Rule 497(c)
Registration No. 2-82143
THE CALIFORNIA MUNI FUND
90 Washington St. * New York, New York 10006 * 1-800-225-6864
PROSPECTUS
APRIL 30, 1997
The California Muni Fund (the "Fund") seeks to provide investors with as
high a level of income that is excluded from gross income for Federal income tax
purposes and exempt from California personal income tax as is consistent with
the preservation of capital. Of course, there can be no assurance that the
Fund's investment objective will be achieved.
The Fund intends to achieve its objective by investing in municipal bonds,
municipal notes and municipal commercial paper, the interest from which is
excluded from gross income for Federal income tax purposes and exempt from
California personal income tax. The Fund will limit its investments to (1)
municipal bonds that are rated within the four highest quality grades as
determined by Moody's Investors Service, Inc. ("Moody's"), Standard & Poor's
Corporation ("S&P"), Fitch Investors Service, Inc. ("Fitch") or Duff & Phelps,
Inc. ("Duff") or, if unrated, are judged by Fund management to be of comparable
quality, and (2) municipal notes and municipal commercial paper that are rated
within the three highest quality grades as determined by Moody's for municipal
notes, or within the three highest quality grades as determined by Moody's or
S&P for municipal commercial paper or, if unrated, are (i) obligations of
issuers having an issue of bonds rated within the four highest quality grades as
determined by Moody's, S&P, Fitch or Duff or (ii) guaranteed as to principal and
interest by the U.S. Government, its agencies or instrumentalities. While the
obligations in which the Fund may invest are generally deemed to have adequate
to very strong protection of principal and interest, those rated within the
lowest of the Fund's selected quality grades may have speculative
characteristics as well.
This Prospectus sets forth concisely the information you should know before
investing in the Fund. You should read it and keep it for future reference. A
Statement of Additional Information containing additional information about the
Fund has been filed with the Securities and Exchange Commission. You may obtain
a copy of the Fund's Statement without charge by writing to the Fund at the
address listed above, or by calling (800) 322-6864. Shareholder inquiries may
also be placed through this number.
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.
THE STATEMENT OF ADDITIONAL INFORMATION DATED APRIL 30, 1997 IS HEREBY
INCORPORATED BY REFERENCE INTO THIS PROSPECTUS.
<PAGE>
- --------------------------------------------------------------------------------
TABLE OF CONTENTS
(left column)
Highlights ................................................................ 2
Fee Table ................................................................. 3
Financial Highlights ...................................................... 4
Investment Objective and Policies ......................................... 5
Investment Strategies ..................................................... 7
Special Considerations .................................................... 9
Calculation of Yield and Performance Data ................................. 10
(right column)
Purchase of Shares ........................................................ 11
Redemption of Shares ...................................................... 13
Determination of Net Asset Value .......................................... 16
Distribution Expenses ..................................................... 16
Management ................................................................ 17
Dividends and Tax Status .................................................. 19
General Information ....................................................... 21
- --------------------------------------------------------------------------------
HIGHLIGHTS
What is The California Muni Fund?
The California Muni Fund is a non-diversified, open-end, management
investment company which seeks to provide investors with as high a level of
income that is excluded from gross income for Federal income tax purposes and
exempt from California personal income tax as is consistent with the
preservation of capital. There is no assurance, however, that the Fund will
achieve its stated objective. See "Investment Objective and Policies".
To achieve this objective, the Fund will invest only in municipal bonds,
municipal notes and municipal commercial paper which meet the Fund's specific
quality criteria (see "Investment Objective and Policies") and which generate
interest that is excluded for Federal income tax purposes and exempt from
California personal income tax.
Management
The Fund is a member of the Fundamental Family of Funds, a group of five
investment companies. Fundamental Portfolio Advisors, Inc. (the "Manager") is
the Fund's investment manager.
The Manager supervises and manages the Fund's investment portfolio and
directs the purchase and sales of its investment securities. The Manager
utilizes an investment committee to manage the assets of the Fund. See
"Management".
Tax-Free Income
The Fund is designed as a convenient investment vehicle for both large and
small investors who are subject to California income tax and who wish to keep
fully invested at competitive tax-free yields while maintaining liquidity of
their investment. Through the purchase of shares of the Fund, investors are able
to combine their investments into a portfolio that is professionally managed and
more varied than they could obtain individually. However, investors should bear
in mind that there are risk considerations associated with certain investment
policies of, and strategies employed by, the Fund, such as those relating to
investments in variable rate bonds, zero coupon bonds and lower quality
municipal obligations, and there can be no assurance that the investment
objective of the Fund will be achieved (see "Special Considerations").
How to Buy and Sell Shares of the Fund?
Shares of the Fund are offered for sale on a continuous basis without any
sales charge at the next determined net asset value per share (see "Purchase of
Shares" and "Determination of Net Asset Value"). Your purchase order becomes
effective immediately if it is received before 4:00 P.M. on any business day.
You may be charged a fee for effecting transactions in the Fund's shares through
securities dealers, banks or other financial institutions.
Shares are redeemable (may be sold) at your option without charge at the
next determined net asset value per share (see "Redemption of Shares"). The Fund
reserves the right, however, to liquidate an account with a value of less than
$100 on 60 days' notice.
2
<PAGE>
Shareholder Services and Privileges
For your convenience, the Fund provides certain services and privileges
which we have suited to your particular needs, including the Automatic
Investment Program and the Exchange, Check Redemption, Telephone Redemption and
Expedited Redemption Privileges (see "Purchase of Shares" and "Redemption of
Shares").
Monthly Dividends
The Fund declares dividends daily and pays them on a monthly basis,
eliminating the need for you to hold your shares until quarter-end to receive
dividend income. Dividends are automatically reinvested at net asset value in
additional Fund shares without any charge. You may elect, however, to receive
them in cash (see "Dividends and Tax Status").
Management and The Fundamental Family of Funds
Fundamental Portfolio Advisors, Inc., 90 Washington Street, New York, New
York 10006, the Fund's investment manager (the "Manager") determines overall
investment strategy for the Fund, subject to the supervision of the Fund's
trustees (see "Management").
The Manager also acts as investment manager to several other mutual fund
portfolios in The Fundamental Family of Funds, including New York Muni Fund
Series of Fundamental Funds, Inc., and the High-Yield Municipal Bond Series, the
Tax-Free Money Market Series and the Fundamental U.S. Government Strategic
Income Fund Series of Fundamental Fixed-Income Fund. Shares of such funds are
exchangeable for shares of the Fund (minimum $1,000 value) at the respective net
asset values per share without any charge and may be exchanged by telephone if
you have previously established this procedure with Fundamental Shareholder
Services, Inc. (see "Purchase of Shares").
FEE TABLE
Shareholder Transaction Expense
Sales Commission on Purchases ........................... None
Sales Commission on Reinvested Dividends ................ None
Redemption Fees ......................................... None
Exchange Fees ........................................... None
Annual Fund Expenses
(as a percentage of average net assets)
Management Fees ......................................... .50%
12b-1 Fees1 ............................................. .50%
Other Expenses
Interest ................................................ .45%
Other ................................................... 1.81%
----
Total Fund Expenses ..................................... 3.26%
====
1As a result of distribution fees of .50% per annum of the Fund's average
daily net assets, a long-term shareholder may pay more than the economic
equivalent of the maximum front-end sales charge permitted by the Rules of
the National Association of Securities Dealers, Inc.
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:
1 year 3 years 5 years 10 years
$33 $100 $170 $356
The purpose of the foregoing table is to assist you in understanding the
various costs and expenses that you will bear directly and indirectly. (For more
complete descriptions of the various costs and expenses, see "Management",
"Distribution Expenses", and the Financial Statements included at the end of the
Fund's Statement of Additional Information.) The expenses and example appearing
in the preceding table have been restated to reflect current fees and operating
expenses. The example shown in the table should not be considered a
representation of past or future expenses, and actual expenses may be greater or
less than those shown.
3
<PAGE>
FINANCIAL HIGHLIGHTS
The following selected per share data and ratios for each of the years in
the ten-year period ended December 31, 1996 has been audited by McGladrey &
Pullen, LLP, independent certified public accountants, whose report on the
Financial Statements and the related notes appear at the end of the Fund's
Statement of Additional Information.
<TABLE>
<CAPTION>
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Year Ended December 31
-------------------------------------------------------------------------------
1996 1995 1994 1993 1992 1991 1990 1989 1988 1987
---- ---- ---- ---- ---- ---- ---- ---- ---- ----
PER SHARE OPERATING PERFORMANCE
(for a share outstanding
throughout the period)
Net Asset Value, Beginning of Period ........... $ 8.91 $ 7.10 $ 9.49 $ 8.81 $ 8.80 $ 8.64 $ 8.82 $ 8.87 $ 8.52 $ 9.23
Income from investment operations:
Net investment income .......................... 0.409 0.419 0.553 0.563 0.604 0.571 0.553 0.535 0.603 0.665
Net realized and unrealized gain
(losses) on investments ...................... (1.120) 1.810 (2.390) 0.876 0.010 0.160 (0.180) 0.167 0.400 (0.545)
Total from investment operations ........... (.711) 2.229 (1.837) 1.439 0.614 0.731 0.373 0.702 1.003 0.120
Less Distributions
Dividends from net investment income ........... (0.409) (0.419) (0.553) (0.563) (0.604) (0.571) (0.533) (0.535) (0.603) (0.665)
Dividends from net realized gains .............. - - - (0.196) - - - (0.216) (0.051) (0.165)
Total distributions ........................ (0.409) (0.419) (0.553) (0.759) (0.604) (0.571) (0.553) (0.751) (0.654) (0.830)
Net Asset Value, End of Period ................. $ 7.79 $ 8.91 $ 7.10 $ 9.49 $ 8.81 $ 8.80 $ 8.64 $ 8.82 $ 8.87 $ 8.52
Total Return ................................... (8.01%) 32.02% (19.89%) 16.80% 7.23% 8.75% 4.39% 5.53% 12.18% 1.46%
RATIOS/SUPPLEMENTAL DATA
Net Assets, End of Period (000) ................ $16,252 $12,622 $10,558 $16,280 $11,549 $9,669 $9,849 $10,766 $10,298 $7,784
Ratios to Average Net Assets:
Interest expense ............................. 0.45% 0.39% 0.98% 0.39% 0.16% 0.14% 0.21% 0.19% 0.15% 0.34%
Operating expenses (1) ....................... 2.81% 2.81% 2.50% 1.77% 1.47% 2.24% 2.27% 2.30% 1.40% 1.27%
Total expenses ............................. 3.26% 3.20% 3.48% 2.16% 1.63% 2.38% 2.48% 2.49% 1.55% 1.61%
Net investment income ...................... 4.88% 5.02% 6.80% 6.04% 6.87% 6.58% 6.36% 5.95% 6.88% 7.66%
Portfolio turnover rate ........................ 89.83% 53.27% 15.88% 51.26% 18.91% 47.34% 42.61% 86.38% 57.62% 31.60%
BANK LOANS
Amount outstanding at end of period (000 omitted) $ 0 $ 0 $1,292 $3,714 $ 0 $ 645 $ 12 $ 151 $ 20 $ 94
Average number of bank loans outstanding during
the period (000 omitted) ...................... $ 823 $ 642 $1,620 $ 958 $ 274 $ 155+ $ 112+ $ 146+ $ 84+ $ 265+
Average number of shares outstanding during the
period (000 omitted) .......................... $1,768 $1,635 $1,711 $1,517 $1,214 $1,115+ $1,192+ $1,183+ $1,089+ $ 735+
Average amount of debt per share during the period 0.47 $ 0.39 $ 0.95 $ 0.68 $ 0.25 $ 0.14 $ 0.18 $ 0.12 $ 0.08 $0.36
- -------------------
+ Monthly Average.
(1) The Manager and others assumed certain expenses of the Fund during the years
ended December 31, 1987, 1988, 1989, 1990, 1991, 1992 and 1993. Had
such expenses not been so assumed, the ratio of operating expenses,
excluding interest expense, would have been 2.84%, 4.13%, 2.55%, 2.81%,
2.70%, 2.13% and 2.66%, respectively.
</TABLE>
4
<PAGE>
INVESTMENT OBJECTIVE AND POLICIES
The Fund's objective is to provide you with as high a level of income that
is excluded from gross income for Federal income tax purposes and exempt from
California personal income tax as is consistent with the preservation of
capital. To achieve this objective, the Fund invests only in municipal bonds,
municipal notes and municipal commercial paper (hereinafter collectively
referred to as "municipal obligations") which generate interest that is, in the
opinion of counsel to the issuer, excluded for Federal income tax purposes and
exempt from California personal income tax, and which meet the following quality
criteria (subject, of course, to the Fund's permissible "Investment Strategies"
described below).
The Fund's investment objective and policies and the investment strategy
with respect to the borrowing activities described below, unless otherwise
noted, are fundamental policies that cannot be changed without the approval of
the holders of a majority of the Fund's outstanding shares. A more detailed
explanation of certain investment policies and the Fund's fundamental investment
restrictions is contained in the Fund's Statement of Additional Information. A
non-fundamental investment restriction of the Fund is that it may not invest
more than 10% of its total assets in municipal obligations of California issuers
that are illiquid or have limited marketability.
As used in this Prospectus (excepting the specific reference in the second
paragraph under the caption "General Information"), the phrase "majority of the
Fund's outstanding shares" means the vote of the lesser of (1) 67% of the Fund's
shares present at a meeting of shareholders if the holders of more than 50% of
the outstanding shares are present in person or by proxy at such a meeting or
(2) more than 50% of the Fund's outstanding shares.
With respect to municipal bonds, the Fund will only invest in those issues
which are rated within the four highest quality grades as determined by Moody's,
S&P, Fitch or Duff or which, if unrated, are judged by Fund management to be of
comparable quality. With respect to municipal notes and municipal commercial
paper, the Fund will only invest in those issues which are rated within the
three highest quality grades as determined by Moody's for municipal notes, or
within the three highest quality grades as determined by Moody's or S&P for
municipal commercial paper or which, if unrated, are (i) obligations of issuers
having an issue of bonds rated within the four highest quality grades as
determined by Moody's, S&P, Fitch or Duff or (ii) guaranteed as to principal and
interest by the U.S. Government, its agencies or instrumentalities. There can be
no assurance that the Fund's objective will be achieved. The Fund's ability to
achieve its objective is subject to the continuing ability of the issuers of
municipal obligations to meet their principal and interest payments, and is
further subject to fluctuations in interest rates as well as other factors.
While the municipal obligations in which the Fund may invest are generally
deemed to have adequate to very strong protection of principal and interest,
certain of the obligations rated within the lowest of the quality grades
described above (i.e., those rated by Moody's as Baa for municipal bonds, MIG-3
for municipal notes and Prime-3 for municipal commercial paper, or those rated
by S&P, Fitch or Duff as BBB for municipal bonds, or those rated by S&P as A-3
for municipal commercial paper) may have speculative characteristics as well.
For example, obligations rated Baa by Moody's have been determined by Moody's to
be neither highly protected nor poorly secured, and although interest payments
and principal security appear adequate for the present, certain protective
elements may be lacking or may be characteristically unreliable over any great
length of time. Similarly, obligations rated BBB by S&P, Fitch or Duff are
regarded by S&P, Fitch and Duff as having adequate capacity to pay interest and
repay principal, and while such obligations normally exhibit adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal for
obligations in this category than in higher rated categories.
It should be noted that ratings are general and not absolute standards of
quality or guarantees of the creditworthiness of an issuer. Subsequent to its
purchase by the Fund, an issue may cease to be rated or the rating may be
reduced. Such an event would not require the Fund to dispose of the issue, but
Fund management would consider such an event in determining whether the Fund
should continue to hold the issue in its portfolio. (See "Special
Considerations-Special Risk Factors Relating to Lower Rated Securities, Zero
Coupon Bonds and Pay-in-Kind Bonds" for a discussion on downgraded securities
that are retained by the Fund.) The purchase of unrated securities is subject to
guidelines that may be set for Fund management from time to time by the Fund's
Board of Trustees. A description of the ratings of municipal obligations as
determined by Moody's, S&P, Fitch and Duff is included in the Fund's Statement
of Additional Information.
5
<PAGE>
As a non-diversified investment company, the Fund could conceivably invest
all of its assets in one issuer. However, in order to qualify as a "regulated
investment company" for Federal income tax purposes, the Fund must comply with
the provisions of Subchapter M of the Internal Revenue Code of 1986, as amended
(the "Code"), which limit the aggregate value of all holdings (except U.S.
Government and cash items, as defined in the Code), each of which exceeds 5% of
the Fund's total assets, to an aggregate amount of 50% of such assets, and which
further limit the holdings of a single issuer (with the same exceptions) to 25%
of the Fund's total assets. Therefore, for our purposes, non-diversification
means that, with regard to the Fund's total assets, 50% of such assets may be
invested in as few as two single issuers. (These limits are measured at the end
of each quarter.) In the event of decline of creditworthiness or default on the
obligations of one or more such issuers exceeding 5%, an investment in the Fund
will involve greater risk than in a fund that has a policy of diversification.
Municipal Obligations
Municipal obligations include debt obligations of states, territories and
possessions of the United States and of any political subdivisions thereof, such
as counties, cities, towns, districts and authorities. Municipal obligations are
issued to raise funds for a variety of purposes, including construction of a
wide range of public facilities, refunding of outstanding obligations, obtaining
funds for general operating expenses, and lending to other public institutions
and facilities. In addition, certain types of qualified private activity bonds
are issued by, or on behalf of, public authorities to obtain funds for privately
operated facilities.
Also included within the definition of municipal obligations are short-term,
tax-exempt debt obligations, known as municipal notes, which are generally
issued in anticipation of receipt by the issuer of revenues from taxes, the
issuance of longer term bonds, or other sources. States, municipalities, and
other issuers of tax-exempt securities may also issue short-term debt, often for
general purposes, known as "municipal commercial paper". All of these
obligations are included within the term "municipal obligations", as used in
this Prospectus, if their interest payments are excluded for Federal income tax
purposes.
Yields on municipal obligations depend on a variety of factors, including
the general condition of the money and municipal securities markets, the size of
a particular offering, the maturity of the obligation and the rating of the
issue. Unlike other types of securities, municipal obligations have
traditionally not been subject to regulation by, or registration with, the
Securities and Exchange Commission.
The two principal classifications of municipal obligations are general
obligation bonds and revenue bonds. General obligation bonds are secured by the
issuer's pledge of its full faith, credit and taxing power for the payment of
principal and interest. Revenue bonds are payable from only the revenues derived
from a particular facility or class of facilities or, in some cases, from the
proceeds of a special excise tax or other specific revenue source. Qualified
private activity bonds that are municipal obligations are, in most cases,
revenue bonds and do not generally constitute the pledge of the credit of the
issuer of such bonds. The credit quality of qualified private activity bonds is
usually related to the credit standing of the industrial user involved. The Fund
reserves the right to make unlimited investments in qualified private activity
bonds, if such bonds meet the Fund's investment criteria. This policy, however,
may cause the Fund to be an inappropriate investment for entities that are
"substantial users" (or related persons thereof) of facilities financed by such
bonds (see "Dividends and Tax Status" herein for more details).
Other types of municipal obligations include municipal lease obligations
which are issued by a state or local government or authority to acquire land and
a wide variety of equipment and facilities. These obligations typically are not
fully backed by the municipality's credit, and their interest may become taxable
if the lease is assigned. If the funds are not available for the following
years' lease payments the lease may terminate, with the possibility of default
on the lease obligation and significant loss to the Fund. Certificates of
participation in municipal lease obligations or installment sales contracts
entitle the holder to a proportionate interest in the lease-purchase payments
made.
There are also a variety of hybrid and special types of municipal
obligations as well as numerous differences in the security of municipal
obligations, both within and between the two principal classifications described
above (see the Fund's Statement of Additional Information for greater details).
6
<PAGE>
Portfolio Transactions and Turnover
The Manager provides the Fund with investment advice and recommendations for
the purchase and sale of portfolio securities. All orders for the purchase and
sale of portfolio securities are placed by the Manager, subject to the general
control of the Fund's trustees.
In seeking to achieve the Fund's objective, the Manager will adjust the
maturity distribution of the Fund's portfolio in anticipation of movements in
interest rates. Longer term securities have historically yielded more than
shorter term securities, but from time to time, the normal yield relationships
between longer and shorter term securities have been reversed. Furthermore,
longer term securities have historically been subject to greater and more rapid
price fluctuations. In periods of rising interest rates, the market value of
municipal obligations generally declines in order to bring the current yield in
line with prevailing interest rates. Conversely, in periods of declining
interest rates, the market value of municipal obligations generally rises.
Although fluctuating interest rates affect the market value of all municipal
obligations, short-term obligations are generally less sensitive to such factors
than long-term obligations. The Manager will attempt to take advantage of price
variability between different sectors of the market, i.e., long, intermediate,
or short or general obligation versus revenue bonds, in order to increase the
Fund's yield by making appropriate purchases and sales of portfolio securities.
Securities with the same general quality rating and maturity, but having
different purposes for issuance, often tend to trade at different yields.
Similarly, securities issued for similar purposes and with the same general
maturity characteristics, but which vary according to the creditworthiness of
their respective issuers, tend to trade at different yields. These yield
differentials tend to fluctuate in response to political and economic
developments as well as temporary imbalances in normal supply and demand
relationships. The Manager monitors these fluctuations closely and will adjust
the Fund's portfolio to take advantage of disparities that may arise. The
Manager may also engage in short-term trading when it believes it is consistent
with the Fund's investment objective.
The frequency of portfolio transactions-the Fund's turnover rates-will vary
from year to year depending upon market conditions. While it is impossible to
predict the number of transactions that will be effected by the Fund, it is
anticipated that the Fund's portfolio turnover rate will not exceed 300%.
However, when Fund management deems it appropriate due to market or other
conditions, the Fund's turnover rate may be greater than anticipated. Because a
high turnover rate increases transaction costs and the possibility of taxable
short-term gains (see "Dividends and Tax Status"), the Manager weighs the added
costs of short-term investment against anticipated gains.
INVESTMENT STRATEGIES
In seeking to achieve its investment objective, the Fund utilizes certain
investment strategies, such as borrowing to purchase additional securities,
investing in participation interests and variable rate instruments and
purchasing municipal obligations that are offered on a "when-issued" basis.
When-lssued Purchases
Municipal securities are frequently offered on a "when-issued" basis. When
so offered, the price and coupon rate are fixed at the time the commitment to
purchase is made, but delivery and payment for the when-issued securities take
place at a later date. Normally, the settlement date occurs between 15-45 days
from the date of purchase. During the period between purchase and settlement, no
interest accrues to the purchase. The price that the Fund would be required to
pay may be in excess of the market value of the security on the settlement date.
While securities may be sold prior to the settlement date, the Fund intends to
purchase such securities for the purpose of actually acquiring them unless a
sale becomes desirable for investment reasons. At the time the Fund makes a
commitment to purchase a municipal security on a when-issued basis, it will
record the transaction and reflect the value of the security in determining its
net asset value. That value may fluctuate from day to day in the same manner as
values of other
7
<PAGE>
municipal securities held by the Fund. The Fund will establish a segregated
account with its custodian bank in which it will maintain cash or liquid debt
securities determined daily to be equal in value to its commitments for
when-issued securities. Generally, both the when-issued securities and the
securities held in the segregated account will tend to experience appreciation
when interest rates decline and depreciation when interest rates increase.
Accordingly, the purchase of when-issued securities may increase the volatility
of the Fund's net asset value. The Fund may invest in when-issued securities
without limitation.
At such time as the Fund is required to pay for when-issued securities, it
will meet its obligation from then-available cash flow, sale of the securities
held in the separate account, sale of other securities, or (although it would
not normally expect to do so) from the sale of the when-issued securities
themselves (which may have a market value greater or less than the Fund's
payment obligation). Sale of securities to meet such obligations carries with it
a greater potential for the realization of capital gains, which are not excluded
from gross income for Federal, state or local income tax purposes.
Participation Interests, Variable and Inverse Floating Rate Instruments
The Fund may purchase participation interests from financial institutions.
These participation interests give the purchaser an undivided interest in one or
more underlying municipal obligations.
The Fund may also invest in municipal obligations which have variable
interest rates that are readjusted periodically. Such readjustment may be based
either upon a predetermined standard, such as a bank prime rate or the U.S.
Treasury bill rate, or upon prevailing market conditions. Many variable rate
instruments are subject to redemption or repurchase at par on demand by the Fund
(usually upon no more than seven days' notice). All variable rate instruments
must meet the quality standards of the Fund. The Manager will monitor the
pricing, quality and liquidity of the variable rate municipal obligations held
by the Fund.
The Fund may purchase inverse floaters which are instruments whose interest
rates bear an inverse relationship to the interest rate on another security or
the value of an index. Changes in the interest rate on the other security or
index inversely affect the residual interest rate paid on the inverse floater,
with the result that the inverse floater's price will be considerably more
volatile than that of a fixed-rate bond. For example, a municipal issuer may
decide to issue two variable rate instruments instead of a single long-term,
fixed-rate bond. The interest rate on one instrument reflects short-term
interest rates, while the interest rate on the other instrument (the inverse
floater) reflects the approximate rate the issuer would have paid on a
fixed-rate bond, multiplied by two, minus the interest rate paid on the
short-term instrument. Depending on market availability, the two portions may be
recombined to form a fixed-rate municipal bond. (See "Special Risk Factors
Relating to Inverse Floating Rate Instruments").
The Fund may invest in municipal securities that pay interest at a coupon
rate equal to a base rate, plus additional interest for a certain period of time
if short-term interest rates rise above a predetermined level or "cap." The
amount of such an additional interest payment typically is calculated under a
formula based on a short-term interest rate index multiplied by a designated
factor.
Borrowing For Investment
The Fund may borrow money to purchase additional portfolio securities but
only from banks in amounts up to 20% of its total assets. The Fund is also
permitted to pledge up to 10% of the value of its total assets to secure such
borrowings. Borrowing for investment increases both investment opportunity and
investment risk. Such borrowings in no way affect the Federal or California
State tax status of the Fund or its dividends. If the investment income on
securities purchased with borrowed money exceeds the interest paid on the
borrowing, the net asset value of the Fund's shares will rise faster than would
otherwise be the case. On the other hand, if the investment income fails to
cover the Fund's costs, including the interest on borrowings or if there are
losses, the net asset value of the Fund's shares will decrease faster than would
otherwise be the case. This is the speculative factor known as leverage.
The Investment Company Act of 1940 (the "1940 Act") requires the Fund to
maintain asset coverage of at least 300% for all such borrowings, and should
such asset coverage at any time fall below 300%, the Fund would be required to
reduce its borrowings within
8
<PAGE>
three days to the extent necessary to meet the requirements of the 1940 Act. To
reduce its borrowings, the Fund might be required to sell securities at a time
when it would be disadvantageous to do so.
In addition, because interest on money borrowed is a Fund expense that it
would not otherwise incur, the Fund may have less net investment income during
periods when its borrowings are substantial. The interest paid by the Fund on
borrowings may be more or less than the yield on the securities purchased with
borrowed funds, depending on prevailing market conditions.
SPECIAL CONSIDERATIONS
Special Risk Factors Relating to California Issuers
Because the Fund intends to limit its investments to municipal obligations which
generate interest that is excluded for Federal income tax purposes and exempt
from California personal income tax, you should carefully consider the special
risks inherent in the investment of municipal obligations of California issuers.
Between October 1991 and July 1994 the State of California's bond ratings were
lowered from AAA to A by S&P, from AAA to A by Fitch and from Aaa to A1 by
Moody's. From mid-1990 to late 1993, California experienced its deepest
recession since the 1930's. As a consequence of large budget imbalances, the
State of California depleted its available cash resources and has had to use a
series of external borrowings to meet its cash needs. For the first time in four
years, California entered the 1995-96 fiscal year with strengthening revenues
based upon an improving economy. The Department of Finance projected that the
General Fund would end the fiscal year with a budget surplus in the Special Fund
for Economic Uncertainties of $28 million. Risks also result fro ar certain
amendments to the California Constitution and other statutes that limit the
taxing and spending authority of California governmental entities, as well as
from the general financial condition of the State of California. These
circumstances may have the effect of impairing the ability of California issuers
to pay interest on, or repay the principal of, their municipal obligations. A
more detailed discussion of this subject is contained in the Fund's Statement of
Additional Information. If in the future an adequate supply of municipal
obligations of California issuers ceased to be available, the Fund's Board of
Trustees would consider recommending alternatives to shareholders, such as
changing the Fund's investment objective or liquidating the Fund. The Manager
does not believe that the current economic conditions in California will have a
significant adverse effect on the Fund's ability to invest in municipal
obligations.
Special Risk Factors Relating to Lower Rated Securities,
Zero Coupon Bonds and Pay-in-Kind Bonds
You should carefully consider the relative risks of the Fund's retaining
downgraded securities in its investment portfolio. These are bonds such as those
rated Ba or lower by Moody's or BB or lower by S&P, Fitch or Duff. They
generally are not meant for short-term investing and may be subject to certain
risks with respect to the issuing entity and to greater market fluctuations than
certain lower yielding, higher rated fixed-income securities. Bonds rated Ba by
Moody's are judged to have speculative elements; their future cannot be
considered as well assured and often the protection of interest and principal
payments may be very moderate. Bonds rated BB by S&P, Fitch or Duff are regarded
as having predominantly speculative characteristics and, while such obligations
have less near-term vulnerability to default than other speculative grade debt,
they face major ongoing uncertainties or exposure to adverse business, financial
or economic conditions which could lead to inadequate capacity to meet timely
interest and principal payments. Bonds rated CC by S&P, Fitch or Duff are
regarded as having the highest degree of speculation; while such bonds may have
some small degree of quality and protective characteristics, these are
outweighed by large uncertainties or major risk exposures to adverse conditions.
Bonds rated as low as Caa by Moody's may be in default or may present elements
of danger with respect to principal or interest.
Retention of downgraded bonds rated Ba or lower by Moody's and BB or lower
by S&P, Fitch or Duff, while generally providing greater income and opportunity
for gain than investments in higher rated bonds, usually entail greater risk of
principal and income (including the possibility of default or bankruptcy of the
issuers of such bonds), and may involve greater volatility of price (especially
during periods of economic uncertainty or change) than investments in higher
rated bonds. However, since yields may vary over time, no specific level of
income can ever be assured. These lower rated, high yielding securities
generally tend to reflect economic changes and short-term corporate and industry
developments to a greater extent than higher rated securities which react
primarily to fluctuations in the general level of interest rates. These lower
rated securities will also be affected by the market's perception of their
9
<PAGE>
credit quality (especially during times of adverse publicity) and the outlook
for economic growth. In the past, economic downturns or an increase in interest
rates have under certain circumstances caused a higher incidence of default by
the issuers of these securities and may do so in the future, especially in the
case of highly leveraged issuers. The prices for these securities may be
affected by legislative and regulatory developments. For example, new Federal
rules require that savings and loan associations gradually reduce their holdings
of high-yield securities. An effect of such legislation may be to significantly
depress the prices of outstanding lower rated high yielding fixed income
securities. Factors adversely affecting the market price and yield of these
securities will adversely affect the Fund's net asset value. In addition, the
retail secondary market for these securities may be less liquid than that of
higher rated bonds; adverse conditions could make it difficult at times for the
Fund to sell certain securities or could result in lower prices than those used
in calculating the Fund's net asset value. Therefore, judgment may at times play
a greater role in valuing these securities than in the case of investment grade
fixed income securities, and it also may be more difficult during certain
adverse market conditions to sell these lower rated securities at their fair
value to meet redemption requests or to respond to changes in the market.
The Fund may invest in zero coupon securities and pay-in-kind bonds (bonds
which pay interest through the issuance of additional bonds), which involve
special considerations. These securities may be subject to greater fluctuations
in value due to changes in interest rates than interest-bearing securities and
thus may be considered more speculative than comparably rated interest-bearing
securities. In addition, current Federal income tax law requires the holder of a
zero coupon security or of certain pay-in-kind bonds to accrue income with
respect to these securities prior to the receipt of cash payments. To maintain
its qualification as a regulated investment company and avoid liability for
Federal income taxes, the Fund may be required to distribute income accrued with
respect to these securities and may have to dispose of portfolio securities
under disadvantageous circumstances in order to generate cash to satisfy these
distribution requirements. Fund management anticipates that investments in zero
coupon securities and pay-in-kind bonds will not ordinarily exceed 25% of the
value of the Fund's total assets. (See "Additional Information Relating to Lower
Rated Securities" in the Statement of Additional Information.)
Special Risk Factors Relating to Inverse Floating Rate Instruments
Changes in interest rates inversely affect the rate paid on inverse floating
rate instruments ("inverse floaters"). The inverse floaters' price will be more
volatile than that of a fixed rate bond. Additionally, some inverse floaters
contain a "leverage factor" whereby the interest rate moves inversely by a
"factor" to the benchmark. For example, the rates on the inverse floating rate
note may move inversely at three times the benchmark rate. Certain interest rate
movements and other market factors can substantially affect the liquidity of
inverse floaters. These instruments are designed to be highly sensitive to
interest rate changes and may subject the holders thereof to extreme reductions
of yield and possibly loss of principal.
Other Considerations
Because the Fund intends to be as fully invested as practicable in municipal
obligations of California issuers and will not invest in taxable obligations,
there may be occasions when the Fund may hold cash that is not earning income.
In addition, there may be occasions when in order to raise cash to meet
redemptions, the Fund might be required to sell securities at a loss.
The Fund's portfolio is non-diversified (see "Investment Objective and
Policies") and may have greater risk than a diversified portfolio.
CALCULATlON OF YIELD AND PERFORMANCE DATA
The Fund may from time to time include yield information in advertisements
or information furnished to existing or proposed shareholders. The Fund's yield
is computed by dividing the Fund's net investment income per share during a base
period of 30 days, or one month, by the net asset value per share of the Fund on
the last day of such base period. The resulting 30-day yield is then
10
<PAGE>
annualized pursuant to the bond equivalent annualization method described below.
The Fund's net investment income per share is determined by dividing the Fund's
net investment income during the base period by the average number of shares of
the Fund entitled to receive dividends during the base period. The Fund's 30-day
yield (computed as described above) is then annualized by a computation that
assumes the Fund's net investment income is earned and reinvested for a
six-month period at the same rate as during the 30-day base period and that the
resulting six-month income will again be generated over an additional period of
six months.
The Fund may also advertise from time to time its taxable equivalent yield.
The Fund's taxable equivalent yield is determined by dividing that portion of
the Fund's yield (calculated as described above) that is tax-exempt by one minus
the stated marginal Federal income tax rate and adding the product to that
portion, if any, of the Fund's yield that is not tax-exempt.
The Fund may also furnish to existing or prospective shareholders
information concerning the average annual total return on an investment in the
Fund for a designated period of time. The average annual total return quotation
for a given period is computed by determining the average annual compounded rate
of return that would cause a hypothetical investment made on the first day of
the designated period (assuming all dividends and distributions are reinvested)
to equal the resulting net asset value of such hypothetical investment on the
last day of the designated period.
The yield and average annual total return quotations of the Fund do not take
into account any required payments for Federal or state income taxes.
The Fund's yield and average annual total return will vary from time to time
depending on market conditions, the composition of the Fund's portfolio, and the
Fund's operating expenses. These factors and possible differences in the methods
used in calculating yields and returns should be considered when comparing the
Fund's performance information to information published with respect to other
investment companies and other investment vehicles. Yield and return quotations
should also be considered relative to changes in the value of the Fund's shares
and the risks associated with the Fund's investment objective and policies. At
anytime in the future, yield and return quotations may be higher or lower than
past yield or return quotations, and there can be no assurance that any
historical yield or return quotation will continue in the future.
The Fund may also include comparative performance information in advertising
or marketing the Fund's shares. Such performance information may include data
from Lipper Analytical Services, Inc. and Morningstar, Inc., or other industry
publications.
For more information regarding the computation of yield or average annual
total return quotations, see the Fund's Statement of Additional Information.
PURCHASE OF SHARES
You may purchase shares directly from the Fund without a sales charge on any
day the New York Stock Exchange is open for business. The public offering price
for shares purchased is the net asset value per share of the Fund next
determined after a purchase order becomes effective. Orders for the purchase of
Fund shares become effective (i) immediately, if received prior to 4:00 P.M. New
York time on any business day. Shares being purchased will begin accruing
dividends on the day following the date of purchase and continue to earn
dividends until the date of redemption. Information regarding transmittal of
funds by bank wire and procurement of a Federal Reserve Draft may be obtained
from your bank. All payments (including checks from individual investors) must
be in U.S. dollars. If your check does not clear, Fundamental Shareholder
Services, Inc. will cancel your purchase and you could be liable for any losses
or fees incurred.
The minimum initial purchase is $1,000 and the minimum subsequent purchase
is $100. Subsequent investments are made in the same manner as an initial
purchase is made.
All shares purchased are confirmed to you and credited to your account at
the net asset value determined as described herein under the heading
"Determination of Net Asset Value". Share certificates are issued only on
written request by you to Fundamental Shareholder Services, Inc., Agent, P.O.
Box 1013, Bowling Green Station, New York, New York 10274-1013. There is no
charge for share
11
<PAGE>
certificates. Certificates are not issued for fractional shares. Certificates
will only be issued in amounts of 1,000 or more shares. The issuance of
certificates may be discontinued at any time without prior notice. The Fund
reserves the right to reject any purchase order. The Fund reserves the right to
limit the number of checks processed at any one time and will notify investors
prior to exercising this right.
Although shares of the Fund may be purchased without a sales charge if you
purchase them directly from the Fund, you may be charged a fee for effecting
transactions in the Fund's shares through securities dealers, banks, or other
financial institutions.
The Fundamental Automatic Investment Program offers a simple way to maintain
a regular investment program. The Fund has waived the initial investment minimum
for you when you open a new account and invest $100 or more per month through
the Fundamental Automatic Investment Program. The Fundamental Automatic
Investment Program allows you to purchase shares (minimum of $50 per
transaction) at regular intervals. Investments are made by transferring funds
directly from your checking, or bank money market account. At your option
investments can be made, once a month on either the fifth or the twentieth day,
or twice a month on both days.
To establish a Fundamental Automatic Investment Program, or to add this
option to your existing account simply complete an authorization form, which can
be obtained by calling 1-800-322-6864. You may cancel this privilege or change
the amount you invest at any time. Initial Program setup and any modifications
may take up to ten days to take effect. There is currently no charge for this
service, and the Fund may terminate or modify this privilege at any time.
Methods of Payment
Payment by Wire: An expeditious method of investing in the Fund is through
the transmittal of Federal funds by bank wire to The Chase Manhattan Bank, N.A.
(the "Bank"). Federal funds transmitted by bank wire to the Bank and received by
it prior to 4:00 P.M. New York time are priced at the net asset value determined
on such day. Federal funds received after 4:00 P.M. New York time will be
available on the next business day. Funds other than Federal funds transmitted
by bank wire may or may not be converted into Federal funds on the day received
by the Bank depending upon the time the funds are received and the bank wiring
the funds. We encourage you to make payment by wire in Federal funds. The Fund
will not be responsible for delays in the wiring system.
To purchase shares by wiring funds, instruct a commercial bank to wire your
money to: The Chase Manhattan Bank, N.A., ABA#021000021, Credit to: United
States Trust Company of New York, A/C#920-1-073195, Further credit to:
Fundamental Family of Funds, A/C#2073919. Instructions for new accounts should
specify the name, address, and social security number of each person in whose
name the shares are to be registered and the name of the Fund. If you are an
existing shareholder, you need only furnish your account number and the name of
the Fund. Failure to submit required information may delay investment.
Payment by Mail: Purchase orders for which remittance is to be made by check
may be submitted directly by mail or otherwise to Fundamental Shareholder
Services, Inc., Agent, P.O. Box 1013, Bowling Green Station, New York, New York
10274-1013. Checks should be made payable to Fundamental Family of Funds.
When opening a new account, you must enclose a completed purchase
application. If you are an existing shareholder, you should enclose the
detachable stub from a monthly account statement you have received or otherwise
indicate your account number and the name of the Fund.
Personal Delivery: For personal delivery instructions, please call the Fund
at (800) 322-6864.
Exchange for Municipal Securities: If you own municipal obligations meeting
the criteria for investment by the Fund, you may exchange such securities for
shares of the Fund. All such exchanges are discretionary with the Fund. If you
desire to make such an exchange, you should contact the Fund prior to delivering
any securities in order to establish that the securities are acceptable for
exchange, to determine what transaction charges, if any, may be imposed and to
obtain delivery instructions for such securities. The value of the securities
being exchanged will be determined in the same manner as the value of the Fund's
portfolio securities is determined (see "Determination of Net Asset Value"); the
specific method of determining the value will be provided to you on request.
12
<PAGE>
The Fund reserves the right to refuse any such exchange, even if the securities
offered by an investor meet the general investment criteria of the Fund. An
investor may recognize a capital gain or loss for Federal income tax purposes
upon such exchange. Maturing bonds or detached coupons submitted within five (5)
business days of the payment date are credited on the payment date.
Exchange Privilege: For your convenience, the Exchange Privilege permits you
to purchase shares in any of the other funds for which Fundamental Portfolio
Advisors, Inc. acts as the investment manager in exchange for shares of the Fund
at respective net asset values per share. Exchange instructions must be given in
writing to Fundamental Shareholder Services, Inc., Agent, P.O. Box 1013, Bowling
Green Station, New York, New York 10274-1013, the Fund's transfer agent, and
must specify the number of shares of the Fund to be exchanged (such shares must
have a current value of at least $1,000) and the fund into which the exchange is
being made. If you have previously established a Telephone Exchange Privilege,
you may telephone exchange instructions by calling Fundamental Shareholder
Services, Inc. However, there are other considerations with respect to losses
resulting from unauthorized telephone transactions. For more detail, see
"Redemption of Shares-Telephone Redemption Privilege." Before any exchange, you
must obtain, and should review, a copy of the current prospectus of the fund
into which your exchange is being made. Prospectuses may be obtained by calling
or writing the Fund.
The Exchange Privilege is only available in those states where such exchange
can legally be made and exchanges may only be made between accounts with
identical account registration and account numbers. Prior to effecting an
exchange, you should consider the investment policies of the fund in which you
are seeking to invest. Any exchange of shares is, in effect, a redemption of
shares in one fund and a purchase of the other fund. You may realize a capital
gain or loss for Federal income tax purposes in connection with an exchange. The
Exchange Privilege may be modified or terminated by the Fund at any time without
notice.
REDEMPTION OF SHARES
Shares of the Fund are redeemable at your option without charge at the next
determined net asset value following receipt by Fundamental Shareholder
Services, Inc. of a redemption request in proper order. To effect a redemption,
you may utilize the Check Redemption Privilege, the Telephone Redemption
Privilege, the Expedited Redemption Privilege, or the regular redemption
procedure. Due to the cost of maintaining an account, the Fund reserves the
right to redeem an account involuntarily, on not less than 60 days' written
notice, at any time an investor has reduced his or her account to less than
$100. During the 60-day period, a shareholder may increase his or her holdings
to $100 or more, and thereby avoid an involuntary redemption.
When redemption requests are received by Fundamental Shareholder Services,
Inc. by 4:00 P.M. New York time on any day during which the net asset value is
determined (see "Determination of Net Asset Value"), the redemption will be
effective on such day, and payment will be made on the next business day based
on the net asset value next determined after receipt of the redemption
instruction. If a redemption notice is received after 4:00 P.M. New York time,
the redemption will be effective on the next business day, and payment will be
made thereafter on the second business day. In the event you wish to liquidate
your holdings, you will be entitled to all dividends declared through the date
of redemption. At times, the Fund may be requested to redeem shares for which it
has not yet received good payment. The Fund may delay, or cause to be delayed,
the mailing of a redemption check until such time as it has assured itself that
good payment has been received from the purchase of such shares, which may take
up to 15 days. In the case of payment by check, the determination of whether the
check has been paid by the paying institution generally takes up to seven days,
but may take longer. You may avoid this delay by purchasing shares by wire or by
using a certified or official bank check drawn on a U.S. bank. In the event of
delays in payment of redemption proceeds, the Fund will take all available steps
to expedite collection of the investment check. If shares were purchased by
check, you may write checks against such shares only after 15 days from the date
the purchase was executed. Shareholders who draw against shares purchased fewer
than 15 days from the date of original purchase, will be charged usual and
customary bank fees. The Fund reserves the right to suspend the right of
redemption or postpone the day of payment (1) during any period when the New
York Stock Exchange is closed (other than customary weekend and holiday
closings), (2) when the trading markets normally used by the Fund are restricted
or an emergency exists as determined by the Securities and
13
<PAGE>
Exchange Commission (the "Commission") as to make the disposal of the Fund's
investments or determination of its net asset value unreasonably impracticable,
or (3) for such other periods as the Commission by order may permit to protect
the Fund's shareholders.
You may realize a taxable capital gain or loss when shares are redeemed,
depending on their net asset value. On all redemption requests (including
redemption checks) for joint accounts, the signatures of all joint owners are
required unless shareholders have designated otherwise.
Check Redemption Privilege
You may request that the Fund provide you with redemption checks ("Checks")
drawn on the Fund's account by either (i) completing the appropriate section of
the application order form or (ii) subsequent written request to the Fund. These
Checks will be sent only to the individuals in whose name the account is
registered and only to the address of record with the Fund. You may use the
Checks in any lawful manner and make them payable to the order of any person or
company in an amount of $100 or more. Dividends continue to be earned until the
Check clears the Fund account and is paid by Fundamental Shareholder Services,
Inc. The Fund may delay, or cause to be delayed, payment of redemption proceeds
until such time as it or Fundamental Shareholder Services, Inc. has assured
itself that good payment has been collected for the purchase of such shares. In
addition, the Fund reserves the right not to honor Check redemption requests if
the shares to be redeemed have been purchased by check within seven days prior
to the date the redemption request is received by Fundamental Shareholder
Services, Inc. unless the check used for investment has been cleared for payment
by your bank. You will be subject to the same rules and regulations that the
Bank applies to checking accounts in general. There is currently no charge to
you for the use of Checks, except that a fee may be imposed by Fundamental
Shareholder Services, Inc. if an investor requests that it stop payment of a
Check or if it cannot honor a Check due to insufficient funds or other valid
reasons.
When a Check is presented to Fundamental Shareholder Services, Inc. for
payment, Fundamental Shareholder Services, Inc., as your agent, will cause the
Fund to redeem a sufficient number of shares in your account to cover the amount
of the Check. Shares for which certificates have been issued may not be redeemed
by Check. Since the net asset value of the Fund's shares changes daily, you
should make certain that the total value of your account is sufficient to cover
the amount of your Check. Otherwise, the Check will be returned marked
insufficient funds. Checks may not be used to close an account. The Check
Redemption Privilege may be modified or terminated at any time by either the
Fund or Fundamental Shareholder Services, Inc.
Telephone Redemption Privilege
You may direct redemptions of up to $150,000 worth of shares per day by
telephone by either (i) completing the appropriate section of the application
form or (ii) subsequent signature guaranteed* written request. Telephone calls
may be recorded. Fundamental Shareholder Services, Inc. will act on instructions
that it reasonably believes to be genuine. The proceeds of the redemption will
only be mailed to the address of record with the Fund, provided that your
account registration has not changed within the last 30 days. The Fund reserves
the right to refuse a telephone redemption and may limit the amount and
frequency. The Telephone Redemption Privilege may be modified or terminated at
any time by either the Fund or Fundamental Shareholder Services, Inc.
Neither the Fund nor its transfer agent will be liable for following
instructions that they reasonably believe to be genuine. It is the Fund's policy
to provide that a written confirmation statement of all telephone call
transactions be mailed to shareholders at their address of record within three
business days after the telephone call transaction. You should verify the
accuracy of telephone call transactions immediately upon receipt of your
confirmation statement. As a result of this policy, you will bear the risk of
loss in the event of a fraudulent telephone exchange or redemption transaction.
- -------
*A signature guarantee must be from an eligible guarantor institution approved
by Fundamental Shareholder Services, Inc. Signature guarantees in proper form
generally will be accepted from domestic banks, a member of a national
securities exchange, credit unions and savings associations, as well as from
participants in the Securities Transfer Agents Municipal Program ("STAMP"). If
you have any questions with respect to signature guarantees, please call the
transfer agent at (800) 322-6864.
14
<PAGE>
Expedited Redemption Privilege
Requests for expedited redemption may be made by wire, letter or telephone
if you have previously filed with Fundamental Shareholder Services, Inc. a
signed telephone authorization form available from the Fund. If the request is
for more than $5,000, proceeds of the expedited redemption will be transferred
by Federal Reserve wire to the bank specified in the authorization form or to a
correspondent bank if your bank is not a member of the Federal Reserve System.
If the correspondent bank fails to notify your bank immediately, there could be
a delay in crediting the funds to your bank account. Proceeds of less than
$5,000 will be mailed to your address. The Fund reserves the right to refuse an
expedited redemption and may limit the amount and frequency. This procedure may
be modified or terminated at any time without prior notice by either the Fund or
Fundamental Shareholder Services, Inc. Any time funds are wired by the Bank, the
proceeds of redemption may be subject to the deduction of the Bank's usual and
customary charges for wiring funds.
In order to qualify to use the Expedited Redemption Privilege, you must
complete the appropriate portion of the new account application and your initial
payment for purchase of the Fund's shares must be drawn on, and redemption
proceeds paid to, the same bank and account as designated on the application.
In order to change the commercial bank or account designated to receive the
redemption proceeds, you must send a written request to Fundamental Shareholder
Services, Inc., Agent, Bowling Green Station, P.O. Box 1013, New York, New York
10274-1013. Such request must be signed by each shareholder with each signature
guaranteed by an eligible guarantor (see above).
Regular Redemption Procedure
You may redeem your shares by sending a written request, together with duly
endorsed share certificates, if any, to Fundamental Shareholder Services, Inc.,
Agent, P.O. Box 1013, Bowling Green Station, New York, New York 10274-1013. All
certificates and all written requests for redemption must be endorsed by you.
For redemptions exceeding $50,000 (and for all written redemption requests,
regardless of amount, made within 30 days following any change in account
registration), your endorsement must be signature guaranteed, as described
above. Fundamental Shareholder Services, Inc. may, at its option, request
further documentation from corporations, executors, administrators, trustees or
guardians. If requested, redemption proceeds of more than $5,000 will be wired
into any member bank of the Federal Reserve System. However, such transaction
may be subject to a deduction of the Bank's usual and customary charges for
wiring funds. The Fund will accept other suitable verification arrangements for
foreign investors. Redemptions by mail will not become effective until all
documents in the form required have been received by Fundamental Shareholder
Services, Inc.
How to Transfer Shares
Shares may be transferred from one person to another by sending to
Fundamental Shareholder Services, Inc. a written request for such transfer,
signed by the registered owner(s) exactly as the account is registered with each
signature guaranteed as described above, with (i) the name(s) of the new
registered owner(s), (ii) the social security number or taxpayer identification
number for the new registration, and (iii) the redemption option elected. If the
shares being transferred are represented by certificates in the possession of
the investor, such certificates, properly signed with signature guarantees, must
also be forwarded to Fundamental Shareholder Services, Inc. In addition,
Fundamental Shareholder Services, Inc. reserves the right to request any
additional documents that may be required for transfer by corporations,
executors, administrators, trustees, and guardians.
Reopening an Account
You may reopen an account with a minimum investment of $100 or more without
filing a new application form during the year in which your account was closed
or during the following calendar year, provided that the information on your
original form is still applicable. The Fund may require you to file a statement
that all information on the original account application form remains
applicable.
15
<PAGE>
DETERMINATION OF NET ASSET VALUE
The net asset value per share is determined as of the close of trading on
the New York Stock Exchange (currently 4:00 p.m., New York time) on each day
that both the New York Stock Exchange and the Fund's custodian bank are open for
business and on any other day during which there is a sufficient degree of
trading in the Fund's portfolio securities that the Fund's net asset value might
be materially affected by changes in the value of its portfolio securities,
unless there have been no shares tendered for redemption or orders to purchase
shares received. The net asset value per share is computed by taking the value
of all assets of the Fund, subtracting the liabilities of the Fund, and dividing
by the number of outstanding shares. For purposes of determining net asset
value, expenses of the Fund are accrued daily and taken into account.
The Fund's portfolio securities are valued on the basis of prices provided
by an independent pricing service when, in the opinion of persons designated by
the Fund's trustees, such prices are believed to reflect the fair market value
of such securities. Prices of non-exchange traded portfolio securities provided
by independent pricing services are generally determined without regard to bid
or last sale prices but take into account institutional size trading in similar
groups of securities, yield, quality, coupon rate, maturity, type of issue,
trading characteristics and other market data. Securities traded or dealt in
upon a securities exchange and not subject to restrictions against resale are
valued at the last quoted sales price, or, in the absence of a sale, at the mean
of the last bid and asked prices. Money market and short-term debt instruments
with a remaining maturity of 60 days or less will be valued on an amortized cost
basis. Municipal daily or weekly variable rate demand instruments will be priced
at par value plus accrued interest. Securities not priced in a manner described
above and other assets are valued by persons designated by the Fund's trustees
using methods which the trustees believe accurately reflects fair value. The
prices realized from the sale of these securities could be less than those
originally paid by the Fund or less than what may be considered the fair value
of such securities.
Included in the portfolio securities of the Fund in determining net asset
value is the value of all when-issued securities that the Fund has committed
itself to purchase. However, the Fund's ability to purchase such securities
remains constant (see "Investment Objective and Policies").
DISTRIBUTION EXPENSES
The Board of Trustees and shareholders of the Fund have approved a plan of
distribution under Rule 12b-1 of the 1940 Act (the "Plan"). Pursuant to the
Plan, the Fund may pay certain promotional and advertising expenses and may
compensate certain registered securities dealers and financial institutions for
services provided in connection with processing orders for the purchase or
redemption of Fund shares, and for furnishing other shareholder services.
Payments by the Fund shall not, in the aggregate, in any fiscal year of the
Fund, exceed one-half of 1% of daily net assets of the Fund for expenses
incurred in distributing and promoting the Fund's shares. The Plan will make
payments only for expenses actually incurred by such dealers and financial
institutions. The Plan will not carry over expenses from year to year, and if
the Plan is terminated in accordance with its terms, the obligation of the Fund
to make payments pursuant to the Plan will cease and the Fund will not be
required to make any payments for expenses incurred after the date the Plan
terminates. The Fund may enter into shareholder processing and service
agreements ("Shareholder Service Agreements") with any securities dealer who is
registered under the Securities Exchange Act of 1934 and is a member in good
standing of the National Association of Securities Dealers, Inc., and with banks
and other financial institutions that may wish to establish accounts or
sub-accounts on behalf of their customers ("Shareholder Service Agents"). The
Fund may pay such Shareholder Service Agents for their services, and to cover
expenses in connection with advertising, sales literature and other promotional
materials on behalf of the Fund, and the fees payable therefor will be reviewed
quarterly by the Fund's Board of Trustees. See "Distribution Plan" in the Fund's
Statement of Additional Information for more details.
On April 16, 1987, the Board of Trustees of the Fund, including a majority
of the disinterested trustees who have no direct or indirect financial interest
in the operation of the Plan or any agreements relating thereto, authorized the
Fund to enter into an agreement with Fundamental Service Corporation, a Delaware
corporation, under the Plan. The agreement provides that the Fund may
16
<PAGE>
pay the usual and customary agency's commission to Fundamental Service
Corporation for producing and placing Fund advertising in newspapers, magazines,
or other periodicals or on radio or television. In addition to the foregoing,
the Fund may pay Fundamental Service Corporation for marketing research and
promotional services specifically relating to the distribution of Fund shares,
including employment expenses of personnel primarily responsible for responding
to inquiries from prospective investors.
The Plan shall continue each year if specifically approved annually by the
Board of Trustees of the Fund and the affirmative vote of a majority of the
trustees who are not interested persons of the Fund, and with no direct or
indirect financial interest in the Plan, by votes cast in person at a meeting
called for such purpose. The Plan may not be amended to increase the maximum
amount of payments by the Fund without shareholder approval, and all material
amendments to the provisions of the Plan must be approved by a vote of the Board
of Trustees and the trustees who have no direct or indirect interest in the
Plan, cast in person at a meeting called for the purpose of such vote.
The Plan provides that Fund management shall provide, and the independent
trustees shall review, quarterly reports setting forth the amounts expended
pursuant to the Plan and the purpose for which the amounts were expended. It
further provides that while the Plan is in effect, the selection and nomination
of those trustees of the Fund who are not interested persons of the Fund, is
committed to the discretion of the independent trustees. During the year ended
December 31, 1996, the Fund incurred expenses amounting to $54,333 under the
Plan, including approximately $28,000 paid to Fundamental Service Corporation
under the Plan.
The Glass-Steagall Act and other applicable laws, among other things,
generally prohibit Federally chartered or supervised banks from engaging in the
business of underwriting, selling, or distributing securities. Accordingly, the
Fund will engage banks as Shareholder Service Agents to perform only
administrative and shareholder servicing functions. While the matter is not free
from doubt, Fund management believes that such laws should not preclude a bank
from acting as a Shareholder Service Agent performing the above-referenced
administrative and shareholder servicing functions. However, judicial or
administrative decisions or interpretations of such laws, as well as changes in
either Federal or state statutes or regulations relating to the permissible
activities of banks or their subsidiaries or affiliates, could prevent a bank
from continuing to perform all or part of its servicing activities. If a bank
were prohibited from so acting, shareholder clients would be permitted to remain
as Fund shareholders and alternative means for continuing the servicing of such
shareholders would be sought. In such event, changes in the operation of the
Fund might occur, and shareholders serviced by such bank might no longer be able
to avail themselves of services then being provided by such a bank. It is not
expected that shareholders would suffer any adverse financial consequences as a
result of any of these occurrences.
MANAGEMENT
The Original Management Agreement appointing Fundamental Portfolio Advisors,
Inc. as the investment manager of the Fund was approved by the Fund's Board of
Trustees on October 1, 1986, and approved by shareholders on January 26, 1987.
Acting pursuant to the current investment management agreement adopted by the
Board of Trustees of the Fund on November 10, 1988, which is substantially
identical to the Original Agreement, Fundamental Portfolio Advisors, Inc. (the
"Manager") serves as the investment manager of the Fund. Its principal place of
business is 90 Washington Street, New York, NY 10006. The Manager has been
providing investment advisory services to the Fundamental Family of Funds since
it was founded in 1986.
The Manager manages and supervises the Fund's investment portfolio and
directs the purchase and sales of its investment securities. The Manager
utilizes an investment committee to manage the assets of the Fund. The committee
is currently composed of the following members: Christopher P. Culp, a portfolio
co-manager affiliated with Tocqueville Asset Management L.P., and Vincent J.
Malanga, a portfolio strategist affiliated with the Manager and Jane Tubis, a
trading assistant affiliated with the Manager.
Christoper P. Culp is serving the Fund on an interim basis without
compensation. He is the co-manager of Tocqueville Government Fund. He was a Vice
President with Belle Haven Investments L.P. from 1994 to 1995, before joining
Tocqueville Asset Management, L.P., and was (i) an independent financial
consultant from 1993 to 1994 and (ii) a bond trader with Swiss Bank Corp. from
1991 to 1993 and with Carroll McEntee, a subsidiary of HSBC Corp., from 1990 to
1991.
17
<PAGE>
Vincent J. Malanga is, and has been for more than the past five years,
Chairman of the Board, Chief Executive Officer, President and Treasurer of the
Fundamental Family of Funds. He is, and has been for more than the past five
years, President, Treasurer, and a Director of the Manager, Executive Vice
President, Secretary and a Director of Fundamental Service Corporation (the
Distributor for certain of the Fundamental Family of Funds) and President of
LaSalle Economics, Inc., an economic consulting firm, and a managing director of
LaSalle Portfolio Management, Inc., a commodity trading adviser.
Jane Tubis is, and has been for more than the past five years, a trading
assistant with the Manager.
The Current Agreement between the Fund and the Manager provides that the
Manager shall, at its own expense, furnish to the Fund office space in the
offices of the Manager or in such other place as may be agreed upon from time to
time, and all necessary office facilities, equipment and personnel for managing
the affairs and investments and supervising the keeping of the Fund's books and
shall arrange, if desired by the Fund, for all directors and executive officers
of the Manager's organization to serve as officers or trustees of the Fund.
Under the terms of the Current Agreement, the Manager assumes and shall pay or
reimburse the Fund for (1) the compensation (if any) of the trustees of the Fund
who are affiliated with, or "interested persons" of, the Manager and all
officers of the Fund as such; and (2) all expenses not specifically assumed by
the Fund where such expenses are incurred by the Manager or by the Fund in
connection with the management of the investment and reinvestment of the assets
of the Fund, and the management of the affairs of the Fund.
Under the terms of the Current Agreement, the following expenses, among
others, incurred in the operation of the Fund, will be borne by the Fund: (1)
charges and expenses for determining from time to time the value of the net
assets of the Fund and the keeping of its books and records; (2) charges and
expenses of auditors; (3) charges and expenses of any custodian, transfer agent,
plan agent, dividend-disbursing agent, and registrar appointed by the Fund; (4)
brokers' commissions, and issue and transfer taxes, chargeable to the Fund in
connection with securities transactions to which the Fund is a party; (5)
insurance premiums, interest charges, dues and fees for membership in trade
associations, and all taxes and fees payable by the Fund to Federal, state, or
other governmental agencies; (6) the cost of share certificates representing
shares of the Fund; (7) fees and expenses involved in registering and
maintaining registrations of the Fund and of its shares with the Commission,
including the preparation of prospectuses for filing with the Commission and any
application for exemption whether or not relating to, or directed toward, the
sale of the Fund's shares; (8) all expenses of shareholders' and trustees'
meetings and of preparing, printing, and distributing notices, proxy statements,
and all reports to shareholders and to governmental agencies; (9) charges and
expenses of legal counsel to the Fund; (10) compensation of those trustees of
the Fund as such who are not affiliated with or "interested persons" of the
Manager or the Fund (other than as trustees); (11) fees and expenses incurred
pursuant to a plan adopted pursuant to Rule 12b-1 under the 1940 Act; and (12)
such nonrecurring or extraordinary expenses as may arise, including litigation
affecting the Fund and any indemnification by the Fund of its trustees,
officers, employees, or agents with respect thereto.
Pursuant to the Current Agreement, the Manager will provide the Fund with
advice and recommendations in the choice of investments and will execute the
Fund's security transactions. These services will be under the supervision of
Mr. Vincent J. Malanga, as trustee, president-treasurer, and chief executive
officer of the Fund. The Current Agreement provides that the Manager shall,
subject to the supervision of the Board of Trustees of the Fund, generally
attend, direct, and manage the affairs of the Fund. In consideration for such
services, the Fund has agreed to pay the Manager an annual fee, accrued daily
and paid monthly, at the following rate on the average daily closing net asset
value of the Fund:
Net Asset Value Annual Rate
-----------------------------------------------------------------------
For assets up to $100,000,000 50/100 of 1%
For assets in excess of $100,000,000 up to $200,000,000 48/100 of 1%
For assets in excess of $200,000,000 up to $300,000,000 46/100 of 1%
For assets in excess of $300,000,000 up to $400,000,000 44/100 of 1%
For assets in excess of $400,000,000 up to $500,000,000 42/100 of 1%
For assets in excess of $500,000,000 40/100 of 1%
18
<PAGE>
The Current Agreement terminates upon assignment and may be terminated
without penalty on 60 days' written notice by a vote of the majority of the
Fund's Board of Trustees or by the holders of a majority of the Fund's
outstanding shares. Unless earlier terminated as described above, the Current
Agreement will continue in effect from year to year if its continuance is
approved at least annually (1) by the Board of Trustees of the Fund or the vote
of the holders of a majority of the outstanding shares of the Fund and (2) in
either event, by a majority of the trustees of the Fund who are not parties to
the Current Agreement or "interested persons" of any such party, by votes cast
in person at a meeting called for the purpose of voting on such approval.
The Fund's independent trustees have retained an investment banking firm to
consider fund organizations willing to manage the Fundamental Funds and to
submit requests for proposals. In addition, the Manager is pursuing an
investment management firm's interest in purchasing certain of the Manager's
assets relating to the Fundamental Funds. Any proposed transaction must be
approved by the Fund's Board of Trustess, including a majority of the
independent trustees, and is subject to approval by the Fund's shareholders.
For further information concerning the management of the Fund, see the
Fund's Statement of Additional Information under the caption "Management of the
Fund."
Portfolio Brokerage
It is the Fund's policy to seek execution of its purchases and sales at the
most favorable prices through responsible broker-dealers and in agency
transactions, at competitive commission rates. The Fund's brokerage allocation
policy may permit the Fund to pay a broker-dealer which furnishes research
services a higher commission than that which might be charged by another
broker-dealer which does not furnish research services, provided that such
commission is deemed reasonable in relation to the value of the services
provided by such broker-dealer (see the Fund's Statement of Additional
Information for a complete discussion of the Fund's brokerage allocation
policy). It is not the Fund's practice to allocate principal business on the
basis of sales of Fund shares which may be made through brokers or dealers,
although broker-dealers effecting purchases of Fund shares for their customers
may participate in principal transactions or brokerage allocation. The Fund may,
however, allocate principal business or brokerage to obtain for the benefit of
the Fund services that the Fund would otherwise have to pay for directly.
DIVIDENDS AND TAX STATUS
Dividends and Distributions
All of the Fund's net investment income, consisting of interest income
accrued less all expenses, is calculated daily and declared as a dividend to
shareholders of record of the Fund at the close of business on the previous day.
Dividends are distributed monthly. Net capital gains, if any, will normally be
distributed annually, before the close of the Fund's tax year and prior to
filing the Fund's tax return.
Dividends and capital gains distributions are normally paid in additional
shares of the Fund. If you wish to receive dividends or distributions in cash,
you must file an election with Fundamental Shareholder Services, Inc., which
election will remain in effect until Fundamental Shareholder Services, Inc. is
notified by you in writing to change the election, at least ten (10) days prior
to payment date.
Taxes
The Fund intends to qualify as a "regulated investment company" for Federal
income tax purposes under Subchapter M of the Code. If the Fund so qualifies, it
will not pay any Federal corporate income taxes on net investment taxable income
or net realized capital gains which are distributed to investors in a timely
manner. If the Fund fails to meet certain distribution requirements at the end
of the calendar year, the Fund will be subject to a 4% excise tax on a portion
of its undistributed taxable income. The Fund intends to make distributions in a
timely manner and, accordingly, does not expect to be subject to Federal income
taxes or the 4% excise tax.
Distributions by the Fund of its tax-exempt interest income (net of
expenses) are designated as exempt-interest dividends and shareholders should
exclude the interest from their gross income for Federal income tax purposes. It
is a policy of the Fund to maximize the percentage of distributions to
shareholders that are not subject to Federal income taxes. However, a small
portion of the Fund's net investment income may under certain circumstances be
taxable, and distributions thereof, as well as distributions of any capital
gains, will be taxable to shareholders. Distributions by the Fund of any taxable
net investment income and of any net short-term capital
19
<PAGE>
gains over its net long-term capital loss are taxable to shareholders as
ordinary income. Such distributions constitute dividends for Federal income tax
purposes but do not qualify for the 70% dividends-received deduction for
corporations. Distributions of any net capital gain are designated as capital
gain dividends and are taxable as long-term capital gains without regard to the
length of time the shareholder has held shares of the Fund. If an investor sells
shares held for six months or less at a loss, the loss will be disallowed to the
extent of any exempt-interest dividends received on the shares and (to the
extent not disallowed) will be treated as a long-term capital loss to the extent
of any capital gain dividends received on the shares.
Tax-exempt interest on specified private activity bonds issued after August
7, 1986 is treated as a tax preference item for purposes of the Federal
alternative minimum tax ("AMT"). Thus, corporate and individual shareholders may
incur an AMT liability as a result of receiving exempt-interest dividends from
the Fund to the extent such dividends are attributable to interest from such
private activity bonds. In addition, because all exempt-interest dividends are
included in a corporate shareholder's adjusted current earnings (which are used
in computing a separate preference item for corporations), corporate
shareholders may incur an AMT liability as a result of receiving exempt-interest
dividends from the Fund. For a description of the AMT, see the Fund's Statement
of Additional Information under the caption "Tax Matters."
Although exempt-interest dividends are excludable from gross income for
Federal income tax purposes, shareholders are required to report the receipt of
exempt-interest dividends, together with other tax-exempt interest, on their
Federal income tax returns. In addition, exempt-interest dividends must be taken
into account in computing the portion, if any, of social security or railroad
retirement benefits that must be included in an individual shareholder's gross
income and subject to Federal income tax. Further, a shareholder of the Fund is
denied a deduction for interest on indebtedness incurred or continued to
purchase or carry shares of the Fund. Moreover, a shareholder who is (or is
related to) a "substantial user" of a facility financed by industrial
development bonds held by the Fund will likely be subject to tax on dividends
paid by the Fund which are derived from interest on such bonds.
Distributions to shareholders will be treated in the manner described above
whether received in cash or reinvested in additional shares of the Fund. In
general, distributions by the Fund are taken into account by the shareholders in
the year in which they are made. However, certain distributions made during
January will be treated as having been paid by the Fund and received by the
shareholders on December 31 of the preceding year.
Under the backup withholding rules of the Code, certain shareholders may be
subject to 31% withholding of Federal income tax on ordinary income dividends,
capital gain dividends and redemption payments made by the Fund. In order to
avoid this backup withholding, a shareholder must provide the Fund with a
correct taxpayer identification number (which for an individual is usually his
or her social security number) and certify that it is a corporation or otherwise
exempt from or not subject to backup withholding.
The exclusion from gross income for Federal income tax purposes of
exempt-interest dividends does not necessarily result in exclusion under the
income or other tax laws of any state or local taxing authority. However, so
long as the Fund holds, at the end of each fiscal quarter, at least 50% of the
value of its assets in municipal bonds issued by the State of California or its
political subdivisions, the exempt-interest dividends paid by the Fund, to the
extent derived from interest on such California municipal bonds, will be exempt
from California personal income taxes for a California resident shareholder (and
for estates and trusts subject to the California personal income tax, such as
private or probate trusts, but not business or commercial trusts).
Exempt-interest dividends will not be excluded in determining California
franchise taxes applicable to corporations or financial institutions. You are
advised to consult with your tax advisors concerning the application of state
and local taxes to an investment in the Fund, which may differ from the Federal
income tax consequences heretofore described.
Statements regarding the tax status of distributions by the Fund will be
mailed annually by Fundamental Shareholder Services, Inc. In the event that a
distribution may not be wholly excludable from gross income for Federal income
tax purposes or exempt from California personal income taxes, the statement will
provide information about the tax-exempt percentage, which may vary from
distribution to distribution.
20
<PAGE>
The foregoing discussion is for general information only. A prospective
shareholder should also review the more detailed discussion of Federal income
tax considerations contained in the Fund's Statement of Additional Information
under the caption "Tax Matters." In addition, each prospective shareholder
should consult with his or her own tax advisor as to the tax consequences of an
investment in the Fund.
GENERAL INFORMATION
Shareholders are entitled to one vote for each full share held (and
fractional votes for fractional shares) and may vote to elect trustees and on
the other matters submitted to meetings of shareholders. Annual meetings of
shareholders are not contemplated by the Fund, but shareholder meetings may be
called and held when necessary and desirable. The Fund's shareholders have the
right, on declaration in writing or vote of more than two-thirds of the Fund's
outstanding shares, to remove a trustee. The Fund's trustees will call a meeting
of shareholders to vote on removing a trustee on the written request of the
record holders of 10% of the Fund's shares. In addition, ten (10) shareholders
of the Fund holding the lesser of $25,000 worth or 1% of the Fund's shares may
advise the trustees in writing that they wish to communicate with other
shareholders for the purpose of requesting a meeting to remove a trustee. The
trustees will then either give the applicants access to the shareholder list or,
if requested by the applicants, mail at the applicants' expense the applicants'
communication to all other shareholders.
No amendment may be made to the Fund's Declaration of Trust without the
affirmative vote of the holders of a majority of the Fund's outstanding shares.
The holders of shares have no preemptive or conversion rights. Shares, when
issued, are fully paid and non-assessable except as set forth in the Fund's
Statement of Additional Information under the caption "Additional Information
about the Organization of the Fund." The Trust may be terminated on the sale of
its assets to another issuer if such sale is approved by the vote of the holders
of a majority of the outstanding shares or on liquidation and distribution of
the Fund's assets, if approved by the holders of a majority of the outstanding
shares. If not so terminated, the Trust will continue indefinitely. (As used in
this paragraph, "a majority of the outstanding shares" means an actual majority
of such shares, which differs from a majority shareholder vote as previously
defined.)
The Fund is a Massachusetts business trust and, subject to their fiduciary
duties arising in connection therewith, trustees of the Fund are responsible for
overall management of the business and affairs of the Fund. The Fund's governing
instrument, the Declaration of Trust, provides that the trustees will not be
liable for errors of judgment or mistakes of fact or law, but nothing in such
document protects a trustee against any liability to which he or she would
otherwise be subject to by reason of willful misfeasance, bad faith, gross
negligence, or reckless disregard of duties involved in the conduct of his or
her office.
Annual and semi-annual reports of the Fund, together with the list of
securities held by the Fund in its portfolio, are mailed to each shareholder.
The Code of Ethics of Fundamental Portfolio Advisors, Inc. and the Fund
prohibits all affiliated personnel from engaging in personal investment
activities which compete with or attempt to take advantage of the Fund's planned
portfolio transactions. The objective of the Code of Ethics of both the Fund and
Fundamental Portfolio Advisors, Inc. is that their operations be carried out for
the exclusive benefit of the Fund's shareholders. Both organizations maintain
careful monitoring of compliance with the Code of Ethics.
The Manager and the Fund's Trustees have cooperated in an investigation
being conducted by the Securities and Exchange Commisssion concerning an
affiliated fund. The Commission's staff is considering recommending to the
Commission the commencement of certain proceedings (but not against the
affiliated fund.)
The custodian for the assets of the Fund is The Chase Manhattan Bank, N.A.
Fundamental Shareholder Services, Inc. performs all services in connection with
the transfer of the shares of the Fund. Shareholder inquiries should be directed
to Fundamental Shareholder Services, Inc. by calling (800) 322-6864.
21
<PAGE>
This Prospectus omits certain information contained in the Fund's
Registration Statement, filed with the Securities and Exchange Commission.
Copies of the Registration Statement, including items omitted herein, may be
obtained from the Commission by paying the charges prescribed under its rules
and regulations. The Fund's Statement of Additional Information included in such
Registration Statement may be obtained without charge from the Fund.
---------------------------
22
<PAGE>
(LEFT SIDE)
THE CALIFORNIA MUNI FUND
90 Washington Street
New York NY 10006
1-800-225-6864
Transfer Agent
Fundamental Shareholder Services, Inc.
P.O. Box 1013
New York, NY 10274
1-800-322-6864
Counsel to the Fund
Kramer, Levin, Naftalis & Frankel
New York, New York
Independent Accountants
McGladrey & Pullen, LLP
New York, New York
No person has been authorized to give any information or to make any
representations other than those contained in this Prospectus and in the Fund's
official sales literature in connection with the offer of the Fund's shares,
and, if given or made, such other information or representations must not be
relied upon as having been authorized by the Fund. This Prospectus does not
constitute an offer in any State in which, or to any person to whom, such
offering may not lawfully be made.
(RIGHT SIDE)
THE CALIFORNIA MUNI FUND
Prospectus
April 30, 1997
<PAGE>
Rule 497(c)
Registration No. 2-82143
STATEMENT OF ADDITIONAL INFORMATION
THE CALIFORNIA MUNI FUND
P.O. Box 1013
Bowling Green Station
New York, New York 10274-1013
(800) 322-6864
This Statement of Additional Information is not a Prospectus and should be read
in conjunction with a Prospectus which may be obtained by writing to the Fund at
the above address, or by calling the Fund at the above telephone number.
Shareholder inquiries may also be placed through this number.
THIS STATEMENT IS DATED APRIL 30, 1997 AND SUPPLEMENTS THE FUND'S PROSPECTUS OF
THE SAME DATE.
<PAGE>
TABLE OF CONTENTS
INTRODUCTION................................................................ 3
INVESTMENT OBJECTIVE AND POLICIES........................................... 3
INVESTMENT RESTRICTIONS..................................................... 4
ADDITIONAL INFORMATION RELATING TO
MUNICIPAL OBLIGATIONS..................................................... 6
ADDITIONAL INFORMATION RELATING TO
LOWER RATED SECURITIES.................................................... 8
MANAGEMENT OF THE FUND...................................................... 10
DISTRIBUTION PLAN........................................................... 14
CALCULATION OF YIELD........................................................ 16
CUSTODIAN AGREEMENT AND INDEPENDENT ACCOUNTANTS............................. 19
TAXES....................................................................... 20
PORTFOLIO TRANSACTIONS...................................................... 27
ADDITIONAL INFORMATION ABOUT THE ORGANIZATION
OF THE FUND............................................................... 29
INFORMATION WITH RESPECT TO CALIFORNIA STATE
AND MUNICIPAL FINANCES..................................................... 30
OTHER INFORMATION........................................................... 46
FINANCIAL STATEMENTS........................................................ 46
INFORMATION WITH RESPECT TO SECURITIES RATINGS............................. A-1
-2-
<PAGE>
INTRODUCTION
The California Muni Fund (the "Fund") is a mutual fund. The rules and
regulations of the United States Securities and Exchange Commission (the "SEC")
require all mutual funds to furnish prospective investors certain information
concerning the activities of the company being considered for investment. This
information is included in a Prospectus dated the same date as this Statement,
which may be obtained without charge from the Fund by writing to or telephoning
the Fund as indicated on the front page of this Statement of Additional
Information. Some of the information required to be in this Statement of
Additional Information is also included in the Fund's Prospectus and, in order
to avoid repetition, reference will be made to sections of the Prospectus.
Additionally, the Prospectus and this Statement of Additional Information omit
certain information contained in the registration statement filed with the SEC.
Copies of the registration statement, including items omitted from the Fund's
Prospectus and this Statement of Additional Information, may be obtained from
the SEC by paying the charges prescribed under its rules and regulations.
INVESTMENT OBJECTIVE AND POLICIES
The objective of the Fund is to provide investors with as high a level
of income that is excluded from gross income for federal income tax purposes and
exempt from California personal income tax as is consistent with the
preservation of capital. There can be no assurance that the Fund will achieve
this objective. In attempting to achieve this objective, the Fund will, as a
fundamental policy, invest only in (1) municipal bonds that are rated within the
four highest quality grades (as determined by Moody's Investors Service, Inc.
("Moody's"), Standard & Poor's Corporation ("S&P"), Fitch Investors Service,
Inc. ("Fitch") or Duff & Phelps, Inc. ("Duff"), the nationally recognized
statistical rating organizations currently rating instruments of the type the
Fund may purchase), or, if unrated, are judged by Fund management to be of
comparable quality, and (2) municipal notes and municipal commercial paper that
are rated within the three highest quality grades as determined by Moody's for
municipal notes, or within the three highest quality grades as determined by
Moody's or S&P for municipal commercial paper or, if unrated, are (i)
obligations of issuers having an issue of bonds rated within the four highest
quality grades as determined by Moody's, S&P, Fitch or Duff or (ii) guaranteed
as to principal and interest by the U.S. Government, its agencies or
instrumentalities. Fundamental policies of the Fund can be changed only by a
majority vote of the shareholders of the Fund (as defined in the Prospectus). (A
"majority shareholder vote" means, in the Prospectus, the affirmative vote of
the holders
-3-
<PAGE>
of lesser of (1) more than 50% of the outstanding shares of the Fund or (2) 67%
or more of the shares present at a meeting if more than 50% of the outstanding
shares are represented at the meeting in person or by proxy.) See "Additional
Information Relating to Municipal Obligations" contained herein for more
detailed descriptions of the various types of municipal obligations.
The Fund may invest up to 100% of its assets in qualified private
activity bonds, and accordingly, the Fund's shares may not be an appropriate
investment for "substantial users" of facilities financed by industrial
development bonds or for investors who are "related persons" to such users.
Generally, an individual will not be a "related person" under the Internal
Revenue Code of 1986, as amended (the "Code") unless he or his immediate family
(spouse, brothers, sisters, ancestors and lineal descendants) own directly or
indirectly in the aggregate more than (i) 50% in value of the outstanding stock
of a corporation or (ii) 50% of the capital or profits interest in a partnership
which is a "substantial user" of a facility financed from the proceeds of
industrial development bonds. "Substantial user" of such facilities is defined
generally in Section 1.103-11(b) of the Treasury Regulations as a "nonexempt
person who regularly uses a part of [a] facility" financed from the proceeds of
a qualified private activity bond in his trade or business.
For more detailed information concerning the Investment Objective and
Investment Policies of the Fund, see the Fund's Prospectus at "Investment
Objective and Policies".
INVESTMENT RESTRICTIONS
The following investment restrictions have been adopted by the Fund as
fundamental policies, which means they can be changed for the Fund only by a
majority shareholder vote. The Fund may not:
(1) Invest in securities other than the municipal obligations described
in the Fund's Prospectus under "Investment Objective and Policies".
(2) Make short sales of securities or purchase securities on margin,
except that the Fund may obtain such short-term credits as are necessary for the
clearance of purchases and sales of portfolio securities.
(3) Borrow money, except from banks, and only in an amount not to
exceed 20% of the Fund's total assets, with such value determined at the time of
borrowing, excluding the amount borrowed.
-4-
<PAGE>
(4) Pledge, assign or otherwise encumber its assets, except that the
Fund may pledge securities having a market value determined at the time of
pledge of up to 10% of the value of its total assets for the purpose of securing
the borrowings referred to in restriction (3) above.
(5) Underwrite securities, except to the extent that the purchase of
municipal obligations directly from an issuer may be deemed to be an
underwriting, or purchase any securities as to which registration under the
Securities Act of 1933 would be required for resale to the public.
(6) Make loans of money or securities, except that the purchase of a
portion of an issue of publicly-distributed debt securities is not considered
the making of a loan.
(7) Invest for the purpose of exercising control or management of
another company.
(8) Purchase securities of other investment companies, except in
connection with a merger, consolidation, reorganization or acquisition of
assets.
(9) Write puts, calls or combinations thereof, or purchase or sell
commodities or commodity futures contracts.
(10) Purchase or sell real estate, although the Fund may purchase
municipal obligations secured by interest in real estate.
(11) Purchase industrial revenue bonds if, as a result, more than 5% of
the Fund's total assets would be invested in industrial revenue bonds where
payment of principal and interest would be the responsibility of companies with
less than three years of operating history.
(12) Purchase or retain the securities of any one issuer if officers or
Trustees of the Fund or the Fund's investment adviser beneficially owning more
than 1/2 of the 1% of the securities of the issuer together beneficially own
more than 5% of the securities of the issuer.
(13) Issue senior securities, as defined in the Investment Company Act
of 1940, except to the extent the Fund may be deemed to have issued securities
by reason of any borrowings permitted by restriction (3) or by purchasing
securities on a when-issued or delayed delivery basis.
(14) Invest 25% or more of the value of its respective total assets in
securities of nongovernmental issuers in the same industry. The identification
of the issuer of the municipal obligations depends on the terms and conditions
of the obligation.
-5-
<PAGE>
If the assets and revenues of an agency, authority, instrumentality or other
political subdivision are separate from those of the government creating the
subdivision and the obligation is backed only by the assets and revenues of the
subdivision, such subdivision is regarded as the sole issuer. Similarly, in the
case of an industrial development revenue bond or pollution control bond, if the
bond is backed only by the assets and revenues of the nongovernmental user, the
nongovernmental user is regarded as the sole issuer. If in either case the
creating government or another entity guarantees an obligation, the guaranty is
regarded as a separate security and treated as an issue of such guarantor.
Although it is not a fundamental policy, the Fund may not invest more
than 10% of its total assets in municipal obligations of California issuers
which are illiquid or which have limited marketability.
ADDITIONAL INFORMATION RELATING TO MUNICIPAL OBLIGATIONS
MUNICIPAL BONDS
Municipal bonds are long-term debt obligations, generally with a
maturity at the time of issuance of greater than three years, of states and
their political subdivisions issued to obtain funds for various public purposes,
including construction of a wide range of public facilities, such as airports,
bridges, highways, housing, hospital, mass transportation, schools, streets and
water and sewer works. Other purposes for which municipal bonds may be issued
include refunding outstanding obligations; obtaining funds for general operating
expenses; or obtaining funds to lend to public or private institutions for
construction of such facilities as educational, hospital and housing facilities.
In addition, certain types of bonds may be issued by public authorities to
finance privately operated housing facilities, sports facilities, convention or
trade show facilities and certain local facilities for water supply, gas,
electricity, or sewage or solid waste disposal. Other types of qualified private
activity bonds, the proceeds of which are used for the construction, equipment,
repair or improvement of privately operated industrial or commercial facilities,
may constitute municipal bonds, although current Federal tax laws place
substantial limitations on the size of such issues.
The two principal classifications of municipal bonds are general
obligation and revenue bonds. General obligation bonds are secured by the
issuer's pledge of faith, credit and taxing power for the payment of principal
and interest. Revenue bonds are payable from only revenues derived from a
particular facility or class of facilities or, in some cases, from the proceeds
of a
-6-
<PAGE>
special excise tax or other specific revenue sources such as from the user of
the facility being financed. Qualified private activity bonds are in most cases
revenue bonds and do not generally constitute the pledge of the credit or taxing
power of the issuer of such bonds. The payment of the principal and interest on
such bonds depends solely on the ability of the user of the facilities financed
by the bonds to meet its financial obligations and the pledge, if any, of real
and personal property so financed as security for such payment.
MUNICIPAL NOTES
Municipal notes are short-term obligations, generally with a maturity
at the time of issuance of from six months to three years. The principal types
of municipal notes include tax anticipation notes, bond anticipation notes,
revenue anticipation notes, and project notes. Tax anticipation notes are sold
to provide working capital to states and municipalities in anticipation of
collection of taxes. Bond anticipation notes are issued to provide funds
temporarily in anticipation of a bond sale. Revenue anticipation notes are sold
in expectation of receipt of other revenues, such as funds under the Federal
Revenue Sharing Program. Project notes are issued by local agencies in
connection with such programs as construction of low-income housing in order to
provide construction financing prior to permanent financing. Project notes are
guaranteed by the U.S. Department of Housing and Urban Development and
consequently are secured by the full faith and credit of the United States.
Municipal notes also include obligations issued at a discount, frequently
referred to as municipal commercial paper, which are likely to be issued to meet
seasonal working capital needs of a municipality or to provide interim
construction financing and are to be paid from general revenues of the
municipality or refinanced with long-term debt. In most cases, municipal
commercial paper is backed by letters of credit, lending agreements, note
repurchase agreements, or other credit facility agreements offered by banks or
other institutions. The Fund would be able to draw on these agreements on a
default under the terms of the documents of the security.
VARIABLE RATE INSTRUMENTS
Municipal bonds and notes are sometimes issued with a variable interest
rate ("variable rate instruments"). The interest rate on variable rate
instruments is usually tied to an objective standard, such as the 90-day
Treasury Bill rate or the prime rate of a bank involved in the financing. Prime
rates can change daily; the auction for 90-day Treasury Bill rates is held
weekly. In addition to having a variable interest rate, any such instruments are
subject to repayment of principal on demand by the Fund,
-7-
<PAGE>
usually in not more than five business days. Both the variable rate feature and
the principal repayment on demand feature tend to reduce fluctuations in the
price of variable rate instruments; these instruments are generally of interest
and sold to institutional investors. Also available are participation interests
in loans to municipal issuers, which are similar except that these loan
participations are made available through a commercial bank that arranges the
tax-exempt loan. Participation interests are frequently backed by an irrevocable
bank letter of credit or a guarantee by a financial institution and give the
Fund the right to demand, on short notice (usually not more than seven days),
payment of all or any part of the principal amount and accrued interest. The
Board of Trustees will determine that the participation interest in the
municipal securities meets the Fund's prescribed quality standards. The Fund's
management has been instructed by the Board of Trustees to monitor the pricing,
quality and liquidity of any variable rate demand instruments held, including
participation interests supported by letters of credit or guarantee, on the
basis of published financial information and reports of the rating agencies and
other analytical sources. The Fund's management will also monitor the
creditworthiness of the guarantor. Banks retain fees for their role in an amount
equal to the excess of the interest paid on the municipal securities over the
negotiated yield at which the participation interests were purchased. In the
event that the participation interest that the Fund acquires includes the right
to demand payment of principal and accrued interest from the issuer of the
participation interest pursuant to a letter of credit or other commitment, the
maturity will be deemed to be equal to the time remaining until the principal
amount can be recovered from the issuer through demand, although the stated
maturity may be in excess of one year. To the extent that variable rate
instruments and loan participations may lack liquidity (unless payable on demand
or within seven days), they are subject to the restriction on illiquid
securities, described herein under the caption "Investment Restrictions".
ADDITIONAL INFORMATION RELATING TO
LOWER RATED SECURITIES
Downgraded securities (i.e., those rated lower than Baa by Moody's or
BBB by S&P, Fitch or Duff or determined by Fund management to be a comparable
quality if unrated) that are retained in the Fund's investment portfolio
generally produce a higher current yield than do securities of higher ratings.
However, these obligations are considered speculative because they involve
greater price volatility and risk than do higher rated securities and the yields
on these securities will tend to fluctuate over time. Although the market value
of all fixed-income securities varies as a result of changes in prevailing
interest rates (e.g., when
-8-
<PAGE>
interest rates rise, the market value of fixed-income securities can be expected
to decline), values of lower rated securities tend to react differently than the
values of higher rated securities. The prices of lower rated securities are less
sensitive to changes in interest rates than higher rated securities. Conversely,
lower rated securities also involve a greater risk of default by the issuer in
the payment of principal and income and are more sensitive to economic downturns
and recessions than higher rated securities. The financial stress resulting from
an economic downturn could have a greater negative effect on the ability of
issuers of lower rated securities to service their principal and interest
payments, to meet projected business goals and to obtain additional financing
than on more creditworthy issuers. In the event of an issuer's default in
payment of principal or interest on such securities, or any other securities in
the Fund's portfolio, the net asset value of the Fund will be negatively
affected. Moreover, as the market for lower rated securities is a relatively new
one which has not yet been tested through a recession, a severe economic
downturn might increase the number of defaults, thereby adversely affecting the
value of all outstanding lower rated municipal bonds and disrupting the market
for such securities. Securities purchased by the Fund as part of an initial
underwriting present an additional risk due to their lack of market history.
These risks are exacerbated with respect to securities rated CCC or lower by
S&P, Fitch or Duff Caa or lower by Moody's. Unrated securities generally carry
the same risks as do lower rated securities.
The Fund may continue to hold lower rated securities that are
structured as zero coupon or pay-in-kind bonds. Such securities may be more
speculative and subject to greater fluctuation in value due to changes in
interest rates than lower rated, income-bearing securities. In addition, zero
coupon and pay-in-kind securities are also subject to the risk that in the event
of a default, a fund may realize no return on its investment, because these
securities do not pay cash interest. Zero coupon, or deferred interest,
securities are debt obligations that do not entitle the holder to any periodic
payment of interest prior to maturity or a specified date when the securities
begin paying current interest (the "cash payment date") and therefore are issued
and traded at a discount from their face amounts or par value. Pay-in-kind
securities are securities that pay interest through the issuance of additional
securities. Holders of zero coupon securities are considered to receive each
year the portion of the original issue discount on such securities that accrues
that year and must include such amount in gross income, even though the holders
receive no cash payments during the year. Consequently, as a fund is accruing
original issue discount on these securities prior to the receipt of cash
payment, it is still subject to the requirement that it distribute substantially
all of its income to its shareholders in order to qualify as a "regulated
investment
-9-
<PAGE>
company" under applicable tax law. Therefore, such fund may have to dispose of
its portfolio securities under disadvantageous circumstances or leverage itself
by borrowing to generate the cash necessary to satisfy its distribution
requirements.
Lower rated securities are typically traded among a smaller number of
broker-dealers rather than in a broad secondary market. Purchasers of lower
rated securities tend to be institutions, rather than individuals, a factor that
further limits the secondary market. To the extent that no established retail
secondary market exists, many lower rated securities may not be as liquid as
Treasury and investment grade securities. The ability of the Fund to sell lower
rated securities will be adversely affected to the extent that such securities
are thinly traded or illiquid. Moreover, the ability of the Fund to value lower
rated securities becomes more difficult, and judgment plays a greater role in
valuation, as there is less reliable, objective data available with respect to
such securities that are thinly traded or illiquid.
Because investors may perceive that there are greater risks associated
with the medium to lower rated securities, the yields and prices of such
securities may tend to fluctuate more than those for securities with a higher
rating. Changes in perception of issuers' creditworthiness tend to occur more
frequently and in a more pronounced manner in the lower quality segments of the
fixed-income securities market than do changes in higher quality segments of
such market, resulting in greater yield and price volatility.
The general legislative environment has included discussions and
legislative proposals relating to the tax treatment of high-yield securities.
Any or a combination of such proposals, if enacted into law, could negatively
affect the value of any high-yield securities in the Fund's portfolio. The
likelihood of any such legislation is uncertain.
MANAGEMENT OF THE FUND
TRUSTEES AND OFFICERS
Trustees and officers of the Fund, together with information as to
their principal business occupations for at least the last five years, are shown
below. Each Trustee who is considered to be an "interested person" of the Fund,
as defined in the Investment Company Act of 1940 (the "1940 Act"), is indicated
by an asterisk (*).
-10-
<PAGE>
James C. Armstrong: Trustee of the Fund. Mr. Armstrong is a partner in
Armstrong/Seltzer Communications Inc., a New York management, consulting and
public relations firm. He was formerly Executive Director, Global Public Affairs
Institute at New York University and Professor, Bell of Pennsylvania Chair in
Telecommunications, Temple University, and is a management consultant. He was
with American Telephone and Telegraph Company for 15 years. His last position
with AT&T was Director, Corporate Policy Analysis. Mr. Armstrong previously held
positions at the Institute for Defense Analysis, the Office of the Postmaster
General, and on the faculty of the University of Maryland. He has been a
consultant to government, academic and business organizations, and has served on
various government-industry task forces and committees. Mr. Armstrong was an
Officer in the United States Navy and holds a Ph.D. in nuclear physics. Mr.
Armstrong's address is 51 Mt. Pleasant Road, Morristown, New Jersey 07960.
James A. Bowers: Trustee of the Fund. Mr. Bowers is a consultant for
CAMBA, Inc., Prototypes (formerly, Director of Finance and Administration), The
American Telephone and Telegraph Company (AT&T) and the RAND Corporation. He was
employed at AT&T for 23 years. His latest position with AT&T was in the Treasury
Department as District Manager-Securities and Exchange Commission Reporting. Mr.
Bowers holds Bachelor of Science and Master of Arts degrees in Economics from
Florida Atlantic University. Mr. Bowers' address is 60 East Eighth Street, New
York, N.Y. 10003.
Clark L. Bullock: Trustee of the Fund. Mr. Bullock is Chairman of the
Board of Shelter Rock Investors Services Corp., a privately-held, New York-based
investment company. He is a Director of Farah, Inc., a clothing manufacturer.
Mr. Bullock received a Masters of Science degree in Mathematical Economics from
Purdue University in 1972 and a Bachelor of Arts degree in International
Relations from the University of Arizona. Mr. Bullock's address is c/o Shelter
Rock Investors, 150 Hopper Avenue, Waldwick, New Jersey 07463.
L. Greg Ferrone: Trustee of the Fund. Mr. Ferrone is a consultant with
IntraNet, Inc., a provider of computer systems to the domestic and international
banking industry. Previously he was the Director of Sales & Marketing for RAV
Communications Inc., Vice President/Regional Manager with National Westminster
Bank USA and an officer at Security Pacific Bank. Mr. Ferrone received a
Bachelor of Science degree from Rensselaer Polytechnic Institute in 1972 and
studied at the Stonier Graduate School of Banking. Mr. Ferrone's address is 83
Ronald Court, Ramsey, New Jersey 07446.
*Vincent J. Malanga: Chairman of the Board, Chief Executive Officer,
President and Treasurer of the Fund, New York Muni Fund, Inc., and Fundamental
Fixed Income Fund. Mr. Malanga is President, Treasurer and a Director
-11-
<PAGE>
of Fundamental Portfolio Advisors, Inc., Executive Vice President, Secretary and
a Director of Fundamental Service Corporation, and President, LaSalle Economics
Inc., an economic consulting firm. Mr. Malanga is a managing director and a 50%
shareholder of LaSalle Portfolio Management, Inc., a commodity trading adviser.
Prior thereto, Mr. Malanga, who holds a Ph.D. in Economics from Fordham
University, was an Economist at the Federal Reserve Bank of New York. Mr.
Malanga's address is 90 Washington Street, 19th Floor, New York, New York 10006.
David P. Wieder: Vice President of the Fund, Secretary of Fundamental
Portfolio Advisors, Inc., and President and a Director of Fundamental
Shareholder Services, Inc. Mr. Wieder holds a Bachelor of Science degree in
Economics from Cornell University. Mr. Wieder's address is 90 Washington Street,
19th Floor, New York, New York 10006.
Carole M. Laible: Secretary of the Fund. Treasurer and Secretary of
Fundamental Shareholders Services, Inc. She was formerly a General Service
Manager for McGladrey & Pullen. Ms. Laible received a Bachelor of Science degree
in Accounting from St. John's University in 1986. Ms. Laible's address is 90
Washington Street, 19th Floor, New York, New York 10006.
All of the Trustees of the Fund are also Directors of Fundamental
Funds, Inc. and Trustees of Fundamental Fixed-Income Fund. All of the officers
of the Fund hold similar offices with Fundamental Funds, Inc. and Fundamental
Fixed-Income Fund.
For services and attendance at board meetings and meetings of
committees which are common to the Fund, Fundamental Fixed-Income Fund and
Fundamental Funds, Inc. (other affiliated mutual funds for which the Fund's
investment manager acts as the investment adviser), each Trustee of the Fund who
is not affiliated with the Fund's investment manager is compensated at the rate
of $6,500 per quarter prorated among the three funds based on their respective
average net assets. Each such Trustee is also reimbursed by the three funds, on
the same basis, for actual out-of-pocket expenses relating to his attendance at
meetings. Some Trustees received additional compensation at a rate of $125 per
hour for services related to serving on the Portfolio Review Committee. For the
fiscal year ended December 31, 1996, Trustees' fees totalling $19,038 were paid
by the Fund to the Trustees as a group. As of the date of this Statement of
Additional Information, Trustees and officers of the Fund as a group owned
beneficially less than 1% of the Fund's outstanding shares.
-12-
<PAGE>
COMPENSATION TABLE
(FOR EACH CURRENT BOARD MEMBER
RECEIVING COMPENSATION FROM
A FUNDAMENTAL FUND FOR THE
MOST RECENTLY COMPLETED FISCAL YEAR)
AGGREGATE COMPENSATION FROM FUND
<TABLE>
<CAPTION>
AGGREGATE
COMPENSATION
PAID BY ALL
FUNDS MANAGED
BY
HIGH-YIELD TAX-FREE U.S. GOV'T FUNDAMENTAL
CALIFORNIA MUNICIPAL MONEY STRATEGIC PORTFOLIO
NAME NY MUNI MUNI BOND MARKET INCOME ADVISORS, INC.
<S> <C> <C> <C> <C> <C> <C>
James C. Armstrong $15,950 $5,394 $151 $10,804 $1,700 $34,000
James A. Bowers 15,950 5,394 151 10,804 1,700 34,000
Clark L. Bullock 12,198 4,125 116 8,262 1,300 26,000
L. Greg Ferrone 12,198 4,125 116 8,262 1,300 26,000
</TABLE>
INVESTMENT MANAGEMENT
Pursuant to a proposal to externalize the portfolio management of the
Fund, the Fund's Board of Trustees on October 1, 1986, approved the appointment
of Fundamental Portfolio Advisors, Inc. as investment manager of the Fund. At a
meeting of shareholders of the Fund held on January 26, 1987, shareholders
approved a Management Agreement (the "Original Agreement") with Fundamental
Portfolio Advisors, Inc. (the "Manager"). A new Management Agreement, which is
substantially identical to the Original Agreement and was adopted by the Board
of Trustees on November 10, 1988, was approved by shareholders on April 27,
1989. The Board of Trustees last approved the Management Agreement on December
31, 1996. Vincent J. Malanga, Chairman of the Board, Chief Executive Officer,
President and Treasurer of the Fund, and Dr. Lance M. Brofman, each own
approximately 48.5% of the outstanding shares of the voting capital stock of the
Manager.
The Manager has agreed that it will notify the Fund's Board of Trustees
before engaging any new clients of material significance; that, if requested,
each Trustee will receive a weekly portfolio transaction statement from the
Manager in order to review all trades made by the Manager; and that if at
anytime three
-13-
<PAGE>
or more Trustees who are "non-interested persons" of the Fund desire to purchase
or sell any security for or of the Fund, the Manager, at the direction of the
"non-interested" Trustees will immediately purchase or sell such security, as
the case may be, at the expense and risk of the Fund.
TRANSFER AGENT
Fundamental Shareholder Services, Inc., P.O. Box 1013, Bowling Green
Station, New York, New York 10274-1013, an affiliate of Fundamental Portfolio
Advisors, Inc. and Fundamental Service Corporation, performs all services in
connection with the transfer of shares of the Fund, acts as its dividend
disbursing agent, and as administrator of the exchange, check redemption,
telephone redemption and expedited redemption privileges of the Fund pursuant to
a Transfer Agency and Service Agreement dated as of February 1, 1990. During the
fiscal year ended December 31, 1996, fees paid to the Transfer Agent by the Fund
amounted to $40,827.
DISTRIBUTION PLAN
The Board of Trustees of the Fund has approved a plan of distribution
under Rule 12b-1 of the 1940 Act (the "Plan"). The Plan was approved by the
shareholders of the Fund at the January 26, 1987 Meeting of Shareholders.
Pursuant to the Plan, the Fund may pay certain promotional and advertising
expenses and compensate certain registered securities dealers and financial
institutions for services provided in connection with the processing of orders
for purchase or redemption of the shares of the Fund and furnishing other
shareholder services.
Payments by the Fund shall not in the aggregate in any fiscal year of
the Fund exceed 1/2 of 1% of daily net assets of the Fund for expenses incurred
in the distribution and promotion of the Fund's shares. The Plan will only make
payments for expenses actually incurred by such dealers and financial
institutions. The Plan will not carry over expenses from year to year and if the
Plan is terminated in accordance with its terms, the obligations of the Fund to
make payments pursuant to the Plan will cease and the Fund will not be required
to make any payments for expenses incurred after the date the Plan terminates.
The Fund may enter into shareholder processing and service agreements (the
"Shareholder Service Agreements") with any securities dealer who is registered
under the Securities Exchange Act of 1934 and a member in good standing of the
National Association of Securities Dealers, Inc., and with banks and other
financial institutions, who may wish to establish accounts or sub-accounts on
behalf of their customers ("Shareholder Service Agents").
-14-
<PAGE>
The fees payable to Shareholder Service Agents under Shareholder
Service Agreements will be negotiated by the Fund's management. The Fund's
management will report quarterly to the Board of Trustees on the rate to be paid
under each such agreement and the amounts paid or payable under such agreements.
It will be based upon an analysis of (1) the contribution that the Shareholder
Service Agent makes to a Fund by increasing Fund assets and reducing expense
ratios; (2) the nature, quality and scope of services being provided by the
Shareholder Service Agent; (3) the cost to the Fund if shareholder services were
provided directly by the Fund or other authorized persons; (4) the costs
incurred by the Shareholder Service Agent in connection with providing services
to the shareholders; and (5) the need to respond to competitive offers of others
which could result in assets being withdrawn from the Fund and an increase in
the expense ratio for the Fund.
On April 16, 1987, the Board of Trustees of the Fund, including a
majority of the "disinterested" Trustees who have no direct or indirect
financial interest in the operation of the Plan or any agreements relating
thereto, authorized the Fund to enter into an agreement with Fundamental Service
Corporation, a Delaware corporation, under the Plan. The agreement provides that
the Fund may pay the usual and customary agency's commission to Fundamental
Service Corporation for producing and placing Fund advertising in newspapers,
magazines or other periodicals, or on radio or television. In addition to the
foregoing, the Fund may pay Fundamental Service Corporation for marketing
research and promotional services specifically relating to the distribution of
Fund shares, including employment expenses of personnel primarily responsible
for responding to inquiries from prospective investors. The following persons
own of record 5% or more of the outstanding shares of voting stock of
Fundamental Service Corporation: Mr. Vincent J. Malanga (43.71%); Mr. Thomas W.
Buckingham (43.71%); and Dr. Lance M. Brofman (9.90%).
The Plan has been renewed to continue in effect until December 31,
1997. The Plan will continue in effect from year to year if specifically
approved at least annually by the Board of Trustees and the affirmative vote of
a majority of the Trustees who are not parties to any Shareholder Service
Agreement or "interested persons" of any such party by votes cast in person at a
meeting called for such purpose. In approving the Plan, the Trustees determined,
in the exercise of their business judgment and in light of their fiduciary
duties as Trustees of the Fund, that there was a reasonable likelihood that the
Plan would benefit the Fund and its shareholders. The Plan may only be renewed
if the Trustees make a similar determination for each subsequent year. The Plan
may not be amended to increase the maximum amount of payments by the Fund to its
Shareholder Service Agents without shareholder approval, and all material
amendments to the provisions of the Plan must be approved by a vote of the Board
of Trustees and of the
-15-
<PAGE>
Trustees who have no direct or indirect interest in the Plan, cast in person at
a meeting called for the purpose of such vote.
The Plan provides that the Fund's management shall provide, and that
the independent Trustees shall review, quarterly reports setting forth the
amounts expended pursuant to the Plan and the purpose for which the amounts were
expended. It further provides that while the Plan is in effect, the selection
and nomination of those Trustees of the Fund who are not "interested persons" of
the Fund are committed to the discretion of the independent Trustees. This does
not prevent the involvement of others in such selection and nomination if the
final decision on any such selection and nomination is approved by a majority of
such disinterested Trustees.
During the year ended December 31, 1996, amounts incurred by the Fund
under the Plan aggregated $54,333, including expenses for: advertising --
$20,523; printing and mailing of Prospectuses to other than current shareholders
- -- $3,344 and sales and shareholder servicing support services -- $30,466. Of
the amount paid on behalf of the Fund during last year, $27,675 was paid to
Fundamental Service Corporation for expenses incurred and services rendered by
it pursuant to the Plan.
CALCULATION OF YIELD
The Fund's yield quotations and average annual total return quotations
as they appear in the Prospectus, this Statement of Additional Information or in
advertising and sales material, are calculated by standard methods prescribed by
the Securities and Exchange Commission.
The Fund's yield is computed by dividing the Fund's net investment
income per share during a base period of 30 days, or one month, by the net asset
value per share of the Fund on the last day of such base period in accordance
with the following formula:
a-b ^6
Yield =[(----- + 1) - 1]
cd
Where: a = dividends and interest earned during the
period
b = expenses accrued for the period (net of
reimbursements)
c = the average daily number of shares outstanding
during the period that were entitled to
receive dividends
-16-
<PAGE>
d = the maximum offering price per share on the
last day of the period.
For purposes of calculating interest earned on debt obligations as provided in
item "a" above:
(1) The yield to maturity of each obligation held by the Fund is
computed based on the market value of the obligation (including actual accrued
interest, if any) at the close of business on the last day of each month, or,
with respect to obligations purchased during the month, the purchase price (plus
actual accrued interest, if any).
(2) The yield to maturity of each obligation is then divided by 360 and
the resulting quotient is multiplied by the market value of the obligation
(including actual accrued interest, if any) to determine the interest income on
the obligation for each day of the subsequent month that the obligation is in
the portfolio. For these purposes, it is assumed that each month has 30 days.
(3) Interest earned on all debt obligations during the 30-day or
one-month period is then totaled.
(4) The maturity of an obligation with a call provision(s) is the next
call date on which the obligation reasonably may be expected to be called or, if
none, the maturity date.
(5) In the case of a tax-exempt obligation issued without original
issue discount and having a current market discount, the coupon rate of interest
of the obligation is used in lieu of yield to maturity to determine interest
income earned on the obligation.
In the case of a tax-exempt obligation with original issue discount
where the discount based on the current market value of the obligation exceeds
the then remaining portion of original issue discount (i.e. market discount),
the yield to maturity used to determine interest income earned on the obligation
is the imputed rate based on the original issue discount calculation. In the
case of a tax-exempt obligation with original issue discount where the discount
based on the current market value of the obligation is less than the then
remaining portion of the original issue discount (market premium), the yield to
maturity used to determine interest income earned on the obligation is based on
the market value of the obligation.
With respect to the treatment of discount and premium on mortgage or
other receivables-backed obligations which are expected to be subject to monthly
payments of principal and interest ("pay
-17-
<PAGE>
downs"), the Fund accounts for gain or loss attributable to actual monthly pay
downs as an increase or decrease to interest income during the period. In
addition, the Fund may elect (1) to amortize the discount or premium on a
remaining security, based on the cost of the security, to the weighted average
maturity date, if such information is available, or to the remaining term of the
security, if the weighted average maturity date is not available, or (2) not to
amortize the discount or premium on a remaining security.
For the purpose of computing yield, dividend income is recognized by
accruing 1/360 of the stated dividend rate of each obligation in the Fund's
portfolio each day that the obligation is in the portfolio. The Fund does not
use equalization accounting in the calculation of yield. Expenses accrued during
any base period, if any, pursuant to the Plan are included among the expenses
accrued during the base period. Any reimbursement accrued pursuant to the Plan
during a base period, if any, will reduce expenses accrued pursuant to such
plan, but only to the extent the reimbursement does not exceed the accrued
expenses for the base period.
The Fund's yield for the one-month period ended December 31, 1996
determined in accordance with the above formula was 4.53%.
Average annual total return quotations are computed by finding the
average annual compounded rates of return that would cause a hypothetical
investment made on the first day of a designated period (assuming all dividends
and distributions are reinvested) to equal the ending redeemable value of such
hypothetical investment on the last day of the designated period in accordance
with the following formula:
^n
P(1+T) = ERV
Where: P = a hypothetical initial payment of $1000
T = average annual total return
n = number of years
ERV = ending redeemable value of a hypothetical $1000 payment
made at the end of a designated period (or fractional
portion thereof)
For purposes of the above computation, it is assumed that all dividends and
distributions made by the Fund are reinvested at net asset value during the
designated period. The average annual return quotation is determined to the
nearest 1/100 of 1%. The average annual total return for the year ended December
31, 1996 was -8.01%. For the five-year period ended December 31, 1996, the
-18-
<PAGE>
average annual total return was 4.03%. The average annual total return was 5.21%
for the ten-year period ended December 31, 1996.
In determining the average annual total return (calculated as provided
above), recurring fees, if any, that are charged to all shareholder accounts are
taken into consideration. For any account fees that vary with the size of the
account, the account fee used for purposes of the above computation is assumed
to be the fee that would be charged to the Fund's mean account size.
The Fund may also from time to time advertise its taxable equivalent
yield. The Fund's taxable equivalent yield is determined by dividing that
portion of the Fund's yield (calculated as described above) that is tax-exempt
by one minus the stated marginal Federal income tax rate and adding the product
to that portion, if any, of the yield of the Fund that is not tax-exempt. The
taxable equivalent yield of the Fund for the one-month period ended December 31,
1996 was 8.27% for a taxpayer whose income was subject to the then highest
combined Federal and California State income tax rate of 45.22%.
The Fund's yield and average annual total return will vary from time to
time depending on market conditions, the composition of the Fund's portfolio and
operating expenses of the Fund. These factors and possible differences in the
methods used in calculating yields and returns should be considered when
comparing performance information regarding the Fund to information published
for other investment companies and other investment vehicles. Yields and return
quotations should also be considered relative to changes in the value of the
Fund's shares and the risks associated with the Fund's investment objective and
policies. At any time in the future, yields and return quotations may be higher
or lower than past yields or return quotations and there can be no assurance
that any historical yield or return quotation will continue in the future.
CUSTODIAN AGREEMENT AND INDEPENDENT ACCOUNTANTS
The Chase Manhattan Bank, N.A. (the "Bank"), 114 West 47th Street, New
York, New York, acts as Custodian of the Fund's cash and securities. The Bank
also acts as bookkeeping agent for the Fund, and in that capacity, monitors the
Fund's accounting records and calculates its net asset value.
-19-
<PAGE>
McGladrey & Pullen, LLP, 555 Fifth Avenue, New York, New York, acts as
independent public accountants for the Fund, performing an annual audit of the
Fund's financial statements and preparing its tax return.
TAXES
The following is only a summary of certain additional tax
considerations generally affecting the Fund and its shareholders that are not
described in the Prospectus. No attempt is made to present a detailed
explanation of the tax treatment of the Fund or its shareholders, and the
discussions here and in the Prospectus are not intended as substitutes for
careful tax planning.
Qualification as a Regulated Investment Company
The Fund has elected to be taxed as a regulated investment company for
federal income tax purposes under Subchapter M of the Code. As a regulated
investment company, the Fund is not subject to federal income tax on the portion
of its net investment income (i.e., taxable interest, dividends and other
taxable ordinary income, net of expenses) and capital gain net income (i.e., the
excess of capital gains over capital losses) that it distributes to
shareholders, provided that it distributes at least 90% of its investment
company taxable income (i.e., net investment income and the excess of net
short-term capital gain over net long-term capital loss) and at least 90% of its
tax-exempt income (net of expenses allocable thereto) for the taxable year (the
"Distribution Requirement"), and satisfies certain other requirements of the
Code that are described below. Distributions by the Fund made during the taxable
year or, under specified circumstances, within twelve months after the close of
the taxable year, will be considered distributions of income and gains of the
taxable year and will therefore satisfy the Distribution Requirement.
If the Fund has a net capital loss (i.e., the excess of capital losses
over capital gains) for any year, the amount thereof may be carried forward up
to eight years and treated as a short-term capital loss which can be used to
offset capital gains in such years. As of December 31, 1996, the Fund has
capital loss carryforwards of $21,892,882 expiring through December 31, 2004.
Under Code Section 382, if the Fund has an "ownership change," ten the Fund's
use of its capital loss carryforwards in any year following the ownership change
will be limited to an amount equal to the net asset value of the Fund
immediately prior to the ownership change multiplied by the highest adjusted
long-term tax-exempt rate (which is published monthly by the Internal Revenue
Service (the "IRS"))in effect for any month in the 3- calendar-
-20-
<PAGE>
month period ending with the calendar month in which the ownership change occurs
(the highest rate for the 3-month period ending in April, 1997 is 5.50%). The
Fund will use its best efforts to avoid having an ownership change. However,
because of circumstances which may be beyond the control of the Fund, there can
be no assurance that the Fund will not have, or has not already had, an
ownership change. If the Fund has or has had an ownership change, any capital
gain net income for any year following the ownership change in excess of the
annual limitation on the capital loss carryforwards will have to be distributed
by the Fund and will be taxable to shareholders as described under "Fund
Distributions" below.
In addition to satisfying the Distribution Requirement, a regulated
investment company must: (1) derive at least 90% of its gross income from
dividends, interest, certain payments with respect to securities loans, gains
from the sale or other disposition of stock or securities or foreign currencies
(to the extent such currency gains are directly related to the regulated
investment company's principal business of investing in stock or securities) and
other income (including but not limited to gains from options, futures or
forward contracts) derived with respect to its business of investing in such
stock, securities or currencies (the "Income Requirement"); and (2) derive less
than 30% of its gross income (exclusive of certain gains on designated hedging
transactions that are offset by realized or unrealized losses on offsetting
positions) from the sale or other disposition of stock, securities or foreign
currencies (or options, futures or forward contracts thereon) held for less than
three months (the "Short- Short Gain Test"). For purposes of these calculations,
gross income includes tax-exempt income. However, foreign currency gains,
including those derived from options, futures and forwards, will not in any
event be characterized as Short-Short Gain if they are directly related to the
regulated investment company's investments in stock or securities (or options or
futures thereon). Because of the Short-Short Gain Test, the Fund may have to
limit the sale of appreciated securities that it has held for less than three
months. However, the Short-Short Gain Test will not prevent the Fund from
disposing of investments at a loss, since the recognition of a loss before the
expiration of the three-month holding period is disregarded for this purpose.
Interest (including original issue discount) received by the Fund at maturity or
upon the disposition of a security held for less than three months will not be
treated as gross income derived from the sale or other disposition of such
security within the meaning of the Short-Short Gain Test. However, income that
is attributable to realized market appreciation will be treated as gross income
from the sale or other disposition of securities for this purpose.
In general, gain or loss recognized by the Fund on the disposition of
an asset will be a capital gain or loss. However,
-21-
<PAGE>
gain recognized on the disposition of a debt obligation (including municipal
obligations) purchased by the Fund at a market discount (generally, at a price
less than its principal amount) will be treated as ordinary income to the extent
of the portion of the market discount which accrued during the period of time
the Fund held the debt obligation.
Treasury Regulations permit a regulated investment company, in
determining its investment company taxable income and net capital gain (i.e.,
the excess of net long-term capital gain over net short-term capital loss) for
any taxable year, to elect (unless it has made a taxable year election for
excise tax purposes as discussed below) to treat all or any part of any net
capital loss, any net long-term capital loss or any net foreign currency loss
incurred after October 31 as if it had been incurred in the succeeding year.
In addition to satisfying the requirements described above, the Fund
must satisfy an asset diversification test in order to qualify as a regulated
investment company. Under this test, at the close of each quarter of the Fund's
taxable year, at least 50% of the value of the Fund's assets must consist of
cash and cash items, U.S. Government securities, securities of other regulated
investment companies, and securities of other issuers (as to each of which the
Fund has not invested more than 5% of the value of the Fund's total assets in
securities of such issuer does not hold more than 10% of the outstanding voting
securities of such issuer), and no more than 25% of the value of its total
assets may be invested in the securities of any one issuer (other than U.S.
Government securities and securities of other regulated investment companies),
or in two or more issuers which the Fund controls and which are engaged in the
same or similar trades or businesses.
If for any taxable year the Fund does not qualify as a regulated
investment company, all of its taxable income (including its net capital gain)
will be subject to tax at regular corporate rates without any deduction for
distributions to shareholders, and such distributions will be taxable to the
shareholders as ordinary dividends to the extent of the Fund's current and
accumulated earnings and profits. Such distributions generally will be eligible
for the dividends-received deduction in the case of corporate shareholders.
Excise Tax on Regulated Investment Companies
A 4% non-deductible excise tax is imposed on a regulated investment
company that fails to distribute in each calendar year an amount equal to 98% of
ordinary taxable income for the calendar year and 98% of capital gain net income
for the one-year period ended on October 31 of such calendar year (or, at the
election of
-22-
<PAGE>
a regulated investment company having a taxable year ending November 30 or
December 31, for its taxable year (a "taxable year election")). (Tax-exempt
interest on municipal obligations is not subject to the excise tax.) The balance
of such income must be distributed during the next calendar year. For the
foregoing purposes, a regulated investment company is treated as having
distributed any amount on which it is subject to income tax for any taxable year
ending in such calendar year.
For purposes of the excise tax, a regulated investment company shall:
(1) reduce its capital gain net income (but not below its net capital gain) by
the amount of any net ordinary loss for the calendar year; and (2) exclude
foreign currency gains and losses incurred after October 31 of any year (or
after the end of its taxable year if it has made a taxable year election) in
determining the amount of ordinary taxable income for the current calendar year
(and, instead, include such gains and losses in determining ordinary taxable
income for the succeeding calendar year).
The Fund intends to make sufficient distributions or deemed
distributions of its ordinary taxable income and capital gain net income prior
to the end of each calendar year to avoid liability for the excise tax. However,
investors should note that the Fund may in certain circumstances be required to
liquidate portfolio investments to make sufficient distributions to avoid excise
tax liability.
Fund Distributions
The Fund anticipates distributing substantially all of its investment
company taxable income for each taxable year. Such distributions will be taxable
to shareholders as ordinary income and treated as dividends for federal income
tax purposes, but will not qualify for the 70% dividends-received deduction for
corporate shareholders.
The Fund may either retain or distribute to shareholders its net
capital gain for each taxable year. The Fund currently intends to distribute any
such amounts. Net capital gain that is distributed and designated as a capital
gain dividend will be taxable to shareholders as long-term capital gain,
regardless of the length of time the shareholder has held his shares or whether
such gain was recognized by the Fund prior to the date on which the shareholder
acquired his shares.
The Fund intends to qualify to pay exempt-interest dividends by
satisfying the requirement that at the close of each quarter of the Fund's
taxable year at least 50% of the Fund's total assets consists of tax-exempt
municipal obligations. Distributions
-23-
<PAGE>
from the Fund will constitute exempt-interest dividends to the extent of the
Fund's tax-exempt interest income (net of expenses and amortized bond premium).
Exempt-interest dividends distributed to shareholders of the Fund are excluded
by them from gross income for federal income tax purposes. However, shareholders
required to file federal income tax returns will be required to report the
receipt of exempt-interest dividends on their returns. Moreover, while
exempt-interest dividends are excluded from gross income for federal income tax
purposes, they may be subject to alternative minimum tax ("AMT") in certain
circumstances and may have other collateral tax consequences discussed below.
Distributions by the Fund of any investment company taxable income or of any net
capital gain will be taxable to shareholders as discussed above.
AMT is imposed in addition to, but only to the extent it exceeds, the
regular tax and is computed -- at a maximum marginal rate of 28% for
noncorporate taxpayers and 20% for corporate taxpayers -- on the excess of the
taxpayer's alternative minimum taxable income ("AMTI") over an exemption amount.
Exempt- interest dividends derived from certain "private activity" municipal
obligations issued after August 7, 1986 will generally constitute an item of tax
preference includable in AMTI for both corporate and noncorporate taxpayers. In
addition, exempt-interest dividends derived from all municipal obligations,
regardless of the date of issue, must be included in adjusted current earnings,
which are used in computing an additional corporate preference item (i.e., 75%
of the excess of a corporate taxpayer's adjusted current earnings over its AMTI
(determined without regard to this item and the AMT net operating loss
deduction)) includable in AMTI.
Exempt-interest dividends must be taken into account in computing the
portion, if any, of social security or railroad retirement benefits that must be
included in an individual shareholder's gross income and subject to federal
income tax. Further, a shareholder of the Fund is denied a deduction for
interest on indebtedness incurred or continued to purchase or carry shares of
the Fund. Moreover, a shareholder who is (or is related to) a "substantial user"
of a facility financed by industrial development bonds held by the Fund will
likely be subject to tax on dividends paid by the Fund which are derived from
interest on such bonds. Receipt of exempt-interest dividends may result in other
collateral federal income tax consequences to certain taxpayers, including
financial institutions, property and casualty insurance companies and foreign
corporations engaged in a trade or business in the United States. Prospective
investors should consult their own tax advisers as to such consequences.
Distributions by the Fund that do not constitute ordinary income
dividends, exempt-interest dividends or capital gain dividends will be treated
as a return of capital to the extent of (and in reduction of) the shareholder's
tax basis in his shares;
-24-
<PAGE>
any excess will be treated as gain from a sale of the shares, as discussed
below.
Distributions by the Fund will be treated in the manner described above
regardless of whether such distributions are paid in cash or reinvested in
additional shares of the Fund (or of another fund). Shareholders receiving a
distribution in the form of additional shares will be treated as receiving a
distribution in an amount equal to the fair market value of the shares received,
determined as of the reinvestment date. In addition, if the net asset value at
the time a shareholder purchases shares of the Fund reflects undistributed
income or gain, or unrealized appreciation in the value of assets held by the
Fund, a subsequent distribution of such amounts will be taxable to the
shareholder in the manner described above, although it economically constitutes
a return of capital.
Ordinarily, shareholders are required to take distributions by the Fund
into account in the year in which they are made. However, dividends declared in
October, November or December of any year and payable to shareholders of record
on a specified date in such a month will be deemed to have been received by the
shareholders (and made by the Fund) on December 31 of such calendar year if such
dividends are actually paid in January of the following year. Shareholders will
be advised annually as to the U.S. federal income tax consequences of
distributions made (or deemed made) to them during the year.
The Fund will be required in certain cases to withhold and remit to the
U.S. Treasury 31% of ordinary income and capital gain dividends, and the
proceeds of redemption of shares, paid to any shareholder who (1) has provided
either an incorrect tax identification number or no number at all, (2) is
subject to backup withholding for failure to report the receipt of interest or
dividend income properly, or (3) has failed to certify to the Fund that it is
not subject to backup withholding or that it is an "exempt recipient" (such as a
corporation).
Sale or Redemption of Shares
A shareholder will recognize gain or loss on the sale or redemption of
shares of the Fund in an amount equal to the difference between the proceeds of
the sale or redemption and the shareholder's adjusted tax basis in the shares.
All or a portion of any loss so recognized may be disallowed if the shareholder
purchases other shares of the Fund within 30 days before or after the sale or
redemption. In general, any gain or loss arising from (or treated as arising
from) the sale or redemption of shares of the Fund will be considered capital
gain or loss and will be long-term capital gain or loss if the shares were held
for longer than
-25-
<PAGE>
one year. However, any capital loss arising from the sale or redemption of
shares held for six months or less will be disallowed to the extent of the
amount of exempt-interest dividends received on such shares and (to the extent
not disallowed) will be treated as a long-term capital loss to the extent of the
amount of capital gain dividends received on such shares. For this purpose, the
special holding period rules of Code Section 246(c)(3) and (4) generally will
apply in determining the holding period of shares. Long-term capital gains of
noncorporate taxpayers are currently taxed at a maximum rate 11.6% lower than
the maximum rate applicable to ordinary income. Capital losses in any year are
deductible only to the extent of capital gains plus, in the case of a
noncorporate taxpayer, $3,000 of ordinary income.
Foreign Shareholders
Taxation of a shareholder who, as to the United States, is a
nonresident alien individual, foreign trust or estate, foreign corporation, or
foreign partnership ("foreign shareholder"), depends on whether the income from
the Fund is "effectively connected" with a U.S. trade or business carried on by
such shareholder.
If the income from the Fund is not effectively connected with a U.S.
trade or business of a foreign shareholder, ordinary income dividends paid to
the shareholder will be subject to U.S. withholding tax at the rate of 30% (or
lower applicable treaty rate) on the gross amount of the dividend. Such a
foreign shareholder would generally be exempt from U.S. federal income tax on
gains realized on the sale of shares of the Fund, capital gain dividends and
exempt-interest dividends and amounts retained by the Fund that are designated
as undistributed capital gains.
If the income from the Fund is effectively connected with a U.S. trade
or business of a foreign shareholder, then ordinary income and capital gain
dividends received in respect of, and any gains realized on the sale of, shares
of the Fund will be subject to U.S. federal income tax at the rates applicable
to U.S. citizens or domestic corporations.
In the case of a foreign noncorporate shareholder, the Fund may be
required to withhold U.S. federal income tax at a rate of 31% on distributions
that are otherwise exempt from withholding (or taxable at a reduced treaty
rate), unless the shareholder furnishes the Fund with proper notification of its
foreign status.
The tax consequences to a foreign shareholder entitled to claim the
benefits of an applicable tax treaty may be different from those described
herein. Foreign shareholders are urged to consult their own tax advisers with
respect to the particular tax
-26-
<PAGE>
consequences to them of an investment in the Fund, including the applicability
of foreign taxes.
Effect of Future Legislation; Local Tax Considerations
The foregoing general discussion of U.S. federal income tax
consequences is based on the Code and Treasury Regulations issued thereunder as
in effect on the date of this Statement. Future legislative or administrative
changes or court decisions may significantly change the conclusions expressed
herein, perhaps with retroactive effect.
Rules of state and local taxation of ordinary income dividends,
exempt-interest dividends and capital gain dividends from regulated investment
companies often differ from the rules for U.S. federal income taxation described
above. Shareholders are urged to consult their tax advisers as to the
consequences of these and other state and local tax rules affecting investment
in the Fund.
PORTFOLIO TRANSACTIONS
The Fund's management provides the Fund with investment advice and
recommendations for the purchase and sale of portfolio securities. Newly issued
securities are usually purchased from the issuer or an underwriter, at prices
including underwriting fees; other purchases and sales are usually placed with
those dealers from whom it appears that the best price or execution will be
obtained. All orders for the purchase and sale of portfolio securities are
placed by the Fund's management, subject to the general control of the Fund's
Trustees. The Fund's management may sell portfolio securities prior to their
maturity if market conditions and other considerations indicate, in the opinion
of the Fund's management, that such sale would be advisable. In addition, the
Fund's management may engage in short-term trading when it believes it is
consistent with the Fund's investment objective. Also, a security may be sold
and another of comparable quality may be simultaneously purchased to take
advantage of what the Fund's management believes to be a temporary disparity in
the normal yield relationship of two securities. The frequency of portfolio
transactions -- the Fund's turnover rates -- will vary from year to year
depending upon market conditions. For the years ended December 31, 1996 and 1995
, the Fund's annual rate of portfolio turnover was approximately 89.83% and
53.27%, respectively. Because a high turnover rate increases transaction costs
and the possibility of taxable short-term gains (see "Dividends and Tax Status"
in the Fund's Prospectus), the Fund's management weighs the added costs of
short-term investment against anticipated gains. The Fund's management is
generally responsible for the
-27-
<PAGE>
implementation, or supervision of the implementation, of investment decisions,
including the allocation of principal business and portfolio brokerage, and the
negotiation of commissions.
It is the Fund's policy to seek execution of its purchases and sales at
the most favorable prices through responsible broker-dealers and, in agency
transactions, at competitive commission rates. When considering broker-dealers,
the Fund will take into account such factors as the price of the security, the
size and difficulty of the order, the rate of commission, if any, the
reliability, financial condition, integrity and general execution and
operational capabilities of competing broker-dealers, and the brokerage and
research services which they provide to the Fund's management. During the years
1986 through 1993, no brokerage commissions were paid by the Fund; all portfolio
transactions were conducted with dealers acting as principal.
The Board of Trustees of the Fund is authorized to adopt a brokerage
allocation policy pursuant to the Securities Exchange Act of 1934 which would
permit the Fund to pay a broker-dealer which does not furnish research services,
or which furnishes research brokerage and research services provided by the
broker-dealer.
Section 28(e)(3) of the Securities and Exchange Act of 1934 defines
"Brokerage and Research Services" as including, among other things, advice as to
the value of securities, the advisability of investing in, purchasing or selling
securities, the availability of securities or purchasers or sellers of
securities, furnishing analyses and reports concerning issuers, industries,
securities, economic factors and trends, portfolio strategy and performance of
accounts, and effecting securities transactions and performing functions
incidental thereto (such as clearance and settlement).
It will not be the Fund's practice to allocate principal business or
brokerage on the basis of sales of Fund shares which may be made through brokers
and dealers, although broker-dealers effecting purchases of Fund shares for
their customers may participate in principal transactions or brokerage
allocation as described above.
From January 1, 1990 to January 31, 1996, the Manager directed
syndicate designations in the aggregate dollar amount of $858,094 to Capital
Institutional Services, Inc. ("CIS") in connection with the Fundamental Funds'
bond purchases through underwriting syndicates. The Manager has represented that
CIS, a third-party research provider, at the Manager's direction, paid portions
of such syndicate designations to approximately 30 different firms that provided
research services used by the Manager in managing the Fundamental Funds,
including Capital Market
-28-
<PAGE>
Services, Inc. ("CMS"). Further, that CMS was paid by CIS $115,000 for research
provided to the Manager. The $115,000 dollar amount paid by CIS to CMS for the
following fiscal years of the Fund was: $35,000 in 1995; $55,000 in 1994; and
$25,000 in 1993. The Manager has also represented that it learned in 1996 that
at all times during the years 1993, 1994 and 1995, CMS was 100% owned by Mr.
Donald E. Newell's wife. Mr. Vincent J. Malanga and Mr. Donald E. Newell are
each executive officers and 50% shareholders of LaSalle Portfolio Management,
Inc. In order to remove any appearance of impropriety concerning all of the
payments made by CIS to CMS in return for research the Manager obtained from
CMS, the Manager reimbursed Fundamental U. S. Government Strategic Income Fund
(the beneficiary of the research) $115,000 out of its own resources.
ADDITIONAL INFORMATION ABOUT THE ORGANIZATION OF THE FUND
The Fund's Declaration of Trust contains an express disclaimer of
shareholder liability for the Fund's acts and oblig ations and requires the Fund
to give notice of such disclaimer in each agreement, obligation or instrument
entered into by the Fund or its Trustees. The Declaration of Trust also provides
that the Fund shall, upon request, assume the defense of any claim made against
any shareholder for any act or obligation of the Fund and satisfy any judgment
thereof. Thus, while Massachusetts laws permit a shareholder of a trust such as
this to be held personally liable under certain circumstances, the risk of a
shareholder incurring financial loss on account of shareholder liability is
highly unlikely and is limited to the highly remote circumstances in which the
Fund would be unable to meet its obligations.
The Fund's Declaration of Trust permits the Trustees to issue an
unlimited number of full and fractional shares of a single class and to divide
or combine the shares into a greater or lesser number of shares without thereby
changing the proportionate beneficial interests in the Fund. Each share
represents an interest in the Fund proportionately equal to the interest of each
other share. Certificates representing the shares of the Fund will not be
issued. Upon liquidation of the Fund, all shareholders of the Fund would share
pro rata in the net assets of the Fund available for distribution to
shareholders. If they deem it advisable and in the best interest of
shareholders, the Board of Trustees of the Fund may create additional classes of
shares which may be different from each other only as to dividends or each of
which may have separate assets and liabilities (in which case any such class
would have a designation including the word "Series"). If additional classes
designated as Series were created, shares of each Series would be entitled to
vote as a Series only to the extent required by the 1940 Act or as permitted by
the Board of Trustees. Rule 18f-2 under the 1940 Act provides that any matter
required by the provisions of the 1940 Act or applicable state law, or
otherwise, to be submitted to the holders of the outstanding
-29-
<PAGE>
voting securities of an investment company such as the Fund, shall not be deemed
to have been effectively acted upon unless approved by the holders of a majority
of the outstanding shares of each Series affected by such matter. Rule 18f-2
further provides that a Series shall be deemed to be affected by a matter unless
it is clear that the interests of each Series in the matter are substantially
identical or that the matter does not significantly affect any interest of such
Series. An example of a matter that would be voted on by each Series is approval
of an investment advisory agreement. However, the Rule exempts the selection of
independent public accountants, the approval of contracts with principal
underwriters and the election of Trustees from the separate voting requirements
of the Rule. Income, direct liabilities and expenses of the Fund not directly
allocable to a particular Series would be allocated among the Series in
proportion to the relative net assets of each Series by the Board of Trustees.
Allocations would be made as often as necessary to comply with Rule 2a-4 under
the 1940 Act.
INFORMATION WITH RESPECT TO CALIFORNIA STATE
AND MUNICIPAL FINANCES
Certain California (the "State") constitutional amendments, legislative
measures, executive orders, civil actions and voter initiatives, as well as the
general financial condition of the State, could adversely affect the ability of
issuers of California Municipal Obligations to pay interest and principal on
such obligations. The following information constitutes only a brief summary,
does not purport to be a complete description, and is based on information drawn
from official statements relating to securities offerings of the State of
California and various local agencies, available as of the date of this
Statement of Additional Information. While the Fund has not independently
verified such information, it has no reason to believe that such information is
not correct in all material respects.
Recent Developments. From mid-1990 to late 1993, the State suffered a
recession with the worst economic, fiscal and budget conditions since the 1930s.
Construction, manufacturing (especially aerospace), exports and financial
services, among others, were all severely affected. Job losses have been the
worst of any post-war recession. Unemployment reached 10.1% in January 1994, but
fell sharply to 7.7% in October and November 1994. According to the State's
Department of Finance, recovery from the recession in California began in 1994.
The recession seriously affected State tax revenues, which basically
mirror economic conditions. It also has caused increased expenditures for health
and welfare programs. The State also has been facing a structural imbalance in
its budget with the largest programs supported by the General Fund (K-12 schools
and
-30-
<PAGE>
community colleges, health and welfare, and corrections) growing at rates higher
than the growth rates for the principal revenue sources of the General Fund. As
a result, the State experienced recurring budget deficits in the late 1980s and
early 1990s. The State Controller reported that expenditures exceeded revenues
for four of the five fiscal years ending with 1991-92. The State had an
operating surplus of approximately $109 million in 1992-93 and $836 million in
1993- 94. However, at June 30, 1994, according to the Department of Finance, the
State's Special Fund for Economic Uncertainties ("SFEU") still had a deficit, on
a budget basis, of approximately $1.8 billion.
The accumulated budget deficits over the past several years, together
with expenditures for school funding which have not been reflected in the
budget, and reduction of available internal borrowable funds, have combined to
significantly deplete the State's cash resources to pay its ongoing expenses. In
order to meet its cash needs, the State has had to rely for several years on a
series of external borrowings, including borrowings past the end of a fiscal
year. Such borrowings are expected to continue in future fiscal years. To meet
its cash flow needs in the 1994-95 fiscal year the State issued, in July and
August 1994, $4.0 billion of revenue anticipation warrants which mature on April
25, 1996, and $3.0 billion of revenue anticipation notes which matured on June
28, 1995.
As a result of the deterioration in the State's budget and cash
situation, the rating agencies reduced the State's credit ratings. Between
October 1991 and July 1994, the rating on the State's general obligation bonds
was reduced by S&P from "AAA" to "A," by Moody's from "Aaa" to "A1" and by Fitch
from "AAA" to "A."
The 1994-95 Fiscal Year Budget (as updated in the January 10, 1995
Governor's Budget) projected $42.4 billion of General Fund revenues and
transfers and $41.7 billion of budgeted expenditures. In addition, the 1994-95
Budget Act anticipates deferring retirement of about $1 billion of the
accumulated budget deficit to the 1995-96 fiscal year when it is intended to be
fully retired by June 30, 1996.
The Governor's Budget for 1995-96 proposed General Fund revenues and
transfers of $42.5 billion and expenditures of $41.7 billion, which was
estimated to leave a balance of approximately $92 million in the budget reserve,
the SFEU, at June 30, 1996 after repayment of the accumulated budget deficits.
The Budget proposal is based on a number of assumptions, including receipt of
$830 million from the Federal government to offset costs of undocumented and
refugee immigrants.
On December 6, 1994, Orange County, California (the "County"), together
with its pooled investment funds (the "County
-31-
<PAGE>
Funds") filed for protection under Chapter 9 of the Federal Bankruptcy Code,
after reports that the County Funds had suffered significant market losses in
their investments, causing a liquidity crisis for the County Funds and the
County. More than 200 other public entities, most of which, but not all, are
located in the County, were also depositors in the County Funds. As of
mid-January 1995, following a restructuring of most of the County Funds' assets
to increase their liquidity and reduce their exposure to interest rate
increases, the County estimated the County Funds' loss at about $1.69 billion,
or about 23% of their initial deposits of approximately $7.5 billion. Many of
the entities which deposited monies in the County Funds, including the County,
faced interim and/or extended cash flow difficulties because of the bankruptcy
filing and may be required to reduce programs or capital projects. The County
has embarked on a fiscal recovery plan based on sharp reductions in services and
personnel, and rescheduling of outstanding short-term debt using certain new
revenues transferred to the County from other local governments pursuant to
special legislation enacted in October 1995.
The State has no existing obligation with respect to any outstanding
obligations or securities of the County or any of the other participating
entities. However, in the event the County is unable to maintain county
administered State programs because of insufficient resources, it may be
necessary for the State to intervene, but the State cannot presently predict
what, if any, action may occur.
On January 17, 1994, an earthquake of the magnitude of an estimated 6.8
on the Richter Scale struck Los Angeles causing significant damage to public and
private structures and facilities. Although some individuals and businesses
suffered losses totaling in the billions of dollars, the overall effect of the
earthquake on the regional and State economy is not expected to be serious.
STATE FINANCES
State monies are segregated into the General Fund and approximately 600
Special Funds. The General Fund consists of the revenues received into the State
Treasury and earnings from State investments, which are not required by law to
be credited to any other fund. The General Fund is the principal operating fund
for the majority of governmental activities and is the depository of most major
State revenue sources.
The SFEU is funded with General Fund revenues and was established to
protect the State from unforeseen reduced levels of revenues and/or
unanticipated expenditure increases. Amounts in the SFEU may be transferred by
the Controller as necessary to meet cash needs of the General Fund. The
Controller is required to return monies so transferred without payment of
interest as soon as
-32-
<PAGE>
there are sufficient monies in the General Fund. For budgeting and accounting
purposes, any appropriation made from the SFEU is deemed an appropriation from
the General Fund. For year-end reporting purposes, the Controller is required to
add the balance in the SFEU to the balance in the General Fund so as to show the
total monies then available for General Fund purposes.
Inter-fund borrowing has been used for many years to meet temporary
imbalances of receipts and disbursements in the General Fund. As of June 30,
1994, the General Fund had outstanding loans in the aggregate principal amount
of $43 million to the General Fund from the SFEU and outstanding loans in the
aggregate principal amount of $5.2 billion, which consisted of $4.0 billion of
internal loans to the General Fund from the SFEU and other Special Funds and
$1.2 billion of external loans represented by the 1994 revenue anticipation
warrants.
Articles XIIIA and XIIIB to the State Constitution and Other Revenue
Law Changes. Prior to 1977, revenues of the State government experienced
significant growth primarily as a result of inflation and continuous expansion
of the tax base of the State. In 1978, State voters approved an amendment to the
State Constitution known as Proposition 13, which added Article XIIIA to the
State Constitution, reducing ad valorem local property taxes by more than 50%.
In addition, Article XIIIA provides that additional taxes may be levied by
cities, counties and special districts only upon approval of not less than a
two-thirds vote of the "qualified electors" of such district, and requires not
less than a two-thirds vote of each of the two houses of the State Legislature
to enact any changes in State taxes for the purpose of increasing revenues,
whether by increased rate or changes in methods of computation.
Primarily as a result of the reductions in local property tax revenues
received by local governments following the passage of Proposition 13, the
Legislature undertook to provide assistance to such governments by substantially
increasing expenditures from the General Fund for that purpose beginning in the
1978-79 fiscal year. In recent years, in addition to such increased
expenditures, the indexing of personal income tax rates (to adjust such rates
for the effects of inflation), the elimination of certain inheritance and gift
taxes and the increase of exemption levels for certain other such taxes had a
moderating impact on the growth in State revenues. In addition, the State has
increased expenditures by providing a variety of tax credits, including renters'
and senior citizens' credits and energy credits.
The State is subject to an annual "appropriations limit" imposed by
Article XIIIB of the State Constitution adopted in 1979. Article XIIIB prohibits
the State from spending "appropriations subject to limitation" in excess of the
appropriations limit imposed. "Appropriations subject to limitations" are
autho-
-33-
<PAGE>
rizations to spend "proceeds of taxes," which consist of tax revenues, and
certain other funds, including proceeds from regulatory licenses, user charges
or other fees to the extent that such proceeds exceed "the cost reasonably borne
by such entity in providing the regulation, product or service." One of the
exclusions from these limitations is "debt service" (defined as "appropriations
required to pay the cost of interest and redemption charges, including the
funding of any reserve or sinking fund required in connection therewith, on
indebtedness existing or legally authorized as of January 1, 1979 or on bonded
indebtedness thereafter approved" by the voters). In addition, appropriations
required to comply with mandates of courts or the Federal government and,
pursuant to Proposition 111 enacted in June 1990, appropriations for qualified
capital outlay projects and appropriations of revenues derived from any increase
in gasoline taxes and motor vehicle weight fees above January 1, 1990 levels are
not included as appropriations subject to limitation. In addition, a number of
recent initiatives were structured or proposed to create new tax revenues
dedicated to certain specific uses, with such new taxes expressly exempted from
the Article XIIIB limits (e.g., increased cigarette and tobacco taxes enacted by
Proposition 99 in 1988). The appropriations limit also may be exceeded in cases
of emergency. However, unless the emergency arises from civil disturbance or
natural disaster declared by the Governor, and the appropriations are approved
by two-thirds of the Legislature, the appropriations limit for the next three
years must be reduced by the amount of the excess.
The State's appropriations limit in each year is based on the limit for
the prior year, adjusted annually for changes in California per capita personal
income and changes in population, and adjusted, when applicable, for any
transfer of financial responsibility of providing services to or from another
unit of government. The measurement of change in population is a blended average
of statewide overall population growth, and change in attendance at local school
and community college ("K-14") districts. As amended by Proposition 111, the
appropriations limit is tested over consecutive two-year periods. Any excess of
the aggregate "proceeds of taxes" received over such two-year periods above the
combined appropriations limits for those two years is divided equally between
transfers to K-14 districts and refunds to taxpayers.
As originally enacted in 1979, the State's appropriations limit was
based on its 1978-79 fiscal year authorizations to expend proceeds of taxes and
was adjusted annually to reflect changes in cost of living and population (using
different definitions, which were modified by Proposition 111). Commencing with
the 1991-92 fiscal year, the State's appropriations limit is adjusted annually
based on the actual 1986-87 limit, and as if Proposition 111 had been in effect.
The State Legislature has enacted legislation to
-34-
<PAGE>
implement Article XIIIB which defines certain terms used in Article XIIIB and
sets forth the methods for determining the State's appropriations limit.
Government Code Section 7912 requires an estimate of the State's appropriations
limit to be included in the Governor's Budget, and thereafter to be subject to
the budget process and established in the Budget Act.
For the 1990-91 fiscal year, the State appropriations limit was $32.7
billion, and appropriations subject to limitation were $7.51 billion under the
limit. The limit for the 1991-92 fiscal year was $34.2 billion, and
appropriations subject to limitations were $3.8 billion under the limit. The
limit for the 1992-93 fiscal year was $35.01 billion, and the appropriations
subject to limitation were $7.53 billion under the limit. The limit for the
1993-94 fiscal year was $36.60 billion, and the appropriations subject to
limitation were $6.74 billion under the limit. The limit for the 1994-95 fiscal
year was $37.55 billion, and the appropriations subject to limitations were
$5.93 billion under the limit. The estimated limit for the 1995-96 fiscal year
is $39.31 billion, and the appropriations subject to limitations are estimated
to be $6.47 billion under the limit.
In November 1988, State voters approved Proposition 98, which changed
State funding of public education below the university level and the operation
of the State's appropriations limit, primarily by guaranteeing K- 14 schools a
minimum share of General Fund revenues. Under Proposition 98 (as modified by
Proposition 111, which was enacted in June 1990), K-14 schools are guaranteed
the greater of (a) 40.3% of General Fund revenues ("Test 1"), (b) the amount
appropriated to K-14 schools in the prior year, adjusted for changes in the cost
of living (measured as in Article XIIIB by reference to California per capita
personal income) and enrollment ("Test 2"), or (c) a third test, which would
replace the second test in any year when the percentage growth in per capita
General Fund revenues from the prior year plus .5% is less than the percentage
growth in California per capita personal income ("Test 3"). Under "Test 3,"
schools would receive the amount appropriated in the prior year adjusted for
changes in enrollment and per capita General Fund revenues, plus an additional
small adjustment factor. If "Test 3" is used in any year, the difference between
"Test 3" and "Test 2" would become a "credit" to schools which would be the
basis of payments in future years when per capita General Fund revenue growth
exceeds per capita personal income growth.
Proposition 98 permits the Legislature by two-thirds vote of both
houses, with the Governor's concurrence, to suspend the K-14 schools' minimum
funding formula for a one-year period. In the fall of 1989, the Legislature and
the Governor utilized this provision to avoid having 40.3% of revenues generated
by a special supplemental sales tax enacted for earthquake relief go to K-14
schools. Proposition 98 also contains provisions transferring
-35-
<PAGE>
certain State tax revenues in excess of the Article XIIIB limit to K-14 schools.
The 1991-92 Budget Act, applying "Test 2" of Proposition 98,
appropriated approximately $18.5 billion for K- 14 schools pursuant to
Proposition 98. During the course of the fiscal year, revenues proved to be
substantially below expectations. By the time the Governor's Budget was
introduced in January 1992, it became clear that per capita growth in General
Fund revenues for 1991-92 would be far smaller than the growth in California per
capita personal income and the Governor's Budget therefore reflected a reduction
in Proposition 98 funding in 1991-92 by applying "Test 3" rather than "Test 2."
In response to the changing revenue situation and to fully fund the
Proposition 98 guarantee in both the 1991-92 and 1992-93 fiscal years without
exceeding it, the Legislature enacted several bills as part of the 1992-93
budget package which responded to the fiscal crisis in education funding. Fiscal
year 1991-92 Proposition 98 appropriations for K-14 schools were reduced by
$1.083 billion. In order to not adversely impact cash received by school
districts, however, a short-term loan was appropriated from the non-Proposition
98 State General Fund. The Legislature then appropriated $16.6 billion to K-14
schools for 1992-93 (the minimum guaranteed by Proposition 98), but designated
$1.083 billion of this amount to "repay" the prior year loan, thereby reducing
cash outlays in 1992-93 by that amount. In addition to reducing the 1991-92
fiscal year appropriations for K-14 schools by $1.083 billion and converting the
amount to a loan (the "inter-year adjustment"), Chapter 703, Statutes of 1992
also made an adjustment to "Test 1," based on the additional $1.2 billion of
local property taxes that were shifted to schools and community colleges. The
"Test 1" percentage changed from 40% to 37%. Additionally, Chapter 703 contained
a provision that if an appellate court should determine that the "Test 1"
recalculation or the inter-year adjustment is unconstitutional, unenforceable or
invalid, Proposition 98 would be suspended for the 1992-93 fiscal year, with the
result that K-14 schools would receive the amount intended by the 1992-93 Budget
Act compromise.
The State Controller stated in October 1992 that, because of a drafting
error in Chapter 703, he could not implement the $1.083 billion reduction of the
1991-92 school funding appropriation, which was part of the inter-year
adjustment. The Legislature untimely enacted corrective legislation as part of
the 1993-94 Budget package to implement the $1.083 billion inter-year adjustment
as originally intended.
In the 1992-93 Budget Act, a new loan of $732 million was made to K-12
schools in order to maintain per-average daily attendance ("ADA") funding at the
same level as 1991-92, at $4,187.
-36-
<PAGE>
An additional loan of $241 million was made to community college districts.
These loans are to be repaid from future Proposition 98 entitlements. (The
teachers' organization lawsuit also seeks to declare invalid the provision
making the $732 million a loan "repayable" from future years' Proposition 98
funds. Including both State and local funds, and adjusting for the loans and
repayments, on a cash basis, total Proposition 98 K-12 funding in 1992-93
increased to $21.5 billion, 2.4% more than the amount in 1992-93 ($21.0
billion).
Based on revised State tax revenues and estimated decreased reported
pupil enrollment, the 1993-94 Budget Act projected that the 1992-93 Proposition
98 Budget Act appropriations of $16.6 billion exceeded a revised minimum
guarantee by $313 million. As a result, the 1993-94 Budget Act reverted $25
million in 1992-93 appropriations to the General Fund. Limiting the reversion to
this amount ensures that per ADA funding for general purposes will remain at the
prior year level of $4,217 per pupil. The 1993-94 Governor's Budget subsequently
proposed deficiency funding of $121 million for school apportionments and
special education, increasing funding per pupil in 1992-93 to $4,244. The
1993-94 Budget Act also designated $98 million in 1992-93 appropriations toward
satisfying prior years' guarantee levels, an obligation that resulted primarily
from updating State tax revenues for 1991-92, and designates $190 million as a
loan repayable from 1993-94 funding.
The 1993-94 Budget Act projected the Proposition 98 minimum funding
level at $13.5 billion based on the "Test 3" calculation where the guarantee is
determined by the change in per capita growth in General Fund revenues, which
are projected to decrease on a year-over-year basis. This amount also takes into
account increased property taxes transferred to school districts from other
local governments.
Legislation accompanying the 1993-94 Budget Act (Chapter 66/93)
provided a new loan of $609 million to K-12 schools in order to maintain per ADA
funding at $4,217 and a loan of $178 million to community colleges.
These loans have been combined with the K-14 1992-93 loans into one loan
totalling $1.760 billion. Repayment of this loan would be from future years'
Proposition 98 entitlements, and would be conditioned on maintaining current
funding levels per pupil for K-12 schools. Chapter 66 also reduced the "Test 1"
percentage to 35% to reflect the property tax shift among local government
agencies.
The 1994-95 Budget Act appropriated $14.4 billion of Proposition 98
funds for K-14 schools based on Test 2. This exceeded the minimum Proposition 98
guarantee by $8 million to
-37-
<PAGE>
maintain K-12 funding per pupil at $4,217. Based upon updated State revenues,
growth rates and inflation factors, the 1994-95 Budget Act appropriated an
additional $286 million within Proposition 98 for the 1993-94 fiscal year, to
reflect a need in appropriations for school districts and county offices of
education, as well as an anticipated deficiency in special education fundings.
These and other minor appropriation adjustments increase the 1993-94 Proposition
98 guarantee to $13.8 billion, which exceeds the minimum guarantee in that year
by $272 million and provides per pupil funding of $4,225.
The 1995-96 Governor's Budget adjusts the 1993-94 minimum guarantee to
reflect changes in enrollment and inflation, and 1993-94 Proposition 98
appropriations were increased to $14.1 billion, primarily to reflect changes in
the statutory continuous appropriation for apportionments. The revised
appropriations now exceed the minimum guarantee by $32 million. This
appropriation level still provides per-pupil funding of $4,225.
The 1994-95 Proposition 98 minimum guarantee also has been adjusted for
changes in factors described above, and is now calculated to be $14.9 billion.
Within the minimum guarantee, the dollars per pupil have been maintained at the
prior year's level; consequently, the 1994-95 minimum guarantee now includes a
loan repayment of $135 million, and the per- pupil funding increases to $4,231.
The 1995-96 Governor's Budget proposes to appropriate $15.9 billion of
Proposition 98 funds to K-14 to meet the guarantee level. Included within the
guarantee is a loan repayment of $379 million for the combined outstanding loans
of $1.76 billion. Funding per pupil is estimated to increase by $61 over 1994-95
to $4,292.
SOURCES OF TAX REVENUE
The California personal income tax, which in 1994-95 contributed about
43% of General Fund revenues, is closely modeled after the Federal income tax
law. It is imposed on net taxable income (gross income less exclusions and
deductions). The tax is progressive with rates ranging from 1% to 9.3%.
Personal, dependent, and other credits are allowed against the gross tax
liability. In addition, taxpayers may be subject to an alternative minimum tax
("AMT") which is much like the Federal AMT. This is designed to ensure that
excessive use of tax preferences does not reduce taxpayers' liabilities below
some minimum level. Legislation enacted in July 1991 added two new marginal tax
rates, at 10% and 11%, effective for tax years 1991 through 1995.
The personal income tax is adjusted annually by the change in the
consumer price index to prevent taxpayers from being
-38-
<PAGE>
pushed into higher tax brackets without a real increase in income.
The sales tax is imposed upon retailers for the privilege of selling
tangible personal property in California. Most retail sales and leases are
subject to the tax. However, exemptions have been provided for certain
essentials such as food for home consumption, prescription drugs, gas,
electricity and water. Sales tax accounted for about 34% of General Fund revenue
in 1994-95. Bank and corporation tax revenues comprised about 13% of General
Fund revenue in 1994-95. In 1989, Proposition 99 added a 25 cents per pack
excise tax on cigarettes, and a new equivalent excise tax on other tobacco
products. Legislation enacted in 1993 added an additional 2 cents per pack for
the purpose of funding breast cancer research.
GENERAL FINANCIAL CONDITION OF THE STATE
In the years following enactment of the Federal Tax Reform Act of 1986,
and conforming changes to the State's tax laws, taxpayer behavior became more
difficult to predict, and the State experienced a series of fiscal years in
which revenue came in significantly higher or lower than original estimates. The
1989-90 fiscal year ended with revenues below estimates and the SFEU was fully
depleted by June 30, 1990. This date essentially coincided with the date of the
most recent recession, and the State subsequently accumulated a budget deficit
in the SFEU approaching $2.8 billion at its peak. The State's budget problems in
recent years also have been caused by a structural imbalance which has been
identified by the current and previous Administrations. The largest General Fund
programs -- K-14 education, health, welfare and corrections -- were increasing
faster than the revenue base, driven by the State's rapid population increases.
Starting in the 1990-91 fiscal year, each budget required multibillion
dollar actions to bring projected revenues and expenditures into balance and to
close large "budget gaps" which were identified. The Legislature and Governor
eventually agreed on significant cuts in program expenditures, some transfers of
program responsibilities and funding from the State to local governments,
revenue increases (particularly in the 1991-92 fiscal year budget), and various
one-time adjustments and accounting changes. However, as the recession took hold
and deepened after the summer of 1990, revenues dropped sharply and expenditures
for health and welfare programs increased as job losses mounted, so that the
State ended each of the 1990- 91 and 1991-92 fiscal years with an unanticipated
deficit in the budget reserve, the SFEU, as compared to projected positive
balances.
As a result of the revenue shortfalls accumulating for the previous two
fiscal years, the Controller in April 1992
-39-
<PAGE>
indicated that cash resources (including borrowing from Special Funds) would not
be sufficient to meet all General Fund obligations due on June 30 and July 1,
1992. On June 25, 1992, the Controller issued $475 million of 1992 Revenue
Anticipation Warrants (the "1992 Warrants") in order to provide funds to cover
all necessary payments from the General Fund at the end of the 1991- 92 fiscal
year and on July 1, 1992. The 1992 Warrants were paid on July 24, 1992. In
addition to the 1992 Warrants, the Controller reported that as of June 30, 1992,
the General Fund had borrowed $1.336 billion from the SFEU and $4.699 billion
from other Special Funds, using all but about $183 million of borrowable cash
resources.
To balance the 1992-93 Governor's Budget, program reductions totalling
$4.365 billion and a revenue and transfer increase of $872 million were proposed
for the 1991-92 and 1992 -93 fiscal years. Economic performance in the State
continued to be sluggish after the 1992-93 Governor's Budget was prepared. By
the time of the "May Revision," issued on May 20, 1992, the Administration
estimated that the 1992-93 Budget needed to address a gap of about $7.9 billion,
much of which was needed to repay the accumulated budget deficits of the
previous two years.
The severity of the budget actions needed led to a long delay in
adopting the budget. With the failure to enact a budget by July 1, 1992, the
State had no legal authority to pay many of its vendors until the budget was
passed. Starting on July 1, 1992, the Controller was required to issue
"registered warrants" in lieu of normal warrants backed by cash to pay many
State obligations. Available cash was used to pay constitutionally mandated and
priority obligations, such as debt service on bonds and revenue anticipation
warrants. Between July 1 and September 4, 1992, the Controller issued an
aggregate of approximately $3.8 billion of registered warrants payable from the
General Fund, all of which were called for redemption by September 4, 1992
following enactment of the 1992-93 Budget Act and issuance by the State of $3.3
billion of interim notes.
The Legislature enacted the 1992-93 Budget Bill on August 29, 1992, and
it was signed by the Governor on September 2, 1992. The 1992-93 Budget Act
provided for expenditures of $57.4 billion and consisted of General Fund
expenditures of $40.8 billion and Special Fund and Bond Fund expenditures of
$16.6 billion. The Department of Finance estimated a balance in the SFEU of $28
million on June 30, 1993.
The $7.9 billion budget gap was closed primarily through cuts in the
program expenditures (principally for health and welfare programs, aid to
schools and support for higher education), together with some increases in
revenues from accelerated collections and changes in tax laws to confirm to
Federal law changes, and a variety of on-time inter-fund transfers and
deferrals. The other major component of the budget compromise was
-40-
<PAGE>
a law requiring local governments to transfer a total of $1.3 billion to K-12
school and community college districts, thereby reducing by that amount General
Fund support for those districts under Proposition 98.
In May 1993, the Department of Finance projected that the General Fund
would end the fiscal year on June 30, 1993 with an accumulated budget deficit of
about $2.8 billion, and a negative fund balance of about $2.2 billion (the
difference being certain reserves for encumbrances and school funding costs). As
a result, the State issued $5 billion of revenue anticipation notes and
warrants.
The Governor's 1993-94 Budget, introduced on January 8, 1993, proposed
General Fund expenditures of $37.3 billion, with projected revenues of $39.9
billion. It also proposed Special Fund expenditures of $12.4 billion and Special
Fund revenues of $12.1 billion. The 1993-94 fiscal year represented the third
consecutive year the Governor and the Legislature were faced with a very
difficult budget environment, requiring revenue actions and expenditure cuts
totaling billions of dollars to produce a balanced budget. To balance the budget
in the face of declining revenues, the Governor proposed a series of revenue
shifts from local government, reliance on increased Federal aid and reductions
in state spending.
The "May Revision" of the Governor's Budget, released on May 20, 1993,
indicated that the revenue projections of the January Budget Proposal were
tracking well, with the full year 1992-93 about $80 million higher than the
January projection. Personal income tax revenue was higher than projected, sales
tax was close to target, and bank and corporation taxes were lagging behind
projections. The May Revision projected the State would have an accumulated
deficit of about $2.75 billion by June 30, 1993. The Governor proposed to
eliminate this deficit over an 18-month period. He also agreed to retain the
0.5% sales tax scheduled to expire June 30 for a six-month period, dedicated to
local public safety purposes, with a November election to determine a permanent
extension. Unlike previous years, the Governor's Budget and May Revision did not
calculate a "gap" to be closed, but rather set forth revenue and expenditure
forecasts and proposals designed to produce a balanced budget.
The 1993-94 Budget Act was signed by the Governor on June 30, 1993,
along with implementing legislation. The Governor vetoed about $71 million in
spending. With enactment of the Budget Act, the State carried out its regular
cash flow borrowing program for the fiscal year, which included the issuance of
approximately $2 billion of revenue anticipation notes that matured on June 28,
1994.
-41-
<PAGE>
The 1993-94 Budget Act was predicated on General Fund revenues and
transfers estimated at $40.6 billion, about $700 million higher than the January
Governor's Budget, but still about $400 million below 1992-93 (and the second
consecutive year of actual decline). The principal reasons for declining
revenues were the continued weak economy and the expiration (or repeal) of three
fiscal steps taken in 1991--a half cent temporary sales tax, a deferral of
operating loss carry forwards, and repeal by initiative of a sales tax on candy
and snack foods.
The 1993-94 Budget Act also assumed Special Fund revenues of $11.9
billion, an increase of 2.9% over 1992-93.
The 1993-94 Budget Act included General Fund expenditures of $38.5
billion (a 6.3% reduction from projected 1992-93 expenditures of $41.1 billion),
in order to keep a balanced budget within the available revenues. The Budget
also included Special Fund expenditures of $12.1 billion, a 4.2% increase.
The 1993-94 Budget Act contained no General Fund tax/revenue increases
other than a two year suspension of the renters' tax credit.
Administration reports during the course of the 1993- 94 fiscal year
indicated that while economic recovery appeared to have started in the second
half of the fiscal year, recessionary conditions continued longer than had been
anticipated when the 1993-94 Budget Act was adopted. Overall, revenues for the
1993 -94 fiscal year were about $800 million lower than original projections,
and expenditures were about $780 million higher, primarily because of higher
health and welfare caseloads, lower property taxes which require greater State
support for K-14 education to make up to shortfall, and lower than anticipated
Federal government payments for immigration-related costs. The reports in May
and June 1994, indicated that revenues in the second half of the 1993-94 fiscal
year were very close to the projections made in the Governor's Budget of January
10, 1994, which was consistent with a slow turn around in the economy.
The Department of Finance's July 1994 Bulletin, which included final
June receipts, reported that June revenues were $114 million (2.5%) above
projection, with final end-of-year results at $377 million (about 1%) above the
May Revision projections. Part of this result was due to the end-of- year
adjustments and reconciliations. Personal income tax and sales tax continued to
track projections. The largest factor in the higher than anticipated revenues
was from bank and corporation taxes, which were $140 million (18.4%) above
projection in June.
During the 1993-94 fiscal year, the State implemented the Deficit
Retirement Plan, which was part of the 1993-94 Budget Act,
-42-
<PAGE>
by issuing $1.2 billion of revenue anticipation warrants in February 1994 that
matured December 21, 1994. This borrowing reduced the cash deficit at the end of
the 1993-94 fiscal year. Nevertheless, because of the $1.5 billion variance from
the original 1993-94 Budget Act assumptions, the General Fund ended the fiscal
year at June 30, 1994 carrying forward an accumulated deficit of approximately
$1.8 billion.
Because of the revenue shortfall and the State's reduced internal
borrowable cash resources, in addition to the $1.2 billion of revenue
anticipation warrants issued as part of the Deficit Retirement Plan, the State
issued an additional $2.0 billion of revenue anticipation warrants that matured
July 26, 1994, which were needed to fund the State's obligations and expenses
through the end of the 1993-94 fiscal year.
The 1994-95 fiscal year represented the fourth consecutive year the
Governor and Legislature were faced with a very difficult budget environment to
produce a balanced budget. Many program cost and budgetary adjustments had
already been made in the last three years. The Governor's Budget Proposal, as
updated in May and June 1994 , recognized that the accumulated deficit could not
be repaid in one year, and proposed a two- year solution. The budget proposal
set forth revenue and expenditure forecasts and revenue and expenditure
proposals which estimated operating surpluses for the budget for both 1994-95
and 1995- 96, and lead to the elimination of the accumulated budget deficit,
estimated at about $1.8 billion at June 30, 1994, by June 30, 1996.
The 1994-95 Budget Act, signed by the Governor on July 8, 1994,
projected revenues and transfers of $41.9 billion, $2.1 billion higher than
revenues in 1993-94. This reflected the Administration's forecast of an
improving economy. Also included in this figure was the projected receipt of
about $360 million from the Federal government to reimburse the State's cost of
incarcerating undocumented immigrants, most of which eventually was not
received.
The 1994-95 Budget Act projected Special Fund revenues of $12.1
billion, a decrease of 2.4% from 1993-94 estimated revenues.
The 1994-95 Budget Act projected General Fund expenditures of $40.9
billion, an increase of $1.6 billion over the 1993-94 fiscal year.
The 1994-95 Budget Act also projected Special Fund expenditures of
$13.7 billion, a 5.4% increase over 1993-94 fiscal year estimated expenditures.
-43-
<PAGE>
The 1994-95 Budget Act contained no tax increases. Under legislation
enacted for the 1993-94 Budget Act, the renters' tax credit was suspended for
two years (1993 and 1994). A ballot proposition to permanently restore the
renters' tax credit after 1995 failed at the June 1994 election. The Legislature
enacted a further one-year suspension of the renters' tax credit, for 1995,
saving about $390 million in the 1995-96 fiscal year.
The 1994-95 Budget Act assumed that the State would use a cash flow
borrowing program in 1994-95 which combines one -year notes and two-year
warrants, which were issued. Issuance of the warrants allows the State to defer
repayment of approximately $1.0 billion of its accumulated budget deficit into
the 1995-96 fiscal year. The Budget Adjustment Law enacted along with the
1994-95 Budget Act is designed to ensure that the warrants will be repaid in the
1995-96 fiscal year.
The Department of Finance Bulletin for April 1995 reported that General
Fund revenues for March 1995 were $28 million, or 1.1%, below forecast, and that
year-to-date General Fund revenues were $110 million, or 0.4%, below forecast.
Initial analysis of the Federal fiscal year 1995 budget by the
Department of Finance indicates that about $98 million was appropriated for
California to offset costs of incarceration of undocumented and refugee
immigrants, less than the $356 million which was assumed in the State's 1994-95
Budget Act.
For the first time in four years, the State entered the 1995-96 fiscal
year with strengthening revenues based on an improving economy. On January 10,
1995, the Governor presented his 1995-96 Fiscal Year Budget Proposal (the
"Proposed Budget"). The Proposed Budget estimated General Fund revenues and
transfers of $42.5 billion (an increase of 0.2% over 1994- 95). This nominal
increase from 1994-95 fiscal year reflected the Governor's realignment proposal
and the first year of his tax cut proposal. Without these two proposals, General
Fund revenues would have been projected at approximately $43.8 billion, or an
increase of 3.3% over 1994-95. Expenditures were estimated at $41.7 billion
(essentially unchanged from 1994-95). Special Fund revenues were estimated at
$13.5 billion (10.7% higher than 1994-95) and Special Fund expenditures were
estimated at $13.8 billion (12.2% higher than 1994-95). The Proposed Budget
projected that the General Fund would end the fiscal year at June 30, 1996 with
a budget surplus in SFEU of about $92 million, or less than 1% of General Fund
expenditures, and will have repaid all of the accumulated budget deficits. The
Department of Finance projected in June 1996 that the General Fund would end the
fiscal year at June 30, 1996 with a budget surplus in SFEU of $28 million.
-44-
<PAGE>
On January 10, 1996, the Governor released his proposed budget for the
Fiscal Year 1996-97 (the "Governor's Budget"). The Governor requested total
General Fund appropriations of about $45.2 billion, based on projected revenues
and transfers of about $45.6 billion, which would leave a budget reserve in SFEU
at June 30, 1997 of about $400 million. The Governor renewed a proposal, which
had been rejected by the Legislature in 1995, for a 15% phased cut in individual
and corporate tax rates over three years (the budget proposal assumes this will
be enacted, reducing revenues in 1996-97 by about $600 million). There was also
a proposal to restructure trial court funding in a way which would result in a
$300 million decrease in General Fund revenues. The Governor requested
legislation to make permanent a moratorium on cost of living increases for
welfare payments, and suspension of a renters tax credit, which otherwise would
go back into effect in the 1996-97 Fiscal Year. He further proposed additional
cuts in certain health and welfare programs, and assumed that cuts previously
approved by the Legislature will receive Federal approval. The Governor's Budget
proposes increases in funding for K-12 schools under Proposition 98, for State
higher education systems (with a second year of no student fee increases), and
for corrections. The Governor's Budget projects external cash flow borrowing of
up to $3.2 billion, to mature by June 30, 1997.
RECENT ECONOMIC TRENDS
Revised employment data indicate that California's recession ended in
1993, and following a period of stability, a solid recovery is now underway. The
State's unemployment rate fell sharply last year, from 10.1% in January to 7.7%
in October and November 1994. The gap between the national and California
jobless rates narrowed from 3.4 percentage points at the beginning of 1994 to an
average of 2 percentage points in October and November. The number of unemployed
Californians fell by nearly 400,000 during the year, while civilian employment
increased more than 300,000 in 1994.
Other indicators, including retail sales, homebuilding activity,
existing home sales and bank lending volume all confirm the State's recovery.
Personal income was severely affected by the Northridge Earthquake,
which reduced the first quarter 1994 figure by $22 billion at an annual rate,
reflecting the uninsured damage to residences and unincorporated businesses. As
a result, personal income growth for all of 1994 was about 4.2%. However,
excluding the Northridge effects, growth would have been in excess of 5%.
Personal income is expected to grow 6.6% for 1995.
-45-
<PAGE>
OTHER INFORMATION
As of March 31, 1997, the Trustees and Officers of the Fund as a group
beneficially owned less than 1% of the outstanding shares of the Fund. As of
such date, no persons were known by Fund management to have owned beneficially,
directly or indirectly, 5% or more of the outstanding shares of the Fund.
FINANCIAL STATEMENTS
Audited financial statements of the Fund for the year ended December
31, 1996 are attached hereto.
-46-
<PAGE>
THE CALIFORNIA MUNI FUND
(LEFT COLUMN)
STATEMENT OF ASSETS AND LIABILITIES
December 31, 1996
- ---------------------------------------------------------------------
ASSETS
Cash .................................................. $ 13,490
Investment in securities at value
(cost $16,775,950) .................................. 16,667,579
Interest receivable ................................... 246,433
-----------
Total assets .................................... 16,927,502
-----------
LIABILITIES
Payables
Dividends ........................................... 45,013
Investment securities purchased ..................... 496,160
Accrued expenses ...................................... 134,750
-----------
Total liabilities ............................... 675,923
-----------
NET ASSETS consisting of:
Accumulated net realized loss ......... $ (272,519)
Unrealized depreciation of
securities .......................... (108,371)
Paid-in-capital applicable to
2,086,694 shares of beneficial
interest (Note 4) ................... 16,632,469
----------- -----------
$16,251,579
===========
NET ASSET VALUE PER SHARE ............................... $7.79
=====
(RIGHT COLUMN)
STATEMENT OF OPERATIONS
Year Ended December 31, 1996
- ---------------------------------------------------------------------
INVESTMENT INCOME
Interest income ........................... $1,158,971
EXPENSES (Notes 2 and 3)
Management fee ............................ $71,024
Custodian and accounting fees ............. 71,221
Transfer agent fees ....................... 40,827
Professional fees ......................... 96,641
Printing and postage ...................... 14,196
Interest .................................. 64,279
Distribution expenses ..................... 54,333
Shareholder communication ................. 23,850
Trustees' fees ............................ 19,038
Miscellaneous ............................. 8,633
-------
Total expenses ...................... 464,042
----------
Net investment income ............... 694,929
----------
REALIZED AND UNREALIZED GAIN
(LOSS) ON INVESTMENTS
Net realized gain on investments .......... 100,733
Unrealized depreciation of
investments for the year ................ (876,013)
----------
Net loss on investments ............. (775,280)
----------
NET DECREASE IN NET ASSETS FROM
OPERATIONS .................................. $ (80,351)
----------
STATEMENTS OF CHANGES IN NET ASSETS
- -------------------------------------------------------------------------------
Year Ended Year Ended
December 31, December 31,
1996 1995
------------ ------------
INCREASE (DECREASE) IN NET ASSETS FROM:
OPERATIONS
Net investment income ............................. $ 694,929 $ 678,642
Net realized gain on investments .................. 100,733 152,418
Unrealized appreciation (depreciation) of
investments for the year ........................ (876,013) 3,192,187
Net increase (decrease) in net assets
from operations ............................. (80,351) 4,023,247
DIVIDENDS PAID TO SHAREHOLDERS FROM
Net investment income ............................. (694,929) (678,642)
CAPITAL SHARE TRANSACTIONS (Note 4) ................. 4,404,527 (1,279,945)
----------- -----------
Total increase .......................... 3,629,247 2,064,660
NET ASSETS:
Beginning of year ................................. 12,622,332 10,557,672
----------- -----------
End of year .......................................$16,251,579 $12,622,332
=========== ===========
See Notes to Financial Statements.
4
<PAGE>
THE CALIFORNIA MUNI FUND
STATEMENT OF INVESTMENTS
December 31, 1996
<TABLE>
- ---------------------------------------------------------------------------------------------------------------
Principal
Amount Issue(degree)(degree)(degree) Type(degree) Rating(degree)(degree) Value
------ ----- ---- ------ -----
<C> <C> <C> <C>
$ 100,000(D) Arvin, Development Corporation, COP, RB, 8.75%, 9/1/18 ........... FCLT NR $ 24,516
8,980,000 Bakersfield, COP, ETM, CAB, 4/15/21 .............................. FCLT AAA 2,213,300
200,000 Beverly Hills, PFA, RB, IFRN*, MBIA Insured, 7.47%, 6/1/15 ....... LRIB AAA 189,528
100,000 CSAC Finance Corp, COP, Sutter County Health Facilities
Project, 7.80%, 1/1/21 ......................................... FCLT BAA1 101,848
460,000 Cabrillo USD, CAB, AMBAC Insured, 8/1/19 ......................... FCLT AAA 125,092
75,000 California, HFA, Home Mortgage, RB, Series A, MBIA Insured,
5.70%, 8/1/10 .................................................. FCSI AAA 76,140
40,000 California Health Facilities Authority, Pomona Valley Community
Hospital Project, Series A, 7.00%, 1/1/17 ...................... FCLT A- 40,874
1,400,000 California PCR, Southern California Edison, 4.70%, 2/28/08 ....... VRDN A1+ 1,399,972
400,000 California Statewide Communities Development Authority,
Cedars Sinai Medical Project, COP, RB, 5.40%, 11/1/15 .......... FCLT A1 373,956
300,000 California Statewide Communities Development Authority,
Cedars Sinai Medical Project, COP, RB, IFRN*, 6.97%,
11/1/15 ........................................................ LRIB A1 251,625
300,000 East Bay, Wastewater System Project, RB, Refunding, AMBAC
Insured, IFRN*, 7.17%, 6/1/20 .................................. LRIB AAA 281,064
500,000 Foothill / Eastern Transportation Corridor Agency, Toll Road
Revenue, CAB, 1/1/26 ........................................... FCLT BBB- 80,455
220,000 Hawthorne, CRA, TAR, 6.75%, 9/1/24 ............................... FCLT BAA 233,437
700,000 Irvine Ranch Water District, COP, LOC Landesbank Hessen,
5.00%, 10/1/00 ................................................. VRDN A1+ 700,000
170,000 Lake Elsinore, USD, Refunding, COP, 6.90%, 2/1/20 ................ FCLT BBB 180,457
15,000 Los Angeles, Home Mortgage, RB, 9.00%, 6/15/18 ................... FCLT A 15,469
800,000 Los Angeles Regional Airports Improvement Corp, LOC Societe
Generale, VRDN, 4.95%, 12/1/25 ................................. VRDN BBB+ 800,000
300,000 Los Angeles, Multiple Capital Facilities Project III, COP, 6.60%,
11/1/11 ........................................................ FCLT BBB 309,768
1,340,319 Los Angeles, HFA, MFH Project C, CAB, RB, 12.00%, 12/1/29 ........ FCLT NR 990,804
35,000 Modesto, Valley Oak Project, RB, 10.60%, 5/1/09 .................. FCSI NR 35,968
350,000 New Haven, USD, AMBAC Insured, CAB, 8/1/16 ....................... FCLT AAA 111,871
800,000 Newport Beach, Hoag Memorial Hospital, SPA Credit Suisse,
5.15%, 10/1/26 ................................................. VRDN A1+ 800,000
250,000 Northern California Power Agency, Multiple Capital Facilities,
RB, MBIA Insured, IFRN*, 9.05%, 8/1/25 ......................... LRIB AAA 286,205
250,000 Northern California Transmission Agency, CA-ORE
Transmission Project, RB, MBIA Insured, IFRN*, 6.92%,
4/29/24 ........................................................ LRIB AAA 225,770
500,000++ Orange County Airport, RB, Refunding, MBIA Insured, 5.62%,
7/1/12 ......................................................... FCLT AAA 499,485
250,000 Orange County, LTA, RB, IFRN*, 7.50%, 2/14/11 .................... LRIB AA 266,348
250,000 Orange County, LTA, RB, IFRN*, 6.85%, 2/14/11 .................... LRIB AAA 268,103
250,000 Palmdale, SFRM, Series A, CAB, 3/1/17 ............................ FCLT AAA 75,740
200,000 Panoche, Water District, COP, 7.50%, 12/1/08 ..................... FCSI BBB 216,714
250,000 Rancho, Water District Financing Authority, RB, Prerefunded @
104, AMBAC Insured, IFRN*, 8.87%, 8/17/21 ...................... LRIB AAA $ 303,263
250,000 Redding, Electric System, COP, Series A, FGIC Insured, IFRN*,
7.44%, 6/1/19 .................................................. LRIB AAA 242,593
</TABLE>
5
<PAGE>
THE CALIFORNIA MUNI FUND
STATEMENT OF INVESTMENTS (continued)
December 31, 1996
<TABLE>
- ---------------------------------------------------------------------------------------------------------------------------------
Principal
Amount Issue(degree)(degree)(degree) Type(D) Rating(D) Value
------ ----- ---- ------ -----
<C> <C> <C> <C>
$ 565,000 Rio, USD, COP, FSA Insured, Convertible, CAB, 9/1/03,
STEP*** ........................................................ FCLT AAA 391,720
175,000 Riverside, HFA, Riverside Apartment Project, RB, 7.87%,
11/1/19 ........................................................ FCLT BB- 171,523
2,000,000 Salinas, Redevelopment Agency, TAB, CGIC Insured, Central
City Project, CAB, 11/1/22 ..................................... FCLT AAA 455,480
500,000 San Bernardino, COP, Series B. MBIA Insured, IFRN*, 6.57%,
7/1/16 ......................................................... INLT AAA 501,425
900,000 San Bernardino, COP, Series PA-38, MBIA Insured, IFRN*,
9.66%, 7/1/16, Rule 144A Security (restricted as to resale
except to qualified institutions)............................... LRIB AAA 864,252
200,000 San Diego Water Authority, COP, FGIC Insured, IFRN*, 7.53%,
4/22/09 ........................................................ LRIB AAA 222,592
1,440,000 San Jose, CRA, Series PA-42(I)A, TAB, MBIA Insured, IFRN*,
5.72%, 8/1/16, Rule 144A Security (restricted as to resale
except to qualified institutions) .............................. LRIB AAA 1,197,259
250,000 Southern California Public Power Authority, FGIC Isured, IFRN*,
6.79%, 7/1/17 .................................................. LRIB AAA 234,435
500,000 Southern California Public Power Authority, AMBAC Insured,
IFRN*, 6.19%, 7/1/15 ........................................... LRIB AAA 458,330
55,000 Tri City, HFA, FNMA/GNMA Collateralized, AMT, 6.45%, 12/1/28 ..... FCLT AAA 56,998
30,000 Tri City, HFA, FNMA/GNMA Collateralized, AMT, Series B,
6.30%, 12/1/28 ................................................. FCLT AAA 30,937
250,000 Tri City, HFA, FNMA/GNMA Collateralized, AMT, Series E,
6.40%, 12/1/28 ................................................. FCLT AAA 256,620
100,000 Upland, HFA, RB, 7.85%, 7/1/20 ................................... FCLT BBB 105,643
-----------
Total Investments (Cost $16,775,950**) $16,667,579
===========
</TABLE>
*Inverse Floating Rate Notes (IFRN) are instruments whose interest rates bear
an inverse relationship to the interest rate on another security or the value
of an index. (see Note 5). Rates shown are at year end.
**Cost is the same for Federal income tax purposes.
***Step Bonds (STEP) are instruments whose interest rate is fixed at an initial
rate and then increases ("Step Up") to another fixed rate until maturity.
(D)Denotes non-income producing security. Security in default.
++When-issued security.
Legend
(left column)
(degree)Type FCLT -Fixed Coupon Long Term
FCSI -Fixed Coupon Short or Intermediate Term
LRIB -Residual Interest Bond Long Term
INLT -Indexed Inverse Floating Rate Bond Long Term
VRDN -Variable Rate Demand Note
(deg)(deg)Ratings If a security has a split rating the highest applicable
rating is used, including published ratings on identicial
credits for individual securities not individually rated.
Ratings are unaudited.
NR -Not Rated
(deg)(deg)(deg)Issue AMBAC American Municipal Bond Assurance Corporation
AMT Alternative Minimum Tax
CAB Capital Appreciation Bond
CGIC Capital Guaranty Insurance Company
COP Certificate of Participation
CRA California Redevelopment Agency
(right column)
ETM Escrowed to Maturity
FGIC Financial Guaranty Insurance Corporation
FNMA Federal National Mortgage Association
FSA Financial Security Assurance, Inc.
GNMA Government National Mortgage Association
HFA Housing Finance Authority
LOC Letter of Credit
LTA Local Transportation Authority
MBIA Municipal Bond Insurance Assurance Corporation
MFH Multi Family Housing
PFA Public Financing Authority
RB Revenue Bond
SFRM Single Family Residential Mortgage
SPA Stand by Bond Purchase Agreement
TAB Tax Allocation Bond
TAR Tax Allocation Refunding
USD Unified School District
See Notes to Financial Statements.
6
<PAGE>
THE CALIFORNIA MUNI FUND
NOTES TO FINANCIAL STATEMENTS
December 31, 1996
- --------------------------------------------------------------------------------
(LEFT COLUMN)
1. Significant Accounting Policies
The California Muni Fund (the Fund) was organized as a Massachusetts
business trust and is registered as an open end management investment company
under the Investment Company Act of 1940. The Fund's objective is to provide as
high a level of income that is excluded from gross income for Federal income tax
purposes and exempt from California personal income tax as is consistent with
the preservation of capital. The following is a summary of significant
accounting policies followed in the preparation of its financial statements:
Valuation of Securities-The Fund's portfolio securities are valued on the
basis of prices provided by an independent pricing service when, in the opinion
of persons designated by the Fund's trustees, such prices are believed to
reflect the fair market value of such securities. Prices of non-exchange traded
portfolio securities provided by independent pricing services are generally
determined without regard to bid or last sale prices but take into account
institutional size trading in similar groups of securities, yield, quality,
coupon rate, maturity, type of issue, trading characteristics and other market
data. Securities traded or dealt in upon a securities exchange and not subject
to restrictions against resale as well as options and futures contracts listed
for trading on a securities exchange or board of trade are valued at the last
quoted sales price, or, in the absence of a sale, at the mean of the last bid
and asked prices. Options not listed for trading on a securities exchange or
board of trade for which over-the-counter market quotations are readily
available are valued at the mean of the current bid and asked prices. Money
market and short-term debt instruments with a remaining maturity of 60 days or
less will be valued on an amortized cost basis. Securities not priced in a
manner described above and other assets are valued by persons designated by the
Fund's trustees using methods which the trustees believe accurately reflects
fair value.
Federal Income Taxes-It is the Fund's policy to comply with the requirements
of the Internal Revenue Code applicable to "regulated investment companies" and
to distribute all of its taxable and tax exempt income to its shareholders.
Therefore, no provision for federal income tax is required.
(RIGHT COLUMN)
Distributions-The Fund declares dividends daily from its net investment
income and pays such dividends on the last business day of each month.
Distributions of net capital gains, if any, realized on sales of investments are
made annually, as declared by the Fund's Board of Trustees. Dividends are
reinvested at the net asset value unless shareholders request payment in cash.
General-Securities transactions are accounted for on a trade date basis.
Interest income is accrued as earned. Premiums and original issue discount on
securities purchased are amortized over the life of the respective securities.
Realized gains and losses from the sale of securities are recorded on an
identified cost basis.
Accounting 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 statements and the reported amounts of increases and decreases in
net assets from operations during the reporting period. Actual results could
differ from those estimates.
2. Investment Advisory Fees and Other Transactions With Affiliates
Under a Management Agreement, the Fund pays an investment management fee to
Fundamental Portfolio Advisors, Inc. (the Manager) equal to 0.5% of the Fund's
average daily net asset value up to $100 million and decreasing by .02% of each
$100 million increase in net assets down to 0.4% of net assets in excess of $500
million.
The Manager and the Fund's Trustees are cooperating in an investigation
being conducted by the Securities and Exchange Commission concerning an
affiliated fund. The Commission's staff indicated an intention to recommend to
the Commission the commencement of certain proceedings.
Pursuant to a Distribution Plan (the Plan) adopted pursuant to Rule12b-1,
promulgated under the Investment Company Act of 1940, the Fund may pay certain
promotional and advertising expenses and may compensate certain registered
securities dealers and financial institutions for services provided in
connection with the processing of orders for purchase or redemption of the
Fund's shares and furnishing
7
<PAGE>
THE CALIFORNIA MUNI FUND
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1996
- --------------------------------------------------------------------------------
(LEFT COLUMN)
other shareholder services. Payments by the Fund shall not in the aggregate, in
any fiscal year, exceed 0.5% of the average daily net assets of the Fund.
Under a Distribution Agreement with Fundamental Service Corporation (FSC),
an affiliate of the Manager, amounts are paid under the Plan to compensate FSC
for the services it provides and the expenses it bears in distributing the
Fund's shares to investors. Fees for those services aggregated approximately
$28,000 for the year ended December 31, 1996.
The Fund compensates Fundamental Shareholder Services, Inc., an affiliate of
the Manager, for the services it provides under a Transfer Agent and Service
Agreement. Transfer agent fees for the year ended December 31, 1996 are set
forth in the statement of operations.
3. Trustees' Fees
All of the Trustees of the Fund are also directors or trustees of two other
affiliated mutual funds for which the Manager acts as investment adviser. For
services and attendance at board meetings and meetings of committees which are
common to each Fund, each Trustee who is not affiliated with the Manager is
compensated at the rate of $6,500 per quarter pro rated among the funds based on
their respective average net assets.
4. Shares of Beneficial Interest
As of December 31, 1996 there were an unlimited number of shares of
beneficial interest (no par value) authorized and capital paid in amounted to
$16,632,469. Transactions in shares were as follows:
Year Ended Year Ended
December 31, 1996 December 31, 1995
------------------ ------------------
Shares Amount Shares Amount
------ ------ ------ ------
Shares sold 29,177,580 $234,552,576 7,881,857 $66,180,540
Shares issued on
reinvestment of
dividends 58,802 472,727 60,506 494,825
Shares redeemed (28,566,533) (230,620,776)(8,012,453) (67,955,310)
------------ ------------ --------- ----------
Net increase (decrease) 669,849 $ 4,404,527 (70,090) ($1,279,945)
============ ============ ========= ==========
(RIGHT COLUMN)
5. Complex Securities and Investment Transactions
Inverse Floating Rate Notes:
The Fund invests in variable rate securities commonly called "inverse
floaters". The interest rates on these securities have an inverse relationship
to the interest rate of other securities or the value of an index. Changes in
interest rate on the other security or index inversely affect the rate paid on
the inverse floater, and the inverse floater's price will be more volatile than
that of a fixed rate bond. Certain interest rate movements and other market
factors can substantially affect the liquidity of IFRN's.
Investment Transactions:
During the year ended December 31, 1996, the cost of purchases and proceeds
from sales of investment securities, other than short-term obligations, were
$12,309,736 and $13,435,031 respectively.
As of December 31, 1996 the net unrealized depreciation of portfolio
securities amounted to $108,371 composed of unrealized appreciation of $654,311
and unrealized depreciation of $762,682. The Fund has a capital loss
carryforward of $272,500 expiring December 31, 2002 available to offset future
capital gains.
6. Line of Credit
The Fund has a line of credit agreement with its custodian bank
collateralized by portfolio securities. Borrowings under this agreement bear
interest linked to the bank's prime rate. The maximum month end and the average
borrowings outstanding during the year ended December 1996, were $2,000,000 and
$823,000, respectively.
8
<PAGE>
THE CALIFORNIA MUNI FUND
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1996
- -------------------------------------------------------------------------------
<TABLE>
<CAPTION>
7. Selected Financial Information
Years Ended December 31,
--------------------------------------------------------------------------
1996 1995 1994 1993 1992
---- ---- --- ---- ----
<S> <C> <C> <C> <C> <C>
PER SHARE OPERATING PERFORMANCE
(for a share outstanding throughout the year)
Net Asset Value, Beginning of Year .................. $ 8.91 $ 7.10 $ 9.49 $ 8.81 $ 8.80
------- ------- ------- ------- ------
Income from investment operations:
Net investment income ............................... .409 .419 .553 .563 .604
Net realized and unrealized gains (losses)
on investments .................................... (1.120) 1.810 (2.390) .876 .010
------- ------- ------- ------- -------
Total from investment operations ............ (.711) 2.229 (1.837) 1.439 .614
------- ------- ------- ------- -------
Less Distributions:
Dividends from net investment income ................ (.409) (.419) (.553) (.563) (.604)
Dividends from net realized gains ................... - - - (.196) -
------- ------- ------- ------- -------
Total distributions ......................... (.409) (.419) (.553) (.759) (.604)
------- ------- ------- ------- -------
Net Asset Value, End of Year ........................ $ 7.79 $ 8.91 $ 7.10 $ 9.49 $ 8.81
======= ======= ======= ======= =======
Total Return ........................................ (8.01%) 32.02% (19.89%) 16.80% 7.23%
RATIOS/SUPPLEMENTAL DATA
Net Assets, End of Year (000) ....................... 16,252 12,622 10,558 16,280 11,549
Ratios to Average Net Assets:
Interest expense .................................. .45% .39% .98% .39% .16%
Operating expenses ................................ 2.81% 2.81% 2.50% 1.77% *1.47%*
------- ------- ------- ------- -------
Total expenses .............................. 3.26% 3.20% 3.48% 2.16% *1.63%*
======= ======= ======= ======= =======
Net investment income ....................... 4.88% 5.02% 6.80% 6.04% *6.87%*
Portfolio turnover rate ............................. 89.83% 53.27% 15.88% 51.26% 18.91%
BANK LOANS
Amount outstanding at end of year (000 omitted) ..... $ 0 $ 0 $1,292 $3,714 0
Average amount of bank loans outstanding
during the year (000 omitted) .................... $ 823 $ 642 $1,690 $ 958 274
Average number of shares outstanding
during the year (000 omitted) .................... 1,768 1,635 1,711 1,517 1,214
Average amount of debt per share during the year .... $ .47 $ .39 $ .95 $ .63 $ .23
</TABLE>
*These ratios are after expense reimbursement of .50% for each of the years
ended December 31, 1993, and 1992.
9
<PAGE>
INDEPENDENT AUDITOR'S REPORT
The Board of Trustees and Shareholders
The California Muni Fund
We have audited the accompanying statement of assets and liabilities
including the statement of investments of The California Muni Fund as of
December 31, 1996 and the related statement of operations for the year then
ended, statements of changes in net assets for each of the two years in the
period then ended, and the selected financial information for each of the five
years in the period then ended. These financial statements and selected
financial information are the responsibility of the Fund's management. Our
responsibility is to express an opinion on these financial statements and
selected financial information based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements and selected
financial information are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. Our procedures included confirmation of securities
owned as of December 31, 1996 by correspondence with the custodian and brokers.
An audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements and selected financial information
referred to above present fairly, in all material respects, the financial
position of The California Muni Fund as of December 31, 1996, the results of its
operations, changes in its net assets, and selected financial information for
the periods indicated, in conformity with generally accepted accounting
principles.
S I G N A T U R E
New York, New York
February 21, 1997
10
<PAGE>
INFORMATION WITH RESPECT TO SECURITIES RATINGS*
Standard & Poor's Corporation.
A description of the applicable Standard & Poor's Corporation rating
symbols and their meanings follows:
S&P's corporate or municipal bond rating is a current assessment of the
creditworthiness of an obligor with respect to a specific debt obligation. This
assessment may take into consideration obligors such as guarantors, insurers, or
lessees.
The bond rating is not a recommendation to purchase or sell a security,
inasmuch as it does not comment as to market price or suitability for a
particular investor.
The ratings are based on current information furnished by the issuer or
obtained by S&P from other sources it considers reliable. S&P does not perform
an audit in connection with any rating and may, on occasion, rely on unaudited
financial information. The ratings may be changed, suspended or withdrawn as a
result of changes in, or unavailability of, such information, or for other
circumstances.
The ratings are based, in varying degrees, on the following
considerations.
(1) Likelihood of default--capacity and willingness of the obligor as
to the timely payment of interest and repayment of principal in accordance with
the terms of the obligation.
(2) Nature and provisions of the obligation.
(3) Protection afforded by, and relative position of, the obligation in
the event of bankruptcy, reorganization or other arrangements under the laws of
bankruptcy and other laws affecting creditors' rights.
AAA--This is the highest rating assigned by S&P to a debt obligation.
Capacity to pay interest and repay principal is extremely strong.
AA--Bonds rated AA have a very strong capacity to pay interest and
repay principal, and differ from the highest rated issue only in small degree.
- ------------------
* As published by the rating companies.
A-1
<PAGE>
A--Bonds rated A have a strong capacity to pay interest and repay
principal, although they are somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions than bonds in higher rated
categories.
BBB--Bonds rated BBB are regarded as having an adequate capacity to pay
interest and repay principal. Whereas they normally exhibit adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal for
bonds in this category than for bonds in the higher rated categories.
Plus(+) or Minus(-): The ratings from "AA" to "BBB" may be modified by
the addition of a plus or minus sign to show relative standing within the major
rating categories.
Provisional Ratings: the letter "p" indicates that the rating is
provisional. A provisional rating assumes the successful completion of the
project being financed by the issuance of the bonds being rated and indicates
that payment of debt service requirements is largely or entirely dependent upon
the successful and timely completion of the project. This rating, however, while
addressing credit quality subsequent to completion of the project, makes no
comment on the likelihood of, or the risk of default upon failure of, such
completion. Accordingly, the investor should exercise his own judgment with
respect to such likelihood and risk.
MOODY'S INVESTORS SERVICE, INC.
A brief description of the applicable Moody's Investors Service, Inc.
rating symbols and their meanings follows:
Aaa--Bonds which are rated Aaa are judged to be the best quality. They
carry the smallest degree of investment risk and are generally referred to as
"gilt edge". Interest payments are protected by a large, or by an exceptionally
stable margin, and principal is secure. While the various protective elements
are likely to change, such changes as can be visualized are most unlikely to
impair the fundamentally strong position of such issues. Their safety is so
absolute that, with the occasional exception of oversupply in a few specific
instances, characteristically, their market value is affected solely by money
market fluctuations.
Aa--Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are generally known as
high grade bonds. They are rated lower than the best bonds because margins of
protection may not be as large as in Aaa securities or fluctuations of
protective elements may be of greater amplitude or there may be other elements
present which make the long-term risks appear somewhat larger than
A-2
<PAGE>
in Aaa securities. Their market value is virtually immune to all but money
market influences, with the occasional exception of oversupply in a few specific
instances.
A--Bonds which are rated A possess many favorable investment attributes
and are to be considered as upper medium grade obligations. Factors giving
security to principal and interest are considered adequate, but elements may be
present which suggest a susceptibility to impairment sometime in the future. The
market value of A-rated bonds may be influenced to some degree by economic
performance during a sustained period of depressed business conditions, but,
during periods of normalcy, A-rated bonds frequently move in parallel with Aaa
and Aa obligations, with the occasional exception of oversupply in a few
specific instances.
Baa--Bonds which are rated Baa are considered as lower medium grade
obligations, i.e., they are neither highly protected nor poorly secured.
Interest payments and principal security appear adequate for the present but
certain protective elements may be lacking or may be characteristically
unreliable over any great length of time. Such bonds lack outstanding investment
characteristics and in fact have speculative characteristics as well. The market
value of Baa-rated bonds is more sensitive to changes in economic circumstances,
and aside from occasional speculative factors applying to some bonds of this
class, Baa market valuations move in parallel with Aaa, Aa and A obligations
during periods of economic normalcy, except in instances of oversupply.
Moody's bond rating symbols may contain numerical modifiers of a
generic rating classification. The modifier 1 indicates that the bond ranks at
the high end of its category; the modifier 2 indicates a mid-range ranking; and
the modifier 3 indicates that the issue ranks in the lower end of its generic
rating category.
Con. (---)--Bonds for which the security depends upon the completion of
some act or the fulfillment of some condition are rated conditionally. These are
bonds secured by (1) earnings of projects under construction, (2) earnings of
projects unseasoned in operation experience, (3) rentals which begin when
facilities are completed, or (4) payments to which some other limiting condition
attaches. Parenthetical rating denotes probable credit stature upon completion
of construction or elimination of condition.
A-3
<PAGE>
FITCH
Ratings
A brief description of the applicable Fitch Investors Service, Inc.
rating symbols and their meanings is as follows:
AAA
Bonds rated AAA are considered to be investment grade and of the
highest credit quality. The obligor has an exceptionally strong ability to pay
interest and repay principal, which is unlikely to be affected by reasonably
foreseeable events.
AA
Bonds rated AA are considered to be investment grade and of the very
high credit quality. The obligor's ability to pay interest and repay principal
is very strong, although not quite as strong as bonds rated AAA. Because bonds
rated in the AAA and AA categories are not significantly vulnerable to
foreseeable future developments, short-term debt of these issuers is generally
rated F-1+.
A
Bonds rated A are considered to be investment grade and of high credit
quality. The obligor's ability to pay interest and repay principal is considered
to be strong, but may be more vulnerable to adverse changes in economic
conditions and circumstances than bonds with higher ratings.
BBB
Bonds rated BBB are considered to be investment grade and of
satisfactory credit quality. The obligor's ability to pay interest and repay
principal is considered to be adequate. Adverse changes in economic conditions
and circumstances, however, are more likely to have an adverse impact on these
bonds and, therefore, impair timely payment. The likelihood that the ratings of
these bonds will fall below investment grade is higher than for bonds with
higher ratings.
BB
Bonds rated BB are considered speculative. The obligor's ability to pay
interest and repay principal may be affected over time by adverse economic
changes. However, business and financial alternatives can be identified which
could assist the obligor in satisfying its debt service requirements.
A-4
<PAGE>
B
Bonds rated B are considered highly speculative. While bonds in this
class are currently meeting debt service requirements, the probability of
continued timely payment of principal and interest reflects the obligor's
limited margin of safety and the need for reasonable business and economic
activity throughout the life of the issue.
CCC
Bonds rated CCC have certain identifiable characteristics, which, if
not remedied, may lead to default. The ability to meet obligations requires an
advantageous business and economic environment.
CC
Bonds rated CC are minimally protected. Default in payment of interest
and/or principal seems probable over time.
C
Bonds rated C are in imminent default in payment of interest or
principal.
DDD, DD AND D
Bonds rated DDD, DD and D are in actual or imminent default of interest
and/or principal payments. Such bonds are extremely speculative and should be
valued on the basis of their ultimate recovery value in liquidation or
reorganization of the obligor. DDD represents the highest potential for recovery
on these bonds and D represents the lowest potential for recovery.
Plus (+) and minus (-) signs are used with a rating symbol to indicate
the relative position of a credit within the rating category. Plus and minus
signs, however, are not used in the AAA Category covering 12-36 months or the
DDD, DD or D categories.
A-5
<PAGE>
DUFF & PHELPS, INC.
RATING
SCALE DEFINITION
AAA Highest credit quality. The risk factors are negligible,
being only slightly more than for risk-free U.S. Treasury
debt.
AA+ High credit quality. Protection factors are strong.
AA- Risk is AA modest but may vary slightly from time to time
AA- because of economic conditions.
A+ Protection factors are average but adequate. However,
A risk factors are more variable and greater in periods of
A- economic stress.
BBB+ Below average protection factors but still considered BBB
sufficient for prudent investment. Considerable BBB-
variability in risk during economic cycles.
BB+ Below investment grade but deemed likely to meet
BB obligations when due. Present or prospective financial
BB- protection factors fluctuate according to industry
conditions or company fortunes. Overall quality may move
up or down frequently within this category.
B+ Below investment grade and possessing risk that
B obligations will not be met when due. Financial
B- protection factors will fluctuate widely according to
economic cycles, industry conditions and/or company fortunes.
Potential exists for frequent changes in the rating within
this category or into a higher or lower rating grade.
CCC Well below investment grade securities. Considerable
uncertainty exists as to timely payment of principal, interest
or preferred dividends. Protection factors are narrow and risk
can be substantial with unfavorable economic/industry
conditions, and/or with unfavorable company developments.
DD Defaulted debt obligations. Issuer failed to meet scheduled
principal and/or interest payments.
DP Preferred stock with dividend arrearages.
A-6
<PAGE>
RATING
SCALE DEFINITION
HIGH GRADE
Duff 1+ Highest certainty of timely payment. Short-term liquidity,
including internal operating factors and/or access to alternative
sources of funds, is outstanding, and safety is just below
risk-free U.S. Treasury short-term obligations.
Duff 1 Very high certainty of timely payment. Liquidity factors are
excellent and supported by good fundamental protection factors.
Risk factors are minor.
Duff 1- High certainty of timely payment. Liquidity factors are strong
and supported by good fundamental protection factors. Risk factors
are very small.
GOOD GRADE
Duff 2 Good certainty of timely payment. Liquidity factors and company
fundamentals are sound. Although ongoing funding needs may enlarge
total financing requirements, access to capital markets is good.
Risk factors are small.
SATISFACTORY GRADE
Duff 3 Satisfactory liquidity and other protection factors qualify issues
as to investment grade. Risk factors are larger and subject to more
variation. Nevertheless, timely payment is expected.
NON-INVESTMENT GRADE
Duff 4 Speculative investment characteristics. Liquidity is not
sufficient to insure against disruption in debt service. Operating
factors and market access may be subject to a high degree of
variation.
DEFAULT
Issuer failed to meet scheduled principal and/or interest payments.
MUNICIPAL NOTE RATINGS
The ratings of Moody's for tax-exempt notes are MIG 1, MIG 2, MIG 3 and
MIG 4. Notes bearing the designation MIG 1 are judged to be of the best quality,
enjoying strong protection from cash
A-7
<PAGE>
flows of funds for their servicing or form established and broad-based access to
the market for refinancing, or both. Notes bearing the designation MIG 2 are
judged to be of high quality, with margins of protection ample although not so
large as in the preceding group. Notes bearing the designation MIG 3 are judged
to be of favorable quality, with all security elements accounted for, but
lacking the undeniable strength of the preceding grades. Market access for
refinancing, in particular, is likely to be less well established. Notes bearing
the designation MIG 4 are judged to be of adequate quality, carrying specific
risk but having protection commonly regarded as required of an investment
security and not distinctly or predominantly speculative.
SHORT-TERM RATINGS
FITCH
Fitch's short-term ratings apply to debt obligations that are payable
on demand or have original maturities of up to three years, including commercial
paper, certificates of deposit, medium-term notes, and municipal and investment
notes.
Although the credit analysis is similar to Fitch's bond rating
analysis, the short-term rating places greater emphasis than bond ratings on the
existence of liquidity necessary to meet the issuer's obligations in a timely
manner.
F-1+
Exceptionally Strong Credit Quality. Issues assigned this rating are
regarded as having the strongest degree of assurance for timely payment.
Very Strong Credit Quality. Issues assigned this rating reflect an
assurance of timely payment only slightly less in degree than issues rated F-1+.
F-1
Very Strong Credit Quality. Issues assigned this rating reflect an
assurance of timely payment only slightly less in degree than issues rated F-1+.
F-2
Good Credit Quality. Issues carrying this rating have a satisfactory
degree of assurance for timely payments, but the margin of safety is not as
great as the F-1+ and F-1 categories.
A-8
<PAGE>
MUNICIPAL COMMERCIAL PAPER RATINGS
Moody's and S&P's ratings grades for commercial paper, set forth below,
are applied to municipal commercial paper as well as taxable commercial paper.
Moody's commercial paper ratings are opinions of the ability of issuers
to repay punctually promissory obligations not having an original maturity in
excess of nine months. Moody's employs the following three designations, all
judged to be investment grade, to indicate the relative repayment capacity of
rated issuers: Prime-1, Highest Quality; Prime-2, Higher Quality; and Prime-3,
High Quality.
S&P's commercial paper rating is a current assessment of the likelihood
of timely payment of debt having an original maturity of no more than 365 days.
Ratings are graded into four categories, ranging from "A" for the highest
quality obligations to "D" for the lowest. Issues assigned A ratings are
regarded as having the greatest capacity for timely payment. Issues in this
category are further refined with the designation 1, 2 and 3 to indicate the
relative degree of safety. The "A-2" designation indicates that the degree of
safety regarding timely payment is very strong. The "A-2" designation indicates
that capacity for timely payment is strong. However, the relative degree of
safety is not as overwhelming as for issues designated "A-1". The "A-3"
designation indicates that the capacity for timely payment is satisfactory. Such
issues, however, are somewhat more vulnerable to the adverse effects of changes
in circumstances than obligations carrying the higher designations. Issues rated
"B" are regarded as having only an adequate capacity for timely payment and such
capacity may be impaired by changing conditions or short-term adversities.
A-9
