Fund's
securities denominated in such foreign currency. The precise matching of the
forward contract amounts and the value of the securities involved generally
will not be possible since the future value of those securities may change
between the date the forward contract is entered into and the date it
matures. The projection of short-term currency market movement is extremely
difficult, and the successful execution of a short-term hedging strategy is
highly uncertain. The Advisor does not intend to enter into such forward
contracts under this second circumstance on a regular or continuous basis.
The Fund will not enter into such forward contracts or maintain a net
exposure to such contracts when the consummation of the contracts would
obligate the Fund to deliver an amount of foreign currency in excess of the
value of the Fund's
12
<PAGE>
securities or other assets denominated in that currency. The Advisor
believes that it is important to have the flexibility to enter into such
forward contracts when it determines that to do so is in the best interest of
the Fund. The Fund's custodian bank segregates cash or equity or debt
securities in an amount not less than the value of the Fund's total assets
committed to forward foreign currency exchange contracts entered into under
the second circumstance. If the value of the securities segregated declines,
additional cash or securities are added so that the segregated amount is not
less than the amount of the Fund's commitments with respect to such
contracts. Under normal circumstances, the Fund expects that any
appreciation (depreciation) on such forward exchange contracts will be offset
approximately by the (depreciation) appreciation in translation of the
underlying foreign investment arising from fluctuations in foreign currency
exchange rates.
The Fund will recognize the unrealized appreciation or depreciation from
the fluctuation in a foreign currency forward contract as an increase or
decrease in the Fund's net assets on a daily basis, thereby providing an
appropriate measure of the Fund's financial position and changes in financial
position.
FOREIGN SECURITIES FOR FUNDS OTHER THAN THE WORLD FUND
Before foreign securities are purchased for Funds other than the World
Fund, the differences between them and U.S. securities are considered. This
includes possible differences in taxation, regulation, trading volume and
currency controls, the possibility of expropriation and lack of uniform
accounting and reporting standards. While there may be investment
opportunities in foreign securities, there also may be investment risks not
usually associated with U.S. securities. At November 30, 1996, the Common
Stock Fund had 3.7%, the Balanced Fund had 4.5%, the Bond Fund had 12.4% of
its net assets invested in foreign securities; the Small Company, Growth,
Tax-Free Income, Pennsylvania, New York, Treasury, Government Securities and
Short Maturity Government Funds had no such investments as of that date.
INVESTMENT RESTRICTIONS
The Company. Certain By-Laws of the Company, which may be changed only
by a shareholder vote, prohibit the purchase of the securities of any company
not in operation continuously for at least three years (including any
predecessor company) and, except for U.S. Government Securities and
obligations of the government of Canada, forbid the purchase of the
securities of any one issuer, if the market value of such securities exceeds
5% of the total market value of all of the Company's securities and cash.
The Company's Board of Directors has also adopted a policy under which
each of the Common Stock Fund, Balanced Fund, Growth Fund and Bond Fund
cannot purchase securities of any one issuer if the market value of such
securities exceeds 5% of the total market value of each such Fund's
securities and cash.
It is also a fundamental policy of the Company that it may not borrow
money, except from banks in an amount up to 5% of a Fund's total assets for
temporary or emergency purposes or to meet redemption requests which might
otherwise require the untimely disposition of securities, and it may not
purchase securities on margin. Also, the Company may not lend its cash or
securities, may not deal in real estate, may not act as underwriter of
securities issued by others, and may not purchase from or sell to any
officer, director or employee of the Company, or the Advisor or underwriter,
or any of their officers or directors, any securities other than shares of
the Company's capital stock. None of its Funds may deal in options,
commodities or commodities contracts except to the extent the Tax-Exempt
Funds may enter into futures transactions and related options for hedging
purposes as described above. None of
13
<PAGE>
the Funds may invest in oil, gas or other mineral exploration or development
programs or leases. None of the Funds will invest more than 5% of its net
assets in warrants valued at the lower of cost or market, or more than 2% of
its net assets in warrants which are not listed on either the New York Stock
Exchange or the American Stock Exchange.
The Company's By-Laws also prohibit the purchase or retention of the
securities of any one issuer if officers and directors of the Company, its
Advisor or underwriter owning individually more than .5% of the securities of
such issuer together own more than 5% of the securities of such issuer.
The Company may not purchase more than 10% of the voting securities of
any issuer. The Company may not invest in companies for purposes of
exercising control or management and may not invest in any securities of any
issuer which the Company is restricted from selling to the public without
registration under the Securities Act of 1933. It also may not purchase for
any Fund securities of any issuer beyond a market value of 5% of such Fund's
net assets, and may not invest in securities which are not readily
marketable. The Company may not make short sales of securities.
Although not a fundamental policy, so long as the Common Stock Fund is
used as the underlying investment vehicle for a National Life separate
account, it is the view of management that its investment policies will be
affected by insurance laws of certain states, principally New York, which,
among other things, may limit most of the Common Stock Fund's investment in
common stocks to the common stocks of listed companies meeting certain
earnings tests. These essentially are qualitative limitations imposed upon
the investments of life insurance companies in order to reduce the risk of
loss.
Restrictions and policies established by resolution of the directors may
be changed by the Board, with any material changes to be reported to
shareholders. Those presently in effect provide that under circumstances
that the directors with the advice of independent investment counsel
determine to be extraordinary, assets of all Funds may be invested entirely
or in part in U.S. Government Securities or an agency thereof, or held as
cash deposits in a bank or trust company having resources of not less than
$2,000,000. The securities of foreign companies or governments may be
selected as being suitable for one or more of the Funds.
THE PENNSYLVANIA FUND. The following investment limitations are
applicable to the Pennsylvania Fund, and may not be changed without a vote of
the Pennsylvania Fund's shareholders.
The Pennsylvania Fund may not:
1. Purchase or sell real estate, except that the Fund may invest in
municipal obligations which are secured by real estate or interests therein.
2. Make loans, except that the Fund may purchase or hold debt
instruments and enter into repurchase agreements pursuant to its investment
objective and policies.
3. Underwrite the securities of other issuers, except to the extent that
the acquisition or disposition of municipal obligations or other securities
directly from the issuer thereof in accordance with the Fund's investment
objective and policies might be deemed to be an underwriting.
4. Purchase securities of companies for the purpose of exercising control.
5. Acquire any other investment company or investment company security,
except in connection with a merger, consolidation, reorganization or
acquisition of assets.
14
<PAGE>
6. Purchase securities on margin, make short sales of securities or
maintain a short position, provided that the Fund may enter into futures
contracts.
7. Issue senior securities except insofar as borrowing in accordance
with the Fund's investment objective and policies might be considered to
result in the issuance of a senior security; provided that the Fund may enter
into futures contracts.
8. Invest in or sell interests in oil, gas or other mineral exploration
development programs.
9. Invest in private activity bonds where the payment of principal and
interest are the responsibility of a company (including its predecessors)
with less than three years of continuous operations.
The above investment limitations are considered at the time that
portfolio securities are purchased.
If a percentage restriction is satisfied at the time of investment, a
later increase or decrease in such percentage resulting from a change in
asset value will not constitute a violation of the restriction.
In order to permit the sale of Pennsylvania Fund shares in certain
states, the Pennsylvania Fund may make commitments more restrictive than the
investment policies and limitations described above. Should the Pennsylvania
Fund determine that any such commitment is no longer in the best interests of
the Fund, it will revoke the commitment by terminating sales of its shares in
the state involved.
MANAGEMENT OF THE FUNDS
Management is made up of (i) the Company's Board of Directors and the
Pennsylvania Fund's Board of Trustees, which consist of the same thirteen
individuals and which are responsible for the Funds' operations; (ii) the
officers of the Company and the Pennsylvania Funds, who are responsible to
the Boards; and (iii) the Advisor which, under agreements with the Company
and the Pennsylvania Fund, supervises and assists in the management of the
Funds and the purchase and sale of securities. In addition, the Advisor has
retained the services of the World Fund Sub-advisor with respect to the World
Fund. See the "The Investment Advisory Contracts", below. Set forth below
is information regarding the directors/trustees and officers of the Company
and the Pennsylvania Fund, their ages and their principal occupations during
the past five years. As of March 1, 1997, the Company's and the Pennsylvania
Fund's directors/trustees and officers as a group owned less than 1% of the
outstanding shares of each Fund. In addition, as of such date, National Life
and its affiliates, each of whose address is National Life Drive, Montpelier,
Vermont 05604, except for American Guaranty & Trust Company, whose address is
220 Continental Drive, Newark, Delaware 19713 owned of record and
beneficially 33,432,906.644 shares amounting to 16.3% of the outstanding
shares of the Company (10% of the voting power) which included 2,728,470.011
shares of the Common Stock Fund amounting to 7.6% of such class,
1,969,167.420 shares of the Balanced Fund amounting to 11.6% of such class,
955,754.938 shares of the Growth Fund amounting to 20% of such class,
872,830.984 shares of the Small Company Fund amounting to 4.4% of such class,
1,329,147.696 shares of the World Fund amounting to 26% of such class,
3,592,170.375 shares of the Bond Fund amounting to 22% of such class,
864,829.360 shares of the Government Securities Fund amounting to 10% of such
class, 219,586.555 shares of Short Maturity Fund amounting to 5.2% of such
class, 20,222,739.080 shares of the Treasury Fund amounting to 24% of such
class, 606,681.695 shares of the Tax-Free Income Fund amounting
15
<PAGE>
to 8.5% of such class, and 4,933.643 shares of the New York Fund amounting to
1.0% of such class. National Life and its affiliates also owned 66,594.887
shares of the Pennsylvania Fund amounting to 2.6% of the outstanding shares
on such date.
KENISTON P. MERRILL* - CHAIRMAN AND DIRECTOR/TRUSTEE
National Life Drive
Montpelier, Vermont 05604
Age 60
Sentinel Advisors Company - Chairman and Chief Executive Officer, 1993 to
present; Sentinel Advisors, Inc. - Chairman and Chief Executive Officer,
1986 to 1993, President and Chief Operating Officer, 1982 to 1986, Director,
1982 to present; National Life - Executive Vice President and Chief
Investment Officer, February, 1994 to 1995, Senior Vice President and Chief
Investment Officer, 1989 to February, 1994, Senior Vice
President-Investments, 1986 to 1989, Vice President, 1982 to 1986; National
Life Investment Management Company, Inc. - Chairman and Chief Executive
Officer, 1990 to 1995, President and Chief Executive Officer, 1986 to 1990,
Director, 1982 to present; Sentinel Cash Management Fund, Inc. - Chairman
and Director, 1990 to 1993, President and Director, 1987 to 1990; American
Guaranty & Trust Company - Director, 1993 to present.
JOSEPH M. ROB - PRESIDENT AND DIRECTOR/TRUSTEE
National Life Drive
Montpelier, Vermont 05604
Age 54
Sentinel Management Company - Chief Executive Officer, 1993 to present;
Sentinel Financial Services Company - Chief Executive Officer, 1993 to
present; Sentinel Administrative Services Company - Chief Executive Officer,
1993 to present; ESI - Chairman, Chief Executive Officer, and Director, 1985
to present, President, 1986 to present; Sentinel Administrative Service
Corporation - Chairman of the Board, 1988 to 1993; Sentinel Cash Management
Fund, Inc. - President, 1990 to 1993, Vice President, 1985 to 1990; American
Guaranty & Trust Company - Chairman, 1993 to present; LSW National Holdings,
Inc. - Director, 1996 to present; Life Insurance Company of the Southwest -
Director, 1996 to present.
RICHARD J. BORDA - DIRECTOR/TRUSTEE
P. O. Box 6091
Carmel, California 93923
Age 65
National Life - Former Vice Chairman of the Board, 1985 to 1990, Director,
1975 to 1991; Sentinel Cash Management Fund, Inc. - Chairman, 1987 to 1990,
President 1985 to 1987, Director, 1985 to 1993; National Life Investment
Management Company, Inc. - Chairman, 1986 to 1990, President, 1985 to 1986,
Director, 1985 to 1990; Sentinel Advisors, Inc. - Chairman, Chief Executive
Officer, 1985 to 1986, Director, 1985 to 1987, 1988 to 1990; ESI - Director,
1985 to 1987, 1988 to 1990; The Monterey Institute for International Studies
- - Vice Chairman, Director and Trustee, 1991 to present; Air Force Aid Society
- - President, 1980 to 1995.
DR. KALMAN J. COHEN - DIRECTOR/TRUSTEE
2312 Honeysuckle Court
Chapel Hill, North Carolina 27514-1711
Age 66
Distinguished Bank Research Professor Emeritus, The Fuqua School of Business,
Duke University, 1993 to present; Distinguished Bank Research Professor, 1974
to 1993; USLIFE
16
<PAGE>
Income Fund, Inc. - Director, 1973 to present; Sentinel Cash Management Fund,
Inc. -Director, 1981 to 1993.
RICHARD D. FARMAN - DIRECTOR/TRUSTEE
555 West Fifth Street, 29th Floor
Los Angeles, California 90013-1011
Age 61
President, Chief Operating Officer and Director - Pacific Enterprises, 1993 to
present; Chairman and Chief Executive Officer - Southern California Gas
Company, 1989 to 1993; Chairman - KCET Public Service Television; Director
and Executive Committee Member - Los Angeles Area Chamber of Commerce;
Director - Union Bank; Past Chairman and Director - American Gas Association;
Director - Interstate Natural Gas Association of America.
JOHN D. FEERICK - DIRECTOR/TRUSTEE
140 West 62nd Street
New York, New York 10023
Age 60
Fordham University School of Law - Dean, 1982 to present; Sentinel Cash
Management Fund, Inc. -Director, 1984 to 1993; American Home Products
Corporation - Director, 1987 to present; The Association of the Bar of the
City of New York - President, 1992 to 1994; New York State Commission on
Government Integrity - Chairman, 1987 to 1990.
RICHARD I. JOHANNESEN, JR. - DIRECTOR/TRUSTEE
87 Whitney Lane
Stowe, Vermont 05672
Age 62
Retired; Former Vice President and Manager - Bond Market Research Department,
Salomon Brothers Inc.
ROBERT B. MATHIAS - DIRECTOR/TRUSTEE
7469 East Pine Avenue
Fresno, California 93727
Age 66
Sports Consultant; formerly Executive Director - National Fitness Foundation;
former U.S. Congressman; ProvidentMutual Investment Shares, Inc. - Director,
1990 to 1993; ProvidentMutual Growth Fund, Inc. - Director, 1990 to 1993.
DEBORAH G. MILLER - DIRECTOR/TRUSTEE
3 Bates Street
Cambridge, Massachusetts 02140
Age 47
Digital Equipment Corporation - Vice President-Americas Systems Business
Unit, 1995 to present; Miller Van Buren, Inc. - Chief Executive Officer, 1994
to 1995; Silicon Graphics - Vice President, 1991 to 1994; International
Business Machines Corporation - General Manager, 1984 to 1987.
STANLEY R. REBER - DIRECTOR/TRUSTEE
1600 Market Street
Philadelphia, Pennsylvania 19103
Age 53
17
<PAGE>
Provident Mutual Life Insurance Company - Executive Vice President, 1988 to
present; prior thereto, Senior Vice President; President and Director of
Market Street Fund, Inc.; President, CEO and Director of Sigma American
Corporation; Director of Providentmutual Life and Annuity Company of America,
Providentmutual Investment Management Company, Providentmutual Holding
Company, 1717 Capital Management Company, Software Development Corp., and
Provestco, Inc.
SUSAN M. STERNE - DIRECTOR/TRUSTEE
5 Glen Court
Greenwich, Connecticut 06830-4505
Age 51
Economic Analysis Associates, Inc. - President and Chief Economist, 1979 to
present; Sentinel Cash Management Fund, Inc. - Director, 1990 to 1993.
ANGELA E. VALLOT - DIRECTOR/TRUSTEE
Arent Fox Kintner Plotkin & Kahn
1675 Broadway, 25th Floor
New York, NY 10019
Age 40
Arent Fox Kintner Plotkin & Kahn - Lawyer, 1990 to present; Trustee, District
of Columbia Retirement Board; Acting Director of the Office of White House
Liason-Clinton-Gore Transition Team, 1993; Member of the Steering Committee
of the NAACP Legal Defense Fund.
JOHN RAISIAN, Ph.D. - DIRECTOR/TRUSTEE
Hoover Institution, Stanford University
Serra and Galvey Streets
Stanford, California 94305-6010
Age 47
Director and Senior Fellow - Hoover Institution, 1991 to present; Director,
Stanford Faculty Club, 1994 to present; Member of the Editorial Board,
Journal of Labor Research, 1983 to present; Member, American Economic
Association, World Affairs Council, Council of Foreign Relations, National
Association of Scholars.
JOHN M. GRAB, JR., C.P.A. - VICE PRESIDENT
National Life Drive
Montpelier, Vermont 05604
Age 50
Sentinel Management Company - Senior Vice President, 1993 to present;
Sentinel Administrative Service Company - Senior Vice President, 1993 to
present; Sentinel Administrative Service Corporation - Senior Vice President
and Chief Financial Officer, 1988 to 1993; ESI - Senior Vice President and
Chief Financial Officer, 1988 to present; American Institute of Certified
Public Accountants; The Vermont Society of Certified Public Accountants.
MARVIN ABER - VICE PRESIDENT AND TREASURER
National Life Drive
Montpelier, Vermont 05604
Age 60
Sentinel Administrative Service Company - Vice President, 1993 to present;
ESI - Vice President, 1988 to present, Treasurer, 1974 to 1988; Sentinel
Administrative Service Corporation - Vice President, 1988 to 1993; National
Life Investment Management Company,
18
<PAGE>
Inc., - Treasurer, 1980 to 1988; Sentinel Cash Management Fund, Inc. -
Treasurer, 1981 to 1993, Assistant Secretary, 1984 to 1993.
D. RUSSELL MORGAN - SECRETARY
National Life Drive
Montpelier, Vermont 05604
Age 41
National Life - Counsel, 1994 to present; Associate Counsel, 1990 to 1994,
Assistant Counsel, 1986 to 1990, Attorney 1985 to 1986; Sentinel Cash
Management Fund, Inc. - Secretary, 1986 to 1993; ESI - Counsel, 1986 to
present; Sentinel Advisors, Inc. - Counsel, 1986 to 1993; Sentinel Advisors
Company - Sentinel Financial Services Company - Sentinel Administrative
Service Company - Counsel, 1993 to present; Life Insurance Company of the
Southwest - Director, 1996 to present; LSW National Holdings, Inc. -
Secretary, 1996 to present.
*As of March 1, 1997, National Life, with which Mr. Merrill and Mr. Rob are
affiliated, together with National Life's affiliates, owned of record and
beneficially the number of shares of the Funds described on pages 15-16 of this
Statement of Additional Information.
"Interested Persons" (as defined in the 1940 Act).
The officers and directors/trustees of the Funds who are employees of
National Life, Provident Mutual, Penn Mutual, or their respective
subsidiaries do not receive any compensation from the Funds. The Company
pays to each director who is not an affiliate of the Advisor an annual fee of
$16,000 plus $1,500 for each meeting of the Board of Directors attended by
the director, and the Pennsylvania Fund pays to each such trustee an annual
fee of $2,500 plus $200 for each meeting of the Board of Trustees attended by
such trustee. The Company and the Pennsylvania Fund also reimburse
directors/trustees for travel and other out-of-pocket expenses incurred by
them in connection with attending such meetings. The aggregate remuneration
paid by the Funds during the fiscal year ended November 30, 1996 to the
officers and directors/trustees of the Funds as a group was $265,033.
The following table sets forth for the fiscal year ended November 30,
1996 compensation paid by the Company and by the Pennsylvania Fund to the
Directors/Trustees who are not affiliated with the Advisor:
<TABLE>
<CAPTION>
Pension or Total
Aggregate Retirement Compensation
Compensation Benefits from Fund
Name of Aggregate From Accrued as and Sentinel
Director/ Compensation Pennsylvania Part of Fund Pennsylvania
Trustee from Company Tax-Free Trust Expense Tax-Free Trust
- ------- ------------ -------------- ------- --------------
<S> <C> <C> <C> <C>
Kalman J. Cohen $22,000 $3,300 None $25,300
Richard J. Borda $23,500 $3,500 None $27,000
Richard D. Farman $20,500 $3,100 None $23,600
John D. Feerick $23,500 $3,500 None $27,000
Richard I. Johannesen $23,500 $3,500 None $27,000
Robert B. Mathias $23,500 $3,500 None $27,000
Deborah G. Miller $23,500 $1,233 None $24,733
Susan M. Sterne $22,000 $3,300 None $25,300
Angela E. Vallot $ 4,000 $ 625 None $ 4,625
</TABLE>
19
<PAGE>
CODE OF ETHICS
The Boards of the Funds have adopted a Code of Ethics pursuant to Rule
17j-1 under the 1940 Act, and the Advisor has adopted a similar Code of
Ethics (together, the "Codes of Ethics"). The Codes of Ethics significantly
restrict the personal investing activities of all employees of the Advisor.
The Codes of Ethics require that all employees preclear any personal
securities transaction (with limited exceptions, such as mutual funds and
government securities). The preclearance requirement and associated
procedures are designed to identify any substantive prohibition or limitation
applicable to the proposed transaction. The substantive restrictions include
a ban on acquiring any securities in an initial public offering, and a
prohibition on profiting from short-term trading in securities. In addition,
no employee may purchase or sell any security which at the time is being
purchased or sold by any mutual fund advised by the Advisor. Furthermore, the
Codes of Ethics provide for seven day trading "blackout periods" which
prohibit trading by employees of the Advisor in proximity to periods of
trading by mutual funds managed by the Advisor in the same (or equivalent)
security.
THE INVESTMENT ADVISORY CONTRACTS
The Advisor provides general supervision of the Funds' investments as
well as certain administrative and related services. As compensation in full
for services rendered under its advisory agreement applicable to all Funds
other than the High Yield Fund, the Company will pay to the Advisor a monthly
fee determined as follows: (1) With respect to the Small Company, Growth,
World and Balanced Funds: 0.70% per annum on the first $200 million of
aggregate average daily net assets of such funds in the aggregate; 0.65% per
annum on the next $100 million of such assets; 0.60% per annum on the next
$100 million of such assets; and 0.55% per annum on such assets in excess of
$400 million. (2) With respect to the Common Stock Fund: 0.55% per annum on
the aggregate average daily net assets of the Fund. (3) With respect to the
Bond, New York, Tax-Free Income, Government Securities and Short Maturity
Government Funds: 0.55% per annum on the first $200 million of aggregate
average daily net assets of such funds in the aggregate; 0.50% per annum on
the next $200 million of such assets; and 0.45% per annum on such assets in
excess of $400 million. (4) With respect to the Treasury Fund: 0.40% per
annum on the first $300 million of aggregate average daily net assets; and
0.35% per annum on such assets in excess of $300 million. For the fiscal
year ended November 30, 1996, such fees aggregated $11,732,548, for the
fiscal year ended November 30, 1995, such fees aggregated $10,156,497, and
for the fiscal year ended November 30, 1994, such fees aggregated $9,511,387.
Under a separate advisory agreement with the High Yield Fund, the
Advisor receives from the High Yield Fund a fee based on the average daily
value of the net assets of the High Yield Fund in accordance with the
following schedule; 0.75% per annum on the first $100 million of average
daily net assets of the High Yield Fund; 0.70% per annum on the next $100
million of such assets; 0.65% per annum on the next $100 million of such assets;
and 0.60% per annum on such assets in excess of $300 million.
As compensation in full for services rendered under its advisory
agreement, the Pennsylvania Fund pays to the Advisor a monthly fee of 0.55%
per annum on the first $50 million of aggregate average daily net assets of
the Fund; 0.50% per annum on the next $50 million of such assets; and 0.45%
per annum on such assets in excess of $100 million. For the fiscal years
ended November 30, 1996, November 30, 1995 and November 30, 1994, the
Pennsylvania Fund paid advisory fees of $189,231, $182,103 and $182,041,
respectively.
Under the Company's advisory agreement applicable to all Funds other than
the High Yield Fund, fees are allocated to the various Funds of the Company
which share common fee schedules in proportion to such Funds' net assets.
Each advisory agreement provides a guarantee by the Advisor that if expenses
(including the management fee but excluding interest, taxes, brokerage fees
and, where permitted, extraordinary expenses) borne by a Fund in any fiscal
year exceed the expense limitations applicable to such Fund imposed by
various state securities regulations, as such limitations may
20
<PAGE>
be lowered or raised from time to time, the Advisor will reimburse such Fund
for any excess. Currently, the most stringent state expense limitation is
2.5% of the first $30,000,000 of average net assets, 2.0% of the next
$70,000,000 of average net assets and 1.5% of the remaining average net
assets of each Fund. The Advisor has agreed to reimburse each Fund for any
expenses in excess of such limitation annually before publication of such
Fund's Annual Report. Each of the Funds' expenses during the past fiscal
year were below the prescribed limitation and therefore no reimbursement was
necessary.
The Company's advisory agreement applicable to all funds other than the
High Yield Fund, which was approved by the Company's shareholders on November
30, 1992, and the advisory agreement applicable to the High Yield Fund, which
was approved by the Company's Board of Directors on March 14, 1997 and the
High Yield Fund's Shareholders on June 20, 1997, must each be approved
annually by vote of the Board of Directors of the Company or by the vote of a
majority of the outstanding voting securities of the applicable Fund, but in
either event it must also be approved by a vote of a majority of the
directors who are not parties to the contract, or "interested persons", as
defined in the 1940 Act, of any such party cast in person at a meeting called
for the purpose of voting on such approval. With respect to the submission
of the Company's advisory agreement applicable to all funds other than the
High Yield Fund for approval by the shareholders, such matters shall be
deemed to be acted upon effectively with respect to any class of the Company
if a majority of the outstanding voting securities of such class vote for
approval of such matter, notwithstanding (A) that such matter has not been
approved by a majority of the outstanding voting securities of any other
class affected by such matter, and (B) that such matter has not been approved
by a vote of a majority of the outstanding voting securities of the Company.
The Pennsylvania Fund's advisory agreement, which was approved by the
shareholders of the Fund on February 19, 1993, must be approved annually by
vote of the Board of Trustees or by the vote of a majority of the outstanding
voting securities of the Pennsylvania Fund, but in either event it must also
be approved by a vote of a majority of the trustees who are not parties to
the contract, or "interested persons", as defined in the 1940 Act, of any
such party cast in person at a meeting called for the purpose of voting on
such approval.
Each advisory agreement will terminate automatically in the event of its
assignment and is terminable at any time without penalty by the Board, or,
with respect to a particular Fund, by a majority of the Fund's outstanding
voting securities on not more than 60 days' written notice to the Advisor and
by the Advisor on 60 days' written notice to the Fund.
As described in the Prospectus, with respect to the World Fund only, the
Advisor has entered into a sub-advisory agreement with the World Fund
Sub-advisor dated March 1, 1997. In accordance with this sub-advisory
agreement, the World Fund Sub-advisor provides the World Fund with a
continuous investment program consistent with its stated investment
objectives and policies. The Advisor pays to the World Fund Sub-advisor a
fee equal to the greater of (i) 0.375% per annum of the World Fund's
aggregate average daily net assets up to $500 million, and 0.30% per annum of
such net assets in excess of $500 million, or (ii) $20,000 per year. Such fee
is paid monthly in arrears. The sub-advisory agreement must be approved
annually in one of the same ways as for the Company's advisory agreement as
described above. The sub-advisory agreement also may be terminated by either
the World Fund Sub-advisor or by action of the Board of Directors of the
Company or the shareholders of the World Fund on 60 days' written notice,
without penalty, and terminates automatically in the event of its assignment.
For the period April 1, 1996 to February 28, 1997, the World Fund Sub-advisor
provided the same services under an identical sub-advisory agreement dated
April 1, 1996, and prior to that, Cashman Farrell & Associates was the
Sub-advisor under a similar sub-advisory agreement. The fees paid to the
World Fund Sub-advisor and Cashman Farrell by the Advisor were $166,806 to
INVESCO for the period April 1, 1996 to November 30, 1996, and $66,645 to
Cashman Farrell for the period December 1, 1995 to March 31, 1996, for a
total of $233,451 for the fiscal year ended November 30, 1996, $165,408 to
Cashman Farrell for the fiscal year ended November 30, 1995, and $122,288 to
Cashman Farrell for the fiscal year ended November 30, 1994.
Also as described in the Prospectus (as supplemented). the Advisor has
entered into a sub-advisory agreement with the High Yield Fund's sub-advisor,
Keystone Investment Management Company ("Keystone"). Pursuant to this
agreement, Keystone provides the Advisor with a continous investment program
consistent with the High Yield Fund's stated investment objectives and policies.
Under this agreement, the Advisor pays a fee to Keystone equal to one half of
the fee paid by the High Yield Fund to the Advisor, provided that the fee paid
by the Advisor to Keystone will always be at least 0.35% per annum of the
average daily net assets of the High Yield Fund. This agreement became effective
June 20, 1997. This sub-advisory agreement may also be terminated by either of
the Advisor or Keystone or by action of the Board of Directors of the Company
or the shareholders of the High Yield Fund on 60 days' writter notice, without
penalty, and terminates automatically in the event of it assignment.
21
<PAGE>
THE DISTRIBUTION CONTRACTS
SFSC acts as the principal underwriter of shares of the Funds, and the
Funds receive the net asset value, as determined for the purpose of
establishing the offering price, of each share sold. SFSC has advised the
Funds that it allows dealer concessions as shown in the Prospectus, except
that items of a promotional nature amounting in value to not more than $100
may be given from time to time as a sales incentive to registered
representatives. SFSC has advised the Funds that its receipts from the sale
of shares, before expenses and after allowance by it of the dealer
concession, were $181,026, $127,814 and $121,401 for the fiscal years ended
November 30, 1996, 1995 and 1994, respectively. During such periods, ESI
received reallowances of $2,788,185, $2,332,813 and $2,733,451, respectively,
1717 Capital Management Company received reallowances of $521,911, $799,854
and $1,102,934, respectively. For the fiscal year ended November 30, 1996,
Janney Montgomery Scott and Hornor Townsend & Kent received reallowances of
$442,399 and $582,120, respectively; and during the period from March 27,
1995 to November 30, 1995 they received reallowances of $148,021 and
$156,325, respectively.
The distribution contracts of the Company and the Pennsylvania Fund may
be terminated by either party thereto on 60 days' written notice, without
penalty, and they terminate automatically in the event of their assignment.
The distribution contracts must be approved annually in one of the same ways
as described above for the advisory agreements.
THE DISTRIBUTION PLANS
The Company and the Pennsylvania Fund have adopted several plans pursuant
to Rule 12b-1 under the 1940 Act. One such plan applies to the Class A
shares of the Company's Funds (other than the Treasury Fund). In addition,
the Short Maturity Government Fund has a separate Supplemental Distribution
Plan applicable only to it. The Pennsylvania Fund has a Distribution Plan
applicable only to it. Finally, the Class B shares of the Small Company,
World, Common Stock, Balanced, Bond and Tax-Free Income Funds have adopted a
Class B Distribution Plan, effective April 1, 1996 (all of these plans are
collectively hereinafter referred to as the "Plans"). The Plans were
extended to include the High Yield Fund's Class A and Class B Shares on March
14, 1997. See "Distribution Plans" in the Prospectus (as supplemented).
The Class A and Class B shares of each Fund (except for the Treasury
Fund) paid fees under the Class A Plan in the amounts set forth below for the
periods indicated:
<TABLE>
<CAPTION>
FUND TOTAL 12b-1 FEES
Year Ended Year Ended Year Ended
November 30, 1996 November 30, 1995 November 30, 1994
--------------------- ----------------- -----------------
A Shares B Shares
<S> <C> <C> <C> <C>
Common Stock $3,345,000 $85,382 $2,545,000 $1,161,000
Balanced 835,591 31,780 741,076 544,500
Growth 189,755 -- 145,000 83,500
Small Company 278,965 6,630 281,355 290,100
World 183,351 10,900 132,778 96,797
Bond 204,195 14,799 196,750 141,500
Government Securities 199,480 -- 210,478 240,000
Short Maturity (1) 123,929 -- 48,200 --
Tax-Free Income 207,052 2,765 211,125 211,325
New York (2) 11,005 -- 6,666 --
22
<PAGE>
Pennsylvania 68,800 -- 66,219 62,300
</TABLE>
(1) Commenced operations on March 24, 1995
(2) Commenced operations on March 27, 1995
The Plan applicable to the Class B shares of the Small Company, World,
Common Stock, Balanced, Bond and Tax-Free Income Funds became effective on
April 1, 1996. It is expected that the amounts payable to SFSC under this
Class B Plan will be equal to 1.00% of the net assets of the Class B shares
of the relevant Funds. SFSC will use such payments to recoup the cost of
commissions paid to brokers at the time of sale of the Class B shares,
service fees to brokers with respect to the Class B shares, and the same
types of other marketing expenses for which SFSC receives reimbursement under
the Plans applicable to the Class A shares.
The Boards of the Funds believe that a consistent cash flow resulting
from the sale of new shares is necessary and appropriate to meet redemptions
and for the Funds to take advantage of buying opportunities without having to
make unwarranted liquidations of portfolio securities. Since SFSC receives no
other compensation from the Funds, the Boards believe it would benefit the
Funds to have monies available for the direct distribution activities of SFSC
in promoting the sale of shares of the Funds.
The Plans have been approved by the Company Board of Directors and the
Pennsylvania Fund's Board of Trustees, including all of the
directors/trustees who are not interested persons as defined in the 1940 Act.
The Plans must be renewed annually by the Boards, including a majority of the
directors/trustees who are not interested persons and who have no direct or
indirect financial interest in the operation of the Plans. It is also
required that the selection and nomination of such directors/trustees be done
by the disinterested directors/trustees. The Plans and any distribution
agreement may be terminated at any time, without penalty, by such
directors/trustees on 60 days' written notice. SFSC or any dealer may also
terminate their respective distribution agreement at any time upon written
notice.
The Plans and any distribution agreement may not be amended to increase
materially the amount spent for distribution expenses or in any other
material way without approval by a majority of the Funds' outstanding shares,
and all such material amendments to any Plan or any distribution agreement
also shall be approved by a vote of a majority of the disinterested
directors/trustees, cast in person at a meeting called for the purpose of
voting on any such amendment.
SFSC is required to report in writing to the Board of Directors of the
Company and the Board of Trustees of the Pennsylvania Fund at least quarterly
on the amounts and purpose of any payments made under the Plans and any
distribution agreement, as well as to furnish the Boards with such other
information as reasonably may be requested in order to enable the Boards to
make informed determinations of whether the Plans should be continued.
THE FUND SERVICES AGREEMENTS
Sentinel Administrative Service Company ("Sentinel Service"), in
accordance with its Fund Services Agreements with the Funds, provides the
Funds with certain fund accounting, financial administration, transfer agency
and shareholder relations services. Sentinel Service performs the transfer
agency responsibilities utilizing, through Investors Fiduciary Trust Company
("IFTC"), the computer system of DST Systems, Inc. ("DST") on a remote basis.
For these services, the Fund Services Agreements provide for the Funds to
pay to Sentinel Service fixed fees totalling $926,500 per year for fund
accounting and financial
23
<PAGE>
administration services. The Agreements also provide for an annual fee for
transfer agency and shareholder relations services to the Company and the
Pennsylvania Fund of $2,563,000 and $37,000, respectively, plus amounts equal
to annual rates of $15 per shareholder account in excess of 106,500 and
1,500, respectively, in each case as of the last day of the month preceding
the installment due date. Each Fund also is responsible for the charges for
remote access to the computer system of DST. Generally, this is a fixed
annual charge per shareholder account, plus certain out-of-pocket expenses,
minus certain credits. The fixed fees are subject to increase under
inflation clauses for fiscal years beginning December 1, 1994, and
thereafter, to the extent approved by the Board of Directors or Board of
Trustees. Fees are payable monthly in arrears.
Total fees payable to Sentinel Service under the Fund Services Agreements
for the years ended November 30, 1996, 1995 and 1994 were $3,526,500, $3,470,333
and $3,358,000, respectively.
Sentinel Service is a Vermont general partnership of which affiliates of
National Life, Provident Mutual and Penn Mutual are the general partners.
The Company's Fund Services Agreement was approved by the Company's
shareholders on November 30, 1992, and the Pennsylvania Fund's Fund Services
Agreement was approved by that Fund's shareholders on February 19, 1993. The
agreements were approved by the Company's Board of Directors and the
Pennsylvania Fund's Board of Trustees on August 13, 1992 and August 14, 1992,
respectively. Each agreement must be approved annually by vote of the Board
or by the vote of a majority of the outstanding voting securities of each
Fund, but in either event it must also be approved by a vote of a majority of
the directors/trustees who are not parties to the contract, or interested
persons, as defined in the 1940 Act, of any such party, cast in person at a
meeting called for the purpose of voting on such approval. The Fund Services
Agreements will terminate automatically in the event of their assignment and
are terminable at any time without penalty by the applicable Board or, as to
a particular Fund, by a majority of the applicable Fund's outstanding voting
securities on not more than 60 days' written notice to Sentinel Service and
by Sentinel Service on 60 days' notice to the Fund.
PORTFOLIO TRANSACTIONS
AND BROKERAGE COMMISSIONS
The Funds' policy in the case of listed securities is to place its orders
with firms that are members of a stock exchange on which such securities are
listed or traded and in the case of securities traded in the over-the-counter
market to deal directly with dealers who are primary market makers in such
securities, without the use of a broker unless the Funds can obtain better
price or execution through the use of a broker. Purchases are made for
investment and not for trading purposes, except for the Bond Fund where
trading may be an important factor. Subject to the direction and control of
the Boards and in accordance with its advisory agreements, the Advisor
supervises the investments of the Funds and, as an essential feature thereof,
places orders for the purchase and sale of portfolio securities and
supervises their execution, including negotiating the amount of the
commission rate paid, in each case at prices it believes to be the best then
available, taking into consideration such factors as price, commission, size
of order, difficulty of execution and skill required of the executing
broker-dealer as well as the extent to which a broker capable of satisfactory
execution may provide research information and statistical and other services
to the Advisor. Sales of shares of the Funds may also be considered as a
factor in the selection of broker-dealers to execute portfolio transactions
for the Funds, subject to the conditions that commissions paid to such
broker-dealers be no higher than would otherwise be paid, and that the prices
be, in the judgment of the Advisor, the best then available.
24
<PAGE>
In making such purchases and sales, the brokerage commissions are paid by
the Funds. The Funds may also buy or sell securities from, or to, dealers
acting as principals.
Section 28(e) of the Securities Exchange Act of 1934, as amended (the
"1934 Act"), which was enacted by Congress in connection with the elimination
of fixed commission rates on May 1, 1975, provides that, except as agreements
such as investment advisory contracts otherwise provide, money managers such
as the Advisor will not be deemed to have acted unlawfully or to have
breached a fiduciary duty if, subject to certain conditions, a broker-dealer
is paid in return for brokerage and research services an amount of commission
for effecting transactions for accounts, such as the Funds, in excess of the
amount of commission another broker-dealer would charge for effecting the
transaction. In order to cause the Funds to pay such greater commissions,
the Advisor has to determine in good faith that the greater commission is
reasonable in relation to the value of the brokerage and research services
provided by the broker-dealer viewed in terms of either a particular
transaction or the Advisor's overall responsibilities to the Funds and to its
other clients.
Brokerage and research services, as provided in Section 28(e) of the 1934
Act, include advice as to the value of securities, the advisability of
investing in, purchasing or selling securities, the availability of
securities or purchasers or sellers of securities; furnishing analyses and
reports concerning issuers, industries, securities, economic factors and
trends, portfolio strategy and the performance of accounts and effecting
securities transactions and performing functions incidental thereto (such as
clearance, settlement and custody).
Although research and market and statistical information from brokers and
dealers can be useful to the Funds and to the Advisor, it is the opinion of
the management of the Funds that such information is only supplementary to
the Advisor's own research effort since the information must still be
analyzed, weighed and reviewed by the Advisor's staff.
The Funds obtain Lipper Directors' Analytical Data from Lipper Analytical
Distributors, Inc., in exchange for fund brokerage commissions, presently in
the amount of $22,000 per year. This service is available only for brokerage
commissions.
Except for implementing the policies stated above, there is no commitment
to place portfolio transactions with brokers or dealers who provide
investment research. The Advisor has advised the Funds that it is not
feasible to assign any precise value to services provided by such brokers and
dealers to it, nor does the use of such services reduce its expense by any
measurable or significant amount. For the years ended November 30, 1996,
1995 and 1994, the Funds paid total brokerage commissions of $1,156,527,
$1,102,148 and $909,949, respectively. Brokerage commissions paid by each
Fund were as follows:
YEAR ENDED
Fund 11/30/96 11/30/95 11/30/94
- ---- -------- -------- --------
Common Stock $656,739 $650,368 $414,244
Balanced 91,540 109,898 115,112
Growth 135,426 108,107 105,150
Small Company 162,972 126,348 131,104
World 109,850 107,427 144,339
Bond --- --- ---
Government Securities --- --- ---
Short Maturity Gov't (1) --- --- N/A
Treasury --- --- ---
Tax-Free Income --- --- ---
New York (2) --- --- N/A
Pennsylvania --- --- ---
25
<PAGE>
(1) Commenced operations on March 24, 1995.
(2) Commenced operations on March 27, 1995.
Such commissions were allocated on the basis of research and statistical
or other services provided by the dealer, although selling group dealers may
have participated therein. Of the total commissions paid by the Funds,
approximately 100% was allocated in 1996, 1995 and 1994 to brokers or dealers
whose furnishing of research information was a factor in their selection.
PORTFOLIO TURNOVER
Purchases for the Small Company, Growth, Common Stock, World, Balanced
and Pennsylvania Funds are made for long-term investment, and not for
short-term trading profits. However, during rapidly changing conditions,
there necessarily may be more portfolio changes than in a more stable period
and these may result in short-term gains or short-term losses. The rates of
portfolio turnover for each of the Funds during the fiscal years ended
November 30, 1996, 1995 and 1994 were as follows:
Year Ended Year Ended Year Ended
Fund 11/30/96 11/30/95 11/30/94
- ---- -------- -------- --------
Common Stock 22% 22% 15%
Balanced 83% 110% 66%
Growth 98% 84% 58%
Small Company 60% 79% 46%
World 14% 32% 30%
Bond 176% 237% 133%
Government Securities 614% 367% 149%
Short Maturity Gov't(1) 120% 58% N/A
Treasury N/A N/A N/A
Tax-Free Income 112% 112% 92%
New York(2) 48% 32% N/A
Pennsylvania 56% 80% 56%
(1) Commenced operations on March 24, 1995.
(2) Commenced operations on March 27, 1995.
In pursuit of the investment objectives of the Bond, Government
Securities, Short Maturity Government, Tax-Free Income and New York Funds, it
is expected that assets will be managed actively. In order to maximize
income and protect the income stream or improve the quality of the portfolio,
in light of market and economic conditions as interpreted or anticipated by
the Advisor, these Funds' portfolios will be monitored constantly and will be
adjusted when deemed appropriate in furtherance of the Funds' investment
objectives. Portfolio turnover is the ratio of the lesser of annual
purchases or sales of portfolio securities to average monthly market value,
not including short-term securities. One of the requirements under the Code
for qualification as a regulated investment company is that less than 30% of
a Fund's gross income be derived from gains from the sale or disposition of
securities held for less than three months.
26
<PAGE>
Accordingly, a Fund may be restricted in effecting portfolio turnover
transactions with regard to items that have been held in such Fund for less
than three months.
CAPITALIZATION
Shares of the Company's common stock and shares of beneficial interest in
the Pennsylvania Fund are fully paid and non-assessable. Each such share is
freely assignable to another bona fide investor by way of pledge (as, for
example, for collateral purposes), gift, settlement of an estate and, also,
by an investor who has held such Fund shares for not less than 30 days. Each
share of the Company is entitled to one vote per dollar of net asset value
per share, on matters on which all Funds of the Company vote as a single
class. Each share of the Pennsylvania Fund entitles the holder to one vote
for all purposes.
The proceeds from the sale of shares of each Fund or class of shares of
the Company and all income, earnings and profits therefrom irrevocably
appertain to the Fund or class of shares. Each such Fund or class of shares
records all liabilities (including accrued expenses) in respect of such Fund
or class of shares, as well as a share of such liabilities (including general
liabilities of the Company) in respect to two or more Funds or classes of
shares, in proportion to their average net assets, or in proportion to the
number of their respective shareholders. The Company's Board has adopted an
"Amended Rule 18f-3 Plan" under which the methods of allocating income and
expenses among classes of shares of each Fund which has both Class A and Class B
shares is specified, and the Company intends to comply fully with the
provisions of Rule 18f-3 under the 1940 Act in allocating income and expenses
among the classes of Funds offering both Class A and Class B shares. If any
reasonable doubt exists as to the Fund or class of shares to which any asset
or liability appertains, the Board may resolve such doubt by resolution.
In the case of dissolution or liquidation of the Company, the
shareholders of each Fund of the Company are entitled to receive ratably per
share the net assets of such Fund, with any general assets of the Company
distributed ratably per share, regardless of the Fund.
Voting rights are non-cumulative, meaning that the holders of more than
50% of the shares voting for the election of directors/trustees can elect
100% of the directors/trustees being voted upon if they choose to do so, and,
in such event the holders of the remaining minority of the shares voting for
the election of directors/trustees will not be able to elect any person or
persons to the Board. As of March 1, 1997, none of the approximately 103,188
shareholders owns as much as 5% of the voting stock of any Fund except
National Life and its affiliates, whose holdings are set forth on pages 15-16
of this Statement of Additional Information, and except for the following
shareholders of the New York Fund: Mr. Louis P. Dicerbo, 261 Madison Avenue,
New York, New York 10016-2303 - 134,546.765 shares amounting to 27% of the
class; Ms. Arlene Federico, 39 Fruitledge Road, Brookville, New York
11545-3315 - 63,087.643 shares amounting to 12.5% of the class; Ms. Donna
Bernstein, 15 Parkway Drive, Roslyn Heights, New York 11577-2705
- -31,798.680 shares amounting to 6.3% of the class, and Ms. Mary Vezza, 1
Hillandale Close, Scarsdale, NY 10583-7659 - 52,706.206 shares amounting to
10% of the class.
HOW TO PURCHASE SHARES
AND
REDUCE SALES CHARGES
Shares of the Funds may be purchased at the public offering price from
any authorized investment dealer as described in the Prospectus. The public
offering price of Class A shares, which are offered by every Fund, is the sum
of the current net asset value per share plus a sales charge which ranges
from 5.0% to 0% of the purchase price. The public offering price of
27
<PAGE>
Class B shares, which are offered by the Common Stock, Balanced, Small
Company, World, Bond, and Tax-Free Income Funds, is equal to the current net
asset value per share. A contingent deferred sales charge ("CDSC") may apply
to redemptions of Class B shares, or to redemptions of Class A shares where
the initial sales charge was zero based on a purchase of $1,000,000 or more.
See "How to Purchase Shares" in the Prospectus.
THE GROUP PURCHASE PROGRAM - Clients of a single registered
representative or group of affiliated registered representatives who make
purchases by opening new accounts within a 60-day period and whose funds for
such purchases all originate from a single other source may aggregate such
purchases for purposes of determining the applicable sales charge level or
CDSC schedule for such purchases.
ISSUANCE OF SHARES AT NET ASSET VALUE
Subject to the applicable provisions of the 1940 Act, certain investors
may purchase Class A shares of the Funds at net asset value. Such investors
are listed in the Prospectus. See "How to Purchase Shares - Reduced Sales
Charges" in the Prospectus.
HOW TO REDEEM SHARES
The Funds normally will buy back your shares on demand on any business
day (as defined below). Class A shares are repurchased at current net asset
value; a CDSC may be payable on redemptions of Class B shares, and will be
deducted from the redemption proceeds. For further information, please refer
to the Prospectus.
DETERMINATION OF NET ASSET VALUE
The net asset value per share of each Fund or class of shares is computed
by dividing the total value of the assets of that Fund or class of shares,
less its liabilities, by the total number of such Fund's or class of shares'
outstanding shares. Equity securities which are traded on a national
securities exchange are valued at the last reported sale price each business
day at the regular close of trading, currently 4:00 p.m. Eastern time.
Equity securities for which there were no sales during the day are valued at
the mean between the latest available bid and asked prices. Fixed-income
securities are valued daily on the basis of valuations furnished by a pricing
service which determines valuations for normal institutional-sized trading
units of debt securities, without exclusive reliance upon quoted prices.
These valuations by the pricing service are believed to reflect more
accurately the fair market value of such securities. Net asset value is
calculated once each business day, at 4:00 p.m. Eastern time, and becomes
effective immediately upon its determination. Orders to purchase shares of
the Funds received by dealers prior to 4:00 p.m. Eastern time will be
confirmed on the basis of such closing price, provided they are received by
the Distributor prior to the close of its business day. Orders received by
dealers after 4:00 p.m. Eastern time will be confirmed on the same basis as
previously stated with respect to the next business day. "Business day"
means a day on which the New York Stock Exchange is open. The New York Stock
Exchange is not open on New Year's Day, Presidents' Day, Good Friday,
Memorial Day, Independence Day, Labor Day, Thanksgiving Day and Christmas Day.
The Treasury Fund values its portfolio securities based on their
amortized cost in accordance with SEC regulations. The amortized cost method
of valuation involves valuing a security at its cost at the time of purchase
and thereafter assuming a constant amortization to maturity of any discount
or premium, regardless of the impact of fluctuating interest rates on the
market value of the instrument. During such periods the yield to investors
in the Treasury Fund
28
<PAGE>
may differ somewhat from that obtained in a similar investment company which
uses mark-to-market value for all of its portfolio securities. For example,
if the use of amortized cost resulted in a lower (higher) aggregate portfolio
value on a particular day, a prospective investor in the Treasury Fund would
be able to obtain a somewhat higher (lower) yield than would result from
investment in such a similar company which utilizes mark-to-market values and
existing investors would receive less (more) investment income. The purpose
of this method of calculation is to attempt to maintain a constant net asset
value per share of $1.00.
In accordance with the SEC rule permitting the use of the amortized cost
method of valuation, the Treasury Fund will maintain a dollar-weighted
average portfolio maturity of 90 days or less, and must purchase instruments
having remaining maturities of 397 days (13 months) or less. In addition,
the Directors of the Company have established procedures designed to
stabilize, to the extent reasonably possible, the Treasury Fund's price per
share as computed for the purpose of sales and redemptions at $1.00. The
Company's Directors will review periodically the Treasury Fund's portfolio
holdings to determine whether a deviation exists between the net asset value
calculated using market quotations and that calculated on an amortized cost
basis. In the event the directors determine that a deviation exists which
may result in material dilution or other unfair results to existing
shareholders, the Treasury Fund will take such corrective action as it
regards as necessary and appropriate, including (i) the reduction of the
number of outstanding shares of the Treasury Fund by having each shareholder
proportionately contribute shares to the Treasury Fund's capital, (ii) the
sale of portfolio instruments prior to maturity to realize capital gains or
losses or to shorten average portfolio maturity, (iii) the withholding of
dividends or (iv) the establishment of a net asset value per share by using
available market quotations. If the number of outstanding shares is reduced
in order to maintain a constant net asset value of $1.00 per share, the
shareholders will contribute proportionately to the Treasury Fund's capital
the number of shares which represent the difference between the amortized
cost valuation and the market valuation of the portfolio. Each shareholder
will be deemed to have agreed to such contribution by such shareholder's
investment in the Treasury Fund.
Since the net income of the Treasury Fund is determined and declared as a
dividend immediately prior to each time the asset value of the Treasury Fund
is determined, the net asset value per share of the Treasury Fund normally
remains at $1.00 per share immediately after each such dividend declaration.
Any increase in the value of a shareholder's investment in the Treasury Fund,
representing the reinvestment of dividend income, is reflected by an increase
in the number of shares of the Treasury Fund in that shareholder's account
and any decrease in the value of a shareholder's investment may be reflected
by a reduction in the number of shares in the account. See "Taxes" below.
29
<PAGE>
COMPUTATION OF MAXIMUM OFFERING AND REDEMPTION PRICES
AT NOVEMBER 30, 1996
Class A Shares:
(Reduced offering prices apply on purchases of $100,000 or more of shares of
the Funds, as described in the prospectus.)
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------
Common Small
Stock Balanced Growth Company World
Fund Fund Fund Fund Fund
<S> <C> <C> <C> <C> <C>
Net assets $1,306,592,040 $297,287,616 $69,816,281 $99,392,706 $71,457,559
Shares outstanding 32,181,137 16,027,384 3,974,158 19,207,900 4,554,373
Net asset value per
share (redemption
price) $40.60 $18.55 $17.57 $5.17 $15.69
Maximum offering
price per share* $42.74 $19.53 $18.49 $5.44 $16.52
- ---------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------
Government Short Maturity
Bond Securities Gov't. Treasury
Fund Fund Fund Fund
<S> <C> <C> <C> <C>
Net assets $99,408,280 $92,299,021 $36,473,694 $80,804,137
Shares outstanding 15,657,296 9,233,946 3,718,756 80,804,137
Net asset value per
share (redemption
price) $6.35 $10.00 $9.81 $1.00
Maximum offering
price per share* $6.61 $10.42 $9.91 $1.00
- -----------------------------------------------------------------------------------------
</TABLE>
- -----------------------------------------------------------------------
Tax-Free
Income New York Pennsylvania
Fund Fund Fund
Net assets $99,967,359 $5,748,597 $35,545,252
Shares outstanding 7,389,500 490,673 2,674,841
Net asset value per
share (redemption
price) $13.53 $11.72 $13.29
Maximum offering
price per share* $14.09 $12.21 $13.84
30
<PAGE>
CLASS B SHARES:
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------
Common Small
Stock Balanced Company World Bond
Fund Fund Fund Fund Fund
<S> <C> <C> <C> <C> <C>
Net assets $27,257,478 $10,948,196 $1,943,029 $3,187,686 $4,714,358
Shares outstanding 671,906 589,175 379,304 204,653 741,210
Net asset value per
share (redemption
price) $ 40.57 $ 18.58 $ 5.12 $ 15.58 $ 6.36
Maximum offering
price per share* $ 40.57 $ 18.58 $ 5.12 $ 15.58 $ 6.36
- ----------------------------------------------------------------------------------------------------
Tax-Free
Treasury Income
Fund Fund
Net assets $3,160,340 $765,605
Shares outstanding 3,160,340 56,555
Net asset value per
share (redemption
price) $ 1.00 $ 13.54
Maximum offering
price per share* $ 1.00 $ 13.54
- ----------------------------------------------------------------------------------------------------
</TABLE>
*For the Small Company Fund, Growth Fund, World Fund, Common Stock Fund and
Balanced Fund, the maximum offering price is 1000/950 times the net asset
value per share. For the Bond Fund, High Yield Fund, Tax-Free Income Fund,
New York Tax-Free Income Fund, Government Securities Fund and Pennsylvania
Tax-Free Trust, the maximum offering price is 1000/960 times the net asset
value per share. For the Short Maturity Government Fund, the maximum
offering price is 1000/990 times the net asset value per share. For the
Treasury Fund, the maximum offering price per share is equal to the net asset
value per share.
**In the case of Class B shares, the maximum offering price is equal to the
net asset value per share.
DIVIDENDS AND CAPITAL GAINS DISTRIBUTIONS
Dividends, as explained in the Prospectus, are paid annually for the
Class A and Class B shares of the Small Company, World and Growth Funds,
quarterly for the Class A and Class B shares of the Balanced and Common Stock
Funds, and monthly for the Class A and Class B shares of the Bond, High Yield
Tax-Free Income, Government Securities, Short Maturity Government,
Pennsylvania and New York Funds. Distributions of any net realized gains on
sales of investments of any Fund for a fiscal year ordinarily are paid in the
month of December
31
<PAGE>
immediately following the November 30th fiscal year-end. Dividends for the
Treasury Fund are declared daily and paid monthly, as described in the
Prospectus.
Except where the shareholder, in the manner described below, has elected
otherwise, any income dividends or capital gains distributions of a Fund will be
made in shares of such Fund at the net asset value at the close of business on
the designated record date, resulting in the automatic reinvestment of cash
dividends and distributions. Such an acquisition of shares involves no sales
charge. Unless the shareholder is participating in a Systematic Withdrawal
Plan, the shareholder may elect to receive in cash either both income dividends
and capital gains distributions or only income dividends or only capital gains.
Such election may be made by written notice to Sentinel Service or by phoning
Investor Services and will take effect for distributions for which the record
date is more than ten days after the receipt by Sentinel Service of such written
notice. The election will remain in effect until revoked by similar notice.
TAXES
GENERAL
Each Fund intends to continue to qualify, and the High Yield Fund
intends to elect and to qualify for the special tax treatment afforded
regulated investment companies ("RICs") under the Code. As long as it so
qualifies, a Fund will not be subject to federal income tax on the part of
its net ordinary income and net realized capital gains which it distributes
to Class A and Class B shareholders. The Company intends to distribute
substantially all of such income.
As discussed in the Prospectus, the Company consists of twelve separate
Funds. Each such Fund is treated as a separate corporation for federal income
tax purposes. Each such Fund is thus considered to be a separate entity in
determining its treatment under the rules for RICs described in the Prospectus.
Losses in one Fund do not offset gains in another Fund, and the requirements
(other than certain organizational requirements) for qualifying for RIC status
are determined at the Fund level rather than at the Company level.
Dividends paid by a Fund from its ordinary income or from an excess of net
short-term capital gains over net long-term capital losses (together referred to
hereafter as "ordinary income dividends"), are taxable to shareholders as
ordinary income for federal income tax purposes, except that "exempt-interest
dividends" (as defined in Section 852(b)(5) of the Code) not subject to federal
income tax are expected to be paid by the Tax-Free Income Fund, "exempt-interest
dividends" not subject to either federal income tax or Pennsylvania personal
income tax are expected to be paid by the Pennsylvania Fund, and "exempt-
interest dividends" not subject to either federal income tax or New York State
and City personal income tax are expected to be paid by the New York Fund, as
described in the Prospectus. Distributions made from an excess of net long-term
capital gains over net short-term capital losses (hereinafter referred to as
"capital gain dividends") are taxable to shareholders as long-term capital gains
for federal income tax purposes, regardless of the length of time the
shareholder has owned such Fund's shares. Any loss upon the sale or exchange of
Fund shares held for six months or less will be disallowed to the extent of any
capital gain dividends received by the shareholder. Distributions in excess of
a Fund's earnings and profits will first reduce the adjusted tax basis of a
holder's shares and, after such adjusted tax basis is reduced to zero, will
constitute capital gains to such holder for federal income tax purposes
(assuming the shares are held as a capital asset).
With the exception of exempt-interest dividends paid by the Tax-Exempt
Funds, dividends are taxable to shareholders for federal income tax purposes
even though they are reinvested in additional shares of the Funds. Not later
than 60 days after the close of its taxable year, each Fund will provide its
shareholders with a written notice designating the amount of any ordinary
32
<PAGE>
income dividends, capital gain dividends, tax-exempt dividends and the
portion of any ordinary income dividends eligible for the dividends received
deduction allowed to corporations under the Code. Generally, distributions
by the Tax-Exempt Funds, the World Fund, the Bond Fund, the Government
Securities Fund, the High Yield Fund, the Short Maturity Government Fund and
the Treasury Fund will not be eligible for the dividends received deduction
allowed to corporations under the Code. The Funds will allocate any
dividends eligible for dividends received deduction between the Class A and
Class B shareholders according to a method (which they believe is consistent
with SEC Rule 18f-3 which authorizes the issuance and sale of multiple
classes of shares) that is based on the gross income allocable to the Class A
and Class B shares during the taxable year, or such other method as the
Internal Revenue Service may prescribe. If a Fund pays a dividend in January
which was declared in the previous October, November or December to
shareholders of record on a specified date in one of such months, then such
dividend will be treated for tax purposes as having been paid by the RIC and
received by its shareholders on December 31st of the year in which the
dividend was declared.
If the value of assets held by the Treasury Fund declines, the Board of
Directors may authorize a reduction in the number of outstanding shares in
shareholders' accounts so as to preserve a net asset value of $1.00 per share.
After such a reduction, the basis of eliminated shares will, for federal income
tax purposes, be added to the basis of shareholders' remaining Fund shares, and
any shareholders disposing of shares at that time may recognize a capital loss.
Distributions, including distributions reinvested in additional shares of the
Fund, will nonetheless be fully taxable for federal income tax purposes, even if
the number of shares in shareholders' accounts has been reduced as described
above.
Under certain provisions of the Code, some shareholders may be subject to a
31% withholding tax on most ordinary income dividends and on capital gain
dividends and redemption payments ("backup withholding"). Generally,
shareholders subject to backup withholding will be those for whom no certified
taxpayer identification number is on file with the Company, or who, to the
Company's knowledge, have furnished an incorrect number. When establishing an
account, an investor must certify under penalty of perjury that such number is
correct and that such investor is not otherwise subject to backup withholding.
Ordinary income dividends paid to shareholders who are nonresident aliens
or foreign entities will be subject to a 30% United States withholding tax under
existing provisions of the Code applicable to foreign individuals and entities,
unless a reduced rate of withholding or a withholding exemption is provided
under applicable treaty law. Nonresident shareholders are urged to consult
their own tax advisors concerning the applicability of the United States
withholding tax.
Dividends and interest received by the World Fund (and to a lesser
extent, some of the other Funds) may give rise to withholding and other taxes
imposed by foreign countries. Tax conventions between certain countries and
the United States may reduce or eliminate such taxes. Shareholders of the
World Fund, may be able to claim United
States foreign tax credits with respect to such taxes, subject to certain
conditions and limitations contained in the Code. If more than 50% in value
of a Fund's total assets at the close of its taxable year consists of
securities of foreign corporations, such Fund will be eligible to file an
election with the Internal Revenue Service pursuant to which shareholders of
the Fund will be required to include their proportionate shares of such
withholding taxes in their United States income tax returns as gross income,
treat such proportionate shares as taxes paid by them, and deduct such
proportionate shares in computing their taxable incomes or, alternatively,
use them as foreign tax credits against their United States income taxes. No
deductions for foreign taxes, however, may be claimed by noncorporate
shareholders who do not itemize deductions. A shareholder that is a
nonresident alien individual or a foreign corporation may be subject to
United States withholding tax on the income resulting from a Fund's election
described in this paragraph but may not be able to claim a credit or
deduction against such United States tax for the foreign
33
<PAGE>
taxes treated as having been paid by such shareholder. Additionally, certain
retirement accounts cannot claim foreign tax credits on investments in
foreign securities held in a Fund. The World Fund and other Funds to the
extent applicable will report annually to shareholders the amount per share
of such withholding taxes. For this purpose, the World Fund will allocate
foreign taxes and foreign source income between the Class A and Class B
shares according to a method similar to that described above for the
allocation of dividends eligible for the dividends received deduction.
No gain or loss will be recognized by Class B shareholders on the
conversion of their Class B shares into Class A shares. A shareholder's
basis in the Class A shares acquired will be the same as such shareholder's
basis in the Class B shares converted, and the holding period of the acquired
Class A shares will include the holding period for the converted Class B
shares.
If a shareholder exercises an Exchange Privilege as described below within
90 days of acquiring such shares, then the loss such shareholder can recognize
on the exchange will be reduced (or the gain increased) to the extent any sales
charge paid to the Company reduces any sales charge such shareholder would have
owed the Company for the shares of the new Fund in the absence of the Exchange
Privilege. Instead, such sales charge will be treated as an amount paid for the
new shares.
A loss realized on a sale or exchange of shares of a Fund will be
disallowed if other Fund shares are acquired (whether through the automatic
reinvestment of dividends or otherwise) within a 61-day period beginning 30 days
before and ending 30 days after the date the shares are disposed of. In such a
case, the basis of the shares acquired will be adjusted to reflect the
disallowed loss.
The Code requires each Fund to pay a non-deductible 4% excise tax to the
extent it does not distribute, during each calendar year, 98% of its ordinary
income, determined on a calendar year basis, and 98% of its capital gains and
foreign currency gains, determined on a November 30th year end, plus certain
undistributed amounts from previous years. The Company anticipates that the
Funds will make sufficient timely distributions to avoid the imposition of the
excise tax. Since the required distributions are based only on taxable income,
the excise tax generally will not apply to the Tax-Exempt Funds, discussed
below.
At November 30, 1996, the Bond, Government Securities and Short Maturity
Government Funds had capital loss carryforwards for federal income tax purposes
of $4,488,182, $6,539,561 and $1,173,287, respectively.
TAX-EXEMPT FUNDS
The Tax-Exempt Funds intend to continue to qualify to pay
exempt-interest dividends. The relevant Code provision states that if, at
the close of each quarter of the respective Fund's taxable year, at least 50%
of the value of its total assets consists of obligations exempt from federal
income tax ("tax-exempt obligations") under Section 103(a) of the Code
(relating generally to obligations of a state or local governmental unit),
such Fund shall be qualified to pay exempt-interest dividends to its
shareholders. Exempt-interest dividends are dividends or any part thereof
paid by a Tax-Exempt Fund which are attributable to interest on tax-exempt
obligations and designated by the Company as exempt-interest dividends in a
written notice mailed to shareholders within 60 days after the close of the
Fund's taxable year. For this purpose, each Tax-Exempt Fund will allocate
interest from tax-exempt obligations (as well as ordinary income, capital
gains and tax preference items discussed below) between the Class A and Class
B shareholders according to a method (which it believes is consistent with
SEC Rule 18f-3, which authorizes the issuance and sale of multiple classes of
shares) that is based on the gross income allocable to the Class A and Class
B shares during the taxable year, or such other method as the Internal
Revenue Service may prescribe. Exempt-interest dividends may be treated by
shareholders for all purposes as items of interest excludable from their
federal gross income under Code Section 103(a). Exempt-interest dividends are
included, however, in determining the portion, if any, of a person's social
security benefits and railroad retirement benefits subject to federal income
taxes. Interest on indebtedness incurred or continued to purchase or carry
shares of a RIC paying exempt-
34
<PAGE>
interest dividends will not be deductible by the shareholder for federal income
tax purposes to the extent attributable to exempt-interest dividends. Each
shareholder is advised to consult a tax advisor with respect to whether exempt-
interest dividends retain the exclusion under Code Section 103(a) if such
shareholder were to be treated as a "substantial user" or "related person" under
Code Section 147(a) with respect to property financed with the proceeds of an
issue of "industrial development bonds" or "private activity bonds", if any,
held by the Tax-Exempt Funds.
All or a portion of the Tax-Exempt Funds' gain from the sale or redemption
of tax-exempt obligations purchased at a market discount will be treated as
ordinary income rather than capital gain. This rule may increase the amount of
ordinary income dividends received by shareholders of these Funds.
Any loss upon the sale or exchange of Tax-Exempt Fund shares held for six
months or less will be disallowed to the extent of any exempt-interest dividends
received by the shareholder. In addition, any such loss that is not disallowed
under the rule stated above will be treated as long-term capital loss to the
extent of any capital gain dividends received by the shareholder.
The Code subjects interest received on certain otherwise tax-exempt
securities to an AMT. The AMT applies to interest received on private
activity bonds issued after August 7, 1986. Private activity bonds are bonds
which, although tax-exempt, are used for purposes other than those generally
performed by governmental units and which benefit non-governmental entities
(E.G., bonds used for industrial development or housing purposes). Income
received on such bonds is classified as an item of "tax preference" which
could subject investors in such bonds, including shareholders of the
Tax-Exempt Funds, to an AMT. The Tax-Exempt Funds may purchase such private
activity bonds, and will report to shareholders within 60 days after the
Tax-Exempt Funds' respective taxable year-ends the portion of such Fund's
dividends declared during the year which constitutes an item of tax
preference for AMT purposes. The Code further provides that corporations are
subject to an AMT based, in part, on certain differences between taxable
income as adjusted for other tax preferences and the corporation's "adjusted
current earnings", which more closely reflect a corporation's economic
income. Because an exempt-interest dividend paid by a Tax-Exempt Fund will
be included in adjusted current earnings, a corporate shareholder may be
required to pay the AMT on exempt-interest dividends paid by such Funds.
The Code provides that every person required to file a tax return must
include on such return the amount of exempt-interest dividends received from the
Tax-Exempt Funds during the taxable year.
TAX TREATMENT OF OPTIONS AND FUTURES TRANSACTIONS
The Tax-Exempt Funds may purchase or sell financial futures contracts and
call and put options on financial futures contracts. In general, unless an
election is available to a fund or an
35
<PAGE>
exception applies, such options and futures contracts that are "Section 1256
contracts" will be "marked to market" for federal income tax purposes at the end
of each taxable year, I.E., each such option or financial futures contract will
be treated as having been sold for its fair market value on the last day of the
taxable year, and any gain or loss attributable to Section 1256 contracts will
be 60% long-term and 40% short-term capital gain or loss. Application of these
rules to Section 1256 contracts held by the Tax-Exempt Funds may alter the
timing and character of distributions to shareholders. The mark-to-market rules
outlined above, however, will not apply to certain transactions entered into by
the Funds solely to reduce the risk of changes in price or interest rates with
respect to its investments.
Code Section 1092, which applies to certain "straddles", may affect the
taxation of the Tax-Exempt Funds' sales of securities and transactions in
financial futures contracts or options thereon and the World Fund's sales of
securities and transactions in forward foreign exchange contracts, discussed
below. Under Section 1092, the Tax-Exempt Funds may be required to postpone
recognition for tax purposes of losses incurred in certain sales of
securities and closing transactions in financial futures contracts or options
thereon. The World Fund likewise may be required to postpone recognition of
losses in connection with its forward foreign exchange contracts.
One of the requirements for qualification as a RIC is that less than 30% of
the Fund's gross income be derived from gains from the sale or other disposition
of securities held for less than three months. Accordingly, the Tax-Exempt
Funds may be restricted in effecting closing transactions within three months
after entering into an options or financial futures contract.
FOREIGN CURRENCY TRANSACTIONS
A forward foreign exchange contract held by the World Fund that is a
Section 1256 contract will be marked to market, as described under "Tax
Treatment of Options and Futures Transactions". However, the character of gain
or loss from such a contract will generally be ordinary under Code Section 988.
The Fund may, nonetheless, elect to treat the gain or loss from certain forward
foreign exchange contracts as capital. In this case, gain or loss realized in
connection with a forward foreign exchange contract that is a Section 1256
contract will be characterized as 60% long-term and 40% short-term capital gain
or loss.
In general, gains from "foreign currencies" and from foreign currency
options, foreign currency futures and forward foreign exchange contracts
relating to investments in stock, securities or foreign currencies will be
qualifying income for purposes of determining whether a Fund qualifies as a RIC.
It is currently unclear, however, who will be treated as the issuer of a foreign
currency instrument or how foreign currency options, foreign currency futures
and forward foreign exchange contracts will be valued for purposes of the RIC
diversification requirements applicable to the World Fund.
Under the Code Section 988, special rules are provided for certain
transactions in a currency other than the taxpayer's functional currency (I.E.,
unless certain special rules apply, currencies other than the U. S. dollar). In
general, foreign currency gains or losses from certain debt instruments, from
certain forward contracts, from futures contracts that are not "regulated
futures contracts" and from unlisted options will be treated as ordinary income
or loss under Code Section 988. In certain circumstances, the Fund may elect
capital gain or loss treatment for such transactions. In general, however, Code
Section 988 gains or losses will increase or decrease the amount of the Fund's
investment company taxable income available to be distributed to shareholders as
ordinary income. Additionally, if Code Section 988 losses exceed other
investment company taxable income during a taxable year, the Fund would not be
able to make any ordinary income dividend distributions, and all or a portion of
distributions made before the losses were realized but in the same taxable year
would be recharacterized as a return of capital to shareholders, thereby
reducing the basis of each shareholder's Fund shares
36
<PAGE>
and resulting in a capital gain for any shareholder who received a distribution
greater than such shareholder's basis in Fund shares (assuming the shares were
held as a capital asset). These rules, however, will not apply to certain
transactions entered into by the World Fund solely to reduce the risk of
currency fluctuations with respect to its investments.
The foregoing is a general and abbreviated summary of the applicable
provisions of the Code and Treasury Regulations presently in effect. For the
complete provisions, reference should be made to the pertinent Code section and
the Treasury Regulations promulgated thereunder. The Code and the Treasury
Regulations are subject to change by legislative, judicial or administrative
action either prospectively or retroactively.
Ordinary income and capital gain dividends may also be subject to state and
local taxes.
Certain states exempt from state income taxation dividends paid by RICs
that are derived from interest on U.S. Government Securities. State law varies
as to whether dividend income attributable to U.S. Government Securities is
exempt from state income taxes.
Shareholders are urged to consult their tax advisors regarding specific
questions as to federal, foreign, state or local taxes. Foreign investors
should consider applicable foreign taxes in their evaluation of an investment in
the Funds.
SHAREHOLDER SERVICES
OPEN ACCOUNT An open account is established automatically for each new
investor, unless elected otherwise, in which all income dividends and any
capital gains distributions are reinvested in additional shares, without charge,
at the then current net asset value. Purchases made in this account will be
made at the offering price on the day federal funds are available to the Funds
as described in the Prospectus.
The Funds reserve the right at any time to vary the initial and subsequent
investment minimums of any Fund and to reject any purchase order.
Policyowners of National Life, Provident Mutual or Penn Mutual who invest
policy dividends may open an account in any of the Funds with a minimum initial
purchase of $50 or more of policy dividends and subsequent assignment of
dividends to the Funds.
Stock certificates will be issued upon written request and without charge.
Except for confirmation of purchases made under the Open Account, the cost
of these shareholder services are borne by the Funds.
AUTOMATED CLEARING HOUSE ("ACH") The ACH Network expedites the transfer of
monies by electronically transmitting funds between member financial
institutions. To take advantage of this convenient fund transfer method, you
must provide Sentinel Service with a pre-designated destination. There is no
charge for this service.
DISTRIBUTION OPTIONS Shareholders of the Funds may elect to reinvest
automatically their income dividends and any capital gains distributions in
additional full and fractional shares of any one of the other Funds at the net
asset value of the selected Fund at the close of business on the valuation date
for the dividend, without the payment of any charge. Before exercising this
option, shareholders should read the portions of the Prospectus relating to the
selected Fund's objectives and policies. The target and original accounts for
dividends must be in different Funds.
37
<PAGE>
AUTOMATIC INVESTMENT PLAN See the Prospectus for information and an
application. The minimum initial investment and subsequent investment is $50.
TELEPHONE INVESTMENT SERVICE See the Prospectus for information and an
application.
CHECK WRITING SERVICE (BOND, GOVERNMENT SECURITIES, SHORT-INTERMEDIATE
GOVERNMENT, TREASURY, TAX-FREE INCOME, NEW YORK AND PENNSYLVANIA FUNDS) A
special feature of the Class A shares of these Funds is the Check Writing
privilege available through IFTC. Any shareholder who would like to draw checks
on his account should check the box on the application captioned "Check Writing
Service" or subsequently, make a written request to the Funds. Checks then will
be provided by IFTC. These checks may be made payable in any amount not less
than $500, except for the Treasury Fund which has a minimum amount of not less
than $250. Withdrawals by check may not be made until shares have been in the
account for at least fifteen (15) days. The price at which shares will be
redeemed to cover a check will be the net asset value determined on the day the
check clears. Potential fluctuations in net asset value of the Funds' shares
should be taken into account when writing checks. If a dividend or capital
gains distribution is paid during the period between writing and clearing of a
check, the shareholder will be entitled to the dividend or distribution, but the
net asset value of the shares will be reduced by the amount of the dividend
payment. Because shareholders cannot determine the exact redemption price of
their shares at the time a check is written, closing an account through check
writing is not possible.
There is no fee for check writing, but, upon notice, a fee for this service
may be charged in the future. Fees are charged for stop payments, insufficient
funds or other valid reasons.
EXCHANGE PRIVILEGE This privilege also permits a shareholder whose
financial needs have changed to transfer an investment from a National Life
Variable Annuity account (presently the only such entity is the Variable
Annuity Account I). Such transfers from a National Life Variable Annuity
account are made without a sales charge on the basis of respective net asset
values after payment of a fee of $75 (in addition to any applicable transfer
taxes) to Sentinel Service for such transfer.
An exchange is a taxable transaction for income tax purposes and any gain
or loss realized is recognizable for such purposes.
REINSTATEMENT PRIVILEGE Shareholders who have redeemed all or part of
their shares may reinvest all or part of the redemption proceeds at the current
net asset value without charge if a written request is received or is postmarked
within one year after the redemption. Short-Intermediate Government Fund
shareholders who have held their shares for 90 days or less, however, may only
use the reinstatement privilege to reinvest in the Short-Intermediate Government
Fund. The privilege may be exercised only once by a shareholder as to any of
the Funds except where the sole purpose of the transaction is to transfer the
shareholder's interest or a portion thereof in the Funds to a trustee or
custodian for such shareholder's Self-Employed Retirement Plan or IRA. If the
shareholder realizes a gain on redemption, the transaction is taxable and
reinvestment will not alter any capital gains tax payable. If the shareholder
realizes a loss on redemption and subsequently uses the reinstatement privilege,
some or all of the loss may not be allowed as a tax deduction depending upon the
amount reinvested.
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If the reinstatement is made for the purpose of effecting a rollover into
an IRA, as described in Section 408(d)(3) of the Code, of a distribution from a
tax sheltered retirement plan which had been invested in shares of the Funds,
such reinvestment of redemption proceeds may be made any time within 60 days
from the date on which the investor received the distribution.
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TOTAL RETURN, YIELD AND TAX-EQUIVALENT YIELD INFORMATION
Each of the Funds (except the Treasury Fund) from time to time may include
its average annual total return in advertisements or information furnished to
present or prospective shareholders. The average annual total return for each
of the Funds (other than the High Yield Fund which commenced operations on
June 23, 1997) for the one, five and ten year periods ended November 30, 1996
were:
<TABLE>
<CAPTION>
Average Annual Total Return for the
-----------------------------------
One Year Ended Five Years Ended Ten Years Ended
November 30, 1996 November 30, 1996 November 30, 1996
----------------- ----------------- -----------------
<S> <C> <C> <C>
Common Stock Fund-A 20.81% 14.87% 12.46%
Common Stock Fund-B 14.90%(5)
Balanced Fund-A 10.73% 10.36% 9.62%
Balanced Fund-B 9.58%(5)
Growth Fund-A 16.48% 10.40% 9.54%
Small Company Fund-A 15.97% 9.47%(1) N/A
Small Company Fund-B 6.22%(5)
World Fund-A 9.68% 13.75%(1) N/A
World Fund-B 7.52%(5)
Bond Fund-A 0.31% 7.12% 7.89%
Bond Fund-B 4.49%(5)
Gov. Sec. Fund-A (1.02%) 6.00% 7.27%
Short Maturity Fund-A 4.58% 6.50%(2) N/A
Tax-Free Income Fund-A 0.52% 6.40% 7.34%(3)
Tax-Free Income Fund-B 4.48%(5)
New York Fund-A 0.48% 5.01(4) N/A
Pennsylvania Fund-A 0.76% 5.77% 6.17%
</TABLE>
(1) For the period from March 1, 1993 (commencement of operations) through
November 30, 1996.
(2) For the period from March 24, 1995 (commencement of operations) through
November 30, 1996.
(3) For the period from October 1, 1990, when Sentinel Tax-Free Income Fund
commenced operations, through November 30, 1996.
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(4) For the period from March 27, 1995 (commencement of operations) through
November 30, 1996.
(5) For the period from April 1, 1996 (commencement of operations) through
November 30, 1996 (not annualized).
The above amounts were computed by assuming a hypothetical initial
payment of $1,000. From this $1,000 the maximum sales load of $50 (5.0% of
the public offering price for the Class A shares of the Common Stock,
Balanced, Growth, Small Company and World Funds; $40 (4.0% of the public
offering price for the Class A shares of the Bond, Government Securities,
Tax-Free Income, New York and Pennsylvania Funds); and $10 (1% for the Class
A shares of the Short Maturity Government Fund) was deducted. It then was
assumed that all of the dividends and distributions by each of the Funds over
the relevant time period were reinvested. It then was assumed that at the
end of the one-, five- or ten-year period, after taking into account all
applicable recurring and nonrecurring expenses, the entire amount was
redeemed. The average annual total return then was calculated by calculating
the annual rate required for the initial payment to grow to the amount which
would have been received upon redemption (i.e., the average annual compound
rate of return). For the Class B shares, the maximum offering price is equal
to the net asset value.
Each Fund's average annual total return and current yield will vary
depending upon market conditions, the securities comprising such Fund's
portfolio, such Fund's operating expenses and the amount of net capital gains or
losses realized by such Fund during the period. An investment in any of the
Funds will fluctuate and an investor's shares, when redeemed, may be worth more
or less than their original cost.
Each of the Funds also from time to time may advertise its total return for
specified periods without subtracting the sales load, to illustrate better the
performance of money already invested in the Fund during those periods.
On occasion, the Funds may compare their average annual total return
figures to mutual fund averages such as those compiled by Lipper Analytical
Services, Inc., and to market indices such as the Dow Jones Industrial Average,
the Standard & Poor's 500 and the Shearson Lehman Aggregate Bond Index.
The Bond, Tax-Free Income, Pennsylvania, New York, Government Securities
and Short Maturity Government Funds' annualized yields for the 30-day period
ended November 30, 1996 were:
Class A Shares Class B Shares
Bond Fund 5.93% 5.03%
Tax-Free Income 4.18% 2.92%
Pennsylvania 4.37% N/A
New York 4.16% N/A
Gov.'t Securities 5.67% N/A
Short Maturity 5.81% N/A
The average daily number of shares outstanding during the period that were
eligible to receive dividends were:
Class A Shares Class B Shares
Bond Fund 15,690,518 707,350
Tax-Free Income 7,411,988 53,781
Pennsylvania 2,669,089 N/A
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New York 502,087 N/A
Gov.'t Securities 9,309,373 N/A
Short Maturity 3,683,026 N/A
Income was computed by totalling the interest earned on all debt obligations
during the 30-day period and subtracting from that amount the total of all
recurring expenses incurred during the period. The 30-day yield then was
annualized on a bond equivalent basis assuming semi-annual reinvestment and
compounding of net investment income.
These Funds also may show yield to those already invested in the Funds by
using the net asset value per share instead of the maximum offering price per
share in the above calculations, which has the effect of raising the quoted
yields. Using net asset values, the yields of the Class A shares of the Bond,
Tax-Free Income, Pennsylvania, New York, Government Securities and Short
Maturity Government Funds as of November 30, 1996 were 6.17 %, 4.35%, 4.55%,
4.33%, 5.91% and 5.87%, respectively. In addition, the Tax-Free Income,
Pennsylvania and New York Funds may quote tax-equivalent yield in
advertisements. The calculation of tax-equivalent yield is described in the
Prospectus. As of November 30, 1996, the tax-equivalent yield of the Tax-Free
Income Fund was 6.80%, the tax-equivalent yield of the Pennsylvania Fund was
7.31%, and the tax-equivalent yield of the New York Fund was 7.58%. For
purposes of the above tax-equivalent yield calculations the assumed federal tax
rate is 36%.
The Treasury Fund normally computes its annualized yield by determining the
net income for a seven-day base period for a hypothetical pre-existing account
having a balance of one share at the beginning of the base period, dividing the
net income by the net asset value of the account at the beginning of the base
period to obtain the base period return, multiplying the result by 365 and then
dividing by seven. In accordance with regulations adopted by the SEC, the
Treasury Fund is required to disclose its annualized yield for certain seven-day
base periods in a standardized manner which does not take into consideration any
realized or unrealized gains or losses on portfolio securities. The SEC also
permits the calculation of a standardized effective or compounded yield. This
is computed by compounding the unannualized base period return which is done by
adding one to the base period return, raising the sum to a power equal to 365
divided by seven and subtracting one from the result.
The yield quoted should not be considered a representation of the yield of
the Treasury Fund in the future since the yield is not fixed. Actual yields
will depend not only on the type, quality and maturities of the investments held
by the Treasury Fund and changes in interest rates on such investments, but also
on changes in the Treasury Fund's expenses during the period.
Yield information may be useful in reviewing the performance of the
Treasury Fund and for providing a basis for comparison with other investment
alternatives. However, the Treasury Fund's yield fluctuates, unlike bank
deposits or other investments which typically pay a fixed yield for a stated
period of time.
GENERAL INFORMATION
Copies of the Amended and Restated Articles of Incorporation and the
By-Laws of the Company, the Amended and Restated Declaration of Trust and the
Code of Regulations of the Pennsylvania Fund, and various agreements referred
to in the Prospectus and this Statement of Additional Information are filed
with the registration statement at the SEC to which reference is made for
their full terms. Such documents and other information filed with the SEC
may be obtained from the SEC upon payment of the fees prescribed by the Rules
of the SEC and are also now available at the SEC's Internet Website at
http://www.sec.gov. All cash and securities of the Funds, except for U.S.
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Government Securities which are represented only in book entry form at the
Federal Reserve Bank, are held by IFTC or in a central depository system in the
name of Investors Fiduciary Trust Company, 127 West 10th Street, Kansas City,
Missouri 64105 as the Funds' Custodian. IFTC is also Dividend Disbursing Agent
for the Funds' shares. Sentinel Service is Transfer Agent and Registrar for the
Funds' shares. All correspondence regarding the Funds should be mailed to
Sentinel Administrative Service Company, P.O. Box 1499, Montpelier, Vermont
05601-1499.
The independent accountants for the Funds are Price Waterhouse LLP, located
at 1177 Avenue of the Americas, New York, New York 10036. The independent
accountants are responsible for auditing the annual financial statements of the
Company and the Pennsylvania Fund.
Counsel for the Funds is Brown & Wood LLP, One World Trade Center, New
York, New York 10048-0557.
FINANCIAL STATEMENTS
Audited financial statements for the Company and for the Pennsylvania Fund
are incorporated by reference to the Funds' 1996 Annual Report to Shareholders.
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<PAGE>
APPENDIX A
DESCRIPTION OF BOND RATINGS -
Moody's describes its ratings for corporate and municipal bonds as follows:
Aaa - Bonds which are rated Aaa are judged to be of the best quality. They
carry the smallest degree of investment risk and generally are referred to as
"gilt edge". Interest payments are protected by a large or 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 generally are 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 risks appear somewhat larger than in Aaa
securities.
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 sometime in the future.
Baa - Bonds which are rated Baa are considered 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.
Rating Requirements: Moody's may apply numerical modifiers 1, 2 and 3 in
each generic rating classification from Aa through B in its bond rating system.
The modifier 1 indicates that the security ranks in the higher end of its
generic rating category; the modifier 2 indicates a mid-range ranking; and the
modifier 3 indicates that the issue ranks in the lower end of its generic rating
category.
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<PAGE>
A Standard & Poor's municipal debt rating is a current assessment of the
creditworthiness of an obligor with respect to a specific obligation. This
assessment may take into consideration obligors such as guarantors, insurers or
lessees.
The debt rating is not a recommendation to purchase, sell or hold a
security, inasmuch as it does not comment as to market price or suitability for
a particular investor.
The ratings are based on current information furnished by the issuer or
obtained by Standard & Poor's from other sources Standard and Poor's considers
reliable. Standard & Poor's does not perform an audit in connection with any
rating and may, on occasion, rely on unaudited financial information. The
ratings may be changed, suspended or withdrawn as a result of changes in, or
unavailability of, such information, or for other circumstances.
The ratings are based, in varying degrees, on the following considerations:
I. - Likelihood of default capacity and willingness of the obligor as to
the timely payment of interest and repayment of principal in accordance with the
terms of the obligation.
II - Nature of and provisions of the obligation.
III - Protection afforded to, 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.
Standard & Poor's describes its ratings for corporate and municipal debt
as follows:
AAA - Debt rated AAA have the highest rating assigned by Standard & Poor's.
Capacity to pay interest and repay principal is extremely strong.
AA - Debt rated AA have a very strong capacity to pay interest and repay
principal and differ from the higher rated issues only in a small degree.
A - Debt rated A have a strong capacity to pay interest and repay principal
although they are somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions than are bonds in higher rated categories.
BBB - Debt rated BBB are regarded as having an adequate capacity to pay
interest and repay principal. Whereas they normally exhibit adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal for
bonds in this category than in higher-rated categories.
BB, B, CCC, CC, C - Debt rated BB, B, CCC, CC and C is regarded, on
balance, as predominantly speculative with respect to capacity to pay interest
and repay principal in accordance with the terms of the obligation. BB
indicates the lowest degree of speculation and C the highest degree of
speculation. While such debt will likely have some quality and protective
characteristics, these are outweighed by large uncertainties or major risk
exposures to adverse conditions.
BB - Debt rated BB has less near-term vulnerability to default than other
speculative issues. However, it faces major ongoing uncertainties or exposure
to adverse business, financial, or economic conditions which could lead to
inadequate capacity to meet timely interest and principal payments. The BB
rating category is also used for debt subordinated to senior debt that is
assigned an actual or implied BBB- rating.
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B - Debt rated B has a greater vulnerability to default but currently has
the capacity to meet interest payments and principal repayments. Adverse
business, financial or economic conditions will likely impair capacity or
willingness to pay interest and repay principal. The B rating category is also
used for debt subordinated to senior debt that is assigned an actual or implied
BB or BB- rating.
CCC - Debt rated CCC has a CURRENTLY identifiable vulnerability to default,
and is dependent upon favorable business, financial and economic conditions to
meet timely payment of interest and repayment of principal. In the event of
adverse business, financial, or economic conditions, it is not likely to have
the capacity to pay interest and repay principal. The CCC rating category is
also used for debt subordinated to senior debt that is assigned an actual or
implied B or B- rating.
CC - The rating CC is typically applied to debt subordinated to senior debt
that is assigned an actual or implied CCC rating.
C - The rating C is typically applied to debt subordinated to senior debt
which is assigned an actual or implied CCC- debt rating. The C rating may be
used to cover a situation where a bankruptcy petition has been filed, but debt
service payments are continued.
CI - The rating CI is reserved for income bonds on which no interest is
being paid.
D - Debt rated D is in payment default. The D rating category is used when
interest payments or principal repayments 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 if debt service payments 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.
NR - Indicates that no rating has been requested, that there is
insufficient information on which to base a rating or that Standard & Poor's
does not rate a particular type of obligation as a matter of policy.
Indicates that continuance of the rating is contingent upon Standard &
Poor's receipt of an executed copy of the escrow agreement or closing
documentation confirming investments and cash flows.
Provisional Ratings - The letter "p" indicates that the rating is
provisional. A provisional rating assumes the successful completion of the
project being financed by the bonds being rated and indicates that payment of
debt service requirements is largely or entirely dependent upon the successful
and timely completion of the project. This rating, however, while addressing
credit quality subsequent to completion of the project, makes no comment on the
likelihood of, or risk of default upon failure of, such completion.
Accordingly, the investor should exercise his own judgment with respect to such
likelihood and risk.
Debt obligations of issuers outside the United States and its territories
are rated on the same basis as domestic corporate and municipal issues. The
ratings measure the creditworthiness of the obligor but do not take into account
currency exchange and related uncertainties.
Bond Investment Quality Standards: Under present commercial bank
regulations issued by the Comptroller of the Currency, bonds rated in the top
four categories ("AAA", "AA", "A", "BBB", commonly known as "investment grade"
ratings) are generally regarded as eligible for
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<PAGE>
bank investment. In addition, the legal investment laws of various states may
impose certain rating or other standards for obligations eligible for investment
by savings banks, trust companies, insurance companies and fiduciaries
generally.
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<PAGE>
APPENDIX B
ECONOMIC CONDITIONS IN NEW YORK
THE INFORMATION SET FORTH BELOW IS DERIVED FROM THE OFFICIAL STATEMENTS
PREPARED IN CONNECTION WITH THE ISSUANCE OF NEW YORK OBLIGATIONS AND OTHER
SOURCES THAT ARE GENERALLY AVAILABLE TO INVESTORS. THE FOLLOWING INFORMATION IS
PROVIDED AS GENERAL INFORMATION INTENDED TO GIVE A RECENT HISTORICAL DESCRIPTION
AND IS NOT INTENDED TO INDICATE FUTURE OR CONTINUING TRENDS IN THE FINANCIAL OR
OTHER CONDITIONS OF NEW YORK CITY (THE "CITY") OR NEW YORK STATE (THE "STATE" OR
"NEW YORK"). THE NEW YORK FUND HAS NOT INDEPENDENTLY VERIFIED THIS INFORMATION.
In recent years, the State, some of its agencies, instrumentalities and
public authorities and certain of its municipalities have faced serious
financial difficulties that could have an adverse effect on the sources of
payment for or the market value of the New York Obligations in which the New
York Fund invests.
NEW YORK CITY
GENERAL. More than any other municipality, the fiscal health of the City
has a significant effect on the fiscal health of the State. The national
economic downturn which began in July 1990 adversely affected the local economy,
which had been declining since late 1989. As a result, the City experienced job
losses in 1990 and 1991 and real Gross City Product ("GCP") fell in those two
years. Beginning in calendar year 1992, the improvement in the national economy
helped stabilize conditions in the City. Employment losses moderated toward
year-end and real GCP increased, boosted by strong wage gains. However, after
noticeable improvements in the City's economy during the calendar year 1994,
economic growth slowed in calendar year 1995. The City's current four-year
financial plan assumes that moderate economic growth will continue through
calendar year 2000. During the 1995 fiscal year, the City experienced
substantial shortfalls in payments of non-property taxes from those forecasted.
For each of the 1981 through 1996 fiscal years, the City achieved balanced
operating results as reported in accordance with generally accepted accounting
principles ("GAAP"). The City was required to close substantial budget gaps in
recent fiscal years in order to maintain balanced operating results. There can
be no assurance that the City will continue to maintain a balanced budget as
required by the State law without additional reductions in City services or
entitlement programs or tax or other revenue increases which could adversely
affect the City's economic base.
Pursuant to the laws of the State, the Mayor is responsible for preparing
the City's four-year financial plan, including the City's current financial plan
for the 1997 through 2000 fiscal years (the "1997-2000 Financial Plan" or "City
Financial Plan"). The City's projections set forth in the City Financial Plan
are based on various assumptions and contingencies which are uncertain and which
may not materialize. Changes in major assumptions could significantly affect
the City's ability to balance its budget as required by State law and to meet
its annual cash flow and financing requirements.
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Implementation of the City Financial Plan is also dependent upon the City's
ability to market its securities successfully in the public credit markets. The
City's financing program for fiscal years 1997 through 2000 contemplates the
issuance of $9 billion of general obligation bonds and $3.8 billion of bonds to
be issued by the New York City Transitional Finance Authority (the "Transitional
Finance Authority") primarily to reconstruct and rehabilitate the City's
infrastructure and physical assets and to make capital investments. The
Transitional Finance Authority was proposed by the City to avoid its
constitutional debt limit. Legislation creating the Transitional Finance
Authority was signed into law by the Governor on March 5, 1997. In addition,
the City issues revenue notes and tax anticipation notes to finance its seasonal
working capital requirements. The success of projected public sales of City
bonds and notes and Transitional Finance Authority bonds will be subject to
prevailing market conditions, and no assurance can be given that such sales will
be completed. If the City were unable to sell its general obligation bonds and
notes or the Transitional Finance Authority were unable to sell its bonds, the
City would be prevented from meeting its planned operating and capital
expenditures.
1997-2000 FINANCIAL PLAN. On November 14, 1996, the City published the
City Financial Plan for the 1997 through 2000 fiscal years, which is a
modification to the City Financial Plan submitted by the City to the New York
State Financial Control Board (the "Control Board") on June 21, 1996 (the "June
Financial Plan"). The June Financial Plan set forth proposed actions by the
City including cost containment in entitlement programs, City agency spending
reductions, additional State aid, revenue initiatives and pension savings to
close a previously projected gap of approximately $2.6 billion for the 1997
fiscal year (July 1, 1996-June 30, 1997). The City Financial Plan takes into
account actual receipts and expenditures and changes in forecast revenues and
expenditures since the June Financial Plan and projects revenues and
expenditures for the 1997 fiscal year balanced in accordance with GAAP. Changes
since the June Financial Plan made in the City Financial Plan for the 1997
fiscal year include an increase in projected tax revenues, a delay in the
assumed receipt of certain rent payments for the City airports from the 1997
fiscal year to the 1998 and 1999 fiscal years, a reduction in assumed State and
Federal aid, increases in overtime, Board of Education and other expenditures, a
reduction in pension costs, and additional agency actions including personnel
reductions. The City Financial Plan also sets forth projections for the 1998
through 2000 fiscal years and outlines a proposed gap-closing program to close
projected budget gaps of $1.2 billion, $2.1 billion and $3.0 billion for the
1998 through 2000 fiscal years, respectively, after successful implementation of
the gap-closing program for the 1997 fiscal year.
The City's projections set forth in the City Financial Plan are based on
various assumptions and contingencies which are uncertain and which may not
materialize. Such assumptions and contingencies include the condition of the
regional and local economies, the impact on real estate tax revenues of the real
estate market, employment growth, wage increases for City employees consistent
with those assumed in the City Financial Plan, continuation of interest earning
assumptions for pension funds assets, the ability of the City's hospital and
educational entities maintain balanced budgets, provision and mandate relief of
State and Federal aid, the impact of proposed Federal and State welfare reforms
on City revenues and adoption of the budget by the City Council in substantially
the form submitted by the Mayor.
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The City Financial Plan is also subject to the ability of the City to
implement the expenditure reductions and to obtain the savings outlined in the
City Financial Plan. In addition, the City may incur expenditures which exceed
those projected in the City Financial Plan. There can be no assurance that
additional gap-closing measures will not be required to enable the City to
achieve a balanced budget in a particular fiscal year. Certain of the proposed
actions are subject to negotiation with the City's municipal unions. Various
other actions proposed for the 1998 through 2000 fiscal years are subject to
approval by the Governor and the State Legislature and the proposed reductions
in spending for entitlement programs may be subject to legal challenge.
The City depends on the State for State aid both to enable the City to
balance its budget and to meet its cash requirements. If the State experiences
revenue shortfalls or spending increases beyond its projections during its 1996-
1997 fiscal year or subsequent fiscal years, such developments could result in
reductions in anticipated State aid to the City. In addition, there can be no
assurance that State budgets in future fiscal years will be adopted by the April
1 statutory deadline and that there will not be adverse effects on the City's
cash flow and additional City expenditures as a result of such reductions or
delays.
The City's financial plans have been the subject of extensive public
comment and criticism. On December 10, 1996, the City Comptroller issued a
report stating that the City Financial Plan includes potential risks of $200
million for the 1997 fiscal year. The City Comptroller's report also identified
total budget risks of up to $1.88 billion, $2.89 billion and $3.59 billion for
the City's 1998, 1999 and 2000 fiscal years, respectively. On December 17,
1996, the Control Board issued a report on the City Financial Plan which
identified risks totaling $286 million, $1.2 billion, $1.3 billion and $1.1
billion for the 1997 through 2000 fiscal years, respectively. On December 12,
1996, the Office of the State Deputy Comptroller of New York (the "OSDC") issued
a report which reviewed the City Financial Plan and concluded that a budget gap
of $38 million and net additional risks of $229 million exist for the 1997
fiscal year. The OSDC report projected budget gaps of $1.3 billion, $2.2
billion and $3.0 billion for the 1998 through 2000 fiscal years, respectively.
It also identified net additional risks of $1.3 billion, $1.2 billion and $1.1
billion for the 1998 through 2000 fiscal years, respectively. On October 31,
1996, the City's Independent Budget Office (the "IBO") released a report
assessing the costs that could be incurred by the City as a result of recent
Federal welfare reforms. Assuming continued moderate economic performance, the
IBO report projects that the City's cost of providing welfare could increase by
$33 million in 1999, growing to $269 million by 2002. Moreover, if the
requirement that all recipients work after two years of receiving benefits is
enforced, these additional costs could total $723 million in 1999 and
approximately $1 billion annually through 2002, reflecting substantial costs for
worker training and supervision of new workers and increased child care costs.
The report further noted that, if economic performance weakened, resulting in an
increased number of public assistance cases, potential costs to the City could
substantially increase. It is reasonable to expect that such reports will
continue to be issued and to engender public comment.
RATINGS. As of January 28, 1997, Moody's Investors Services, Inc.
("Moody's") rated the City's outstanding general obligation bonds "Baa1",
Standard & Poor's Ratings Services ("Standard & Poor's") rated such bonds "BBB+"
and Fitch Investors Service ("Fitch") rated
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such bonds "A--". On July 10, 1995, Standard & Poor's revised downwards its
ratings on outstanding general obligation bonds of the City from "A--" to
"BBB+". On November 25, 1996, Standard & Poor's issued a report which stated
that, if the City reached its debt limit without the ability to issue bonds
through other means, it would cause deterioration in the City's infrastructure
and significant cutbacks in the City's capital plan which would eventually
impact the City's economy and revenues, and could have eventual negative credit
implications. On February 28, 1996, Fitch placed the City's general obligation
bonds on FitchAlert with negative implications. On November 5, 1996, Fitch
removed the City's general obligation bonds from FitchAlert, although Fitch
stated that the outlook remains negative. Such ratings reflect only the view of
Moody's, Standard & Poor's and Fitch, from which an explanation of the
significance of such ratings may be obtained. There is no assurance that such
ratings will continue for any given period of time or that they will not be
revised downward or withdrawn entirely. Any such downward revision or
withdrawal could have an adverse effect on the market prices of City bonds.
OUTSTANDING INDEBTEDNESS. As of September 30, 1996, the City had
approximately $25.1 billion of long-term debt and as of October 24, 1996, the
New York City Municipal Water Finance Authority (the "Water Authority") had
approximately $6.6 billion of aggregate principal amount of outstanding bonds
and $400 million aggregate principal amount of outstanding commercial paper
notes.
Debt service on Water Authority obligations is secured by fees and charges
collected from the users of the City's water and sewer system. State and
Federal regulations require the City's water supply to meet certain standards to
avoid filtration. The City's water supply now meets all technical standards and
the City's current efforts are directed toward protection of the watershed area.
The City has taken the position that increased regulatory, enforcement and other
efforts to protect its water supply, relating to such matters as land use and
sewage treatment, will preserve the need for filtration. The U.S. Environmental
Protection Agency has granted the City a waiver of filtration regulations
through December 15, 1996 and has stated it will issue a waiver through April,
2002 if the City and State implement certain protective actions estimated to
cost approximately $400 million. Preliminary estimates of the costs of such
filtration are from $4 to $8 billion. Such an expenditure could cause
significant increases in City water and sewer charges.
LITIGATION. The City is a defendant in a significant number of lawsuits.
Such litigation includes, but is not limited to, routine litigation incidental
to the performance of its governmental and other functions, actions commenced
and claims asserted against the City arising out of alleged constitutional
violations, alleged torts, alleged breaches of contracts and other alleged
violations of law and condemnation proceedings and other tax and miscellaneous
actions. While the ultimate outcome and fiscal impact, if any, on the
proceedings and claims are not currently predictable, adverse determination in
certain of them might have a material adverse effect upon the City's ability to
carry out the City Financial Plan. As of June 30, 1996, the City estimated its
potential future liability on account of all outstanding claims to be
approximately $2.8 billion.
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NEW YORK STATE
CURRENT ECONOMIC OUTLOOK. The national economy began to expand in 1991 and
has added over 11 million jobs since early 1992. Although the State has added
approximately 240,000 jobs since late 1992, employment growth in the state has
been hindered during recent years by significant cutbacks in the computer and
instrument manufacturing, utility, defense and banking industries.
The State expected New York's economy to continue to expand modestly during
1996. Moderate growth is projected to continue in 1997 for employment, wages,
and personal income, followed by a slight slowing in 1998. On an average annual
basis, the State's employment growth is projected to be 0.7 percent in 1996, 0.8
percent in 1997, and 0.6 percent in 1998 while personal income growth is
projected to be 5.2 percent in 1996, 4.5 percent in 1997, and 4.2 percent in
1998.
STATE FINANCIAL PLAN FOR THE 1996-1997 FISCAL YEAR. The State's budget for
its 1996-1997 fiscal year (April 1, 1996-March 31, 1997) was enacted by the
State Legislature on July 13, 1996, more than three months after the start of
the fiscal year. Prior to adoption of the budget, the State Legislature enacted
appropriations for disbursements considered to be necessary for State operations
and other purposes, including all necessary appropriations for debt service.
The State Financial Plan for the 1996-1997 fiscal year (the "State Financial
Plan") is based on the State's budget as enacted by the Legislature and signed
into law by the Governor, as well as actual results through the third quarter of
the 1996-1997 fiscal year.
The State Financial Plan projects a General Fund balanced on a cash basis
with total projected receipts of $34.159 billion and total projected
disbursements of $32.895 billion. The State of Financial Plan includes gap-
closing actions to offset a previously projected budget gap of $3.9 billion.
Such gap-closing actions include, among others, reductions in the State
workforce, spending reductions in health care and education programs, projected
increases in tax collections, and pension and debt service savings. Despite a
projected budget surplus in the 1996-1997 fiscal year, there can be no assurance
that additional gap-closing measures will not be required and there is no
assurance that any such measures will enable the State to achieve a balanced
budget for its 1996-1997 fiscal year.
On January 14, 1997, the Governor released the Executive Budget for the
State's 1997-1998 fiscal year (the "Executive Budget") which the State
Legislature must enact and the Governor must sign in order to become law. The
1997-1998 Financial Plan projects General Fund receipts of $32.88 billion, a
decrease of $88 million from the 1996-1997 fiscal year projected level. General
Fund disbursements are projected at $32.84 billion, a decrease of $56 million
from projected spending levels for the 1996-1997 fiscal year. The Executive
Budget projects balance on a cash basis but identifies a potential budget gap of
approximately $2.3 billion due primarily to the effect of implementation of
previously enacted tax reduction programs, the loss of non-recurring revenues
available in the 1996-1997 fiscal year, growth in Medicaid, collective
bargaining agreements, and higher fixed costs such as pensions and debt service.
Proposed gap-closing actions in the Executive Budget include cost containment in
State Medicaid, spending reductions, the use of a portion of a projected 1996-
1997 fiscal year budget
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surplus, and other actions. The Executive Budget also anticipates a significant
increase in Federal aid to the State related to the Medicaid program and the new
Federal welfare block grant. There can be no assurance that the Executive
Budget will be enacted as proposed, the cost containment and spending reduction
programs can be implemented as proposed or the anticipated increase in Federal
aid will materialize as expected.
The Executive Budget projects budget imbalances of $988 million for the
1998-1999 fiscal year and $1.224 billion for 1999-2000 which are expected to be
closed primarily through spending reductions. The Executive Budget contains
several new tax initiatives which are projected to reduce total receipts by $170
million in the 1997-1998 fiscal year. In addition, there has been discussion of
additional tax reductions, beyond those reflected in the State's current
projections for the 1997-1998 fiscal year that, if enacted, could make it more
difficult to achieve budget balance over this period.
The State Financial Plan and the Executive Budget are based upon forecasts
of national and State economic activity. Economic forecasts have frequently
failed to predict accurately the timing and magnitude of changes in the national
and State economies. Many uncertainties exist in forecasts of both the national
and State economies, including consumer attitudes toward spending, Federal
financial and monetary policies, the availability of credit and the condition of
the world economy, which could have an adverse effect on the State. There can
be no assurance that the State economy will not experience worse-than-predicted
results in the 1996-1997 and subsequent fiscal years, with corresponding
material and adverse effects on the State's projections of receipts and
disbursements.
Owing to these and other factors, the State may face substantial potential
budget gaps in future years resulting from a significant disparity between tax
revenues from a lower recurring receipts base and the spending required to
maintain State programs at mandated levels. Any such recurring imbalance would
be exacerbated by the use by the State of nonrecurring resources to achieve
budgetary balance in a particular fiscal year. To correct any recurring
budgetary imbalance, the State would need to take significant actions to align
recurring receipts and disbursements in future fiscal years.
The State Financial Plan contains actions that provide nonrecurring
resources or savings as well as actions that impose baseline losses of receipts.
The Division of the Budget estimates the net amount of nonrecurring resources
used in the State Financial Plan to be at least $1.3 billion and approximately
$66 million for the State's 1997-1998 Financial Plan. In addition to these
nonrecurring actions, the adoption of the three-year 20% reduction in the
State's personal income tax in combination with business tax reductions enacted
in 1994 will reduce State tax receipts by as much as $4.5 billion by the 1997-
1998 fiscal year.
The Governor is required to submit a balanced budget to the State
Legislature and has indicated that he will close any potential imbalances in the
State's 1997-1998 Financial Plan primarily through General Fund expenditure
reductions and without increases in taxes or deferrals of scheduled tax
reductions. The State's 1997-1998 Financial Plan reflects, and the 1998-1999
Financial Plan is expected to reflect, a continuing strategy of substantially
reduced
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state spending. There can be no assurance, however, that the State's actions
will be sufficient to preserve budget balances in the then current or future
fiscal years.
On August 22, 1996, the President signed into law the Personal
Responsibility and Work Opportunity Reconciliation Act of 1996. The new law
abolishes the Federal Aid to Families with Dependent Children program, and
creates a new Temporary Assistance to Needy Families program (TANF) funded with
a fixed Federal block grant to states. The new law also imposes (with certain
exceptions) a five-year durational limit on TANF recipients, requires that
virtually all recipients be engaged in work or community service activities
within two years of receiving benefits, and limits assistance provided to
certain immigrants and other classes of individuals. States are required to
comply with the new Federal welfare reform law no later than July 1, 1997.
States who fail to meet these Federally mandated job participation rates, or who
fail to conform with certain other Federal standards, face potential sanctions
in the form of a reduced Federal block grant.
On October 16, 1996, the Governor submitted the State's TANF implementation
plan to the Federal government as required under the new Federal welfare law.
Submission of this plan to the Federal government requires New York State to
begin compliance with certain time limits on welfare benefits and permits the
State to become eligible for approximately $2.36 million in Federal block grant
funding. On December 13, 1996, the States's plan was approved by the Federal
government. The Governor has introduced legislation necessary to conform with
Federal law for consideration by the Legislature in the 1997 legislative
session. Given the size and scope of the changes required under Federal law, it
is likely that these proposals will produce extensive public discussions. There
can be no assurances that the State legislature will enact welfare reform
proposals as submitted by the Governor and as required under Federal law.
It is expected that funding levels provided under the Federal TANF block
grant will be higher than currently anticipated in the State Financial Plan.
However, the net fiscal impact of any changes to the State's welfare programs
that are necessary to conform with Federal law will be dependent upon such
factors as the ability of the State to avoid any Federal fiscal penalties, the
level of additional resources required to comply with any new State and/or
Federal requirements, and the division of non-Federal welfare costs between the
State and its localities.
Uncertainties with regard to both the economy and potential decisions at
the Federal level add further pressure on future budget balance in New York
State. Specific budget proposals being discussed at the Federal level but not
included in the State's current economic forecast would (if enacted) have a
disproportionately negative impact on the longer-term outlook for the State's
economy as compared to other states.
The State anticipates that its capital programs will be financed, in part,
by State and public authorities borrowings in the 1996-1997 fiscal year. The
State expects to issue $411 million in general obligations bonds (including
$153.6 million for purposes of redeeming outstanding Bond Anticipation Notes
("BANs")), and $154 million in general obligation commercial paper. The
Legislature has also authorized up to $101 million in certificates of
participation during the State's 1996-1997 fiscal year for equipment purchases.
Borrowings by
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public authorities pursuant to lease-purchase and contractual-obligation
financings for capital programs of the State are projected to aggregate $2.7
billion.
PRIOR FISCAL YEARS. The State ended its 1995-1996 fiscal year in balance,
with a reported 1995-1996 General Fund cash surplus of $445 million. Prior to
adoption of the State's 1995-1996 fiscal year budget, the State had projected a
potential budget gap of approximately $5 billion, which was closed primarily
through spending reductions, cost containment measures, State agency actions and
local assistance reforms.
In July 1995, the State Comptroller issued its audit of the State's 1994-
1995 fiscal year prepared in accordance with generally accepted auditing
standards. The State completed its 1994-1995 fiscal year with a General Fund
operating deficit of $1.426 billion, as compared with an operating surplus of
$914 million for the previous fiscal year. The 1994-1995 fiscal year deficit
was caused by several factors, including the use of $1.026 billion of the 1993-
1994 fiscal year surplus in the 1994-1995 fiscal year and the adoption of
changes in accounting methodologies by the State Comptroller.
LOCAL GOVERNMENT ASSISTANCE CORPORATION. In 1990, as part of a State
fiscal reform program, legislation was enacted creating the Local Government
Assistant Corporation (the "LGAC"), a public benefit corporation empowered to
issue long-term obligations to fund certain payments to local governments
traditionally funded through the State's annual seasonal borrowing. As of June
1995, LGAC has issued bonds to provide net proceeds of $4.7 billion completing
the program. The impact of LGAC's borrowing is that the State is able to meet
its cash flow needs without relying on short-term seasonal borrowing.
FINANCING ACTIVITIES. State financing activities include general
obligation debt of the State and State-guaranteed debt, to which the full faith
and credit of the State has been pledged, as well as lease-purchase and
contractual-obligation financings, moral obligation financings and other
financings through public authorities and municipalities, where the State's
obligation to make payments for debt service is generally subject to annual
appropriation by the State Legislature.
As of March 31, 1996, the total amount of outstanding general obligation
debt was approximately $5.047 billion, including $293 million in BANs. The
total amount of moral obligation debt was approximately $7.269 billion, and
$20.343 billion of bonds issued primarily in connection with lease-purchase and
contractual-obligation financing of State capital programs were outstanding.
PUBLIC AUTHORITIES. The fiscal stability of the State is related, in part,
to the fiscal stability of its public authorities. Public authorities are not
subject to the constitutional restrictions on the incurrence of debt which apply
to the State itself, and may issue bonds and notes within the amounts of, and as
otherwise restricted by, their legislative authorization. As of September 30,
1995, the most recent date for which such information is available, there were
17 public authorities that had outstanding debt of $100 million or more and the
aggregate outstanding debt, including refunding bonds, of these 17 public
authorities was $73.45 billion. The State's access to the public credit markets
could be impaired and the market price of its
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outstanding debt may be adversely affected, if any of its public authorities
were to default in their respective obligations.
RATINGS. Currently, Moody's, Standard & Poor's and Fitch rate New York
State's outstanding general obligation bonds "A2", "A-" and "A+", respectively.
Ratings reflect only the respective views of such organizations, and explanation
of the significance of such ratings must be obtained from the rating agency
furnishing the same. There is no assurance that a particular rating will
continue for any given period of time or that any such rating will not be
revised downward or withdrawn entirely if, in the judgement of the agency
originally establishing the rating, circumstances so warrant. A downward
revision or withdrawal of such ratings, or either of them, may have an effect on
the market price of the New York State Obligations in which the New York Fund
invests.
LITIGATION. The State is a defendant in numerous legal proceedings
including, but not limited to, claims asserted against the State arising from
alleged torts, alleged breaches of contracts, condemnation proceedings and other
alleged violations of State and Federal laws. State programs are frequently
challenged on State and Federal constitutional grounds. Adverse developments in
legal proceedings or the initiation of new proceedings could affect the ability
of the State to maintain a balanced State Financial Plan in any given fiscal
year. The State believes that the State Financial Plan includes sufficient
reserves for the payment of judgments that may be required during the 1996-1997
fiscal year. There can be no assurance, however, that an adverse decision in
one or more legal proceedings would not exceed the amount of such reserves for
the payment of judgments or materially impair the State's financial operations.
OTHER LOCALITIES. Certain localities in addition to the City could have
financial problems leading to requests for additional State assistance during
the State's 1996-1997 fiscal year and thereafter. The potential impact on the
State of such actions by localities is not included in the projections of the
State receipts and disbursements in the State's 1996-1997 fiscal year.
Fiscal difficulties experienced by the City of Yonkers ("Yonkers") resulted
in the creation of the Financial Control Board for Yonkers (the "Yonkers Board")
by the State in 1984. The Yonkers Board is charged with oversight of the fiscal
affairs of Yonkers. Future actions taken by the Governor or the State
Legislature to assist Yonkers could result in allocation of State resources in
amounts that cannot yet be determined.
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APPENDIX C
ECONOMIC AND FINANCIAL CONDITIONS IN PENNSYLVANIA
THE FOLLOWING INFORMATION IS A BRIEF SUMMARY OF FACTORS AFFECTING THE
ECONOMY OF THE COMMONWEALTH AND DOES NOT PURPORT TO BE A COMPLETE DESCRIPTION OF
SUCH FACTORS. OTHER FACTORS WILL AFFECT ISSUERS. THE SUMMARY IS BASED
PRIMARILY UPON ONE OR MORE PUBLICLY AVAILABLE OFFERING STATEMENTS RELATING TO
DEBT OFFERINGS OF COMMONWEALTH ISSUERS; HOWEVER, IT HAS NOT BEEN UPDATED NOR
WILL IT BE UPDATED DURING THE YEAR. THE TRUST HAS NOT INDEPENDENTLY VERIFIED
THE INFORMATION.
Many factors affect the financial condition of the Commonwealth of
Pennsylvania (also referred to as the "Commonwealth") and its political
subdivisions, such as social, environmental and economic conditions, many of
which are not within the control of such entities. Pennsylvania and certain of
its counties, cities and school districts and public bodies (most notably the
City of Philadelphia) have from time to time in the past encountered financial
difficulties which have adversely affected their respective credit standings.
Such difficulties could affect outstanding obligations of such entities,
including obligations held by the Fund.
The General Fund, the Commonwealth's largest fund, receives all tax
revenues, non-tax revenues and Federal grants and entitlements that are not
specified by law to be deposited elsewhere. The majority of the Commonwealth's
operating and administrative expenses are payable from the General Fund. Debt
service on all bonded indebtedness of the Commonwealth, except that issued for
highway purposes or for the benefit of other special revenue funds, is payable
from the General Fund.
For the five year period from fiscal 1992 through fiscal 1996, revenues
and other sources (determined on a "GAAP" basis) increased by an average
annual rate of 4.6%. Intergovernmental revenues increased by an average
annual rate of 13.2% due, in part, to an accounting change. Tax revenues
during this period increased an average of 2.5% as modest economic growth,
low inflation rates and several tax rate reductions and other tax reduction
measures constrained growth of tax revenues. The tax reduction measure
followed a $2.7 billion tax increase adopted for the 1992 fiscal year.
Expenditures and other uses during the fiscal 1992 through fiscal 1996
period rose at an average annual rate of 6.0%, led by increases of 14.2% for
protection of persons and property. A prison expansion program and other
correctional program expenses are responsible for the large percentage increase
in this area. Efforts to control costs for various social welfare programs and
the presence of favorable economic conditions have led to a modest 5.6% increase
for public health and welfare costs for the five year period.
The fund balance at June 30, 1996 totaled $635.2 million, a $547.7 million
increase from the balance of $87.5 million at June 30, 1992.
Fiscal 1995 was the fourth consecutive fiscal year the Commonwealth
reported an increase in the fiscal year-end unappropriated balance. The fiscal
1995 unappropriated surplus (prior to reserves for transfer to the Tax
Stabilization Reserve Fund) was $540 million, an increase of $204.2 million over
the fiscal 1994 unappropriated surplus (prior to transfers). Commonwealth
revenues were $459.4 million (2.9%) above the estimate of revenues used at the
time the budget was enacted. The higher than estimated revenues from tax
sources were due to faster economic growth in the national and state economy
than had been projected when the budget was adopted. Expenditures from
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Commonwealth revenues (excluding pooled financing expenditures), including $65.5
million of supplemental appropriations enacted at the close of the 1995 fiscal
year, totaled $15,674 million, representing an increase of 5% over spending
during fiscal 1994.
For GAAP purposes, the General Fund recorded a $49.8 million deficit for
fiscal 1995, leading to a decline in the fund balance to $688.3 million at June
30, 1995. The two items which predominately contributed to the decline in the
fund balance were (i) the use of a more comprehensive procedure to compute the
liabilities for certain public welfare programs, leading to an increase for the
year-end accruals, and (ii) a change in the methodology used to calculate the
year-end accrual for corporate tax payables which increased the tax refund
liability by $72 million for the 1995 fiscal year when compared to the previous
fiscal year.
The fiscal 1996 unappropriated surplus (prior to transfer to the Tax
Stabilization Reserve Fund) was $183.8 million, $65.5 million above estimate.
Net expenditures and encumbrances from Commonwealth revenues, including $113
million of supplemental appropriations (but excluding pooled financing
expenditures) totalled $16,129.9 million. Expenditures exceeded available
revenues and lapses by $253.2 million. The difference was funded from a planned
partial drawdown of the $437 million fiscal year adjusted beginning
unappropriated surplus.
Commonwealth revenues (prior to tax refunds) for fiscal 1996 increased by
$113.9 million over the prior year to $16,338.5 million (representing a growth
rate of .7%). Tax rate reductions and other tax law changes substantially
reduced the amount and rate of revenue growth for the fiscal year. It is
estimated the tax changes enacted for the fiscal year reduced Commonwealth
revenues by $283.4 million.
For GAAP purposes, the fiscal 1996 fund balance was drawn down $53.1
million to $635.2 million. A planned drawdown of the budgetary unappropriated
surplus during the fiscal year contributed to expenditures and other uses
exceeding revenues and other sources by $28.0 million. As a result, the
unreserved fund balance declined by $61.1 million, reducing the balance to
$381.8 million at the end of fiscal 1996. Total revenues and other sources
increased by 8.7% for the fiscal year, led by a 24.2% increase in
intergovernmental revenues (due mainly to an accounting change in the way in
which food stamps coupon revenue received from the federal government is counted
as income to the Commonwealth). Expenditures and other uses increased by 8.6%
for fiscal 1996.
The enacted fiscal 1997 budget provides for expenditures from Commonwealth
revenues of $16,375.8 million, an increase of .6% over appropriated amounts from
Commonwealth revenues for fiscal 1996. The fiscal 1997 budget is based on
anticipated Commonwealth revenues (before refunds) of $16,744.5 million, an
increase over actual fiscal 1996 revenues of 2.5%. The revenue estimate includes
provisions for a $15 million tax credit program enacted with the fiscal 1997
budget for businesses creating new jobs. Staggered corporation tax years will
cause fiscal 1997 revenues to continue to be affected by the business tax
reductions enacted during the two prior completed fiscal years. Those
reductions, together with the new jobs, creation tax credit, cause revenue
growth comparisons between fiscal 1996 and 1997 to be understated. When these
tax changes are taken into account, revenues in the fiscal 1997 budget are
anticipated to increase at the rate of 3%. The fiscal 1997 revenue estimate is
based on a forecast of the national economy for real gross domestic product to
slow to a growth rate of 2% for 1996 and below 1.5 percent for 1997. This is
based on the assumption that the Federal Reserve Board does not cut interest
rates and that foreign economic
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growth is weak. The consequence of this economic scenario is a U.S. economy with
very low growth, slow gains in consumer spending, declining inflation rates, but
increasing unemployment.
Increased authorized spending for fiscal 1997 is driven largely by
increased costs of the corrections and probation and payroll programs. The
fiscal 1997 budget contains an appropriation increase in excess of $110 million
for these programs. The fiscal 1997 budget also contains some departmental
restructurings.
Providing funding for certain programs increases required reductions and
savings in other programs funded from the General Fund. A major reform of the
current welfare system was enacted in May 1996 to encourage recipients toward
self-sufficiency through work requirements, to provide temporary support for
families showing personal responsibility and to maintain safeguards for those
who cannot help themselves.
The fiscal 1997 budget anticipated receiving $60 million of proceeds from
the securitization of $151.7 million of loans held by the Sunny Day Fund. This
fund was created to finance large-scale economic development loans to attract
significant employment opportunities to the Commonwealth. Its funding was
generally obtained from General Fund appropriations. The fund has been
abolished and its loans have been transferred to the Pennsylvania Industrial
Development Fund ("PIDA"). In September 1996, PIDA issued bonds secured by its
loan revenues, including the Sunny Day Fund loans. These bond proceeds will be
used to refund outstanding debt of the Commonwealth. The effect of this
transaction on the fiscal 1997 budget is to reduce the amount of debt service
needed to be appropriated from the General Fund by $84.7 million.
The fiscal 1997 budget is based on the presumption that federally enacted
reforms to Medicaid will raise the federal reimbursement percentage for those
costs to 57% from an approximate 53% rate for fiscal 1996. The Higher
reimbursement rate was anticipated to provide an additional $260 million of
federal funds during fiscal 1997 and enable the Commonwealth to reduce its
appropriations for the medical assistance program by a like amount for fiscal
1997. However, the U.S. Congress has not approved the legislation making these
changes and current expectations are that additional federal funds will not be
available at the time and in the amount as anticipated in the approved fiscal
1997 budget. The Commonwealth expects to use intergovernmental transfer funds
obtained through a pooling transaction to help make up the loss of this funding.
The fiscal 1997 budget assumes a drawdown of the $156.3 million fiscal year
beginning unappropriated surplus to fund the enacted level of appropriations
within the current estimate of revenues.
Actual Commonwealth revenues for the fiscal year through January 1997 are
$189.2 million above estimates levels. The higher than estimated revenues are
attributed to economic conditions in the nation and the state exceeding the
projections used to project revenues.
On February 4, 1997, the Governor presented his proposed budget for fiscal
1998. Total Commonwealth revenues before reductions for refunds and proposed
tax changes are estimated to be $17,339.2 million, 2.4% above revised estimates
for fiscal 1997. Proposed appropriations total $16,915.7 million, a 2.7%
increase over currently estimated fiscal 1997 appropriations. The proposed
fiscal 1998 budget assumes a drawdown of the currently estimated $177.6 million
unappropriated surplus at June 30, 1997. Four tax law proposals and a proposed
increase transfer of
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taxes to a special purpose are included in the proposed budget. Together these
items are estimated to reduce fiscal 1998 revenues by $66.9 million. All
require legislative enactment.
A disaster emergency was declared by the Governor and a federal major
disaster declaration was made by the President of the United States for certain
counties in the Commonwealth for a blizzard and subsequent flooding in January,
1996. Substantial damage to public and private facilities occurred and many
municipalities' financial resources have been strained by the costs of
responding to these weather-related conditions. A special session of the
General Assembly was convened by the Governor to consider legislation to respond
to these needs. Legislation was enacted that authorized $110 million of general
obligation debt to provide for the state's share of the required match for
federal public assistance and disaster mitigation funds. The legislation also
appropriated $13 million from tax amnesty receipts to fund the state match for
the federal individual assistance program, and authorized the use of current
Motor License Fund revenues for capital projects to repair flood damaged state
highways and bridges.
Pennsylvania has historically been identified as a heavy industry state
although that reputation has changed over the last thirty years as the coal,
steel and railroad industries declined and the Commonwealth's business
environment readjusted to reflect a more diversified industrial base. This
economic readjustment was a direct result of a long-term shift in jobs,
investment and workers away from the northeast part of the nation. Currently,
the major sources of growth in Pennsylvania are in the service sector, including
trade, medical and the health services, education and financial institutions.
Nonagricultural employment in Pennsylvania over the last ten years
increased at an annual rate of 1.02%. This compares to a .36% rate for the
Middle Atlantic region and 1.8% rate for the United States as a whole during the
period 1986 through 1995. For the last three years, employment in the
Commonwealth has increased 3.4%, as compared to 2.9% growth in the Middle
Atlantic region. The unemployment rate in Pennsylvania for January, 1997,
stood at a seasonably adjusted rate of 4.7%. The seasonably adjusted national
unemployment rate for January, 1997, was 5.4%.
The current Constitutional provisions pertaining to Commonwealth debt
permit the issuance of the following types of debt: (i) debt to suppress
insurrection or rehabilitate areas affected by disaster, (ii) electorate-
approved debt, (iii) debt for capital projects subject to an aggregate debt
limit of 1.75 times the annual average tax revenues of the preceding five fiscal
years, and (iv) tax anticipation notes payable in the fiscal year of issuance.
All debt except tax anticipation notes must be amortized in substantial and
regular amounts.
Debt service on all bonded indebtedness of Pennsylvania, except that issued
for highway purposes or the benefit of other special revenue funds, is payable
from Pennsylvania's General Fund, which receives all Commonwealth revenues that
are not specified by law to be deposited elsewhere. As of June 30, 1996, the
Commonwealth had $5,054.5 million of general obligation debt outstanding.
Other state-related obligations include "moral obligations". Moral
obligation indebtedness may be issued by the Pennsylvania Housing Finance Agency
("PHFA"), a state-created agency which provides financing for housing for lower
and moderate income families, and The Hospitals and Higher Facilities Authority
of Philadelphia, a municipal authority organized by the City of Philadelphia to,
among other things, acquire and prepare various sites for use as intermediate
care facilities for the mentally retarded. PHFA's bonds, but not its notes, are
partially secured by a
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capital reserve fund required to be maintained by PHFA in an amount equal to the
maximum annual debt service on its outstanding bonds in any succeeding calendar
year. PHFA is not permitted to borrow additional funds as long as any
deficiency exists in the capital reserve fund.
The Commonwealth, through several of its departments and agencies, has
entered into various agreements to lease, as lessee, certain real property and
equipment, and to make lease payments for the use of such property and
equipment. Some of those leases and their respective lease payments are, with
the Commonwealth approval, pledged as security for debt obligations issued by
certain public authorities or other entities within the state. All lease
payments due from Commonwealth departments and agencies are subject to and
dependent upon an annual spending authorization approved through the
Commonwealth's annual budget process. The Commonwealth is not required by law
to appropriate or otherwise provide monies from which the lease payments are to
be made. The obligations to be paid from such lease payments are not bonded
debt of the Commonwealth.
Certain state-created agencies have statutory authorization to incur debt
for which state appropriations to pay debt service thereon is not required. The
debt of these agencies is funded by assets of, or revenues derived from, the
various projects financed and is not a statutory or moral obligation of the
Commonwealth. Some of these agencies, however, are indirectly dependent on
Commonwealth operating appropriations. In addition, the Commonwealth maintains
pension plans covering all state employees, public school employees and
employees of certain state-related organizations. For their fiscal years ended
in 1996, the State Employees' Retirement System had no accrued unfunded
liability (or any surplus) and the Public School Employees' Retirement System
had a total unfunded actuarial accrued liability of $1,459 million.
The City of Philadelphia is the largest city in the Commonwealth with an
estimated population of 1,585,577 according to the 1990 Census. Legislation
providing for the establishment of Pennsylvania Intergovernmental Cooperation
Authority ("PICA") to assist Philadelphia in remedying fiscal emergencies was
enacted by the Pennsylvania General Assembly and approved by the Governor in
June 1991. PICA is designed to provide assistance through the issuance of
funding debt and to make factual findings and recommendations to Philadelphia
concerning its budgetary and fiscal affairs. At this time, Philadelphia is
operating under a five-year fiscal plan approved by PICA on April 30, 1996.
PICA has issued $1.76 billion of its Special Tax Revenue Bonds. This
financial assistance has included the refunding of certain city general
obligation bonds, funding of capital projects and the liquidation of the
Cumulative General Fund balance deficit as of June 30, 1992 of $224.9 million.
the audited General Fund balance of Philadelphia as of June 30, 1996 shows a
surplus of approximately $118.5 million, up from approximately $80.5 million as
of June 30, 1995.
No further bonds are to be issued by PICA for the purposes of financing a
capital project or deficit as the authority for such bond sales expired December
31, 1994. PICA's authority to issue debt for the purpose of financing a cash
flow deficit expired on December 31, 1996. Its ability to refund existing
outstanding debt is unrestricted. PICA had $1,146.2 million in special revenue
bonds outstanding as of June 30, 1996.
There is various litigation pending against the Commonwealth, its officers
and employees. In 1978, the Pennsylvania General Assembly approved a limited
waiver of sovereign immunity. Damages for any loss are limited to $250,000 for
each person and $1 million for each accident. The
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Supreme Court held that this limitation is constitutional. Approximately 3,500
suits against the Commonwealth are pending.
The following are among the cases with respect to which the Office of
Attorney General and the Office of General Counsel have determined that an
adverse decision may have a material effect on governmental operations of the
Commonwealth:
BABY NEAL V. COMMONWEALTH, ET AL.
In 1990, the American Civil Liberties Union and other various named
plaintiffs filed an action against the Commonwealth in Federal court seeking an
order that would require the Commonwealth to provide additional funding for
child welfare services. No figures for the amount of funding sought are
available. However, a similar lawsuit filed in the Commonwealth Court of
Pennsylvania was resolved through a court approved settlement which provides,
among other things, for Commonwealth funding for such services in fiscal year
1991 and a commitment to pay Pennsylvania counties $30 million over five years.
In December 1994, the Third Circuit Court of Appeals reversed the District
Court's denial of the plaintiff's motion for class certification with respect to
the interests of 16 minor plaintiffs. As a result, the District Court has
recently certified the class and the parties have resumed discovery.
COUNTY OF ALLEGHENY V. COMMONWEALTH OF PENNSYLVANIA
On December 7, 1987, the Supreme Court of Pennsylvania held that the
statutory scheme for county funding of the judicial system is in conflict with
the pennsylvania Constitution. However, judgment was stayed in order to afford
the General Assembly an opportunity to enact appropriate funding legislation
consistent with its opinion. Since that time, the Supreme Court has denied
various actions and motions by several Pennsylvania municipalities to compel the
Commonwealth to comply with the Supreme Court's 1987 decision or to restore
funding for local courts and district Justices to levels existing in 1987. On
December 7, 1992, the State Association of County Commissioners filed a new
action in mandamus seeking to compel the Commonwealth to comply with the Supreme
Court's decision in COUNTY OF ALLEGHENY. The Commonwealth has filed a response
in opposition to the new action. The Court issued the writ on July 26, 1996,
and appointed a special master to devise and submit a plan for implementation.
It recently granted an extension of time within which the special master must
file his report and announced the establishment of a committee comprised of
members of the Executive Department, the Legislative Department and the special
master, to develop an implementation plan. Following the issuance of the writ,
the President Pro Tempore of the Senate and the Speaker of the House filed a
petition seeking reconsideration from the Court. the General Assembly has yet
to consider legislation implementing the Pennsylvania Supreme Court's judgment.
FIDELITY BANK V. COMMONWEALTH OF PENNSYLVANIA
On November 30, 1989, Fidelity Bank, N.A. ("Fidelity") filed an action in
challenging the constitutional validity of a 1989 amendment increasing the bank
shares tax and related legislation. The Commonwealth Court ruled in favor of
the Commonwealth finding no constitutional deficiencies in the tax increase, but
invalidating one element of the legislation which provided a credit to new banks
(the "new bank tax credit"). Fidelity, the Commonwealth and certain intervener
banks appealed to the Pennsylvania Supreme Court. However, pursuant to a
Settlement Agreement dated as of April 21, 1995, the Commonwealth agreed to
enter a credit in favor of Fidelity in the amount of
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$4,100,000 in settlement of the constitutional and non-constitutional issues.
The credit represents approximately 5% of the potential claim of Fidelity, had
the constitutional issues been resolved in its favor.
Pursuant to a separate Settlement Agreement dated as of April 21, 1995, the
Commonwealth also settled with the intervening banks with respect to issues
concerning the new bank tax credit.
Notwithstanding the foregoing settlements, other banks have filed
protective petitions which are currently pending at the various
administrative agencies challenging the validity of the 1989 tax increase.
One or more of these banks may seek to raise the issues which were
adjudicated by Fidelity, although not brought to resolution by the
Pennsylvania Supreme Court.
PENNSYLVANIA ASSOCIATION OF RURAL AND SMALL SCHOOLS (PARSS) V. CASEY
In January 1991, an association of rural and small schools and several
other parties filed a lawsuit against then Governor Robert P. Casey and former
Secretary of Education, Donald M. Carroll challenging the constitutionality of
the Commonwealth system for funding local school districts. The litigation
consists of two parallel cases, one in the Commonwealth Court of Pennsylvania
and one in the United States District Court for the Middle District of
Pennsylvania. The federal court case has been indefinitely stayed pending
resolution of the state court case. The Commonwealth Court trial was held in
January, 1997. The record remains open to permit respondents to
cross-examine a surprise witness presented by Petitioners, and to permit
respondents to present their own experts. The parties expect to complete all
testimony in the spring of 1997.
AUSTIN V. DEPARTMENT OF CORRECTIONS, ET AL.
In November 1990, the American Civil Liberties Union filed a class
action lawsuit in the United States District Court for the Eastern District
of Pennsylvania on behalf of inmate populations in various Pennsylvania
correctional institutions, challenging the conditions of confinement and
seeking injunctive relief. On January 17, 1995, the Court approved a
Settlement Agreement between the parties, pursuant to which the Commonwealth
paid $1.3 million in attorneys' fees to the plaintiffs' attorneys, with an
additional $100,000 paid in connection with the dismissal of a preliminary
injunction relating to certain health issues. The parties are presently
complying with monitoring provisions outlined in the Settlement Agreement.
The monitoring phase will expire on January 6, 1998. The attorneys' fees for
the 3-year monitoring period will not exceed $60,000 in any one year.
ENVIROTEST/SYNTERRA PARTNERS
On December 15, 1995, Envirotest Systems Corporation, Envirotest Partners
("Envirotest") and the Commonwealth of Pennsylvania entered into a Settlement
Agreement pursuant to which the parties settled all claims which Envirotest
might have against the Commonwealth arising from the suspension of an emissions
testing program. Under the Settlement Agreement, Envirotest is to receive $145
million, with interest at 6% per annum, in payments of $25 million in 1995, and
$40 million each in 1996, 1997 and 1998. An additional $11 million may be
required to be paid in 1998 depending on the results of property liquidations by
Envirotest. Pursuant to a Consent to Assignment entered into in November,
1996, Envirotest has assigned its right, title and interest in the base
settlement.
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PENNSYLVANIA HUMAN RELATIONS COMMISSION V. SCHOOL DISTRICT OF PHILADELPHIA, ET
AL. V. COMMONWEALTH OF PENNSYLVANIA, ET AL.
On November 3, 1995, the Commonwealth of Pennsylvania and the Governor of
Pennsylvania, along with the City of Philadelphia and the Mayor of Philadelphia
were joined as additional respondents in an enforcement action commenced in
Commonwealth Court in 1973 by the Pennsylvania Human Relations Commission
against the School District of Philadelphia pursuant to the Pennsylvania Human
Relations Act. The enforcement action was pursued to remedy unintentional
conditions of segregation in the public schools of Philadelphia. The
Commonwealth and the City were joined in the "remedial phase" of the proceeding
"to determine their liability, if any, to pay additional costs necessary to
remedy the unlawful conditions found to exist in the Philadelphia public
schools."
On February 28, 1996, the School District of Philadelphia filed a third-
party complaint against the Commonwealth of Pennsylvania asking Commonwealth
Court to require the Commonwealth to "supply such funding as is necessary for
full compliance with the November 28, 1994 and other remedial orders of the
Commonwealth Court." In addition, a group of interveners on March 4, 1996 filed
a third-party complaint against the Commonwealth of Pennsylvania and the City of
Philadelphia requesting Commonwealth Court to declare that "it is the obligation
of the Commonwealth and the City to supply the additional funds identified as
necessary for the District to fully comply with the orders of the Commonwealth
Court," and to require the Commonwealth and the City to supply such additional
funding as is necessary for the District to comply with the orders.
On April 30, 1996, Commonwealth Court Judge Doris A. Smith overruled the
Commonwealth's and City's preliminary objections seeking dismissal of the claims
against them. The Commonwealth and the City thereafter filed answers to the
complaints, asserting numerous defenses. The Commonwealth also asserted a
cross-claim against the City of Philadelphia claiming that if any party is
liable, sole liability rests with the City, in the alternative, the Commonwealth
argued that if it is held to be liable, it has a right of indemnity or of
contribution against the City.
Trial commenced on May 30, 1996. During the course of the trial, upon
motion of the Commonwealth, the Pennsylvania Supreme Court on July 3, 1996
assumed extraordinary plenary jurisdiction and directed Judge Smith to conclude
the proceedings within 60 days and to file with the Supreme Court findings of
fact, conclusions of law and a final opinion.
On August 20, 1996, Judge Smith issued an Opinion and Order pursuant to
which judgment was entered in favor of the School District of Philadelphia and
the interveners and against the Commonwealth of Pennsylvania and the Governor of
Pennsylvania. Judgment was also entered in favor of the City of Philadelphia
and the Mayor of Philadelphia with respect to the intervener's claim and on the
cross-claim filed by the Commonwealth and Governor. The Judge ordered the
Commonwealth and Governor to submit a plan to the Court within thirty days
detailing the means by which the Commonwealth will effectuate the transfer of
additional funds payable to the School District of Philadelphia to enable it to
comply with the remedial order during fiscal year 1996-1997 and any future years
during which the School District establishes its fiscal incapacity to fund the
remedial programs. Judge Smith specifically found that "[b]ecause of the lack
of adequate funds to comply with the remedial order, the School District is
entitled to additional resources for 1996-1997 of $45.1 million."
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On August 30, 1996, the Commonwealth filed exceptions to the Findings of
Fact, Conclusions of Law and Opinion and Order of Judge Smith along with a
Motion to Vacate the purported Order and a Notice of Appeal and Jurisdictional
Statement.
On September 10, 1996, the Pennsylvania Supreme Court issued an order
granting the Commonwealth's Motion to Vacate and directed its Prothonotary to
establish a briefing schedule and date for oral argument. It also issued a
further order limiting the issues to be addressed and stated that the
Commonwealth Court is divested of jurisdiction of the matter and all further
proceedings in the Commonwealth Court are stayed pending further order of the
Supreme Court. The Supreme Court retained jurisdiction in the matter. On
January 28, 1997, the Supreme Court issued an Order directing the parties to
brief certain specific issues relative to the lower court proceedings.
RIDGE V. STATE EMPLOYEES' RETIREMENT BOARD
On December 29, 1993, Joseph H. Ridge, a former judge of the Allegheny
Court of Common Pleas, filed in the Commonwealth Court a Petition for Review in
the Nature of Complaint in Mandamus and for a Declaratory Judgment against the
State Employees' Retirement Board alleging that the use of gender distinct
actuarial factors for benefits based upon his pre-August 1, 1983 service
violates the equal protection and equal rights clauses of the Pennsylvania
Constitution. The lawsuit requests that the petitioner's benefits be "topped
up" to equal those that a similarly situated female would be receiving. A
decision adverse to the Retirement Board could be applicable to other members of
the State Employees' Retirement System and Public School Employees Retirement
System. The Commonwealth Court granted the Retirement Board's preliminary
objection to Judge Ridge's claims for punitive damages, attorneys fees and
compensatory damages (other than a recalculation of his pension benefits should
he prevail). On November 20, 1996, the Commonwealth Court heard oral arguments
en banc on Judge Ridge's motion for judgment of the pleadings. A decision on
that motion is pending. On February 13, 1997, the Commonwealth Court denied
Judge Ridge's motion for judgment on the pleadings.
YESENIA MARRERRO, ET AL. V. COMMONWEALTH, ET AL.
On February 24, 1997, five residents of the City of Philadelphia, on their
own behalf, and on behalf of their school-aged children, joined by the City of
Philadelphia, the School District of Philadelphia, and two non-profit
organizations, filed in the Commonwealth Court a civil action for declaratory
judgment against the Commonwealth of Pennsylvania, the General Assembly of
Pennsylvania, the presiding officers of the General Assembly, the Governor of
Pennsylvania, the State Board of Education, the Department of Education, and the
Secretary of Education, claiming that the statutory education financing system
is unconstitutional as applied to the School District of Philadelphia and that
the system of funding public education violates the constitutional mandate to
provide a thorough and efficient system of education in the City of
Philadelphia. The lawsuit also alleges that a scheme for financing public
education precludes the Commonwealth from providing the constitutionally
required "thorough and efficient system of public education" in the
circumstances faced by the School District of Philadelphia, and that the
defendants have failed to provide the School District of Philadelphia with
resources and other assistance necessary to provide all of its students with the
quality of education to which they are constitutionally entitled. Among other
things, the petitioners seek a declaration that the legislature must amend the
present or enact new education legislation so as to assure that education
funding for the School District of Philadelphia accounts and makes adequate
provision for the greater and special educational challenges and needs of
students in the School District in order to address their disadvantage.
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* * *
Currently, Pennsylvania general obligation bonds are rated AA- by Standard
& Poor's and Fitch, and A1 by Moody's. There can be no assurance that the
economic conditions on which these ratings are based will continue or that
particular bond issues will not be adversely affected by changes in economic or
political conditions.
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