CORNERSTONE CALIFORNIA MUNI FUND
a series of
(THE CALIFORNIA MUNI FUND)
PROSPECTUS
APRIL 30, 1999
AS WITH ALL MUTUAL FUNDS, THE SECURITIES AND EXCHANGE COMMISSION HAS NOT
APPROVED OR DISAPPROVED THESE SECURITIES OR PASSED UPON THE ADEQUACY OF THIS
PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
<PAGE>
TABLE OF CONTENTS
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Risk/Return Summary.......................................................... 3
Financial Highlights......................................................... 6
Investment Objective and Principal Investment Strategies.................... 7
Principal Risks.............................................................. 11
Year 2000.................................................................... 15
Management................................................................... 15
Pricing of Fund Shares....................................................... 16
Purchase of Shares........................................................... 17
Redemption of Shares......................................................... 20
Distribution Expenses........................................................ 24
Dividends and Tax Matters.................................................... 25
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<PAGE>
RISK/RETURN SUMMARY
Investment Objective and Principal Strategy Overview
The Fund seeks to provide a high level of income that is excluded from federal
and California personal income tax. The Fund will attempt to achieve its
objective by investing at least 80% of its assets in municipal obligations that
are exempt from federal and California State income taxes and at least 65% of
the Fund's assets will be invested in California municipal obligations. In
addition, the Fund will invest in "when-issued" securities and variable rate
instruments, and borrow for investment purposes. The municipal obligations held
by the Fund will be in the four highest quality grades for bonds as determined
by independent rating services or the unrated equivalent as determined by the
Fund. The Fund invests in municipal obligations that have maturities ranging
from less than one year to over fifteen years.
Principal Risks of Investing in the Fund
There is no guarantee that the Fund will achieve its stated objective. In fact,
you could lose money by investing in the Fund. In making your investment
decision, you should understand that the Fund's net asset value (NAV), yield,
and total return may be adversely affected by any or all of the following
factors:
o Rising interest rates cause the prices of debt securities to decrease
and falling rates cause the prices of debt securities to increase.
Securities with longer maturities can be more sensitive to interest rate
changes. In effect, the longer the maturity of a security, the greater
the impact a change in interest rates could have on the security's
price. Variable and inverse floating rate instruments and zero coupon
bonds, in particular, are extremely sensitive to interest rate changes.
o Certain issuers of securities may fail to make timely payments of
interest and principal on the Fund's investments.
o Because the Fund invests its assets mainly in the issuers of a single
state, California, it may become subject to greater losses arising from
adverse political or economic events specific to the state.
o The Fund is non-diversified, which means that a relatively high
percentage of the Fund's assets may be invested in a limited number of
issuers. Consequently, its performance may be more vulnerable to changes
in the market value of a single issuer or group of issuers.
o Borrowing for investment purposes, otherwise known as leveraging, is a
speculative practice that could result in losses for the Fund that would
be greater in degree than if leverage was not employed.
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o It is expected that a substantial portion of the assets of the Fund
will be derived from professional money managers and investors who
intend to invest in the Fund as part of an asset-allocation or
market-timing investment strategy. These investors are likely to redeem
or exchange their Fund shares frequently to take advantage of
anticipated changes in market conditions. The strategies employed by
investors in the Fund may result in considerable assets moving in and
out of the Fund. Consequently, the Fund expects that it will generally
experience significant portfolio turnover, which will likely cause
higher expenses and additional costs and may adversely affect the
ability of the Fund to meet its investment objective.
Summary of Past Performance
The bar chart and table shown below indicate the risks of investing in the Fund.
The bar chart shows the performance of the Fund for each of the last 10 calendar
years. The table shows how the Fund's average annual return for 1, 5, and 10
years compare with those of a broad measure of market performance.
Bar Chart
The bar chart illustrates how the Fund's returns vary from year to year. As
always, past performance is no way to predict future performance.
<TABLE>
<CAPTION>
1998 1997 1996 1995 1994 1993 1992 1991 1990 1989
==== ==== ==== ==== ==== ==== ==== ==== ==== ====
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
4.03% 11.33% (8.01)% 32.02% (19.89)% 16.80% 7.23% 8.75% 4.39% 5.53
%
</TABLE>
The Fund's best performance for one quarter was 14.15% for the quarter ended
3/31/95. The Fund's worst performance for one quarter was (9.24)% for the
quarter ended 3/31/94.
Average Annual Total Returns
The table below shows the Fund's average annual total returns for the 1, 5, and
10 year periods of the Fund's existence in comparison to the Lehman Brothers
Municipal Bond Index for the same periods. The table provides some indication of
the risks of investing in the Fund by showing how the Fund's average annual
total returns for the periods noted compare with that of a broad measure of
market performance. As always, past performance is no way to predict future
performance.
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<TABLE>
<CAPTION>
Average Annual Returns as One Year 5 Years 10 Years
of 12/31/98
<S> <C> <C> <C>
Cornerstone California Muni Fund 4.03% 2.42% 5.39%
Lehman Brothers Municipal 6.48% 6.22% 8.22%
Bond Index
</TABLE>
Fees and Expenses of the Fund
This table describes the fees and expenses that you may pay if you buy and hold
shares of the Fund.
<TABLE>
<CAPTION>
Shareholder Fees (fees paid directly from your investment)
<S> <C>
Maximum Sales Charge (Load) Imposed on Purchases .........................................None
Maximum Deferred Sales Charge (Load)..................................................... None
Maximum Sales Charge (Load) Imposed on Reinvested Dividends
and other Distributions................................................................. None
Redemption Fee........................................................................... $12*
Exchange Fee............................................................................. None
Maximum Account Fee...................................................................... None
Annual Fund Operating Expenses (expenses that are deducted from Fund assets)
Management Fees......................................................................... 0.50%
Distribution [and/or Service] (12b-1) Fees.............................................. 0.50%
Other Expenses...........................................................................1.78%
Total Annual Fund Operating Expenses.................................................... 2.78%
</TABLE>
* The Transfer Agent charges a $12 service fee for each payment of
redemption proceeds made by wire.
Example: This example is intended to help you compare the cost of
investing in the Fund with the cost of investing in other mutual funds.
The Example assumes that you invest $10,000 in the Fund for the time
periods indicated and then redeem all of your shares at the end of those
periods. The Example also assumes that your investment has a 5% return each year
and that the Fund's operating expenses remain the same. Although your actual
costs may be higher or lower, based on these assumptions your costs would be:
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<PAGE>
1 Year 3 Years 5 Years 10 Years
------ ------- ------- --------
$281 $862 $1,469 $3,109
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<PAGE>
FINANCIAL HIGHLIGHTS
The financial highlights table is intended to help you understand the
Fund's financial performance for the past 5 years. Certain information reflects
financial results for a single Fund share. The total returns in the table
represent the rate that an investor would have earned or lost on an investment
in the Fund (assuming reinvestment of all dividends and distributions). This
information has been audited by McGladrey & Pullen, LLP, whose report, along
with the Fund's financial statements, are included in the Annual Report which is
available upon request:
<TABLE>
<CAPTION>
Year Ended December 31,
1998+ 1997 1996 1995 1994
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Per share operating performance
(for a share outstanding throughout the year)
Net Asset Value, Beginning of Year............. $8.27 $7.79 $8.91 $7.10 $9.49
----- ----- ----- ----- -----
Income from investment operations:
Net investment income.......................... 0.48 0.38 0.41 0.42 0.55
Net realized and unrealized gains (losses)
on investments............................. (0.20) 0.48 (1.12) 1.81 (2.39)
------ ---- ------ ---- ------
Total from investment operations....... 0.28 0.86 (0.71) 2.23 (1 .84)
---- ---- ------ ---- -------
Less Distributions:
Dividends from net investment income........... (0.48) (0.38) (0.41) (0.42) (0.55)
Dividends from net realized gains.............. (0.17) -- -- -- --
------ ------ ------ ------- ------
Total distributions........................ (0.65) (0.38) (0.41) (0.42) (0.55)
Net Asset Value, End of Year................... $7.90 $8.27 $7.79 $8.91 $7.10
===== ===== ===== ===== =====
Total Return................................... 4.03% 11.33% (8 .01%) 32.02% (19.89%)
RATIOS/SUPPLEMENTAL DATA $9,408 $13,832 $16,252 $12,622 $10,558
Net Assets, End of Year (000)..................
Ratios to Average Net Assets: .64% .42% .45% .39% .98%
Interest expense...........................
Operating expenses......................... 2.14% 2.95%* 2.81% 2.81% 2.50%
----- ------ ----- ----- -----
Total expenses......................... 2.78%** 3.37%* 3.26% 3.20% 3.48%
===== ===== ===== ===== =====
Net investment income................. 5.38% 4.55%* 4.88% 5.02% 6.80%
Portfolio turnover rate........................ 282.21% 70.86% 89 .83% 53.27% 15.88%
</TABLE>
* These ratios are after expense reimbursement of .03%, for the year ended
December 31, 1997.
** This ratio would have been 2.82%, net of expenses paid indirectly of 0.04%
for the year ended December 31, 1998.
+ See "Management" for changes in investment adviser during 1998.
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INVESTMENT OBJECTIVE AND PRINCIPAL INVESTMENT STRATEGIES
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 will invest at least 80% of its
assets in municipal obligations that are exempt from federal and California
personal income taxes and at least 65% of the Fund's assets will be invested in
California municipal obligations. 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.
Credit Quality of Issuers
The Fund attempts to achieve its objective by investing substantially all
(at least 80%) of its total assets in municipal obligations defined herein which
are rated within the four highest quality grades for bonds 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 within the three highest quality grades for municipal notes as determined by
Moody's, S&P, Fitch or Duff or, if unrated, are judged by Fund management to be
of comparable quality, and which are issued by the State of California, its
political subdivisions, and its other duly constituted authorities and
corporations.
While the municipal 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 quality grades described above are
considered medium-grade obligations which 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. Ratings are relative
and subjective and, although ratings may be useful in evaluating the safety of
interest and principal payments, they do not evaluate the market value risk of
these bonds. The Fund's ability to achieve its investment objective may be more
dependent on the Manager's credit analysis than might be the case for a fund
that
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invested in higher rated securities only. 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.
Maturities of Investments
The Fund invests in municipal obligations that have remaining maturities
ranging from short-term maturities (less than one year) to long-term maturities
(in excess of fifteen years). The longer the maturity of a municipal obligation,
the greater the impact of fluctuating interest rates on the market value of the
instrument. 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. During periods of
rapidly rising interest rates, the Fund intends to adopt various corrective
measures (i.e., shortening the average length of maturities of portfolio
securities, raising the overall quality of portfolio investments) in order to
minimize the effect of such rates on per share net asset value during such
periods.
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 (excluding those just referred to as "municipal commercial paper")
are included within the term "municipal obligations," as used in this
Prospectus, if their interest payments are excluded for federal income tax
purposes.
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
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<PAGE>
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 invest up to 20% of its total assets in qualified private activity
bonds, if such bonds meet the Fund's investment criteria.
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.
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 municipal securities held by the Fund.
Zero Coupon Bonds
Zero coupon bonds are purchased at a discount from the face amount because
the buyer receives only the right to a fixed payment on a certain date in the
future and does not receive any periodic interest payments. The effect of owning
instruments which do not make current interest payments is that a fixed yield is
earned not only on the original investment but also, in effect, on accretion
during the life of the obligations. This implicit reinvestment of earnings at
the same rate eliminates the risk of being unable to reinvest distributions at a
rate as high as the implicit yields on the Zero coupon bond, but at the same
time eliminates the holder's ability to reinvest at higher rates. For this
reason, Zero coupon bonds are subject to substantially greater price
fluctuations during periods of changing market interest rates than are
comparable securities which pay interest currently, which fluctuation increases
in accordance with the length of the period to maturity.
Delayed-Delivery Transactions
The Fund may buy and sell securities on a "delayed-delivery" basis, with
payment and delivery taking place at a future date. The market value of
securities purchased in this way
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<PAGE>
may change before the delivery date, which could affect the market value of the
Fund's assets, and could increase fluctuations in the Fund's yield and net asset
value. Ordinarily, the Fund will not earn interest on the securities purchased
until they are delivered.
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.
The Fund may purchase various types of structured municipal bonds whose
interest rates fluctuate according to changes in other interest rates for some
period and then revert to a fixed rate. The relationship between the interest
rate on these bonds and the other interest rate or index may be direct or
inverse, or it may be based on the relationship between two other interest rates
such as the relationship between taxable and tax-exempt interest rates.
Borrowing For Investment and For Other Purposes
The Fund may borrow money from banks (including its custodian bank) or from
other lenders to the extent permitted under applicable law, for temporary or
emergency purposes, to meet redemptions or for purposes of leveraging and may
pledge its 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.
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<PAGE>
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 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.
Portfolio Transactions and Turnover
The Manager may sell portfolio securities prior to their maturity if market
conditions and other considerations indicate, in the opinion of the Manager,
that such sale would be advisable. In addition, the Manager may 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. A high
turnover rate (over 100%) increases transaction costs and the possibility of
taxable short-term gains (see "Dividends and Tax Matters") which, in turn, will
reduce the Fund's return. Therefore, the Manager weighs the added costs of
short-term investment against anticipated gains.
Temporary Defensive Positions
To offset fluctuations in share value, Fund management will attempt to adopt
a temporary defensive posture during periods of economic difficulty affecting
either the economy as a whole or, more specifically, individual issuers involved
in the Fund's portfolio. Such practice may include, among other modifications,
reducing or eliminating holdings in securities of issuers such as state and
local governments which the Fund believes may be adversely affected by changing
economic conditions or political events, shortening average maturity and/or
upgrading the average quality of the Fund's portfolio. These defensive measures
may have the effect of reducing the income to the Fund from the portfolio.
Moreover, notwithstanding the imposition of such measures, Fund management may
not be able to foresee developments in the economy sufficiently in advance to
avoid significant declines in market value. To the extent that the Fund is in a
temporary defensive posture, the Fund's investment objective may not be
achieved.
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<PAGE>
PRINCIPAL RISKS
Interest Rate Risk
Rising interest rates cause the prices of debt securities to decrease and
falling rates cause the prices of debt securities to increase. Securities with
longer maturities can be more sensitive to interest rate changes. In effect, the
longer the maturity of a security, the greater the impact a change in interest
rates could have on the security's price. Short-term (less than one year) and
long-term (greater than one year) interest rates do not necessarily move in the
same direction or the same amount. Short term securities tend to react to
changes in short-term interest rates, and long-term securities tend to react to
changes in long-term interest rates.
Credit Risk
Certain issuers of securities may fail to make timely payments of interest
and principal on the Fund's investments. Such failure may arise from changes in
the financial condition of an issuer, changes in specific economic or political
conditions affecting an issuer, and changes in general economic or political
conditions. Investment grade debt securities tend to be less sensitive to these
changes than debt securities rated below investment grade. There is, however, no
guarantee that a high credit rating will insure timely payments from the issuer.
Concentration Risk
Because the Fund invests its assets mainly in the issuers of a single state,
California, it is subject to greater losses arising from adverse political or
economic events affecting California issuers. 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 has depleted its available
cash resources and has had to use a series of external borrowings to meet its
cash needs. Risks also result from 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. Recently, Moody's upgraded the debt
rating on California general obligation bonds to Aa3. The rating reflects a
stable credit outlook based on the State's recovery from the 1990's recession
and an improved financial condition. 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.
Diversification Risk
Because the Fund may invest a greater percentage of its assets in a few
issuers, there is an increased likelihood that a few issuers of securities may
cause losses to the Fund. In the event
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<PAGE>
of decline of creditworthiness or default on the obligations of one or more such
issuers exceeding 5% of the Fund's assets, an investment in the Fund will
involve greater risk than in a fund that has a policy of diversification. Many
of the Fund's portfolio securities will be obligations which are related in such
a way that an economic, business or political development or change affecting
one such security also would affect the other portfolio securities (e.g.,
securities the interest on which is paid from revenues of similar types of
projects). As a result, the Fund's portfolio may be subject to greater risk as
compared to a portfolio composed of more varied obligations or issuers.
Furthermore, the relatively high degree of similarities among the issuers of
obligations in the Fund's portfolio may result in a greater degree of
fluctuation in the market value of the portfolio.
Market-Timing
It is expected that a substantial portion of the assets of the Fund will be
derived from professional money managers and investors who intend to invest in
the Fund as part of an asset-allocation or market-timing investment strategy.
These investors are likely to redeem or exchange their Fund shares frequently to
take advantage of anticipated changes in market conditions. The strategies
employed by investors in the Fund may result in considerable assets moving in
and out of the Fund. Consequently, the Manager expects that the Fund will
generally experience significant portfolio turnover, which will likely cause
higher expenses and additional costs and affect the Fund's performance.
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.
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<PAGE>
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
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.
Special Risk Factors Relating to Inverse Floating Rate Instruments
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Changes in interest rates inversely affect the rate paid on inverse floating
rate instruments ("inverse floaters"). The inverse floater's price will be more
volatile than that of a fixed rate bond. Additionally, some inverse floater's
contain a "leverage factor" whereby the interest rate moves inversely by a
"factor" to the benchmark. For example, the rates on the inverse st floating
rate note may move inversely at three times the benchmark rate. Certain interest
rate st 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.
YEAR 2000
The Fund's securities trades, pricing and accounting services and other
operations could be adversely affected if the computer systems of the adviser,
distributor, custodian or transfer agent were unable to recognize dates after
1999. The adviser and other service providers have told the Funds that they are
taking action to prevent, and do not expect the funds to suffer from,
significant year 2000 problems.
In addition, problems processing year 2000 data could also have adverse
effects on the computer systems of the issuers or entities that comprise the
Fund's portfolio securities. If such issuers or entities are unable to properly
address the year 2000 problem, then it could have an adverse effect on the
operations of such issuer, which, in turn, would result in a drop in market
value for the securities and a loss for the Fund. This problem may exist to a
greater degree with respect to investments by the Fund in the securities of
non-U.S. issuers. Generally, non-U.S. issuers have not devoted the resources
necessary to properly address the year 2000 problem. Therefore, the problems
noted above for domestic issuers of securities held by the Fund is likely to be
exacerbated for the securities of non-U.S. issuers.
MANAGEMENT
The Fund is managed by Cornerstone Equity Advisors, Inc. ("Cornerstone"
or the "Manager"). Cornerstone's principal business address is 67 Wall Street,
New York, New York 10005. Cornerstone is an investment adviser registered with
the Securities and Exchange Commission. Prior to its association with the Fund,
Cornerstone managed approximately $20 million of assets for private and
institutional accounts. As investment manager, Cornerstone manages and
supervises the Fund's investment portfolio and directs the purchase and sales of
its investment securities.
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Cornerstone received advisory fees and reimbursements for its costs
totaling $13,718, which amounted to 0.50% of the Fund's average net assets for
the period from September 29, 1998 to December 31, 1998. During the year 1998,
Fundamental Portfolio Advisors, Inc. served as investment adviser to the Fund
(from January 1, to May 31, 1998), and Tocqueville Asset Management L.P. served
as interim investment adviser to the Fund (from June 1, to September 28, 1998)
each at the same fee rate applicable to Cornerstone's current and interim
advisory contracts.
The Fund's portfolio manager is Mr. Stephen C. Leslie, Chairman and
Chief Executive Officer of Cornerstone. Mr. Leslie has been associated with
Cornerstone since its inception in 1997. Dating back to 1994, Mr. Leslie has
held the following positions: he was a partner of Wall Street Capital Group, a
merchant bank; he was a partner of Wall Street Investment Corp., a
broker/dealer; he was a partner of Tucker Anthony Securities, a broker/dealer;
and he was a senior vice-president of Pryor McClendon Counts & Co., a
broker/dealer.
PRICING OF FUND SHARES
The price of Fund shares is based on the Fund's 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 Fund's shares will not be priced on the following days when the New York
Stock Exchange is closed: New Year's Day, Dr. Martin Luther King Jr.'s Day,
Presidents' Day, Good Friday, Memorial Day, Independence Day, Labor Day,
Thanksgiving Day, and Christmas Day. 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. Fur purposes of
determining net asset value, expenses of the Fund are accrued daily and taken
into account.
The value used by the Fund in computing the current price per share for the
purpose of purchase and redemption of Fund shares (the net asset value per
share) means an amount which reflects calculations to the nearest 1/10th of one
cent.
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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 Board of 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. 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.
The Fund's most recent asset value can be obtained by calling 1-800-322-6864
7 days a week, 24 hours a day. To obtain more detailed information on the Fund's
net asset value, yield and performance you can call 1-800-322-6864 weekdays 9:00
AM-8:00 PM Eastern time.
PURCHASE OF SHARES
You may purchase shares directly from the Fund without a load 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 your purchase will be canceled and you could be
liable for any losses or fees incurred. Firstar Mutual Fund Services, LLC will
charge a $20 fee against a shareholders account for any payment check returned
to the Custodian.
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<PAGE>
The minimum initial purchase is $1,000 and the minimum subsequent purchase
is $100. (The foregoing minimum investment may be modified or waived at any time
at our discretion). 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 "Pricing of
Fund Shares." Share certificates are issued only on written request by you to
Cornerstone Family of Funds, c/o Firstar Mutual Fund Services, LLC, P.O. Box
701, Milwaukee, WI 53201-0701. There is no charge for share 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
purchase order checks processed at any one time and will notify investors prior
to exercising this right. If this right is exercised, the Fund will return
checks immediately.
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 Cornerstone 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 Cornerstone Automatic Investment Program. The Program permits an existing
shareholder to purchase additional shares of any Fund (minimum $50 per
transaction) at regular intervals. Under the Automatic Investment Program,
shares are purchased by transferring funds from a shareholder's checking or bank
money market account in an amount of $50 or more designated by the shareholder.
At the shareholder's option, the account designated will be debited and shares
will be purchased on the date selected by the shareholder. There must be a
minimum of seven days between automatic purchases. If the date selected by the
shareholder is not a business day, funds will be transferred the next business
day thereafter. Only an account maintained at a domestic financial institution
which is an Automated Clearing House member may be so designated. To establish
an Automatic Investment Account, complete and sign the appropriate section of
the Purchase Application and send it to the Transfer Agent. Shareholders may
cancel this privilege or change the amount of purchase at any time by calling
1-800-322-6864 or by mailing written notification to: Cornerstone Family of
Funds, c/o Firstar Mutual Fund Services, LLC, P.O. Box 701, Milwaukee, WI
53201-0701. The change will be effective five business days following receipt of
notification by the Transfer Agent. A Fund may modify or terminate this
privilege at any time or charge a service fee, although no such fee currently is
contemplated. However, a $20 fee will be imposed by Firstar Mutual Fund
Services, LLC, if sufficient funds are not available in the shareholder's
account at the time of the automatic transaction.
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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 Firstar Bank Milwaukee, 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:
Firstar Bank Milwaukee, N.A.
777 East Wisconsin Avenue
Milwaukee, Wisconsin 53202
ABA # 075000022
Credit: Firstar Mutual Fund Services, LLC
Account # 112952137
Further credit: The Cornerstone Family of Funds
Name of shareholder and account number (if known)
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 to Cornerstone Family of Funds, c/o Firstar
Mutual Fund Services, LLC, P.O. Box 701, Milwaukee, WI 53201-0701. The U.S.
Postal Service and other independent delivery services are not agents of the
Fund. Therefore, deposit of purchase requests in the mail or with such services
does not constitute receipt by Firstar Mutual Fund Services, LLC, or the Fund.
Please do not mail letters by overnight courier to the post office box address.
Purchase requests sent by overnight or express mail should be directed to:
Cornerstone Family of Funds, c/o Firstar Mutual Fund Services, LLC, Third Floor,
615 East Michigan Street, Milwaukee, Wisconsin 53202. Checks should be made
payable to Cornerstone Family of Funds.
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<PAGE>
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 an 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 1-800-322-6864.
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 that the value of the
Fund's portfolio securities is determined; the specific method of determining
the value will be provided to you on request. 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. A capital gain or loss for federal
income tax purposes may be realized by the investor following the 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 Fund management acts as
the investment manager in exchange for shares of the Fund at respective net
asset values per share. Exchange instructions may be given in writing to Firstar
Mutual Fund Services, LLC, Agent, P.O. Box 701, Milwaukee, WI 53201-0701, the
Fund's transfer agent, and must specify the number of shares of the Fund to be
exchanged and the fund into which the exchange is being made. The telephone
exchange privilege will be made available to shareholders automatically. You may
telephone exchange instructions by calling Firstar Mutual Fund Services, LLC, at
1-800-322-6864. 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. See also "Telephone
Redemption Privilege" for a discussion of the Fund's policy with respect to
losses resulting from unauthorized telephone transactions.
The Exchange Privilege is only available in those states where such
exchanges 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 recognize 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 after giving 60
days' prior notice. The Fund reserves the right to reject any specific order,
including purchases by exchange.
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<PAGE>
A Completed Purchase Application must be received by the Transfer Agent
before the Exchange, Check Redemption, Telephone Redemption or Expedited
Redemption Privileges may be used.
REDEMPTION OF SHARES
Shares of the Fund are redeemable at your option without charge at the next
determined net asset value following receipt by Firstar Mutual Fund Services,
LLC, 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 Firstar Mutual Fund Services, LLC,
by 4:00 P.M. New York time on any day during which the net asset value is
determined (see "Pricing of Fund Shares"), 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
from the purchase date. 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 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.
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<PAGE>
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 Firstar Mutual Fund Services, LLC.
The Fund may delay, or cause to be delayed, payment of redemption proceeds until
such time as it or Firstar
Mutual Fund Services, LLC 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 received by Firstar Mutual Fund
Services, LLC within 15 days from the purchase date if the shares to be redeemed
have been purchased by check . 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 the Checks, except that Firstar Mutual
Fund Services, LLC, imposes a $20 charge 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 for payment, Firstar Mutual Fund Services, LLC, 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 stock 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
by either the Fund or Firstar Mutual Fund Services, LLC, upon 60 days' written
notice to shareholders.
Telephone Redemption Privilege
You may direct redemptions of up to $150,000 worth of shares per day by
telephone either (i) by completing the appropriate section of the application
form or (ii) by later signature guaranteed* written request. Telephone calls
will be recorded. Firstar Mutual Fund Services, LLC, 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, or a preauthorized bank
address. (Available only if established on the account application and if there
has been no change of address by telephone within the preceding 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 Firstar
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<PAGE>
Mutual Fund Services, LLC. 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 3 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.
Expedited Redemption Privilege
Requests for expedited redemption may be made by letter or telephone for
amounts equal to or exceeding $5,000, if you have previously filed with Firstar
Mutual Fund Services, LLC, a signed telephone authorization form available from
the Fund, or completed the appropriate Section of the Application Form. If the
request is for more than $5,000, proceeds of the expedited redemption will be
transferred by Federal Reserve wire to the commercial bank specified in the
authorization form or to a correspondent bank if your bank is not a member of
the Federal Reserve System. Firstar Mutual Fund Services, LLC, charges a $12
service fee for each payment of redemption proceeds made by Federal wire. This
fee will be deducted from your account. 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 privilege may be modified or terminated at any time without prior
notice by either the Fund or Firstar Mutual Fund Services, LLC. 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.
Requests by letter should be addressed to Cornerstone Family of Funds, c/o
Firstar Mutual Fund Services, LLC, P.O. Box 701, Milwaukee, WI 53201-0701.
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 Cornerstone Family of
Funds, c/o Firstar Mutual Fund Services, LLC, P.O. Box 701, Milwaukee, WI
53201-0701. Such request must be signed by each shareholder with each signature
guaranteed by an eligible guarantor (see above).
- --------------
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<PAGE>
*A signature guarantee must be from an eligible guarantor institution approved
by Cornerstone. 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 Medallion Program ("STAMP"). If you have any questions with
respect to signature guarantees, please call the transfer agent at 1-800-
322-6864.
Regular Redemption Procedure
You may redeem your shares by sending a written request, together with duly
endorsed stock certificates, if any, to Cornerstone Family of Funds, c/o Firstar
Mutual Fund Services, LLC, P.O. Box 701, Milwaukee, WI 53201-0701. 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. Firstar Mutual Fund Services, LLC, 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. The U.S. Postal Service and other independent delivery
services are not agents of the Fund. Therefore, deposit of redemption requests
in the mail or with such services does not constitute receipt by Firstar Mutual
Fund Services, LLC, or the Fund. Please do not mail letters by overnight courier
to the post office box address. Redemption requests sent by overnight or express
mail should be directed to: Cornerstone Family of Funds, c/o Firstar Mutual Fund
Services, Third Floor, 615 East Michigan Street, Milwaukee, Wisconsin 53202.
Redemptions by mail will not become effective until all documents in the form
required have been received by Firstar Mutual Fund Services, LLC.
Requests for redemption subject to any special condition, or which specify
an effective date other than as provided herein, cannot be accepted and will be
returned to you.
How to Transfer Shares
Shares may be transferred from one person to another by sending to Firstar
Mutual Fund Services, LLC, 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 Firstar Mutual Fund Services, LLC. In addition, Firstar
Mutual Fund Services, LLC, reserves the right to request any additional
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<PAGE>
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.
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. If the Plan is terminated in accordance with its terms, the
obligation of the Fund to make payments pursuant to the Plan, including any
prior expenses carried forward, will cease and the Fund will not be required to
make any payments for expenses incurred after the date the Plan terminates.
Because these payments are paid out of the Fund's assets on a continual basis
over time, these fees will increase the cost of your investment and may cost you
more than other types of sales charges.
DIVIDENDS AND TAX MATTERS
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. year
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
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<PAGE>
Firstar Mutual Fund Services, LLC, which election will remain in effect until
Firstar Mutual Fund Services, LLC is notified by you in writing to change the
election, at least ten (10) days prior to payment date.
Tax Matters
The Fund intends to qualify as a regulated investment company, which
means that it pays no federal income tax on the earnings or capital gains it
distributes to its shareholders.
o Exempt-interest dividends from the Fund will be exempt from federal
regular income tax and California income tax.
o Ordinary dividends from the Fund are taxable as ordinary income and
dividends from the Fund's long-term capital gains are taxable as capital
gain.
o Dividends are treated in the same manner for federal income tax purposes
whether you receive them in the form of cash or additional shares. They
may also be subject to state and local taxes.
o Certain dividends paid to you in January will be taxable as if they had
been paid the previous December.
o We will mail you tax statements annually showing the amounts and tax
status of the distributions you received.
o When you sell (redeem) or exchange shares of the Fund, you must
recognize any gain or loss.
o Because your tax treatment depends on your purchase price and tax
position, you should keep your regular account statements for use in
determining your tax.
***We provide this tax information for your general information. You should
consult your own tax adviser about the tax consequences of investing in the
Fund.***
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FOR MORE INFORMATION
FOR INVESTORS WHO WANT MORE INFORMATION ON THE FUND, THE FOLLOWING DOCUMENTS ARE
AVAILABLE FREE UPON REQUEST:
Annual/Semi-Annual Reports: contain performance data and information on
portfolio holdings for the Fund's most recently completed fiscal year or half
year and, on an annual basis, a statement from portfolio management and the
auditor's report.
Statement of Additional Information (SAI): contains more detailed information
about the Fund's policies, investment restrictions, risks and business
structure. This prospectus incorporates the SAI by reference.
Copies of these documents and answers to questions about the Fund may be
obtained without charge by contacting:
CORNERSTONE CALIFORNIA MUNI FUND
67 Wall Street
New York NY 10005
1-800- 322-6864
Information about the Fund (including the SAI) can be viewed and copied at the
Public Reference Room of the Securities and Exchange Commission (the "SEC") in
Washington, D.C. Copies of this information may be obtained, upon payment of a
duplicating fee, by writing the Public Reference Room of the SEC, Washington,
D.C. 20549-6009. Information on the operation of the Public Reference Room may
be obtained by calling the SEC at 1-800-SEC- 0330. Reports and other information
about the Fund may be viewed on-screen or downloaded from the SEC's Internet
site at http://www.sec.gov.
================================================================================
FOR MORE INFORMATION ON OPENING A NEW ACCOUNT, MAKING
CHANGES TO EXISTING ACCOUNTS, PURCHASING, EXCHANGING OR
REDEEMING SHARES, OR OTHER INVESTOR SERVICES, PLEASE CALL:
1-800-(322- 6864)
Monday through Friday
9:00 a.m. to 8:00 p.m. (EST)
================================================================================
The Fund's Investment Company Act File number is 811-3674.
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STATEMENT OF ADDITIONAL INFORMATION
CORNERSTONE CALIFORNIA MUNI FUND
A SERIES OF THE CALIFORNIA MUNI FUND
This Statement of Additional Information provides certain
detailed information concerning the Fund. It is not a prospectus. The Fund's
Prospectus may be obtained, without charge, by writing to the Fund at
Cornerstone Family of Funds, c/o Firstar Mutual Fund Services, LLC, P.O. Box
701, Milwaukee, WI 53201-0701, or by calling (800) 322-6864. This Statement of
Additional Information should be read in conjuction with the Fund's Prospectus
dated April 30, 1999, and the Fund's Annual Report dated December 31, 1998,
which are hereby incorporated by reference.
THIS STATEMENT IS DATED APRIL 30, 1999 AND SUPPLEMENTS
THE FUND'S PROSPECTUS OF THE SAME DATE.
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TABLE OF CONTENTS
Page
----
FUND HISTORY ............................................................. 3
NON-PRINCIPAL INVESTMENT STRATEGIES AND RISKS .................. 3
INVESTMENT LIMITATIONS ........................................... 15
MANAGEMENT OF THE FUND ........................................... 17
OWNERSHIP OF SECURITIES .................................................. 20
INVESTMENT MANAGEMENT AND OTHER SERVICES ................................. 20
DISTRIBUTION PLAN ................................................ 22
PORTFOLIO TRANSACTIONS............................................ 24
TAXES............................................................. 25
DESCRIPTION OF SHARES............................................. 30
CERTAIN LIABILITIES............................................... 31
PURCHASE OF SHARES ....................................................... 32
PRICING OF SHARES ........................................................ 32
CALCULATION OF YIELD...................................................... 32
FINANCIAL STATEMENTS.............................................. 35
APPENDIX..........................................................A-1
APPENDIX..................................................................B-1
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FUND HISTORY
The California Muni Fund (the "Company") is a Massachusetts
business trust that was organized on January 26, 1983. The Company is a
non-diversified management investment company and has one series bearing the
name Cornerstone California Muni Fund (the "Fund").
NON-PRINCIPAL INVESTMENT STRATEGIES AND RISKS
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 of the 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 also invest in the following instruments or employ
the strategies noted below:
Futures Contracts
A futures contract is an agreement between two parties to buy and
sell a security for a set price on a future date. Futures contracts are traded
on designated "contract markets" which, through their clearing corporations,
guarantee performance of the contracts. Presently, there are futures contracts
based on such debt securities as long-term U.S. Treasury Bonds, Treasury Notes,
Government National Mortgage Association modified pass-through
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mortgage-backed securities, three-month U.S. Treasury Bills, and bank
certificates of deposit. Although most futures contracts call for actual
delivery or acceptance of debt securities, the contracts usually are closed out
before the settlement date without the making or taking of delivery. A futures
contract sale is closed out by effecting a futures contract purchase for the
same aggregate amount of the specific type of debt security and the same
delivery date. If the sale price exceeds the offsetting purchase price, the
seller would be paid the difference and would realize a gain. If the offsetting
purchase price exceeds the sale price, the seller would pay the difference and
would realize a loss. Similarly, a futures contract purchase is closed out by
effecting a futures contract sale for the same aggregate amount of the specific
type of debt security and the same delivery date. If the offsetting sale price
exceeds the purchase price, the purchaser would realize a gain, whereas if the
purchase price exceeds the offsetting sale price, the purchaser would realize a
loss. There is no assurance that the Fund will be able to enter into a closing
transaction. In the unlikely event that the Fund was unable to enter into a
closing transaction of an open futures or options position, the Fund could be
forced to perform certain actions as specified by the futures or options
contract. This would depend on the type of outstanding contract involved. The
two types of methods by which futures and options contracts are closed in the
absence of offsetting trades are by index value and by delivery.
Futures and options contracts in financial instruments such as
municipal bonds and LIBOR rates, settle by index value. That means that on the
last trading day of the contract, all outstanding contracts are automatically
closed out at the value of the index that day. The effect on the Fund would be
exactly the same as if a closing transaction had been effected at that price.
Futures and options in financial instruments such as Treasury
bonds and notes, if not closed out, will result in actual delivery of the
securities in question. The holder of a long futures contract or an option
contract that was exercised could be forced to purchase (take delivery of) a
specified amount of securities at a specified price. Likewise the entity that
was short a futures contract or option that did not enter into a closing
transaction prior to expiration, could be forced to deliver a specific amount of
securities at a specified price according to the terms of the futures or option
contract.
The inability of the Fund to enter into a closing contract could
result in the Fund being forced to deliver or take delivery of a specific amount
of securities at a specific price. Disposing of or obtaining the specified
securities could involve considerable expense to the Fund and could affect the
Fund's net asset value.
When the futures contract is entered into, each party deposits
with a broker or in a segregated custodial account approximately 5% of the
contract amount, called the "initial margin." The segregated custodial account
will be in an amount equal to the total market value of the futures contract,
less the initial margin deposited therefor. Subsequent payments to and from the
broker or account, called "variation margin," will be made on a daily basis as
the price of the underlying debt security fluctuates making the long and short
positions of the futures contract more or less valuable, a process known as
"mark to the market."
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The purpose of a futures contract, in the case of a portfolio
holding long-term municipal debt securities, is to gain the benefit of changes
in interest rates without actually buying or selling long-term debt securities.
Generally, if market interest rates increase, the value of outstanding debt
securities declines (and vice versa). Entering into a futures contract for the
sale of debt securities has an effect similar to the actual sale of such
securities, although the sale of the futures contract might be accomplished more
easily and quickly given the greater liquidity in the futures market. For
example, if the Fund holds long-term debt securities and it anticipates a rise
in long-term interest rates, it could, in lieu of disposing of its portfolio
securities, enter into futures contracts for the sale of similar long-term
securities. If rates increased and the value of the Fund's portfolio securities
declined, the value of the Fund's futures contracts would increase, thereby
protecting the Fund by preventing net asset value from declining as much as it
otherwise would have declined. Similarly, entering into futures contracts for
the purchase of debt securities has an effect similar to the actual purchase of
the underlying securities, but permits the continued holding of securities other
than the underlying securities. For example, if the Fund expects long-term
interest rates to decline, it might enter into futures contracts for the
purchase of long-term securities in order to gain rapid market exposure that may
offset anticipated increases in the cost of securities it intends to purchase,
while continuing to hold higher-yield, short-term securities or waiting for the
long-term market to stabilize. The Board of Directors has adopted a percentage
restriction limiting the aggregate market value of the futures contracts the
Fund holds to an amount not to exceed 20% of the market value of its total
assets.
Options
An option gives the holder a right to buy or sell futures
contracts, or securities, in the future. The Fund will only buy options listed
on national securities exchanges except for agreements, sometimes called cash
puts, which may accompany the purchase of a new issue of bonds from a dealer.
Unlike a futures contract, which requires the parties to the contract to buy and
sell a security on a set date, an option on a futures contract, for example,
merely entitles its holder to decide on or before a future date whether to enter
into such a contract. If the holder decides not to enter into the contract, all
that is lost is the price, called the "premium," paid for the option. Further,
because the value of the option is fixed at the point of sale, there are no
daily cash payments to reflect the change in the value of the underlying
contract. However, since an option gives the buyer the right to enter into a
contract at a set price for a fixed period of time, its value does change daily,
and the change is reflected in the net asset value of the Fund.
In addition to options on futures contracts, there are options
that give the buyer the right to buy or sell actual debt securities, such as
tax-exempt bonds. Currently, the market for options on tax-exempt securities is
very small. It is anticipated that it will become substantially larger in the
future. A put option gives the buyer of the option the right to sell a
designated security for a set price, and a call option gives the buyer the right
to buy a security for a set price on or before a specified date. The "writer,"
or seller, of a call option, for example, is required to sell the security
described in the option to the holder of the option, if
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the holder decides to buy such security. For undertaking this obligation, the
writer receives a premium, less the commission charged by a broker, which the
writer retains regardless of whether the option is exercised. The Fund will only
write call options on securities it holds in its portfolio, (referred to as
covered call writing) or will write "cash secured puts," as defined below. The
buyer of such a put pays the Fund a premium for the option to sell to the Fund a
specific bond at a specified price within a specified period of time. The Fund
will maintain adequate cash reserves to purchase the underlying bond should the
put option be exercised, by placing in a segregated account, only liquid assets,
such as cash, U.S. Government securities or other appropriate high-grade debt
obligations ("cash secured puts"). The Fund retains the premium whether or not
the option is exercised. However, the Fund will be obligated to purchase the
bond at the exercise price regardless of how much the market value of the bond
has declined below the exercise price. As a covered call option writer, the Fund
earns additional income from premiums, but it risks losing any appreciation of
the security covered by the option if interest rates decline. Option writing can
be used advantageously to generate incremental income when the outlook is for
relatively stable bond prices; however, such income may be taxable. The
aggregate market value of the options on debt securities held or written by the
Fund may not exceed 25% of the Fund's total net assets. The risk involved in
writing options (or selling futures) is not limited to the value of the options,
since the maximum potential loss to the Fund is the cost of closing out the
short options (or futures) positions which theoretically has no limit.
Participation in options transactions involves certain risks.
Investing in Other Investment Companies
The Fund may invest indirectly in municipal obligations by
investing in other investment companies. Such investments may involve the
payment of premiums above the net asset value of such issuers' portfolio
securities, are subject to limitations under the Investment Company Act of 1940
and are constrained by market availability. As a shareholder in an investment
company, the Fund would bear its ratable share of that investment company's
expenses, including its advisory and administration fees. The Fund would
continue to pay its own management fees and other expenses with respect to its
investments in shares of a closed-end investment company.
Lending of Portfolio Securities
In order to generate income, the Fund may lend its portfolio
securities in an amount up to 33-1/3% of total assets to broker-dealers, major
banks or other recognized domestic institutional borrowers of securities not
affiliated with the Manager. The borrower at all times during the loan must
maintain cash or cash equivalent collateral or provide to the Fund an
irrevocable letter of credit equal in value to at least 100% of the value of the
securities loaned. During the time portfolio securities are on loan, the
borrower pays the Fund any dividends or interest paid on such securities, and
the Fund may invest the cash collateral in high-grade, short-term, tax-exempt
instruments and earn income, or it may receive an
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agreed-upon amount of interest income from the borrower who has delivered
equivalent collateral or a letter of credit.
Repurchase Agreements
The Fund may enter into repurchase agreement transactions. Under
a repurchase agreement, the Fund acquires a debt instrument for a relatively
short period (usually not more than one week) subject to the obligation of the
seller to repurchase and the Fund to resell such debt instrument at a fixed
price. The resale price is in excess of the purchase price in that it reflects
an agreed-upon market interest rate effective for the period of time during
which the Fund's money is invested. The Fund's repurchase agreements will at all
times be fully collateralized in an amount at least equal to the purchase price
including accrued interest earned on the underlying securities. The instruments
held as collateral are valued daily, and as the value of instruments declines,
the Fund will require additional collateral. If the seller defaults and the
value of the collateral securing the repurchase agreement declines, the Fund may
incur a loss. Repurchase agreements are considered by the staff of the
Securities and Exchange Commission to be loans by the Fund.
Reverse Repurchase Agreements
The Fund may enter into reverse repurchase agreement transactions
only in amounts such that the total of the reverse repurchase agreements and all
other borrowings combined will not exceed 33-1/3% of the Fund's total assets at
the time it enters into a reverse repurchase agreement. Such transactions
involve the sale of securities held by the Fund, with an agreement that the Fund
will repurchase such securities at an agreed upon price and date. The Fund will
employ reverse repurchase agreements when necessary to meet unanticipated net
redemptions so as to avoid liquidating other portfolio investments during
unfavorable market conditions, or as a technique to enhance income. At the time
it enters into a reverse repurchase agreement, the Fund will place in a
segregated custodial account high-quality liquid debt securities having a dollar
value equal to the repurchase price. The Fund will utilize reverse repurchase
agreements when the interest income to be earned from portfolio investments is
greater than the interest expense incurred as a result of the reverse repurchase
transactions. Any reverse repurchase agreement entered into by the Fund
constitutes a borrowing, has leveraging effects and makes the Fund's net asset
value more volatile.
Illiquid Securities
The Fund will not invest more than 15% of its net assets (taken
at market value) in illiquid securities, including repurchase agreements with
maturities in excess of seven days.
The Fund may invest in securities that are subject to
restrictions on resale because they have not been registered under the
Securities Act of 1933 (the "1933 Act"). These securities are sometimes referred
to as private placements. Although securities which may be resold only
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to "qualified institutional buyers" in accordance with the provisions of Rule
144A under the 1933 Act are technically considered "restricted securities", the
Fund may purchase Rule 144A securities without regard to the limitation on
investments in illiquid securities described above, provided that a
determination is made that such securities have a readily available trading
market. Fund management will determine the liquidity of Rule 144A securities
under the supervision of the Fund's Board of Directors. The liquidity of Rule
144A securities will be monitored by Fund management and, if as a result of
changed conditions, it is determined that a Rule 144A security is no longer
liquid, the Fund's holding of illiquid securities will be reviewed to determine
what, if any, action is required to assure that the Fund does not exceed its
applicable percentage limitation for investments in illiquid securities.
Fund management anticipates that the market for certain
restricted securities such as inverse floaters that are created in the secondary
market will expand further as a result of this relatively new regulation and the
development of automated systems for the trading, clearing and settlement of
unregistered securities, as more institutions and dealers invest in and make
markets in these securities.
In reaching liquidity decisions, Fund management will consider,
inter alia, the following factors: (1) the frequency of trades and quotes for
the security; (2) the number of dealers wanting to purchase or sell the security
and the number of other potential purchasers; (3) dealer undertakings to make a
market in the security and (4) the nature of the security and the nature of the
marketplace trades (e.g., the time needed to dispose of the security, the method
of soliciting offers and the mechanics of the transfer).
Private Activity Bonds
The Fund may invest up to 20% 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" with respect 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. A "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.
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Special Risk Factors Relating to Futures and Options
There are certain risks in investing in options and interest rate
futures contracts. With respect to the use of futures contracts, although the
Fund intends to purchase or sell futures contracts only if there is an active
market for such contracts, no assurance can be given that a liquid market will
exist for any particular contract at any particular time. Many futures exchanges
and boards of trade limit the amount of fluctuation permitted in futures
contract prices during a single trading day. Once the daily limit has been
reached in a particular contract, no trades may be made that day at a price
beyond that limit. Futures contract prices could move to the daily limit for
several consecutive trading days with little or no trading, thereby preventing
prompt liquidation of futures positions and potentially subjecting the Fund to
substantial losses. If it is not possible, or the Fund determines not to close a
futures position in anticipation of adverse price movements, the Fund will be
required to make daily cash payments of variation margin. In such circumstances,
an increase in the value of the portion of the portfolio being hedged, if any,
may offset partially or completely losses on the futures contract.
In addition, no assurance can be given that the price of the
securities being hedged will correlate with the price movements in a futures
contract and thus provide an offset to losses on the futures contract. However,
the risk of imperfect correlation generally tends to diminish as the maturity
date of the futures contract approaches.
The Manager could also be incorrect in its expectations about the
direction or degree of various interest rate movements in the time span within
which the movements take place. Predicting interest rate direction involves
skills and techniques different from those used in most investment strategies,
and there is no guarantee that such predictions will be accurate.
The risk the Fund assumes when it buys an option is the loss of
the premium paid for the option. In order to benefit from buying an option, the
price of the underlying security must change sufficiently to cover the premium
paid, the commissions paid, both in the acquisition of the option and in a
closing transaction, or the exercise of the option and subsequent sale of the
underlying security. (The Fund could enter into a closing transaction by
purchasing an option if it had previously sold one, or by selling an option if
it had previously bought one, with the same terms as the option previously
acquired.) Nevertheless, the price change in the underlying security does not
assume a profit, because prices in the options market may not reflect such a
change.
The risk involved in writing options on futures contracts the
Fund owns, or on securities held in its portfolio, is that there could be an
increase in the market value of such contracts or securities. In such case, the
option would be exercised and the asset would be sold at a lower price than the
cash market price. To some extent, the risk of not realizing a gain could be
reduced by entering into a closing transaction. However, the cost of closing the
option and terminating the Fund's obligation might be more or less than the
premium received when it originally wrote the option. Further, the Fund might
not be able to close the option because
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of insufficient activity in the options market. The risk involved in writing
options (or selling futures) is not limited to the value of the options, since
the maximum potential loss to the Fund is the cost of closing out the short
options (or futures) positions which theoretically has no limit.
Finally, in deciding whether to use futures contracts or options,
consideration must be given to brokerage commission costs, which are normally
higher than those associated with general securities transactions.
Special Risk Factors Relating to Lower Rated Municipal Bonds
You should carefully consider the relative risks of investing in
the higher yielding (and, therefore, higher risk) securities in which the Fund
may invest. These are bonds such as those rated Ba to Caa by Moody's or BB to CC
by S&P, Fitch or Duff or, if unrated, are judged by Fund management to be of
comparable quality. 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. The Fund will not purchase bonds in default.
Investments in 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 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. Lower rated
securities will also be affected by the market's perception of their 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
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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.
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 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.
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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, 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
-12-
<PAGE>
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 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
-13-
<PAGE>
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 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 being enacted is uncertain.
-14-
<PAGE>
INVESTMENT LIMITATIONS
In addition to the Fund's investment objective, 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) 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.
-15-
<PAGE>
(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. 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.
Temporary Defensive Investments
The Fund retains the flexibility to respond to changes in the
market or in the economy. Consequently, the Fund may use a temporary defensive
investment strategy. When employing a temporary defensive investment strategy,
the Fund may hold cash (U.S. dollars), or invest without limitation in taxable,
high quality short term money market instruments. Any net interest income
derived from taxable securities and distributed by the Fund will be taxable as
ordinary income when distributed.
Portfolio Turnover
The Fund's portfolio turnover rate was approvimately 71% for the
year ended December 31, 1997, and was approximately 282% for the year ended
December 31, 1998. A substantial portion of the Fund's assets was derived from
professional money managers and investors who invest in the Fund as part of an
asset-allocation or market-timing investment strategy. These investors redeem or
exchange their Fund shares frequently to take advantage
-16-
<PAGE>
of anticipated changes in market conditions. The strategies employed by
investors in the Fund resulted in considerable assets moving in an out of the
Fund. Consequently, the Fund experienced significant portfolio turnover during
the year ended December 31, 1998.
MANAGEMENT OF THE FUND
Trustees and Officers
The business of the Company is managed under the direction of the Board
of Trustees. Specifically, the Board of Trustees is responsible for oversight of
the Fund by reviewing and approving necessary agreements with the Fund's service
providers, and mandating policies for the Fund's operations.
Trustees and officers of the Fund, together with information as to their
principal business occupations during the last five years, are shown below. Each
director who is considered to be an "interested person" of the Fund, as defined
in the 1940 Act, is indicated by as asterisk (*). The Board Members listed below
were elected by the Fund's shareholders at a Special Meeting held on March 12,
1999.
-17-
<PAGE>
<TABLE>
<CAPTION>
=====================================================================================================
Position(s) Held Principal Occupation(s) During
Name, Address, and Age with Fund Past Five Years
- -----------------------------------------------------------------------------------------------------
<S> <C> <C>
William J. Armstrong Trustee Vice President and Treasurer,
Ingersoll Rand Company Ingersoll-Rand Company (5/86 -
200 Chestnut Ridge Road Present); Trustee, Chase Vista
Woodcliff Lake, NJ 07675 Funds.
Age: 56
- -----------------------------------------------------------------------------------------------------
L. Greg Ferrone Trustee Consultant (3/99-Present);
83 Ronald Court Senior Manager, ARC Partners
Ramsey, New Jersey 07446 (10/97 - 3/99); Consultant,
IntraNet, Inc. (4/90 - 10/97);
Age: 47 Sales & Marketing Director,
RAV Communications (4/85 -
4/90); Vice President/Regional
Manager, National Westminster
Bank USA (3/78 - 4/85).
- -----------------------------------------------------------------------------------------------------
Stephen C. Leslie* President and Chairman and CEO,
Cornerstone Equity Advisors Trustee Cornerstone Equity Advisors
Inc. Inc. (6/97 - Present); Partner,
67 Wall Street Wall Street Capital Group (3/97
New York, New York 10005 - 6/97); Partner, Wall Street
Investment Corp. (11/95 -3/97);
Age: 45 Partner, Tucker Anthony
Securities (8/95 - 10/95); Senior
Vice President, Pryor
McClendon Counts & Co. (5/94
- 8/95); Senior Vice President,
Siebert Capital Markets (6/93 -
5/94).
- -----------------------------------------------------------------------------------------------------
G. John Fulvio* Treasurer/Chief Treasurer, Cornerstone Equity
Speer & Fulvio Financial Officer Advisors, Inc. (4/97 - Present);
60 East 42nd Street and Trustee Partner, Speer & Fulvio (3/87 -
New York, New York 10165 Present).
Age: 41
- -----------------------------------------------------------------------------------------------------
-18-
<PAGE>
- -----------------------------------------------------------------------------------------------------
Leroy E. Rodman Trustee Counsel, Morrison, Cohen,
Morrison, Cohen, Singer & Singer & Weinstein, LLP
Weinstein, LLP (1996 - Present); Senior Partner,
750 Lexington Avenue Teitelbaum, Hiller, Rodman,
New York, NY 10022 Paden & Hibsher, P.C. (1990 -
Age: 85 1996).
- -----------------------------------------------------------------------------------------------------
Dr. Yvonne Scruggs-Leftwich Trustee Executive Director and Chief
11510 Bucknell Drive Operating Officer, Black
Condo #204 Leadership Forum, Inc.;
Wheaton, MD 20902 Director, Joint Center For
Age: 65 Political and Economic Studies
(1991 - Present).
=====================================================================================================
</TABLE>
Mr. Leslie is the chief portfolio manager and Mr. Fulvio the Treasurer
of the Fund's adviser, Cornerstone Equity Advisors, Inc. All of the Trustees of
the Fund are also Trustees of Cornerstone Fixed-Income Funds and Directors of
Cornerstone Funds, Inc.
For services and attendance at board meetings and meetings of committees
which are common to the Fund, Cornerstone Fixed-Income Funds and Cornerstone
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
$5,000 per quarter prorated among the three funds based on their respective net
assets at the end of each quarter. Each such Trustee is also reimbursed by the
three funds, on the same basis, for actual out-of-pocket expenses relating to
his or her attendance at meetings. Some Trustees received additional
compensation at a rate of $125 per hour for services related to servicing on the
Portfolio Review Committee. 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.
<TABLE>
<CAPTION>
COMPENSATION TABLE
(for each current Board Member for the
most recently completed fiscal year)
==========================================================================================================
Pension or Total
Retirement Compensation
Aggregate Benefits Accrued Estimated Annual From Fund and
Name of Person*, Compensation as Part of Fund Benefits Upon Fund Complex
Position From Fund Expenses Retirement Paid to Trustees
- -------- --------- -------- ---------- ----------------
-19-
<PAGE>
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
L. Greg Ferrone, $12,401 N/A N/A $19,500
Director
==========================================================================================================
</TABLE>
* Mr. Ferrone is the only current Board Member who served in that capacity
during the fiscal year ended 1998.
OWNERSHIP OF SECURITIES
As of March 31, 999, except as set forth below, no person owned
beneficially or of record more than 5% of the outstanding shares of the Fund. As
of that date, the officers and Board Members of the Fund beneficially owned less
than 1% of the shares of the Fund.
Number of Percentage of
Name & Address Shares Owned Outstanding Shares
Joan R. Warner 57,204.729 5.72%
1 Ellis Court
Alameda, CA 94501-6405
Brigette G. Altmetz 50,684.260 5.06%
Erik F. Altmetz JT TEN
1475 Old Hauf Road
Pasadena, CA 91107
INVESTMENT MANAGEMENT AND OTHER SERVICES
Advisory Services
The Fund is currently managed by Cornerstone Equity Advisors, Inc.
("Cornerstone" or the "Manager"). Cornerstone's Chairman and Chief Executive
Officer is Mr. Stephen C. Leslie, who is also President of the Fund. Mr. Leslie
is one of two individuals who may be considered a "control person" of
Cornerstone. Cornerstone's Treasurer, Mr. G. John Fulvio, is the Treasurer and
Chief Financial Officer of the Fund. Mr. Fulvio is not considered a "control
person" of Cornerstone.
Cornerstone receives an advisory fee equal to the following percentages
of the Fund's average daily net asset value:
-20-
<PAGE>
<TABLE>
<CAPTION>
Average Daily Net Asset Value Annual Fee Payable
----------------------------- ------------------
<S> <C>
Net asset value to $100,000,000 .50%
Net asset value of $100,000,000 or more but less than $200,000,000 .48%
Net asset value of $200,000,000 or more but less than $300,000,000 .46%
Net asset value of $300,000,000 or more but less than $400,000,000 .44%
Net asset value of $400,000,000 or more but less than $500,000,000 .42%
Net asset value of $500,000,000 or more .40%
</TABLE>
The fee levels noted above are identical to those received by the Fund's
previous advisers, Tocqueville Asset Management, L.P. ("Tocqueville"), and
Fundamental Portfolio Advisors, Inc. ("FPA").
From September 29, 1998 to December 31, 1998 Cornerstone received
an aggregate advisory fee of $13,718. From June 1, 1998 to September 28, 1998
Tocqueville, as an interim adviser, received an aggregate advisory fee of
$20,667. From January 1, 1998 to May 30, 1998 FPA received an aggregate advisory
fee of $25,259. For the fiscal year ended December 31, 1997 FPA received an
aggregate advisory fee of $63,726. For the fiscal year ended December 31, 1996
FPA received an aggregate advisory fee of $787,962.
Administrator, Transfer Agent, and Accounting Agent
Firstar Mutual Fund Services, LLC, 615 East Michigan Street,
Milwaukee, WI 53201-0701 currently acts as Administrator, Transfer Agent, and
Accounting Agent of the Fund. Firstar Mutual Fund Services, LLC provides various
administrative and accounting services necessary for the operations of the Fund.
Services provided by the Administrator include: facilitating general Fund
management; monitoring Fund compliance with federal and state regulations;
supervising the maintenance of the Fund's general ledger, the preparation of the
Fund's financial statements, the determination of the net asset value of the
Fund's assets and the declaration and payment of dividends and other
distributions to shareholders; and preparing specified financial, tax and other
reports. The Fund pays the Administrator an annual fee for administrative
services of 0.06% on the first $200 million on the Fund's average net assets;
0.05% of the next $300 million of the Fund's average net assets; 0.03% of the
remaining value of the Fund's average net assets, subject to a minimum annual
fee of $30,000 for the Fund. The Fund reimburses the Administrator for certain
out-of-pocket expenses. In addition, the Fund pays Firstar Mutual Funds
Services, LLC a fee for accounting services of $25,000 on the first $40 million
of assets, and 0.02% annually on the next $200 million of such assets; and 0.01%
of any remaining assets, determined as of the end of the month; plus certain
expenses.
Custodian and Independent Public Accountant
-21-
<PAGE>
Firstar Bank Milwaukee, N.A. (the "Bank"), 615 East Michigan
Street, Milwaukee, WI 53201-0701, acts as Custodian of the Fund's cash and
securities.
McGladrey & Pullen, LLP acts as independent certified public
accountants for the Fund, performing an annual audit of the Fund's financial
statements and preparing its tax returns.
DISTRIBUTION PLAN
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 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. 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"). For processing investor purchase and redemption
orders, responding to inquiries from Fund shareholders concerning the status of
their accounts and operations of the Fund and communicating with the Fund, the
Fund may pay each such Shareholder Service Agent to cover expenditures for
advertising, sales literature and other promotional materials on behalf of the
Fund.
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 the management's analysis of (1) the contribution that the
Shareholder Service Agent makes to the 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 Servicing Agent in connection
with providing services to 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.
No interested persons of the Fund had a direct or indirect
financial interest in the operation or plan or related agreements. 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
-22-
<PAGE>
agreement with Cresvale International (US) LLC ("Cresvale") under the Plan. The
agreement provides that the Fund may pay the usual and customary agency's
commission to Cresvale for producing and placing Fund advertising in newspapers,
magazines or other periodicals, on radio or television, or in direct marketing
campaigns. In addition to the foregoing, the Fund may pay
Cresvale for marketing research and promotional services specifically relating
to the distribution of Fund shares, including office space, facilities and
equipment, salaries, training and administrative expenses, computer systems and
software, communications, supplies, photocopying and similar types of expenses.
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 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 is committed to the discretion of the independent Trustees.
During the year ended December 31, 1998, the Fund paid $19,602
for expenses incurred pursuant to the Plan, which amount was spent in the
distribution of the Fund's shares, including expenses for: advertising -- ($
192); printing and mailing of Prospectuses to other than current shareholders --
($3,006); and sales, and shareholder servicing support services and other
distribution services, -- ($16,404). Of the amount paid by the Fund during last
year, $6,400 was paid to Fundamental Service Corporation, and $9,000 was paid to
Tocqueville Securities, LP for expenses incurred and services rendered by it
pursuant to the Plan.
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
-23-
<PAGE>
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, 1997 and 1996, the Fund's annual rate of portfolio turnover was
approximately 70.86% and 89.83%, 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 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.
During the last three fiscal years from 1996-98, the Fund paid $ -0-, $
- -0-, and $ -0-, respectively, in brokerage commissions.
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).
-24-
<PAGE>
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.
TAXES
The following is only a summary of certain additional federal income 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 count toward satisfaction of the Distribution
Requirement.
In addition to satisfying the Distribution Requirement, a regulated
investment company must 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").
In general, gain or loss recognized by the Fund on the disposition of an
asset will be a capital gain or loss. However, 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
-25-
<PAGE>
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 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 its total assets in
securities of such issuer and 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 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.
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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 a 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 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.
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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 generally will 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; any excess will be treated as gain realized 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 realized but
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
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31 of such calendar year provided 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) 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 failed to
provide a correct taxpayer identification number, (2) is subject to backup
withholding for failure properly to report the receipt of interest or dividend
income, 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 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. 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 carried on by 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 or redemption of shares of the Fund, capital
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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 carried on by 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. taxpayers.
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 subject to withholding 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 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 of Additional Information. 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 may 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.
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 = 2[(----- + 1) - 1]
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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
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.
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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 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, 1997
determined in accordance with the above formula was 3.32%.
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:
P(1+T)n = 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, 1998 was 4.03%. For the five-year period ended December 31, 1998,
the average annual total return was 2.42%. The average annual total return was
5.39% for the ten-year period ended December 31, 1998.
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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, 1998 was .496% for a taxpayer whose income was subject to the
then highest combined Federal and California State income tax rate of 39.60%.
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.
DESCRIPTION OF SHARES
The Fund's Declaration of Trust permits its Board of Trustees to
authorize the issuance of an unlimited number of full and fractional shares of
beneficial interest (without par value), which may be divided into such separate
series as the Trustees may establish. The Fund currently has one series of
shares: the Cornerstone California Muni Fund. The Trustees may establish
additional series of shares, and may 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 equal proportionate interest in
the Fund with each other share. The shares of any additional series would
participate equally in the earnings, dividends and assets of the particular
series, and would be entitled to vote separately to approve investment advisory
agreements or changes in investment restrictions, but shareholders of all series
would vote together in the election and selection of Trustees and accountants.
Upon liquidation of the Fund, each shareholder is entitled to share pro rata in
the net assets available for distribution.
Shareholders are entitled to one vote for each share held and may
vote in the election of Trustees and on other matters submitted to meetings of
shareholders. Although Trustees are not elected annually by the shareholders,
shareholders have under certain
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circumstances the right to remove one or more Trustees. No material amendment
may be made to the Fund's Declaration of Trust without the affirmative vote of a
majority of its shares. Shares have no preemptive or conversion rights. Shares
are fully paid and non-assessable, except as set forth below. See "Certain
Liabilities."
CERTAIN LIABILITIES
As a Massachusetts business trust, the Fund's operations are
governed by its Declaration of Trust dated January 26, 1983, a copy of which is
on file with the office of The Secretary of the Commonwealth of Massachusetts.
Theoretically, shareholders of a Massachusetts business trust may, under certain
circumstances, be held personally liable for the obligations of the trust.
However, the Declaration of Trust contains an express disclaimer of shareholder
liability for acts or obligations of the Fund or any series of the Fund and
requires that notice of such disclaimer be given in each agreement, obligation
or instrument entered into or executed by the Fund or its Trustees. Moreover,
the Declaration of Trust provides for the indemnification out of Fund property
of any shareholders held personally liable for any obligations of the Fund or
any series of the Fund. 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
thereon. Thus, the risk of a shareholder incurring financial loss beyond his or
her investment because of shareholder liability would be limited to
circumstances in which the Fund itself will be unable to meet its obligations.
In light of the nature of the Fund's business, the possibility of the Fund's
liabilities exceeding its assets, and therefore a shareholder's risk of personal
liability, is extremely remote.
The Declaration of Trust further provides that the Fund shall
indemnify each of its Trustees and officers against liabilities and expenses
reasonably incurred by them, in connection with, or arising out of, any action,
suit or proceeding, threatened against or otherwise involving such Trustee or
officer, directly or indirectly, by reason of being or having been a Trustee or
officer of the Fund. The Declaration of Trust does not authorize the Fund to
indemnify any Trustee or officer against any liability to which he or she would
otherwise be subject by reason of or for willful misfeasance, bad faith, gross
negligence or reckless disregard of such person's duties.
PURCHASE OF SHARES
For information regarding the manner in which shares of the Fund
are offered to the public, see "Purchase of Shares" in the Prospectus.
PRICING OF SHARES
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The net asset value of shares of the Fund 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. This determination is made once during each such day
as of the close of the New York Stock Exchange by deducting the amount of the
Fund's liabilities from the value of its assets and dividing the difference by
the number of its shares outstanding. Debt securities (other than short-term
obligations), including listed issues, are valued on the basis of valuations
furnished by a pricing service which utilizes both dealer-supplied valuations
and electronic data processing techniques which take into account appropriate
factors such as institution-size trading in similar groups of securities, yield,
quality, coupon rate, maturity, type of issue, trading characteristics and other
market data, without exclusive reliance upon exchange or over-the-counter
prices, because such valuations are believed to reflect more accurately the fair
value of such securities. Use of the pricing service has been approved by the
Board of Trustees. Short-term obligations are valued at amortized cost, which
constitutes fair value as determined by the Board of Trustees. Portfolio
securities for which there are no such valuations are valued at fair value as
determined in good faith by or at the direction of the Board of Trustees.
FINANCIAL STATEMENTS
The Financial Statements for the Fund are incorporated by
reference to the Fund's Audited Annual Report dated December 31, 1998.
Shareholders will receive a copy of the Audited Annual Report at no additional
charge when requesting a copy of the Statement of Additional Information.
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APPENDIX A
SPECIAL FACTORS AFFECTING THE CALIFORNIA MUNI FUND
The financial condition of the State of California (the "State" or
"California"), its public authorities and local governments could affect the
market values and marketability of, and therefore the net asset value per share
and the interest income of, The California Muni Fund, or result in the default
of existing obligations, including obligations which may be held by The
California Muni Fund. The following section provides only a brief summary of the
complex factors affecting the State's financial condition, and is based on
information obtained from an Official Statement dated December 9, 1998 relating
to $600,000,000 State of California General Obligation Bonds and the Governor's
Budget Summary 1999-2000. The information contained in such publicly available
documents has not been independently verified. It should be noted that the
creditworthiness of obligations issued by local issuers may be unrelated to the
State's creditworthiness, and that there is no obligation on the part of the
State to make payment on such local obligations in the event of default in the
absence of a specific guarantee or pledge provided by the State.
Limits on Spending and Taxes
Under California constitutional amendments, the State is subject to an
annual appropriations limit. The limit may be exceeded in cases of emergency.
The State's yearly appropriations limit is based on the limit for the prior
year, adjusted annually for changes in California per capita personal income and
population and any transfers of financial responsibility of providing services
to or from another unit of government.
On November 8, 1988, voters approved Proposition 98, a combined
initiative constitutional amendment and statute, which changed State funding of
public education below the university level and the operation of the State
appropriations limit, primarily by guaranteeing local schools and community
colleges ("K-14 schools") a minimum share of General Fund revenues. Under
Proposition 98, K-14 schools are guaranteed the greater of a fixed percentage of
General Fund revenues and the prior year's appropriation adjusted for growth.
During the recession, General Fund revenues for several years were less
than originally projected, so that the original Proposition 98 appropriations
turned out to be higher than the minimum percentage provided in the law. The
Legislature responded to these developments by designating the "extra"
Proposition 98 payments in one year as a "loan" from future years' entitlements.
By implementing these actions, per-pupil funding from Proposition 98 sources
stayed almost constant at approximately $4,200 from Fiscal Year 1991-92 to
Fiscal Year 1993-94.
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In 1992, a lawsuit was filed, called California Teachers' Association v.
Gould, which challenged the validity of these off-budget loans. The settlement
in this case provides, among other things, that both the State and K-14 schools
share in the repayment of prior years' emergency loans to schools. Of the total
$1.76 billion in loans, the State will repay $935 million by forgiveness of the
amount owed, while schools will repay $825 million. The State share of the
repayment will be reflected as an appropriation above the current Proposition 98
base calculation. The schools' share of the repayment will count as
appropriations that count toward satisfying the Proposition 98 guarantee, or
from "below" the current base. Repayments are spread over the eight-year period
of 1994-95 through 2001-02 to mitigate any adverse fiscal impact. The 1998-99
Budget Act appropriated $250 million as repayment of prior years' loans to
schools, as part of the settlement in this case.
Short-Term Borrowing of California
As part of its cash management program, the State has regularly issued
short-term obligations to meet cash flow needs. Between spring 1992 and summer
1994, the State had depended upon external borrowing, including borrowings
extending into the subsequent fiscal year, to meet its cash needs, including
repayment of maturing Notes and Warrants. The State issued $1.7 billion of
revenue anticipation notes for the 1998-99 Fiscal Year, which notes are to
mature on June 30, 1999.
The State Treasurer is working closely with the State Controller and the
Department of Finance to manage the State's cash flow on a regular basis, with
the goal of reducing the State's external cash flow borrowing. The three offices
are also working to develop programs to use commercial paper in whole or in part
for the State's cash flow borrowing needs, and for construction period financing
for both general obligation bond-funded and lease-revenue bond-funded projects.
As of March 1, 1997 the Finance Committees had authorized the issuance of
approximately $3.356 billion of commercial paper notes, but as of that date only
$367.78 million aggregate principal amount of general obligation commercial
paper notes was actually issued and outstanding.
The State has always paid the principal of and interest on its general
obligation bonds, general obligation commercial paper, lease-purchase debt and
short-term obligations, including revenue anticipation notes and revenue
anticipation warrants when due.
1998-99 Fiscal Year Budget
When the Governor released his proposed 1998-99 Fiscal Year Budget on
January 9, 1998, he projected General Fund revenues for the 1998-99 Fiscal Year
of $55.4 billion, and proposed expenditures in the same amount.
The Legislature passed the 1998-99 Budget Bill on August 11, 1998, and
the Governor signed it on August 21, 1998. In signing the Budget Bill, the
Governor used his line-item veto
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power to reduce expenditures by $1.360 billion from the General Fund, and $160
million from Special Funds. Of this total, the Governor indicated that about
$250 million of vetoed funds were "set aside" to fund programs for education.
Vetoed items included education funds, salary increases and many individual
resources and capital projects.
The 1998-99 Budget Act is based on projected General Fund revenues and
transfers of $57.0 billion (after giving effect to various tax reductions
enacted in 1997 and 1998), a 4.2% increase from revised 1997-98 figures. Special
Fund revenues were estimated at $14.3 billion.
After giving effect to the Governor's vetoes, the Budget Act provides
authority for expenditures of $57.3 billion from the General Fund (a 7.3%
increase from 1997-98), $14.7 billion from Special Funds, and $3.4 billion from
bond funds. The Budget Act projects a balance in the State's budget reserve (the
Special Fund for Economic Uncertainties or SFEU) at June 30, 1999 (but without
including the "set aside" veto amount) of $1.255 billion, a little more than 2%
of General Fund revenues. The Budget Act assumes the State will carry out its
normal intra-year cash flow borrowing in the amount of $1.7 billion of revenue
anticipation notes, which were issued on October 1, 1998.
The most significant feature of the 1998-99 budget was agreement on a
total of $1.4 billion of tax cuts. The central element is a bill that provides
for a phased-in reduction of the Vehicle License Fee (VLF). Since the VLF is
currently transferred to cities and counties, the bill provides for the General
Fund to replace the lost revenues. Starting on January 1, 1999, the VLF will be
reduced by 25% at a cost to the General Fund of approximately $500 million in
the 1998-99 Fiscal Year and about $1 billion annually thereafter.
In addition to the cut in VLF, the 1998-99 budget includes both
temporary and permanent increases in the personal income tax dependent credit
($612 million General Fund cost in 1998-99, but less in future years), a
nonrefundable renters' tax credit ($133 million), and various targeted business
tax credits ($106 million).
Other significant elements of the 1998-99 Budget Act are as follows:
1. Proposition 98 funding for K-12 schools is increased by $1.7 billion
in General Fund moneys over revised 1997-98 levels, about $300 million higher
than the minimum Proposition 98 guaranty. An additional $600 million was
appropriated to "settle up" prior years' Proposition 98 entitlements, and was
primarily devoted to one-time uses such as block grants, deferred maintenance,
and computer and laboratory equipment. The Budget also includes $250 million as
repayment of prior years' loans to schools, as part of the settlement of
California Teachers' Association v. Gould.
2. Funding for higher education increased substantially above the level
called for in the Governor's four- year compact. General Fund support was
increased by $340 million (15.6%) for the University of California and $267
million (14.1%) for the California State University
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system. In addition, Community Colleges received a $300 million (6.6%) increase
under Proposition 98.
3. The Budget includes increased funding for health, welfare and social
services programs. A 4.9% grant increase was included in the basic welfare
grants, the first increase in those grants in 9 years.
4. Funding for the judiciary and criminal justice programs increased by
about 11% over 1997-98, primarily to reflect increased State support for local
trial courts and a rising prison population.
5. The Budget also included new funding for resources projects,
dedication of $376 million of General Fund moneys for capital outlay projects,
funding of a 3% State employee salary increase, funding of 2,000 new Department
of Transportation positions to accelerate transportation construction projects,
and funding of the Infrastructure and Economic Development Bank ($50 million).
6. The State received approximately $167 million of federal
reimbursements to offset costs related to the incarceration of undocumented
alien felons for federal fiscal year 1997. The State anticipates receiving
approximately $195 million in federal reimbursements for federal fiscal year
1998.
After the Budget Act was signed, and prior to the close of the
Legislative session on August 31, 1998, the Legislature passed a variety of
fiscal bills. The Governor had until September 30, 1998 to sign or veto these
bills. The bills with the most significant fiscal impact that the Governor
signed include $235 million for certain water system improvements in southern
California, $243 million for the State's share of the purchase of
environmentally sensitive forest lands, $178 million for state prisons, $160
million for housing assistance ($40 million of which was included in the 1998-99
Budget Act and an additional $120 million reflected in Proposition 1A), and $125
million for juvenile facilities. The Governor also signed bills totaling $223
million for educational programs that were part of his $250 million veto "set
aside," and $32 million for local governments fiscal relief. In addition, he
signed a bill reducing by $577 million the State's obligation to contribute to
the State Teachers' Retirement System in the 1998-99 Fiscal Year.
Based solely on the legislation enacted, on a net basis, the reserve for
June 30, 1999, was reduced by $256 million. On the other hand, 1997-98 revenues
have been increased by $160 million. The revised June 30, 1999, reserve is
projected to be $1,159 million or $96 million below the level projected in the
Budget Act. In November 1998, the Legislative Analyst's Office released a report
predicting that General Fund revenues for 1998-99 would be somewhat lower, and
expenditures somewhat higher, than the Budget Act forecasts, but the net
variance would be within the projected $1.2 billion year-end reserve amount.
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1995-96 through 1997-98 Fiscal Years
The State's financial condition improved markedly during the 1995-96,
1996-97 and 1997-98 fiscal years, with a combination of better than expected
revenues, slowdown in growth of social welfare programs, and continued spending
restraint based on the actions taken in earlier years. The State's cash position
also improved, and no external deficit borrowing has occurred over the end of
these three fiscal years.
The economy grew strongly during these fiscal years and, as a result,
the General Fund received substantially greater tax revenues (around $2.2
billion in 1995-96, $1.6 billion in 1996-97 and $2.2 billion in 1997-98) than
initially forecast when the related budgets were enacted. These additional funds
were largely directed to school spending as mandated by Proposition 98, and to
make up shortfalls from reduced federal health and welfare aid in 1995-96 and
1996-97. The accumulated budget deficit from the recession years was finally
eliminated. The Department of Finance estimates that the State's budget reserve
(the SFEU) totaled $639.8 million as of June 30, 1997 and $1.782 billion at June
30, 1998.
The following were major features of the 1997-98 Budget Act:
1. For the second year in a row, the Budget contained a large increase
in funding for K-14 education under Proposition 98, reflecting strong revenues
that exceeded initial budgeted amounts. Part of the nearly $1.75 billion of
increased spending was allocated to prior fiscal years.
2. The Budget Act reflected payment of $1.228 billion to satisfy a court
judgment in a lawsuit regarding payments to the State pension fund, and brought
funding of the State's pension contribution back to the quarterly basis that
existed prior to the deferral actions that were invalidated by the courts.
3. Funding from the General Fund for the University of California and
the California State University system was increased by about 6% ($121 million
and $107 million respectively), and there was no increase in student fees.
4. Unlike prior years, this Budget Act did not depend on uncertain
federal budget actions. About $300 million in federal funds, already included in
the federal Fiscal Year 1997 and 1998 budgets, was included in the Budget Act,
to offset incarceration costs for illegal aliens.
5. The Budget Act contained no tax increases, and no tax reductions. The
Renters Tax Credit was suspended for another year, saving approximately $500
million.
Fiscal Years Prior to 1995-96
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Pressures on the State's budget in the late 1980's and early 1990's were
caused by a combination of external economic conditions (including a recession
which began in 1990) and growth of the largest General Fund programs--K-14
education, health, welfare and corrections--at rates faster than the revenue
base. During this period, expenditures exceeded revenues in four out of six
years up to 1992-93, and the State accumulated and sustained a budget deficit
approaching $2.8 billion at its peak on June 30, 1993. Between the 1991-92 and
1994-95 Fiscal Years, each budget required multibillion dollar actions to bring
projected revenues and expenditures into balance, including significant cuts in
health and welfare program expenditures; transfers of program responsibilities
and funding from the State to local governments; transfer of about $3.6 billion
in annual local property tax revenues from other local governments to local
school districts, thereby reducing State funding for schools under Proposition
98; and revenue increases (particularly in the 1991-92 Fiscal Year), most of
which were for a short duration.
Despite these budget actions, the effects of the recession led to large,
unanticipated budget deficits. By the 1993-94 Fiscal Year, the accumulated
deficit was so large that it was impractical to retire the deficit in one year,
so a two-year program was implemented, using the issuance of revenue
anticipation warrants to carry a portion of the deficit over the end of the
fiscal year. When the economy failed to recover sufficiently in 1993-94, a
second two-year plan was implemented in 1994-95, again using cross-fiscal
revenue anticipation warrants to partly finance the deficit into the 1995-96
fiscal year.
Another consequence of the accumulated budget deficits, together with
other factors such as disbursement of funds to local school districts "borrowed"
from future fiscal years and hence not shown in the annual budget, was to
significantly reduce the State's cash resources available to pay its ongoing
obligations. When the Legislature and the Governor failed to adopt a budget for
the 1992-93 Fiscal Year by July 1, 1992, which would have allowed the State to
carry out its normal annual cash flow borrowing to replenish its cash reserves,
the Controller issued registered warrants to pay a variety of obligations
representing prior years' or continuing appropriations and mandates from court
orders. Available funds were used to make constitutionally-mandated payments,
such as debt service on bonds and warrants. Between July 1 and September 4,
1992, when the budget was adopted, the State Controller issued a total of
approximately $3.8 billion of registered warrants.
Economic Overview
California's economy is the largest among the 50 states and one of the
largest in the world. Recent economic expansion has been marked by strong growth
in high technology business services (including computer software),
construction, computers and electronic components.
During 1998, California's economic growth outpaced that of the nation, a
performance that will most likely be repeated in the coming year. Even with a
slowdown in job growth, it
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is expected that employment in 1999 will increase by 2.4% in California, twice
the rate of increase for the nation as a whole.
The strong economy, along with a robust stock market, helped to generate
higher revenues to the State. In fiscal year 1997-98, revenues from personal
income tax receipts, the largest single resource of revenue to the General Fund,
grew by 20%. Overall tax receipts grew by 11%. This trend in tax revenues is
also the result of baby boomers passing through their prime earning years.
Within the next decade, however, this generation will begin to retire, slowing
the rise in personal income tax revenues.
Despite major disruptions in international markets during 1998,
California's economy has weathered the Asian financial storm with relatively
modest damage. Aerospace and electronics manufacturing employment peaked in
March, and by November had lost almost 15,000 jobs, or nearly 3% of the
industries' workforce. Total nonfarm employment started 1998 with annual growth
above 3.5%, but more recently the year-to-year pace has slowed to approximately
2.7%. Increased exports to NAFTA trading partners and Europe compensated for
declines in California's exports to Southeast Asian countries over the past
year.
The construction industry led California's employment growth in 1998.
From October 1997 to October 1998, construction jobs in the state increased by
more than 9%. By the end of 1998, residential permits reached 126,000 units, an
increase of more than 13.5% over 1997. In the previous year, permits totaled
111,000 units, topping 100,000 for the first time since 1991. Non-residential
construction activity remained quite strong, with building permit value up
almost 18%.
Apart from construction, California's economy continued to expand in
1998. Non-farm employment growth averaged 3.2% and personal income was up more
than 6%. The jobless rate was below 6% most of the year.
Rising incomes and confidence in the economy have propelled housing
sales and prices to record levels in many parts of California. The San
Francisco-San Jose metropolitan area has seen the greatest price appreciation
and is now the most expensive housing market in the nation. Statewide, sales of
existing single family homes in 1998 are expected to show a 10% increase over
1997 levels. By the end of the year, the median price should surpass the peak in
1991.
The healthy economic climate and recent revisions to the State's welfare
system have produced a major turnaround in the growth of California's welfare
population. This trend began in 1996, when there was a slight decline in
California's public assistance caseloads, the first since 1980. In 1997, there
was a drop of almost 5%. As of August 1998, caseloads were down by nearly 10%
over the previous 12 months.
California's future rests on its investments in the State's education
system. The State's economy is increasingly driven by technology-oriented
industries, and a supply of skilled
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workers is indispensable to the health of the economy. Recent increases in
funding for California's public education system represent progress in meeting
this need.
Credit Rating
Moody's has assigned a rating of Aa3 to the general obligation bonds of
the State of California. The rating reflects the state's deep and diverse
economic base, its improved credit condition, including the rebuilding of cash
and budget reserves, and long-term structural budget condition, even under
assumptions of slowing economic growth. The credit outlook is stable.
The state's Aa3 rating is the product of its robust economy, offset by a
financial condition that shows dramatic improvement, but still lags that of most
states. The California economy has fully recovered from the recession of the
early 1990's, and continues to outpace the United States in terms of employment
and personal income growth. Diversification has positioned it for further
expansion, although at a slower pace than has been realized over the last
several years. General fund balance sheet deficits accumulated during the
recession have been substantially reversed and liquidity has been restored. New
five-year financial projections based on reasonable expenditure and revenue
assumptions indicate that the state has the capacity to maintain long-term
budget balance, even if economic growth slows. Budget reserves are funded at
levels that, while still low by national standards, would preserve liquidity in
a mild economic downturn. Its debt position is moderate though slowly increasing
as the state addresses its infrastructure needs.
At Aa3, California's rating is lower than that of most of the country's
large industrialized states, including Illinois, Texas, and Florida (each rated
Aa2), Michigan, New Jersey and Ohio (all Aa1), but is higher than New York
State's A2 rating. California shares the Aa3 rating with Pennsylvania,
Massachusetts and Connecticut. California's ranking among the states reflects
its still relatively weak, though improved, balance sheet condition, and its
above average exposure to international economic uncertainty. In addition, we
expect that California would move more slowly than most states to stem financial
deterioration in the event of economic recession due to its inflexible budget
structure and complex political environment.
The Aa3 general obligation rating is based on the following factors:
Credit Strengths
- Economic recovery is now well-established and broad based, and absent
a national recession, continued, though slowing, job and income growth is
expected.
- Financial performance benefits from economic recovery's positive
impact on economically sensitive income and sales taxes.
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- Long term spending pressures from caseload driven demand in social
services, schools, and prisons have eased compared to earlier expectations and
can be funded with available revenues.
- Liquidity from cash resources outside General Fund shows strong
improvement.
- Contingent reserve position significantly improved, offering moderate
protection against economic uncertainties.
Credit Weaknesses
- Financial flexibility remains limited due to education expenditures
mandated by Proposition 98.
- Lack of formalized mid-year budget correction capabilities leaves the
state exposed in periods of revenue under-performance.
- Future capital needs could weaken debt position if debt affordability
recommendations are not adhered to.
- Economically-sensitive tax structure produces revenue volatility.
- The state faces above-average exposure to international economic
conditions, particularly in Asia.
Litigation
The State is currently involved in certain legal proceedings that, if
decided against the State, may require the State to make significant future
expenditures or may impair future revenue sources. Following are significant
lawsuits involving the State as of December 9, 1998:
On June 24, 1998, plaintiffs in Howard Jarvis Taxpayers Association et
al. v. Kathleen Connell filed a complaint challenging the authority of the State
Controller to make payments from the State Treasury in the absence of a state
budget. On July 21, 1998, the trial court issued a preliminary injunction
prohibiting the State Controller from paying moneys from the State Treasury for
fiscal year 1998-99, with certain limited exceptions, in the absence of a state
budget. The preliminary injunction, among other things, prohibited the State
Controller from making any payments pursuant to any continuing appropriation.
On July 22, 1998, the State Controller asked the California Supreme
Court to immediately stay the trial court's preliminary injunction and to
overrule the order granting the preliminary injunction on the merits. On July
29, 1998, the Supreme Court transferred the State
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Controller's request to the Court of Appeal. The matters are now pending before
the Court of Appeal.
In Hayes v. Commission on State Mandates, certain local school districts
sought reimbursements for special education programs for handicapped children.
The State Board of Control, which was succeeded by the Commission on State
Mandates (COSM), decided in favor of the local school districts. The decision
was appealed by the Director of Finance in the trial court and was remanded to
the COSM for redetermination. The COSM expanded the claim to include
supplemental claims filed by seven additional educational institutions. The
potential liability to the State has been estimated at more than $1 billion. A
final consolidated decision was expected to be issued in late 1998.
In State v. Stringfellow, the State is seeking recovery for cleanup
costs of a toxic waste site presently owned by the State. Present estimates of
the cleanup range from $300 million to $800 million.
The State is a defendant in a coordinated action involving 3,000
plaintiffs seeking recovery for damages caused by the Yuba River flood of 1986.
The State's potential liability to all plaintiffs in this lawsuit ranges from
$800 million to $1.5 billion.
Year 2000
The State's reliance on information technology in every aspect of its
operations has made Year 2000 related information technology ("IT") issues a
high priority for the State. The Department of Information Technology ("DOIT"),
an independent office reporting directly to the Governor, is responsible for
ensuring the State's information technology processes are fully functional
before the year 2000.
In the July Quarterly Report, the DOIT estimates total Year 2000 costs
identified by the departments under its supervision at about $239 million, of
which more than $100 million was projected to be expended in fiscal years
1998-99 and 1999-2000. The October Quarterly Report indicated the total costs
were then estimated to be at least $290 million, and the estimate would likely
increase in the future. These costs are part of much larger overall IT costs
incurred annually by State departments and do not include costs for remediation
for embedded technology, desktop systems and additional costs resulting from
discoveries in the testing process. For fiscal year 1998-99, the Legislature
created a $20 million fund for unanticipated Year 2000 costs, which can be
increased if necessary.
Although the DOIT reports that State departments are making substantial
progress overall toward the goal of Year 2000 compliance, the task is very large
and will likely encounter unexpected difficulties. The State cannot predict
whether all mission critical systems will be ready and tested by late 1999 or
what impact failure of any particular IT system(s) or of outside interfaces with
State IT systems might have. The State Treasurer's Office and the State
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Controller's Office report that they are both on schedule to complete their Year
2000 remediation projects by December 31, 1998, allowing full testing during
1999.
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APPENDIX B
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 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
A-2
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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.
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
A-3
<PAGE>
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.
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
A-4
<PAGE>
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.
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
A-5
<PAGE>
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.
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
A-6
<PAGE>
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 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+
A-7
<PAGE>
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.
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-8
