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[THE MERGER FUND LOGO]
100 Summit Lake Drive
Valhalla, New York 10595
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A no-load, open-end, nondiversified investment company which seeks capital
growth by engaging in merger arbitrage.
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PROSPECTUS
DECEMBER 30, 1997
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This prospectus sets forth concisely the information about the Fund that a
prospective investor should know before investing. Please retain it for future
reference. A Statement of Additional Information dated December 30, 1997 is
available upon request without charge and may be obtained by writing to the
Fund's Administrator, Firstar Trust Company, P.O. Box 701, Milwaukee, Wisconsin
53201-0701. The Statement of Additional Information, which is incorporated by
reference into this prospectus, has been filed with the Securities and Exchange
Commission.
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The Fund pays to its principal underwriter and others an annual fee of up
to 0.25%, as authorized by its Rule 12b-1 plan of distribution. There can be no
assurance that the Fund's investment objective will be achieved, and its
investment policy entails capital risk. Each investor should carefully consider
his ability to assume the risks involved before making an investment in the
Fund.
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Effective June 1, 1996, the Fund was closed to new investors. Shareholders
in the Fund as of May 31, 1996 may purchase additional shares, subject only to
the terms set forth herein. Investment advisors and financial planners who held
Fund shares in omnibus accounts as of May 31, 1996 may continue to make
purchases in such accounts. The Fund reserves the right to resume sales to new
investors at any time but has no present plans to do so.
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THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES
AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE
SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED
UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE
CONTRARY IS A CRIMINAL OFFENSE.
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TABLE OF CONTENTS
<TABLE>
<S> <C>
FUND EXPENSES.............................................................................. 1
CONDENSED FINANCIAL INFORMATION............................................................ 2
INVESTMENT OBJECTIVES AND POLICIES......................................................... 3
Risk Factors.......................................................................... 3
Leverage Through Borrowing............................................................ 4
Short Sales and Put and Call Options.................................................. 4
Investment Restrictions............................................................... 5
INVESTMENT ADVISER......................................................................... 5
PRINCIPAL UNDERWRITER...................................................................... 6
CUSTODIAN, TRANSFER AGENT, DIVIDEND PAYING AGENT,
ACCOUNTING SERVICES AGENT AND ADMINISTRATOR................................................ 6
PLANS OFFERED BY THE FUND.................................................................. 6
The Merger Fund IRA Plan.............................................................. 6
Fund Investors Keogh Plans............................................................ 7
HOW TO PURCHASE SHARES..................................................................... 7
Automatic Investment Plan............................................................. 7
NET ASSET VALUE............................................................................ 8
REDEMPTIONS................................................................................ 8
Systematic Withdrawal Plan............................................................ 9
TAX STATUS, DIVIDENDS AND DISTRIBUTIONS.................................................... 9
ORGANIZATION AND CAPITALIZATION............................................................ 10
SHAREHOLDER COMMUNICATIONS................................................................. 10
</TABLE>
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FUND EXPENSES(1)
(FOR THE TEN MONTH FISCAL YEAR ENDED SEPTEMBER 30, 1997)
<TABLE>
<S> <C>
SHAREHOLDER TRANSACTION EXPENSES................................................ None(2)
ANNUAL FUND OPERATING EXPENSES
(as a percentage of average net assets)
Advisory Fees.............................................................. 1.00%
Rule 12b-1 Distribution Fees............................................... 0.16%
Other Expenses............................................................. 0.20%(3)
-----
Total Operating Expenses........................................................ 1.36%
</TABLE>
EXAMPLE
You would pay the following expenses on a $1,000 investment, assuming (1) 5%
annual return and (2) redemption at the end of each time period:
<TABLE>
<CAPTION>
1 YEAR 3 YEARS 5 YEARS 10 YEARS
<S> <C> <C> <C>
$14 $43 $74 $164
</TABLE>
Notes:
(1) The purpose of the table is to assist investors in understanding the various
costs and expenses that investors in the Fund will bear directly or
indirectly. See "INVESTMENT ADVISER", "PRINCIPAL UNDERWRITER" AND
"CUSTODIAN, TRANSFER AGENT, DIVIDEND PAYING AGENT, ACCOUNTING SERVICES AGENT
AND ADMINISTRATOR." THE EXAMPLE PROVIDED ABOVE SHOULD NOT BE CONSIDERED A
REPRESENTATION OF PAST OR FUTURE EXPENSES. ACTUAL EXPENSES MAY BE GREATER OR
LESS THAN THOSE SHOWN IN THE EXAMPLE.
(2) No sales loads or transaction fees are charged in connection with the
purchase or redemption of Fund shares. Shareholders will be assessed fees
for outgoing wire transfers, returned checks and stop payment orders at
prevailing rates charged by Firstar Trust Company.
(3) Each IRA and Keogh account will be charged a $12.50 annual maintenance fee
as well as fees for certain transactions.
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THE MERGER FUND
CONDENSED FINANCIAL INFORMATION
(FOR THE FISCAL YEARS ENDED NOVEMBER 30, 1988 - 1996 AND THE FISCAL TEN MONTHS
ENDED SEPTEMBER 30, 1997) (AUDITED)
THE TABLE BELOW SETS FORTH CERTAIN INFORMATION COVERING THE FUND'S INVESTMENT
RESULTS FOR THE PERIODS INDICATED.
FURTHER FINANCIAL DATA AND RELATED NOTES ARE CONTAINED IN THE STATEMENT OF
ADDITIONAL INFORMATION,
WHICH IS AVAILABLE UPON REQUEST.
<TABLE>
<CAPTION>
TEN MONTHS
ENDED
SEPTEMBER 30, YEAR ENDED NOVEMBER 30,
------------- --------------------------------------------------------------
1997 1996 1995 1994 1993 1992
------------- -------- -------- -------- ------- -------
<S> <C> <C> <C> <C> <C> <C>
Net Asset Value, beginning of
period............................... $15.41 $14.87 $13.72 $13.70 $12.34 $12.51
-------- -------- -------- ------- ------- -------
Income from investment operations:
Net investment income/(loss)....... 0.02(5)(6) 0.20(5)(6) 0.08(5)(6) -- (5)(6) (0.07)(5)(6) (0.12)(5)
Net realized and unrealized gain
(loss) on investments........... 1.35 1.24 1.78 1.08 2.10 0.65
-------- -------- -------- ------- ------- -------
Total from investment operations... 1.37 1.44 1.86 1.08 2.03 0.53
Less Distributions:
Dividends from net investment
income.......................... (0.19) (0.08) -- -- -- (0.03)
Distributions from net realized
gains........................... (1.24) (0.82) (0.71) (1.06) (0.67) (0.67)
-------- -------- -------- ------- ------- -------
Total distributions................ (1.43) (0.90) (0.71) (1.06) (0.67) (0.70)
-------- -------- -------- ------- ------- -------
Net Asset Value, end of period........ $15.35 $15.41 $14.87 $13.72 $13.70 $12.34
-------- -------- -------- ------- ------- -------
Total Return.......................... 9.68%(8) 10.26% 14.26% 8.41% 17.24% 4.45%
Supplemental Data and Ratios:
Net assets, end of period
(000's)......................... $445,987 $489,084 $243,082 $170,344 $25,173 $11,611
Ratio of operating expenses to
average net assets.............. 1.36%(4)(9) 1.36%(4) 1.41%(4) 1.58%(4) 2.19%(4) 2.75%(4)
Ratio of interest expense and
dividends on short positions to
average net assets.............. 2.93%(9) 0.95% 2.42% 1.72% 1.91% 2.28%
Ratio of net investment
income/(loss) to average net
assets.......................... 0.13%(9) 1.36% 0.57% (0.03)% (0.57)% (1.42)%
Portfolio turnover rate............ 271.24% 276.99% 290.48% 390.34%(7) 186.00%(7) 231.40%(7)
Average commission rate per
share........................... $0.0373 $0.0434
<CAPTION>
1991 1990 1989 1988
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<S> <C> <C> <C> <C> <C>
Net Asset Value, beginning of
period............................... $11.43 $12.03 $11.50 $10.10
------- ------- ------- -------
Income from investment operations:
Net investment income/(loss)....... 0.02(5) (0.16)(2)(5) (0.02) 0.04
Net realized and unrealized gain
(loss) on investments........... 1.79 0.70 0.66 1.74
------- ------- ------- -------
Total from investment operations... 1.81 0.54 0.64 1.78
Less Distributions:
Dividends from net investment
income.......................... -- -- (0.11) (0.07)
Distributions from net realized
gains........................... (0.73) (1.14) -- (0.31)
------- ------- ------- -------
Total distributions................ (0.73) (1.14) (0.11) (0.38)
------- ------- ------- -------
Net Asset Value, end of period........ $12.51 $11.43 $12.03 $11.50
------- ------- ------- -------
Total Return.......................... 16.84% 4.57% 5.66% 18.15%
Supplemental Data and Ratios:
Net assets, end of period
(000's)......................... $10,281 $9,599 $11,006 $8,421
Ratio of operating expenses to
average net assets.............. 3.05(1)(4) 3.26(1)(3)(4) 2.80%(1) 2.57%
Ratio of interest expense and
dividends on short positions to
average net assets.............. 1.01% 1.20% -- --
Ratio of net investment
income/(loss) to average net
assets.......................... 0.21% (1.20)% (0.17)% 0.39%
Portfolio turnover rate............ 311.51%(7) 357.39%(7) 430.44%(7) 187.16%(7)
Average commission rate per
share...........................
</TABLE>
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(1) Reflects certain non-recurring expenses associated with the Fund's
restructuring as of January 31, 1989.
(2) Net investment income before reimbursement of expenses by the investment
adviser for the year ended November 30, 1990 would have been $(0.17).
(3) Operating expense ratio before reimbursement by investment adviser was
3.31%.
(4) For the ten months ended September 30, 1997 and for the years ended November
30, 1996, 1995, 1994, 1993, 1992, 1991 and 1990 the operating expense ratio
excludes interest expense and dividends on short positions. The ratios
including interest expense and dividends on short positions for the ten
months ended September 30, 1997 and for the years ended November 30, 1996,
1995, 1994, 1993, 1992, 1991 and 1990 were 4.29%, 2.31%, 3.83%, 3.30%,
4.10%, 5.03%, 4.06% and 3.46%, respectively.
(5) Net investment income before interest expense and dividends on short
positions for the ten months ended September 30, 1997 and for the years
ended November 30, 1996, 1995, 1994, 1993, 1992, 1991 and 1990 was $0.38,
$0.35, $0.42, $0.21, $0.17, $0.07, $0.10 and ($0.15), respectively.
(6) Net investment income (loss) per share represents net investment income for
the respective fiscal year divided by the monthly average shares of
beneficial interest outstanding throughout each year.
(7) The numerator for the portfolio turnover rate includes the lesser of
purchases or sales (including both long and short positions). The
denominator includes the average long position throughout the year.
(8) Not annualized.
(9) Annualized.
NOTE: FROM THE FUND'S INCEPTION THROUGH JANUARY 31, 1989, THE AYCO CORPORATION
SERVED AS INVESTMENT ADVISER TO THE FUND. DURING THIS PERIOD, WESTCHESTER
CAPITAL MANAGEMENT, INC., THE FUND'S CURRENT INVESTMENT ADVISER, AND TWO OTHER
NON-ARBITRAGE INVESTMENT ADVISERS WERE RETAINED BY THE AYCO CORPORATION TO
MANAGE VARYING PORTIONS OF THE FUND'S ASSETS. THE ABOVE INVESTMENT RESULTS,
THEREFORE, ARE NOT NECESSARILY REPRESENTATIVE OF THE RESULTS THAT WOULD HAVE
BEEN REALIZED HAD WESTCHESTER CAPITAL MANAGEMENT, INC. BEEN THE SOLE INVESTMENT
ADVISER TO THE FUND.
Further information regarding the Fund's performance is contained in the Fund's
Annual Report, a copy of which may be obtained without charge.
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INVESTMENT OBJECTIVES AND POLICIES
The Fund seeks to achieve capital growth by engaging in merger arbitrage.
The Fund's investment adviser is Westchester Capital Management, Inc. (the
"Adviser").
Under normal market conditions, the Fund will invest at least 65% of its
assets in the equity securities of companies which are involved in publicly
announced mergers, takeovers and other corporate reorganizations ("merger
arbitrage investments"). Depending upon the level of merger activity and other
economic and market conditions, the Fund may temporarily invest a substantial
portion of its assets in cash or cash equivalents, including money market
instruments such as Treasury bills and other short-term obligations of the
United States Government, its agencies or instrumentalities; negotiable bank
certificates of deposit; prime commercial paper; and repurchase agreements with
respect to the above securities.
Merger arbitrage is a highly specialized investment approach generally
designed to profit from the successful completion of proposed mergers,
takeovers, tender offers, leveraged buyouts, spin-offs, liquidations and other
types of corporate reorganizations. Although a variety of strategies may be
employed depending upon the nature of the reorganizations selected for
investment, the most common merger arbitrage activity involves purchasing the
shares of an announced acquisition target at a discount to their expected value
upon completion of the acquisition. As compared to conventional investing,
merger arbitrage results are considered by the Adviser to be less sensitive to
the overall trend of stock prices. Over the last three-year period, the Fund's
"beta" (a statistical measure of market-related risk, whereby a fund's
sensitivity to movements in the Standard & Poor's 500 Stock Index is expressed
relative to the Index's beta of 1.0) has averaged less than 0.2. The Adviser
believes that this number is significantly lower than comparable figures for
other equity mutual funds seeking capital growth. While some periods will be
more conducive to a merger arbitrage strategy than others, a systematic,
disciplined arbitrage program may produce attractive rates of return, even in
flat or down markets. The principal risk associated with the Fund's merger
arbitrage investments is that certain of the proposed reorganizations may be
renegotiated or terminated, in which case losses may be realized.
The Fund's investment objective of achieving capital growth by engaging in
merger arbitrage is a fundamental policy which may not be changed without
shareholder approval. Except as otherwise stated, the Fund's other investment
objectives and policies are not fundamental and may be changed without obtaining
approval by the Fund's shareholders.
RISK FACTORS
The Fund's investment program will involve investment techniques and
securities holdings which entail risks, in some cases different from the risks
ordinarily associated with investments in equity securities. To the extent that
the Fund's assets are invested in a smaller number of issues, there is a
somewhat greater risk associated with investment in the Fund than in a
diversified investment company, as defined in the Investment Company Act of
1940.
The Fund intends to invest a portion of its assets to seek short-term
capital appreciation, which can be expected to increase the portfolio turnover
rate and as a result cause increased brokerage commission costs. It is currently
anticipated that the Fund's annual portfolio turnover rate may exceed 300%. In
addition, a high turnover rate may expose shareholders to a higher current
realization of capital gains, and thus a higher current tax liability, than may
be associated with investments in other investment companies which emphasize
long-term investment strategies and thus have a lower turnover rate.
The Fund is not intended to provide a balanced investment program. The Fund
is intended to be an investment vehicle only for that portion of an investor's
capital which can appropriately be exposed to risk. Each investor should
evaluate an investment in the Fund in terms of the investor's own investment
goals.
3
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LEVERAGE THROUGH BORROWING
The Fund may borrow from banks or by entering into reverse repurchase
agreements to increase its portfolio holdings of securities. Such borrowings may
be on a secured or unsecured basis at fixed or variable rates of interest. A
reverse repurchase agreement is functionally identical to a repurchase agreement
except that the roles of the parties are reversed so that the Fund will sell the
underlying security with the promise to repurchase. The Investment Company Act
of 1940 requires the Fund to maintain continuous asset coverage of not less than
300% with respect to all borrowings. This allows the Fund to borrow for such
purposes an amount (when taken together with any borrowings for temporary or
emergency purposes as described below) equal to as much as 50% of the value of
its net assets (not including such borrowings). If such asset coverage should
decline to less than 300% due to market fluctuations or other reasons, the Fund
may be required to dispose of some of its portfolio holdings within three days
in order to reduce the Fund's debt and restore the 300% asset coverage, even
though it may be disadvantageous from an investment standpoint to dispose of
assets at that time. Leveraging will exaggerate any increase or decrease in the
net asset value of the Fund's portfolio, and in that respect may be considered a
speculative practice. The interest which the Fund must pay on borrowed money,
together with any additional fees to maintain a line of credit or any minimum
average balances required to be maintained, are additional costs which will
reduce or eliminate any net investment income and may also offset any potential
capital gains. Unless the appreciation and income, if any, on assets acquired
with borrowed funds exceed the costs of borrowing, the use of leverage will
diminish the investment performance of the Fund compared with what it would have
been without leverage.
The Fund, like many other investment companies, may also borrow money for
temporary or emergency purposes, but such borrowings, together with all other
borrowings, may not exceed 33% of the value of the Fund's gross assets when the
loan is made.
SHORT SALES AND PUT AND CALL OPTIONS
The Fund may employ various hedging techniques, such as short selling and
the selective use of put and call options, in an effort to reduce the risks
associated with certain of its investments. For example, when the terms of a
proposed acquisition call for the exchange of common stock and/or other
securities, the common stock of the company to be acquired may be purchased and,
at approximately the same time, an equivalent amount of the acquiring company's
common stock and/or other securities may be sold short. Any such short sale will
be made with the intention of later closing out ("covering") the short position
with the securities of the acquiring company received upon consummation of the
acquisition. The purpose of the short sale is to protect against a decline in
the market value of the acquiring company's securities prior to the
acquisition's completion. However, should the acquisition be called off or
otherwise not completed, the Fund may realize losses on both its long position
in the target company's shares and its short position in the acquirer's
securities.
At all times when the Fund does not own, or have an unconditional right to
receive, securities which are sold short, the Fund will maintain a segregated
account consisting of cash, cash equivalents and liquid securities equal in
value on a daily marked-to-market basis to the securities sold short.
The purchase of put options may be similarly used for hedging purposes. A
put option is a short-term contract which gives the purchaser of the option, in
return for a premium paid, the right to sell the underlying security at a
specified price upon exercise of the option at any time prior to the expiration
of the option. The market price of a put option will normally vary inversely
with the market price of the underlying security. Consequently, by purchasing
put options on merger arbitrage stocks, it may be possible for the Fund to
partially offset any decline in the market value of certain of the equity
positions held by the Fund. Also, as part of a merger arbitrage strategy
involving a pending corporate reorganization, the Fund may also write (sell)
uncovered put options. As a matter of fundamental policy, which may not be
changed without shareholder approval, the value of
4
<PAGE> 7
all put options purchased or sold by the Fund, as measured by the premiums paid
or received, may not exceed 25% of the Fund's net assets.
The sale of covered call options may also be used by the Fund to reduce the
risks associated with individual investments and to increase total investment
return. In return for the premium income, the Fund will give up the opportunity
to profit from an increase in the market price of the underlying security above
the exercise price so long as its obligations under the contract continue,
except insofar as the premium represents a profit. The sale of call options will
not be used for speculative purposes, and, accordingly, call options will be
written solely as covered call options; that is, options on securities which the
Fund owns at the time the call is sold. As a matter of fundamental policy, the
value of securities underlying call options written by the Fund may not exceed
50% of the Fund's net assets. In addition, the Fund may purchase call options
only for the purpose of closing out previously written covered call options.
The Adviser believes that, when used for hedging purposes, short sales and
options transactions should be viewed less as speculative strategies than as
techniques to help protect the assets of the Fund against unfavorable market
conditions that might otherwise adversely affect certain of its investments.
Nonetheless, a substantial percentage of the investments made by the Fund will
not lend themselves to hedging strategies and, even when available, such
strategies may not be successful. Also, options transactions involve special
risks including (i) possible imperfect correlation between the price movements
of the option and the underlying security and (ii) lack of assurance of a liquid
secondary market at any particular time and possible exchange- imposed price
fluctuation limits, either of which may make it difficult or impossible to close
a position when so desired.
INVESTMENT RESTRICTIONS
The investment restrictions set forth below have been adopted by the Fund
as fundamental policies which may be changed only by a vote of the Fund's
shareholders. The Fund may not invest more than 5% of its total assets in
enterprises with less than three years of continuous operation; may not invest
more than 10% of its assets in the securities of any one issuer; may not
purchase more than 10% of an issuer's voting securities; may not invest more
than 10% of its assets in restricted securities or securities without readily
available market quotations, including repurchase agreements having a maturity
of more than seven days; may not borrow money in an amount exceeding 33% of its
total assets; and may not invest more than 25% of its total assets in securities
of companies in the same industry. The Fund may not invest more than 5% of its
net assets in warrants or more than 2% of its net assets in warrants not listed
on specified national stock exchanges. The Fund may make short sales but only
under certain conditions to the extent of 50% of its net assets. The value of
securities of any one company in which the Fund is short may not exceed the
lesser of 10% of its net assets or 10% of any class of such company's
securities.
INVESTMENT ADVISER
Westchester Capital Management, Inc., 100 Summit Lake Drive, Valhalla, New
York 10595, a registered investment adviser since 1980, is the Fund's investment
adviser. Westchester Capital Management, Inc. and affiliates also manage merger
arbitrage programs for other institutional investors, including offshore funds
and private limited partnerships. Subject to the authority of the Fund's Board
of Trustees, the Adviser is responsible for the overall management of the Fund's
business affairs. The Adviser charges an annual advisory fee of 1.0% of the
average daily net assets of the Fund. The fee charged the Fund is higher than
those typically paid by other mutual funds. This higher fee is attributable in
part to the higher expense incurred by the Adviser and the specialized skills
required to manage a portfolio of merger arbitrage investments.
Mr. Frederick W. Green acts as the President of the Adviser and also serves
as the President and a Trustee of the Fund. Ms. Bonnie L. Smith is the Vice
President of the Adviser as well as the Vice President, Treasurer
5
<PAGE> 8
and Secretary of the Fund. Mr. Green and Ms. Smith have been primarily
responsible for the day-to-day management of the Fund's portfolio since January
1989.
PRINCIPAL UNDERWRITER
The Fund's principal underwriter is Mercer Allied Company, L.P. ("Mercer"),
One Wall Street, Albany, New York 12205, a majority-owned subsidiary of The Ayco
Company, L.P. ("Ayco"), a registered investment adviser principally engaged in
personal financial counseling.
The Fund has adopted a plan of distribution (the "Plan") pursuant to Rule
12b-1 under the Investment Company Act of 1940. Under the Plan, the Fund may pay
to Mercer, any broker-dealer with whom Mercer or the Fund has entered into a
contract to distribute the Fund's shares, or any other qualified financial
services firm, compensation for services with respect to shares held or
purchased by their respective customers or in connection with the purchase of
shares attributable to their efforts. The amount of such compensation paid in
any one year shall not exceed 0.25% annually of the average daily net assets of
the Fund, payable as a service fee for providing record keeping, subaccounting,
subtransfer agency and/or shareholder liaison services. In addition, the Adviser
may pay amounts from its own resources for the provision of such services.
CUSTODIAN, TRANSFER AGENT, DIVIDEND PAYING AGENT,
ACCOUNTING SERVICES AGENT AND ADMINISTRATOR
Firstar Trust Company, P.O. Box 701, Milwaukee, Wisconsin 53201-0701 is the
Fund's custodian, transfer agent and dividend paying agent.
Firstar Trust Company also serves as the Fund's accounting services agent
and Fund Administrator. As such, Firstar Trust Company provides a variety of
administrative and accounting services to the Fund, such as accounting relating
to the Fund's portfolio and portfolio transactions, the determination of net
asset value and pricing of the Fund's shares of beneficial interest, and
maintaining the books of account of the Fund.
PLANS OFFERED BY THE FUND
Additional information about any of the plans described below may be
obtained by contacting the Adviser at 100 Summit Lake Drive, Valhalla, New York
10595 (telephone (914) 741-5600).
THE MERGER FUND IRA PLAN
The Fund makes available The Merger Fund IRA Plan for individuals to
establish an Individual Retirement Account ("IRA") under which shares of the
Fund may be purchased. The Merger Fund IRA Plan can be used to make regular IRA
contributions, and can also be used for a rollover or transfer from an existing
IRA, or for a rollover from a qualified retirement plan from which the
individual receives a lump-sum distribution.
An annual maintenance fee of $12.50 will be charged for each IRA account.
In addition, a $15.00 fee will be assessed to any IRA account which is
transferred to a successor trustee, distributed to a participant or for which a
refund of excess contribution is paid. These fees are subject to change upon
notification by Firstar Trust Company to the Fund.
The Fund also makes available to qualifying shareholders a "Roth IRA,"
which is a new form of IRA created by the Taxpayer Relief Act of 1997.
Shareholders should consult with their own financial advisers to determine
eligibility.
6
<PAGE> 9
FUND INVESTORS KEOGH PLANS
The Fund makes available the Fund Investors Defined Contribution Prototype
Plan and the Fund Investors Defined Benefit Prototype Plan (referred to
collectively in this prospectus as the "Fund Investors Keogh Plans"), for
corporations, self-employed individuals or partnerships, to establish a
qualified retirement plan under which shares of the Fund may be purchased. The
Fund Investors Keogh Plans can accept a transfer or qualified rollover from an
existing qualified retirement plan from which an individual receives a lump-sum
distribution, as well as regular annual contributions.
An annual maintenance fee of $12.50 will be charged for each Keogh account.
In addition, a $15.00 fee will be assessed to any Keogh account which is
transferred to a successor trustee or distributed to a participant, or for which
a refund of excess contribution is paid. These fees are subject to change upon
notification by Firstar Trust Company to the Fund.
HOW TO PURCHASE SHARES
Shares of the Fund may be purchased at net asset value without any sales or
other charge by sending a completed application form to The Merger Fund, c/o
Firstar Trust Company, P.O. Box 701, Milwaukee, Wisconsin 53201-0701. However,
applicants should not send any correspondence by overnight courier to this post
office box address. Correspondence sent by overnight courier should be addressed
to the Fund at Firstar Trust Company, Mutual Fund Services, Third Floor, 615
East Michigan Street, Milwaukee, Wisconsin 53202. The minimum initial investment
for individuals, IRAs, corporations, partnerships or trusts is $2,000. There is
no minimum for subsequent investments. There is no minimum investment
requirement for Keogh Plans. Shares of the Fund are offered on a continuous
basis. The Fund, however, reserves the right, in its sole discretion, to reject
any application to purchase shares. Applications will not be accepted unless
they are accompanied by a check drawn on a U.S. bank, savings and loan, or
credit union in U.S. funds for the full amount of the shares to be purchased.
After an account is opened, additional shares may be purchased by sending a
check payable to "The Merger Fund," together with a note stating the name(s) on
the account and the account number, to Firstar Trust Company, P.O. Box 701,
Milwaukee, Wisconsin 53201-0701. All shares will be purchased at the net asset
value per share next determined after receipt of the shareholder's application
in proper order and acceptance of such application by the Fund. No share
certificates will be issued unless requested in writing. Shares of the Fund may
also be purchased through authorized broker-dealers who may charge for their
services.
The custodian will charge a $20.00 fee against a shareholder's account, in
addition to any loss sustained by the Fund, for any payment check returned to
the custodian for insufficient funds.
Shareholders should contact the Administrator at (800) 343-8959 to obtain
the latest wire instructions for wiring funds to Firstar Trust Company for the
purchase of Fund shares and to notify Firstar Trust Company that a wire transfer
is coming.
AUTOMATIC INVESTMENT PLAN
A shareholder may also participate in the Fund's Automatic Investment Plan,
an investment plan that automatically debits money from the shareholder's bank
account and invests it in the Fund through the use of electronic funds transfers
or automatic bank drafts. After making an initial investment of at least $2,000,
shareholders may elect to make subsequent investments by transfers of a minimum
of $100 on specified days of each month into their established Fund account.
Shareholders should contact the Administrator at (800) 343-8959 for more
information about the Fund's Automatic Investment Plan.
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<PAGE> 10
NET ASSET VALUE
The net asset value per share of the Fund will be determined on each day
when the New York Stock Exchange (the "Exchange") is open for business at the
close of the Exchange and will be computed by determining the aggregate market
value of all assets of the Fund less its liabilities, and then dividing by the
total number of shares outstanding. The determination of net asset value for a
particular day is applicable to all applications for the purchase of shares as
well as all requests for the redemption of shares received at or before the
close of trading on the Exchange on that day.
REDEMPTIONS
Fund shareholders will be entitled to redeem all or any portion of the
shares credited to their accounts by submitting a written request for redemption
to: The Merger Fund, c/o Firstar Trust Company, P.O. Box 701, Milwaukee,
Wisconsin 53201-0701. Upon the receipt of such a request in "proper order," as
described below, the shareholder will receive a check based on the net asset
value next determined after the redemption request has been received, which may
be more or less than the amount originally invested. If the shares to be
redeemed represent an investment made by check, the Fund reserves the right to
withhold the proceeds until the check clears. It will normally take up to three
days to clear local checks and up to seven days to clear other checks.
A redemption request will be considered to have been received in "proper
order" if the following conditions are satisfied:
(i) the request is in writing, indicates the number of shares to be redeemed
and identifies the shareholder's account number;
(ii) the request is signed by the shareholder(s) exactly as the shares are
registered;
(iii) the request is accompanied by certificates, if any, issued representing
the shares, which have been endorsed for transfer (or are themselves
accompanied by an endorsed stock power) exactly as the shares are
registered; and
(iv) if the redemption proceeds are requested to be sent other than to the
address of record or if the proceeds of a requested redemption exceed
$25,000, the signature(s) on the request is/are guaranteed by an eligible
signature guarantor.
Questions concerning a redemption request may be addressed to the Fund at
its principal office. No redemption request will become effective until all
documents have been received in "proper order" by Firstar Trust Company.
Shareholders who have an IRA or other retirement plan must indicate on
their redemption request whether or not to withhold federal income tax.
Redemption requests failing to indicate an election not to have federal tax
withheld will be subject to withholding.
Shareholders may also redeem Fund shares through broker-dealers holding
such shares who have made arrangements with the Fund permitting redemptions by
telephone or facsimile transmission. These broker-dealers may charge a fee for
this service.
If a shareholder's transactions at any time reduce the shareholder's
account in the Fund to below $1,000 in value, the Fund may notify the
shareholder that, unless the account is brought up to at least such minimum
amount, the Fund may, within a reasonable time, redeem all shares in the account
and close it by making payment to the shareholder.
8
<PAGE> 11
Shareholders who effect redemptions by wire transfer will pay a $12.00 wire
transfer fee to the Transfer Agent to cover costs associated with the transfer.
In addition, a shareholder's bank may impose a charge for receiving wires.
SYSTEMATIC WITHDRAWAL PLAN
Individuals in whose accounts shares of the Fund are held or accounts in
which shares are allocated to The Merger Fund IRA Plan, the Fund Investors Keogh
Plans or other qualified retirement plan, which accounts in each case have a
current account value of at least $10,000, may adopt a Systematic Withdrawal
Plan to provide for periodic distributions for an annual fee of $15.00 per plan,
which fee is subject to change upon notification by Firstar Trust Company to the
Fund. By using the Systematic Withdrawal Plan, a shareholder can request
monthly, quarterly or other periodic checks for any designated amount of $500 or
more. A Systematic Withdrawal Plan may be opened by making an application to
Firstar Trust Company.
TAX STATUS, DIVIDENDS AND DISTRIBUTIONS
The Fund has qualified and elected to be treated as a regulated investment
company under the Internal Revenue Code of 1986, as amended (the "Code") and
intends to continue to so qualify. In any taxable year in which it qualifies as
such and distributes all of its net investment income and net capital gain in
accordance with the timing requirements of the Code, it will be exempt from
federal income and excise taxes.
The Fund intends to distribute substantially all of its net investment
income and net capital gain in December. Both distributions will be in shares of
the Fund unless a shareholder elects to receive cash. Dividends from net
investment income (including any excess of net short-term capital gain over net
long-term capital loss) are taxable to investors as ordinary income, while
distributions of net capital gain (the excess of net long-term capital gain over
net short-term capital loss) are taxable as long-term capital gain regardless of
the shareholder's holding period for the shares. A portion of the Fund's income
distributions may be eligible for the 70% dividends-received deduction for
domestic corporate shareholders. Certain dividends or distributions declared in
October, November or December will be taxed to shareholders as if received in
December if they are paid during the following January.
Each year the Fund informs its shareholders of the amount and type of its
distributions. The Fund is required by federal tax law to withhold 31% of
dividends (including capital gain dividends) and redemption proceeds for
accounts (other than those of corporations and certain other exempt entities)
without a certified taxpayer identification number ("TIN") and certain other
certified information or with respect to which the IRS or a broker has notified
the Fund that withholding is required due to an incorrect TIN or a failure to
report taxable interest or dividends. The shareholder also must certify that the
number is correct and that he/she is not subject to backup withholding. The
certification is included as part of the share purchase application form. If the
shareholder does not have a social security number, he/she should indicate on
the purchase form that an application to obtain a number is pending. The Fund is
required to withhold taxes if a number is not delivered to the Fund within seven
days.
IRA's, Keogh plans and other qualified retirement plans are exempt from
federal income taxation under the Code.
This summary is not intended to be, nor should it be, construed as legal or
tax advice to any current holder of the Fund's shares. The Fund's shareholders
are urged to consult their own tax advisors to determine the tax consequences to
them of their ownership of the Fund's shares.
9
<PAGE> 12
ORGANIZATION AND CAPITALIZATION
The Fund is an open-end management investment company established under the
laws of the Commonwealth of Massachusetts by Declaration of Trust dated April
12, 1982, as amended and restated on August 22, 1989. The Fund's activities are
supervised by its Trustees, who are elected by the Fund's shareholders. The
Declaration of Trust permits the Trustees to issue an unlimited number of full
and fractional shares. The Trustees are also empowered by the Declaration of
Trust and the By-Laws to create additional series of shares, or portfolios. Each
share represents an equal proportionate interest in the Fund.
As permitted by Massachusetts law, there will normally be no meetings of
shareholders for the purpose of electing Trustees unless and until such time as
less than a majority of the Trustees holding office have been elected by
shareholders. In such an event, the Trustees then in office will call a
shareholders' meeting for the election of Trustees. Except for the foregoing and
unless removed by action of the shareholders in accordance with the Fund's
By-Laws, the Trustees shall continue to hold office and may appoint successor
Trustees. The Trustees shall only be liable in cases of their willful
misfeasance, bad faith, gross negligence or reckless disregard of their duties.
Shares entitle their holders to one vote per share. Shares have
noncumulative voting rights, do not have preemptive or subscription rights and
are transferable.
SHAREHOLDER COMMUNICATIONS
Shareholders of the Fund will receive quarterly schedules of investments,
unaudited semi-annual financial statements and audited year-end financial
statements certified by the Fund's independent certified public accountants.
Each report will show the investments owned by the Fund and the market values
thereof as determined in accordance with the policies of the Fund and will
provide other information about the Fund and its operations.
Shareholder inquiries should be directed to Firstar Trust Company, Mutual
Fund Services, P.O. Box 701, Milwaukee, Wisconsin 53201-0701 (telephone (800)
343-8959). Any correspondence sent by overnight courier service should be
addressed to the Fund at Firstar Trust Company, Third Floor, 615 East Michigan
Street, Milwaukee, Wisconsin 53202.
10
<PAGE> 13
INVESTMENT ADVISER
Westchester Capital Management, Inc.
100 Summit Lake Drive
Valhalla, NY 10595
(914) 741-5600
ADMINISTRATOR, TRANSFER AGENT, DIVIDEND
PAYING AGENT, SHAREHOLDER
SERVICING AGENT & CUSTODIAN
Firstar Trust Company
P.O. Box 701
Milwaukee, WI 53201-0701
(800) 343-8959
TRUSTEES
Frederick W. Green
William H. Bohnett
Michael J. Downey
James P. Logan III
Frank A. McDermott, Jr.
EXECUTIVE OFFICERS
Frederick W. Green, President
Bonnie L. Smith, Vice President, Treasurer
and Secretary
COUNSEL
Fulbright & Jaworski L.L.P.
666 Fifth Avenue
New York, NY 10103
INDEPENDENT ACCOUNTANTS
Price Waterhouse LLP
100 East Wisconsin Avenue
Milwaukee, WI 53202
[THE MERGER FUND LOGO]
PROSPECTUS
DECEMBER 30, 1997
<PAGE> 14
THE MERGER FUND
100 Summit Lake Drive
Valhalla, New York 10595
A no-load, open-end, nondiversified investment company which seeks
capital growth by engaging in merger arbitrage.
STATEMENT OF ADDITIONAL INFORMATION
DECEMBER 30, 1997
This Statement of Additional Information is not a prospectus and should
be read in conjunction with the prospectus of The Merger Fund dated December
30, 1997, a copy of which may be obtained without charge by writing to the
Fund's Administrator, Firstar Trust Company, P.O. Box 701, Milwaukee, Wisconsin
53201-0701.
The Fund pays to its principal underwriter and others an annual fee of
up to 0.25%, as authorized by its Rule 12b-1 plan of distribution. There can be
no assurance that the Fund's investment objective will be achieved, and its
investment policy entails capital risk. Each investor should carefully consider
his ability to assume the risks involved before making an investment in the
Fund.
<PAGE> 15
TABLE OF CONTENTS
INVESTMENT OBJECTIVES AND POLICIES.......................................... 1
Merger Arbitrage........................................................... 1
Special Risks of Over-the-Counter Options Transactions..................... 2
Investment Restrictions.................................................... 3
INVESTMENT ADVISER AND PRINCIPAL UNDERWRITER................................ 6
Investment Adviser and Advisory Contract................................... 6
Principal Underwriter...................................................... 7
MANAGEMENT.................................................................. 9
Trustees and Officers...................................................... 9
Remuneration............................................................... 10
SERVICES AND PLANS OFFERED BY THE FUND...................................... 11
The Merger Fund IRA Plan................................................... 11
Fund Investors Keogh Plans................................................. 11
Systematic Withdrawal Plan................................................. 12
NET ASSET VALUE............................................................. 12
ADDITIONAL INFORMATION ABOUT REDEMPTIONS.................................... 13
TAX STATUS.................................................................. 13
ORGANIZATION AND CAPITALIZATION............................................. 20
General ................................................................... 20
Shareholder and Trustee Liability.......................................... 20
ALLOCATION OF PORTFOLIO BROKERAGE........................................... 22
PORTFOLIO TURNOVER.......................................................... 23
INDEPENDENT ACCOUNTANTS..................................................... 23
CUSTODIAN, TRANSFER AGENT, DIVIDEND PAYING AGENT,
ACCOUNTING SERVICES AGENT AND ADMINISTRATOR................................. 24
COUNSEL..................................................................... 25
EXPERTS..................................................................... 25
APPENDIX.................................................................... 26
Covered Option Writing..................................................... 26
-i-
<PAGE> 16
Money Market Instruments................................................... 26
Repurchase Agreements...................................................... 26
Short Selling.............................................................. 27
FINANCIAL STATEMENTS........................................................ 28
-ii-
<PAGE> 17
INVESTMENT OBJECTIVES AND POLICIES
(See "INVESTMENT OBJECTIVES AND
POLICIES" in the Fund's prospectus.)
The Merger Fund (the "Fund") is a no-load, open-end, nondiversified,
registered management investment company which seeks to achieve capital growth
by engaging in merger arbitrage. The Fund's adviser is Westchester Capital
Management, Inc., 100 Summit Lake Drive, Valhalla, New York 10595 (the
"Adviser").
Trading to seek short-term capital appreciation can be expected to
cause the Fund's portfolio turnover rate to be substantially higher than that of
the average equity-oriented investment company and, as a result, may involve
increased brokerage commission costs which will be borne directly by the Fund
and ultimately by its investors. See "Allocation of Portfolio Brokerage" and
"Portfolio Turnover." Certain investments of the Fund may, under certain
circumstances, be subject to rapid and sizable losses, and there are additional
risks associated with the Fund's overall investment strategy, which may be
considered speculative.
Merger Arbitrage.
Although a variety of strategies may be employed depending upon the
nature of the reorganizations selected for investment, the most common merger
arbitrage activity involves purchasing the shares of an announced acquisition
target at a discount from the expected value of such shares upon completion of
the acquisition. The size of the discount, or spread, and whether the potential
reward justifies the potential risk, are functions of numerous factors affecting
the riskiness and timing of the acquisition. Such factors include the status of
the negotiations between the two companies (for example, spreads typically
narrow as the parties advance from an agreement in principle to a definitive
agreement), the complexity of the transaction, the number of regulatory
approvals required, the likelihood of government intervention on antitrust or
other grounds, the type of consideration to be received and the possibility of
competing offers for the target company.
Because the expected gain on an individual arbitrage investment is
normally considerably smaller than the possible loss should the transaction be
unexpectedly terminated, Fund assets will not be committed unless the proposed
acquisition or other reorganization plan appears to the Adviser to have a
substantial probability of success. The expected timing of each transaction is
also extremely important since the length of time that the Fund's capital must
be committed to any given reorganization will affect the rate of return realized
by the Fund, and delays can substantially reduce such returns. See "Portfolio
Turnover."
<PAGE> 18
The Adviser will be guided by the following general principles in
making investments for the Fund:
1. Securities will be purchased only after a reorganization is
announced or when one or more publicly disclosed events point toward the
likelihood of some type of reorganization within a reasonable period of time.
2. Before an initial position will be established in a newly announced
reorganization, a preliminary analysis will be made of the proposed transaction
to determine the probability and timing of a successful completion. A more
detailed review will take place before the position is enlarged.
3. In deciding whether or to what extent to invest in any given
reorganization, the Adviser will place particular emphasis on the credibility,
strategic motivation and financial resources of the participants, and the
liquidity of the securities involved in the transaction.
4. The risk-reward characteristics of each arbitrage position will be
assessed on an ongoing basis, and the Fund's holdings will be adjusted
accordingly.
5. The Adviser will attempt to invest in as many attractive
reorganizations as can be effectively monitored in order to minimize the impact
on the Fund of losses resulting from the termination of any given proposed
transaction.
6. The Adviser will invest the Fund's assets in both negotiated, or
"friendly," reorganizations and non-negotiated, or "hostile," takeover attempts,
but in either case the Adviser's primary consideration will be the likelihood
that the transaction will be successfully completed.
Special Risks of Over-the-Counter Options Transactions.
As part of its merger arbitrage strategy, the Fund may engage in
transactions in options and futures contracts which are traded over-the-counter
("OTC transactions"). OTC transactions differ from exchange-traded transactions
in several respects. OTC transactions are transacted directly with dealers and
not with a clearing corporation. Without the availability of a clearing
corporation, OTC transaction pricing is normally done by reference to
information from market makers, which information is carefully monitored by the
Adviser and verified in appropriate cases.
As the OTC transactions are transacted directly with dealers, there is
a risk of nonperformance by the dealer as a result of the insolvency of such
dealer or otherwise, in which event the Fund may experience a loss. An OTC
transaction may only be terminated voluntarily by entering into a closing
transaction with the dealer with whom the Fund originally dealt. Any such
cancellation, if agreed to, may require the Fund to pay a premium to that
dealer. In those cases in which the Fund has entered into a covered transaction
and cannot voluntarily terminate the transaction,
-2-
<PAGE> 19
the Fund will not be able to sell the underlying security until the investment
instrument expires or is exercised or different cover is substituted. In such
cases, the Fund may not be able to sell an underlying security even though it
might otherwise be advantageous to do so.
It is the Fund's intention to enter into OTC transactions only with
dealers which agree to, and which are expected to be capable of, entering into
closing transactions with the Fund, although there is no assurance that a dealer
will voluntarily agree to terminate the transaction. There is also no assurance
that the Fund will be able to liquidate an OTC transaction at any time prior to
expiration. OTC transactions for which there is no adequate secondary market
will be considered illiquid.
Investment Restrictions.
The following investment restrictions have been adopted by the Fund as
fundamental policies and may be changed only by the affirmative vote of a
majority of the outstanding shares of the Fund. As used in this Statement of
Additional Information and in the Fund's prospectus, the term "majority of the
outstanding shares of the Fund" means the vote of (i) 67% or more of the Fund's
shares present at a meeting, if the holders of more than 50% of the outstanding
shares of the Fund are present or represented by proxy, or (ii) more than 50% of
the Fund's outstanding shares, whichever is less.
These investment restrictions provide that:
(1) The Fund may not issue senior securities other than to evidence
borrowings as permitted in paragraph (5) below.
(2) The Fund may not make short sales of securities (unless by virtue
of its ownership of other securities at the time of such sale, it owns or has a
prospective right to receive, without the payment of additional compensation,
securities equivalent in kind and amount to the securities sold). The total
market value of all securities sold short may not exceed 50% of the value of the
net assets of the Fund, and the value of securities of any one issuer in which
the Fund is short may not exceed the lesser of 10% of the value of the Fund's
net assets or 10% of the securities of any class of any issuer.
(3) The Fund may not purchase securities on margin, except that the
Fund may obtain such short-term credits as may be necessary for the clearance of
purchases and sales of securities.
(4) The Fund may not (a) purchase call options except to terminate,
through a closing purchase transaction, its obligation with respect to a
previously written covered call option; (b) sell uncovered (naked) call options;
(c) sell covered call options the underlying securities of which have an
aggregate value (determined as of the date the calls are sold) exceeding 50% of
the value of the net assets of the Fund;
-3-
<PAGE> 20
or (d) invest in put options to the extent that the premiums on protective put
options exceed 25% of the value of its net assets; provided that the provisions
of this paragraph (4) shall not prevent the purchase, ownership, holding or sale
of forward contracts with respect to foreign securities or currencies.
(5) The Fund may not borrow money except that it may borrow (i) from
banks to purchase or carry securities or other investments, (ii) from banks for
temporary or emergency purposes, or (iii) by entering into reverse repurchase
agreements, if, immediately after any such borrowing, the value of the Fund's
assets, including all borrowings then outstanding less its liabilities, is equal
to at least 300% of the aggregate amount of borrowings then outstanding (for the
purpose of determining the 300% asset coverage, the Fund's liabilities will not
include amounts borrowed). Any such borrowings may be secured or unsecured. The
Fund may issue securities (including senior securities) appropriate to evidence
the indebtedness, including reverse repurchase agreements, which the Fund is
permitted to incur.
(6) The Fund may not pledge, mortgage or hypothecate its assets, except
that to secure borrowings as permitted in paragraph (5) above, the Fund may
pledge securities having a market value at the time of pledge not exceeding 33%
of the value of its total assets. The Fund may, in addition, pledge securities
having a market value at the time of pledge not exceeding 50% of the value of
its net assets to secure short sales as permitted in paragraph (2) above or
covered option writing as permitted in paragraph (4) above.
(7) The Fund may not underwrite or participate in the marketing of
securities issued by other persons except to the extent that the Fund may be
deemed to be an underwriter under federal securities laws in connection with the
disposition of portfolio securities.
(8) The Fund may not knowingly purchase or otherwise acquire securities
which are subject to legal or contractual restrictions on resale or invest more
than 10% of its total assets in securities without readily available market
quotations, including repurchase agreements having a maturity of more than seven
days.
(9) The Fund may not concentrate its investments in any industry. No
more than 25% of the value of the total assets of the Fund may be invested in
the securities of issuers having their principal business activities in the same
industry.
(10) The Fund may not purchase or sell real estate or real estate
mortgage loans as such, but this restriction shall not prevent the Fund from
investing in readily marketable interests in real estate investment trusts,
readily marketable securities of companies which invest in real estate, or
obligations secured by real estate or interests therein.
(11) The Fund may not purchase or sell commodities or commodity
contracts.
-4-
<PAGE> 21
(12) The Fund may not make loans, except that subject to paragraph (8),
the Fund may enter into repurchase agreements maturing in seven days or less.
(13) The Fund may not purchase warrants, valued at the lower of cost or
market, in excess of 5% of the net assets of the Fund (taken at current value);
provided that this shall not prevent the purchase, ownership, holding or sale of
warrants of which the grantor is the issuer of the underlying securities.
Included within that amount, but not to exceed 2% of the value of the Fund's net
assets, may be warrants which are not listed on the New York or American Stock
Exchange. Warrants acquired by the Fund at any time in units or attached to
securities are not subject to this restriction.
(14) The Fund may not invest in interests (other than equity stock
interests or debentures) in oil, gas or other mineral exploration or development
programs.
(15) The Fund may not invest in companies for the purpose of exercising
control or management.
(16) The Fund may not purchase or retain the securities of any issuer,
other than its own securities, if, to the knowledge of the Fund's management,
the Trustees and officers, or the directors and employees of the Fund's
investment adviser, who individually own beneficially more than 1/2% of the
outstanding securities of such issuer, together own beneficially more than 5% of
such outstanding securities.
(17) The Fund may not invest more than 5% of the value of its total
assets in the securities of issuers which, together with any predecessors, have
been in continuous operation for less than three years.
(18) The Fund may not participate on a joint or a joint and several
basis in any trading account in securities.
(19) The Fund may not purchase securities of other investment
companies, except by purchases in the open market where no underwriter or
dealer's commission or profit is involved, other than customary brokers'
commissions, and except as they may be acquired as part of a merger,
consolidation or acquisition of assets.
(20) The Fund may not invest more than 10% of its total assets (taken
at market value) in the securities of any one issuer, except those issued or
guaranteed by the United States Government, its agencies or instrumentalities.
(21) The Fund may not purchase securities of any one issuer if as a
result more than 10% of the voting securities of such issuer would be held by
the Fund.
-5-
<PAGE> 22
If a particular percentage restriction as set forth above is adhered to
at the time of investment, a later increase or decrease in percentage resulting
from a change in values or assets will not constitute a violation of that
restriction.
INVESTMENT ADVISER AND PRINCIPAL UNDERWRITER
(See "INVESTMENT ADVISER" and "PRINCIPAL
UNDERWRITER" in the Fund's prospectus.)
Investment Adviser and Advisory Contract.
The Fund's investment advisory contract with the Adviser (the "Advisory
Contract") provides that the Fund pay all of the Adviser's expenses, including,
without limitation, (i) the costs incurred in connection with registration and
maintenance of its registration under the Securities Act of 1933, as amended,
the Investment Company Act of 1940, as amended, and state securities laws and
regulations, (ii) preparation of and printing and mailing reports, notices and
prospectuses to current shareholders, (iii) transfer taxes on the sales of the
Fund's shares and on the sales of portfolio securities, (iv) brokerage
commissions, (v) custodial and shareholder transfer charges, (vi) legal,
auditing and accounting expenses, (vii) expenses of servicing shareholder
accounts, (viii) insurance expenses for fidelity and other coverage, (ix) fees
and expenses of Trustees who are not "interested persons" within the meaning of
the Investment Company Act of 1940, (x) expenses of Trustee and shareholder
meetings and (xi) any expenses of distributing the Fund's shares which may be
payable pursuant to a Plan of Distribution adopted pursuant to Rule 12b-1 under
the Investment Company Act of 1940. The Fund is also liable for such
nonrecurring expenses as may arise, including litigation to which the Fund may
be a party. The Fund has an obligation to indemnify each of its officers and
Trustees with respect to such litigation but not against any liability to which
he would otherwise be subject by reason of willful misfeasance, bad faith, gross
negligence, or reckless disregard of the duties involved in the conduct of his
office.
The Adviser receives an advisory fee, payable monthly, for the
performance of its services at an annual rate of 1.0% (1/12 of 1% monthly) of
the average daily net assets of the Fund. The fee will be accrued daily for the
purpose of determining the offering and redemption price of the Fund's shares.
The Advisory Contract will continue in effect from year to year
provided such continuance is approved at least annually by (i) a vote of the
majority of the Fund's Trustees who are not parties thereto or "interested
persons" (as defined in the Investment Company Act of 1940) of the Fund or the
Adviser, cast in person at a meeting specifically called for the purpose of
voting on such approval and by (ii) the majority vote of either all of the
Fund's Trustees or the vote of a majority of the outstanding shares of the Fund.
The Advisory Contract may be terminated without penalty on 60 days' written
notice by a vote of a majority of the Fund's Trustees or by
-6-
<PAGE> 23
the Adviser, or by holders of a majority of the Fund's outstanding shares. The
Advisory Contract shall terminate automatically in the event of its assignment.
For the fiscal years ended November 30, 1995 and 1996 ,the Fund
incurred advisory fees of $2,040,921 and $4,114,105, respectively, to the
Adviser. For the fiscal year ended September 30, 1997, the fund incurred
advisory fees of $3,864,592.
Principal Underwriter.
The Fund's principal underwriter is Mercer Allied Company, L.P.
("Mercer"), One Wall Street, Albany, New York 12205. Mercer is a Delaware
limited partnership organized in 1994, and is currently majority-owned by The
Ayco Company, L.P. Mercer is a broker-dealer registered under the Securities
Exchange Act of 1934 and a member of the National Association of Securities
Dealers, Inc.
The Fund has adopted a plan of distribution dated January 31, 1989, as
amended and restated on July 1, 1993 (the "Plan") pursuant to Rule 12b-1 under
the Investment Company Act of 1940. Under the Plan, the Fund may pay to Mercer,
to any broker-dealer with whom Mercer or the Fund has entered into a contract to
distribute Fund shares, or to any other qualified financial services firm,
compensation for services with respect to shares held or purchased by their
respective customers or in connection with the purchase of shares attributable
to their efforts. The amount of such compensation paid in any one year shall not
exceed 0.25% annually of the average daily net assets of the Fund.
The Plan provides that Mercer will furnish to the Trustees and the
Trustees will review, at least quarterly, a report of distribution expenses
incurred under the Plan and the purposes for which such expenses were incurred.
The Plan will remain in effect from year to year provided such continuance is
approved at least annually by the vote of a majority of the Fund's Trustees who
are not "interested persons" (as defined in the Investment Company Act of 1940)
of the Fund, the Adviser or Mercer and who have no direct or indirect interest
in the operation of the Plan or any related agreement (the "Rule 12b-1
Trustees"), cast in person at a meeting called for the purpose of voting on such
approval, and additionally by a vote of either a majority of the Fund's Trustees
or a majority of the outstanding shares of the Fund.
The Plan may be terminated at any time by vote of a majority of the
Rule 12b-1 Trustees or by vote of a majority of the Fund's outstanding shares.
The Plan may not be amended to increase materially the amount of distribution
expenses payable under the Plan without approval of the Fund's shareholders. In
addition, all material amendments to the Plan must be approved by the Trustees
in the manner described above.
The Fund has distribution and/or service contracts with authorized
dealers and distributors of the Fund's shares and others, all of which contracts
incorporate the
-7-
<PAGE> 24
terms of the Plan and have been approved by the Trustees, including the Rule
12b-1 Trustees. Pursuant to their respective contracts, for the fiscal year
ended September 30, 1997, the Fund incurred expenses of $618,416 of which
$58,429 was paid or accrued to Mercer and $559,987 was paid or accrued to
others.
-8-
<PAGE> 25
MANAGEMENT
Trustees and Officers.
The Fund's Trustees and officers are listed below. Except as indicated,
each Trustee has held the office shown or other offices in the same company for
the last five years.
The "interested" Trustees as defined in the Investment Company Act of
1940 are indicated by an asterisk(*).
<TABLE>
<CAPTION>
Position(s) Held Principal Occupation(s)
Name and Address Age with the Fund During the Past 5 Years
- ---------------- --- ----------------- ------------------------
<S> <C> <C> <C>
Frederick W. Green* 51 President and Trustee President of Westchester
Westchester Capital Capital Management, Inc.,
Management, Inc. the Fund's Adviser.
100 Summit Lake Drive
Valhalla, NY 10595
Bonnie L. Smith 49 Vice President, Vice President of
Westchester Capital Treasurer and Secretary Westchester Capital
Management, Inc. Management, Inc., the
100 Summit Lake Drive Fund's Adviser.
Valhalla, NY 10595
William H. Bohnett* 49 Assistant Secretary and Partner in the law firm of
Fulbright & Jaworski L.L.P. Trustee Fulbright & Jaworski L.L.P.
666 Fifth Avenue
New York, NY 10103
James P. Logan III 61 Trustee President of James P. Logan
James P. Logan & Co., Inc. & Co., Inc., an executive
144 East 44th Street search firm.
New York, NY 10017
Frank A. McDermott, Jr. 79 Trustee President of JFM Associates,
217 Northeast Edgewater Inc., a management
Drive consulting firm. Also,
Stuart, FL 34996 Director of Orange and
Rockland Utilities, Inc.
Michael J. Downey 54 Trustee Consultant and independent
2 Parsons Lane financial adviser since July
Rochester, NY 14610 1993. Chairman and Chief
Executive Officer of
Prudential Mutual Fund
Management, May 1987 to
June 1993. President and
Director of Asia Pacific
Fund, Inc.
</TABLE>
-9-
<PAGE> 26
<TABLE>
<CAPTION>
Position(s) Held Principal Occupation(s)
Name and Address Age with the Fund During the Past 5 Years
- ---------------- --- ----------------- ------------------------
<S> <C> <C> <C>
Mary Kraft 29 Assistant Secretary Trust Officer of Firstar
Firstar Trust Company Trust Company LLP.
615 East Michigan Street
Milwaukee, WI 53202
</TABLE>
As of December 8, 1997, the Trustees and officers of the Fund, as a
group, owned 23,663.390 shares of beneficial interest of the Fund, and
49,982.345 shares were owned by the Adviser's retirement funds.
Remuneration.
Management considers that Messrs. Logan, McDermott and Downey are not
"interested persons" (as defined in the Investment Company Act of 1940) of the
Fund or the Adviser. The fees of the non-interested Trustees (currently $4,000
per year and $1,000 per meeting attended), in addition to their out-of-pocket
expenses in connection with attendance at Trustees meetings, are paid by the
Fund. For the fiscal year ended September 30, 1997, the Fund paid the
following in Trustees' fees:
COMPENSATION TABLE
(for the fiscal year ended September 30, 1997)
<TABLE>
<CAPTION>
Aggregate Pension or Estimated
Compensation Retirement Benefits Annual Total
from Accrued as Part of Benefits upon Compensation
Name of Trustee Registrant Fund Expenses Retirement from Registrant
- --------------- ------------ ------------------- ------------- ---------------
<S> <C> <C> <C> <C>
Frederick W. Green 0 0 0 0
William H. Bohnett 0 0 0 0
Michael J. Downey $8,000 0 0 $8,000
James P. Logan 8,000 0 0 8,000
Frank McDermott, Jr. 7,000 0 0 7,000
</TABLE>
-10-
<PAGE> 27
SERVICES AND PLANS OFFERED BY THE FUND
(See "PLANS OFFERED BY THE FUND" in the Fund's prospectus.)
The costs of services rendered to the Fund's investors by its transfer
agent, Firstar Trust Company ("Firstar") are paid for by the Fund; however, in
order to cover abnormal administrative costs, investors requesting an historical
transcript of their account will be charged a fee based upon the number of years
researched. The Fund reserves the right, on 60 days' written notice, to charge
investors to cover other administrative costs of services provided to
shareholders.
The Merger Fund IRA Plan.
The Fund makes available an Individual Retirement Account ("IRA"),
known as "The Merger Fund IRA Plan." The Merger Fund IRA Plan provides
individuals with the opportunity to establish an IRA in order to purchase shares
of the Fund. The Merger Fund IRA Plan can also be used for a transfer from an
existing IRA, or for a rollover from a qualified retirement plan from which the
individual receives a lump-sum distribution. The form of The Merger Fund IRA
Plan meets the requirements of Section 408 of the Internal Revenue Code. Firstar
acts as custodian for The Merger Fund IRA Plan, and the adoption of The Merger
Fund IRA Plan by each individual is subject to acceptance or rejection by
Firstar in its capacity as custodian.
The fund also makes available to qualifying shareholders a "Roth IRA,"
which is a new form of IRA created by the taxpayer relief act of 1997.
Shareholders should consult with their own financial advisers to determine
eligibility.
Fund Investors Keogh Plans.
The Fund makes available the Fund Investors Defined Contribution
Prototype Plan (the "Fund Investors Defined Contribution Keogh Plan") and the
Fund Investors Defined Benefit Prototype Plan (the "Fund Investors Defined
Benefit Keogh Plan"). The Fund Investors Defined Contribution Keogh Plan and the
Fund Investors Defined Benefit Keogh Plan (collectively hereinafter referred to
as the "Fund Investors Keogh Plans") provide opportunities to corporations,
self-employed individuals and partnerships to establish qualified retirement
plans under which shares of the Fund may be purchased. The Fund Investors Keogh
Plans can, in most cases, also accept a transfer or a rollover from an existing
qualified retirement plan from which an individual receives a lump-sum
distribution of the individual's entire account balance in such plan. A defined
benefit qualified retirement plan specifies what a participant's pension benefit
will be, and the employer (including a self-employed individual) adopting the
plan must then fund the plan on an actuarial basis so it can pay the promised
benefit. A defined contribution qualified retirement plan does not promise any
definite benefit but instead provides for certain contributions to be made to
the plan, and a participant's ultimate benefit depends on the amount that has
accumulated
-11-
<PAGE> 28
in his account. The Fund Investors Keogh Plans have received an opinion from the
Internal Revenue Service approving the plans as prototype plans which meet the
requirements of Sections 401 and 501 of the Internal Revenue Code of 1986, as
amended. The Fund Investors Keogh Plans are in the process of being submitted to
the Internal Revenue Service for additional approval of certain amendments
required by recent changes in tax law. Firstar acts as custodian of the Fund
Investors Keogh Plans. The Fund Investors Keogh Plans as adopted by each
employer (including a self-employed individual) or partnership are subject to
acceptance or rejection by Firstar in its capacity as trustee of the Fund
Investors Keogh Plans.
Systematic Withdrawal Plan.
Shareholders participating in the Fund's Systematic Withdrawal Plan
should note that disbursements may be based on the redemption of a fixed dollar
amount, fixed number of shares, percent of account or declining balance. Any
income, dividends and capital gain distributions on shares held in Systematic
Withdrawal Plan accounts will be reinvested in additional Fund shares.
Systematic Withdrawal Plan payments will be made out of the proceeds realized
from the redemption of Fund shares held in the account. These redemptions made
to effect withdrawal payments may reduce or exhaust entirely the original
investment held under the Plan. A Systematic Withdrawal Plan may be terminated
at any time by the shareholder or the Fund upon written notice and will be
automatically terminated when all Fund shares in the shareholder's account under
the Plan have been liquidated.
NET ASSET VALUE
(See "NET ASSET VALUE" in the Fund's prospectus.)
The net asset value per share of the Fund will be determined on each
day when the New York Stock Exchange is open for business and will be computed
by taking the aggregate market value of all assets of the Fund less its
liabilities, and dividing by the total number of shares outstanding. Each
determination will be made (i) by valuing portfolio securities, including open
short positions, which are traded on the New York Stock Exchange, American Stock
Exchange and on the Nasdaq National Market System at the last reported sales
price on that exchange; (ii) by valuing put and call options which are traded on
the Chicago Board Options Exchange or any other domestic exchange at the last
sale price on such exchange; (iii) by valuing listed securities and put and call
options for which no sale was reported on a particular day and securities traded
on the over-the-counter market at the mean between the last bid and asked
prices; and (iv) by valuing any securities or other assets for which market
quotations are not readily available at fair value in good faith and under the
supervision of the Trustees, although the actual calculation may be done by
others. The Adviser reserves the right to value securities, including options,
at prices other than last-sale prices when such last-sale prices are believed
unrepresentative of fair market value as determined in good faith by the
Adviser.
-12-
<PAGE> 29
The assets of the Fund received for the issue or sale of its shares,
and all income, earnings, profits and proceeds thereof, subject only to the
rights of creditors, shall constitute the underlying assets of the Fund. In the
event of the dissolution or liquidation of the Fund, the holders of shares of
the Fund are entitled to share pro rata in the net assets of the Fund available
for distribution to shareholders.
ADDITIONAL INFORMATION ABOUT REDEMPTIONS
(See "REDEMPTIONS" in the Fund's prospectus.)
Supporting documents in addition to those listed under "Redemptions" in
the Fund's prospectus will be required from executors, administrators, trustees,
or if redemption is requested by one other than the shareholder of record. Such
documents include, but are not restricted to, stock powers, trust instruments,
certificates of death, appointments as executor, certificates of corporate
authority and waiver of tax required in some states when settling estates.
Under the Investment Company Act of 1940, a shareholder's right to
redeem shares and to receive payment therefor may be suspended at times: (a)
when the New York Stock Exchange is closed, other than customary weekend and
holiday closings; (b) when trading on that exchange is restricted for any
reason; (c) when an emergency exists as a result of which disposal by the Fund
of securities owned by it is not reasonably practicable or it is not reasonably
practicable for the Fund fairly to determine the value of its net assets,
provided that applicable rules and regulations of the Securities and Exchange
Commission (or any succeeding governmental authority) will govern as to whether
the conditions prescribed in (b) or (c) exist; or (d) when the Securities and
Exchange Commission by order permits a suspension of the right to redemption or
a postponement of the date of payment on redemption. In case of suspension of
the right of redemption, payment of a redemption request will be made based on
the net asset value next determined after the termination of the suspension.
TAX STATUS
(See "TAX STATUS, DIVIDENDS AND DISTRIBUTIONS" in the Fund's prospectus.)
The Fund has qualified and elected to be treated as a regulated
investment company under the Internal Revenue Code of 1986, as amended (the
"Code"), and intends to continue to so qualify, which requires compliance with
certain requirements concerning the sources of its income, diversification of
its assets, and the amount and timing of its distributions to shareholders. Such
qualification does not involve supervision of management or investment practices
or policies by any government agency or bureau. By so qualifying, the Fund will
not be subject to federal income or excise tax on its net investment income or
net capital gain which are distributed to
-13-
<PAGE> 30
shareholders in accordance with the applicable timing requirements. Net
investment income and net capital gain of the Fund will be computed in
accordance with Section 852 of the Code.
The Fund intends to distribute all of its net investment income, any
excess of net short-term capital gains over net long-term capital losses, and
any excess of net long-term capital gains over net short-term capital losses in
accordance with the timing requirements imposed by the Code and therefore will
not be required to pay any federal income or excise taxes. Distributions of net
investment income and net capital gain will be made after September 30, the end
of each fiscal year, and no later than December 31 of each year. Both types of
distributions will be in shares of the Fund unless a shareholder elects to
receive cash.
The Fund is subject to a 4% nondeductible excise tax on certain
undistributed amounts of ordinary income and capital gain under a prescribed
formula contained in Section 4982 of the Code. The formula requires payment to
shareholders during a calendar year of distributions representing at least 98%
of the Fund's ordinary income for the calendar year and at least 98% of its
capital gain net income (i.e., the excess of its capital gains over capital
losses) realized during the one-year period ending October 31 during such year
plus 100% of any income that was neither distributed nor taxed to the Fund
during the preceding calendar year. Under ordinary circumstances, the Fund
expects to time its distributions so as to avoid liability for this tax.
Net investment income is made up of dividends and interest less
expenses. Net capital gain for a fiscal year is computed by taking into account
any capital loss carryforward of the Fund.
The following discussion of tax consequences is for the general
information of shareholders who are subject to tax. Shareholders that are IRAs,
Keogh plans or other qualified retirement plans are exempt from income taxation
under the Code.
To the extent that the Fund retains any of its net long-term capital
gain for the year for reinvestment, requiring federal corporate income taxes to
be paid thereon by the Fund, the Fund will elect to treat the undistributed net
long-term capital gain as having been distributed to shareholders. As a result,
each shareholder will report for federal income tax purposes its proportionate
share of the undistributed net long-term capital gain, will be able to claim his
proportionate share of federal income taxes paid by the Fund on that amount as a
credit against his own federal income tax liability and will be able to claim a
refund to the extent that the credit exceeds such tax liability. In addition,
each shareholder of the Fund will be entitled to increase the adjusted tax basis
of his Fund shares by the difference between his pro rata share of such
undistributed gain and his deemed tax credit.
-14-
<PAGE> 31
Distributions of taxable net investment income and the excess of net
short-term capital gain over net long-term capital loss are taxable to
shareholders as ordinary income.
Dividends from domestic corporations may comprise some portion of
the Fund's gross income. To the extent that such dividends constitute a portion
of the Fund's gross income, a portion of the income distributions received by
corporations from the Fund may be eligible for the 70% deduction for dividends
received. Taxable corporate shareholders will be informed of the portion of
dividends which so qualify. Receipt of qualifying dividends may result in the
reduction of a corporate shareholder's tax basis in its shares by the untaxed
portion of such dividends if they are treated as "extraordinary dividends" under
Section 1059 of the Code. The dividends-received deduction is reduced to the
extent the shares of the Fund with respect to which the dividends are received
are treated as debt-financed under federal income tax law and is eliminated if
the shares are deemed to have been held for less than 46 days (91 days for
preferred stock) during the 90-day (180 days for preferred stock) period
beginning on the date which is 45 days (90 days for preferred stock) before the
ex-dividend date (for this purpose, holding periods are reduced for periods
where the risk of loss with respect to shares is diminished). The same
restrictions apply to the Fund with respect to its ownership of the
dividend-paying stock. In addition, the deducted amount is included in the
calculation of the federal alternative minimum tax, if any, applicable to such
corporate shareholders.
Distributions of net capital gain ("capital gain dividends") are
taxable to shareholders as long-term capital gain, regardless of the length of
time the shares of the Fund have been held by such shareholders. Capital gain
dividends are not eligible for the dividends-received deduction. The Taxpayer
Relief Act of 1997 (the "1997 Act") made substantial changes to the maximum
effective tax rates and holding periods applicable to capital gains realized by
noncorporate taxpayers. In general, for transactions taken into account during
taxable years ending on or after May 7, 1997, a noncorporate shareholder's net
capital gains will be taxed either at a maximum rate of 20% for property held
more than 18 months or 28% with respect to property held for more than one year
but not more than 18 months. The Internal Revenue Service recently issued Notice
97-64, which describes forthcoming temporary rules permitting regulated
investment companies to designate different classes of capital gain dividends
(e.g., 20% or 28%). The Fund will provide information relating to the portions
of any capital gain dividend that may be treated by individual shareholders as
eligible for the maximum 20% rate and the maximum 28% rate.
A redemption of Fund shares by a shareholder will result in the
recognition of taxable gain or loss depending upon the difference between the
amount realized and his tax basis in his Fund shares. Such gain or loss is
treated as a capital gain or loss if the shares are held as capital assets.
Under the 1997 Act, in the case of a noncorporate shareholder, if such shares
were held for more than 18 months at the time of disposition such gain will be
long-term capital gain and will be taxed at a maximum effective rate of 20%; if
such shares were held for more than one year but not
-15-
<PAGE> 32
more than 18 months at the time of disposition, such gain will be taxed at a
maximum effective rate of 28%; and if such shares were held for one year or less
at the time of disposition, such gain will be short-term capital gain and will
be taxed at a maximum effective rate of 39.6%. Capital gains of corporate
shareholders will be long-term or short-term depending upon whether the
shareholder's holding period exceeds one year, and are not subject to varying
effective tax rates. However, any loss realized upon the redemption of shares
within six months from the date of their purchase will be treated as a long-term
capital loss to the extent of any amounts treated as capital gain dividends
during such six-month period. All or a portion of any loss realized upon the
redemption of shares may be disallowed to the extent shares are purchased
(including shares acquired by means of reinvested dividends) within 30 days
before or after such redemption.
All distributions will be included in the individual shareholder's
alternative minimum taxable income and in the income which may be subject to tax
under the alternative minimum tax for corporations.
Distributions of taxable net investment income and net capital gain
will be taxable as described above, whether received in shares or in cash.
Shareholders electing to receive distributions in the form of additional shares
will have a cost basis for federal income tax purposes in each share so received
equal to the net asset value of a share on the reinvestment date.
All distributions of taxable net investment income and net capital
gain, whether received in shares or in cash, must be reported by each taxable
shareholder on his or her federal income tax return. Dividends or distributions
declared in October, November or December as of a record date in such a month,
if any, will be deemed to have been received by shareholders on December 31, if
paid during January of the following year. Redemptions of shares may result in
tax consequences (gain or loss) to the shareholder and are also subject to these
reporting requirements.
An individual may generally make a deductible IRA contribution in an
amount up to $2,000 for any taxable year if (i) neither the individual nor his
or her spouse is an active participant in an employer's retirement plan ("Plan
Participant"), or (ii) the individual (and his or her spouse, if applicable) has
an adjusted gross income ("AGI") below a certain level ("Threshold Level"). For
the 1997 tax year, the Threshold Level is $40,000 for married individuals filing
a joint return (with a phase-out of the deduction for AGI between $40,000 and
$50,000) and $25,000 for a single individual (with a phase-out of the deduction
for AGI between $25,000 and $35,000). For the 1998 year, the Threshold Level is
scheduled to increase to $50,000 for married individuals filing a joint return
(with a phase-out of the deduction for AGI between $50,000 and $60,000) and
$30,000 for a single individual (with a phase-out of the deduction for AGI
between $30,000 and $40,000). The Threshold Levels are scheduled to continue to
gradually increase through the year 2007. For tax years beginning in 1998, there
is a separate Threshold Level and phase-out limit that applies to certain
individuals who are not Plan Participants but whose spouses are Plan
-16-
<PAGE> 33
Participants. These individuals can make a deductible IRA contribution for a
taxable year if their AGI does not exceed $150,000 (with a phase-out of the
deduction for AGI between $150,000 and $160,000).
There are a number of additional forms of IRAs that may be
available, including an IRA for nonworking spouses. Shareholders should contact
their tax adviser for more information.
Distributions by the Fund result in a reduction in the net asset
value of the Fund's shares. Should a distribution reduce the net asset value
below a shareholder's cost basis, such distribution would nevertheless be
taxable to the shareholder as ordinary income or capital gain as described
above, even though, from an investment standpoint, it may constitute a partial
return of capital. In particular, investors should consider the tax implications
of buying shares just prior to a distribution. The price of shares purchased at
that time includes the amount of the forthcoming distribution. Those purchasing
just prior to a distribution will then receive a partial return of capital upon
the distribution, which will nevertheless be taxable to them.
Under the 1997 Act, if the Fund makes a "constructive sale" of an
"appreciated financial position," the Fund will recognize gain as if the
position were sold at fair market value on the date of such constructive sale.
Constructive sales include short sales of substantially identical property,
offsetting national principal contracts with respect to substantially identical
property and futures and forward contracts to deliver substantially identical
property. However, transactions that otherwise would be treated as constructive
sales are disregarded if closed within 30 days after the close of the taxable
year and the Fund holds the position and does not hedge such position for 60
days thereafter. In addition, to the extent provided in regulations (which have
not yet been promulgated), a constructive sale also occurs if a taxpayer enters
into one or more other transactions (or acquires one or more positions) that
have "substantially the same effect" as the transactions described above.
Appreciated financial positions include positions with respect to stock, debt,
instruments or partnership interests if gain would be recognized on a
disposition at fair market value. If the constructive sale rules apply,
adjustments are made to the basis and holding period of the affected financial
position.
Equity options (including call and put options on stock) and
over-the-counter options on debt securities written or purchased by the Fund
will be subject to tax under Section 1234 of the Code. The character of any gain
or loss recognized (i.e., long-term or short-term) generally will depend, in the
case of a lapse or sale of the option, on the Fund's holding period for the
option, and in the case of an exercise of the option, on the Fund's holding
period for the underlying security. The purchase of a put option may constitute
a short sale for federal income tax purposes, causing an adjustment in the
holding period of the underlying security or a substantially identical security
in the Fund's portfolio. If the Fund writes a put or call option, no gain is
recognized upon its receipt of a premium. If the option lapses or is closed out,
any gain
-17-
<PAGE> 34
or loss is treated as short-term capital gain or loss. If a call option
is exercised, the character of the gain or loss depends on the holding period of
the underlying security. The exercise of a put option written by the Fund is not
a taxable transaction for the Fund.
Any listed nonequity options written or purchased by the Fund
(including options on debt securities) will be governed by Section 1256 of the
Code. Absent a tax election to the contrary, gain or loss attributable to the
lapse, exercise or closing out of any such position will be treated as 60%
long-term and 40% short-term capital gain or loss, and on the last trading day
of the Fund's fiscal year, all outstanding Section 1256 positions will be marked
to market (i.e., treated as if such positions were closed out at their closing
price on such day), with any resulting gain or loss recognized as 60% long-term
and 40% short-term capital gain or loss.
Ordinarily, gains and losses realized from portfolio transactions
will be treated as capital gain or loss. However, all or a portion of the gain
or loss from the disposition of non-U.S. dollar denominated securities
(including debt instruments, certain financial forward, futures and option
contracts, and certain preferred stock) may be treated as ordinary income or
loss under Section 988 of the Internal Revenue Code. In addition, all or a
portion of the gain realized from the disposition of market discount bonds will
be treated as ordinary income under Section 1276 of the Internal Revenue Code.
Generally, a market discount bond is defined as any bond bought by the Fund
after its original issuance at a price below its face or accreted value.
Finally, all or a portion of the gain realized from engaging in "conversion
transactions" may be treated as ordinary income under Section 1258 of the
Internal Revenue Code. "Conversion transactions" are defined to include certain
forward, futures, option and straddle transactions, transactions marketed or
sold to produce capital gains, or transactions described in Treasury regulations
to be issued in the future.
Offsetting positions held by the Fund involving certain financial
forward, futures or options contracts (including certain foreign currency
forward contracts or options) may constitute "straddles." "Straddles" are
defined to include "offsetting positions" in actively traded personal property.
The tax treatment of "straddles" is governed by Sections 1092 and 1258 of the
Internal Revenue Code, which, in certain circumstances, override or modify the
provisions of Sections 1256 and 988. If the Fund were treated as entering into
"straddles" by reason of its engaging in certain forward contracts or options
transactions, such "straddles" would be characterized as "mixed straddles" if
the forward contracts or options transactions comprising a part of such
"straddles" were governed by Section 1256. The Fund may make one or more
elections with respect to "mixed straddles." Depending on which election is
made, if any, the results to the Fund may differ. If no election is made to the
extent the "straddle" rules apply to positions established by the Fund, losses
realized by the Fund will be deferred to the extent of unrealized gain in the
offsetting position. Moreover, as a result of the "straddle" rules, short-term
capital loss on "straddle" positions may be recharacterized as long-term capital
loss, and long-term capital gains may be treated as short-term capital gains.
-18-
<PAGE> 35
Under the Code, the Fund will be required to report to the Internal
Revenue Service all distributions of taxable income and capital gains as well as
gross proceeds from the redemption or exchange of Fund shares, except in the
case of certain exempt shareholders. Under the backup withholding provisions of
Section 3406 of the Code, distributions of taxable net investment income and net
capital gain and proceeds from the redemption or exchange of the shares of a
regulated investment company may be subject to withholding of federal income tax
at the rate of 31% in the case of non-exempt shareholders who fail to furnish
the investment company with their taxpayer identification numbers and with
required certifications regarding their status under the federal income tax law,
or if the Fund is notified by the IRS or a broker that withholding is required
due to an incorrect TIN or a previous failure to report taxable interest or
dividends. If the withholding provisions are applicable, any such distributions
and proceeds, whether taken in cash or reinvested in additional shares, will be
reduced by the amounts required to be withheld.
Shareholders of the Fund may be subject to state and local taxes on
distributions received from the Fund and on redemptions of the Fund's shares.
Each distribution is accompanied by a brief explanation of the form
and character of the distribution. In January of each year the Fund issues to
each shareholder a statement of the federal income tax status of all
distributions.
The Fund is organized as a Massachusetts business trust and
generally will not be liable for any income or franchise tax in the Commonwealth
of Massachusetts. If the Fund qualifies as a regulated investment company for
federal income tax purposes and pays no federal income tax, it generally will
also not be liable for New York State income taxes, other than a nominal
corporation franchise tax (as adjusted by the applicable New York State
surtaxes).
The foregoing discussion is a general summary of certain of the
material U.S. federal income tax consequences to U.S. persons (as defined below)
of owning and disposing of shares in the Fund. This summary is based on the
provisions of the Code, final, temporary and proposed U.S. Treasury Regulations
promulgated thereunder, and administrative and judicial interpretations thereof,
all as in effect on the date hereof, and all of which are subject to change,
possibly with retroactive effect. Moreover, shareholders should note that the
recently enacted 1997 Act contains provisions which are subject to varying
interpretations, the full impact and significance of which will remain unclear
until they have been definitively interpreted by the Internal Revenue Service
and the courts.
The foregoing discussion of U.S. federal income tax law relates
solely to the application of that law to U.S. persons; i.e., U.S. citizens and
residents and U.S. domestic corporations, partnerships, estates the income of
which is includible in its gross income for U.S. federal income tax purposes
without regard to its source, or trusts if either: (i) a U.S. court is able to
exercise primary supervision over the administration of the trust and one or
more U.S. fiduciaries have the authority to control all the
-19-
<PAGE> 36
substantial decisions of the trust or (ii) the trust was in existence on August
20, 1996 and, in general, would have been treated as a U.S. person under rules
applicable prior to such time, provided the trust elects to continue such
treatment thereafter. Each shareholder who is not a U.S. person should consider
the U.S. and foreign tax consequences of ownership of shares of the Fund,
including the possibility that such a shareholder may be subject to a U.S.
withholding tax at a rate of 30% (or at a lower rate under an applicable income
tax treaty) on amounts constituting ordinary income received by him or her.
This summary does not deal with all aspects of U.S. federal income
taxation that may be relevant to particular shareholders in light of their
particular circumstances. Accordingly, shareholders should consult their tax
advisers about the application of the provisions of tax law described in this
statement of additional information in light of their particular tax situations.
ORGANIZATION AND CAPITALIZATION
(See "ORGANIZATION AND CAPITALIZATION" in the Fund's prospectus.)
General.
The Fund is an open-end investment company established under the
laws of the Commonwealth of Massachusetts by Declaration of Trust dated April
12, 1982, as amended and restated on August 22, 1989 (the "Declaration of
Trust"). Previously known as the Risk Portfolio of The Ayco Fund, the Fund
commenced doing business as The Merger Fund on January 31, 1989. The Fund's name
was formally changed to The Merger Fund on August 22, 1989.
Shares entitle their holders to one vote per share. Shares have
noncumulative voting rights, which means that holders of more than 50% of the
shares voting for the election of Trustees can elect all Trustees and, in such
event, the holders of the remaining shares voting for the election of Trustees
will not be able to elect any person or persons as Trustees. Shares have no
preemptive or subscription rights, and are transferable.
Shareholder and Trustee Liability.
The Fund is an entity of the type commonly known as a "Massachusetts
business trust." Under Massachusetts law, shareholders of such a trust may,
under certain circumstances, be held personally liable as partners for the
obligations of the trust. The Declaration of Trust contains an express
disclaimer of shareholder liability for acts or obligations of the Fund and
provides for indemnification out of Fund property of any shareholder held
personally liable for the obligations of the Fund. Thus, the risk of a
shareholder incurring financial loss on account of shareholder liability is
limited to circumstances in which the Fund itself would be unable to meet
-20-
<PAGE> 37
its obligations. Management believes that, in view of the above, the risk of
personal liability of shareholders is remote. The Declaration of Trust does not
require the Fund to hold annual meetings of shareholders. However, the Fund will
hold special meetings when required by federal or state securities laws. The
holders of at least 10% of the Fund's outstanding shares have the right to call
a meeting of shareholders for the purpose of voting upon the removal of one or
more Trustees, and in connection with any such meeting, the Fund will comply
with the provisions of Section 16(c) of the Investment Company Act of 1940
relating to shareholder communications.
The Declaration of Trust further provides that the Trustees will not
be liable for errors of judgment or mistakes of fact or law, but nothing in the
Declaration of Trust protects a Trustee against any liability to which he would
otherwise be subject by reason of willful misfeasance, bad faith, gross
negligence, or reckless disregard of the duties involved in the conduct of his
office.
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<PAGE> 38
ALLOCATION OF PORTFOLIO BROKERAGE
Subject to the supervision of the Trustees, decisions to buy and
sell securities for the Fund are made by the Adviser. The Adviser is authorized
by the Trustees to allocate the orders placed by it on behalf of the Fund to
brokers or dealers who may, but need not, provide research or statistical
material or other services to the Fund or the Adviser for the Fund's use. Such
allocation is to be in such amounts and proportions as the Adviser may
determine.
In selecting a broker or dealer to execute each particular
transaction, the Adviser will take the following into consideration: the best
net price available; the reliability, integrity and financial condition of the
broker or dealer; the size of and difficulty in executing the order; and the
value of the expected contribution of the broker or dealer to the investment
performance of the Fund on a continuing basis. Brokers or dealers executing a
portfolio transaction on behalf of the Fund may receive a commission in excess
of the amount of commission another broker or dealer would have charged for
executing the transaction if the Adviser determines in good faith that such
commission is reasonable in relation to the value of brokerage, research and
other services provided to the Fund.
In allocating portfolio brokerage, the Adviser may select brokers or
dealers who also provide brokerage, research and other services to other
accounts over which the Adviser exercises investment discretion. Some of the
services received as the result of Fund transactions may primarily benefit
accounts other than the Fund, while services received as the result of portfolio
transactions effected on behalf of those other accounts may primarily benefit
the Fund. The Adviser is unable to quantify the amount of commissions set forth
below which were paid as a result of such services because a substantial number
of transactions were effected through brokers which provide such services but
which were selected principally because of their execution capabilities.
For the fiscal years ended November 30, 1995 and 1996, the Fund paid
brokerage commissions of approximately $1,162,149 and $2,467,162, respectively.
For the fiscal year ended September 30, 1997, the Fund paid brokerage
commissions of approximately $2,298,674.
-22-
<PAGE> 39
PORTFOLIO TURNOVER
The portfolio turnover rate may be defined as the ratio of the
lesser of annual sales or purchases to the monthly average value of the
portfolio, excluding from both the numerator and the denominator (1) securities
with maturities at the time of acquisition of one year or less and (2) short
positions. For the fiscal year ended September 30, 1997, the Fund's portfolio
annual turnover rate was 271.24%. The Fund will invest portions of its assets to
seek short-term capital appreciation. The Fund's investment objective and
corresponding investment policies can be expected to cause the portfolio
turnover rate to be substantially higher than that of the average
equity-oriented investment company.
Merger arbitrage investments are characterized by a high turnover
rate because, in general, a relatively short period of time elapses between the
announcement of a reorganization and its completion or termination. The majority
of mergers and acquisitions are consummated in less than six months, while
tender offers are normally completed in less than two months. Liquidations and
certain other types of corporate reorganizations usually require more than six
months to complete. The Fund will generally benefit from the timely completion
of the proposed reorganizations in which it has invested, and a correspondingly
high portfolio turnover rate would be consistent with, although it would not
necessarily ensure, the achievement of the Fund's investment objective.
Short-term trading involves increased brokerage commissions, which expense is
ultimately borne by the shareholders.
Fund management believes that the fiscal 1997 portfolio turnover
rate of 271.24% is within the range to be expected for a merger arbitrage fund,
and anticipates that the 1998 rate will be within the same range.
INDEPENDENT ACCOUNTANTS
The Fund has selected Price Waterhouse LLP, 100 East Wisconsin
Avenue, Milwaukee, Wisconsin 53202, as its independent accountants.
-23-
<PAGE> 40
CUSTODIAN, TRANSFER AGENT, DIVIDEND PAYING AGENT,
ACCOUNTING SERVICES AGENT AND ADMINISTRATOR
(See "CUSTODIAN, TRANSFER AGENT, DIVIDEND PAYING AGENT, ACCOUNTING
SERVICES AGENT AND ADMINISTRATOR" in the Fund's prospectus.)
Firstar, a Wisconsin trust company with its principal offices in
Milwaukee, Wisconsin, is custodian of the assets of the Fund. The custody
services performed by Firstar include maintaining custody of the Fund's assets,
record keeping, processing of portfolio securities transactions, collection of
income, special services relating to put and call options and making cash
disbursements. Firstar is also custodian for The Merger Fund IRA Plan and
trustee for the Fund Investors Keogh Plans. Firstar takes no part in determining
the investment policies of the Fund or in deciding which securities are
purchased or sold by the Fund. The Fund pays to Firstar a custodian fee, payable
monthly, at the annual rate of .020% of the total value of the Fund's assets,
plus a fee for each transaction with respect to the Fund's portfolio securities,
which varies depending on the nature of the transaction.
Firstar is also the Fund's transfer agent and dividend paying agent.
Its principal address is 615 East Michigan Street, Milwaukee, Wisconsin 53202.
The transfer agent services provided by Firstar include: performing customary
transfer agent functions; making dividend and distribution payments;
administering shareholder accounts in connection with the issuance, transfer and
redemption of the Fund's shares; performing related record keeping services;
answering shareholders correspondence; mailing reports, proxy statements,
confirmations and other communications to shareholders; and filing tax
information returns. Firstar's transfer agent fee is equal to a maximum of
$14.00 per shareholder account.
Accounting services for the Fund are provided pursuant to a separate
agreement with Firstar. The Fund pays Firstar a minimum annual fee of $22,000
plus an additional .010% of the value of the Fund's net assets in excess of $40
million up to $200 million and .005% of the value of the Fund's net assets in
excess of $200 million.
Under the Fund Administration Servicing Agreement, Firstar maintains
the books, accounts and other documents required by the Investment Company Act
of 1940; prepares the Fund's financial statements and tax returns; prepares
certain reports and filings with the Securities and Exchange Commission;
furnishes statistical and research data, clerical, accounting and bookkeeping
services and office supplies; and generally assists in all aspects of the Fund's
operations. Firstar, as Administrator, furnishes office space and all necessary
office facilities, equipment and executive personnel for performing the services
required pursuant to the agreement. For the foregoing, the Fund pays Firstar a
fee, payable monthly, at the annual rate of .050% of the Fund's first $100
million of average aggregate daily net assets, .040% of the next $400 million
and .030% of the Fund's average daily net assets in excess of $500 million. The
Fund also reimburses the Administrator for all out-of-pocket expenses.
-24-
<PAGE> 41
The fees charged to the Fund by Firstar for custody, transfer agent,
fund accounting and administration services are competitive with fees charged by
other providers of such services within the investment company industry.
COUNSEL
The firm of Fulbright & Jaworski L.L.P. is counsel to the Fund.
EXPERTS
The financial statements incorporated in this Statement of
Additional Information have been so incorporated in reliance upon the report of
Price Waterhouse LLP, independent accountants given on authority of said firm,
as experts in accounting and auditing.
-25-
<PAGE> 42
APPENDIX
Some of the terms used in this Statement of Additional Information
and the Fund's prospectus are described below.
Covered Option Writing.
A call option is a short-term contract which gives the purchaser of
the option, in return for a premium paid, the right to buy, and the writer the
obligation to sell, the underlying security at the exercise price at any time
upon the assignment of an exercise notice prior to the expiration of the option,
regardless of the market price of the security during the option period. A
covered call option is an option written on a security which is owned by the
writer throughout the option period.
The Fund will write covered call options both to reduce the risks
associated with certain of its investments and to increase total investment
return. In return for the premium income, the Fund will give up the opportunity
to profit from an increase in the market price of the underlying security above
the exercise price so long as its obligations under the contract continue,
except insofar as the premium represents a profit. Moreover, in writing the
option, the Fund will retain the risk of loss should the price of the security
decline, which loss the premium is intended to offset. Unlike the situation in
which the Fund owns securities not subject to a call option, the Fund, in
writing call options, must assume that the call may be exercised at any time
prior to the expiration of its obligations as a writer, and that in such
circumstances the net proceeds realized from the sale of the underlying
securities pursuant to the call may be substantially below the prevailing market
price. The Adviser may deem it desirable to close out a particular position
prior to the expiration of the option through the purchase of an equivalent
option, in which case the underlying security may either be sold or retained in
the Fund's portfolio.
Money Market Instruments.
Money market instruments are liquid, short-term, high-grade debt
instruments, including United States Government obligations, commercial paper,
certificates of deposit and bankers' acceptances.
Repurchase Agreements.
Repurchase agreements are agreements by which a person purchases a
security and simultaneously commits to resell that security to the seller (a
member bank of the Federal Reserve System or recognized securities dealer) at an
agreed upon price on an agreed upon date within a number of days (usually not
more than seven) from the date of purchase. The resale price reflects the
purchase price plus an agreed upon market rate of interest which is unrelated to
the coupon rate or maturity of the
-26-
<PAGE> 43
purchased security. A repurchase agreement involves the obligation of the seller
to repurchase the securities at the agreed upon price, which obligation is in
effect secured by the value of the underlying security. The Fund may enter into
repurchase agreements with respect to obligations in which the Fund is
authorized to invest.
Short Selling.
A short sale is a transaction involving the sale of a security that
is not owned by the seller, the security having been borrowed from a third party
by the seller in order to make delivery to the buyer. In a transaction of this
type, the seller has a continuing obligation to replace the borrowed security;
and until such replacement, the broker retains the proceeds from the sale and
the seller is required to pay to the lender any dividends or interest due to
holders of the security. Although the seller's obligation to the lender can be
met by purchasing the security in the open market and delivering it against the
short position, the Fund will effect short sales only in anticipation of
replacing the borrowed security with an identical security received upon the
successful completion of a merger, acquisition or exchange offer. (This strategy
is illustrated by the following example: Company A proposes to acquire Company B
through a merger in which each outstanding common share of Company B is
exchanged for two shares of Company A. Assume that following the announcement of
the merger terms, Company A's stock is trading at $20 while Company B's shares
are trading at $35, or $5 below the market value of Company A's offer (2 x $20
per A Share). Believing that the proposed merger represents an attractive
arbitrage opportunity, but wanting to protect against a decline in the market
price of Company A's stock prior to the completion of the acquisition, the Fund
purchases 1,000 shares of Company B at a total cost of $35,000 plus commissions,
and, at approximately the same time, borrows and sells short 2,000 shares of
Company A, yielding proceeds of $40,000 less commissions. The Fund is now
hedged; that is, a decline in the market price of Company A's stock will not
reduce the Fund's potential profit should the deal go through. Upon completion
of the merger, the 1,000 shares of Company B held by the Fund are exchanged for
2,000 shares of Company A. These shares are then delivered to the lender,
thereby satisfying the Fund's obligation to replace the borrowed shares, and the
proceeds from the short sale become available to the Fund. In this example a
profit of $5,000 less commissions and any other expenses is realized.) However,
should the merger, acquisition or exchange offer be terminated or otherwise not
completed, the Fund will be required to satisfy its obligation to the lender by
making an open-market purchase, and to the extent the price paid exceeds the
proceeds from the short sale, the Fund will incur a loss on the transaction. The
amount of any such loss will be increased by the amount of any dividends or
interest the Fund may be required to pay in connection with the short sale.
-27-
<PAGE> 44
FINANCIAL STATEMENTS
The statement of assets and liabilities, including the schedules of
investments, of options written and of securities sold short, as of September
30, 1997, the related statements of operations and of cash flows for the fiscal
year ended September 30, 1997, statements of changes in net assets for the
fiscal years ended September 30, 1997 and November 30, 1996, financial
highlights, and notes to the financial statements and the independent
accountants' report to the Trustees and shareholders of the Fund dated November
7, 1997 are attached hereto.
Effective December 1, 1996, the Fund changed its fiscal year to end
on September 30 in each year, commencing with the fiscal year which ran from
December 1, 1996 through September 30, 1997.
-28-
<PAGE> 45
THE MERGER FUND
SCHEDULE OF INVESTMENTS
SEPTEMBER 30, 1997
<TABLE>
<CAPTION>
SHARES VALUE
- ------------- ------------
<C> <S> <C>
COMMON STOCKS -- 97.98%*
AEROSPACE -- 2.31%*
84,697 Northrop-Grumman Corporation(1).................................. $ 10,280,098
------------
ALTERNATIVE ENERGY -- 3.16%*
880,000 Wheelabrator Technologies, Inc.(1)............................... 14,080,370
------------
BANKS -- 9.31%*
30,500 Advanta Corporation, Class B..................................... 831,125
334,800 Barnett Banks, Inc............................................... 23,687,100
313,200 Signet Banking Corporation....................................... 16,991,100
------------
41,509,325
------------
BROADCASTING -- 0.72%*
43,500 SFX Broadcasting, Inc.**......................................... 3,214,958
------------
BUSINESS FORMS -- 0.48%*
101,000 Data Documents, Inc.**........................................... 2,133,625
------------
ELECTRIC UTILITIES -- 5.14%*
25,000 Energy Group PLC ADR(1)(3)....................................... 1,038,382
1,294,000 Energy Group PLC(3).............................................. 13,639,388
280,400 Kansas City Power & Light Company................................ 8,258,825
------------
22,936,595
------------
FERTILIZERS -- 1.27%*
159,400 Freeport McMoRan, Inc.(1)........................................ 5,678,625
------------
GIFTWARE -- 0.53%*
73,554 Syratech Corporation**(5)........................................ 2,362,922
------------
HEALTH CARE INFORMATION SERVICES -- 4.08%*
531,800 Medic Computer Systems, Inc.**................................... 18,214,150
------------
HOTELS & GAMING -- 2.25%*
148,300 ITT Corporation**................................................ 10,035,824
------------
INSURANCE -- 19.57%*
383,400 American States Financial Corporation (1)........................ 18,019,800
451,800 Equitable of Iowa Companies (1).................................. 30,270,600
252,000 ING Groep NV ADR................................................. 11,576,250
66,500 Integon Corporation(1)........................................... 1,729,000
438,500 Washington National Corporation.................................. 14,223,844
400,000 Western National Corporation (1)................................. 11,475,000
------------
87,294,494
------------
MEDICAL DEVICES -- 0.21%*
59,700 Circon Corporation**............................................. 932,813
------------
</TABLE>
See notes to the financial statements.
F-1
<PAGE> 46
<TABLE>
<CAPTION>
SHARES VALUE
- ------------- ------------
<C> <S> <C>
MULTI-INDUSTRY -- 1.70%*
513,772 Figgie International, Inc., Class A **(1)........................ $ 7,578,137
------------
NATURAL GAS TRANSMISSION & MARKETING -- 4.74%*
416,500 Enron Global Power & Pipelines L.L.C. (1)........................ 14,317,188
113,800 Tejas Gas Corporation**.......................................... 6,835,113
------------
21,152,301
------------
OIL & GAS EXPLORATION -- 9.02%*
342,700 Cairn Energy USA, Inc.**......................................... 4,754,963
558,300 Chauvco Resources Ltd.** (1)(3).................................. 12,241,096
91,000 Louisiana Land and Exploration Company (1)....................... 7,126,438
326,700 Monterey Resources, Inc. (1)..................................... 6,860,700
116,000 Pennzoil Company(2).............................................. 9,243,750
------------
40,226,947
------------
OILFIELD EQUIPMENT & SERVICES -- 6.28%*
243,527 National-Oilwell, Inc.**(1)...................................... 18,218,836
235,411 Readings & Bates Corporation**................................... 9,784,270
------------
28,003,106
------------
PAPER AND FOREST PRODUCTS -- 2.30%*
65,300 Mosinee Paper Corporation(1)(2).................................. 2,212,038
387,200 Pacific Forest Products Ltd.** (1)(3)............................ 8,050,606
------------
10,262,644
------------
PHARMACEUTICAL DISTRIBUTION -- 3.26%*
359,900 Bergen Brunswig Corporation, Class A(1).......................... 14,532,013
------------
REAL ESTATE INVESTMENT TRUST -- 2.08%
202,200 Beacon Properties Corporation (4)................................ 9,262,615
------------
RETAILERS -- 0.75%*
136,000 The Limited, Inc................................................. 3,323,500
------------
SAVINGS & LOANS -- 1.42%*
15,000 Great Financial Corporation...................................... 639,375
207,800 Standard Financial, Inc.(5)...................................... 5,678,551
------------
6,317,926
------------
SCIENTIFIC INSTRUMENTS -- 1.06%*
101,000 Fisher Scientific International, Inc............................. 4,740,688
------------
SECURITIES BROKERAGE -- 0.50%
30,000 Quick & Reilly Group, Inc........................................ 1,123,125
15,000 Salomon, Inc..................................................... 1,127,813
------------
2,250,938
------------
SHIPPING -- 4.44%*
614,300 APL Ltd.......................................................... 19,809,175
------------
</TABLE>
See notes to the financial statements.
F-2
<PAGE> 47
<TABLE>
<CAPTION>
SHARES VALUE
- ------------- ------------
<C> <S> <C>
TELEPHONY -- 9.76%*
436,000 CommNet Cellular, Inc.**......................................... $ 15,287,250
637,427 MCI Communications Corporation (1)............................... 18,724,418
414,648 Metrocall Rights(5).............................................. 0
263,800 Palmer Wireless, Inc.** (1)...................................... 4,616,500
243,900 USLD Communications Corporation**................................ 4,893,244
------------
43,521,412
------------
VOICE MESSAGING -- 1.65%*
216,700 Boston Technology, Inc.**........................................ 7,340,713
------------
TOTAL COMMON STOCKS
(Cost $421,410,456)............................................ 436,995,914
------------
CONVERTIBLE PREFERRED STOCKS -- 0.38%*
25,000 Integon Corporation (Cost $1,657,500)............................ 1,684,375
------------
CONTRACTS
(100 SHARES
PER CONTRACT)
- -------------
PUT OPTIONS PURCHASED -- 0.05%*
1,010 Corporate Express, Inc.
Expiration December 1997, Exercise Price $18.20
(Cost $124,640)(5)............................................. 66,660
2,439 LCI International, Inc.
Expiration January 1998, Exercise Price $21.60
(Cost $150,764)(5)............................................. 104,877
6,524 Texaco, Inc.
Expiration November 1997, Exercise Price $49.50
(Cost $64,488)(5).............................................. 26,096
737 Western Resources, Inc.
Expiration May 1998, Exercise Price $29.09
(Cost $36,113)(5).............................................. 39,061
------------
236,694
------------
PAR VALUE
- -------------
CONVERTIBLE BONDS -- 1.11%*
$5,360,000 IVAX Corporation Debentures CLB (Acquired March 1997, Cost
$4,566,323), 6.50%, 11/15/01(1)(5)............................. 4,958,000
------------
TOTAL INVESTMENTS
(Cost $428,010,284)............................................ $443,874,983
=============
</TABLE>
- ------------------------------
* Calculated as a percentage of net assets.
** Non-income producing security.
(1) All or a portion of the shares have been committed as collateral for open
short positions.
(2) All or a portion of the shares have been committed as collateral for
when-issued securities.
(3) Foreign security.
(4) All or a portion of the shares have been committed as collateral for the
credit facility.
(5) Fair valued security.
See notes to the financial statements.
F-3
<PAGE> 48
THE MERGER FUND
SCHEDULE OF OPTIONS WRITTEN
SEPTEMBER 30, 1997
<TABLE>
<CAPTION>
CONTRACTS
(100 SHARES
PER CONTRACT) VALUE
- ------------- ----------
<C> <S> <C>
Corporate Express, Inc. -- Put
1,010 Expiration December 1997, Exercise Price $15.00(1).................... $ 3,030
1,010 Expiration December 1997, Exercise Price $20.00(1).................... 76,760
ITT Corporation -- Call
783 Expiration October 1997, Exercise Price $65.00........................ 234,900
900 Expiration November 1997, Exercise Price $65.00....................... 334,324
LCI International, Inc. -- Put
2,439 Expiration January 1998, Exercise Price $20.40(1)..................... 26,829
2,439 Expiration January 1998, Exercise Price $26.40(1)..................... 224,388
Pennzoil Company -- Call
800 Expiration October 1997, Exercise Price $70.00........................ 790,000
360 Expiration October 1997, Exercise Price $75.00........................ 193,500
Texaco Inc. -- Put
6,524 Expiration November 1997, Exercise Price $60.50(1).................... 0
Western Resource -- Put
737 Expiration May 1998, Exercise Price $34.90(1)......................... 87,703
----------
TOTAL OPTIONS WRITTEN
(Premiums received $2,294,272)...................................... $1,971,434
==========
</TABLE>
- ------------------------------
(1) Fair valued security.
See notes to the financial statements.
F-4
<PAGE> 49
THE MERGER FUND
SCHEDULE OF SECURITIES SOLD SHORT
SEPTEMBER 30, 1997
<TABLE>
<CAPTION>
SHARES VALUE
- -------- ------------
<C> <S> <C>
21,800 Abercrombie & Fitch Company........................................... $ 572,250
30,500 Advanta Corporation Class A........................................... 888,312
558,300 Alliance Pipeline Right *............................................. 542,668
52,000 American General Corporation.......................................... 2,697,500
238,998 British Telecommunications PLC ADR.................................... 15,923,242
138,775 Burlington Resources, Inc............................................. 7,120,892
271,223 Cardinal Health, Inc.................................................. 19,256,833
558,300 Chauvco International *............................................... 1,768,694
13,050 Compaq Computers Corporation.......................................... 975,487
140,875 Comverse Technology, Inc.............................................. 7,431,156
100,970 Corporate Express, Inc................................................ 2,132,991
291,600 Equity Office Properties Trust **..................................... 9,873,764
278,295 Falcon Drilling Company, Inc.......................................... 9,827,292
289,410 First Union Corporation............................................... 17,242,026
17,400 Fleet Financial Group, Inc............................................ 1,140,787
170,460 IMC Global, Inc....................................................... 6,008,715
252,000 ING Groep NV ADR...................................................... 11,576,250
104,800 Intimate Brands, Inc.................................................. 2,443,150
184,825 LCI International, Inc................................................ 4,920,966
101,060 Lockheed Martin Corporation........................................... 10,775,523
370,116 Meridian Resource Corporation......................................... 4,880,905
243,500 National-Oilwell, Inc................................................. 18,216,844
397,507 NationsBank Corporation............................................... 24,595,746
252,068 Pioneer Natural Resources Company..................................... 10,522,336
9,000 Star Banc Corporation................................................. 413,438
51,300 TCF Financial Corporation............................................. 2,997,844
113,258 Texaco, Inc........................................................... 6,958,288
17,000 Travelers Group, Inc.................................................. 1,160,250
91,720 Wausau Paper Mills Company............................................ 2,247,140
126,590 Western Resources, Inc................................................ 4,346,342
------------
TOTAL SECURITIES SOLD SHORT
(Proceeds $197,033,929)............................................. $209,457,631
=============
</TABLE>
- ------------------------------
* When-issued security.
** Real estate investment trust.
See notes to the financial statements.
F-5
<PAGE> 50
THE MERGER FUND
STATEMENT OF ASSETS AND LIABILITIES
SEPTEMBER 30, 1997
<TABLE>
<S> <C> <C>
ASSETS:
Investments, at value (Cost $428,010,284)
See accompanying schedule................................... $443,874,983
Deposit at brokers for short sales............................. 43,672,654
Receivable from brokers for proceeds on securities sold
short....................................................... 186,738,903
Receivable for investments sold................................ 12,824,083
Receivable for Fund shares sold................................ 291,853
Receivable for options written................................. 1,354,955
Receivable for forward currency exchange contracts............. 37,147
Interest receivable............................................ 131,618
Dividends receivable........................................... 69,718
Other receivables.............................................. 271,317
------------
Total Assets........................................... 689,267,231
LIABILITIES:
Loan payable (Note 10)......................................... $ 4,000,000
Securities sold short, at value (Proceeds of $197,033,929)
See accompanying schedule................................... 209,457,631
Payable for investment securities purchased.................... 25,910,447
Short-term borrowings.......................................... 358,854
Options written, at value (Premiums received $2,294,272)
See accompanying schedule................................... 1,971,434
Payable for forward currency exchange contracts................ 66,027
Payable for Fund shares repurchased............................ 704,647
Accrued interest payable....................................... 76,285
Investment advisory fee payable................................ 379,342
Distribution fees payable...................................... 99,436
Dividends payable on short positions........................... 105,904
Accrued expenses and other payables............................ 150,339
------------
Total Liabilities...................................... 243,280,346
------------
NET ASSETS....................................................... $445,986,885
=============
NET ASSETS consist of:
Accumulated undistributed net investment income................ $ 589,493
Accumulated undistributed net realized gain on investments
sold, securities sold short and option contracts expired or
closed...................................................... 40,431,188
Net unrealized appreciation (depreciation) on:
Investments................................................. 15,864,699
Short positions............................................. (12,423,702)
Written options............................................. 322,838
Forward currency exchange contracts......................... (28,880)
Paid-in capital................................................ 401,231,249
------------
Total Net Assets....................................... $445,986,885
=============
NET ASSET VALUE, offering price and redemption price per share
($445,986,885 / 29,045,978 shares of beneficial interest
outstanding)................................................... $15.35
</TABLE>
See notes to the financial statements.
F-6
<PAGE> 51
THE MERGER FUND
STATEMENT OF OPERATIONS
FOR THE TEN MONTHS ENDED SEPTEMBER 30, 1997
<TABLE>
<S> <C> <C>
INVESTMENT INCOME:
Interest..................................................... $11,368,419
Dividend income on long positions
(net of foreign withholding taxes of $393,212)............ 5,117,152
Other income................................................. 610,698
-----------
Total investment income................................... 17,096,269
-----------
EXPENSES:
Investment advisory fee...................................... $ 3,864,592
Distribution fees............................................ 618,416
Transfer agent and shareholder servicing agent fees.......... 163,068
Federal and state registration fees.......................... 38,932
Professional fees............................................ 96,567
Trustees' fees and expenses.................................. 25,060
Custody fees................................................. 121,262
Administration fee........................................... 168,150
Reports to shareholders...................................... 116,598
Other........................................................ 40,634
------------
Total operating expenses before interest expense and
dividends on short positions............................ 5,253,279
Interest expense............................................. 5,613,543
Dividends on short positions (net of foreign withholding
taxes of $572,316)........................................ 5,721,709
-----------
Total expenses............................................ 16,588,531
-----------
NET INVESTMENT INCOME.......................................... 507,738
-----------
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:
Realized gain (loss) on:
Long and foreign currency transactions.................... 50,911,619
Short transactions........................................ (11,318,575)
Option contracts expired or closed........................ 911,553
Forward currency exchange contracts....................... 514,587
------------
Total realized gain....................................... 41,019,184
Change in unrealized (depreciation) appreciation on:
Investments............................................... 2,040,333
Short positions........................................... (2,137,282)
Written options........................................... 792,924
Forward currency exchange contracts....................... (28,880)
-----------
NET REALIZED AND UNREALIZED GAIN ON INVESTMENTS................ 41,686,279
-----------
NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS........... $42,194,017
============
</TABLE>
See notes to the financial statements.
F-7
<PAGE> 52
THE MERGER FUND
STATEMENT OF CASH FLOWS
FOR THE TEN MONTHS ENDED SEPTEMBER 30, 1997
<TABLE>
<S> <C> <C>
CASH PROVIDED (USED) BY FINANCING ACTIVITIES:
Sales of Capital Shares..................................... $ 117,907,516
Repurchases of Capital Shares............................... (199,238,027)
--------
Cash Used in Capital Share Transactions..................... (81,330,511)
Cash Used in Borrowings..................................... (192,891,146)
Distributions Paid in Cash*................................. (3,960,567)
--------
$(278,182,224)
--------
CASH (USED) PROVIDED BY OPERATIONS:
Purchases of Investments.................................... (2,016,514,802)
Net Proceeds from Sales of Short-Term Investments........... 91,244,756
Proceeds from Sales of Investments.......................... 2,142,829,337
--------
217,559,291
--------
Decrease in Deposit at Brokers and Custodian for Short
Sales..................................................... 58,393,593
Net Investment Income....................................... 507,738
Net Change in Receivables/Payables Related to Operations.... 1,362,401
--------
60,263,732 277,823,023
-------- --------
Net Decrease in Cash........................................ (359,201)
Cash, Beginning of Year..................................... 359,201
--------
Cash, End of Year........................................... $ 0
========
</TABLE>
- ------------------------------
*Non-cash financing activities include reinvestment of dividends of $39,886,639.
See notes to the financial statements.
F-8
<PAGE> 53
THE MERGER FUND
STATEMENT OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
TEN MONTHS ENDED YEAR ENDED
SEPTEMBER 30, 1997 NOV. 30, 1996
------------------ -------------
<S> <C> <C>
Net investment income....................................... $ 507,738 $ 5,582,632
Net realized gain on investments sold, forward currency
exchange contracts, securities sold short and option
contracts expired or closed............................... 41,019,184 39,120,063
Change in unrealized (depreciation) appreciation of
investments, forward currency exchange contracts, short
positions and call and put options........................ 667,095 (7,331,567)
------------------ -------------
Net increase in net assets resulting from operations........ 42,194,017 37,371,128
Distributions to shareholders from:
Net investment income..................................... (5,757,534) (1,258,321)
Net realized gains........................................ (38,089,672) (13,482,010)
------------------ -------------
Total dividends and distributions......................... (43,847,206)(1) (14,740,331)
------------------ -------------
Net (decrease) increase in net assets from capital share
transactions (Note 6)..................................... (41,443,872) 223,370,882
------------------ -------------
Net (decrease) increase in net assets....................... (43,097,061) 246,001,679
NET ASSETS:
Beginning of period......................................... 489,083,946 243,082,267
------------------ -------------
End of period (including accumulated undistributed net
investment income of $589,493 and $5,323,073,
respectively)............................................. $445,986,885 $ 489,083,946
================ =============
</TABLE>
- ---------------
(1) Total distribution includes $36,911,680 of ordinary income, of which 5% is
eligible for the corporate dividends received deduction.
See notes to the financial statements.
F-9
<PAGE> 54
THE MERGER FUND
FINANCIAL HIGHLIGHTS
Selected per share data is based on a share of beneficial interest outstanding
throughout each year.
<TABLE>
<CAPTION>
TEN MONTHS
ENDED YEAR ENDED NOVEMBER 30,
SEPTEMBER 30, ----------------------------------------------------
1997 1996 1995 1994 1993
------------- -------- -------- -------- -------
<S> <C> <C> <C> <C> <C>
Net Asset Value, beginning of period........... $15.41 $14.87 $13.72 $13.70 $12.34
Income from investment operations:
Net investment income (loss)................. 0.02(2)(3) 0.20(2)(3) 0.08(2)(3) --(2)(3) (0.07)(2)(3)
Net realized and unrealized gain on
investments................................ 1.35 1.24 1.78 1.08 2.10
------------- -------- -------- -------- -------
Total from investment operations............. 1.37 1.44 1.86 1.08 2.03
Less distributions:
Dividends from net investment income......... (0.19) (0.08) -- -- --
Distributions from net realized gains........ (1.24) (0.82) (0.71) (1.06) (0.67)
------------- -------- -------- -------- -------
Total distributions.......................... (1.43) (0.90) (0.71) (1.06) (0.67)
------------- -------- -------- -------- -------
Net Asset Value, end of period................. $15.35 $15.41 $14.87 $13.72 $13.70
============ ========= ========= ========= ========
Total Return................................... 9.68%(5) 10.26% 14.26% 8.41% 17.24%
Supplemental Data and Ratios:
Net assets, end of period (000's)............ $ 445,987 $489,084 $243,082 $170,344 $25,173
Ratio of operating expenses to average net
assets..................................... 1.36%(1)(6) 1.36%(1) 1.41%(1) 1.58%(1) 2.19%(1)
Ratio of interest expense and dividends on
short positions to average net assets...... 2.93%(6) 0.95% 2.42% 1.72% 1.91%
Ratio of net investment income (loss) to
average net assets......................... 0.13%(6) 1.36% 0.57% (0.03)% (0.57)%
Portfolio turnover rate...................... 271.24% 276.99% 290.48% 390.34%(4) 186.00%(4)
Average commission rate per share............ $ 0.0373 $ 0.0434
</TABLE>
- ------------------------------
(1) For the ten months ended September 30, 1997, and for the years ended
November 30, 1996, 1995, 1994 and 1993, the operating expense ratio excludes
interest expense and dividends on short positions. The ratios including
interest expense and dividends on short positions for the ten months ended
September 30, 1997, and for the years ended November 30, 1996, 1995, 1994
and 1993, were 4.29%, 2.31%, 3.83%, 3.30% and 4.10%, respectively.
(2) Net investment income before interest expense and dividends on short
positions for the ten months ended September 30, 1997, and for the years
ended November 30, 1996, 1995, 1994 and 1993, was $0.38 $0.35, $0.42, $0.21
and $0.17, respectively.
(3) Net investment income (loss) per share represents net investment income for
the respective year divided by the monthly average shares of beneficial
interest outstanding throughout each year.
(4) The numerator for the portfolio turnover rate includes the lesser of
purchases or sales (including both long and short positions). The
denominator includes the average long position throughout the year.
(5) Not annualized.
(6) Annualized.
See notes to the financial statements.
F-10
<PAGE> 55
THE MERGER FUND
NOTES TO THE FINANCIAL STATEMENTS
SEPTEMBER 30, 1997
NOTE 1 -- ORGANIZATION
The Merger Fund (the "Fund") is a no-load, open-end, non-diversified
investment company organized as a trust under the laws of the Commonwealth of
Massachusetts on April 12, 1982, and registered under the Investment Company Act
of 1940 (the "1940 Act"), as amended. The Fund was formerly known as the Risk
Portfolio of The Ayco Fund. In January of 1989, the Fund's fundamental policies
were amended to permit the Fund to engage exclusively in merger arbitrage. At
the same time, Westchester Capital Management, Inc. became the Fund's investment
adviser, and the Fund began to do business as The Merger Fund. Merger arbitrage
is a highly specialized investment approach generally designed to profit from
the successful completion of proposed mergers, takeovers, tender offers,
leveraged buyouts, liquidations and other types of corporate reorganizations.
Effective December 1, 1996 the Fund's fiscal year end was changed to September
30 from November 30.
NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES
The following is a summary of significant accounting policies consistently
followed by the Fund in the preparation of its financial statements. These
policies are in conformity with generally accepted accounting principles.
A. Investment Valuation
Investments in securities and commodities (including options) are valued at
the last sales price on the securities or commodities exchange on which such
financial instruments are primarily traded. Securities not listed on an exchange
or securities for which there were no transactions are valued at the average of
the current bid and asked prices. Securities for which there are no such
valuations are valued at fair value as determined in good faith by management
under the supervision of the Board of Trustees. At September 30, 1997, such
securities represent 2.1% of investments, at value. The investment adviser
reserves the right to value securities, including options, at prices other than
last-sale prices or the average of current bid and asked prices when such prices
are believed unrepresentative of fair market value as determined in good faith
by the adviser. Investments in United States government securities (other than
short-term securities) are valued at the average of the quoted bid and asked
prices in the over-the-counter market. Short term investments are carried at
amortized cost, which approximates market value.
B. Transactions with Brokers for Short Sales
Cash and liquid securities in the amount of $196,204,634 have been
committed as collateral for open short investment positions and are on deposit
in segregated accounts with the brokers and custodian. The Fund's receivable
from brokers for proceeds on securities sold short and deposit at brokers for
short sales are with three major securities dealers. The Fund does not require
the brokers to maintain collateral in support of the receivable from the broker
for proceeds on securities sold short.
C. Federal Income Taxes
No provision for federal income taxes has been made since the Fund has
complied to date with the provisions of the Internal Revenue Code applicable to
regulated investment companies and intends to
F-11
<PAGE> 56
THE MERGER FUND
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997
NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
continue to so comply in future years and to distribute investment company net
taxable income and net capital gains to shareholders. Additionally, the Fund
intends to make all required distributions to avoid federal excise tax.
D. Written Option Accounting
The Fund writes covered call options to hedge portfolio investments.
Uncovered put options can also be written by the Fund as part of a merger
arbitrage strategy involving a pending corporate reorganization. When the Fund
sells an option, an amount equal to the premium received by the Fund is included
in the Statement of Assets and Liabilities as an asset and an equivalent
liability. The amount of the liability is subsequently marked-to-market to
reflect the current value of the option written. By writing an option, the Fund
may become obligated during the term of the option to deliver or purchase the
securities underlying the option at the exercise price if the option is
exercised. Option contracts are valued at the last sales price reported on the
date of valuation. If no sale is reported, the option contract written is valued
at the average of the current bid and asked price reported on the day of
valuation. When an option expires on its stipulated expiration date or the Fund
enters into a closing purchase transaction, the Fund realizes a gain or loss if
the cost of the closing purchase transaction differs from the premium received
when the option was sold without regard to any unrealized gain or loss on the
underlying security, and the liability related to such option is eliminated.
When an option is exercised, the premium originally received decreases the cost
basis of the security (or increases the proceeds on a sale of the security), and
the Fund realizes a gain or loss from the sale of the underlying security.
E. Purchased Option Accounting
The Fund purchases put options to hedge portfolio investments. Call options
may be purchased only for the purpose of closing out previously written covered
call options. Premiums paid for option contracts purchased are included in the
Statement of Assets and Liabilities as an asset. Option contracts are valued at
the last sales price reported on the date of valuation. If no sale is reported,
the option contract purchased is valued at the average of the current bid and
asked price reported on the day of valuation. When option contracts expire or
are closed, realized gains or losses are recognized without regard to any
unrealized gains or losses on the underlying securities.
F. Distributions to Shareholders
Dividends from net investment income and net realized capital gains, if
any, are declared and paid annually.
G. Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
F-12
<PAGE> 57
THE MERGER FUND
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997
NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
H. Foreign Securities
Investing in securities of foreign companies and foreign governments
involves special risks and considerations not typically associated with
investing in U.S. companies and the U.S. government. These risks include
revaluation of currencies and future adverse political and economic
developments. Moreover, securities of many foreign companies and foreign
governments and their markets may be less liquid and their prices more volatile
than those of securities of comparable U.S. companies and the U.S. government.
I. Foreign Currency Translations
The books and records of the Fund are maintained in U.S. dollars. Foreign
currency transactions are translated into U.S. dollars on the following basis:
(i) market value of investment securities, assets and liabilities at the daily
rates of exchange, and (ii) purchases and sales of investment securities,
dividend and interest income and certain expenses at the rates of exchange
prevailing on the respective dates of such transactions. For financial reporting
purposes, the Fund does not isolate changes in the exchange rate of investment
securities from the fluctuations arising from changes in the market prices of
securities. However, for federal income tax purposes the Fund does isolate and
treat as ordinary income the effect of changes in foreign exchange rates on
realized gain or loss from the sale of investment securities and payables and
receivables arising from trade date and settlement date differences.
J. When-Issued Securities
The Fund may sell securities on a when-issued or delayed delivery basis.
Although the payment and interest terms of these securities are established at
the time the Fund enters into the agreement, these securities may be delivered
for cash proceeds at a future date. The Fund records sales of when-issued
securities and reflects the values of such securities in determining net asset
value in the same manner as other open short sale positions. The Fund segregates
and maintains at all times cash, cash equivalents, or other liquid securities in
an amount at least equal to the market value for when-issued securities.
K. Other
Investment and shareholder transactions are recorded on the trade date.
Realized gains and losses from security transactions are recorded on the
identified cost basis. Dividend income and distributions to shareholders are
recorded on the ex-dividend date. Interest is accounted for on the accrual
basis. Investment income includes $8,901,087 of interest earned on receivables
from brokers for proceeds on securities sold short and deposits. Other income
consists of cash settlements of class action lawsuits on securities held by the
Fund. Generally accepted accounting principles require that permanent financial
reporting and tax differences be reclassified in the capital accounts. For the
period
F-13
<PAGE> 58
THE MERGER FUND
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997
NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
ended September 30, 1997, $516,216 was reclassified from accumulated
undistributed net realized gains to accumulated undistributed net investment
income.
NOTE 3 -- AGREEMENTS
The Fund's investment adviser is Westchester Capital Management, Inc. (the
"Adviser") pursuant to an investment advisory agreement dated January 31, 1989.
Under the terms of this agreement, the Adviser is entitled to receive a fee,
calculated daily and payable monthly, at the annual rate of 1.00% of the Fund's
average daily net assets.
Firstar Trust Company, a subsidiary of Firstar Corporation, a publicly held
bank holding company, serves as custodian, transfer agent, administrator and
accounting services agent for the Fund.
Distribution services are performed pursuant to distribution contracts with
Mercer Allied Company, L.P. ("Mercer"), the Fund's principal underwriter, and
other broker-dealers.
NOTE 4 -- SHORT POSITIONS
The Fund may sell securities short for hedging purposes. For financial
statement purposes, an amount equal to the settlement amount is included in the
Statement of Assets and Liabilities as an asset and an equivalent liability. The
amount of the liability is subsequently marked-to-market to reflect the current
value of the short position. Subsequent fluctuations in the market prices of
securities sold, but not yet purchased, may require purchasing the securities at
prices which may differ from the market value reflected on the Statement of
Assets and Liabilities. The Fund is liable for any dividends payable on
securities while those securities are in a short position. As collateral for its
short positions, the Fund is required under the 1940 Act to maintain segregated
assets consisting of cash, cash equivalents or liquid securities. These
segregated assets are required to be adjusted daily to reflect changes in the
value of the securities sold short.
NOTE 5 -- RELATED PARTY TRANSACTIONS
William H. Bohnett, Esq., a partner of Fulbright & Jaworski L.L.P., serves
as a Trustee and Assistant Secretary of the Fund. Fulbright & Jaworski L.L.P.
furnishes legal services to the Fund. For the ten months ended September 30,
1997, the Fund paid $68,074 for such services.
Certain officers of the Fund are also officers of the Adviser.
NOTE 6 -- SHARES OF BENEFICIAL INTEREST
The Trustees have the authority to issue an unlimited amount of shares of
beneficial interest without par value.
F-14
<PAGE> 59
THE MERGER FUND
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997
NOTE 6 -- SHARES OF BENEFICIAL INTEREST (CONTINUED)
Changes in shares of beneficial interest were as follows:
<TABLE>
<CAPTION>
TEN MONTHS ENDED YEAR ENDED
SEPTEMBER 30, 1997 NOVEMBER 30, 1996
--------------------------- ---------------------------
SHARES AMOUNT SHARES AMOUNT
----------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
Sold......................... 8,129,829 $ 117,907,516 28,042,908 $ 412,955,551
Issued as reinvestment of
dividends.................. 2,826,841 39,886,639 901,799 12,721,008
Redeemed..................... (13,652,842) (199,238,027) (13,551,329) (202,305,677)
----------- ------------- ----------- -------------
Net increase (decrease)...... (2,696,172) $ (41,443,872) 15,393,378 $ 223,370,882
============ ============== ============ ==============
</TABLE>
Effective June 1, 1996, The Merger Fund was closed to new investors.
NOTE 7 -- INVESTMENT TRANSACTIONS
Purchases and sales of securities for the ten months ended September 30,
1997 (excluding short-term investments, options and short positions) aggregated
$1,356,674,264 and $1,446,540,240, respectively.
At September 30, 1997, gross unrealized appreciation and depreciation of
investments for federal income tax purposes were:
<TABLE>
<S> <C>
Appreciation............................................................. $19,018,636
(Depreciation)........................................................... (6,622,467)
-----------
Net unrealized appreciation on investments............................... $12,396,169
============
</TABLE>
At September 30, 1997, the cost of investments for federal income tax
purposes was $431,478,814. The primary difference between the cost amount for
book purposes and tax purposes is due to deferred wash sale losses.
NOTE 8 -- OPTION CONTRACTS WRITTEN
The premium amount and the number of option contracts written during the
ten months ended September 30, 1997, were as follows:
<TABLE>
<CAPTION>
PREMIUM NUMBER OF
AMOUNT CONTRACTS
------------ ---------
<S> <C> <C>
Options outstanding at November 30, 1996.................... $ 3,834,076 16,523
Options written............................................. 20,512,268 88,918
Options closed.............................................. (6,270,849) (24,842)
Options exercised........................................... (12,532,720) (44,903)
Options expired............................................. (3,248,503) (18,694)
------------ ---------
Options outstanding at September 30, 1997................... $ 2,294,272 17,002
============= ========
</TABLE>
F-15
<PAGE> 60
THE MERGER FUND
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997
NOTE 9 -- DISTRIBUTION PLAN
The Fund has adopted a Plan of Distribution (the "Plan") dated July 1,
1993, as amended, pursuant to Rule 12b-1 under the 1940 Act. Under the Plan, the
Fund will compensate its principal underwriter, Mercer, and any other
broker-dealers with whom Mercer or the Fund has entered into a contract to
distribute Fund shares ("Dealers"). Under the Plan, the amount of compensation
paid in any one year shall not exceed 0.25% of the average daily net assets of
the Fund, payable as a service fee to Mercer and Dealers for providing personal
service and maintenance of shareholder accounts. For the ten months ended
September 30, 1997, the Fund incurred $618,416 pursuant to the Plan.
The Plan will remain in effect from year to year provided such continuance
is approved at least annually by a vote either of a majority of the Trustees,
including a majority of the non-interested Trustees, or a majority of the Fund's
outstanding shares.
NOTE 10 -- CREDIT FACILITY
Custodial Trust Company has made available to the Fund a $230 million
credit facility pursuant to a Loan and Security Agreement ("Agreement") dated
March 18, 1992 (subsequently amended) for the purpose of purchasing portfolio
securities. The Agreement can be terminated by either the Fund or Custodial
Trust Company with three months' prior notice. For the period December 1, 1996
through June 16, 1997, outstanding principal amounts under the credit facility
bore interest at a rate per annum of 0.50% plus the Broker Call Rate quoted by
Bear Stearns Securities Corp. at its office in New York on credit extended up to
$25 million on any given day and the Broker Call Rate plus 0.25% for the amount
of the loan which exceeds $25 million. For the period June 17, 1997 through
September 30, 1997 the interest rate on the outstanding principal amount changed
to the Federal Funds Rate plus 0.625% (weighted average rate of 6.52% during the
ten months ended September 30, 1997). The interest rate will change on January
1, 1998 to the Federal Funds Rate plus 1.00%. Advances are collateralized by
securities owned by the Fund and held separately in a special custody account
pursuant to a Special Custody Agreement dated March 31, 1994. During the ten
months ended September 30, 1997, the Fund had an outstanding average daily
balance of $100,221,151. The maximum amount outstanding during the ten months
ended September 30, 1997, was $208,000,000. Interest expense amounted to
$5,517,613 for the ten months ended September 30, 1997. At September 30, 1997,
the Fund had a loan payable balance of $4,000,000, and the securities
collateralizing the Agreement amounted to $8,887,722.
The Fund had short-term borrowings at September 30, 1997, in the amount of
$358,854 from Firstar Corporation. The short-term borrowings were repaid within
seven days.
F-16
<PAGE> 61
THE MERGER FUND
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997
NOTE 11 -- FORWARD CURRENCY EXCHANGE CONTRACTS
At September 30, 1997, the Fund had entered into "position hedge" forward
currency exchange contracts that obligate the Fund to deliver and receive
currencies at specified future dates. The net unrealized depreciation of $28,880
is included in the net unrealized appreciation (depreciation) section of the
accompanying financial statements. The terms of the open contracts are as
follows:
<TABLE>
<CAPTION>
CURRENCY TO U.S. $ VALUE AT CURRENCY TO U.S. $ VALUE AT
SETTLEMENT DATE BE DELIVERED SEPTEMBER 30, 1997 BE RECEIVED SEPTEMBER 30, 1997
- ----------------- ---------------------------- ------------------ ------------------------ ------------------
<C> <S> <C> <C> <C>
11/14/97 11,228,800 Canadian Dollars $ 8,142,340 8,179,487 U.S. Dollars $ 8,179,487
1/30/98 9,750,000 British Pounds 15,666,027 15,600,000 U.S. Dollars 15,600,000
------------------ ------------------
$ 23,808,367 $ 23,779,487
=================== ===================
</TABLE>
F-17
<PAGE> 62
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Trustees and Shareholders
of The Merger Fund
In our opinion, the accompanying statement of assets and liabilities,
including the schedules of investments, of options written and of securities
sold short, and the related statements of operations, of cash flows and of
changes in net assets and financial highlights present fairly, in all material
respects, the financial position of The Merger Fund (the "Fund") at September
30, 1997, the results of its operations and its cash flows for the period from
December 1, 1996 through September 30, 1997, the changes in its net assets for
the period from December 1, 1996 through September 30, 1997 and for the year
ended November 30, 1996, and the financial highlights for the period from
December 1, 1996 through September 30, 1997 and for each of the two years ended
November 30, 1996, in conformity with generally accepted accounting principles.
These financial statements and financial highlights (hereafter referred to as
"financial statements") are the responsibility of the Fund's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these financial statements in accordance
with generally accepted auditing standards which require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits, which included confirmation of securities at
September 30, 1997 by correspondence with the custodian and brokers and the
application of alternative auditing procedures where confirmations from brokers
were not received, provide a reasonable basis for the opinion expressed above.
The financial statements of The Merger Fund for the years ended November 30,
1993 and November 30, 1994 were audited by other independent accountants whose
report dated December 21, 1994 expressed an unqualified opinion on those
statements.
/S/ Price Waterhouse LLP
Milwaukee, Wisconsin
November 7, 1997
F-18
