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THE MAINSTAY FUNDS
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STATEMENT OF ADDITIONAL INFORMATION
MAY 1, 1997
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The MainStay Funds (the "Trust") is an open-end management investment
company (or mutual fund) currently consisting of fourteen series: California
Tax Free Fund, Capital Appreciation Fund, Convertible Fund, Equity Index Fund,
Government Fund, High Yield Corporate Bond Fund, International Bond Fund,
International Equity Fund, Money Market Fund, New York Tax Free Fund, Strategic
Income Fund, Tax Free Bond Fund, Total Return Fund and Value Fund (individually
or collectively referred to as a "Fund" or the "Funds"). The investment adviser
for thirteen of the Funds is MacKay-Shields Financial Corporation ("MacKay-
Shields" or the "Adviser"). The investment adviser for the Equity Index Fund is
Monitor Capital Advisors, Inc. ("Monitor" or the "Adviser"). MacKay-Shields and
Monitor are sometimes jointly referred to as the "Advisers."
This Statement of Additional Information is not a prospectus and
should be read in conjunction with the Prospectus of the Trust dated May 1,
1997, as amended or supplemented from time to time, a copy of which may be
obtained without charge by writing to NYLIFE Distributors Inc., (the
"Distributor") 260 Cherry Hill Road, Parsippany, NJ 07054 or by calling 1-800-
MAINSTAY (1-800-624-6782).
No dealer, salesman or any other person has been authorized to give
any information or to make any representations, other than those contained in
this Statement of Additional Information or in the related Prospectus, in
connection with the offers contained herein, and, if given or made, such other
information or representations must not be relied upon as having been authorized
by the Funds or the Distributor. This Statement of Additional Information and
the related Prospectus do not constitute an offer by the Trust or by the
Distributor to sell or a solicitation of any offer to buy any of the securities
offered hereby in any jurisdiction to any person to whom it is unlawful to make
such offer in such jurisdiction.
Shareholder inquiries should be made by writing directly to MainStay
Shareholder Services, Inc., P.O. Box 8401, Boston, Massachusetts 02266-8401, or
by calling 1-800-MAINSTAY. In addition, you can make inquiries through your
registered representative.
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TABLE OF CONTENTS
PAGE IN
STATEMENT OF
ADDITIONAL
INFORMATION
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ADDITIONAL INVESTMENT POLICIES OF THE MONEY MARKET FUND..... 5
INVESTMENT PRACTICES AND INSTRUMENTS COMMON TO MULTIPLE
FUNDS...................................................... 7
Repurchase Agreements.................................. 7
Lending of Portfolio Securities........................ 9
Bank Obligations....................................... 10
U.S. Government Securities............................. 11
Debt Securities........................................ 11
Convertible Securities................................. 12
Arbitrage 13
Foreign Securities..................................... 13
Foreign Currency Transactions.......................... 14
Foreign Index-Linked Instruments....................... 18
Brady Bonds............................................ 18
Municipal Securities................................... 19
Industrial Development and Pollution Control Bonds..... 24
Variable Rate Demand Notes ("VRDNs")................... 25
Floating and Variable Rate Securities.................. 25
Zero Coupon Bonds...................................... 26
Standby Commitments -- Obligations with Puts Attached.. 26
When-Issued Securities................................. 27
Mortgage-Related and Other Asset-Backed Securities..... 28
Short Sales Against the Box............................ 37
Options on Securities.................................. 38
Options on Foreign Currencies.......................... 44
Securities Index Options............................... 46
Futures Transactions................................... 47
Swap Agreements........................................ 58
Loan Participation Interests........................... 61
Risks Associated with Debt Securities.................. 63
Risks of Investing in High Yield Securities ("Junk
Bonds")............................................... 63
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HIGH YIELD CORPORATE BOND FUND
AND STRATEGIC INCOME FUND
SPECIAL CONSIDERATIONS........... 64
EQUITY INDEX FUND SPECIAL CONSIDERATIONS.................... 65
TOTAL RETURN FUND
SPECIAL CONSIDERATIONS........... 65
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CALIFORNIA TAX FREE FUND AND NEW YORK TAX FREE FUND
SPECIAL CONSIDERATIONS....................................... 65
Risk Factors Affecting California Municipal Securities.. 65
Risk Factors Affecting New York Municipal Securities.... 76
THE EQUITY INDEX FUND GUARANTEE.............................. 96
ADDITIONAL FUNDAMENTAL INVESTMENT RESTRICTIONS............... 98
ADDITIONAL NON-FUNDAMENTAL INVESTMENT RESTRICTIONS........... 99
TRUSTEES AND OFFICERS........................................ 102
THE ADVISERS, THE ADMINISTRATOR AND THE DISTRIBUTOR.......... 109
Investment Advisory Agreements.......................... 109
Administration Agreements............................... 112
Distribution Agreement.................................. 115
Other Services.......................................... 122
Expenses Borne by the Trust............................. 123
PORTFOLIO TRANSACTIONS AND BROKERAGE......................... 124
NET ASSET VALUE.............................................. 129
SHAREHOLDER INVESTMENT ACCOUNT............................... 132
SHAREHOLDER SERVICING AGENT.................................. 132
PURCHASES, REDEMPTION AND REPURCHASE......................... 132
Letter of Intent ("LOI")................................ 132
Suspension of Redemptions............................... 133
TAX-DEFERRED RETIREMENT PLANS................................ 133
Cash or Deferred Profit Sharing Plans Under Section
401(k) for Corporations and Self-Employed
Individuals 133
Individual Retirement Account ("IRA")................... 133
403(b)(7) Tax Sheltered Account......................... 135
General Information..................................... 135
CALCULATION OF PERFORMANCE QUOTATIONS........................ 135
TAX STATUS................................................... 144
Taxation of the Funds................................... 144
Character of Distributions to Shareholders -- General... 145
Character of Distributions to Shareholders -- The Tax-
Free Funds............................................ 146
Discount 148
Users of Bond-Financed Facilities....................... 148
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Excise Tax.............................................. 149
Taxation of Options, Futures and Similar Instruments.... 149
Passive Foreign Investment Companies.................... 151
Foreign Currency Gains and Losses....................... 152
Commodity Investments................................... 152
Dispositions of Fund Shares............................. 153
Tax Reporting Requirements.............................. 154
Foreign Taxes........................................... 155
State and Local Taxes - General......................... 156
Explanation of Fund Distributions....................... 156
Additional Information Regarding the Equity Index Fund.. 157
Additional Information Regarding the California Tax
Free Fund and New York Tax Free Fund
Annual Statements....................................... 159
General Information..................................... 160
ORGANIZATION AND CAPITALIZATION.............................. 160
General 160
Voting Rights........................................... 160
Shareholder and Trustee Liability....................... 161
OTHER INFORMATION............................................ 161
Independent Accountants................................. 161
Legal Counsel........................................... 162
Share Ownership of the Funds............................ 162
Code of Ethics.......................................... 163
FINANCIAL STATEMENTS......................................... 163
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ADDITIONAL INVESTMENT POLICIES OF THE MONEY MARKET FUND
Each Fund has a separate investment objective or objectives which it
pursues through separate investment policies, as described in the Prospectus.
The following discussion elaborates on the presentation of the Money Market
Fund's investment policies contained in the Prospectus.
The Fund may invest its assets in U.S. dollar-denominated securities of
U.S. or foreign issuers and in securities of foreign branches of U.S. banks,
such as negotiable certificates of deposit (Eurodollars). Since the portfolio
of the Fund may contain such securities, an investment therein involves
investment risks that are different in some respects from an investment in a
fund which invests only in debt obligations of U.S. domestic issuers. Such
risks may include future political and economic developments, the possible
imposition of foreign withholding taxes on interest income payable on the
securities held in the portfolio, possible seizure or nationalization of foreign
deposits, the possible establishment of exchange controls or the adoption of
other foreign governmental restrictions which might adversely affect the payment
of the principal of and interest on securities in the portfolio.
All of the assets of the Fund generally will be invested in obligations
which mature in 397 days or less and substantially all of these
investments will be held to maturity; however, securities collateralizing
repurchase agreements may have maturities in excess of 397 days. The
Fund will, to the extent feasible, make portfolio investments primarily in
anticipation of or in response to changing economic and money market conditions
and trends. The dollar-weighted average maturity of the Fund's portfolio may
not exceed 90 days. Consistent with the provisions of a rule of the Securities
and Exchange Commission ("SEC"), the Fund invests only in U.S. dollar-
denominated money market instruments that present minimal credit risk and, with
respect to 95% of its total assets, measured at the time of investment, that are
of the highest quality. The Adviser shall determine whether a security presents
minimal credit risk under procedures adopted by the Fund's Board of Trustees. A
money market instrument will be considered to be of the highest quality (1) if
rated in the highest rating category (i.e., Aaa or Prime-1 by Moody's, AAA or A-
1 by S&P's) by (i) any two nationally recognized statistical rating
organizations ("NRSROs") or, (ii) if rated by only one NRSRO, by that NRSRO, and
whose acquisition is approved or ratified by the Board of Trustees; (2) if
issued by an issuer that has short-term debt obligations of comparable maturity,
priority, and security, and that are rated in the highest rating category by (i)
any two NRSRO's or, (ii) if rated by only one NRSRO, by that NRSRO, and
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whose acquisition is approved or ratified by the Board of Trustees; or (3) an
unrated security that is of comparable quality to a security in the highest
rating category as determined by the Adviser and whose acquisition is approved
or ratified by the Board of Trustees. With respect to 5% of its total assets,
measured at the time of investment, the Fund may also invest in money market
instruments that are in the second-highest rating category for short-term debt
obligations (i.e., rated Aa or Prime-2 by Moody's or AA or A-2 by S&P).
The Fund may not invest more than 5% of its total assets, measured at the
time of investment, in securities of any one issuer that are of the highest
quality, except that the Fund may exceed this 5% limitation with respect to 25%
of its assets for up to three business days after the purchase of a security of
any one issuer and except that this limitation shall not apply to U.S.
government securities or securities subject to certain puts. The Fund may not
invest more than the greater of 1% of its total assets or one million dollars,
measured at the time of investment, in securities of any one issuer that are in
the second-highest rating category, except that this limitation shall not apply
to U.S. government securities or securities subject to certain puts. In the
event that an instrument acquired by the Fund is downgraded or otherwise ceases
to be of the quality that is eligible for the Fund, the Adviser, under
procedures approved by the Board of Trustees (or the Board of Trustees itself if
the Adviser becomes aware an unrated security is downgraded below high quality
and the Adviser does not dispose of the security within five business days)
shall promptly reassess whether such security presents minimal credit risk and
determine whether or not to retain the instrument.
Pursuant to the rule, the Fund uses the amortized cost method of valuing
its investments, which facilitates the maintenance of the Fund's per share net
asset value at $1.00. The amortized cost method, which is normally used to
value all of the Fund's portfolio securities, involves initially valuing a
security at its cost and thereafter amortizing to maturity any discount or
premium, regardless of the impact of fluctuating interest rates on the market
value of the instrument.
The Trustees have also established procedures designed to stabilize, to the
extent reasonably possible, the Fund's price per share as computed for the
purpose of sales and redemptions at $1.00. Such procedures include review of
the Fund's portfolio by the Trustees, at such intervals as they deem
appropriate, to determine whether the Fund's net asset value calculated by using
available market quotations or market equivalents (the determination of value by
reference to interest rate levels, quotations of comparable securities and other
factors) deviates from $1.00 per share based on amortized cost.
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The extent of deviation between the Fund's net asset value based upon
available market quotations or market equivalents and $1.00 per share based on
amortized cost will be periodically examined by the Trustees. If such deviation
exceeds 1/2 of 1%, the Trustees will promptly consider what action, if any, will
be initiated. In the event the Trustees determine that a deviation exists which
may result in material dilution or other unfair results to investors or existing
shareholders, they will take such corrective action as they regard to be
necessary and appropriate, including the sale of portfolio instruments prior to
maturity to realize capital gains or losses or to shorten average portfolio
maturity; withholding part or all of dividends or payment of distributions from
capital or capital gains; redemptions of shares in kind; or establishing a net
asset value per share by using available market quotations or equivalents. In
addition, in order to stabilize the net asset value per share at $1.00, the
Trustees have the authority (1) to reduce or increase the number of shares
outstanding on a pro rata basis, and (2) to offset each shareholder's pro rata
portion of the deviation between the net asset value per share and $1.00 from
the shareholder's accrued dividend account or from future dividends.
The Fund may hold cash for the purpose of stabilizing its net asset value
per share. Holdings of cash, on which no return is earned, would tend to lower
the yield on the Fund's shares.
The Fund may also, consistent with the provisions of the rule, invest in
securities with a face maturity of more than 397 days, provided that the
security is either a variable or floating rate security, that meets the
guidelines of Rule 2a-7 with respect to maturity.
INVESTMENT PRACTICES AND INSTRUMENTS COMMON TO MULTIPLE FUNDS
The Funds may engage in the following investment practices or invest in the
following instruments to the extent permitted in the Prospectus.
REPURCHASE AGREEMENTS
The Funds may enter into repurchase agreements with member banks of the
Federal Reserve System or member firms of the National Association of Securities
Dealers, Inc. that meet the repurchase agreement creditworthiness guidelines
established by the Trustees. The Equity Index Fund will enter into repurchase
agreements only with domestic banks with total assets in excess of one billion
dollars or primary government securities dealers reporting to the Federal
Reserve Bank of New York, and with
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respect to securities of the type in which the Fund may invest. In addition,
the International Bond and International Equity Funds may enter into domestic or
foreign repurchase agreements with certain sellers deemed to be creditworthy
pursuant to guidelines adopted by the Trustees.
A repurchase agreement, which provides a means for a Fund to earn income on
uninvested cash for periods as short as overnight, is an arrangement under which
the purchaser (i.e., the Fund) purchases a U.S. government or other high quality
short-term debt obligation (the "Obligation") and the seller agrees, at the time
of sale, to repurchase the Obligation at a specified time (usually not more than
a week in the case of the Equity Index Fund, California Tax Free Fund and New
York Tax Free Fund) and price. A repurchase agreement with foreign banks may be
available with respect to government securities of the particular foreign
jurisdiction. The custody of the Obligation will be maintained by the Fund's
Custodian. The value of the purchased securities, including any accrued
interest, will at all times exceed the value of the repurchase agreement. The
repurchase price may be higher than the purchase price, the difference being
income to the Fund, or the purchase and repurchase prices may be the same, with
interest at a stated rate due to the Fund together with the repurchase price
upon repurchase. In either case, the income to the Fund is unrelated to the
interest rate on the Obligation subject to the repurchase agreement.
The income on repurchase agreements may be subject to federal and state
income taxes when distributed by a Fund as a dividend to shareholders. Subject
to applicable limitations, the Tax Free Bond Fund will enter into repurchase
agreements as a means of earning income on its cash reserves when, in the
judgment of the Adviser, shareholders would benefit more from receiving taxable
income thereon than from earning no income or tax-free income at a lower rate on
such reserves.
For purposes of the 1940 Act, a repurchase agreement is deemed to be a loan
from the Fund to the seller of the Obligation. It is not clear whether a court
would consider the Obligation purchased by the Fund subject to a repurchase
agreement as being owned by the Fund or as being collateral for a loan by the
Fund to the seller. In the event of the commencement of bankruptcy or
insolvency proceedings with respect to the seller of the Obligation before
repurchase of the Obligation under a repurchase agreement, the Fund may
encounter delays and incur costs before being able to sell the security. Delays
may involve loss of interest or decline in price of the Obligation. If the
court characterizes the transaction as a loan and the Fund has not perfected a
security interest in the Obligation, the Fund may be required to return the
Obligation to the seller's estate
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and be treated as an unsecured creditor of the seller. As an unsecured
creditor, the Fund would be at risk of losing some or all of the principal and
income involved in the transaction. As with any unsecured debt instrument
purchased for the Funds, the Advisers seek to minimize the risk of loss from
repurchase agreements by analyzing the creditworthiness of the obligor, in this
case the seller of the Obligation. Apart from the risk of bankruptcy or
insolvency proceedings, there is also the risk that the seller may fail to
repurchase the security. However, if the market value of the Obligation subject
to the repurchase agreement becomes less than the repurchase price (including
accrued interest), the Fund will direct the seller of the Obligation to deliver
additional securities so that the market value of all securities subject to the
repurchase agreement equals or exceeds the repurchase price.
The Strategic Income Fund, California Tax Free Fund and New York Tax Free
Fund may enter into reverse repurchase agreements. A Fund will maintain a
segregated account consisting of liquid assets to cover its obligations under
reverse repurchase agreements. Each of the California Tax Free Fund and New
York Tax Free Fund will limit its investments in reverse repurchase agreements
and other borrowing to no more than 10% of its total assets. The Strategic
Income Fund will limit its investments in reverse repurchase agreements to no
more than 5% of its total assets.
LENDING OF PORTFOLIO SECURITIES
Each Fund, except the Tax Free Bond Fund and the Money Market Fund, may
seek to increase its income by lending portfolio securities. Under guidelines
adopted by the Funds' Board, such loans may be made to institutions, such as
broker-dealers, and are required to be secured continuously by collateral in
cash or U.S. government securities maintained on a current basis at an amount at
least equal to the market value of the securities loaned. The Fund would have
the right to call a loan and obtain the securities loaned at any time generally
on less than five days' notice. For the duration of a loan, the Fund would
continue to receive the equivalent of the interest or dividends paid by the
issuer on the securities loaned and would also receive compensation from the
investment of the collateral. The Fund would not, however, have the right to
vote any securities having voting rights during the existence of the loan, but
the Fund would call the loan in anticipation of an important vote to be taken
among holders of the securities or of the giving or withholding of their consent
on a material matter affecting the investment. The Trust, on behalf of certain
of the Funds, has entered into an agency agreement with Merrill Lynch Portfolio
Services, Inc. which acts as the Funds' agent in making loans of
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portfolio securities and short-term money market investments of the cash
collateral received, under the supervision and control of the Funds' Advisers.
As with other extensions of credit there are risks of delay in recovery of,
or even loss of rights in, the collateral should the borrower of the securities
fail financially or breach its agreement with a Fund. However, the loans would
be made only to firms deemed by the Adviser to be creditworthy and approved by
the Board, and when, in the judgment of the Adviser, the consideration which can
be earned currently from securities loans of this type justifies the attendant
risk. The value of securities loaned will not exceed 33% of the value of the
total assets of the lending Fund. In addition, pursuant to guidelines adopted
by the Board, each Fund is prohibited from lending more than 5% of its assets to
any one counterparty.
BANK OBLIGATIONS
Time deposits are nonnegotiable deposits maintained in a banking
institution for a specified period of time at a stated interest rate. Time
deposits which may be held by the Funds will not benefit from insurance from the
Bank Insurance Fund or the Savings Association Insurance Fund administered by
the Federal Deposit Insurance Corporation.
Certificates of deposit are certificates evidencing the obligation of a
bank to repay funds deposited with it for a specified period of time.
Bankers' acceptances are credit instruments evidencing the obligation of a
bank to pay a draft drawn on it by a customer. These instruments reflect the
obligation both of the bank and of the drawer to pay the full amount of the
instrument upon maturity.
Investments in the obligations of banks are deemed to be "cash equivalents"
if, at the date of investment, the banks have capital surplus and individual
profits (as of the date of their most recently published financials) in excess
of $100,000,000, or if, with respect to the obligations of other banks and
savings and loan associations, such obligations are federally insured. The
Equity Index Fund will not be subject to the above restriction to the extent it
invests in banks obligations of United States banks (including foreign branches)
which have more than $1 billion in total assets at the time of investment and
are members of the Federal Reserve System or are examined by the Comptroller of
the Currency or whose deposits are insured by the Federal Deposit Insurance
Corporation. The Equity Index Fund also may invest in certificates of deposit
of savings and loan
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associations (federally or state chartered and federally insured) having total
assets in excess of $1 billion.
U.S. GOVERNMENT SECURITIES
Securities issued or guaranteed by the U.S. government or its agencies or
instrumentalities include U.S. Treasury securities, which differ only in their
interest rates, maturities and times of issuance. Treasury bills have initial
maturities of one year or less; Treasury notes have initial maturities of one to
ten years; and Treasury bonds generally have initial maturities of greater than
ten years. Some obligations issued or guaranteed by U.S. government agencies
and instrumentalities, for example, Government National Mortgage Association
("GNMA") pass-through certificates, are supported by the full faith and credit
of the U.S. Treasury; others, such as those of the Federal Home Loan Banks, by
the right of the issuer to borrow from the Treasury; others, such as those
issued by the Federal National Mortgage Association ("FNMA"), by the
discretionary authority of the U.S. government to purchase certain obligations
of the agency or instrumentality; and others, such as those issued by the
Student Loan Marketing Association, only by the credit of the agency or
instrumentality. While the U.S. government provides financial support to such
U.S. government-sponsored agencies or instrumentalities, no assurance can be
given that it will always do so, and it is not so obligated by law. See
"Mortgage-Related and Other Asset-Backed Securities." The Equity Index Fund
will invest in such securities only when it is satisfied that the credit risk
with respect to the issuer is minimal.
DEBT SECURITIES
Debt securities may have fixed, variable or floating (including inverse
floating) rates of interest. To the extent that a Fund invests in debt
securities, it will be subject to certain risks. The value of the debt
securities held by a Fund, and thus the NAV of the shares of a Fund, generally
will fluctuate depending on a number of factors, including, among others,
changes in the perceived creditworthiness of the issuers of those securities,
movements in interest rates, the average maturity of a Fund's investments,
changes in relative values of the currencies in which a Fund's investments are
denominated relative to the U.S. dollar, and the extent to which a Fund hedges
its interest rate, credit and currency exchange rate risks. Generally, a rise
in interest rates will reduce the value of fixed income securities held by a
Fund, and a decline in interest rates will increase the value of fixed income
securities held by a Fund.
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CONVERTIBLE SECURITIES
The Capital Appreciation Fund, Convertible Fund, High Yield Corporate Bond
Fund, International Bond Fund, International Equity Fund, Strategic Income Fund,
Total Return Fund and Value Fund may invest in securities convertible into
common stock. Such investments may be made, for example, if the Adviser
believes that a company's convertible securities are undervalued in the market.
Convertible securities eligible for inclusion in the Funds' portfolios include
convertible bonds, convertible preferred stocks, or warrants.
Convertible securities, until converted, have the same general
characteristics as other fixed income securities insofar as they generally
provide a stable stream of income with generally higher yields than those of
equity securities of the same or similar issuers. By permitting the holder to
exchange his investment for common stock, convertible securities may also enable
the investor to benefit from increases in the market price of the underlying
common stock. Therefore, convertible securities generally offer lower interest
or dividend yields than non-convertible securities of similar quality.
As with all fixed income securities, the market value of convertible
securities tends to decline as interest rates increase and, conversely, tends to
increase as interest rates decline. The unique feature of the convertible
security is that as the market price of the underlying common stock declines, a
convertible security tends to trade increasingly on a yield basis, and so may
not experience market value declines to the same extent as the underlying common
stock. When the market price of the underlying common stock increases, the
price of a convertible security increasingly reflects the value of the
underlying common stock and may rise accordingly. While no securities
investment is without some risk, investments in convertible securities generally
entail less risk than investments in the common stock of the same issuer.
Holders of fixed income securities (including convertible securities) have
a claim on the assets of the issuer prior to the holders of common stock in case
of liquidation. However, convertible securities are typically subordinated to
similar non-convertible securities of the same issuer.
Accordingly, convertible securities have unique investment characteristics
because (i) they have relatively high yields as compared to common stocks, (ii)
they have defensive characteristics since they provide a fixed return even if
the market price of the underlying common stock declines, and (iii)
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they provide the potential for capital appreciation if the market price of the
underlying common stock increases.
A convertible security may be subject to redemption at the option of the
issuer at a price established in the charter provision or indenture pursuant to
which the convertible security is issued. If a convertible security held by a
Fund is called for redemption, the Fund will be required to surrender the
security for redemption, convert it into the underlying common stock or sell it
to a third party.
ARBITRAGE
Each Fund, except the California Tax Free Fund, Equity Index Fund,
International Bond Fund, International Equity Fund, New York Tax Free Fund and
Tax Free Bond Fund, may sell in one market a security which it owns and
simultaneously purchase the same security in another market, or it may buy a
security in one market and simultaneously sell it in another market, in order to
take advantage of differences between the prices of the security in the
different markets. Although the Funds do not actively engage in arbitrage, such
transactions may be entered into only with respect to debt securities and will
occur only in a dealer's market where the buying and selling dealers involved
confirm their prices to the Fund at the time of the transaction, thus
eliminating any risk to the assets of a Fund.
FOREIGN SECURITIES
Except for the California Tax Free Fund, Government Fund, New York Tax Free
Fund and Tax Free Bond Fund, each Fund may invest, without limit, subject to the
other investment policies applicable to the Fund, in U.S. dollar-denominated and
non-dollar-denominated foreign debt and equity securities and in certificates of
deposit issued by foreign banks and foreign branches of U.S. banks, to any
extent deemed appropriate by the Advisers. Under current SEC rules relating to
the use of the amortized cost method of portfolio securities valuation, the
Money Market Fund is restricted to purchasing U.S. dollar-denominated
securities, but it is not otherwise precluded from purchasing securities of
foreign issuers.
Investors should carefully consider the appropriateness of foreign
investing in light of their financial objectives and goals. While foreign
markets may present unique investment opportunities, foreign investing involves
risks not associated with domestic investing. Securities markets in other
countries are not always as efficient as those in the U.S. and are sometimes
less liquid and more volatile. Other risks involved in investing in the
securities of foreign issuers include
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differences in accounting, auditing and financial reporting standards; limited
publicly available information; the difficulty of assessing economic trends in
foreign countries; generally higher commission rates on foreign portfolio
transactions; the possibility of nationalization, expropriation or confiscatory
taxation; adverse changes in investment or exchange control regulations (which
may include suspension of the ability to transfer currency from a country);
government interference, including government ownership of companies in certain
sectors, wage and price controls, or imposition of trade barriers and other
protectionist measures; difficulties in invoking legal process abroad and
enforcing contractual obligations; political, social or economic instability
which could affect U.S. investments in foreign countries; and potential
restrictions on the flow of international capital. Additionally, foreign
securities and dividends and interest payable on those securities may be subject
to foreign taxes, including foreign withholding taxes, and other foreign taxes
may apply with respect to securities transactions. Additional costs associated
with an investment in foreign securities may include higher transaction, custody
and foreign currency conversion costs. In the event of litigation relating to a
portfolio investment, the Funds may encounter substantial difficulties in
obtaining and enforcing judgments against non-U.S. resident individuals and
companies. Investment in emerging market countries presents risks in greater
degree than, and in addition to, those presented by investment in foreign
issuers in general.
FOREIGN CURRENCY TRANSACTIONS
Many of the foreign securities in which the Funds invest will be
denominated in foreign currencies. Changes in foreign exchange rates will
affect the value of securities denominated or quoted in foreign currencies.
Exchange rate movements can be large and can endure for extended periods of
time, affecting either favorably or unfavorably the value of the Funds' assets.
However, each Fund, except the California Tax Free Fund, the Equity Index Fund,
the Government Fund, the Money Market Fund, the New York Tax Free Fund and the
Tax Free Bond Fund, may, to the extent it invests in foreign securities, enter
into forward foreign currency transactions in order to protect against
uncertainty in the level of future foreign currency exchange rates. Each of
these Funds may enter into contracts to purchase foreign currencies to protect
against an anticipated rise in the U.S. dollar price of securities it intends to
purchase and may enter into contracts to sell foreign currencies to protect
against the decline in value of its foreign currency-denominated portfolio
securities due to a decline in the value of the foreign currencies against the
U.S. dollar. In addition, a Fund may use one currency (or a basket of
currencies) to hedge against adverse
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changes in the value of another currency (or a basket of currencies) when
exchange rates between the two currencies are correlated.
Foreign currency transactions in which the Funds may engage include forward
foreign currency contracts, currency exchange transactions on a spot (i.e.,
----
cash) basis, put and call options on foreign currencies and foreign exchange
futures contracts. A forward foreign currency exchange contract involves an
obligation to purchase or sell a specific currency at a future date, which may
be any fixed number of days (usually less than one year) from the date of the
contract agreed upon by the parties, at a price set at the time of the contract.
These contracts are traded in the interbank market conducted directly between
traders (usually large commercial banks) and their customers. A forward
contract generally has no deposit requirement, and no commissions are charged at
any stage for trades. Although foreign exchange dealers do not charge a fee for
conversion, they do realize a profit based on the difference (the spread)
between the price at which they are buying and selling various currencies.
Normally, consideration of the prospect for currency parities will be
incorporated in a longer term investment decision made with regard to overall
diversification strategies. However, the Adviser believes that it is important
to have the flexibility to enter into such forward contracts when it determines
that the best interest of a Fund will be served by entering into such a
contract. Generally, the Adviser believes that the best interest of a Fund will
be served if a Fund is permitted to enter into forward contracts under specified
circumstances. First, when a Fund enters into, or anticipates entering into, a
contract for the purchase or sale of a security denominated in a foreign
currency, it may desire to "lock in" the U.S. dollar price of the security. By
entering into a forward contract for the purchase or sale, for a fixed amount of
U.S. dollars, of the amount of foreign currency involved in the underlying
security transaction, a Fund will be able to insulate itself from a possible
loss resulting from a change in the relationship between the U.S. dollar and the
subject foreign currency during the period between the date on which the
security is purchased or sold and the date on which payment is made or received,
although a Fund would also forego any gain it might have realized had rates
moved in the opposite direction. This technique is sometimes referred to as a
"settlement" hedge or "transaction" hedge.
Second, when the Adviser believes that the currency of a particular foreign
country may suffer a substantial decline against the U.S. dollar, it may enter
into a forward contract to sell, for a fixed amount of dollars, the amount of
foreign
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currency approximating the value of some or all of a Fund's portfolio securities
denominated in such foreign currency. Such a hedge (sometimes referred to as a
"position" hedge) will tend to offset both positive and negative currency
fluctuations, but will not offset changes in security values caused by other
factors. The Fund also may hedge the same position by using another currency
(or a basket of currencies) expected to perform in a manner substantially
similar to the hedged currency ("proxy hedge"). The precise matching of the
forward contract amounts and the value of the securities involved will not
generally be possible since the future value of such securities in foreign
currencies will change as a consequence of market movements in the value of
those securities between the date the forward contract is entered into and the
date it matures. With respect to positions that constitute "transaction" or
"position" hedges (including "proxy" hedges), a Fund will not enter into forward
contracts to sell currency or maintain a net exposure to such contracts if the
consummation of such contracts would obligate the Fund to deliver an amount of
foreign currency in excess of the value of the Fund's portfolio securities or
other assets denominated in that currency (or the related currency, in the case
of a "proxy" hedge).
Finally, a Fund may enter into forward contracts to shift its investment
exposure from one currency into another currency that is expected to perform
inversely with respect to the hedged currency relative to the U.S. dollar. This
type of strategy, sometimes known as a "cross-currency" hedge, will tend to
reduce or eliminate exposure to the currency that is sold, and increase exposure
to the currency that is purchased, much as if the Fund had sold a security
denominated in one currency and purchased an equivalent security denominated in
another. "Cross-currency" hedges protect against losses resulting from a
decline in the hedged currency, but will cause the Fund to assume the risk of
fluctuations in the value of the currency it purchases.
At the consummation of the forward contract, a Fund may either make
delivery of the foreign currency or terminate its contractual obligation to
deliver the foreign currency by purchasing an offsetting contract obligating it
to purchase at the same maturity date the same amount of such foreign currency.
If a Fund chooses to make delivery of the foreign currency, it may be required
to obtain such currency for delivery through the sale of portfolio securities
denominated in such currency or through conversion of other assets of the Fund
into such currency. If a Fund engages in an offsetting transaction, the Fund
will realize a gain or a loss to the extent that there has been a change in
forward contract prices. Closing purchase transactions with respect to forward
contracts are usually
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effected with the currency trader who is a party to the original forward
contract.
A Fund's dealing in forward contracts will be limited to the transactions
described above. Of course, a Fund is not required to enter into such
transactions with regard to its foreign currency-denominated securities and will
not do so unless deemed appropriate by the Adviser. A Fund generally will not
enter into a forward contract with a term of greater than one year.
In cases of transactions which constitute "transaction" hedges, or
"position" hedges (including "proxy" hedges) or "cross-currency" hedges that
involve purchase and sale of two different foreign currencies directly through
the same foreign currency contract, a Fund may deem its forward currency hedge
position to be covered by underlying Fund portfolio securities or may establish
a Segregated Account with its Custodian in an amount equal to the value of the
Fund's total assets committed to the consummation of the subject hedge.
The Segregated Account will consist of liquid assets. In the case of
"anticipatory" hedges and "cross-currency" hedges that involve the purchase and
sale of two different foreign currencies indirectly through separate forward
currency contracts, the Fund will establish a Segregated Account with its
Custodian as described above. In the event a Fund establishes a Segregated
Account, the Fund will mark-to-market the value of the assets in the Segregated
Account. If the value of the liquid assets placed in the separate account
declines, additional liquid assets will be placed in the account by the Fund on
a daily basis so that the value of the account will equal the amount of the
Fund's commitments with respect to such contracts.
It should be realized that this method of protecting the value of a Fund's
portfolio securities against a decline in the value of a currency does not
eliminate fluctuations in the underlying prices of the securities. It simply
establishes a rate of exchange which can be achieved at some future point in
time. It also reduces any potential gain which may have otherwise occurred had
the currency value increased above the settlement price of the contract. The
Funds cannot assure that the techniques discussed above will be successful.
Successful use of forward contracts depends on the investment manager's skill in
analyzing and predicting relative currency values. Forward contracts alter a
Fund's exposure to currency exchange rate activity and could result in losses to
the Fund if currencies do not perform as investment managers anticipate. A Fund
may also incur significant costs when converting assets from one currency to
another. Contracts to sell foreign currency would limit any potential gain
which might be realized by a Fund if the value of the hedged currency increases.
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The Adviser believes active currency management can be employed as an
overall portfolio risk management tool. For example, in their view, foreign
currency management can provide overall portfolio risk diversification when
combined with a portfolio of foreign securities, and the market risks of
investing in specific foreign markets can at times be reduced by currency
strategies which may not involve the currency in which the foreign security is
denominated.
A Fund's foreign currency transactions may be limited by the requirements
of Subchapter M of the Code for qualification as a regulated investment company.
FOREIGN INDEX-LINKED INSTRUMENTS
As part of its investment program, and to maintain greater flexibility, the
International Bond Fund, International Equity Fund and Strategic Income Fund
may, subject to compliance with each Fund's limitations applicable to its
investment in debt securities, invest in instruments issued by the U.S. or a
foreign government or by private issuers that return principal and/or pay
interest to investors in amounts which are linked to the level of a particular
foreign index ("foreign index-linked instruments"). Foreign index-linked
instruments have the investment characteristics of particular securities,
securities indexes, futures contracts or currencies. Such instruments may take
a variety of forms, such as debt instruments with interest or principal payments
determined by reference to the value of a currency or commodity at a future
point in time.
A foreign index may be based upon the exchange rate of a particular
currency or currencies or the differential between two currencies, or the level
of interest rates in a particular country or countries, or the differential in
interest rates between particular countries. In the case of foreign index-
linked instruments linking the interest component to a foreign index, the amount
of interest payable will adjust periodically in response to changes in the level
of the foreign index during the term of the foreign index-linked instrument.
BRADY BONDS
Each of the Convertible Fund, High Yield Corporate Bond Fund, International
Bond Fund, Strategic Income Fund and Total Return Fund may invest a portion of
its assets in Brady Bonds, which are securities created through the exchange of
existing commercial bank loans to sovereign entities for new obligations in
connection with debt restructurings. Brady Bonds may be collateralized or
uncollateralized and are issued in various
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currencies (primarily the U.S. dollar). Brady bonds are not considered U.S.
government securities.
U.S. dollar-denominated, collateralized Brady Bonds, which may be fixed
rate par bonds or floating rate discount bonds, are generally collateralized in
full as to principal by U.S. Treasury zero coupon bonds having the same maturity
as the Brady Bonds. Interest payments on these Brady Bonds generally are
collateralized on a one-year or longer rolling-forward basis by cash or
securities in an amount that, in the case of fixed rate bonds, is equal to at
least one year of interest payments or, in the case of floating rate bonds,
initially is equal to at least one year's interest payments based on the
applicable interest rate at that time and is adjusted at regular intervals
thereafter. Certain Brady Bonds are entitled to "value recovery payments" in
certain circumstances, which in effect constitute supplemental interest payments
but generally are not collateralized. Brady Bonds are often viewed as having
three or four valuation components: (i) the collateralized repayment of
principal at final maturity; (ii) the collateralized interest payments; (iii)
the uncollateralized interest payments; and (iv) any uncollateralized repayment
of principal at maturity (these uncollateralized amounts constitute the
"residual risk").
Brady Bonds involve various risk factors including the history of defaults
with respect to commercial bank loans by public and private entities of
countries issuing Brady Bonds. There can be no assurance that Brady Bonds in
which the Fund may invest will not be subject to restructuring arrangements or
to requests for new credit, which may cause the Fund to suffer a loss of
interest or principal on any of its holdings.
MUNICIPAL SECURITIES
Municipal securities generally are understood to include debt obligations
issued by, or on behalf of, states, territories and possessions of the United
States and their political sub-divisions, agencies and instrumentalities and the
District of Columbia, to obtain funds for various public purposes, including
construction of a wide range of public facilities, refunding of outstanding
obligations, payment of general operating expenses and extensions of loans to
public institutions and facilities. The yields on municipal securities depend
upon a variety of factors, including general economic and monetary conditions,
general money market conditions, general conditions of the municipal securities
market, the financial condition of the
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issuer, the size of a particular offering, the maturity of the obligations
offered and the rating of the issue or issues. Municipal securities also may be
subject to the provisions of bankruptcy, insolvency and other laws affecting the
rights and remedies of creditors, such as the Federal Bankruptcy Code, and laws,
if any, which may be enacted by Congress or state legislatures extending the
time for payment of principal or interest, or both, or imposing other
constraints upon enforcement of such obligations or upon the ability of
municipalities to levy taxes. There is also the possibility that, as a result of
litigation or other conditions, the power or ability of any one or more issuers
to pay, when due, the principal of, and interest on, its or their municipal
securities may be materially and adversely affected.
Tax Anticipation Notes are used to finance working capital needs of
municipalities and are issued in anticipation of various seasonal tax revenues,
to be payable from these specific future taxes. They are usually general
obligations of the issuer, secured by the taxing power for the payment of
principal and interest.
Revenue Anticipation Notes are issued in expectation of receipt of other
kinds of revenue, such as federal revenues. They, also, are usually general
obligations of the issuer.
Bond Anticipation Notes are normally issued to provide interim financial
assistance until long-term financing can be arranged. The long-term bonds then
provide funds for the repayment of the notes.
Construction Loan Notes are sold to provide construction financing for
specific projects. After successful completion and acceptance, many projects
receive permanent financing through the FHA under the FNMA or GNMA.
Project Notes are instruments sold by the Department of Housing and Urban
Development ("HUD") but issued by a state or local housing agency to provide
financing for a variety of programs. They are backed by the full faith and
credit of the U.S. government, and generally carry a term of one year or less.
Short-Term Discount Notes (tax-exempt commercial paper) are short-term (365
days or less) promissory notes issued by municipalities to supplement their cash
flow.
Municipal Bonds, which meet longer-term capital needs and generally have
maturities of more than one year when issued, have two principal
classifications: general obligation bonds and revenue bonds. Issuers of
general obligation bonds include
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states, counties, cities, towns and regional districts. The proceeds of these
obligations are used to fund a wide range of public projects, including
construction or improvement of schools, highways and roads, and water and sewer
systems. The basic security behind general obligation bonds is the issuer's
pledge of its full faith, credit and taxing power for the payment of principal
and interest. The taxes that can be levied for the payment of debt service may
be limited or unlimited as to the rate or amount of special assessments.
A revenue bond is not secured by the full faith, credit and taxing power of
an issuer. Rather, the principal security for a revenue bond is generally the
net revenue derived from a particular facility, group of facilities or, in some
cases, the proceeds of a special excise or other specific revenue source.
Revenue bonds are issued to finance a wide variety of capital projects,
including: electric, gas, water, and sewer systems; highways, bridges, and
tunnels; port and airport facilities; colleges and universities; and hospitals.
Although the principal security behind these bonds may vary, many provide
additional security in the form of a debt service reserve fund which may be used
to make principal and interest payments on the issuer's obligations. Housing
finance authorities have a wide range of security and credit enhancement
guarantees available to them, including partially or fully insured mortgages,
rent subsidized and/or collateralized mortgages, and/or the net revenues from
housing or other public projects. Some authorities are provided further security
in the form of a state's assurance (although without obligation) to make up
deficiencies in the debt service reserve fund.
An entire issue of Municipal Bonds may be purchased by one or a small
number of institutional investors such as the Funds.
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Thus, the issue may not be said to be publicly offered. Unlike securities which
must be registered under the Securities Act of 1933 prior to offer and sale,
unless an exemption from such registration is available, Municipal Bonds which
are not publicly offered may nevertheless be readily marketable. A secondary
market exists for Municipal Bonds which were not publicly offered initially.
The Tax Free Bond Fund may invest more than 25% of its total assets in
Municipal Bonds the issuers of which are located in the same state and may
invest more than 25% of its total assets in Municipal Bonds the security of
which is derived from any one of the following categories: hospitals and health
facilities; turnpikes and toll roads; ports and airports; colleges and
universities; public housing authorities; general obligations of states and
localities; lease rental obligations of states and local authorities; state and
local housing finance authorities; municipal utilities systems; bonds that are
secured or backed by the Treasury or other U.S. government guaranteed
securities; or industrial development and pollution control bonds. There could
be economic, business or political developments which might affect all Municipal
Bonds of a similar type. However, the Fund believes that the most important
consideration affecting risk is the quality of Municipal Bonds.
The Tax Free Bond Fund may engage in short-term trading (selling securities
held for brief periods of time, usually less than three months) if the Adviser
believes that such transactions, net of costs including taxes, if any, would
improve the overall return on its portfolio. The needs of different classes of
lenders and borrowers and their changing preferences and circumstances have in
the past caused market dislocations unrelated to fundamental creditworthiness
and trends in interest rates which have presented market trading opportunities.
There can be no assurance that such dislocations will occur in the future or
that the Fund will be able to take advantage of them. The Fund generally limits
its voluntary short-term trading to the extent necessary to qualify as a
"regulated investment company" under the Code.
There are, in addition, a variety of hybrid and special types of municipal
obligations, such as municipal lease obligations, as well as numerous
differences in the security of Municipal Bonds both within and between the two
principal classifications described above. Municipal lease obligations are
municipal securities that may be supported by a lease or an installment purchase
contract issued by state and local government authorities to acquire funds to
obtain the use of a wide variety of equipment and facilities such as fire and
sanitation vehicles, computer equipment and other capital assets.
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These obligations, which may be secured or unsecured, are not general
obligations and have evolved to make it possible for state and local governments
to obtain the use of property and equipment without meeting constitutional and
statutory requirements for the issuance of debt. Thus, municipal lease
obligations have special risks not normally associated with Municipal Bonds.
These obligations frequently contain "non-appropriation" clauses that provide
that the governmental issuer of the obligation has no obligation to make future
payments under the lease or contract unless money is appropriated for such
purposes by the legislative body on a yearly or other periodic basis. In
addition to the "nonappropriation" risk, many municipal lease obligations have
not yet developed the depth of marketability associated with Municipal Bonds;
moreover, although the obligations may be secured by the leased equipment, the
disposition of the equipment in the event of foreclosure might prove difficult.
For the purpose of each Fund's investment restrictions, the identification of
the "issuer" of Municipal Bonds which are not General Obligation Bonds is made
by the Adviser on the basis of the characteristics of the Municipal Bonds as
described above, the most significant of which is the source of funds for the
payment of principal of and interest on such Bonds.
In order to limit certain of these risks, the California Tax Free Fund, New
York Tax Free Fund and Tax Free Bond Fund will not invest more than 10% (15% in
the case of the Strategic Income Fund) of its assets in municipal lease
obligations that are illiquid (along with all other illiquid securities). The
liquidity of municipal lease obligations purchased by the Funds will be
determined pursuant to guidelines approved by the Board of Trustees. Factors
considered in making such determinations may include: the frequency of trades
and quotes for the obligation; the number of dealers willing to purchase or sell
the security and the number of other potential buyers; the willingness of
dealers to undertake to make a market in the security; the nature of marketplace
trades; the obligation's rating; and, if the security is unrated, the factors
generally considered by a rating agency.
There may be other types of municipal securities that become available
which are similar to the foregoing described municipal securities in which each
Fund may invest.
INCOME LEVEL AND CREDIT RISK Municipal obligations are subject to the
----------------------------
provisions of bankruptcy, insolvency and other laws affecting the rights and
remedies of creditors, such as the Federal Bankruptcy Code, and laws, if any,
which may be enacted by Congress or state legislatures extending the time for
payment of principal or interest, or both, or imposing other constraints
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upon enforcement of such obligations or upon municipalities to levy taxes. There
is also the possibility that as a result of litigation or other conditions, the
power or ability of any one or more issuers to pay, when due, principal or
interest on its or their municipal obligations may be materially affected.
Although the Funds' quality standards are designed to minimize the credit risk
of investing in Municipal Bonds, that risk cannot be entirely eliminated.
TAX CONSIDERATIONS With respect to the California Tax Free Fund, New York
------------------
Tax Free Fund and Tax Free Bond Fund, income derived by a Fund from taxable
investments, including but not limited to securities lending transactions,
repurchase transactions, options and futures transactions, and investments in
commercial paper, bankers' acceptances and certificates of deposit will be
taxable for federal, state and local income tax purposes when distributed to
shareholders. Income derived by a Fund from interest on direct obligations of
the U.S. government will be taxable for federal income tax purposes when
distributed to shareholders but, provided that the Fund meets the requirements
of state law and properly designates distributions to shareholders, such
distributions may be excludable from income for state personal income tax
purposes. A portion of original issue discount relating to stripped Municipal
Bonds and their coupons may also be treated as taxable income under certain
circumstances.
The Tax Reform Act of 1986 ("TRA") has limited the types and volume of
Municipal Bonds qualifying for the federal income tax exemption for interest,
and results in the treatment of tax-exempt interest on certain Municipal Bonds
as a tax preference item included in the alternative minimum tax base for
corporate and noncorporate shareholders. In addition, all tax-exempt interest
may result in or increase a corporation's liability under the corporate
alternative minimum tax, because a portion of the difference between corporate
"adjusted current earnings" and alternative minimum taxable income is treated as
a tax preference item. Further, a issuer's failure to comply with the detailed
and numerous requirements imposed by the TRA after bonds have been issued may
increase the likelihood of retroactive revocation of the tax-exempt status of
certain Municipal Bonds after their issuance. The Funds intend to monitor
developments in the municipal bond market to determine whether any defensive
action should be taken.
INDUSTRIAL DEVELOPMENT AND POLLUTION CONTROL BONDS
Industrial Development Bonds which pay tax-exempt interest are, in most
cases, revenue bonds and are issued by, or on behalf of, public authorities to
raise money to finance various privately operated facilities for business,
manufacturing, housing, sports, and pollution control. These bonds are also
used to finance public facilities such as airports, mass transit systems, ports,
and parking. The payment of the principal and interest on such bonds is solely
dependent on the ability of the facility's user to meet its financial
obligations and the pledge, if any, of the real and personal property so
financed as security for such payments. These bonds are generally not secured
by the taxing power of the municipality but are secured by the revenues of the
authority derived from payments by the industrial user.
Industrial Development and Pollution Control Bonds, although nominally
issued by municipal authorities, are generally not secured by the taxing power
of the municipality but are secured
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by the revenues of the authority derived from payments by the industrial user.
Industrial Development Bonds issued after the effective date of the TRA, as well
as certain other bonds, are now classified as "private activity bonds." Some,
but not all, private activity bonds issued after that date qualify to pay tax-
exempt interest.
VARIABLE RATE DEMAND NOTES ("VRDNS")
The California Tax Free Fund, New York Tax Free Fund and Tax Free Bond Fund
may invest in tax-exempt obligations which contain a floating or variable
interest rate adjustment formula and an unconditional right of demand to receive
payment of the unpaid principal balance plus accrued interest upon a short
notice period prior to specified dates, generally at 30, 60, 90, 180 or 365-day
intervals. The interest rates are adjustable at various intervals to the
prevailing market rate for similar investments, such adjustment formula being
calculated to maintain the market value of the VRDN at approximately the par
value of the VRDN on the adjustment date. The adjustments are typically based
upon the prime rate of a bank or some other appropriate interest rate adjustment
index.
The California Tax Free Fund, New York Tax Free Fund and Tax Free Bond Fund
may also invest in VRDNs in the form of participation interests ("Participating
VRDNs") in variable rate tax-exempt obligations held by a financial institution,
typically a commercial bank ("Institution"). Participating VRDNs provide a Fund
with a specified undivided interest (up to 100%) of the underlying obligation
and the right to demand payment of the unpaid principal balance plus accrued
interest on the Participating VRDNs from the Institution upon a specified number
of days' notice, not to exceed seven days. In addition, the Participating VRDN
is backed up by an irrevocable letter of credit or guaranty of the Institution.
A Fund has an undivided interest in the underlying obligation and thus
participates on the same basis as the Institution in such obligation, except
that the Institution typically retains fees out of the interest paid or the
obligation for servicing the obligation, providing the letter of credit and
issuing the repurchase commitment.
FLOATING AND VARIABLE RATE SECURITIES
Floating and variable rate securities provide for a periodic adjustment in
the interest rate paid on the obligations. The terms of such obligations must
provide that interest rates are adjusted periodically based upon an interest
rate adjustment index as provided in the respective obligations. The adjustment
intervals may be regular, and range from daily up to annually, or may be based
on an event, such as a change in the prime rate.
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The interest rate on a floating rate debt instrument ("floater") is a
variable rate which is tied to another interest rate, such as a money-market
index or Treasury bill rate. The interest rate on a floater resets periodically,
typically every six months. While, because of the interest rate reset feature,
floaters provide the Funds with a certain degree of protection against rises in
interest rates, the Funds will participate in any declines in interest rates as
well.
The interest rate on a leveraged inverse floating rate debt instrument
("inverse floater") resets in the opposite direction from the market rate of
interest to which the inverse floater is indexed. An inverse floater may be
considered to be leveraged to the extent that its interest rate varies by a
magnitude that exceeds the magnitude of the change in the index rate of
interest. The higher degree of leverage inherent in inverse floaters is
associated with greater volatility in their market values. Accordingly, the
duration of an inverse floater may exceed its stated final maturity. Certain
inverse floaters may be deemed to be illiquid securities for purposes of the
Funds' limitations on investments in such securities.
ZERO COUPON BONDS
The Funds, except the Equity Index Fund, may purchase zero coupon bonds,
which are debt obligations issued without any requirement for the periodic
payment of interest. Zero coupon bonds are issued at a significant discount
from face value. The discount approximates the total amount of interest the
bonds would accrue and compound over the period until maturity at a rate of
interest reflecting market rate at the time of issuance. Because interest on
zero coupon bonds is not distributed on a current basis but is, in effect,
compounded, zero coupon bonds tend to be subject to greater market risk than
interest paying securities of similar maturities. The discount represents
income, a portion of which the Funds must accrue and distribute every year even
though a Fund receives no payment on the investment in that year. Zero coupon
bonds tend to be more volatile than conventional debt securities.
STANDBY COMMITMENTS -- OBLIGATIONS WITH PUTS ATTACHED
The California Tax Free Fund, New York Tax Free Fund, Strategic Income Fund
and Tax Free Bond Fund may purchase municipal securities together with the right
to resell the securities to the seller at an agreed-upon price or yield within a
specified period prior to the maturity date of the securities. Although it is
not a put option in the usual sense, such a right to resell is commonly known as
a "put" and is also referred to as a "standby
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commitment." Each Fund may pay for a standby commitment either separately, in
cash, or in the form of a higher price for the securities which are acquired
subject to the standby commitment, thus increasing the cost of securities and
reducing the yield otherwise available from the same security. The Adviser
understands that the Internal Revenue Service (the "IRS") has issued a revenue
ruling to the effect that, under specified circumstances, a registered
investment company will be the owner of tax-exempt municipal obligations
acquired subject to a put option. The IRS has also issued private letter rulings
to certain taxpayers (which do not serve as precedent for other taxpayers) to
the effect that tax-exempt interest received by a regulated investment company
with respect to such obligations will be tax-exempt in the hands of the company
and may be distributed to its shareholders as exempt-interest dividends. The IRS
has subsequently announced that it will not ordinarily issue advance ruling
letters as to the identity of the true owner of property in cases involving the
sale of securities or participation interests therein if the purchaser has the
right to cause the security, or the participation interest therein, to be
purchased by either the seller or a third party. Each of the California Tax Free
Fund, New York Tax Free Fund and Tax Free Bond Fund intends to take the position
that it is the owner of any municipal obligations acquired subject to a standby
commitment and that tax-exempt interest earned with respect to such municipal
obligations will be tax-exempt in its hands; however, no assurance can be given
that this position would prevail if challenged. In addition, there is no
assurance that standby commitments will be available to a Fund, nor has the
California Tax Free Fund, New York Tax Free Fund or Tax Free Bond Fund assumed
that such commitments would continue to be available under all market
conditions.
A standby commitment may not be used to affect a Fund's valuation of the
municipal security underlying the commitment. Any consideration paid by a Fund
for the standby commitment, whether paid in cash or by paying a premium for the
underlying security, which increases the cost of the security and reduces the
yield otherwise available from the same security, will be accounted for by the
Fund as unrealized depreciation until the standby commitment is exercised or has
expired.
WHEN-ISSUED SECURITIES
The Funds may from time to time purchase securities on a "when-issued"
basis. Debt securities, including municipal bonds, are often issued in this
manner. The price of such securities, which may be expressed in yield terms, is
fixed at the time a commitment to purchase is made, but delivery of and payment
for the when-issued securities take place at a later date. Normally, the
settlement date occurs within one month of the purchase (60
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days for municipal bonds and notes). During the period between purchase and
settlement, no payment is made by the Fund and no interest accrues to the Fund.
To the extent that assets of a Fund are held in cash pending the settlement of a
purchase of securities, that Fund would earn no income; however, it is the
Trust's intention that each Fund will be fully invested to the extent
practicable and subject to the policies stated herein. Although when-issued
securities may be sold prior to the settlement date, the Trust intends to
purchase such securities with the purpose of actually acquiring them unless a
sale appears desirable for investment reasons.
At the time the Trust makes the commitment on behalf of a Fund to purchase
a security on a when-issued basis, it will record the transaction and reflect
the amount due and the value of the security in determining the Fund's net asset
value. The market value of the when-issued security may be more or less than
the purchase price payable at the settlement date. The Trustees do not believe
that a Fund's net asset value or income will be exposed to additional risk by
the purchase of securities on a when-issued basis. Each Fund will establish a
segregated account in which it will maintain liquid assets at least equal in
value to commitments for when-issued securities. Such segregated securities
either will mature or, if necessary, be sold on or before the settlement date.
MORTGAGE-RELATED AND OTHER ASSET-BACKED SECURITIES
Each Fund may buy Mortgage-related securities. Mortgage-related securities
are interests in pools of residential or commercial mortgage loans or leases,
including mortgage loans made by savings and loan institutions, mortgage
bankers, commercial banks and others. Pools of mortgage loans are assembled as
securities for sale to investors by various governmental, government-related and
private organizations (see "Mortgage Pass-Through Securities"). The Funds, to
the extent permitted in the Prospectus, may also invest in debt securities which
are secured with collateral consisting of mortgage-related securities (see
"Collateralized Mortgage Obligations"), and in other types of mortgage-related
securities. Like other fixed-income securities, when interest rates rise, the
value of a mortgage-related security generally will decline; however, when
interest rates are declining, the value of a mortgage-related security with
prepayment features may not increase as much as other fixed-income securities.
MORTGAGE PASS-THROUGH SECURITIES Interests in pools of mortgage-related
--------------------------------
securities differ from other forms of debt securities, which normally provide
for periodic payment of interest in fixed amounts with principal payments at
maturity or
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specified call dates. Instead, mortgage pass-through securities provide a
monthly payment which consists of both interest and principal payments. In
effect, these payments are a "pass-through" of the monthly payments made by the
individual borrowers on their residential mortgage loans, net of any fees paid
to the issuer or guarantor of such securities. Additional payments are caused by
repayments of principal resulting from the sale of the underlying residential
property, refinancing or foreclosure, net of fees or costs which may be
incurred. Some mortgage-related securities (such as securities issued by the
GNMA) are described as "modified pass-through." These securities entitle the
holder to receive all interest and principal payments owed on the mortgage pool,
net of certain fees, at the scheduled payment dates regardless of whether or not
the mortgagor actually makes the payment. Some mortgage pass-through
certificates may include securities backed by adjustable-rate mortgages which
bear interest at a rate that will be adjusted periodically.
Early repayment of principal on mortgage pass-through securities (arising
from prepayments of principal due to sale of the underlying property,
refinancing, or foreclosure, net of fees and costs which may be incurred) may
expose a Fund to a lower rate of return upon reinvestment of principal. Also,
if a security subject to prepayment has been purchased at a premium, in the
event of prepayment the value of the premium would be lost.
Payment of principal and interest on some mortgage pass-through securities
(but not the market value of the securities themselves) may be guaranteed by the
full faith and credit of the U.S. government (in the case of securities
guaranteed by GNMA); or guaranteed by agencies or instrumentalities of the U.S.
Government (in the case of securities guaranteed by FNMA or FHLMC, which are
supported only by the discretionary authority of the U.S. government to purchase
the agency's obligations).
The principal governmental guarantor of mortgage-related securities is the
GNMA. GNMA is a wholly owned U.S. government corporation within the U.S.
Department of Housing and Urban Development ("HUD"). GNMA is authorized to
guarantee, with the full faith and credit of the U.S. government, the timely
payment of principal and interest on securities issued by institutions approved
by GNMA (such a savings and loan institutions, commercial banks and mortgage
bankers) and backed by pools of FHA-insured or VA-guaranteed mortgages.
Government-related guarantors (i.e., not backed by the full faith and
credit of the U.S. government) include the FNMA and the FHLMC. FNMA is a
government-sponsored corporation owned entirely by private stockholders. It is
subject to general regulation by
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<PAGE>
the Secretary of Housing and Urban Development and acts as a government
instrumentality under authority granted by Congress. FNMA purchases conventional
(i.e., not insured or guaranteed by any government agency) residential mortgages
from a list of approved seller/servicers which include state and federally
chartered savings and loan associations, mutual savings banks, commercial banks
and credit unions and mortgage bankers. Pass-through securities issued by FNMA
are guaranteed as to timely payment of principal and interest by FNMA but are
not backed by the full faith and credit of the U.S. government. FNMA is
authorized to borrow from the U.S. Treasury to meet its obligations.
FHLMC was created by Congress in 1970 for the purpose of increasing the
availability of mortgage credit for residential housing. It is a government-
sponsored corporation and acts as a government instrumentality under authority
granted by Congress. FHLMC was formerly owned by the twelve Federal Home Loan
Banks and is now owned entirely by private stockholders. FHLMC issues
Participation Certificates ("Pcs") which represent interests in conventional
mortgages from FHLMC's national portfolio. FHLMC guarantees the timely payment
of interest and collection of principal, but Pcs are not backed by the full
faith and credit of the U.S. government.
If either fixed or variable rate pass-through securities issued by the U.S.
government or its agencies or instrumentalities are developed in the future, the
Funds reserve the right to invest in them.
Commercial banks, savings and loan institutions, private mortgage insurance
companies, mortgage bankers and other secondary market issuers also create pass-
through pools of conventional residential mortgage loans. Such issuers may, in
addition, be the originators and/or servicers of the underlying mortgage loans
as well as the guarantors of the mortgage-related securities. Pools created by
such non-governmental issuers generally offer a higher rate of interest than
government and government-related pools because there are no direct or indirect
government or agency guarantees of payments in the former pools. However,
timely payment of interest and principal of these pools may be supported by
various forms of insurance or guarantees, including individual loan, title, pool
and hazard insurance and letters of credit. The insurance and guarantees are
issued by governmental entities, private insurers and the mortgage poolers.
Such insurance and guarantees and the creditworthiness of the issuers thereof
will be considered in determining whether a mortgage-related security meets the
Funds' investment quality standards. There can be no assurance that the private
insurers or guarantors can meet their obligations under the insurance
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<PAGE>
policies or guarantee arrangements. The Funds may buy mortgage-related
securities without insurance or guarantees if, through an examination of the
loan experience and practices of the originator/servicers and poolers, the
Adviser determines that the securities meet the Funds' quality standards.
PRIVATELY ISSUED MORTGAGE-RELATED SECURITIES The mortgage-related
--------------------------------------------
securities in which the Funds may invest may be: (i) privately issued securities
which are collateralized by pools of mortgages in which each mortgage is
guaranteed as to payment of principal and interest by an agency or
instrumentality of the U.S. government; (ii) privately issued securities which
are collateralized by pools of mortgages in which payment of principal and
interest is guaranteed by the issuer and such guarantee is collateralized by
U.S. government securities; and (iii) other privately issued securities in which
the proceeds of the issuance are invested in mortgage-backed securities and
payment of the principal and interest is supported by the credit of an agency or
instrumentality of the U.S. government.
The California Tax Free Fund, New York Tax Free Fund and Equity Index Fund,
however, may not invest in non-government mortgage pass-through securities.
Although the market for such securities is becoming increasingly liquid,
securities issued by certain private organizations may not be readily
marketable. No Fund will purchase mortgage-related securities or any other
assets which in the Advisers' opinion are illiquid if, as a result, more than
10% (15% in the case of the International Equity Fund, International Bond and
Strategic Income Funds) of the value of the Fund's total assets will be
illiquid.
COLLATERALIZED MORTGAGE OBLIGATIONS (CMOS) A CMO is a hybrid between a
------------------------------------------
mortgage-backed bond and a mortgage pass-through security. Interest and prepaid
principal is paid, in most cases, semiannually. CMOs may be collateralized by
whole mortgage loans, but are more typically collateralized by portfolios of
mortgage pass-through securities guaranteed by GNMA, FHLMC, or FNMA and their
income streams.
CMOs are structured into multiple classes, each bearing a different stated
maturity. Actual maturity and average life will depend upon the prepayment
experience of the collateral. CMOs are structured into multiple classes, each
bearing a different stated maturity - actual maturing and average life will
depend upon the prepayment experience of the collateral. CMOs provide for a
modified form of call protection through a de facto breakdown of the underlying
--------
pool of mortgages according to how quickly the loans are repaid. Monthly
payment of principal received from the pool of underlying mortgages, including
prepayments, is first returned to investors holding the shortest
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maturity class. Investors holding the longer maturity classes receive principal
only after the first class has been retired. An investor is partially guarded
against a sooner than desired return of principal because of the sequential
payments.
In a typical CMO transaction, a corporation ("issuer") issues multiple
series (e.g., A, B, C, Z) of CMO bonds ("Bonds"). Proceeds of the Bond Offering
are used to purchase mortgages or mortgage pass-through certificates
("Collateral"). The Collateral is pledged to a third-party trustee as security
for the Bonds. Principal and interest payments from the Collateral are used to
pay principal on the Bonds in the order A, B, C, Z. The Series A, B, and C
Bonds all bear current interest. Interest on the Series Z Bond is accrued and
added to principal and a like amount is paid as principal on the Series A, B or
C Bond currently being paid off. When the Series A, B and C Bonds are paid in
full, interest and principal on the Series Z Bond begins to be paid currently.
With some CMOs, the issuer serves as a conduit to allow loan originators
(primarily builders or savings and loan associations) to borrow against their
loan portfolios.
FHLMC COLLATERALIZED MORTGAGE OBLIGATIONS FHLMC CMOs are debt obligations
-----------------------------------------
of FHLMC issued in multiple classes having different maturity dates which are
secured by the pledge of a pool of conventional mortgage loans purchased by
FHLMC. Unlike FHLMC Pcs, payments of principal and interest on the CMOs are
made semiannually, as opposed to monthly. The amount of principal payable on
each semiannual payment date is determined in accordance with FHLMC's mandatory
sinking fund schedule, which, in turn, is equal to approximately 100% of FHA
prepayment experience applied to the mortgage collateral pool. All sinking fund
payments in the CMOs are allocated to the retirement of the individual classes
of bonds in the order of their stated maturities. Payment of principal on the
mortgage loans in the collateral pool in excess of the amount of FHLMC's minimum
sinking fund obligation for any payment date are paid to the holders of the CMOs
as additional sinking fund payments. Because of the "pass-through" nature of
all principal payments received on the collateral pool in excess of FHLMC's
minimum sinking fund requirement, the rate at which principal of the CMOs is
actually repaid is likely to be such that each class of bonds will be retired in
advance of its scheduled maturity date.
If collection of principal (including prepayments) on the mortgage loans
during any semiannual payment period is not sufficient to meet FHLMC's minimum
sinking fund obligation on the next sinking fund payment date, FHLMC agrees to
make up the deficiency from its general funds.
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<PAGE>
Criteria for the mortgage loans in the pool backing the CMOs are identical
to those of FHLMC Pcs. FHLMC has the right to substitute collateral in the event
of delinquencies and/or defaults.
OTHER MORTGAGE-RELATED SECURITIES Other mortgage-related securities
---------------------------------
include securities other than those described above that directly or indirectly
represent a participation in, or are secured by and payable from, mortgage loans
on real property, including CMO residuals or stripped mortgage-backed
securities, and may be structured in classes with rights to receive varying
proportions of principal and interest. Other mortgage-related securities may be
equity or debt securities issued by agencies or instrumentalities of the U.S.
government or by private originators of, or investors in, mortgage loans,
including savings and loan associations, homebuilders, mortgage banks,
commercial banks, investment banks, partnerships, trusts and special purpose
entities of the foregoing.
CMO RESIDUALS CMO residuals are derivative mortgage securities issued by
-------------
agencies or instrumentalities of the U.S. government or by private originators
of, or investors in, mortgage loans, including savings and loan associations,
homebuilders, mortgage banks, commercial banks, investment banks and special
purpose entities of the foregoing.
The cash flow generated by the mortgage assets underlying a series of CMOs
is applied first to make required payments of principal and interest on the
CMOs and second to pay the related administrative expenses of the issuer. The
residual in a CMO structure generally represents the interest in any excess cash
flow remaining after making the foregoing payments. Each payment of such excess
cash flow to a holder of the related CMO residual represents income and/or a
return of capital. The amount of residual cash flow resulting from a CMO will
depend on, among other things, the characteristics of the mortgage assets, the
coupon rate of each class of CMO, prevailing interest rates, the amount of
administrative expenses and the prepayment experience on the mortgage assets.
In particular, the yield to maturity on CMO residuals is extremely sensitive to
prepayments on the related underlying mortgage assets, in the same manner as an
interest-only ("IO") class of stripped mortgage-backed securities. See
"Stripped Mortgage-Backed Securities." In addition, if a series of a CMO
includes a class that bears interest at an adjustable rate, the yield to
maturity on the related CMO residual will also be extremely sensitive to changes
in the level of the index upon which interest rate adjustments are based. As
described below with respect to stripped mortgage-backed securities, in certain
circumstances a portfolio
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<PAGE>
may fail to recoup fully its initial investment in a CMO residual.
CMO residuals are generally purchased and sold by institutional investors
through several investment banking firms acting as brokers or dealers. The CMO
residual market has only very recently developed and, accordingly, CMO residuals
currently may not have the liquidity of other more established securities
trading in other markets. Transactions in CMO residuals are generally completed
only after careful review of the characteristics of the securities in question.
In addition, CMO residuals may or, pursuant to an exemption therefrom, may not
have been registered under the Securities Act of 1933, as amended. CMO
residuals, whether or not registered under such Act, may be subject to certain
restrictions on transferability, and may be deemed "illiquid" and subject to a
Fund's limitations on investment in illiquid securities.
Under certain circumstances, a Fund's investment in residual interests in
"real estate mortgage investment conduits" ("REMICs") may cause shareholders of
that Fund to be deemed to have taxable income in addition to their Fund
dividends and distributions and such income may not be eligible to be reduced
for tax purposes by certain deductible amounts, including net operating loss
deductions. In addition, in some cases, the Fund may be required to pay taxes
on certain amounts deemed to be earned from a REMIC residual. Prospective
investors may wish to consult their tax advisors regarding REMIC residual
investments by a Fund.
CMOs and REMICs may offer a higher yield than U.S. government securities,
but they may also be subject to greater price fluctuation and credit risk. In
addition, CMOs and REMICs typically will be issued in a variety of classes or
series, which have different maturities and are retired in sequence. Privately
issued CMOs and REMICs are not government securities nor are they supported in
any way by any governmental agency or instrumentality. In the event of a
default by an issuer of a CMO or a REMIC, there is no assurance that the
collateral securing such CMO or REMIC will be sufficient to pay principal and
interest. It is possible that there will be limited opportunities for trading
CMOs and REMICs in the over-the-counter market, the depth and liquidity of which
will vary from time to time. Under recent legislation, holders of "residual"
interests in REMICs (including the Fund) could be required to recognize
potential phantom income, as could shareholders (including unrelated business
taxable income for tax-exempt shareholders) of funds that hold such interests.
The Fund will consider this legislation in determining whether to invest in
residual interests.
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<PAGE>
GOVERNMENT FUND The Government Fund may invest in securities
---------------
collateralized by mortgages or pools of mortgages the issuer of which has
qualified to be treated as a "REMIC". CMOs and REMICs may offer a higher yield
than U.S. government securities, but they may also be subject to greater price
fluctuation and credit risk. In addition, CMOs and REMICs typically will be
issued in a variety of classes or series, which have different maturities and
are retired in sequence. Privately issued CMOs and REMICs are not government
securities nor are they supported in any way by any governmental agency or
instrumentality. In the event of a default by an issuer of a CMO or a REMIC,
there is no assurance that the collateral securing such CMO or REMIC will be
sufficient to pay principal and interest. It is possible that there will be
limited opportunities for trading CMOs and REMICs in the over-the-counter
market, the depth and liquidity of which will vary from issue to issue and from
time to time. Under recent legislation, holders of "residual" interests in
REMICs (including the Fund) could be required to recognize potential phantom
income, as could shareholders (including unrelated business taxable income for
tax-exempt shareholders) of funds that hold such interests. The Government Fund
will consider this legislation in determining whether to invest in residual
interests.
The Government Fund will not invest in any privately issued CMOs that do
not meet the requirements of Rule 3a-7 under the 1940 Act if, as a result of
such investment, more than 5% of the Fund's net assets would be invested in any
one CMO, more than 10% of the Fund's net assets would be invested in CMOs and
other investment company securities in the aggregate, or the Fund would hold
more than 3% of any outstanding issue of CMOs.
STRIPPED MORTGAGE-BACKED SECURITIES Stripped mortgage-backed securities
-----------------------------------
("SMBS") are derivative multi-class mortgage securities. SMBS may be issued by
agencies or instrumentalities of the U.S. government, or by private originators
of, or investors in, mortgage loans, including savings and loan associations,
mortgage banks, commercial banks, investment banks and special purpose entities
of the foregoing.
SMBS are usually structured with two classes that receive different
proportions of the interest and principal distributions on a pool of mortgage
assets. A common type of SMBS will have one class receiving some of the
interest and most of the principal from the mortgage assets, while the other
class will receive most of the interest and the remainder of the principal. In
the most extreme case, one class will receive all of the interest (the
interest-only or "IO" class), while the other class will receive all of the
principal (the principal-only or "PO" class). The yield to maturity on an IO
class is extremely
B-35
<PAGE>
sensitive to the rate of principal payments (including prepayments) on the
related underlying mortgage assets, and a rapid rate of principal payments may
have a material adverse effect on a Fund's yield to maturity from these
securities. If the underlying mortgage assets experience greater than
anticipated prepayments of principal, a Fund may fail to fully recoup its
initial investment in these securities even if the security is in one of the
highest rating categories.
Although SMBS are purchased and sold by institutional investors through
several investment banking firms acting as brokers or dealers, these securities
were only recently developed. As a result, established trading markets have not
yet developed and, accordingly, these securities may be deemed "illiquid" and
subject to a Fund's limitations on investment in illiquid securities.
RISKS ASSOCIATED WITH MORTGAGE-BACKED SECURITIES The value of some
------------------------------------------------
mortgage-backed securities in which the Funds may invest may be particularly
sensitive to changes in prevailing interest rates, and, like the other
investments of the Funds, the ability of a Fund to successfully utilize these
instruments may depend in part upon the ability of an Adviser to forecast
interest rates and other economic factors correctly. If an Adviser incorrectly
forecasts such factors and has taken a position in mortgage-backed securities
that is or becomes contrary to prevailing market trends, the Funds could be
exposed to the risk of a loss.
Investment in mortgage-backed securities poses several risks, including
prepayment, market, and credit risk. Prepayment risk reflects the chance that
borrowers may prepay their mortgages faster than expected, thereby affecting the
investment's average life and perhaps its yield. Whether or not a mortgage loan
is prepaid is almost entirely controlled by the borrower. Borrowers are most
likely to exercise their prepayment options at a time when it is least
advantageous to investors, generally prepaying mortgages as interest rates fall,
and slowing payments as interest rates rise. Besides the effect of prevailing
interest rates, the rate of prepayment and refinancing of mortgages may also be
affected by home value appreciation, ease of the refinancing process and local
economic conditions.
Market risk reflects the chance that the price of the security may
fluctuate over time. The price of mortgage-backed securities may be
particularly sensitive to prevailing interest rates, the length of time the
security is expected to be outstanding, and the liquidity of the issue. In a
period of unstable interest rates, there may be decreased demand for certain
types of mortgage-backed securities, and a Fund invested
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<PAGE>
in such securities and wishing to sell them may find it difficult to find a
buyer, which may in turn decrease the price at which they may be sold.
Credit risk reflects the chance that a Fund may not receive all or part of
its principal because the issuer or credit enhancer has defaulted on its
obligations. Obligations issued by U.S. government-related entities are
guaranteed as to the payment of principal and interest, but are not backed by
the full faith and credit of the U.S. government. The performance of private
label mortgage-backed securities, issued by private institutions, is based on
the financial health of those institutions.
OTHER ASSET-BACKED SECURITIES Several types of asset-backed securities
-----------------------------
have already been offered to investors, including CARS/SM/ ("Certificates for
Automobile Receivables/SM/"). CARS/SM/ represent undivided fractional interests
in a trust ("trust") whose assets consist of a pool of motor vehicle retail
installment sales contracts and security interests in the vehicles securing the
contracts. Payments of principal and interest on CARS/SM/ are passed-through
monthly to certificate holders, and are guaranteed up to certain amounts and for
a certain time period by a letter of credit issued by a financial institution
unaffiliated with the trustee or originator of the trust. An investor's return
on CARS/SM/ may be affected by early prepayment of principal on the underlying
vehicle sales contracts. If the letter of credit is exhausted, the trust may be
prevented from realizing the full amount due on a sales contract because of
state law requirements and restrictions relating to foreclosure sales of
vehicles and the obtaining of deficiency judgments following such sales or
because of depreciation, damage or loss of a vehicle, the application of federal
and state bankruptcy and insolvency laws, or other factors. As a result,
certificate holders may experience delays in payments or losses if the letter of
credit is exhausted.
The Advisers expect that other asset-backed securities (unrelated to
mortgage loans) will be offered to investors in the future. Consistent with its
investment objectives and policies, a Fund also may invest in other types of
asset-backed securities.
SHORT SALES AGAINST THE BOX
A short sale is a transaction in which a Fund sells through a broker a
security it does not own in anticipation of a possible decline in market price.
A short sale "against the box" is a short sale in which, at the time of the
short sale, a Fund owns or has the right to obtain securities equivalent in kind
and amount. Each of the Funds will only enter into short sales
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<PAGE>
against the box. A Fund may enter into a short sale against the box among other
reasons, to hedge against a possible market decline in the value of the security
owned or to defer recognition of a gain or loss for federal income tax purposes
on the security owned by the Fund. If the value of a security sold short against
the box increases, the Fund would suffer a loss when it purchases or delivers to
the selling broker the security sold short. The proceeds of the short sale are
retained by the broker pursuant to applicable margin rules. In addition, the
Fund may segregate assets, equal in value to 50% of the value of the short sale,
in a special account with the Fund's custodian. The segregated assets are
pledged to the broker pursuant to applicable margin rules. If a broker, with
which the Fund has open short sales, were to become bankrupt, a Fund could
experience losses or delays in recovering gains on short sales. The Funds will
only enter into short sales against the box with brokers the Advisers believe
are creditworthy. Short sales against the box will be limited to no more than
25% of a Fund's assets.
OPTIONS ON SECURITIES
WRITING CALL OPTIONS Any Fund, except the Equity Index Fund, the Money
--------------------
Market Fund and the Tax Free Bond Fund, may sell ("write") covered call options
on the portfolio securities of such Fund in an attempt to enhance investment
performance. The California Tax Free Fund and New York Tax Free Fund may
purchase and sell both put and call options on debt securities in standardized
contracts traded on national securities exchanges, boards of trade, or similar
entities, or quoted on NASDAQ, and agreements, sometimes called "cash puts,"
which may accompany the purchase of a new issue of bonds from a dealer. A call
option sold by a Fund is a short-term contract, having a duration of nine months
or less, which gives the purchaser of the option the right to buy, and imposes
on the writer of the option--in return for a premium received--the obligation to
sell, the underlying security at the exercise price upon the exercise of the
option at any time prior to the expiration date, regardless of the market price
of the security during the option period. A call option may be covered by,
among other things, the writer owning the underlying security throughout the
option period, or by holding, on a share-for-share basis, a call on the same
security as the call written, where the exercise price of the call held is equal
to or less than the price of the call written, or greater than the exercise
price of a call written if the difference is maintained by the Fund in liquid
assets in a segregated account with its custodian.
A Fund will write covered call options both to reduce the risks associated
with certain of its investments and to increase
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<PAGE>
total investment return through the receipt of premiums. In return for the
premium income, the Fund will give up the opportunity to profit from an increase
in the market price of the underlying security above the exercise price so long
as its obligations under the contract continue, except insofar as the premium
represents a profit. Moreover, in writing the call option, the Fund will retain
the risk of loss should the price of the security decline, which loss the
premium is intended to offset in whole or in part. A Fund, in writing call
options, must assume that the call may be exercised at any time prior to the
expiration of its obligations as a writer, and that in such circumstances the
net proceeds realized from the sale of the underlying securities pursuant to the
call may be substantially below the prevailing market price. Covered call
options and the securities underlying such options will be listed on national
securities exchanges, except for certain transactions in options on debt
securities and foreign securities.
During the option period, the covered call writer has, in return for the
premium received on the option, given up the opportunity to profit from a price
increase in the underlying securities above the exercise price, but, as long as
its obligation as a writer continues, has retained the risk of loss should the
price of the underlying security decline.
A Fund may protect itself from further losses due to a decline in value of
the underlying security or from the loss of ability to profit from appreciation
by buying an identical option, in which case the purchase cost may offset the
premium. In order to do this, the Fund makes a "closing purchase transaction"--
the purchase of a call option on the same security with the same exercise price
and expiration date as the covered call option which it has previously written
on any particular security. The Fund will realize a gain or loss from a closing
purchase transaction if the amount paid to purchase a call option in a closing
transaction is less or more than the amount received from the sale of the
covered call option. Also, because increases in the market price of a call
option will generally reflect increases in the market price of the underlying
security, any loss resulting from the closing out of a call option is likely to
be offset in whole or in part by unrealized appreciation of the underlying
security owned by the Fund. When a security is to be sold from the Fund's
portfolio, the Fund will first effect a closing purchase transaction so as to
close out any existing covered call option on that security.
A closing purchase transaction may be made only on a national or foreign
securities exchange (an "Exchange") which provides a secondary market for an
option with the same exercise price and expiration date, except as discussed
below. There is
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<PAGE>
no assurance that a liquid secondary market on an Exchange or otherwise will
exist for any particular option, or at any particular time, and for some options
no secondary market on an Exchange or otherwise may exist. If the Fund is unable
to effect a closing purchase transaction involving an exchange-traded option,
the Fund will not sell the underlying security until the option expires or the
Fund delivers the underlying security upon exercise. A closing purchase
transaction for an over-the-counter option may be made only with the other party
to the option. Once an option writer has received an exercise notice, it cannot
effect a closing purchase transaction in order to terminate its obligation under
the option and must deliver or purchase the underlying securities at the
exercise price.
Each Fund pays brokerage commissions and dealer spreads in connection with
writing covered call options and effecting closing purchase transactions, as
well as for purchases and sales of underlying securities. The writing of
covered call options could result in significant increases in a Fund's portfolio
turnover rate, especially during periods when market prices of the underlying
securities appreciate. Subject to the limitation that all call and put option
writing transactions be covered, the Funds may, to the extent determined
appropriate by the Advisers, engage without limitation in the writing of options
on U.S. government securities. Subject to the limitation that all call and put
option writing transactions be covered, and limitations imposed on regulated
investment companies under federal tax law, the International Bond Fund and
International Equity Fund may, to the extent determined appropriate by the
Adviser, engage without limitation in the writing of options on their portfolio
securities.
WRITING PUT OPTIONS Each Fund, except the Equity Index Fund, the Money
-------------------
Market Fund and the Tax Free Bond Fund, may also write covered put options. Put
options written by a Fund are agreements by a Fund, for a premium received by
the Fund, to purchase specified securities at a specified price if the option is
exercised during the option period. A put option written by the Fund is
"covered" if the Fund maintains liquid assets with a value equal to the exercise
price in a segregated account with its custodian. A put option is also
"covered" if the Fund holds on a share-for-share basis a put on the same
security as the put written, where the exercise price of the put held is equal
to or greater than the exercise price of the put written, or less than the
exercise price of the put written if the difference is maintained by the Fund in
liquid assets in a segregated account with its custodian.
The premium which the Funds receive from writing a put option will reflect,
among other things, the current market price
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<PAGE>
of the underlying security, the relationship of the exercise price to such
market price, the historical price volatility of the underlying security, the
option period, supply and demand and interest rates.
A covered put writer assumes the risk that the market price for the
underlying security will fall below the exercise price, in which case the writer
could be required to purchase the security at a higher price than the then-
current market price of the security. In both cases, the writer has no control
over the time when it may be required to fulfill its obligation as a writer of
the option.
The Funds may effect a closing purchase transaction to realize a profit on
an outstanding put option or to prevent an outstanding put option from being
exercised. The Funds also may effect a closing purchase transaction, in the
case of a put option, to permit the Funds to maintain their holdings of the
deposited U.S. Treasury obligations, to write another put option to the extent
that the exercise price thereof is secured by the deposited U.S. Treasury
obligations, or to utilize the proceeds from the sale of such obligations to
make other investments.
If a Fund is able to enter into a closing purchase transaction, the Fund
will realize a profit or loss from such transaction if the cost of such
transaction is less or more than the premium received from the writing of the
option respectively. After writing a put option, the Fund may incur a loss
equal to the difference between the exercise price of the option and the sum of
the market value of the underlying security plus the premium received from the
sale of the option.
In addition, the Funds may also write straddles (combinations of covered
puts and calls on the same underlying security). The extent to which the Funds
may write covered put and call options and enter into so-called "straddle"
transactions involving put or call options may be limited by the requirements of
the Internal Revenue Code of 1986, as amended (the "Code") for qualification as
a regulated investment company and the Trust's intention that each Fund qualify
as such. Subject to the limitation that all call and put option writing
transactions be covered, the Funds may, to the extent determined appropriate by
the Advisers, engage without limitation in the writing of options on U.S.
government securities.
PURCHASING OPTIONS Each Fund, except the Equity Index Fund, Money Market
------------------
Fund and the Tax Free Bond Fund, may purchase put or call options which are
traded on an Exchange or in the over-the-counter market. Options traded in the
over-the-counter market may not be as actively traded as those listed on an
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Exchange. Accordingly, it may be more difficult to value such options and to be
assured that they can be closed out at any time. The Funds will engage in such
transactions only with firms the Advisers deem to be of sufficient
creditworthiness so as to minimize these risks.
The Funds may purchase put options on securities to protect their holdings
in an underlying or related security against a substantial decline in market
value. Securities are considered related if their price movements generally
correlate with one another. A Fund would buy a put option in anticipation of a
decline in the market value of such securities. The purchase of a put option
would entitle the Fund, in exchange for the premium paid, to sell a security at
a specified price upon exercise of the option during the option period. The
purchase of put options on securities held in the portfolio or related to such
securities will enable a Fund to preserve, at least partially, unrealized gains
occurring prior to the purchase of the option on a portfolio security without
actually selling the security. In addition, the Fund will continue to receive
interest or dividend income on the security. The put options purchased by the
Fund may include, but are not limited to, "protective puts" in which the
security to be sold is identical or substantially identical to a security
already held by the Fund or to a security which the Fund has the right to
purchase. The Fund would ordinarily recognize a gain if the value of the
securities decreased during the option period below the exercise price
sufficiently to cover the premium. The Fund would recognize a loss if the value
of the securities remained above the difference between the exercise price and
the premium.
The Funds may also purchase call options on securities the Funds intend to
purchase to protect against substantial increases in prices of such securities
pending their ability to invest in an orderly manner in such securities. The
purchase of a call option would entitle the Fund, in exchange for the premium
paid, to purchase a security at a specified price upon exercise of the option
during the option period. The Fund would ordinarily realize a gain if the value
of the securities increased during the option period above the exercise price
sufficiently to cover the premium. The Fund would have a loss if the value of
the securities remained below the sum of the premium and the exercise price
during the option period. In order to terminate an option position, the Funds
may sell put or call options identical to those previously purchased, which
could result in a net gain or loss depending on whether the amount received on
the sale is more or less than the premium and
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other transaction costs paid on the put or call option when it was purchased.
SPECIAL RISKS ASSOCIATED WITH OPTIONS ON SECURITIES Exchange markets in
---------------------------------------------------
U.S. government securities options are a relatively new and untested concept,
and it is impossible to predict the amount of trading interest that may exist
in such options. The same types of risk apply to over-the-counter trading in
options. There can be no assurance that viable markets will develop or continue
in the United States or abroad.
A Fund's purpose in selling covered options is to realize greater income
than would be realized on portfolio securities transactions alone. A Fund may
forego the benefits of appreciation on securities sold pursuant to call options,
or pay a higher price for securities acquired pursuant to put options written by
the Fund. If a put or call option purchased by a Fund is not sold when it has
remaining value, and if the market price of the underlying security, in the case
of a put, remains equal to or greater than the exercise price, or, in the case
of a call, remains less than or equal to the exercise price, the Fund will not
be able to exercise profitably the option and will lose its entire investment in
the option. Also, the price of a put or call option purchased to hedge against
price movements in a related security may move more or less than the price of
the related security. The Capital Appreciation Fund, Convertible Fund,
Government Fund, High Yield Corporate Bond Fund, Money Market Fund, Total Return
Fund and Value Fund will not purchase a put or call option if, as a result, the
amount of premiums paid for all put and call options then outstanding would
exceed 10% of the value of the Fund's total assets. Regarding the International
Bond Fund and International Equity Fund, each Fund has undertaken to a state
securities commission that it will not purchase a put, call, straddle or spread
if, as a result, the amount of premiums paid for such positions would exceed 5%
of the value of the Fund's net assets.
The Fund would ordinarily realize a gain if the value of the securities
increased during the option period above the exercise price sufficiently to
cover the premium. The Fund would have a loss if the value of the securities
remained below the sum of the premium paid and the exercise price during the
option period. The ability of a Fund to successfully utilize options may depend
in part upon the ability of the Adviser to forecast interest rates and other
economic factors correctly.
The hours of trading for options on securities may not conform to the hours
during which the underlying securities are traded. To the extent that the
options markets close before the markets for the underlying securities,
significant price and rate
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movements can take place in the underlying markets that cannot be reflected in
the options markets.
OPTIONS ON FOREIGN CURRENCIES
Each Fund, except the California Tax Free Fund, the Equity Index Fund, the
Government Fund, the Money Market Fund, the New York Tax Free Fund and the Tax
Free Bond Fund, may, to the extent that it invests in foreign securities,
purchase and write options on foreign currencies for hedging purposes in a
manner similar to that of the Fund's transactions in currency futures contracts
or forward contracts. For example, a decline in the dollar value of a foreign
currency in which portfolio securities are denominated will reduce the dollar
value of such securities, even if their value in the foreign currency remains
constant. In order to protect against such declines in the value of portfolio
securities, a Fund may purchase put options on the foreign currency. If the
value of the currency does decline, that Fund will have the right to sell such
currency for a fixed amount of dollars which exceeds the market value of such
currency, resulting in a gain that may offset, in whole or in part, the negative
effect of currency depreciation on the value of the Fund's securities
denominated in that currency.
Conversely, if a rise in the dollar value of a currency in which securities
to be acquired are denominated is projected, thereby increasing the cost of such
securities, a Fund may purchase call options on such currency. If the value of
such currency does increase, the purchase of such call options would enable the
Fund to purchase currency for a fixed amount of dollars which is less than the
market value of such currency, resulting in a gain that may offset, at least
partially, the effect of any currency-related increase in the price of
securities the Fund intends to acquire. As in the case of other types of
options transactions, however, the benefit a Fund derives from purchasing
foreign currency options will be reduced by the amount of the premium and
related transaction costs. In addition, if currency exchange rates do not move
in the direction or to the extent anticipated, a Fund could sustain losses on
transactions in foreign currency options which would deprive it of a portion or
all of the benefits of advantageous changes in such rates.
A Fund may also write options on foreign currencies for hedging purposes.
For example, if a Fund anticipates a decline in the dollar value of foreign
currency-denominated securities due to declining exchange rates, it could,
instead of purchasing a put option, write a call option on the relevant
currency. If the expected decline occurs, the option will most likely not be
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exercised, and the decrease in value of portfolio securities will be offset by
the amount of the premium received by the Fund.
Similarly, instead of purchasing a call option to hedge against an
anticipated increase in the dollar cost of securities to be acquired, a Fund
could write a put option on the relevant currency. If rates move in the manner
projected, the put option will expire unexercised and allow the Fund to offset
such increased cost up to the amount of the premium. As in the case of other
types of options transactions, however, the writing of a foreign currency option
will constitute only a partial hedge up to the amount of the premium, and only
if rates move in the expected direction. If unanticipated exchange rate
fluctuations occur, the option may be exercised and a Fund would be required to
purchase or sell the underlying currency at a loss which may not be fully offset
by the amount of the premium. As a result of writing options on foreign
currencies, a Fund also may be required to forgo all or a portion of the
benefits which might otherwise have been obtained from favorable movements in
currency exchange rates.
A call option written on foreign currency by a Fund is "covered" if that
Fund owns the underlying foreign currency subject to the call or securities
denominated in that currency or has an absolute and immediate right to acquire
that foreign currency without additional cash consideration (or for additional
cash consideration held in a segregated account by its custodian) upon
conversion or exchange of other foreign currency held in its portfolio. A call
option is also covered if a Fund holds a call on the same foreign currency for
the same principal amount as the call written where the exercise price of the
call held (a) is equal to or less than the exercise price of the call written or
(b) is greater than the exercise price of the call written if the amount of the
difference is maintained by a Fund in liquid assets in a segregated account with
its custodian.
As with other kinds of options transactions, the writing of an option on
foreign currency will constitute only a partial hedge up to the amount of the
premium received and a Fund could be required to purchase or sell foreign
currencies at disadvantageous exchange rates, thereby incurring losses. The
purchase of an option on foreign currency may constitute an effective hedge
against exchange rate fluctuations, although, in the event of rate movements
adverse to a Fund's position, a Fund may forfeit the entire amount of the
premium plus related transaction costs. Options on foreign currencies to be
written or purchased by a Fund will be traded on U.S. and foreign exchanges or
over-the-counter.
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A Fund also may use foreign currency options to protect against potential
losses in positions denominated in one foreign currency against another foreign
currency in which the Fund's assets are or may be denominated. There can be no
assurance that a liquid market will exist when a Fund seeks to close out an
option position. Furthermore, if trading restrictions or suspensions are imposed
on the options markets, a Fund may be unable to close out a position.
Currency options traded on U.S. or other exchanges may be subject to
position limits which may limit the ability of a Fund to reduce foreign currency
risk using such options. Over-the-counter options differ from traded options in
that they are two-party contracts with price and other terms negotiated between
buyer and seller and generally do not have as much market liquidity as
exchanged-traded options. Foreign currency exchange-traded options generally
settle in cash, whereas options traded over-the-counter may settle in cash or
result in delivery of the underlying currency upon exercise of the option.
SECURITIES INDEX OPTIONS
The Funds may purchase call and put options on securities indexes (only
call options on the S&P 500 Composite Price Index in the case of the Equity
Index Fund) for the purpose of hedging against the risk of unfavorable price
movements which may adversely affect the value of a Fund's securities. The
Equity Index Fund may purchase call options on the S&P 500 Index to protect
against increases in the prices of securities underlying the Index that the
Equity Index Fund intends to purchase pending its ability to invest in such
securities in an orderly manner.
Unlike a securities option, which gives the holder the right to purchase or
sell specified securities at a specified price, an option on a securities index
gives the holder the right to receive a cash "exercise settlement amount" equal
to (i) the difference between the value of the underlying securities index on
the exercise date and the exercise price of the option, multiplied by (ii) a
fixed "index multiplier." In exchange for undertaking the obligation to make
such a cash payment, the writer of the securities index option receives a
premium.
A securities index fluctuates with changes in the market values of the
securities included in the index. For example, some securities index options
are based on a broad market index such as the S&P 500 Composite Price Index or
the N.Y.S.E. Composite Index, or a narrower market index such as the S&P 100
Index. Indexes may also be based on an industry or market segment such as the
AMEX Oil and Gas Index or the Computer and Business Equipment Index. Options on
stock indexes are currently
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traded on the following exchanges, among others: The Chicago Board Options
Exchange, New York Stock Exchange, and American Stock Exchange. Options on other
types of securities indexes, which do not currently exist, including indexes on
debt securities, may be introduced and traded on exchanges in the future. If
such options are introduced, the Funds will not purchase them until they have
appropriately amended or supplemented the Prospectus or Statement of Additional
Information, or both.
The effectiveness of hedging through the purchase of securities index
options will depend upon the extent to which price movements in the portion of
the securities portfolio being hedged correlate with price movements in the
selected securities index. Perfect correlation is not possible because the
securities held or to be acquired by a Fund will not exactly match the
securities represented in the securities indexes on which options are based. In
addition, the purchase of securities index options involves essentially the same
risks as the purchase of options on futures contracts. The principal risk is
that the premium and transaction costs paid by a Fund in purchasing an option
will be lost as a result of unanticipated movements in prices of the securities
comprising the securities index on which the option is based. Gains or losses
on a Fund's transactions in securities index options depend on price movements
in the securities market generally (or, for narrow market indexes, in a
particular industry or segment of the market) rather than the price movements of
individual securities held by a Fund. In this respect, purchasing a securities
index put (or call) option is analogous to the purchase of a put (or call) on a
securities index futures contract.
A Fund may sell securities index options prior to expiration in order to
close out its positions in securities index options which it has purchased. A
Fund may also allow options to expire unexercised.
FUTURES TRANSACTIONS
The California Tax Free Fund, Convertible Fund, Government Fund, High Yield
Corporate Bond Fund, International Bond Fund, International Equity Fund, New
York Tax Free Fund, Strategic Income Fund, Tax Free Bond Fund and Total Return
Fund may purchase and sell futures contracts on debt securities and on indexes
of debt securities in order to attempt to protect against the effects of adverse
changes in interest rates, to lengthen or shorten the average maturity or
duration of a Fund's portfolio and for other appropriate risk management
purposes. For example, a Fund may purchase futures contracts as a substitute
for the purchase of longer-term debt securities to
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lengthen the average duration of a Fund's portfolio of fixed-income securities.
The Government Fund may enter into futures contracts and purchase and write
options on futures, which are not U.S. government securities. In order to
attempt to hedge against changes in interest rates and to seek current income.
Such futures contracts would obligate the Fund to make or take delivery of
certain debt securities or an amount of cash upon expiration of the futures
contract, although most futures positions typically are closed out through an
offsetting transaction prior to expiration. The Capital Appreciation Fund,
Convertible Fund, Equity Index Fund, International Equity Fund, Strategic Income
Fund, Total Return Fund and Value Fund may purchase and sell stock index futures
to hedge the equity portion of those Funds' securities portfolios with regard to
market (systematic) risk (involving the market's assessment of overall economic
prospects), as distinguished from stock-specific risk (involving the market's
evaluation of the merits of the issuer of a particular security). These Funds,
and the International Bond Fund, may also purchase and sell other futures when
deemed appropriate, in order to hedge the equity or non-equity portions of their
portfolios. In addition, each Fund, except the California Tax Free Fund, Equity
Index Fund, Government Fund, Money Market Fund, New York Tax Free Fund and Tax
Free Bond Fund may, to the extent it invests in foreign securities, enter into
contracts for the future delivery of foreign currencies to hedge against changes
in currency exchange rates. Each of the Funds may also purchase and write put
and call options on futures contracts of the type into which such Fund is
authorized to enter and may engage in related closing transactions. In the
United States, all such futures on debt securities, debt index futures, stock
index futures, foreign currency futures and related options will be traded on
exchanges that are regulated by the Commodity Futures Trading Commission
("CFTC"). Subject to applicable CFTC rules, the Funds also may enter into
futures contracts traded on the following foreign futures exchanges: Frankfurt,
Tokyo, London and Paris, as long as trading on the aforesaid foreign futures
exchanges does not subject a Fund to risks that are materially greater than the
risks associated with trading on U.S. exchanges. The International Bond Fund and
International Equity Fund are not limited to the above-listed exchanges.
A futures contract is an agreement to buy or sell a security or currency
(or to deliver a final cash settlement price in the case of a contract relating
to an index or otherwise not calling for physical delivery at the end of trading
in the contracts), for a set price at a future date. When interest rates are
changing and portfolio values are falling, futures contracts can offset a
decline in the value of a Fund's current portfolio securities. When interest
rates are changing and portfolio values are rising, the purchase of futures
contracts can secure
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better effective rates or purchase prices for the Fund than might later be
available in the market when the Fund makes anticipated purchases. In the United
States, futures contracts are traded on boards of trade which have been
designated "contract markets" by the CFTC. Currently, there are futures
contracts based on a variety of instruments, indexes and currencies, including
long-term U.S. Treasury bonds, Treasury notes, GNMA certificates, three-month
U.S. Treasury bills, three-month domestic bank certificates of deposit, a
municipal bond index and various stock indexes.
When a purchase or sale of a futures contract is made by a Fund, the Fund
is required to deposit with its custodian (or broker, if legally permitted) a
specified amount of liquid assets ("initial margin"). The margin required for a
futures contract is set by the exchange on which the contract is traded and may
be modified during the term of the contract. The initial margin is in the
nature of a performance bond or good faith deposit on the futures contract which
is returned to the Fund upon termination of the contract assuming all
contractual obligations have been satisfied. Each Fund expects to earn interest
income on its initial margin deposits. A futures contract held by a Fund is
valued daily at the official settlement price of the exchange on which it is
traded. Each day the Fund pays or receives cash, called "variation margin,"
equal to the daily change in value of the futures contract. This process is
known as "marking-to-market." Variation margin does not represent a borrowing
or loan by a Fund but is instead a settlement between the Fund and the broker of
the amount one would owe the other if the futures contract expired. In
computing daily net asset value, each Fund will mark-to-market its open futures
positions.
A Fund is also required to deposit and maintain margin with respect to put
and call options on futures contracts written by it. Such margin deposits will
vary depending on the nature of the underlying futures contract (and the related
initial margin requirements), the current market value of the option, and other
futures positions held by the Fund.
Positions taken in the futures markets are not normally held until delivery
or final cash settlement is required, but are instead liquidated through
offsetting transactions which may result in a gain or a loss. While futures
positions taken by a Fund will usually be liquidated in this manner, the Fund
may instead make or take delivery of underlying securities or currencies
whenever it appears economically advantageous to the Fund to do so. A clearing
organization associated with the exchange on which futures are traded assumes
responsibility for closing-out transactions and guarantees that as between the
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clearing members of an exchange, the sale and purchase obligations will be
performed with regard to all positions that remain open at the termination of
the contract.
FUTURES ON DEBT SECURITIES A futures contract on a debt security is a
--------------------------
binding contractual commitment which, if held to maturity, will result in an
obligation to make or accept delivery, during a particular future month, of
securities having a standardized face value and rate of return. By purchasing
futures on debt securities--assuming a "long" position--a Fund will legally
obligate itself to accept the future delivery of the underlying security and pay
the agreed-upon price. By selling futures on debt securities--assuming a
"short" position--it will legally obligate itself to make the future delivery of
the security against payment of the agreed-upon price. Open futures positions
on debt securities will be valued at the most recent settlement price, unless
such price does not appear to the Advisers to reflect the fair value of the
contract, in which case the positions will be valued by or under the direction
of the Trustees.
Hedging by use of futures on debt securities seeks to establish, more
certainly than would otherwise be possible, the effective rate of return on
portfolio securities. A Fund may, for example, take a "short" position in the
futures market by selling contracts for the future delivery of debt securities
held by the Fund (or securities having characteristics similar to those held by
the Fund) in order to hedge against an anticipated rise in interest rates that
would adversely affect the value of the Fund's portfolio securities. When
hedging of this character is successful, any depreciation in the value of
portfolio securities will be substantially offset by appreciation in the value
of the futures position.
On other occasions, a Fund may take a "long" position by purchasing futures
on debt securities. This would be done, for example, when the Fund intends to
purchase particular securities and it has the necessary cash, but expects the
rate of return available in the securities markets at that time to be less
favorable than rates currently available in the futures markets. If the
anticipated rise in the price of the securities should occur (with its
concomitant reduction in yield), the increased cost to the Fund of purchasing
the securities will be offset, at least to some extent, by the rise in the value
of the futures position taken in anticipation of the subsequent securities
purchase. A Fund may also purchase futures contracts as a substitute for the
purchase of longer-term securities to lengthen the average duration of the
Fund's portfolio.
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The Fund could accomplish similar results by selling securities with long
maturities and investing in securities with short maturities when interest rates
are expected to increase or by buying securities with long maturities and
selling securities with short maturities when interest rates are expected to
decline. However, by using futures contracts as a risk management technique,
given the greater liquidity in the futures market than in the cash market, it
may be possible to accomplish the same result more easily and more quickly.
Because the only futures contracts currently available to hedge the Tax
Free Bond Fund's portfolio of municipal obligations are futures on various U.S.
government securities and futures on a municipal securities index, perfect
correlation between that Fund's futures positions and portfolio positions may be
difficult to achieve.
SECURITIES INDEX FUTURES A securities index futures contract does not
------------------------
require the physical delivery of securities, but merely provides for profits and
losses resulting from changes in the market value of the contract to be credited
or debited at the close of each trading day to the respective accounts of the
parties to the contract. On the contract's expiration date a final cash
settlement occurs and the futures positions are simply closed out. Changes in
the market value of a particular stock index futures contract reflect changes in
the specified index of equity securities on which the contract is based. A
stock index is designed to reflect overall price trends in the market for equity
securities.
Stock index futures may be used to hedge the equity portion of a Fund's
securities portfolio with regard to market (systematic) risk, as distinguished
from stock-specific risk. The Funds may enter into stock index futures to the
extent that they have equity securities in their portfolios. Similarly, the
Funds may enter into futures on debt securities indexes (including the municipal
bond index) to the extent they have debt securities in their portfolios. By
establishing an appropriate "short" position in securities index futures, a Fund
may seek to protect the value of its portfolio against an overall decline in the
market for securities. Alternatively, in anticipation of a generally rising
market, a Fund can seek to avoid losing the benefit of apparently low current
prices by establishing a "long" position in securities index futures and later
liquidating that position as particular securities are in fact acquired. To the
extent that these hedging strategies are successful, the Fund will be affected
to a lesser degree by adverse overall market price movements, unrelated to the
merits of specific portfolio securities, than would otherwise be the case. A
Fund may also purchase futures on debt securities or indexes as a substitute
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for the purchase of longer-term debt securities to lengthen the average duration
of the Fund's debt portfolio.
The Funds do not intend to use U.S. stock index futures to hedge positions
in securities of non-U.S. companies.
CURRENCY FUTURES A sale of a currency futures contract creates an
----------------
obligation by a Fund, as seller, to deliver the amount of currency called for in
the contract at a specified future time for a specified price. A purchase of a
currency futures contract creates an obligation by a Fund, as purchaser, to take
delivery of an amount of currency at a specified future time at a specified
price. A Fund may sell a currency futures contract, if the Adviser anticipates
that exchange rates for a particular currency will fall, as a hedge against a
decline in the value of the Fund's securities denominated in such currency. If
the Adviser anticipates that exchange rates will rise, the Fund may purchase a
currency futures contract to protect against an increase in the price of
securities denominated in a particular currency the Fund intends to purchase.
Although the terms of currency futures contracts specify actual delivery or
receipt, in most instances the contracts are closed out before the settlement
date without the making or taking of delivery of the currency. Closing out of a
currency futures contract is effected by entering into an offsetting purchase or
sale transaction. To offset a currency futures contract sold by a Fund, the
Fund purchases a currency futures contract for the same aggregate amount of
currency and delivery date. If the price in the sale exceeds the price in the
offsetting purchase, the Fund is immediately paid the difference. Similarly, to
close out a currency futures contract purchased by the Fund, the Fund sells a
currency futures contract. If the offsetting sale price exceeds the purchase
price, the Fund realizes a gain, and if the offsetting sale price is less than
the purchase price, the Fund realizes a loss.
A risk in employing currency futures contracts to protect against the price
volatility of portfolio securities denominated in a particular currency is that
changes in currency exchange rates or in the value of the futures position may
correlate imperfectly with changes in the cash prices of a Fund's securities.
The degree of correlation may be distorted by the fact that the currency
futures market may be dominated by short-term traders seeking to profit from
changes in exchange rates. This would reduce the value of such contracts for
hedging purposes over a short-term period. Such distortions are generally minor
and would diminish as the contract approached maturity. Another risk is that
the Adviser could be incorrect in its expectation as to the direction or extent
of various exchange
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rate movements or the time span within which the movements take place.
OPTIONS ON FUTURES For bona fide hedging and other appropriate risk
------------------
management purposes, the Funds also may purchase and write call and put options
on futures contracts which are traded on exchanges that are licensed and
regulated by the CFTC for the purpose of options trading, or, subject to
applicable CFTC rules, on foreign exchanges. It is the current policy of the
Trust that the Funds will purchase or write only options on futures contracts
that are traded on a U.S. or foreign exchange or board of trade. The Funds also
may engage in related closing transactions with respect to options on futures. A
"call" option on a futures contract gives the purchaser the right, in return for
the premium paid, to purchase a futures contract (assume a "long" position) at a
specified exercise price at any time before the option expires. A "put" option
gives the purchaser the right, in return for the premium paid, to sell a futures
contract (assume a "short" position), for a specified exercise price at any time
before the option expires.
Upon the exercise of a "call," the writer of the option is obligated to
sell the futures contract (to deliver a "long" position to the option holder) at
the option exercise price, which will presumably be lower than the current
market price of the contract in the futures market. Upon exercise of a "put,"
the writer of the option is obligated to purchase the futures contract (deliver
a "short" position to the option holder) at the option exercise price, which
will presumably be higher than the current market price of the contract in the
futures market. When an entity exercises an option and assumes a "long" futures
position, in the case of a "call," or a "short" futures position, in the case of
a "put," its gain will be credited to its futures margin account, while the loss
suffered by the writer of the option will be debited to its account. However,
as with the trading of futures, most participants in the options markets do not
seek to realize their gains or losses by exercise of their option rights.
Instead, the writer or holder of an option will usually realize a gain or loss
by buying or selling an offsetting option at a market price that will reflect an
increase or a decrease from the premium originally paid.
Options on futures contracts can be used by a Fund to hedge substantially
the same risks and for the same duration and risk management purposes as might
be addressed or served by the direct purchase or sale of the underlying futures
contracts. If the Fund purchases an option on a futures contract, it may obtain
benefits similar to those that would result if it held the futures position
itself.
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The purchase of put options on futures contracts is a means of hedging a
Fund's portfolio against the risk of rising interest rates, declining securities
prices or declining exchange rates for a particular currency. The purchase of a
call option on a futures contract represents a means of hedging against a market
advance affecting securities prices or currency exchange rates when the Fund is
not fully invested or of lengthening the average maturity or duration of a
Fund's portfolio. Depending on the pricing of the option compared to either the
futures contract upon which it is based or upon the price of the underlying
securities or currencies, it may or may not be less risky than ownership of the
futures contract or underlying securities or currencies.
In contrast to a futures transaction, in which only transaction costs are
involved, benefits received in an option transaction will be reduced by the
amount of the premium paid as well as by transaction costs. In the event of an
adverse market movement, however, the Fund will not be subject to a risk of loss
on the option transaction beyond the price of the premium it paid plus its
transaction costs, and may consequently benefit from a favorable movement in the
value of its portfolio securities or the currencies in which such securities are
denominated that would have been more completely offset if the hedge had been
effected through the use of futures.
If a Fund writes options on futures contracts, the Fund will receive a
premium but will assume a risk of adverse movement in the price of the
underlying futures contract comparable to that involved in holding a futures
position. If the option is not exercised, the Fund will realize a gain in the
amount of the premium, which may partially offset unfavorable changes in the
value of securities held by or to be acquired for the Fund. If the option is
exercised, the Fund will incur a loss in the option transaction, which will be
reduced by the amount of the premium it has received, but which may partially
offset favorable changes in the value of its portfolio securities or the
currencies in which such securities are denominated.
The writing of a call option on a futures contract constitutes a partial
hedge against declining prices of the underlying securities or the currencies in
which such securities are denominated. If the futures price at expiration is
below the exercise price, the Fund will retain the full amount of the option
premium, which provides a partial hedge against any decline that may have
occurred in the Fund's holdings of securities or the currencies in which such
securities are denominated.
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The writing of a put option on a futures contract is analogous to the
purchase of a futures contract. For example, if the Fund writes a put option on
a futures contract on debt securities related to securities that the Fund
expects to acquire and the market price of such securities increases, the net
cost to a Fund of the debt securities acquired by it will be reduced by the
amount of the option premium received. Of course, if market prices have
declined, the Fund's purchase price upon exercise may be greater than the price
at which the debt securities might be purchased in the securities market.
While the holder or writer of an option on a futures contract may normally
terminate its position by selling or purchasing an offsetting option of the same
series, a Fund's ability to establish and close out options positions at fairly
established prices will be subject to the maintenance of a liquid market. The
Funds will not purchase or write options on futures contracts unless the market
for such options has sufficient liquidity such that the risks associated with
such options transactions are not at unacceptable levels.
LIMITATIONS ON PURCHASE AND SALE OF FUTURES CONTRACTS AND OPTIONS ON
--------------------------------------------------------------------
FUTURES CONTRACTS In general, the Funds will engage in transactions in futures
- -----------------
contracts and related options only for bona fide hedging and other appropriate
risk management purposes, and not for speculation. With respect to positions in
futures and related options that do not constitute bona fide hedging positions,
a Fund will not enter into a futures contract or futures option contract if,
immediately thereafter, the aggregate initial margin deposits relating to such
positions plus premiums paid by it for open futures option positions, less the
amount by which any such options are "in-the-money," would exceed 5% of the
Fund's total assets. A call option is "in-the-money" if the value of the futures
contract that is the subject of the option exceeds the exercise price. A put
option is "in-the-money" if the exercise price exceeds the value of the futures
contract that is the subject of the option.
When purchasing a futures contract, a Fund will maintain with its custodian
(and mark-to-market on a daily basis) liquid assets that, when added to the
amounts deposited with a futures commission merchant as margin, are equal to the
market value of the futures contract. Alternatively, the Fund may "cover" its
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position by purchasing a put option on the same futures contract with a strike
price as high or higher than the price of the contract held by the Fund.
When selling a futures contract, a Fund will maintain with its custodian
(and mark-to-market on a daily basis) liquid assets that, when added to the
amount deposited with a futures commission merchant as margin, are equal to the
market value of the instruments underlying the contract. Alternatively, the Fund
may "cover" its position by owning the instruments underlying the contract (or,
in the case of an index futures contract, a portfolio with a volatility
substantially similar to that of the index on which the futures contract is
based), or by holding a call option permitting the Fund to purchase the same
futures contract at a price no higher than the price of the contract written by
the Fund (or at a higher price if the difference is maintained in liquid assets
with the Fund's custodian).
When selling a call option on a futures contract, a Fund will maintain with
its custodian (and mark-to-market on a daily basis) liquid assets that, when
added to the amounts deposited with a futures commission merchant as margin,
equal the total market value of the futures contract underlying the call option.
Alternatively, the Fund may cover its position by entering into a long position
in the same futures contract at a price no higher than the strike price of the
call option, by owning the instruments underlying the futures contract, or by
holding a separate call option permitting the Fund to purchase the same futures
contract at a price not higher than the strike price of the call option sold by
the Fund.
When selling a put option on a futures contract, a Fund will maintain with
its custodian (and mark-to-market on a daily basis) liquid assets that equal the
purchase price of the futures contract, less any margin on deposit.
Alternatively, the Fund may cover the position either by entering into a short
position in the same futures contract, or by owning a separate put option
permitting it to sell the same futures contract so long as the strike price of
the purchased put option is the same or higher than the strike price of the put
option sold by the Fund.
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The requirements for qualification as a regulated investment company also
may limit the extent to which a Fund may enter into futures, futures options or
forward contracts. See "Tax Status."
RISKS ASSOCIATED WITH FUTURES AND FUTURES OPTIONS There are several risks
-------------------------------------------------
associated with the use of futures contracts and futures options as hedging
techniques. A purchase or sale of a futures contract may result in losses in
excess of the amount invested in the futures contract. There can be no
guarantee that there will be a correlation between price movements in the
hedging vehicle and in the Fund's securities being hedged. In addition, there
are significant differences between the securities and futures markets that
could result in an imperfect correlation between the markets, causing a given
hedge not to achieve its objectives. The degree of imperfection of correlation
depends on circumstances such as variations in speculative market demand for
futures and futures options on securities, including technical influences in
futures trading and futures options, and differences between the financial
instruments being hedged and the instruments underlying the standard contracts
available for trading in such respects as interest rate levels, maturities, and
creditworthiness of issuers. A decision as to whether, when and how to hedge
involves the exercise of skill and judgment, and even a well-conceived hedge may
be unsuccessful to some degree because of market behavior or unexpected interest
rate trends. It is also possible that, when a Fund has sold stock index futures
to hedge its portfolio against a decline in the market, the market may advance
while the value of the particular securities held in the Fund's portfolio may
decline. If this occurred, the Fund would incur a loss on the futures contracts
and also experience a decline in the value of its portfolio securities.
Futures exchanges may limit the amount of fluctuation permitted in certain
futures contract prices during a single trading day. The daily limit
establishes the maximum amount that the price of a futures contract may vary
either up or down from the previous day's settlement price at the end of the
current trading session. Once the daily limit has been reached in a futures
contract subject to the limit, no more trades may be made
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on that day at a price beyond that limit. The daily limit governs only price
movements during a particular trading day and therefore does not limit potential
losses because the limit may work to prevent the liquidation of unfavorable
positions. For example, futures prices have occasionally moved to the daily
limit for several consecutive trading days with little or no trading, thereby
preventing prompt liquidation of positions and subjecting some holders of
futures contracts to substantial losses.
In addition to the risks that apply to all options transactions, there are
several special risks relating to options on futures contracts. The ability to
establish and close out positions in such options will be subject to the
development and maintenance of a liquid market in the options. It is not
certain that such a market will develop. Although the Funds generally will
purchase only those options and futures contracts for which there appears to be
an active market, there is no assurance that a liquid market on an exchange will
exist for any particular option or futures contract at any particular time. In
the event no such market exists for particular options, it might not be possible
to effect closing transactions in such options with the result that a Fund would
have to exercise options it has purchased in order to realize any profit and
would be less able to limit is exposure to losses on options it has written.
Many of the contracts discussed above are relatively new
instruments without a significant trading history. As a result, there can be no
assurance that an active secondary market will develop or continue to exist. If
the price of a futures contract changes more than the price of the securities or
currencies, the Fund will experience either a loss or a gain on the futures
contracts which will not be completely offset by changes in the price of the
securities or currencies which are the subject of the hedge. In addition, it is
not possible to hedge fully or perfectly against currency fluctuations affecting
the value of securities denominated in foreign currencies because the value of
such securities is likely to fluctuate as a result of independent factors not
related to currency fluctuations.
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SWAP AGREEMENTS
The International Bond Fund, International Equity Fund and Strategic Income
Fund may enter into interest rate, index and currency exchange rate swap
agreements for purposes of attempting to obtain a particular desired return at a
lower cost to the Fund than if the Fund had invested directly in an instrument
that yielded that desired return or for other portfolio management purposes.
Swap agreements are two party contracts entered into primarily by institutional
investors for periods ranging from a few weeks to more than one year. In a
standard "swap" transaction, two parties agree to exchange the returns (or
differentials in rates of return) earned or realized on particular predetermined
investments or instruments. The gross returns to be exchanged or "swapped"
between the parties are calculated with respect to a "notional amount," i.e.,
----
the return on or increase in value of a particular dollar amount invested at a
particular interest rate, in a particular foreign currency, or in a "basket" of
securities representing a particular index. The "notional amount" of the swap
agreement is only a fictive basis on which to calculate the obligations which
the parties to a swap agreement have agreed to exchange. Commonly used swap
agreements include interest rate caps, under which, in return for a premium, one
party agrees to make payments to the other to the extent that interest rates
exceed a specified rate, or "cap"; interest rate floors, under which, in return
for a premium, one party agrees to make payments to the other to the extent that
interest rates fall below a specified level, or "floor"; and interest rate
collars, under which a party sells a cap and purchases a floor or vice versa in
an attempt to protect itself against interest rate movements exceeding given
minimum or maximum levels. A Fund's obligations (or rights) under a swap
agreement will generally be equal only to the net amount to be paid or received
under the agreement based on the relative values of the positions held by each
party to the agreement (the "net amount"). A Fund's obligations under a swap
agreement will be accrued daily (offset against any amounts owing to the Fund)
and any accrued but unpaid net amounts owed to a swap counterparty will be
covered by the maintenance of a segregated account consisting of liquid assets
to avoid any potential leveraging of the Fund's portfolio. Commonly used swap
agreements include interest rate caps, under which, in return for a premium, one
party agrees to make payments to the other to the extent that interest rates
exceed a specified rate, or "cap"; interest rate floors, under which, in return
for a premium, one party agrees to make payments to the other to the extent that
interest rates fall below a specified level, or "floor"; and interest rate
collars, under which a party sells a cap and purchases a floor or vice versa in
an attempt to protect itself against interest rate movements exceeding given
minimum or maximum levels. A Fund will not enter into a swap agreement with
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any single party if the net amount owed or to be received under existing
contracts with that party would exceed 5% of the Fund's assets.
Whether a Fund's use of swap agreements will be successful in furthering
its investment objective will depend on the Adviser's ability correctly to
predict whether certain types of investments are likely to produce greater
returns than other investments. Because they are two party contracts and because
they may have terms of greater than seven days, swap agreements may be
considered to be illiquid. Moreover, a Fund bears the risk of loss of the amount
expected to be received under a swap agreement in the event of the default or
bankruptcy of a swap agreement counterparty. The Adviser will cause a Fund to
enter into swap agreements only with counterparties that would be eligible for
consideration as repurchase agreement counterparties under the Fund's repurchase
agreement guidelines. Certain restrictions imposed on the Funds by the Code may
limit the Funds' ability to use swap agreements. The swaps market is a
relatively new market and is largely unregulated. It is possible that
developments in the swaps market, including potential government regulation,
could adversely affect a Fund's ability to terminate existing swap agreements or
to realize amounts to be received under such agreements.
Certain swap agreements are exempt from most provisions of the Commodity
Exchange Act ("CEA") and, therefore, are not regulated as futures or commodity
option transactions under the CEA, pursuant to regulations approved by the CFTC
effective February 22, 1993. To qualify for this exemption, a swap agreement
must be entered into by "eligible participants," which include the following,
provided the participants' total assets exceed established levels: a bank or
trust company, savings association or credit union, insurance company,
investment company subject to regulation under the Investment Company Act of
1940, commodity pool, corporation, partnership, proprietorship, organization,
trust or other entity, employee benefit plan, governmental entity, broker-
dealer, futures commission merchant, natural person, or regulated foreign
person. To be eligible, natural persons and most other entities must have total
assets exceeding $10 million; commodity pools and employee benefit plans must
have assets exceeding $5 million. In addition, an eligible swap transaction
must meet three conditions. First, the swap agreement may not be part of a
fungible class of agreements that are standardized as to their material economic
terms. Second, the creditworthiness of parties with actual or potential
obligations under the swap agreement must be a material consideration in
entering into or determining the terms of the swap agreement, including pricing,
cost or credit enhancement
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terms. Third, swap agreements may not be entered into and traded on or through a
multilateral transaction execution facility.
This exemption is not exclusive, and participants may continue to rely on
existing exclusions for swaps, such as the Policy Statement issued in July 1989
which recognized a safe harbor for swap transactions from regulation as futures
or commodity option transactions under the CEA or its regulations. The Policy
Statement applies to swap transactions settled in cash that (1) have
individually tailored terms, (2) lack exchange-style offset and the use of a
clearing organization or margin system, (3) are undertaken in conjunction with a
line of business, and (4) are not marketed to the public.
LOAN PARTICIPATION INTERESTS
A Fund's investment in loan participation interests may take the form of
participation interests in, assignments or novations of a corporate loan
("Participation Interests"). The Participation Interests may be acquired from
an agent bank, co-lenders or other holders of Participation Interests
("Participants"). In a novation, a Fund would assume all of the rights of the
lender in a corporate loan, including the right to receive payments of principal
and interest and other amounts directly from the borrower and to enforce its
rights as a lender directly against the borrower. As an alternative, a Fund may
purchase an assignment of all or a portion of a lender's interest in a corporate
loan, in which case, a Fund may be required generally to rely on the assigning
lender to demand payment and enforce its rights against the borrower, but would
otherwise be entitled to all of such lender's rights in the corporate loan. A
Fund also may purchase a Participation Interest in a portion of the rights of a
lender in a corporate loan. In such a case, a Fund will be entitled to receive
payments of principal, interest and fees, if any, but generally will not be
entitled to enforce its rights directly against the agent bank or the borrower;
rather a Fund must rely on the lending institution for that purpose. A Fund
will not act as an agent bank, a guarantor or sole negotiator or a structure
with respect to a corporate loan.
In a typical corporate loan involving the sale of Participation Interests,
the agent bank administers the terms of the corporate loan agreement and is
responsible for the collection of principal and interest and fee payments to the
credit of all lenders which are parties to the corporate loan agreement. The
agent bank in such cases will be qualified under the 1940 Act to serve as a
custodian for a registered investment company such as the Trust. A Fund
generally will rely on the agent bank or an intermediate Participant to collect
its portion of the payments on the corporate loan. The agent bank monitors
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the value of the collateral and, if the value of the collateral declines, may
take certain action, including accelerating the corporate loan, giving the
borrower an opportunity to provide additional collateral or seeking other
protection for the benefit of the Participants in the corporate loan, depending
on the terms of the corporate loan agreement. Furthermore, unless under the
terms of a participation agreement a Fund has direct recourse against the
borrower (which is unlikely), a Fund will rely on the agent bank to use
appropriate creditor remedies against the borrower. The agent bank also is
responsible for monitoring compliance with covenants contained in the corporate
loan agreement and for notifying holders of corporate loans of any failures of
compliance. Typically, under corporate loan agreements, the agent bank is given
broad discretion in enforcing the corporate loan agreement, and is obligated to
use only the same care it would use in the management of its own property. For
these services, the borrower compensates the agent bank. Such compensation may
include special fees paid on structuring and funding the corporate loan and
other fees paid on a continuing basis.
A financial institution's employment as an agent bank may be terminated in
the event that it fails to observe the requisite standard of care or becomes
insolvent, or has a receiver, conservator, or similar official appointed for it
by the appropriate bank regulatory authority or becomes a debtor in a bankruptcy
proceeding. A successor agent bank generally will be appointed to replace the
terminated bank, and assets held by the agent bank under the corporate loan
agreement should remain available to holders of corporate loans. If, however,
assets held by the agent bank for the benefit of a Fund were determined by an
appropriate regulatory authority or court to be subject to the claims of the
agent bank's general or secured creditors, a Fund might incur certain costs and
delays in realizing payment on a corporate loan, or suffer a loss of principal
and/or interest. In situations involving intermediate Participants similar
risks may arise.
When a Fund acts as co-lender in connection with a participation interest
or when a Fund acquires a participation interest the terms of which provide
that a Fund will be in privity of contract with the corporate borrower, a Fund
will have direct recourse against the borrower in the event the borrower fails
to pay scheduled principal and interest. In all other cases, a Fund will look
to the agent bank to enforce appropriate credit remedies against the borrower.
In acquiring participation interests a Fund will conduct analysis and evaluation
of the financial condition of each such co-lender and participant to ensure that
the participation interest meets a Fund's qualitative standards. There is a
risk that there may not be a readily
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available market for loan participation interests and, in some cases, this could
result in a Fund disposing of such securities at a substantial discount from
face value or holding such security until maturity. When a Fund is required to
rely upon a lending institution to pay the Fund principal, interest, and other
amounts received by the lending institution for the loan participation, the Fund
will treat both the borrower and the lending institution as an "issuer" of the
loan participation for purposes of certain investment restrictions pertaining to
the diversification and concentration of the Fund's portfolio. The Funds
consider loan participation interests not subject to puts to be illiquid.
RISKS ASSOCIATED WITH DEBT SECURITIES
To the extent that a Fund invests in debt securities, it will be subject to
certain risks. The value of the debt securities held by a Fund, and thus the
net asset value of the shares of beneficial interest of the Fund, generally will
fluctuate depending on a number of factors, including, among others, changes in
the perceived creditworthiness of the issuers of those securities, movements in
interest rates, the average maturity of the Fund's investments, changes in the
relative values of the currencies in which the Fund's investments are
denominated relative to the U.S. dollar, and the extent to which the Fund hedges
its interest rate, credit and currency exchange rate risks. Generally, a rise
in interest rates will reduce the value of fixed income securities held by a
Fund, and a decline in interest rates will increase the value of fixed income
securities held by a Fund.
RISKS OF INVESTING IN HIGH YIELD SECURITIES ("JUNK BONDS")
High yield bonds may be more susceptible to real or perceived adverse
economic and competitive industry conditions than higher grade bonds. The
prices of high yield bonds have been found to be less sensitive to interest-rate
changes than
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more highly rated investments, but more sensitive to adverse economic downturns
or individual corporate developments. A projection of an economic downturn or of
a period of rising interest rates, for example, could cause a decline in high
yield bond prices because the advent of a recession could lessen the ability of
a highly leveraged company to make principal and interest payments on its debt
securities.
Adverse publicity and investor perceptions, whether or not based on
fundamental analysis, may decrease the values and liquidity of high yield bonds,
especially in a thinly traded market.
Legislation designed to limit the use of high yield bonds in corporate
transactions may have a material adverse effect on a Fund's net asset value and
investment practices. In addition, there may be special tax considerations
associated with investing in high yield bonds structured as zero coupon or
payment-in-kind securities. A Fund records the interest on these securities
annually as income even though it receives no cash interest until the security's
maturity or payment date. Also, distributions of such amounts generally will be
taxable to shareholders even if the Fund does not distribute cash to them.
Therefore, in order to pay taxes on this interest, shareholders may have to
redeem some of their shares to pay the tax or the Fund may have to sell some of
its assets to reduce the Fund's assets and may thereby increase its expense
ratio and decrease its rate of return.
HIGH YIELD CORPORATE BOND FUND
AND STRATEGIC INCOME FUND
SPECIAL CONSIDERATIONS
Corporate debt securities may bear fixed, contingent, or variable rates of
interest and may involve equity features, such as conversion or exchange rights
or warrants for the acquisition of stock of the same or a different issuer,
participations based on revenues, sales or profits, or the purchase of common
stock in a unit transaction (where corporate debt securities and common stock
are offered as a unit).
When- and if-available, debt securities may be purchased at a discount from
face value. However, the Funds do not intend to hold such securities to
maturity for the purpose of achieving potential capital gains, unless current
yields on these securities remain attractive. From time to time, each Fund may
purchase securities not paying interest or dividends at the time acquired if, in
the opinion of the Adviser, such securities have the potential for future income
(or capital appreciation, if any).
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Since shares of the Funds represent an investment in securities with
fluctuating market prices, the value of shares of each Fund will vary as the
aggregate value of the Funds' portfolio securities increases or decreases.
Moreover, the value of the debt securities that each Fund purchases may
fluctuate more than the value of higher rated debt securities. These lower rated
fixed income securities generally tend to reflect short-term corporate and
market developments to a greater extent than higher rated securities which react
primarily to fluctuations in the general level of interest rates. Changes in the
value of securities subsequent to their acquisition will not affect cash income
or yields to maturity to the Funds but will be reflected in the net asset value
of the Funds' shares.
EQUITY INDEX FUND SPECIAL CONSIDERATIONS
The Equity Index Fund is managed using mathematical algorithms to determine
which stocks are to be purchased or sold to replicate the S&P 500 Index to the
extent feasible. From time to time, adjustments may be made in the Fund's
portfolio because of changes in the composition of the Index, but such changes
should be infrequent. No attempt is made to manage the portfolio in the
traditional sense using economic, financial and market analysis.
The Adviser believes that the indexing approach described above is an
effective method of simulating percentage changes in the S&P 500 Index.
TOTAL RETURN FUND
SPECIAL CONSIDERATIONS
Although the Total Return Fund does not intend to seek short-term profits,
securities in its portfolio will be sold whenever the Adviser believes it is
appropriate to do so without regard to the length of time the particular
security may have been held, subject to certain tax requirements for
qualification as a regulated investment company under the Code. A high turnover
rate involves greater expenses to the Fund and may increase the possibility of
shareholders realizing taxable capital gains. The Fund engages in portfolio
trading if it believes a transaction, net of costs (including custodian
charges), will help in achieving its investment objective.
CALIFORNIA TAX FREE FUND AND NEW YORK TAX FREE FUND
SPECIAL CONSIDERATIONS
RISK FACTORS AFFECTING CALIFORNIA MUNICIPAL SECURITIES
The following information as to certain California State ("State") risk
factors is given to investors in view of the policy of the MainStay California
Tax Free Fund of concentrating its investments in California municipal issuers.
Such information constitutes only a brief discussion, does not purport to be a
complete description and is based on information from sources believed by the
Trust to be reliable, including official statements relating to securities
offerings of California and municipal issuers, and periodic publications by
national ratings organizations. Such information, however, has not been
independently verified by the Trust.
Certain California constitutional amendments, legislative measures,
executive orders, administrative regulations and voter
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initiatives, as discussed below, could adversely affect the market values and
marketability of, or result in default of, existing obligations of the State.
Obligations of the State or local governments may also be affected by budgetary
pressures affecting the State and economic conditions in the State. The
following information constitutes only a brief summary and is not intended as a
complete description.
Certain of the California municipal securities in which the Fund may invest
may be obligations of issuers which rely in whole or in part on California State
revenues for payment of these obligations. Property tax revenues and a portion
of the State's General Fund surplus are distributed to counties, cities and
their various taxing entities and the State assumes certain obligations
theretofore paid out of local funds. Whether and to what extent a portion of
the State's General Fund will be distributed in the future to counties, cities
and their various entities, is unclear.
Certain of the California municipal securities may be obligations of
issuers who rely in whole or in part on ad valorem real property taxes as a
source of revenue. On June 6, 1978, Proposition 13 added Article XIIIA to the
California Constitution. The effect of Article XIIIA is to limit ad valorem
taxes on real property and to restrict the ability of taxing entities to
increase real property tax revenues.
Legislation enacted by the California legislature to implement Article
XIIIA (Statutes of 1978, Chapter 292, as amended) provides that notwithstanding
any other law, local agencies may not levy any ad valorem property tax except to
pay debt service on indebtedness approved by the voters prior to July 1, 1978,
and that each county will levy the maximum tax permitted by Article XIIIA of
$4.00 per $100 assessed valuation. The apportionment of property taxes in
fiscal years after 1978-79 was revised pursuant to Statutes of 1979, Chapter
282, which provides relief funds from State moneys beginning in fiscal year
1979-80 and is designed to provide a permanent system for sharing State taxes
and budget funds with local agencies. Under Chapter 282, cities and counties
receive more of the remaining property tax revenues collected under Proposition
13 instead of direct State aid. School districts receive a correspondingly
reduced amount of property taxes, but receive compensation directly from the
State and are given additional relief.
The application and interpretation of Article XIIIA has been and will
probably continue to be the subject of numerous lawsuits in the California
courts. It is not possible to predict the outcome of litigation or the ultimate
scope and impact of Article XIIIA, its implementing legislation and regulations
issued by the
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California State Board of Equalization. The outcome of such litigation, however,
could substantially impact local property tax collections and the ability of
State agencies, local governments and districts to make future payments on
outstanding debt obligations.
On November 4, 1986, California voters approved an initiative statute known
as "Proposition 62." This statute (i) requires that any tax for general
governmental purposes imposed by local governments be approved by resolution or
ordinance adopted by a two-thirds vote of the governmental entity's legislative
body and by a majority vote of the electorate of the governmental entity; (ii)
requires that any special tax (defined as taxes levied for other than general
governmental purposes) imposed by a local governmental entity be approved by a
two-thirds vote of the voters within that jurisdiction; (iii) restricts the use
of revenues from a special tax to the purposes or for the service for which the
special tax was imposed; (iv) prohibits the imposition of ad valorem taxes on
real property by local governmental entities except as permitted by Article
XIIIA of the California Constitution; (v) prohibits the imposition of
transaction taxes and sales taxes on the sale of real property by local
governments; (vi) requires that any tax imposed by a local government on or
after August 1, 1985 be ratified by a majority of the electorate within two
years of the adoption of the initiative or be terminated by November 15, 1988;
(vii) requires that, in the event a local government fails to comply with the
provisions of this measure, a reduction in the amount of tax revenue allocated
to such local government occur in an amount equal to the revenues received by
such entity attributable to the tax levied in violation of the initiative; and
(viii) permits these provisions to be amended exclusively by the voters of the
State of California. In September 1988, the California Court of Appeals held
that it was unconstitutional to require that local tax measures be submitted to
the electorate, as described in (vi) above.
In September 1995, the California Supreme Court upheld the
constitutionality of Proposition 62, creating uncertainty as to the legality of
certain local taxes enacted by non-charter cities in California without voter
approval. It is not possible to predict the impact of the decision.
In November 1996, California voters approved Proposition 218. The
initiative applied the provisions of Proposition 62 to all entities, including
charter cities. It requires that all taxes for general purposes obtain a simple
majority popular vote and that taxes for special purposes obtain a two-thirds
majority vote. Prior to the effectiveness of Proposition 218, charter cities
could levy certain taxes such as transient occupancy taxes
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and utility user's taxes without a popular vote. Proposition 218 will also limit
the authority of local governments to impose property-related assessments, fees
and charges, requiring that such assessments be limited to the special benefit
conferred and prohibiting their use for general governmental services.
Proposition 218 also allows voters to use their initiative power to reduce or
repeal previously-authorized taxes, assessments, fees and charges.
The State is subject to an annual appropriations limit imposed by Article
XIIIB of the State Constitution (the "Appropriations Limit"). The
Appropriations Limit does not restrict appropriations to pay debt service on the
bonds or other voter-authorized bonds. Article XIIIB prohibits the State from
spending "appropriations subject to limitation" in excess of the Appropriations
Limit. "Appropriations subject to limitation," with respect to the State, are
authorizations to spend "proceeds of taxes," which consist of tax revenues, and
certain other funds, including proceeds from regulatory licenses, user charges
or other fees to the extent that such proceeds exceed "the cost reasonably borne
by that entity in providing the regulation, product or service," but "proceeds
of taxes" exclude most State subventions to local governments, tax refunds and
some benefit payments such as unemployment insurance. No limit is imposed on
appropriations of funds which are not "proceeds of taxes," such as reasonable
user charges or fees and certain other non-tax funds.
Not included in the Appropriations Limit are appropriations for the debt
service costs of bonds existing or authorized by January 1, 1979, or
subsequently authorized by the voters, appropriations required to comply with
mandates of courts or the federal government and, pursuant to Proposition 111,
appropriations for qualified capital outlay projects and appropriations of
revenues derived from any increase in gasoline taxes and motor vehicle weight
fees above January 1, 1990 levels, and appropriation of certain special taxes
imposed by initiative (e.g., increased cigarette and tobacco taxes enacted by
Proposition 99 in 1988). The Appropriations Limit may also be exceeded in cases
of emergency.
The State's Appropriations Limit in each year is based on the limit for the
prior year, adjusted annually for changes in State per capita personal income
and changes in population, and adjusted, when applicable, for any transfer of
financial responsibility of providing services to or from another unit of
government. The measurement of change in population is a blended average of
statewide overall population growth, and change in attendance at local school
and community college ("K-14") districts. As amended by Proposition 111, the
Appropriations
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Limit is tested over consecutive two-year periods. Any excess of the aggregate
"proceeds of taxes" received over such a two-year period above the combined
Appropriations Limits for those two years is divided equally between transfers
to K-14 districts and refunds to taxpayers.
The legislature enacted legislation to implement Article XIIIB which
defines certain terms used in Article XIIIB and sets forth the methods for
determining the Appropriations Limit. California Government Code Section 7912
requires an estimate of the Appropriations Limit to be included in the
Governor's Budget, and thereafter to be subject to the budget process and
established in the Budget Act.
On November 9, 1988, the State's voters approved Proposition 98, a combined
initiative constitutional amendment and statute called the "Classroom
Instructional Improvement and Accountability Act." Proposition 98 changed State
funding of public education below the university level and the operation of the
State Appropriations Limit, primarily by guaranteeing K-14 schools a minimum
share of General Fund revenues. Under Proposition 98 (as modified by
Proposition 111, enacted on June 5, 1990), K-14 schools are guaranteed the
greater of (a) in general, a fixed percent of General Fund revenues ("Test 1"),
(b) the amount appropriated to K-14 schools in the prior year, adjusted for
changes in the cost of living (measured as in Article XIIIB by reference to
State per capita personal income) and enrollment ("Test 2"), or (c) a third
test, which would replace Test 2 in any year when the percentage growth in per
capita General Fund revenues from the prior year plus one half of one percent is
less than the percentage growth in State per capita personal income ("Test 3").
Under Test 3, schools would receive the amount appropriated in the prior year
adjusted for changes in enrollment and per capita General Fund revenues, plus an
additional small adjustment factor. If Test 3 is used in any year, the
difference between Test 3 and Test 2 would become a "credit" to schools which
would be the basis of payments in future years when per capita General Fund
revenue growth exceeds per capita personal income growth. Legislation adopted
prior to the end of the 1988-89 fiscal year, implementing Proposition 98,
determined the K-14 schools' funding guarantee under Test 1 to be 40.3 percent
of the General Fund tax revenues, based on 1986-87 appropriations. The
percentage has been adjusted to approximately 35 percent to account for a
subsequent redirection of local property taxes, since such redirection directly
affects the share of General Fund revenues to schools.
Proposition 98 permits the legislature by two-thirds vote of both houses,
with the Governor's concurrence, to suspend the K-14 schools' minimum funding
formula for a one-year period.
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Proposition 98 also contains provisions transferring certain State tax revenues
in excess of the Article XIIIB limit to K-14 schools.
During the recent 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 "extra"
Proposition 98 payments in one year as a "loan" from future years' Proposition
98 entitlements, and also intended that the "extra" payments would not be
included in the Proposition 98 "base" for calculating future years'
entitlements. In 1992, a lawsuit was filed, called California Teachers'
--------------------
Association v. Gould, which challenged the validity of these off-budget loans.
- --------------------
As part of the negotiations leading to the 1995-96 Budget Act, an oral agreement
was reached to settle this case. The formal settlement required adoption of
legislation satisfactory to the parties to implement its terms, which has
occurred. The court gave final approval of the settlement in late July, 1996.
The settlement 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 Director of Finance has certified that a settlement has occurred,
allowing approximately $351 million in appropriations from the 1995-96 fiscal
year to be disbursed to schools in August 1996.
Substantially increased General Fund revenues, above initial budget
projections, in the 1994-95 and 1995-96 fiscal years have resulted in
retroactive increases in Proposition 98 appropriations from subsequent fiscal
years' budgets.
Certain California municipal securities in the Fund may be obligations
which are secured in whole or in part by a mortgage or deed of trust on real
property. Upon the default of a mortgage or deed of trust with respect to
California real property, the creditor's nonjudicial foreclosure rights under
the power of sale contained in the mortgage or deed of trust are subject to the
constraints imposed by California law upon transfers of title to real property
by private power of sale.
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During the three-month period beginning with the filing of a formal notice of
default, the debtor is entitled to reinstate the home mortgage by making any
overdue payments. Under standard loan servicing procedures, the filing of the
formal notice of default does not occur unless at least three full monthly
payments have become due and remain unpaid. The power of sale is exercised by
posting and publishing a notice of sale for at least 20 days after expiration of
the three-month reinstatement period. Therefore, the effective minimum period
for foreclosing on a mortgage could be in excess of seven months after the
initial default. Such time delays in collections could disrupt the flow of
revenues available to an issuer for the payment of debt service on the
outstanding obligations if such defaults occur with respect to a substantial
number of home mortgages or deeds of trust securing an issuer's obligations.
Certain California municipal securities in the Fund may be obligations
which finance the acquisition of single family home mortgages for low- and
moderate-income mortgagors. These obligations may be payable solely from
revenues derived from the home mortgages, and are subject to the California
statutory limitations described above applicable to obligations secured by real
property. Under California anti-deficiency legislation, there is no personal
recourse against a mortgagor of a single family residence purchased with the
loan secured by the mortgage.
Under California law, mortgage loans secured by single family owner-
occupied dwellings may be prepaid at any time. Prepayment charges on such
mortgage loans may be imposed only with respect to voluntary prepayments made
during the first five years of the term of the mortgage loan, and cannot in any
event exceed six months' advance interest on the amount prepaid in excess of 20
percent of the original principal amount of the mortgage loan. This limitation
could affect the flow of revenues available to an issuer for debt service on the
outstanding debt obligations which financed such home mortgages.
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After suffering through a severe recession, since the start of 1994 the
State's economy has been on a steady recovery. Employment increased by over
500,000 in 1994 and 1995, and the pre-recession employment level is expected to
be matched by early 1996. The strongest growth has been in export-related
industries, business services, electronics, entertainment and tourism, all of
which have offset the recession-related losses which were heaviest in aerospace
and defense-related industries, finance and insurance.
The recession seriously affected State tax revenues and caused an increase
in expenditures for health and welfare programs. As a result, the State
experienced recurring budget deficits in the late 1980's and early 1990's. The
State Controller reports that expenditures exceeded revenues for four of six
years, and the State accumulated a budget deficit of about $2.8 billion at its
peak at June 30, 1993.
The State's cash condition became so serious from late spring 1992 until
1995, that the State had to rely on the issuance of short-term notes which
matured in a subsequent fiscal year to finance its ongoing deficit and pay
current obligations. With the repayment of the last of these deficit notes in
April, 1996, the State does not plan to rely further on external borrowing
across fiscal years, but will continue its normal cash flow.
On January 17, 1994, a major earthquake measuring an estimated 6.8 on the
Richter Scale struck Los Angeles. Significant property damage to private and
public facilities occurred in a four-county area including northern Los Angeles
County, Ventura County, and parts of Orange and San Bernardino Counties. The
possibility exists that another such earthquake could create a major dislocation
of the State economy.
The State of California entered the 1995-96 budget negotiations with the
smallest nominal "budget gap" to be closed in many years, with strengthening
revenues and reduced caseload growth based on an improving economy.
Nonetheless, serious policy differences between the Governor and the legislature
prevented timely enactment of the budget. The 1995-96 Budget Act was signed by
the Governor on August 3, 1995, 34 days after the start of the fiscal year. The
Budget Act projected General Fund revenues and transfers of $44.1 billion, a 3.5
percent increase from the prior year. Expenditures were budgeted at $43.4
billion, a four percent increase. The Department of Finance projected that,
after repaying the last of the carryover budget deficit, there would be a
positive balance of $28 million in the budget reserve, the Special Fund for
Economic Uncertainties ("SFEU"), at June 30, 1996. The Budget Act also
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projected Special Fund revenues of $12.7 billion and appropriated Special Fund
expenditures of $13.0 billion.
The Governor's proposed budget for 1996-97 projected General Fund revenues
and transfers of about $45.6 billion and proposed total General Fund
appropriations of about $45.2 billion. The Governor's proposed budget renewed a
proposal, which had been rejected by the legislature in 1995, for a 15% cut in
personal and corporate tax rates, phased in over a three-year period. In May
1996, the State Department of Finance updated revenue estimates to $47.1 billion
for 1996-97, assuming enactment of the Governor's proposed tax cut, and
expenditure estimates to $46.5 billion.
The Department of Finance's May Revision to the 1996-97 Governor's Budget,
released on May 21, 1996 (the "May Revision"), updated the projections for the
1995-96 fiscal year, so that revenues and transfers were estimated to be $46.1
billion, some $2 billion over the original fiscal year estimate, which was
attributed to the strong economic recovery. Expenditures also increased, to an
estimated $45.4 billion, as a result of the requirement to expend revenues for
schools under Proposition 98, and, among other things, failure of the federal
government to enact welfare reform and to budget new aid for illegal immigrant
costs.
The 1996-97 Budget Act was signed by the Governor on July 15, 1996, along
with various implementing bills. The Governor vetoed about $82 million of
appropriations (both General Fund and Special Fund). With the signing of the
Budget Act, the State implemented its regular cash flow borrowing program with
the issuance of $3.0 billion of Revenue Anticipation Notes to mature on June 30,
1997. The Budget Act appropriates a modest budget reserve in the SFEU of $305
million, as of June 30, 1997. The Department of Finance projects that, on June
30, 1997, the State's available internal borrowable (cash) resources will be
$2.9 billion, after payment of all obligations due by that date, so that no
cross-fiscal year borrowing will be needed.
The legislature rejected the Governor's proposed 15% cut in personal income
taxes (to be phased over three years), but did approve a 5% cut in bank and
corporation taxes, to be effective for income years starting on January 1, 1997.
As a result, revenues for the fiscal year will be an estimated $550 million
higher than projected in the May Revision, and are now estimated to total
$47.643 billion, a 3.3 percent increase over the final estimated 1995-96
revenues. Special Fund revenues are estimated to be $13.3 billion. The Budget
Act contains General Fund appropriations totaling $47.251 billion, a 4.0 percent
increase
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over the final estimated 1995-96 expenditures. Special Fund expenditures are
budgeted at $12.6 billion.
Other major features of the 1996-1997 Budget Act include an increase of 1.6
billion (General Fund) and $1.65 billion total above revised 1995-96 levels for
Proposition 98 funding, reductions in health and welfare costs, increases in
educational funding, and increased funding for the State's prison inmate
population. The 1996-97 Budget Act contained no tax increases. There was a
reduction in corporate taxes. In addition, the legislature adopted a further
one-year suspension of the Renters Tax Credit, saving $520 million in
expenditures.
Following enactment of the 1996-97 Budget Act, Congress passed and the
President signed (on August 22, 1996) the Personal Responsibility and Work
Opportunity Act of 1996 making a fundamental reform of the current welfare
system. Among many provisions, the Law includes: (i) conversion of Aid to
Families with Dependent Children from an entitlement program to a block grant
titled Temporary Assistance for Needy Families (TANF), with lifetime time limits
on TANF recipients, work requirements and other changes; (ii) provisions denying
certain federal welfare and public benefits to legal noncitizens, allowing
states to elect to deny additional benefits (including TANF) to legal
noncitizens, and generally denying almost all benefits to illegal immigrants;
and (iii) changes in the Food Stamp program, including reducing maximum benefits
and imposing work requirements.
The states are required to implement the new TANF program not later than
July 1, 1997 and provides California approximately $3.7 billion in block grant
funds for fiscal year 1996-97 for the provisions of the law. States are allowed
to implement TANF as soon as possible and will receive a prorated block grant
effective the date of application. The California State Plan is to be submitted
in time to allow grant reductions to be implemented effective January 1, 1997
and to allow the State to capture approximately $267 million in additional
federal block grant funds over the currently budgeted level. None of the other
federal changes needed to achieve the balance of the $660 million cost savings
were enacted. Thus, in lieu of the $660 million savings initially assumed to be
saved, it is now projected that savings will total approximately $360 million.
On January 9, 1997,the Governor released his proposed budget for fiscal
year 1997-98. Assuming continuing strength in the economy, the Governor
projects General Fund revenues of $50.7 billion, and proposes expenditures of
$50.3 billion, to leave a budget reserve in the SFEU of $550 million at June 30,
1998. The Governor proposed further programs to reduce class
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size in lower primary grades, using excess revenues from fiscal year 1996-97. He
also proposed a further cut in corporate taxes, and sweeping changes in public
assistance programs to respond to the new federal welfare reform law.
On December 6, 1994, Orange County, California (the "County"), together
with its pooled investment funds (the "Funds") filed for protection under
Chapter 9 of the federal Bankruptcy Code, after reports that the Funds had
suffered significant market losses in their investments, causing a liquidity
crisis for the Funds and the County. More than 200 other public entities, most
of which, but not all, are located in the County, were also depositors in the
Funds. The bankruptcy filing stemmed from approximately $1.7 billion in losses
suffered by the County's investment pool due to investments in high risk
"derivative" securities. On June 12, 1996, it emerged from bankruptcy after the
successful sale of $880 million in municipal bonds allowed the County to pay off
the last of its creditors. On January 7, 1997, the County returned to the
municipal bond market with a $136 million bond issue maturing in 13 years at an
insured yield of 7.23%.
The State is a party to numerous legal proceedings, many of which normally
recur in governmental operations. In addition, the State is involved in certain
other legal proceedings which, if decided against the State, may require the
State to make significant future expenditures or may impair future revenue
sources.
Among the more significant lawsuits pending against the State are the
following: (i) cases relating to the State's method of determining the tax on
gross insurance premiums, in which the State faces losses of approximately $200
million; (ii) on appeal, an action seeking reimbursement for alleged state-
mandated costs, in which the State faces losses of approximately $1 billion, if
all potentially eligible school districts pursue timely claims; (iii) lawsuits
related to contamination at the Stringfellow toxic waste site; (iv) an action
involving damages caused by the Yuba River flood of February 1986 with potential
liability to 3,000 plaintiffs, ranging from $800 million to $1.5 billion; (v) a
claim that payment of wages in registered warrants violated the Fair Labor
Standards Act, which involves maximum damages of approximately $500 million;
(vi) a claim involving the constitutionality of the 1992-93 Budget Act-related
legislation which redirected approximately $1.3 billion in local tax revenues
from localities to schools wherein the parties are currently negotiating a
settlement, subject to court approval; (vii) a lawsuit involving the reduction
of the State's Aid to Families with Dependent Children ("AFDC") payments in
1992, 1993, and 1994; (viii) a lawsuit involving the 1994-95 Budget Act's
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2.3 percent reduction in AFDC payments; (ix) an appeal by the State of a
judgment that legislation unconstitutionally impaired the vested contract rights
of Public Employees' Retirement System members.
Due to the State's continuing budget problems, the State's general
obligation bonds were downgraded in July 1994 from A1" to "Aa" by Moody's, from
"A+" to "A" by S&P. The ratings companies expressed uncertainty in the State's
ability to balance its budget by 1996. However, on July 30, 1996, citing the
State's improving economy and budget situation, S&P upgraded the State's general
obligation bonds from "A" to "A+". There can be no assurance that such ratings
will continue for any given period of time or that they will not in the future
be further revised or withdrawn.
RISK FACTORS AFFECTING NEW YORK MUNICIPAL SECURITIES
The following information as to certain New York State ("State") and New
York City ("City") risk factors is given to investors in view of the policy of
the MainStay New York Tax Free Fund of concentrating its investments in New York
municipal issuers. Such information constitutes only a brief discussion, does
not purport to be a complete description and is based on information from
sources believed by the Trust to be reliable, including official statements
relating to securities offerings of New York and municipal issuers, and periodic
publications by national ratings organizations. Such information, however, has
not been independently verified by the Trust.
There are a number of methods by which the State may incur debt. The State
may issue general obligations bonds. Under the State Constitution, the State
may not, with limited exceptions for emergencies, undertake long-term general
obligation borrowing (i.e., borrowing for more than one year) unless the
borrowing is authorized in a specific amount for a single work or purpose by the
legislature and approved by the voters. There is no limitation on the amount of
long-term general obligation debt that may be so authorized and subsequently
incurred by the State.
The State may undertake short-term borrowings without voter approval (i) in
anticipation of the receipt of taxes and revenues, by issuing tax and revenue
anticipation notes; and (ii) in anticipation of the receipt of proceeds from the
sale of duly authorized but unissued general obligation bonds, by issuing bond
anticipation notes. The State may also, pursuant to specific constitutional
authorization, directly guarantee certain obligations of the State's authorities
("Authorities"). Payments of debt service on State general obligation and
State-
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guaranteed bonds and notes are legally enforceable obligations of the State.
The State also employs additional long-term financing mechanisms, lease-
purchase and contractual-obligation financings, which involve obligations of
public authorities or municipalities that are State-supported but not general
obligations of the State. As of March 31, 1996, the total amount of outstanding
general obligation debt was $5.05 billion, including $293.6 billion in bond
anticipation notes.
The fiscal stability of the State is related in part to the fiscal
stability of its public authorities. As of September 30, 1995, the date of the
latest data available, 17 public authorities had outstanding debt of $100
million or more. The aggregate outstanding debt, including refunding bonds, of
all State public authorities was $73.45 billion.
Public authority operating expenses and debt service costs are generally
paid by revenues generated by the projects financed or operated, such as tolls
charged for the use of highways, bridges or tunnels, rentals charged for housing
units, and charges for occupancy at medical care facilities. In addition, State
legislation authorizes several financing techniques for public authorities.
Also, there are statutory arrangements providing for State local assistance
payments otherwise payable to localities to be made under certain circumstances
to public authorities. Although the State has no obligation to provide
additional assistance to localities whose local assistance payments have been
paid to public authorities under these arrangements, if local assistance
payments are diverted, the affected localities could seek additional State
assistance. Some authorities also receive moneys from State appropriations to
pay for the operating costs of certain of their programs. The Metropolitan
Transit Authority (the "MTA") receives the bulk of this money in order to
provide transit and commuter services.
In 1990, as part of a State fiscal reform program, legislation was enacted
creating the "New York Local Government Assistance Corporation" ("LGAC"), a
public benefit corporation empowered to issue long-term obligations to fund
certain payments to local governments traditionally funded through the State's
annual seasonal borrowing. Over a period of years, the issuance of those long-
term obligations, which are to be amortized over no more than 30 years, was
expected to eliminate the need for continued short-term seasonal borrowing. The
legislation also dedicated revenues equal to one-quarter of the four cent State
sales and use tax to pay debt service on these bonds. In addition, the
legislation imposed a cap on the annual seasonal borrowing of the State at $4.7
billion, less net proceeds of bonds issued by LGAC and bonds issued to provide
for capitalized
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interest, except in cases where the Governor and the legislative leaders have
certified both the need for additional borrowing and a schedule for reducing it
to the cap. If borrowing above the cap is thus permitted in any fiscal year, it
is required by law to be reduced to the cap by the fourth fiscal year after the
limit was first exceeded.
As of June 1995, LGAC had issued bonds and notes to provide net proceeds of
$4.7 billion completing the program. The impact of LGAC's borrowing is that the
State is able to meet its cash flow needs in the first quarter of the fiscal
year without relying on short-term seasonal borrowings. The 1995-96 State
Financial Plan includes no spring borrowing, nor did the 1994-95 State Financial
Plan, which represented the first time in 35 years there was no short-term
seasonal borrowing. This reflects the success of the LGAC program in permitting
the State to accelerate local aid payments from the first quarter of the current
fiscal year to the fourth quarter of the previous fiscal year.
On January 6, 1992, Moody's lowered from "A" to "Baa1" its rating of those
State bonds that are backed by annual legislative appropriations. On February
11, 1997, Moody's downgraded its rating of the State's general obligation bonds
from "A" to "A2".
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On January 13, 1992, S&P lowered its rating of the State's general
obligation bonds from "A" to "A-".
OVERVIEW
The State's previous fiscal year commenced on April 1, 1996, and ended on
March 31, 1997, and is referred to herein as the State's 1996-97 fiscal year.
The State's budget for the 1996-97 fiscal year was enacted by the legislature on
July 13, 1996, more than three months after the start of the fiscal year. The
State Financial Plan for the 1996-97 fiscal year was formulated on July 25, 1996
and is based on the State's budget as enacted by the legislature and signed into
law by the Governor, as well as actual results for the first quarter of the
current fiscal year.
After adjustments for comparability between fiscal years, the adopted 1996-
97 budget projects a year-over-year increase in General Fund disbursements of
0.2 percent. Adjusted State Funds (excluding federal grants) disbursements are
projected to increase by 1.6 percent from the prior fiscal year. All
Governmental Funds projected disbursements increase by 4.1 percent over the
prior fiscal year, after adjustments for comparability.
The 1996-97 State Financial Plan is projected to be balanced on a cash
basis. As compared to the Governor's proposed budget as revised on March 20,
1996, the State's adopted budget for 1996-97 increases General Fund spending by
$842 million, primarily from increases for education, special education and
higher education ($563 million). The balance represents funding increases to a
variety of other programs, including community projects and increased assistance
to fiscally distressed cities. Resources used to fund these additional
expenditures include $540 million in increased revenues projected for 1996-97
based on higher-than-projected tax collections during the first half of calendar
1996, $110 million in projected receipts from a new State tax amnesty program,
and other resources including certain non-recurring resources. The total amount
of non-recurring resources included in the 1996-97 State budget is projected by
DOB to be $1.3 billion, or 3.9 percent of total General Fund receipts.
The General Fund is the principal operating fund of the State and is used
to account for all financial transactions,
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except those required to be accounted for in another fund. It is the State's
largest fund and receives almost all State taxes and other resources not
dedicated to particular purposes.
The General Fund is projected to be balanced on a cash basis for the 1996-
97 fiscal year. Total receipts and transfers from other funds are projected to
be $33.17 billion, an increase of $365 million from the prior fiscal year.
Total General Fund disbursements and transfers to other funds are projected to
be $33.12 billion, an increase of $444 million from the total in the prior
fiscal year.
Projected General Fund disbursements are reduced by a total of $73 million,
with changes made in most major categories of the 1995-96 State Financial Plan.
The reduction in overall spending masks the impact of deficiency requests
totaling more than $140 million, primarily for school aid and tuition assistance
to college students. Offsetting reductions in spending are attributable to the
continued maintenance of strict controls on spending through the fiscal year by
State agencies, yielding savings of $50 million. Reductions of $49 million in
support for capital projects reflect a stringent review of all capital spending.
Reductions of $30 million in debt service costs reflect savings from refundings
undertaken in the current fiscal year, as well as savings from lower interest
rates in the financial market. Finally, the 1995-96 Financial Plan reflects re-
estimates based on actual results through November, the largest of which is a
reduction of $70 million in projected costs for income maintenance. This
reduction is consistent with declining caseload projections.
The net impact of these and other factors is expected to produce a
potential imbalance in receipts and disbursements in the State fiscal year 1996-
97. The Governor has proposed to close this potential imbalance primarily
through General Fund expenditure reductions and without increases in taxes or
deferrals of scheduled tax reductions.
The State Comptroller prepares a comprehensive annual financial report on
the basis of generally accepted accounting principles ("GAAP") for governments.
In 1996-97, the General Fund GAAP-basis Financial Plan shows revenues of $30.40
billion, total expenditures of $30.98 billion, and net other financing source
and uses of $741 million. The surplus of $168 million reflects the expected
reservation of $85 million of cash in the Contingency Reserve Fund, as well as
the positive fiscal impact of the recommendations proposed in the Executive
Budget. After the accrual of liabilities expected to be paid in 1997-98, at
lower levels than in 1996-97, the General Fund benefits by
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another $300 million in savings beyond the levels budgeted on a cash basis. This
positive impact is offset by a decline of $180 million in revenue accruals.
The Governor presented his 1997-98 Executive Budget to the legislature on
January 14, 1997. There can be no assurance that the legislature will enact the
Executive Budget as proposed by the Governor into law, or that the State's
adopted budget projections will not differ materially and adversely from the
projections set forth in the Executive Budget. As of April 1, 1997, the
beginning of fiscal year 1997-1998, the legislature had failed to pass a 1997-
1998 budget.
The Executive Budget proposes $2.3 billion in actions to balance the 1997-
98 Financial Plan. Before reflecting any actions proposed by the Governor to
restrain spending, General Fund disbursements for 1997-98 were projected to grow
by approximately 4 percent. This increase would have resulted from growth in
Medicaid, higher fixed costs such as pensions and debt service, collective
bargaining agreements, inflation, and the loss of non-recurring resources that
offset spending in 1996-97. General Fund receipts were projected to fall by
roughly 3 percent. This reduction would have been attributable to modest growth
in the State's economy and underlying tax base, the loss of non-recurring
revenues available in 1996-97 and implementation of previously enacted tax
reduction programs.
The Executive Budget proposes to close this gap primarily through a series
of spending reductions and Medicaid cost containment measures, the use of a
portion of the 1996-97 projected budget surplus, and other actions. The 1997-98
Financial Plan projects receipts of $32.88 billion and spending $32.84 billion.
The Division of the Budget believes that the economic assumptions and
projections of receipts and disbursements accompanying the 1997-98 Executive
Budget are reasonable. However, the economic and financial condition of the
State may be affected by various financial, social, economic and political
factors. Those factors can be very complex, can vary from fiscal year to fiscal
year, and are frequently the result of actions taken not only by the State but
also by entities, such as the federal government, that are outside the State's
control. Because of the uncertainty and unpredictability of changes in these
factors, their impact cannot be fully included in the assumptions underlying the
State's projections. There can be no assurance that the State economy will not
experience results that are worse than predicted, with corresponding material
and adverse effects on the State's financial projections.
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To make progress toward addressing recurring budgetary imbalances, the
1997-98 Executive Budget proposes significant actions to align recurring
receipts and disbursements in future fiscal years. However, there can be no
assurance that the legislature will enact the Governor's proposals or that the
State's actions will be sufficient to preserve budgetary balance or to align
recurring receipts and disbursements in either 1997-98 or in future fiscal
years.
In addition, there has been discussion of additional tax reductions, beyond
those reflected in the State's current projections for 1997-98 and the out years
that, if enacted, could make it more difficult to achieve budget balance over
this period. In particular, modifying the State's sales tax treatment of
clothing has been discussed. The State now receives approximately $700 million
annually under the current tax statutes from taxation on clothing, and
localities receive a roughly equivalent amount.
Uncertainties with regard to both the economy and potential decisions at
the federal level add further pressure on future budget balance in New York
State. Risks to the Financial Plan include either a financial market or broader
economic "correction" during the period, a risk heightened by the relatively
lengthy expansions currently underway. In addition, a normal "forecast error"
of one percentage point in the expected growth rate could raise or lower
receipts by $600 million during the last year of the projection period.
Potential changes to federal tax law could alter the federal definitions of
income on which many State taxes rely. Similarly, the Financial Plan assumes no
significant federal disallowances or other actions which could affect State
finances.
On August 22, 1996, the President signed into law the Personal
Responsibility and Work Opportunity Reconciliation Act of 1996. This federal
legislation fundamentally changed the programmatic and fiscal responsibilities
for administration of welfare programs at the federal, state and local levels.
The new law abolishes the federal Aid to Families with Dependent Children
program (AFDC), and creates a new Temporary Assistance to Needy Families program
(TANF) funded with a fixed federal block grant to states. The new law also
imposes (with certain exceptions) a five-year durational limit on TANF
recipients, requires that virtually all recipients be engaged in work or
community service activities within two years of receiving benefits, and limits
assistance provided to certain immigrants and other classes of individuals.
States are required to meet work activity participation targets for their TANF
caseload; these requirements are phased in over time. State that fail to meet
these federally mandated job participation rates, or that fail to conform with
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certain other federal standards, face potential sanctions in the form of a
reduced federal block grant.
On October 16, 1996, the Governor submitted the State's TANF implementation
plan to the federal government as required under the new federal welfare law.
On December 13, 1996, the State's plan was approved by the federal government.
Legislation will be required to implement the State's TANF plan, and the
Governor has introduced legislation necessary to conform with federal law.
States are required to comply with the new federal welfare reform law no later
than July 1, 1997. There can be no assurances that the State legislature will
enact welfare reform proposals as submitted by the Governor and as required
under federal law.
The State Financial Plan is based upon forecasts of national and State
economic activity developed through both internal analysis and review of State
and national economic forecasts prepared by commercial forecasting services and
other public and private forecasters. Economic forecasts have frequently failed
to predict accurately the timing and magnitude of changes in the national and
the State economies. Many uncertainties exist in forecasts of both the national
and State economies, including consumer attitudes toward spending, the extent of
corporate and governmental restructuring, federal fiscal and monetary policies,
the level of interest rates, and the condition of the world economy, which could
have an adverse effect on the State. There can be no assurance that the State
economy will not experience results in the current fiscal year that are worse
than predicted, with corresponding material and adverse effects on the State's
projections of receipts and disbursements.
Projections of total State receipts in the State Financial Plan are based
on the State tax structure in effect during the fiscal year and on assumptions
relating to basic economic factors and their historical relationships to State
tax receipts. In preparing projections of State receipts, economic forecasts
relating to personal income, wages, consumption, profits and employment have
been particularly important. The projection of receipts from most tax or
revenue sources is generally made by estimating the change in yield of such tax
or revenue source caused by economic and other factors, rather than by
estimating the total yield of such tax or revenue source from its estimated tax
base. The forecasting methodology, however, ensures that State fiscal year
estimates for taxes that are based on a computation of annual liability, such as
the business and personal income taxes, are consistent with estimates of total
liability under such taxes.
Projections of total State disbursements are based on assumptions relating
to economic and demographic factors, levels
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of disbursements for various services provided by local governments (where the
cost is partially reimbursed by the State), and the results of various
administrative and statutory mechanisms in controlling disbursements for State
operations. Factors that may affect the level of disbursements in the fiscal
year include uncertainties relating to the economy of the nation and the State,
the policies of the federal government, and changes in the demand for and use of
State services.
The Division of the Budget believes that its projections of receipts and
disbursements relating to the current State Financial Plan, and the assumptions
on which they are based, are reasonable. Actual results, however, could differ
materially and adversely from any projections. In the past, the State has taken
management actions and made use of internal sources to address potential State
Financial Plan shortfalls, and DOB believes it could take similar actions should
variances occur in its projections for the current fiscal year.
In recent years, State actions affecting the level of receipts and
disbursements, the relative strength of the State and regional economy, actions
of the federal government and other factors, have created structural budget gaps
for the State. These gaps resulted from a significant disparity between
recurring revenues and the costs of maintaining or increasing the level of
support for State programs. To address a potential imbalance in any given fiscal
year, the State would be required to take actions to increase receipts and/or
reduce disbursements as it enacts the budget for that year, and under the State
Constitution, the Governor is required to propose a balanced budget each year.
There can be no assurance, however, that the legislature will enact the
Governor's proposals or that the State's actions will be sufficient to preserve
budgetary balance in a given fiscal year or to align recurring receipts and
disbursements in future fiscal years.
Constitutional challenges to State laws have limited the amount of taxes
which political subdivisions can impose on real property. In 1979, the State's
highest court declared unconstitutional a State law allowing localities and
school districts to impose a special increase in real estate property taxes in
order to raise funds for pensions and other uses. Additional court actions have
been brought against the State, certain agencies and municipalities relating to
financing, the amount of real estate tax, the use of tax revenues and other
matters.
Certain litigation pending against the State, its subdivisions and their
officers and employees could have a substantial and long-term adverse effect on
State finances. The
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State is a party to numerous legal proceedings, many of which normally recur in
governmental operations. Because of the prospective nature of these proceedings,
no estimate of the potential loss can be made.
Among the more significant of these cases are those that involve: (i) the
validity and fairness of agreements and treaties by which various Indian tribes
transferred title to the State of approximately six million acres of land in
central New York; (ii) certain aspects of the State's Medicaid policies and its
rates and regulations, including reimbursements to providers of mandatory and
optional Medicaid services; (iii) contamination in the Love Canal area of
Nigeria Falls; (iv) alleged responsibility of State officials to assist in
remedying racial segregation in the City of Yonkers; (v) an action, in which the
State is a third party defendant, for injunctive or other appropriate relief,
concerning liability for the maintenance of stone groins constructed along
certain areas of Long Island's shoreline; (vi) a challenge to the practice of
reimbursing certain Office of Mental Health patient care expenses from the
client's Social Security benefits; (vii) an action against New York State and
New York City officials alleging inadequate shelter allowances to maintain
proper housing;(viii) an action challenging the assessment of the petroleum
business tax as unconstitutional; (ix) an action seeking reimbursement from the
State for certain costs arising out of the provision of preschool services and
programs for children with physical disabilities; (x) actions challenging
regulations that establish excess medical malpractice premium rates for the
1986-87 through 1995-96 and 1996-97 fiscal years, respectively; and (xi) an
action challenging the enactment of the Clean Water/Clean Air Bond Act of 1996
and its implementing legislation as against the State Constitution.
The legal proceedings noted above involve State finances, State programs
and miscellaneous tort, real property and contract claims in which the State is
a defendant and the monetary damages sought are substantial. These proceedings
could affect adversely the financial condition of the State. Adverse
developments in these proceedings or the initiation of new proceedings could
affect the ability of the State to maintain a balanced State Financial Plan. An
adverse decision in any of these proceedings could exceed the amount of the
State Financial Plan reserve for the payment of judgments and, therefore, could
affect the ability of the State to maintain a balanced State Financial Plan.
The fiscal health of the State may also be affected by the fiscal health
of New York City ("the City"), which continues to
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require significant financial assistance from the State. The City depends on
State aid both to enable the City to balance its budget and to meet its cash
requirements. The State could also be affected by the ability of the City to
market its securities successfully in the public credit markets. The City has
achieved balanced operating results for each of its fiscal years since 1981 as
reported in accordance with the then-applicable GAAP standards.
Certain localities outside New York City have experienced financial
problems and have requested and received additional State assistance during the
last several State fiscal years. The potential impact on the State of any
future requests by localities for additional assistance is not included in the
projections of the State's receipts and disbursements for the State's 1996-97
fiscal year.
Fiscal difficulties experienced by the City of Yonkers resulted in the re-
establishment of the Financial Control Board for the City of Yonkers by the
State in 1984. That Board is charged with oversight of the fiscal affairs of
Yonkers. Future actions taken by the State to assist Yonkers could result in
increased State expenditures for extraordinary local assistance.
Beginning in 1990, the City of Troy experienced a series of budgetary
deficits that resulted in the establishment of a Supervisory Board for the City
of Troy in 1994. The Supervisory Board's powers were increased in 1995, when
Troy MAC was created to help Troy avoid default on certain obligations. The
legislation creating Troy MAC prohibits the City of Troy from seeking federal
bankruptcy protection while Troy MAC bonds are outstanding.
Seventeen municipalities received extraordinary assistance during the 1996
legislative session through $50 million in special appropriations targeted for
distressed cities.
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From time to time, federal expenditure reductions could reduce, or in some
cases eliminate, federal funding of some local programs and accordingly might
impose substantial increased expenditure requirements on affected localities.
If the State, the City or any of the public authorities were to suffer serious
financial difficulties jeopardizing their respective access to the public credit
markets, the marketability of notes and bonds issued by localities within the
State could be adversely affected. Localities also face anticipated and
potential problems resulting from certain pending litigation, judicial decisions
and long-range economic trends. Long-range potential problems of declining
urban population, increasing expenditures and other economic trends could
adversely affect localities and require increasing State assistance in the
future.
NEW YORK CITY
The national economic downturn which began in July 1990 adversely affected
the local economy, which had been declining since late 1989. As a result, the
City experienced job losses in 1990 and 1991 and real Gross City Product ("GCP")
fell in those two years. Beginning in calendar year 1992, the improvement in
the national economy helped stabilize conditions in the City. Employment losses
moderated toward year end and real GCP increased, boosted by strong wage gains.
After noticeable improvements in the City's economy during calendar year 1994,
economic growth slowed in calendar year 1995, and the City's current four-year
financial plan assumes that moderate economic growth will continue through
calendar year 2000.
For each of the 1981 through 1995 fiscal years, the City achieved balanced
operating results as reported in accordance with generally accepted accounting
principles ("GAAP"). The City was required to close substantial budget gaps in
recent years in order to maintain balanced operating results. For fiscal year
1995, the City adopted a budget which halted the trend in recent years of
substantial increases in City-funded spending from one year to the next. There
can be no assurance that the City will continue to maintain a balanced budget as
required by State law without additional tax or other revenue increases or
reductions in City services, which could adversely affect the City's economic
base.
Currently, the City and its Covered Organizations (i.e., these which
receive or may receive moneys from the City directly, indirectly or
contingently) operate under a four-year financial plan (the "Financial Plan")
which the City prepares annually and
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periodically updates. The City's Financial Plan includes its capital, revenue
and expense projections and outlines proposed gap closing programs for years
with projected budget gaps. The City's projections set forth in the Financial
Plan are based on various assumptions and contingencies, some of which are
uncertain and may not materialize. Unforeseen developments and changes in major
assumptions could significantly affect the City's ability to balance its budget
as required by State law and to meet its annual cash flow and financing
requirements.
The staffs of the Control Board, OSDC and the City Comptroller issue
periodic reports on the City's Financial Plans which analyze the City's
forecasts of revenues and expenditures, cash flow, and debt service requirements
for, and Financial Plan compliance by, the City and its Covered Organizations.
According to recent staff reports, the City's economy has experienced weak
employment and moderate wage and income growth throughout the mid-1990s.
Although this trend is expected to continue for the rest of the decade, there is
the risk of a slowdown in the City's economy in the next few years, which would
depress revenue growth and put further strains on the City's budget. These
reports have also indicated that recent City budgets have been balanced in part
through the use of non-recurring resources; that the City's Financial Plan tends
to rely on actions outside its direct control; that the City has not yet brought
its long-term expenditure growth in line with recurring revenue growth; and that
the City is therefore likely to continue to face substantial future budget gaps
that must be closed with reduced expenditures and/or increased revenues.
Implementation of the Financial Plan is also dependent upon the City's
ability to market its securities successfully in the public credit markets. The
City's financing program for fiscal years 1997 through 2000 contemplates the
issuance of $5.7 billion of general obligation bonds and $4.5 billion of bonds
to be issued by the proposed New York City Infrastructure Finance Authority
primarily to reconstruct and rehabilitate the City's infrastructure and physical
assets and to make other capital investments. The creation of the
Infrastructure Finance Authority, which is subject to the enactment of State
legislation, is being proposed by the City as part of the City's effort to avoid
conflict with the forecast level of the constitutional restrictions on the
amount of debt the City is authorized to issue. In addition, the City issues
revenue and tax anticipation notes to finance its seasonal working capital
requirements. The success of projected public sales of City bonds and notes and
Infrastructure Finance Authority bonds will be subject to prevailing market
conditions, and no assurance can be given that such sales will be completed. If
the City were unable to sell its general obligation bonds and notes or bonds of
the
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proposed Infrastructure Finance Authority, it would be prevented from meeting
its planned capital and operating expenditures. Future developments concerning
the City and public discussion of such developments, as well as prevailing
market conditions, may affect the market for outstanding City general obligation
bonds and notes.
The 1997-2000 Financial Plan projects revenues and expenditures for the
1996 fiscal year balanced in accordance with generally accepted accounting
principles ("GAAP"). The projections for the 1996 fiscal year reflect proposed
actions to close a previously projected gap of approximately $3.1 billion for
the 1996 fiscal year. The proposed actions in the Financial Plan for the 1996
fiscal year include (i) a reduction in spending of $400 million, primarily
affecting public assistance and Medicaid payments by the City; (ii) expenditure
reductions in agencies, totaling $1.2 billion; (iii) transitional labor savings,
totaling $600 million; and (iv) the phase-in of the increased annual pension
funding cost due to revisions resulting from an actuarial audit of the City
pension systems, which would reduce such costs in the 1996 fiscal year.
In connection with its Financial Plan, the City has outlined a gap-closing
program for the 1998 through 2000 fiscal years to eliminate the remaining $1.2
billion, $2.1 billion and $3.0 billion projected budget gaps for such fiscal
years. This program, which is not specified in detail, assumes additional
agency programs to reduce expenditures or increase revenues by $400 million,
$950 million and $1.4 billion in the 1998 through 2000 fiscal years,
respectively; additional revenue initiatives and asset sales of $76 million,
$229 million and $281 million in the 1998 through 2000 fiscal years,
respectively; additional Federal and State aid of $250 million, $250 million and
$325 millon in the 1998 through 2000 fiscal years, respectively; additional
reductions in entitlement costs of $400 million, $600 million and $975 million
in the 1998 through 2000 fiscal years, respectively; and availability in each of
the 1998 through 2000 fiscal years of $100 million of the General Reserve.
The City's projected budget gaps for the 1999 and 2000 fiscal years do not
reflect the savings expected to result from prior years' programs to close the
gaps set forth in the Financial Plan. Thus, for example, recurring savings
anticipated from the actions which the City proposes to take to balance the
fiscal year 1998 budget are not taken into account in projecting the budget gaps
for the 1999 and 2000 fiscal years.
Although the City has maintained balanced budgets in each of its last
sixteen fiscal years and is projected to achieve
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balanced operating results for the 1997 fiscal year, there can be no assurance
that the gap-closing actions proposed in the Financial Plan can be successfully
implemented or that the City will maintain a balanced budget in future years
without additional State aid, revenue increases or expenditure reductions.
Additional tax increases and reductions in essential City services could
adversely affect the City's economic base.
On November 14, 1996, the City submitted to the Control Board the Financial
Plan for the 1997 through 2000 fiscal years, which relates to the City, BOE and
the City University of New York ("CUNY").
The 1997-2000 Financial Plan published on November 14, 1996 reflects actual
receipts and expenditures and changes in forecast revenues and expenditures
since the prior financial plan submitted to the Control Board on June 21, 1996
(the "June Financial Plan". The 1997-2000 Financial Plan projects revenues
and expenditures for 1997 fiscal year balanced in accordance with GAAP, and
projects gaps of $1.2 billion, $2.1 billion and $3.0 billion for the 1998, 1999
and 2000 fiscal years, respectively. Changes since the June Financial Plan
include (i) an increase in projected tax revenues of $450 million, $120 million,
$50 million and $45 millon in fiscal years 1997 through 2000, respectively; (ii)
a delay in the assumed receipt of $304 million relating to projected rent
payments for the City airports from the 1997 fiscal year to the 1998 and 1999
fiscal years, and a $34 million reduction in assumed State and Federal aid for
the 1997 fiscal year; (iii) an approximately $200 million increase in projected
overtime and other expenditures in each of the fiscal years 1997 through 2000;
(iv) a $70 million increase in expenditures for BOE in the 1997 fiscal year for
school text books; (v) a reduction in projected pension costs of $34 million,
$50 million, $49 million and $47 million in fiscal years 1997 through 2000,
respectively; and (vi) additional agency actions totaling $179 millon, $386
million, $473 million and $589 million in fiscal years 1997 through 2000,
including personnel reductions through attrition and early retirement.
The Financial Plan assumes (i) approval by the Governor and the State
legislature of the extension of the 12.5% personal income tax surcharge, which
expired on December 31, 1996 and is projected to provide revenue of $170
million, $463 million, $492 million, and $521 million, in the 1997 through 2000
fiscal years, respectively; (ii) collection of the projected rent payments for
the City's airports, totalling $270 million and $180 million in the 1998 and
1999 fiscal years, respectively, which may depend on the successful completion
of negotiations with the Port Authority or the enforcement of the City's rights
under the existing leases thereto through pending legal actions; (iii) the
ability of HHC
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and BOE to identify actions to offset substantial City and State revenue
reductions and the receipt by BOE of additional State aid; (iv) State approval
of the cost containment initiatives and State aid proposed by the City; and (v)
a reduction in City funding for labor settlements for certain public authorities
or corporations. Legislation extending the 12.5% personal income tax surcharge
beyond December 31, 1996, was not enacted in the special legislative session
held in December 1996. Such legislation may be enacted in the 1997 State
legislative session. The Financial Plan does not reflect any increased costs
which the City might incur as a result of welfare legislation recently enacted
by Congress or legislation proposed by the Governor, which would, if enacted,
implement such Federal welfare legislation. In addition, the economic and
financial condition of the City may be affected by various financial, social,
economic and political factors which could have a material effect on the
City.
In January, the Mayor is expected to publish a Modification (the "January
Modification") to the financial plan for the City's 1997 through 2001 fiscal
years and a preliminary budget for the City's 1998 fiscal year. The January
Modification will reflect changes since the Financial Plan, including the City's
program to address the currently forecasted gap of approximately $1.2 billion in
the 1998 fiscal year. The gap-closing program, as proposed in the Financial
Plan, is currently being further developed and is subject to change in
connection with the January Modification. The Governor released the 1997-1998
Executive Budget on January 14, 1997, which will be considered for adoption by
the State legislature. Based on a preliminary evaluation of currently available
information, the City's Office of Management and Budget ("OMB") believes that
the reductions in Medicaid reimbursement rates and other entitlement and welfare
initiatives proposed in the 1997-1998 Executive Budget, if approved by the State
legislature without change, would provide the City with a portion of the $650
million of additional aid and reductions in entitlement costs assumed in the
City's gap-closing program for the 1998 fiscal year. OMB expects that the
January Modification will reflect additional initiatives proposed by the City
relating to reductions in entitlement costs and additional intergovernmental
aid, which would be dependent upon State legislative approval. Certain proposed
cost containment and other initiatives have been previously considered and
rejected by the State legislature. The nature and extent of the impact on the
City of the State budget, when adopted, is uncertain, and no assurance can be
given that the State actions included in the State adopted budget may not have a
significant adverse impact on the City's budget and its Financial Plan. It can
be expected that the proposals contained in the January Modification to close
the projected budget gap for the 1998 fiscal year will engender
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substantial public debate which will continue through the time the budget is
scheduled to be adopted in June 1997.
The City Comptroller and other agencies and public officials have issued
reports and made public statements which, among other things, state that
projected revenues may be less and future expenditures may be greater than
forecasted in the City Plan. It is reasonable to expect that such reports and
statements will continue to be issued and to engender public comment.
On July 16, 1996, the staff of the City Comptroller issued a report on the
Financial Plan. The report concluded that the City's fiscal situation remains
serious, and that the City faces budgetary risks of approximately $787 million
to $941 million for the 1997 fiscal year, which may increase to as much as $4.31
billion for fiscal year 2000.
Estimates of the City's revenues and expenditures is based on numerous
assumptions and are subject to various uncertainties. If expected federal or
State aid is not forthcoming, if unforeseen developments in the economy
significantly reduce revenues derived from economically sensitive taxes or
necessitate increased expenditures for public assistance, if the City should
negotiate wage increases for its employees greater than the amounts provided for
in the City's financial plan or if other uncertainties materialize that reduce
expected revenues or increase projected expenditures, then, to avoid operating
deficits, the City may be required to implement additional actions, including
increases in taxes and reductions in essential City services. The City might
also seek additional assistance from the State.
On January 20, 1995, Moody's lowered its rating on the City's general
obligations bonds to "Baa1" from "A." In July 1995, S&P revised its rating
on the City's general obligation bonds downward to "BBB+." S&P stated that
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"structural budgetary balance remains elusive because of persistent softness in
the City's economy, highlighted by weak job growth and a growing dependence on
the historically volatile financial services sector." Other factors identified
by S&P in lowering its ratings on City general obligation bonds, included a
trend of using one-time measures, including debt refinancings, to close
projected budget gaps, dependence on unratified labor savings to help balance
the City's financial plan, optimistic projections of additional federal and
State aid or mandate relief, a history of cash flow difficulties caused by State
budget delays and continued high debt levels.
Both the State and City face potential economic problems which could
seriously affect the ability of both the State and City to meet their financial
obligations. The economic problems of New York City adversely affect the State
in numerous ways. In addition, for decades the State economy has grown more
slowly than that of the nation as a whole, resulting in a decline in the
position of New York as one of the country's wealthier states. The causes of
this decline are varied and complex and some causes reflect international and
national trends beyond the State's and City's control.
SPECIAL CONSIDERATIONS AFFECTING PUERTO RICO
The following highlights some of the more significant financial trends and
problems affecting the Commonwealth of Puerto Rico (the Commonwealth or Puerto
Rico) and is based on information drawn from official statements and
prospectuses relating to the securities offerings of Puerto Rico and its
agencies and instrumentalities. Such information, however, has not been
independently verified by the Trust.
The economy of Puerto Rico is closely integrated with that of the United
States. In fiscal 1994, trade with the United States accounted for
approximately 87% of Puerto Rico's exports and approximately 67% of its imports.
In this regard, Puerto Rico experienced a $4.3 billion positive adjusted
merchandise trade balance in fiscal 1994. Since 1983, Puerto Rico has
experienced a wide ranging economic expansion with growth in almost every sector
of its economy and record levels of employment.
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Since fiscal 1985, personal income, both aggregate and per capita, have
increased consistently each fiscal year. In fiscal 1994, aggregate personal
income was $25.7 billion and personal income per capita was $7,047. Gross
domestic product in fiscal year 1991, 1992, 1993, 1994, and 1995 was $22.8
billion, $23.7 billion, $25.2 billion, $26.6 billion, and $28.3 billion,
respectively. For fiscal 1996, an increase in gross product of 2.7% over fiscal
1995 was forecasted. However, actual growth in the Puerto Rico economy will
depend on several factors, including the state of the U.S. economy, the exchange
rate for the U.S. dollar, increases in exports and visitors to the Commonwealth,
the price stability of oil imports, the level of federal transfers, and the cost
of borrowing. Due to uncertainties with respect to these factors, there is no
assurance that the economy of Puerto Rico will continue to grow.
Puerto Rico's economy continued to expand throughout the five year period
from fiscal 1990 through fiscal 1994. While trends in the Puerto Rico economy
generally follow those of the United States, Puerto Rico did not experience a
recession in 1991 as the United States did. This was primarily because of low
oil prices, low interest rates, and Puerto Rico's strong manufacturing base,
which has a large component of non-cyclical industries. Other factors
contributing to Puerto Rico's decade-long expansion include commonwealth-
sponsored economic development programs, the relatively stable prices of oil
imports, low exchange rates for the U.S. dollar, the level of federal transfers,
and the relatively low cost of borrowing funds during the period. These factors
will continue to affect Puerto Rico's economic growth rate in fiscal 1996 and
beyond.
Puerto Rico has made marked improvements in fighting unemployment.
Although unemployment is at relatively low historical levels for the
Commonwealth, it remains above the U.S. average. The unemployment rate declined
from 16.0% to 13.8% from fiscal 1994 to fiscal 1995. As of October 1995, the
unemployment rate stood at 15.0%. Despite this relative downturn, there is a
possibility that the unemployment rate will increase if there are changes in
factors that directly impact the economy of Puerto Rico.
Puerto Rico has a diversified economy with the manufacturing and service
sectors comprising the principal sectors. Manufacturing is the largest sector
in terms of gross domestic product. In fiscal 1995, manufacturing generated
$17.7 billion (or 41.8%) of gross domestic product. In the last two decades,
industrial development has tended to be more capital intensive and more
dependent on skilled labor. Manufacturing has experienced a basic change over
the years as a result of the
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influx of higher wage, high technology industries such as pharmaceuticals,
electronics, computers, microprocessors, scientific instruments, and high
technology machinery. The service sector, which includes wholesale and retail
trade, finance and real estate, ranks second in its contribution to gross
domestic product and is the economic sector that employs the greatest number of
people. In fiscal 1995, the service sector generated $15 billion in gross
domestic product (or 37.5%) and employed over 478,000 people. Growth in
construction and tourism also contributed to increased economic activity in
fiscal 1995. The government sector of the Commonwealth also plays an important
role in the economy of the island. In fiscal 1994, the government accounted for
$4.1 billion of Puerto Rico's gross domestic product and provided 22.2% of total
employment. Tourism also contributed significantly to the island economy and
total visitor expenditures amounted to $1.8 million in fiscal 1995.
One of the factors assisting the development of the manufacturing sector is
the federal and Commonwealth tax incentives, most notably section 936 of the
United States Internal Revenue Code of 1986, as amended and the Commonwealth's
Industrial Incentives Program. Section 936 currently grants U.S. corporations
that meet certain criteria and elect its application a credit (the Section 936
credit) against their U.S. corporate income tax on the portion of the tax
attributable to (i) income derived from the active conduct of a trade or
business in Puerto Rico (active business income) or from the sale or exchange of
substantially all of the assets used in the active conduct of such trade or
business, and (ii) qualified possession source investment income. The Industrial
Incentives Program, through the 1987 Industrial Incentives Act, grants
corporations engaged in certain qualified activities a fixed 90% exemption from
Commonwealth income and property taxes and a 60% exemption from municipal
license taxes.
Pursuant to amendments to the Internal Revenue Code (the Code) for taxable
years commencing after 1993, two alternative limitations apply to the Section
936 credit against active business income and sale of assets income, as
previously described. The first option limits the credit against such income to
40% of the credit allowable previous to the amendments of 1993, with a five-year
phase-in period starting at 60% of the current allowable credit (the Percentage
Limitation). The second option limits the allowable credit to the sum of (i)
60% of qualified compensation paid to employees (as defined in the Code), (ii) a
specified percentage of depreciation deductions,and (iii) a portion of the
Puerto Rico income taxes paid by the Section 936 corporation, up to a 9%
effective tax rate (the Economic Activity Limitation).
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On August 20, 1996, President Clinton signed into law a bill that will
phase out Section 936 tax credits over a nine-year period, ending January 1,
2006. The effect on Puerto Rico's economy of the phased elimination of Section
936 tax credit will not be certain for a number of years. The impact on future
investment and employment is more uncertain.
The Constitution of Puerto Rico provides a limitation on the amount of
general obligation debt that can be issued. The Commonwealth's policy has been
and continues to be to maintain the level of such debt within a prudent range
below the constitutional limitation. Historically, the Commonwealth has
maintained a fiscal policy which provides for a prudent relationship between the
growth of public sector debt and the growth of the economic base required to
service that debt. The Commonwealth also has sought opportunities to realize
debt service savings by refunding outstanding debt with obligations bearing
lower interest rates. In certain years, this policy has had the effect of
causing the rate of growth of public sector debt to be higher than the rate of
growth of gross domestic product. Over the fiscal years 1991 to 1995, public
sector debt increased 24.7% while gross product rose 24.4%. Short-term debt
outstanding relative to total debt was 7.5% as of November 30, 1995.
THE EQUITY INDEX FUND GUARANTEE
NYLIFE Inc. ("NYLIFE") and the Equity Index Fund have entered into a
Guaranty Agreement (the "Guarantee") for the benefit of shareholders. The
Guarantee has been issued for the benefit of all shareholders and has been
issued at no cost to the Equity Index Fund or its shareholders. The Guarantee
Date (as defined in the Prospectus) with respect to a particular Equity Index
Fund share will be 10 years after the purchase date of such share. If, on a
particular Guarantee Date, payments must be made under the terms of the
Guarantee, the terms of the Guarantee will obligate NYLIFE unconditionally and
irrevocably to pay to the Equity Index Fund's transfer and dividend disbursing
agent for the benefit of shareholders with that Guarantee Date an amount equal
to the difference between the Guaranteed Amount and net asset value per each
Guaranteed Share (as defined in the Prospectus) outstanding. The Equity Index
Fund's transfer and dividend disbursing agent will forward the difference
between the Guaranteed Amount and the net asset value directly to each
individual shareholder.
A Guaranteed Share is a unit that will at all times be equal to the net
asset value of one share initially purchased by the investor plus the net asset
value of all dividends and distributions attributable to such share (which
includes
B-96
<PAGE>
cumulative dividends and distributions paid with respect to any additional
shares of the Fund received as dividends and distributions) paid during the
period from the date of purchase to the Guarantee Date. A Guaranteed Share (the
unit to which the Guaranteed Amount will apply) is not the same as a share of
the Fund. Shareholders who redeem shares, or who elect to receive dividends and
distributions in cash, will own fewer units to which the Guaranteed Amount
applies (i.e., they will own fewer Guaranteed Shares) and therefore will lose
----
a portion of the benefit of the Guarantee with respect to any such redemption or
dividends or distributions received in cash.
NYLIFE will pay any amounts owing under the Guarantee to the Fund's
transfer and dividend disbursing agent on the third business day following a
Guarantee Date. A pro rata portion of any amounts so paid will then be
forwarded to each shareholder holding, as of the close of business on such date,
Guaranteed Shares with that Guarantee Date. If the Guarantee Date should fall on
a weekend or on a holiday, the Guarantee Date shall be the first business day
following the Guarantee Date. The Guarantee is intended to assure each owner of
Guaranteed Shares on a Guarantee Date that he or she will be able to recover, as
of the Guarantee Date, at a minimum, the Guaranteed Amount (with no adjustment
for inflation or the time value of money). The Guarantee will benefit any holder
of such Guaranteed Shares on the relevant Guarantee Date, who need not be the
original purchaser, and who, for example, may own such shares by gift or
inheritance.
Although the Equity Index Fund does not intend to pay dividends and
distributions in cash to shareholders (unless a shareholder elects to receive
payments in cash), such dividends and distributions which are reinvested will be
taxable to shareholders. See "Tax Status." The Guaranteed Amount does not
reflect any adjustment for the payment of taxes by a shareholder on dividends
and distributions received from the Equity Index Fund.
The obligations, if any, of NYLIFE under the Guarantee shall be discharged
when all required payments are made in full to the transfer and dividend
disbursing agent for the benefit of the shareholders or if the Equity Index
Fund's net asset value on a Guarantee Date is such that no amounts are payable
to shareholders under the terms of the Guarantee. Payment obligations under the
Guarantee will be solely the obligations of NYLIFE. Neither the Equity Index
Fund, New York Life Insurance Company, Monitor, NYLIFE Distributors, any of
their affiliates nor any other party is undertaking any obligation to the Equity
Index Fund or its shareholders with respect to the Guarantee.
B-97
<PAGE>
Although the Guarantee has been arranged for by the Equity Index Fund and
is created under contract between the Equity Index Fund and NYLIFE, the Equity
Index Fund has no interest in, and specifically disclaims any interest in, the
proceeds payable under the Guarantee, which are payable solely to the
shareholders with a particular Guarantee Date. The designation of such
shareholders as the sole beneficiaries of the Guarantee may not be changed by
either the Equity Index Fund or such shareholders. The Guarantee is neither
transferable nor assignable by the Equity Index Fund or the shareholders it
benefits, nor may the Equity Index Fund or its shareholders cancel or waive
rights under the Guarantee. The Guarantee cannot be surrendered by either the
Fund or its shareholders for cash, except in the event that payment is made
pursuant to its terms. Neither the Equity Index Fund nor its shareholders may
use the Guarantee as a pledge for a loan, nor may the Equity Index Fund or its
shareholders obtain any loan from NYLIFE with respect to amounts that may be
payable pursuant to the Guarantee.
The foregoing is only a summary, and not a complete statement of the
principal terms of the Guarantee. Reference is made to the Guarantee, a
specimen copy of which has been filed as an exhibit to the Registration
Statement. This summary is subject thereto and qualified in its entirety by
such reference.
ADDITIONAL FUNDAMENTAL INVESTMENT RESTRICTIONS
In addition to the fundamental investment restrictions contained in the
Prospectus, the Trustees of the Trust also have adopted the following
fundamental investment restrictions, which may not be changed with respect to
any Fund without the approval of the majority of the outstanding voting
securities of that Fund, as defined under the 1940 Act.
The Trust may not, on behalf of any Fund:
1. Act as an underwriter of securities issued by others, except to the
extent that a Fund may be considered an underwriter within the meaning of the
1933 Act, as amended, in the disposition of portfolio securities.
2. Issue senior securities, except as appropriate to evidence indebtedness
that a Fund is permitted to incur and except for shares of existing or
additional series of the Trust.
The following fundamental investment restriction is applicable to the Tax
Free Bond Fund only. The Tax Free Bond Fund must:
B-98
<PAGE>
1. Invest at least 80% of the Fund's net assets in securities the interest
on which is exempt from regular federal income tax, except that the Fund may
temporarily invest more than 20% of its net assets in securities the interest
income on which may be subject to regular federal income tax.
The following fundamental investment restrictions are applicable to the
Equity Index Fund only. The Equity Index Fund may not:
1. Purchase securities of any company having less than three years'
continuous operations (including operations of any predecessors) if such
purchase would cause the value of the Fund's investments in all such companies
to exceed 5% of the value of its total assets.
2. Purchase securities of closed-end investment companies except (a) in
the open market where no commission other than the ordinary broker's commission
is paid, which purchases are limited to a maximum of (i) 3% of the total
outstanding voting stock of any one closed-end investment company, (ii) 5% of
the Fund's net assets with respect to the securities issued by any one closed-
end investment company, and (iii) 10% of the Fund's net assets in the aggregate,
or (b) those received as part of a merger or consolidation. The Fund may not
purchase the securities of other open-end investment companies.
3. Hold the securities of any issuer when more than 1/2 of 1% of the
issuer's securities are owned beneficially by one or more of the Fund's officers
or Trustees or by one or more of the officers or directors of the Fund's
underwriter or investment manager.
4. Enter into repurchase agreements providing for settlement in more than
seven days after notice or purchase securities which are not readily marketable,
if, in the aggregate, more than 10% of the value of the Fund's total assets
would be so invested.
5. Invest in the securities of a company for the purpose of exercising
management or control, but the Fund will vote the securities it owns in its
portfolio as a shareholder in accordance with its views.
6. Purchase, sell or write puts, calls or combinations thereof, except
that the Fund may enter into transactions in stock index options and futures as
described in the Prospectus and in this Statement of Additional Information.
B-99
<PAGE>
The following fundamental investment restrictions are applicable only to
the California Tax Free Fund and New York Tax Free Fund. The California Tax
Free Fund and New York Tax Free Fund may not:
1. Sell securities short, or purchase securities on margin, except that
the Fund may enter into and make margin deposits in connection with transactions
in options, futures and options on futures.
2. Invest in companies for the purpose of exercising control.
3. Invest in securities of other investment companies, except as they may
be acquired as part of a merger, consolidation or acquisition of assets.
ADDITIONAL NON-FUNDAMENTAL INVESTMENT RESTRICTIONS
In addition to the Trust's fundamental investment restrictions, the
Trustees of the Trust have voluntarily adopted certain policies and restrictions
which are observed in the conduct of the affairs of the Funds, except the
California Tax Free Fund, New York Tax Free Fund, International Bond Fund,
International Equity Fund, Equity Index Fund and Strategic Income Fund. These
represent intentions of the Trustees based upon current circumstances. They
differ from fundamental investment policies in that the following additional
investment restrictions may be changed or amended by action of the Trustees
without requiring prior notice to or approval of shareholders.
In accordance with such policies and restrictions, a Fund may not:
(a) purchase from or sell portfolio securities of a Fund to any of the
officers or Trustees of the Trust, its investment advisers, its principal
underwriter or the officers, or directors of its investment advisers or
principal underwriter;
(b) invest more than 10% of the assets of a Fund (taken at market
value at the time of the investment) in "illiquid securities," illiquid
securities being defined to include securities subject to legal or
contractual restrictions on resale (other than restricted securities
eligible for resale pursuant to Rule 144A under the Securities Act of
1933), repurchase agreements maturing in more than seven days, certain
options traded over the counter that a Fund has written, securities for
which market
B-100
<PAGE>
quotations are not available, or other securities which legally or in the
opinion of the Adviser is deemed illiquid;
(c) invest assets in securities of other open-end investment
companies, but a Fund may invest in shares of the Money Market Fund if
double advisory fees are not assessed, may invest up to 5% of its assets in
closed-end investment companies (which would cause a Fund to pay duplicate
fees), and may purchase or acquire up to 10% of the outstanding voting
stock of a closed-end investment company (foreign banks or their agencies
or subsidiaries are not considered investment companies for the purposes of
this limitation);
(d) invest in other companies for the purpose of exercising control or
management;
(e) purchase securities on margin or make short sales, except in
connection with arbitrage transactions or unless, by virtue of its
ownership of other securities, it has the right to obtain securities
equivalent in kind and amount to the securities sold and, if the right is
conditional, the sale is made upon the same conditions, except that the
Trust may obtain such short-term credits as may be necessary for the
clearance of purchases and sales of securities and in connection with
transactions involving forward foreign currency exchange contracts;
(f) purchase or sell any put or call options or any combination
thereof, except that the Trust may purchase and sell or write (i) options
on any futures contracts into which it may enter, (ii) put and call options
on currencies, securities indexes and covered put and call options on
securities, and (iii) may also engage in closing purchase transactions with
respect to any put and call option position it has entered into; and except
that the Government Fund may not write any covered put options on U.S.
government securities if, as a result, more than 50% of its total assets
(taken at current value) would be subject to put options written by such
Fund; or
(g) purchase, with respect to the Government Fund, any call option,
long futures contract or long option on a futures contract if, at the date
of purchase, realized net losses from such transactions during the fiscal
year to date exceed 5% of such Fund's average net assets during such
period.
The following investment restrictions are non-fundamental, operating
policies of the International Bond Fund, International
B-101
<PAGE>
Equity Fund and Strategic Income Fund, and may be amended by the Board of
Trustees without shareholder approval:
(a) As an operating policy, a Fund may not sell securities short,
except for covered short sales or unless it owns or has the right to obtain
securities equivalent in kind and amount to the securities sold short, and
provided that transactions in options, futures and forward contracts are
deemed not to constitute short sales of securities.
(b) As an operating policy, a Fund may not purchase securities on
margin, except that the Fund may obtain such short-term credits as are
necessary for the clearance of transactions, and provided that margin
payments in connection with futures contracts and options on futures
contracts shall not constitute the purchase of securities on margin. This
restriction is not applicable to the Strategic Income Fund.
(c) As an operating policy, a Fund may not invest in securities which
are not readily marketable, or the disposition of which is restricted under
federal securities laws (collectively, "illiquid securities"), other than
Rule 144A securities determined to be liquid pursuant to guidelines adopted
by the Trust's Board of Trustees if, as a result, more than 15% of the
Fund's net assets would be invested in illiquid securities. A Fund may not
invest more than 15% of its net assets in repurchase agreements providing
for settlement in more than seven days, or in other instruments which for
regulatory purposes or in the Adviser's opinion may be deemed to be
illiquid, such as a certain portion of options traded in the over-the-
counter market, and securities being used to cover options a Fund has
written.
(d) As an operating policy, a Fund may not acquire or retain the
securities of any other investment company if, as a result, more than 3% of
such investment company's outstanding shares would be held by the Fund,
more than 5% of the value of the Fund's total assets would be invested in
shares of such investment company or more than 10% of the value of the
Fund's assets would be invested in shares of investment companies in the
aggregate, except in connection with a merger, consolidation, acquisition,
or reorganization.
"Value" for the purposes of all investment restrictions shall mean the
value used in determining a Fund's net asset value.
B-102
<PAGE>
In addition, though not a fundamental policy, the California Tax Free and
New York Tax Free Funds will not sell securities short, except that each Fund
reserves the right to sell securities short "against the box."
In addition, though not a fundamental policy, the Equity Index Fund may not
engage in arbitrage transactions, nor may it purchase warrants (excluding those
acquired by the Equity Index Fund in units or attached to securities), nor will
the Equity Index Fund sell securities short or buy on margin, except that the
Fund reserves the right to sell securities short "against the box."
If a percentage restriction is adhered to at the time of investment, a
later change in percentage resulting from a change in values or assets will not
constitute a violation of such restriction.
TRUSTEES AND OFFICERS
Information pertaining to the Trustees and officers of the Trust is set
forth below. Trustees deemed to be "interested
persons" of the Trust for purposes of the 1940 Act are indicated by an asterisk.
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATION(S)
NAME, ADDRESS AND AGE POSITION(S) WITH TRUST DURING PAST 5 YEARS
- --------------------- ---------------------- ---------------------
<S> <C> <C>
Alice T. Kane* Chairperson and Executive Vice President, New York Life
51 Madison Avenue Trustee Insurance Company, 1992 to present;
New York, NY 10010 General Counsel, 1992 to 1995;
Age: 49 Corporate Secretary, 1989 to 1994;
Senior Vice President and General
Counsel, 1986 to 1992; Director and
Chairperson, MainStay Institutional
Funds Inc., 1994 to present; Director,
New York Life Foundation, 1992 to
1995; Director, New York Life
International Investment Inc., 1988 to
present; Director, NYLIFE Inc., 1990 to
present; Director, Greystone Realty
Corporation, 1994 to present; Director,
Monitor Capital Advisors, Inc., 1994 to
present; Director, NYLCare Health
Plans, Inc. (formerly Sanus Corp. Health
Systems), 1984 to present; Director,
MacKay-Shields Financial Corporation,
1994 to present; Director, New York
Life Benefit Services Inc. (pension
consultant and third party
</TABLE>
B-103
<PAGE>
<TABLE>
<S> <C> <C>
administrator), 1994 to present; Director,
NYLIFE Securities Inc., 1994 to present;
Director, Eagle Strategies Corp.
(registered investment adviser), 1994 to
present; Director, NYLIFE Distributors
Inc., 1994 to present; Director, NYL
Management Limited, 1995 to present;
Director, NYL Trust Company, 1995 to
present; Director, NYLINK Insurance
Agency Incorporated, 1996 to present;
Director, Japan Gamma Asset
Management Limited, 1995 to present;
Director, New York Life Worldwide
Holding, Inc., 1995 to present; Director,
New York Life and Health Insurance
Company, 1996 to present; Director,
MainStay Shareholder Services, Inc.,
1997 to present; Director, NASD
Regulation, Inc., 1996 to present; and
Member, Board of Governors of the
National Association of Securities
Dealers, Inc., 1994 to 1996.
Walter W. Ubl* President, Chief Senior Vice President, New York Life
51 Madison Avenue Executive Officer and Insurance Company, 1995 to present;
New York, NY 10010 Trustee Vice President, 1984 to 1995; Vice
Age: 55 President in charge of Mutual Funds
Department, 1989 to present; Director
and Vice President, NYLIFE
Distributors Inc., 1993 to present; and
Director and Senior Vice President
NYLIFE Securities Inc., 1996 to present.
</TABLE>
B-104
<PAGE>
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATION(S)
NAME, ADDRESS AND AGE POSITION(S) WITH TRUST DURING PAST 5 YEARS
- --------------------- ---------------------- ---------------------
<S> <C> <C>
Harry G. Hohn* Trustee Retired Chairman and Chief Executive
51 Madison Avenue Officer, New York Life Insurance
New York, NY 10010 Company; Chairman of the Board and
Age 65 Chief Executive Officer, New York Life
Insurance Company, 1990 to 1997; Vice
Chairman of the Board, New York Life
Insurance Company, 1986 to 1990;
Director, New York Life Insurance
Company, 1985 to 1986; Director,
Million Dollar Roundtable Foundation,
1996 to present; Director, Insurance
Marketplace Standards Association, 1996
to present; Director, Witco Corporation,
1989 to present; Member, International
Advisory Board of Credit Commercial de
France, 1995 to present; and a Life
Fellow of the American Bar Foundation.
Donald K. Ross* Trustee Retired Chairman and Chief Executive
953 Cherokee Lane Officer, New York Life Insurance
Franklin Lakes, NJ 07417 Company; Director, New York Life
Age: 71 Insurance Company, 1978 to 1996;
President, New York Life Insurance
Company, 1986 to 1990; Chairman of the
Board, New York Life Insurance
Company, 1981 to 1990; Chief Executive
Officer, New York Life Insurance
Company, 1981 to 1990; Director,
MacKay-Shields Financial Corporation,
1984 to present; and Trustee,
Consolidated Edison Company of New
York, Inc., 1976 to present.
</TABLE>
B-105
<PAGE>
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATION(S)
NAME, ADDRESS AND AGE POSITION(S) WITH TRUST DURING PAST 5 YEARS
- --------------------- ---------------------- ---------------------
<S> <C> <C>
Edward J. Hogan Trustee Independent management consultant,
Box 2321 1991 to 1995; President, Westinghouse -
Sun Valley, ID 83353 Airship Industries, Inc. and Managing
Age: 64 Director, Airship Industries U.K., Ltd.,
1987 to 1990.
Nancy Maginnes Trustee Member, Council of Rockefeller
Kissinger University, New York, NY, 1991 to
Hendersons Road present; Trustee, Council of Rockefeller
Kent, CT 06757 University, 1995 to present; Trustee,
Age: 63 Animal Medical Center, 1993 to present;
and Trustee, The Masters School, 1994
to present.
Terry L. Lierman Trustee President, Capitol Associates, Inc., 1984
426 C Street, N.E. to present; President, Employee Health
Washington, D.C. 20002 Programs, 1990 to present; Vice
Age: 49 Chairman, TheraCom Inc., 1994 to
present; Member, UNICEF National
Board, 1993 to present; Director,
Harvard University, Pollin Institute, 1995
to present; Director, PeacePac, 1994 to
present; and Commissioner, State of
Maryland, Higher Education
Commission, 1995 to present.
Donald E. Nickelson Trustee Vice Chairman, Harbour Group
1701 Highway A-1-A Industries, Inc., 1991 to present;
Suite 101 Director, PaineWebber Group, 1980 to
Vero Beach, FL 32963 1993; President, PaineWebber Group,
Age: 63 1988 to 1990; Chairman of the Board,
PaineWebber Properties, 1985 to 1989;
Director, Harbour Group, 1986 to
present; Director, CPA 10 Real Estate
Inv. Trust, 1990 to present; Director,
CIP 11 Real Estate Inv. Trust, 1991 to
present; Chairman of the Board and
Director, Rapid Rock Industries, Inc.,
1986 to present; Director and Chairman
of the Board, Del Industries, 1990 to
present; Trustee, Jones Foundation (Los
Angeles), 1978 to present; Director,
Allied Healthcare Products, Inc., 1992 to
present; Director, Sugen, Inc., 1992 to
present; Director and Chairman of the
Board, Greenfield Industries, Inc., 1993
to present; Director, DT Industries, 1992
</TABLE>
B-106
<PAGE>
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATION(S)
NAME, ADDRESS AND AGE POSITION(S) WITH TRUST DURING PAST 5 YEARS
- --------------------- ---------------------- ---------------------
<S> <C> <C>
to present; Chairman of the Board,
Omniquip International, Inc., 1996 to
present; and Advisory Panel, Sedgwick
James of NY, 1996 to present.
Richard S. Trutanic Trustee Managing Director, The Somerset Group
1155 Connecticut Ave. (financial advisory firm), 1990 to present;
N.W., Suite 400 Senior Vice President, Washington
Washington, DC 20036 National Investment Corporation
Age: 44 (financial advisory firm), 1985 to 1990;
Director, Allin Communications
Corporation, 1996 to present; and
Director and Member of Executive
Committee, Southern Net, Inc., 1986 to
1990.
- ---------------------------------------------------------------------------------------------------------
OFFICERS (OTHER THAN TRUSTEES)
- ---------------------------------------------------------------------------------------------------------
Jefferson C. Boyce Senior Vice President Senior Vice President, MainStay
51 Madison Avenue Institutional Funds Inc., 1995 to present;
New York, NY 10010 Senior Vice President, New York Life
Age: 39 Insurance Company, 1994 to present;
Director, NYLIFE Distributors Inc.,
1993 to present; and Chief
Administrative Officer, Pension, Mutual
Funds, Structured Finance, Corporate
Quality, Human Resources and
Employees' Health Departments, New
York Life Insurance Company, 1992 to
1994.
Anthony W. Polis Vice President and Vice President, New York Life Insurance
51 Madison Avenue Chief Financial Company, 1988 to present; Director,
New York, NY 10010 Officer Vice President and Chief Financial
Age: 53 Officer, NYLIFE Securities Inc., 1988 to
present; Vice President and Chief
Financial Officer, NYLIFE Distributors
Inc., 1993 to present; Treasurer,
MainStay Institutional Funds Inc., 1990
to present; Treasurer, MainStay VP
Series Fund, Inc., 1993 to present;
Assistant Treasurer, MainStay VP Series
Fund, Inc., 1992 to 1993; Vice President
and Treasurer, Eclipse Financial Asset
Trust, 1992 to present; Vice President
and Chief Financial Officer, Eagle
</TABLE>
B-107
<PAGE>
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATION(S)
NAME, ADDRESS AND AGE POSITION(S) WITH TRUST DURING PAST 5 YEARS
- --------------------- ---------------------- ---------------------
<S> <C> <C>
Strategies Corp. (registered investment
adviser), 1993 to present.
Richard Zuccaro Tax Vice President Vice President, New York Life Insurance
51 Madison Avenue Company, 1995 to present; Vice
New York, NY 10010 President -- Tax, New York Life
Age: 46 Insurance Company, 1986 to 1995; Tax
Vice President, NYLIFE Securities Inc.,
1987 to present; Tax Vice President,
NAFCO, Inc., 1990 to present; Tax Vice
President, NYLIFE Depositary Inc., 1990
to present; Tax Vice President, NYLIFE
Inc., 1990 to present; Tax Vice President,
NYLIFE Insurance Company of
Arizona, 1990 to present; Tax Vice
President, NYLIFE Realty Inc., 1991 to
present; Tax Vice President, NYLICO
Inc., 1991 to present; Tax Vice President,
New York Life Fund Inc., 1991 to
present; Tax Vice President, New York
Life International Investment, Inc., 1991
to present; Tax Vice President, NYLIFE
Equity Inc., 1991 to present; Tax Vice
President, NYLIFE Funding Inc., 1991
to present; Tax Vice President, NYLCO
Inc., 1991 to present; Tax Vice President,
MainStay VP Series Fund, Inc., 1991 to
present; Tax Vice President, CNP Realty,
1991 to present; Tax Vice President,
New York Life Worldwide Holding Inc.,
1992 to present; Tax Vice President,
NYLIFE Structured Asset Management
Co. Ltd., 1992 to present; Tax Vice
President, MainStay Institutional Funds
Inc., 1992 to present; Tax Vice President,
NYLIFE Distributors Inc., 1993 to
present; Vice President & Assistant
Controller, New York Life Insurance
and Annuity Corp., 1995 to present, and
Assistant Controller, 1991 to present;
Vice President, NYLCARE Health
Plans, Inc., 1995 to present; Vice
President - Tax, New York Life and
Health Insurance Co., 1996 to present;
and Tax Vice President, NYL Trust
Company, 1996 to present.
</TABLE>
B-108
<PAGE>
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATION(S)
NAME, ADDRESS AND AGE POSITION(S) WITH TRUST DURING PAST 5 YEARS
- --------------------- ---------------------- ----------------------
<S> <C> <C>
A. Thomas Smith III Secretary Vice President and Associate General
51 Madison Avenue Counsel, New York Life Insurance
New York, NY 10010 Company, 1997 to present; Associate
Age: 39 General Counsel, New York Life
Insurance Company, 1996 to 1997;
Assistant General Counsel, New York
Life Insurance Company, 1994 to 1996;
Secretary, MainStay Institutional Funds
Inc., MainStay VP Series Fund, Inc.,
New York Life Fund Inc., and Eclipse
Financial Asset Trust, 1994 to present;
Secretary, Eagle Strategies Corp.
(registered investment adviser), 1996 to
present; and Assistant General Counsel,
Dreyfus Corporation, 1991 to 1993.
</TABLE>
As indicated in the above table, certain Trustees and officers also hold
positions with MacKay-Shields, Monitor, New York Life Insurance Company, NYLIFE
Securities Inc. and/or NYLIFE Distributors Inc.
The Independent Trustees of the Trust receive from the Trust an annual
retainer of $40,000 and a fee of $1,000 for each Board of Trustees meeting and
for each Board committee meeting attended and are reimbursed for all out-of-
pocket expenses related to attendance at such meetings. Trustees who are
affiliated with New York Life Insurance Company do not receive compensation from
the Trust.
For the fiscal year ended December 31, 1996, the Trustees received the
following compensation from the Trust and from certain other investment
companies (as indicated) that have the same investment advisers as the Trust or
an investment adviser that is an affiliated person of one of the Trust's
investment advisers:
B-109
<PAGE>
<TABLE>
<CAPTION>
Total Compensation
Aggregate From Registrant
Name of Compensation and Fund Complex
Trustee from the Trust Paid to Trustees
- ------- -------------- ------------------
<S> <C> <C>
Edward J. Hogan* $0 $0
Nancy M. Kissinger $46,000 $46,000
Terry L. Lierman $45,000 $45,000
Donald E. Nickelson $45,000 $45,000
Richard S. Trutanic $44,000 $44,000
Ralph A. Pfeiffer** $33,000 $33,000
</TABLE>
* Mr. Hogan was elected to his position as Trustee of the Trust on October
28, 1996.
** Mr. Pfeiffer passed away on September 13, 1996.
As of April 25, 1997, the Trustees and officers of the Trust as a group
owned less than 1% of the outstanding shares of any class of beneficial interest
of each of the Funds.
THE ADVISERS, THE ADMINISTRATOR AND THE DISTRIBUTOR
INVESTMENT ADVISORY AGREEMENTS
Pursuant to the Investment Advisory Agreements for Capital Appreciation
Fund, Value Fund, Convertible Fund, High Yield Corporate Bond Fund, Government
Fund, and Money Market Fund dated May 1, 1986; the Investment Advisory Agreement
for Tax Free Bond Fund dated May 29, 1987; the Investment Advisory Agreement for
Total Return Fund dated December 28, 1987; the Investment Advisory Agreements
for California Tax Free Fund and New York Tax Free Fund dated September 6, 1991;
the Investment Advisory Agreement for Equity Index Fund dated November 5, 1990;
the Investment Advisory Agreements for International Bond Fund and International
Equity Fund dated August 25, 1994; and the Investment Advisory Agreement for
Strategic Income Fund dated January 28, 1997, MacKay-Shields or Monitor, each
subject to the supervision of the Trustees of the Trust and in conformity with
the stated policies of each Fund of the Trust, manages the investment operations
of the respective Funds that it advises and the composition of each such Fund's
portfolio, including the purchase, retention, disposition and loan of
securities.
On April 27, 1987 the shareholders of Capital Appreciation Fund, Value
Fund, Convertible Fund, High Yield Corporate Bond Fund, Government Fund, and
Money Market Fund approved their respective Investment Advisory Agreements and
in connection with the reorganization of such Fund as a series of the Trust, the
B-110
<PAGE>
shareholders of the MacKay-Shields MainStay Tax Free Bond Fund approved an
Investment Advisory Agreement with MacKay-Shields substantially identical to the
Tax Free Bond Fund's current Investment Advisory Agreement with MacKay-Shields.
On April 25, 1988 the shareholders of Total Return Fund, approved its Investment
Advisory Agreement. On December 8, 1992, shareholders of California Tax Free
Fund and New York Tax Free Fund approved their respective Investment Advisory
Agreements with MacKay-Shields. On September 8, 1994, the sole initial
shareholder of International Bond Fund and International Equity Fund approved
their respective Investment Advisory Agreements with MacKay-Shields. On February
3, 1997 the sole initial shareholder of Strategic Income Fund approved the
Investment Advisory Agreement with MacKay-Shields. Each Investment Advisory
Agreement will remain in effect for two years following its effective date, and
will continue in effect thereafter only if such continuance is specifically
approved at least annually by the Trustees or by vote of a majority of the
outstanding voting securities of the particular Fund (as defined in the 1940 Act
and in a rule under the Act) and, in either case, by a majority of the Trustees
who are not "interested persons" of the Trust or MacKay-Shields or Monitor (as
the term is defined in the 1940 Act). The Investment Advisory Agreements for
each Fund except Strategic Income Fund were last approved by the Trustees,
including a majority of the Trustees who are not "interested persons" of the
Trust or MacKay-Shields or Monitor (as defined in the 1940 Act), at a meeting
held on April 28, 1997.
The Advisers have each authorized any of their directors, officers and
employees who have been elected or appointed as Trustees or officers of the
Trust to serve in the capacities in which they have been elected or appointed.
In connection with the services it renders, the Advisers bear the salaries and
expenses of all of its personnel.
For the fiscal years ended December 31, 1996 and December 31, 1995, and the
period September 1, 1994 through December 31, 1994, the amount of the advisory
fee paid by each Fund to the Adviser was as follows:
B-111
<PAGE>
<TABLE>
<CAPTION>
Year Ended Year Ended September 1, 1994
December 31, December 31, through
1996 1995 December 31, 1994*
------------ ------------ ------------------
<S> <C> <C> <C>
California Tax Free Fund.... $ 45,307++ $ 29,964++ $ 14,030
Capital Appreciation Fund... 3,429,258 2,155,386 543,137
Convertible Fund............ 2,444,000 1,027,604 206,175
Equity Index Fund........... 163,785 81,072 20,578
Government Fund............. 2,643,801 3,056,716 1,062,816
High Yield Corporate Bond
Fund.................... 5,816,110 3,930,939 1,068,277
International Bond Fund+.... 68,489++ 52,534++ 10,037++
International Equity Fund+.. 342,100 166,703 27,355
Money Market Fund........... 397,071++ 391,304++ 93,386++
New York Tax Free Fund...... 29,457++ 31,482++ 14,397
Strategic Income Fund....... N/A+++
Tax Free Bond Fund.......... 1,579,820 1,610,982 525,805
Total Return Fund........... 3,087,111 2,396,247 674,170
Value Fund.................. 2,682,642 1,932,406 518,495
- -------------------------
</TABLE>
* The Funds changed their fiscal year end from August 31 to December 31.
+ The International Bond Fund and International Equity Fund commenced
operations on September 13, 1994.
++ After expense reimbursement.
+++ The Strategic Income Fund commenced operations on February 28, 1997.
The Adviser and the Administrator have voluntarily agreed to limit the
expenses of the Money Market Fund, described above to the extent that such
expenses for a month would exceed on an annualized basis .70%, respectively, of
the average daily net assets of the Fund. For the period September 1, 1994
through December 31, 1994, $173,990 would have been incurred by the Money Market
Fund had such expenses not been limited. For the fiscal years ended December
31, 1995 and 1996, $674,279 and $870,226, respectively, would have been incurred
by the Money Market Fund had such expenses not been limited.
The Adviser voluntarily agreed to reimburse 50% of certain expenses for the
California Tax Free Fund and the New York Tax Free Fund to the extent that
operating expenses exceed on an annualized basis .99% of the daily average net
assets of those Funds. For the fiscal period September 1, 1994 through December
31, 1994, the expense reimbursements to the California Tax Free Fund and the New
York Tax Free Fund totaled $5,418 and $5,167, respectively. For the fiscal year
ended December 31, 1995, the
B-112
<PAGE>
expense reimbursements to the California Tax Free Fund and New York Tax Free
Fund were $16,845 and $14,242, respectively. And, for the fiscal year ended
December 31, 1996, the expense reimbursements to the California Tax Free Fund
and New York Tax Free Fund were $11,228 and $19,912, respectively.
Regarding the International Bond Fund, the Adviser and Administrator each
agreed that a portion of its fees would not be imposed, pursuant to the
applicable contracts, until such time as the Fund reaches $50 million in net
assets. After deducting the foregoing fee waiver, the advisory fee paid by the
International Bond Fund for the period September 13, 1994 to December 31, 1994
equalled an annual rate of 0.25% and for the fiscal years ended December 31,
1995 and 1996 equalled an annual rate of 0.25% and 0.25%, respectively.
The Investment Advisory Agreements provide that MacKay-Shields or Monitor
shall not be liable to the Funds for any error of judgment by MacKay-Shields or
Monitor or for any loss sustained by the Funds or NYLIFE Distributors Inc.
except in the case of MacKay-Shields' or Monitor's willful misfeasance, bad
faith, gross negligence or reckless disregard of duty. Each Agreement also
provides that it shall terminate automatically if assigned and that it may be
terminated without penalty by either party upon no more than 60 days' nor less
than 30 days' written notice.
ADMINISTRATION AGREEMENTS
NYLIFE Distributors Inc. ("NYLIFE Distributors" or the "Administrator") acts
as administrator for the Funds pursuant to the Administration Agreements which
are dated January 1, 1994 (August 25, 1994 in the case of the International Bond
Fund and International Equity Fund and January 28, 1997 in the case of the
Strategic Income Fund). Prior to that time, NYLIFE Securities Inc. ("NYLIFE
Securities"), an affiliated company, had acted as administrator. The
Administrator has authorized any of its directors, officers and employees who
have been elected or appointed as Trustees or officers of the Trust to serve in
the capacities in which they have been elected or appointed. In connection with
its administration of the business affairs of the Funds, and except as indicated
in the Prospectus under the heading "Investment Advisers, Administrator and
Distributor," the Administrator bears the following expenses:
(a) the salaries and expenses of all personnel of the Trust and the
Administrator, except the fees and expenses of Trustees not affiliated with the
Administrator or the Advisers; and
B-113
<PAGE>
(b) all expenses incurred by the Administrator in connection with
administering the ordinary course of the Funds' business, other than those
assumed by the Trust.
The Administration Agreements also provide that in the event the expenses of a
Fund (including the fees of the Fund's Adviser and the Administrator, but
excluding interest, taxes, organization expenses, brokerage commissions,
distribution expenses, litigation and indemnification expenses and other
extraordinary expenses) for any fiscal year exceed the limits set by a state
securities commission, the Administrator will reduce its fees payable by each
such Fund by 50% (80% in the case of the Equity Index Fund) of the amount of
such excess to the extent of that Fund's fee.
The Administration Agreements for the Funds were approved by the Trustees,
including a majority of the Trustees who are not "interested persons" of the
Trust or NYLIFE Distributors (as the term is defined in the 1940 Act) at a
meeting held on October 25, 1993 (and at a meeting held on July 25, 1994 for the
International Bond Fund and International Equity Fund and at a meeting held on
January 27, 1997 for the Strategic Income Fund). The Administration Agreements
for each Fund except the Strategic Income Fund were reapproved by the Trustees,
including a majority of the Trustees who are not "interested persons" of the
Trust or NYLIFE Distributors, at a meeting held on April 28, 1997.
For the fiscal year ended December 31, 1996, the fiscal year ended December
31, 1995 and the fiscal period September 1, 1994 through December 31, 1994, the
amount of the administration fee paid by each Fund was as follows:
B-114
<PAGE>
<TABLE>
<CAPTION>
Year Ended Year Ended September 1, 1994
December 31, December 31, through
1996 1995 December 31, 1994*
------------ ------------ ------------------
<S> <C> <C> <C>
California Tax Free Fund.... $ 45,307++ $ 29,964++ $ 14,030
Capital Appreciation Fund... 3,429,258 2,155,386 543,137
Convertible Fund............ 2,444,000 1,027,604 206,175
Equity Index Fund........... 365,118++ 324,287 20,578
Government Fund............. 2,643,801 3,056,716 1,062,816
High Yield Corporate Bond
Fund.................... 5,816,110 3,930,939 1,068,277
International Bond Fund+.... 41,100++ 31,522++ 10,037++
International Equity Fund+.. 228,066 111,135 27,355
Money Market Fund........... 397,071++ 391,304++ 93,386++
New York Tax Free Fund...... 29,457++ 31,481++ 14,397
Strategic Income Fund....... N/A+++
Tax Free Bond Fund.......... 1,579,820 1,610,982 525,805
Total Return Fund........... 3,087,111 2,396,247 674,170
Value Fund.................. 2,682,642 1,932,406 518,495
</TABLE>
_______________________
* The Funds changed their fiscal year end from August 31 to December 31.
+ The International Bond Fund and International Equity Fund commenced
operations on September 13, 1994.
++ After expense reimbursement.
+++ The Strategic Income Fund commenced operations on February 28, 1997.
For the fiscal year ended December 31, 1996, the fiscal year ended December
31, 1995, and the period September 1, 1994 through December 31, 1994, the
expenses of each Fund did not exceed the most restrictive applicable state
expense limitation.
The Administrator and the Adviser have voluntarily agreed to assume the
expenses of the Money Market Fund described above to the extent that such
expenses for a month would exceed on an annualized basis .70% of the average
daily net assets of that
B-115
<PAGE>
Fund. For the fiscal year ended December 31, 1996, the fiscal year ended
December 31, 1995, and the period September 1, 1994 through December 31, 1994,
$870,226, $674,279, and $173,990 in expenses would have been incurred by the
Money Market Fund, respectively, had such expenses not been limited.
The Administrator has voluntarily agreed to reimburse 50% of certain
expenses for the California Tax Free Fund and the New York Tax Free Fund to the
extent that operating expenses exceed on an annualized basis .99% of the daily
average net assets of that Fund. For the period September 1, 1994 to December
31, 1994 the expense reimbursements to the California Tax Free Fund and New York
Tax Free Fund were $5,418 and $5,167, respectively. For the fiscal year ended
December 31, 1995, the expense reimbursements to the California Tax Free Fund
and New York Tax Free Fund were $16,845 and $14,242 respectively. And, for the
fiscal year ended December 31, 1996, the expense reimbursements to the
California Tax Free Fund and New York Tax Free Fund were $11,228 and $19,912,
respectively. NYLIFE Distributors reserves the right to terminate or revise this
limitation when the assets of a Fund reach $25 million.
Effective January 1, 1996, in the event the total expenses of the Equity
Index Fund for any fiscal year exceed 0.80% of the value of the Fund's average
annual net assets, the Administrator will reduce its fee payable by the Fund by
the difference between the Fund's total expenses and 0.80%. This reduction
amounted to $290,022 for the year ended December 31, 1996. This fee waiver is
voluntary and may be terminated at any time.
Regarding the International Bond Fund, the Adviser and Administrator each
agreed that a portion of its fees would not be imposed, pursuant to the
applicable contracts, until such time as the Fund reaches $50 million in net
assets. After deducting the foregoing fee waiver, the administration fee paid
by the International Bond Fund for the period September 13, 1994 to December 31,
1994 equalled an annual rate of 0.15% and for the fiscal years ended December
31, 1995 and 1996 equalled an annual rate of 0.15% and 0.15%, respectively.
DISTRIBUTION AGREEMENT
NYLIFE Distributors also acts as the Principal Underwriter and Distributor
of the Funds' shares pursuant to the Distribution Agreement with the Trust dated
January 1, 1994. Prior to that time, NYLIFE Securities Inc., an affiliated
company, had acted as principal underwriter. NYLIFE Securities sells shares of
the Funds pursuant to a dealer agreement with the Distributor. The Distributor
and other broker-dealers will pay commissions to salesmen as well as the cost of
printing and mailing prospectuses
B-116
<PAGE>
to potential investors and of any advertising incurred by them in connection
with their distribution of Trust shares. In addition, the Distributor will pay
for a variety of account maintenance and personal services to shareholders after
the sale.
The Distribution Agreement for the Funds was approved by the Trustees,
including a majority of the Trustees who are not "interested persons" (as the
term is defined in the 1940 Act) of the Trust nor have any direct or indirect
financial interest in the operation of the distribution plan or in any related
agreement (the "Independent Trustees") at a meeting held on October 25, 1993.
The Distribution Agreement for the International Bond Fund and the International
Equity Fund was approved by the Trustees, including a majority of the Trustees
who are not "interested persons" of the Trust (as the term is defined in the
1940 Act) at a meeting held on July 25, 1994. The Distribution Agreement for
the Strategic Income Fund was approved by the Trustees, including a majority of
the Trustees who are not "interested persons" of the Trust (as the term is
defined in the 1940 Act) at a meeting held on January 27, 1997. The
Distribution Agreements were reapproved by the Trustees, including a majority of
the Independent Trustees, at a meeting held on April 28, 1997.
As disclosed in the Prospectus, each of the Funds (except the Money Market
Fund and the Equity Index Fund, which does not offer Class B shares) has adopted
separate plans of distribution pursuant to Rule 12b-1 under the 1940 Act for
each class of shares of each Fund (the "Class A Plans", the "Class B Plans" and,
collectively, the "Plans"). Under the Class A Plans, Class A shares of each
Fund pay the Distributor a monthly fee at the annual rate of 0.25% of the
average daily net assets of each Fund's Class A shares for distribution or
service activities, as designated by the Distributor. The Class A Plans for
each of the Funds other than the California Tax Free Fund, New York Tax Free
Fund, Equity Index Fund and Strategic Income Fund were approved by the sole
initial shareholder of the Class A of shares of each Fund on December 31, 1994.
The Class A Plans were approved by the shareholders of the California Tax Free
Fund, New York Tax Free Fund and the Equity Index Fund at a Special Meeting of
Shareholders held on December 28, 1994 and the Class A Plan was approved by the
sole initial shareholder of the Strategic Income Fund on February 3, 1997.
Regarding the California Tax Free Fund, the New York Tax Free Fund and the
Equity Index Fund, the Trustees of the Trust, including a majority of the
Trustees who are not interested persons of the Trust and who have no direct or
indirect financial interest in the operation of such Plan (the "Independent
Trustees"), by vote cast in person at a meeting called for the purpose of voting
on such Plans, initially approved the Plan now designated as the Class A Plans
on July 25,
B-117
<PAGE>
1994. Regarding the Strategic Income Fund, the Trustees of the Trust, including
a majority of the Trustees who are not interested persons of the Trust and who
have no direct or indirect financial interest in the operation of such Plan (the
"Independent Trustees"), by vote cast in person at a meeting called for the
purpose of voting on such Plan, initially approved the Class A Plan on January
27, 1997.
As noted above, the Class B shares of each Fund (except the Money Market
Fund and the Equity Index Fund, which does not offer Class B shares) also have
adopted Rule 12b-1 distribution plans. Originally, Rule 12b-1 plans of
distribution were adopted by each of the Funds (except the California Tax Free
Fund, New York Tax Free Fund and Money Market Fund) for the then sole existing
class of shares of the Funds. More specifically, Rule 12b-1 distribution plans
were approved on February 3, 1997 by the sole initial shareholder of the
Strategic Income Fund, on September 8, 1994 by the sole initial shareholder of
each of the International Bond Fund and International Equity Fund, on April 25,
1988 by the shareholders of the Total Return Fund, on May 29, 1987 by the sole
initial shareholder of the Tax Free Bond Fund and on April 27, 1987 by the
shareholders of the Capital Appreciation Fund, Convertible Fund, Government
Fund, High Yield Corporate Bond Fund and Value Fund. The Trustees of the Trust,
including a majority of the Trustees who are not interested persons of the Trust
and who have no direct or indirect financial interest in the operation of such
plans of distribution, by vote cast in person at meetings called for the purpose
of voting on such Plans, initially approved the Plans of the Total Return Fund
on October 26, 1987, initially approved the Plans of the Tax Free Bond Fund on
April 27, 1987, and initially approved the Plans of the Capital Appreciation
Fund, Convertible Fund, Government Fund, High Yield Corporate Bond Fund and
Value Fund on April 28, 1986. In addition, on October 31, 1988, the Trustees of
the Trust, including a majority of the Trustees who are not interested persons,
amended the Tax Free Bond Fund's Plan to permanently reduce the amount of the
distribution fee to be imposed subsequent to that date. On October 26, 1992, the
Trustees of the Trust, including a majority of the Trustees who are not
interested persons of the Trust, amended each of the plans of distribution to
provide that a portion of total amount of the distribution fee as a service fee,
to pay for a variety of account maintenance and personal services to
shareholders after the sale. On October 25, 1993, the Trustees of the Trust,
including a majority of the Trustees who are not interested persons of the
Trust, amended each of the plans of distribution to reflect that NYLIFE
Distributors would serve as principal underwriter of the Funds' shares,
effective January 1, 1994. Prior to the implementation of the multi-class
distribution system the distribution plans in effect for the Funds were
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<PAGE>
amended and redesignated and, now, are applicable only to the Class B shares of
each Fund. On October 30, 1995, the Trustees of the Trust, including a majority
of the Trustees who are not interested persons of the Trust, amended the Class A
Plans and the Class B Plans to clarify that the Plans contemplate payment for
expenses that may generally be characterized as administrative.
Regarding the California Tax Free Fund and New York Tax Free Fund, the
Class B Plans were approved by the sole initial shareholder of the Class B
shares of each Fund on December 31, 1994. The Trustees of the Trust, including a
majority of the Trustees who are not interested persons of the Trust and who
have no direct or indirect financial interest in the operation of such Plans, by
vote cast in person at meetings called for the purpose of voting on such Plans,
initially approved such Plans now designated as the Class B Plans on October 24,
1994.
Regarding the International Bond Fund and International Equity Fund, the
Trustees of the Trust, including a majority of the Trustees who are not
interested persons of the Trust and who have no direct or indirect financial
interest in the operation of such Plans (the "Independent Trustees"), by vote
cast in person at meetings called for the purpose of voting on such Plans,
initially approved the distribution plans now designated as the Class B Plans on
July 25, 1994, and the Class A Plans on October 24, 1994. Regarding the
Strategic Income Fund, the Class B Plan for the Fund was approved on February 3,
1997 by the sole initial shareholder of the Fund. The Trustees of the Trust,
including a majority of the Trustees who are not interested persons of the Trust
and who have no direct or indirect financial interest in the operation of such
plan of distribution, by vote cast in person at a meeting called for the purpose
of voting on such Plan, initially approved the Class B Plan of the Fund on
January 27, 1997.
Under the Class B plans, each Fund's Class B shares other than Strategic
Income Fund pay a monthly distribution fee to the Distributor at the annual rate
of 0.75% (0.25% in the case of the California Tax Free Fund, New York Tax Free
Fund and the Tax Free Bond Fund) of the lesser of (a) the aggregate gross sales
of the Fund's Class B shares since the inception of the Funds (not including
reinvestment of dividends and capital gains distributions from the Fund), less
the aggregate net asset value of the Class B shares exchanged or redeemed since
the Fund's inception upon which a contingent deferred sales charge has been
imposed or upon which such charge has been waived, or (b) the average daily net
assets attributable to the Fund's Class B shares. Pursuant to the Class B
Plans, the Class B shares of each Fund also pay a service fee to the Distributor
at the annual
B-119
<PAGE>
rate of 0.25% of the average daily net assets of the Fund's Class B shares.
Regarding the Strategic Income Fund, under the Class B plan, the Fund's Class B
shares pay a monthly distribution fee to the Distributor at the annual rate of
0.75% of the average daily net assets attributable to the Fund's Class B shares.
Pursuant to the Class B Plan, the Class B shares of the Strategic Income Fund
also pay a service fee to the Distributor at the annual rate of 0.25% of the
average daily net assets of the Fund's Class B shares.
Once approved by a vote of a majority of the outstanding voting securities
of a class of shares of a Fund, each Plan shall continue in effect thereafter,
provided such continuance is approved annually by a vote of the Trustees in the
manner described above. No Plan may be amended to increase materially the
amount to be spent for the services described therein without approval of the
shareholders of the affected class of shares of a Fund, and all material
amendments of each Plan must also be approved by the Trustees in the manner
described above. Each Plan may be terminated at any time, without payment of
any penalty, by vote of a majority of the Trustees who are not interested
persons of the Trust and who have no direct or indirect financial interest in
the operations of the Plan, or by a vote of a majority of the outstanding voting
securities of the affected Fund (as defined in the 1940 Act) on not more than 30
days' written notice to any other party to the Plan. So long as any Plan is in
effect, the selection and nomination of Trustees who are not such interested
persons has been committed to those Trustees who are not such interested
persons. The Trustees have determined that, in their judgment, there is a
reasonable likelihood that each Plan will benefit the respective Fund and its
shareholders. Pursuant to both the Class A and Class B Plans, the Distributor
shall provide the Trust for review by the Trustees, and the Trustees shall
review at least quarterly, a written report of the amounts expended under each
Plan and the purpose for which such expenditures were made. In the Trustees'
quarterly review of each Plan, they will consider its continued appropriateness
and the level of compensation provided therein.
At a meeting held on April 28, 1997, the Trustees of the Trust, including a
majority of the Independent Trustees, approved the continuation of the Plans.
Pursuant to a rule of the National Association of Securities Dealers, Inc.,
the amount which a Fund may pay for distribution expenses, excluding service
fees, is limited to 6.25% of the gross sales of the Fund's shares since
inception of the Fund's Plan, plus interest at the prime rate plus 1% per annum
(less any contingent deferred sales charges paid by shareholders to the
B-120
<PAGE>
Distributor or distribution fee (other than service fees) paid by the Funds to
the Distributor).
For the fiscal year ended December 31, 1996, the Funds paid distribution
and service fees pursuant to the Class A and Class B Plans as follows:
Amount of Fee Amount of Fee
Pursuant to Pursuant to
Class A Plan Class B Plan
------------- -------------
California Tax Free Fund........ $ 46,788 $ 19,206
Capital Appreciation Fund....... 212,203 8,346,723
Convertible Fund................ 109,177 5,623,832
Equity Index Fund............... 409,463 N/A
Government Fund................. 38,937 7,206,791
High Yield Corporate Bond Fund.. 190,154 16,701,333
International Bond Fund......... 29,310 141,984
International Equity Fund....... 39,917 395,760
Money Market Fund............... N/A N/A
New York Tax Free Fund.......... 42,333 14,072
Strategic Income Fund*.......... N/A N/A
Tax Free Bond Fund.............. 33,245 2,367,663
Total Return Fund............... 122,644 7,048,842
Value Fund...................... 114,102 6,604,450
* The Strategic Income Fund commenced operations on February 28, 1997.
For the fiscal year ended December 31, 1996, the fiscal year ended December
31, 1995, and the period September 1, 1994 through December 31, 1994, NYLIFE
Distributors retained the following amounts in sales charges for sales of Class
A shares of the Funds, as applicable:
B-121
<PAGE>
<TABLE>
<CAPTION>
Year Ended Year Ended September 1, 1994
December 31, December 31, through
1996 1995 December 31, 1994*
------------ ------------ ------------------
<S> <C> <C> <C>
California Tax Free Fund....... $ 35,009 $ 57,181 $ 25,670
Capital Appreciation Fund(1). 1,430,417 718,806 --
Convertible Fund(1)............ 903,782 529,361 --
Equity Index Fund.............. 1,968,993 308,486 133,857
Government Fund(1)............. 96,545 95,975 --
High Yield Corporate Bond
Fund(1).................... 1,413,313 782,534 --
International Bond Fund+(1).... 54,586 10,984 --
International Equity Fund+(1) 91,571 63,684 --
Money Market Fund(1)........... N/A N/A N/A
New York Tax Free Fund......... 22,774 35,722 21,343
Strategic Income Fund++........ N/A N/A N/A
Tax Free Bond Fund(1).......... 51,345 62,656 --
Total Return Fund(1)........... 334,470 233,202 --
Value Fund(1).................. 574,807 413,692 --
- -----------------------
</TABLE>
* The Funds changed their fiscal year end from August 31 to December 31.
+ The International Bond Fund and International Equity Fund commenced
operations on September 13, 1994.
++ The Strategic Income Fund commenced operations on February 28, 1997.
(1) The Fund began offering Class A shares on January 3, 1995.
For the fiscal year ended December 31, 1996, contingent deferred sales
charges were paid by investors on the redemption of Class B shares of each Fund,
as follows:
<TABLE>
<CAPTION>
Year Ended
December 31,
1996
-----------
<S> <C>
California Tax Free Fund(2)..... $ 2,008
Capital Appreciation Fund....... 966,555
Convertible Fund................ 852,359
Equity Index Fund............... N/A
Government Fund................. 952,234
High Yield Corporate Bond Fund.. 1,482,294
International Bond Fund......... 27,332
</TABLE>
B-122
<PAGE>
<TABLE>
<S> <C>
International Equity Fund....... 48,979
Money Market Fund(1)............ 640,623
New York Tax Free Fund(2)....... 2,810
Strategic Income Fund (3)....... N/A
Tax Free Bond Fund.............. 605,386
Total Return Fund............... 745,382
Value Fund...................... 712,915
</TABLE>
- ----------
* The Funds changed their fiscal year end from August 31 to December 31.
(1) The amount shown represents proceeds from contingent deferred sales charges
which were assessed on redemptions of shares which had previously been
exchanged from other Funds into the Money Market Fund.
(2) The Fund began offering Class B shares on January 3, 1995.
(3) The Strategic Income Fund commenced operations on February 28, 1997.
For the fiscal year ended December 31, 1996, it is estimated that the
following amounts were spent with respect to the Class A shares of each Fund:
California Tax Free Fund spent $89,152 on compensation to dealers; Capital
Appreciation Fund spent $1,501,787 on compensation to dealers; Convertible Fund
spent $920,619 on compensation to dealers; Equity Index Fund spent $1,909,644 on
compensation to dealers; Government Fund spent $173,229 on compensation to
dealers; High Yield Corporate Bond Fund spent $1,466,889 on compensation to
dealers; International Bond Fund spent $186,704 on compensation to dealers;
International Equity Fund spent $105,124 on compensation to dealers; New York
Tax Free Bond Fund spent $19,981 on compensation to dealers; Tax Free Bond Fund
spent $128,691 on compensation to dealers; Total Return Fund spent $381,683 on
compensation to dealers; and Value Fund spent $645,363 on compensation to
dealers.
For the fiscal year ended December 31, 1996, it is estimated that the
following amounts were spent for distribution-related activities with respect to
the Class B shares of each Fund:
<TABLE>
<CAPTION>
Printing And Approximate
Mailing Total Amount
Prospectuses Spent By
Sales to other Compensation Compensation NYLIFE
Material than to to Sales Distributors
and Current Distribution Sales Distribution With Respect
Advertising Shareholders Personnel Personnel Other Costs to Each Fund
----------- ------------- ------------ ------------ ---------- ------------ ------------
<S> <C> <C> <C> <C> <C> <C> <C>
California Tax Free
Fund................... $ 73,801 $ 1,535 $ 189,852 $ 30,604 $ 44,742 $ 747,673 $ 1,088,207
</TABLE>
B-123
<PAGE>
<TABLE>
<S> <C> <C> <C> <C> <C> <C> <C>
Capital Appreciation
Fund................... 758,717 421,361 3,141,106 650,035 1,450,098 15,825,633 22,246,951
Convertible Fund........ 249,150 242,683 1,013,084 210,885 469,303 14,788,597 16,973,703
Government Fund......... 128,893 329,715 544,630 115,854 253,004 2,672,887 4,044,982
High Yield Corporate
Bond Fund.............. 933,969 756,839 3,917,489 810,212 1,813,951 29,791,670 38,024,130
International Bond
Fund................... 9,150 5,966 38,118 7,981 17,983 263,481 342,679
International Equity
Fund................... 34,089 15,940 152,765 33,208 75,613 896,403 1,208,020
New York Tax Free Fund.. 17,892 1,102 52,265 8,571 16,894 191,834 288,558
Strategic Income Fund*.. 0 0 0 0 0 0 0
Tax Free Fund........... 57,743 196,491 273,828 58,731 130,519 1,314,695 2,032,007
Total Return Fund....... 304,008 360,068 1,360,199 290,227 658,192 6,647,325 9,620,019
Value Fund.............. 371,691 320,958 1,540,187 320,666 714,276 8,899,927 12,167,704
Total................... 2,939,103 2,652,658 12,223,522 2,536,975 5,644,576 82,040,127 108,036,960
* The Strategic Income Fund commenced operations on February 28, 1997.
</TABLE>
OTHER SERVICES
Pursuant to an Accounting Agreement with the Trust, dated January 1, 1994,
NYLIFE Distributors performs certain bookkeeping and pricing services for the
Funds. Each Fund will bear an allocable portion of the cost of providing these
services to the Trust.
In addition, each Fund other than the Strategic Income Fund reimbursed
NYLIFE Securities and NYLIFE Distributors for the cost of certain correspondence
to shareholders and establishing shareholder accounts.
For fiscal years ended December 31, 1995 and 1996, the period September 1,
1994 through December 31, 1994, the amount of recordkeeping fee paid by each
Fund was as follows:
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<TABLE>
<CAPTION>
Year Ended Year Ended September 1, 1994
December 31, December 31, through
1996 1995 December 31, 1994*
------------ ------------ ------------------
<S> <C> <C> <C>
California Tax Free Fund.... $ N/A $ N/A $ N/A
Capital Appreciation Fund... 145,721 95,042 24,684
Convertible Fund............ 81,568 57,184 13,603
Equity Index Fund........... N/A N/A N/A
Government Fund............. 114,622 128,798 42,333
High Yield Corporate Bond
Fund.................... 233,333 164,329 45,331
International Bond Fund+.... 12,511 12,000 3,600
International Equity Fund+.. 22,075 12,668 3,600
Money Market Fund........... 62,593 53,064 16,047
New York Tax Free Fund...... N/A N/A
Strategic Income Fund++..... N/A
Tax Free Bond Fund.......... 80,430 79,801 24,274
Total Return Fund........... 126,154 103,032 29,600
Value Fund.................. 116,985 85,935 23,809
</TABLE>
- ----------
* The Funds changed their fiscal year end from August 31 to December 31.
+ The International Bond Fund and International Equity Fund commenced
operations on September 13, 1994.
++ The Strategic Income Fund commenced operations on February 28, 1997.
EXPENSES BORNE BY THE TRUST
Except for the expenses to be paid by the Advisers and the Administrator
as described in the Prospectus, the Trust, on behalf of each Fund, is
responsible under its Administration Agreement for the payment of expenses
related to each Fund's operations, including (i) the fees payable to the
Advisers and the Administrator, (ii) the fees and expenses of Trustees who are
not affiliated with the Advisers or the Administrator, (iii) certain fees and
expenses of the Trust's Custodian and Transfer Agent, including the cost of
pricing a Fund's shares, (iv) the
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charges and expenses of the Trust's legal counsel and independent accountants,
(v) brokers' commissions and any issue or transfer taxes chargeable to the
Trust, on behalf of a Fund, in connection with its securities transactions, (vi)
the fees of any trade association of which a Fund or the Trust is a member,
(vii) the cost of share certificates representing shares of a Fund, (viii)
reimbursement of a portion of the organization expenses of a Fund and the fees
and expenses involved in registering and maintaining registration of the Trust
and of its shares with the SEC and registering the Trust as a broker or dealer
and qualifying its shares under state securities laws, including the preparation
and printing of the Trust's registration statements and prospectuses for such
purposes, (ix) allocable communications expenses with respect to investor
services and all expenses of shareholders' and Trustees' meetings and preparing,
printing and mailing prospectuses and reports to shareholders, (x) litigation
and indemnification expenses and other extraordinary expenses not incurred in
the ordinary course of a Fund's business, (xi) any expenses assumed by the Fund
pursuant to its plan of distribution, and (xii) all taxes and business fees
payable by a Fund to federal, state or other governmental agencies. Fees and
expenses of legal counsel, registering shares, holding meetings and
communicating with shareholders include an allocable portion of the cost of
maintaining an internal legal and compliance department.
PORTFOLIO TRANSACTIONS AND BROKERAGE
Purchases and sales of securities on a securities exchange are effected by
brokers, and the Funds pay a brokerage commission for this service. In
transactions on stock exchanges in the United States, these commissions are
negotiated, whereas on many foreign stock exchanges these commissions are fixed.
In the over-the-counter markets, securities (i.e., Municipal Bonds and other
debt securities) are generally traded on a "net" basis with dealers acting as
principal for their own accounts without a stated commission, although the price
of the security usually includes a profit to the dealer. Transactions in
certain over-the-counter securities also may be effected on an agency basis,
when the total price paid (including commission) is equal to or better than the
best total prices available from other sources. In underwritten offerings,
securities are purchased at a fixed price which includes an amount of
compensation to the underwriter, generally referred to as the underwriter's
concession or discount. On occasion, certain money market instruments may be
purchased directly from an issuer, in which case no commissions or discounts are
paid.
Regarding the California Tax Free Fund and New York Tax Free Fund, newly
issued securities normally are purchased directly
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from the issuer or from an underwriter acting as principal. Other purchases and
sales usually are placed with those dealers from which it appears that the best
price or execution will be obtained; those dealers may be acting as either
agents or principals. The purchase price paid by a Fund to underwriters of newly
issued securities usually includes a concession paid by the issuer to the
underwriter, and purchases of after-market securities from dealers normally are
executed at a price between the bid and asked prices.
The primary consideration in placing portfolio security transactions with
broker-dealers for execution is to obtain and maintain the availability of
execution at the most favorable prices and in the most effective manner
possible. The Advisers attempt to achieve this result by selecting broker-
dealers to execute portfolio transactions on behalf of each Fund and their
other clients on the basis of the broker-dealers' professional capability, the
value and quality of their brokerage services and the level of their brokerage
commissions. Consistent with the foregoing primary considerations, the Rules of
Fair Practice of the NASD and such other policies as the Trustees may determine,
the Advisers may consider sales of shares of the Funds as a factor in the
selection of broker-dealers to execute the Funds' portfolio transactions.
NYLIFE Securities (the "Affiliated Broker") may act as broker for the
Trust. In order for the Affiliated Broker to effect any portfolio transactions
for the Trust, the commissions, fees or other remuneration received by the
Affiliated Broker must be reasonable and fair compared to the commissions, fees
or other remuneration paid to other brokers in connection with comparable
transactions involving similar securities being purchased or sold on an exchange
during a comparable period of time. This standard would allow the Affiliated
Broker to receive no more than the remuneration which would be expected to be
received by an unaffiliated broker in a commensurate arms-length transaction.
The Trust will not deal with the Affiliated Broker in any portfolio transaction
in which the Affiliated Broker acts as principal.
Under each Investment Advisory Agreement and as permitted by Section 28(e)
of the Securities Exchange Act of 1934 (the "1934 Act"), the Adviser may cause a
Fund to pay a broker-dealer (except the Affiliated Broker) which provides
brokerage and research services to the Adviser an amount of commission for
effecting a securities transaction for a Fund in excess of the amount other
broker-dealers would have charged for the transaction if the Adviser determines
in good faith that the greater commission is reasonable in relation to the value
of the brokerage and research services provided by the executing
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<PAGE>
broker-dealer viewed in terms of either a particular transaction or the
Adviser's overall responsibilities to the Trust or to its other clients. The
term "brokerage and research services" includes advice as to the value of
securities, the advisability of investing in, purchasing, or selling securities,
and the availability of securities or of purchasers or sellers of securities;
furnishing analyses and reports concerning issuers, industries, securities,
economic factors and trends, portfolio strategy and the performance of accounts;
and effecting securities transactions and performing functions incidental
thereto such as clearance and settlement.
Although commissions paid on every transaction will, in the judgment of the
Advisers, be reasonable in relation to the value of the brokerage services
provided, commissions exceeding those which another broker might charge may be
paid to broker-dealers (except the Affiliated Broker) who were selected to
execute transactions on behalf of the Trust and the Advisers' other clients in
part for providing advice as to the availability of securities or of purchasers
or sellers of securities and services in effecting securities transactions and
performing functions incidental thereto such as clearance and settlement.
Broker-dealers may be willing to furnish statistical, research and other
factual information or services ("Research") to the Advisers for no
consideration other than brokerage or underwriting commissions. Securities may
be bought or sold through such broker-dealers, but at present, unless otherwise
directed by the Trust, a commission higher than one charged elsewhere will not
be paid to such a firm solely because it provided Research to an Adviser.
Research provided by brokers is used for the benefit of all of the Advisers'
clients and not solely or necessarily for the benefit of the Trust. The
Advisers' investment management personnel attempt to evaluate the quality of
Research provided by brokers. Results of this effort are sometimes used by the
Advisers as a consideration in the selection of brokers to execute portfolio
transactions.
In certain instances there may be securities which are suitable for a
Fund's portfolio as well as for that of another Fund or one or more of the other
clients of the Advisers. Investment decisions for a Fund and for the Advisers'
other clients are made with a view to achieving their respective investment
objectives. It may develop that a particular security is bought or sold for
only one client even though it might be held by, or bought or sold for, other
clients. Likewise, a particular security may be bought for one or more clients
when one or more other clients are selling that same security. Some
simultaneous transactions are inevitable when several clients receive investment
advice from the same investment adviser,
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<PAGE>
particularly when the same security is suitable for the investment objectives of
more than one client. When two or more clients are simultaneously engaged in the
purchase or sale of the same security, the securities are allocated among
clients in a manner believed to be equitable to each. It is recognized that in
some cases this system could have a detrimental effect on the price or volume of
the security in a particular transaction as far as a Fund is concerned. The
Trust believes that over time its ability to participate in volume transactions
will produce better executions for the Funds.
The investment advisory fee that the Trust pays on behalf of each Fund to
the Advisers will not be reduced as a consequence of the Advisers' receipt of
brokerage and research services. To the extent a Fund's portfolio transactions
are used to obtain such services, the brokerage commissions paid by the Fund
will exceed those that might otherwise be paid, by an amount which cannot be
presently determined. Such services would be useful and of value to the
Advisers in serving both the Funds and other clients and, conversely, such
services obtained by the placement of brokerage business of other clients would
be useful to the Advisers in carrying out their obligations to the Funds.
Investors may, subject to the approval of the Trust, NYLIFE Distributors and the
Adviser, purchase shares of a Fund with liquid securities that are eligible for
purchase by that Fund and that have a value that is readily ascertainable.
These transactions will be effected only if the Adviser intends to retain the
security in the Fund as an investment. The Trust reserves the right to amend or
terminate this practice at any time.
For the fiscal years ended December 31, 1995 and 1996 and the period
September 1, 1994 through December 31, 1994,* each of the following Funds paid
brokerage commissions as follows:
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<PAGE>
<TABLE>
<CAPTION>
Total Brokerage Total Brokerage Commissions
Commissions Paid Paid to Affiliated Persons
---------------- --------------------------
September 1, 1994 September 1, 1994
Year Ended Year ended through Year ended Year ended through
Dec. 31, 1996 Dec. 31, 1995 Dec. 31, 1994 Dec. 31, 1996 Dec. 31, 1995 Dec. 31, 1994
------------- ------------- ----------------- ------------- ------------- -----------------
<S> <C> <C> <C> <C> <C> <C>
Capital Appreciation Fund.. $ 882,877 $ 681,250 $ 126,845 $ --- $ --- $ ---
Convertible Fund........... 1,952,991 674,139 151,524 --- --- ---
Equity Index Fund.......... 63,111 7,018 2,364 --- --- ---
Government Fund............ 20,809 71,818 27,123 --- --- ---
High Yield Corporate Bond
Fund...................... 1,187,150 1,207,587 333,548 --- 1,970(0%)(1) ---
International Equity Fund+. 215,696 135,267 54,215 --- --- ---
Strategic Income Fund++.... N/A
Total Return Fund.......... 399,858 436,507 102,550 --- --- ---
Value Fund................. 1,354,707 1,055,169 246,712 --- 5,074(0%)(1) 1,540(1%)(1)
</TABLE>
***
<TABLE>
Total Brokerage
Commissions Paid
Total Amount of Transactions to Brokers that
Where Commissions Paid Provided Research
------------------------------------------------------- -----------------------
September 1, 1994
Year Ended Year Ended through Year ended
December 31, 1996 December 31, 1995 December 31, 1994 December 31, 1996
----------------- ----------------- ----------------- -----------------
<S> <C> <C> <C> <C>
Capital Appreciation Fund.. $ 571,478,397(0.0%)(2) $391,017,677(0.0%)(2) $71,345,660(0.0%)(2) $ 880,764
Convertible Fund........... 1,296,465,108(0.0%)(2) 395,570,645(0.0%)(2) 81,374,040(0.0%)(2) 1,942,771
Equity Index Fund.......... 64,348,135(0.0%)(2) 5,863,505(0.0%)(2) 1,660,008 63,111
Government Fund............ 275,083,720(0.0%)(2) 712,117,650(0.0%)(2) 291,468,420(0.0%)(2) 20,809
High Yield Corporate Bond
Fund...................... 2,471,387,854(0.0%)(2) 1,414,045,455(0.0%)(2) 375,961,540(0.0%)(2) 1,084,021
International Equity Fund+. 49,098,906(0.0%)(2) 33,559,758(0.0%)(2) 12,781,223 215,696
Strategic Income Fund++.... N/A
Total Return Fund.......... 271,187,968(0.0%)(2) 604,631,476(0.0%)(2) 153,671,710(0.0%)(2) 398,594
Value Fund................. 848,170,710(0.0%)(2) 544,224,812(0.0%)(2) 141,666,160(0.1%)(2) 1,347,479
</TABLE>
- ----------
* The Funds changed their fiscal year end from August 31 to December 31.
(1) Percent of total commissions paid.
(2) Percent of total transactions involving the payment of commissions effected
through affiliated persons.
+ The International Equity Fund commenced operations on September 13, 1994.
++ The Strategic Income Fund commenced operations on February 28, 1997.
The California Tax Free Fund, International Bond Fund, Money Market Fund,
New York Tax Free Fund and Tax Free Bond Fund paid no brokerage commissions
during the year ended December 31, 1996, the year ended December 31, 1995, and
the period from September 1, 1994 through December 31, 1994.
Capital Appreciation Fund held common stock in Schwab (Charles) valued at
$14,480,000 and commercial paper of American Express Credit Corp. valued at
$22,585,000; Convertible Fund held commercial paper of American Express Credit
Corp. valued at $38,000,000; Total Return Fund held long-term bonds of
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<PAGE>
Lehman Brothers Holdings Inc., 7.375%, due 5/15/07, valued at $2,623,462, long-
term bonds of Merrill Lynch & Co., Inc., 6.65%, due 1/15/99, valued at
$4,016,442, long-term bonds of PaineWebber Group Inc., 7.75%, due 9/1/02, valued
at $1,032,540, long-term bonds of Salomon Inc., 6.70%, due 12/1/98, valued at
$2,182,152, common stock in Schwab (Charles) valued at $7,472,000 and commercial
paper of American Express Credit Corp. valued at $15,285,000; Value Fund held
commercial paper of American Express Credit Corp. valued at $21,922,000.
Investors may, subject to the approval of the Trust, NYLIFE Distributors
and the Adviser to the particular Fund, purchase shares of a Fund with liquid
securities that are eligible for purchase by that Fund and that have a value
that is readily ascertainable. These transactions will be effected only if the
Adviser intends to retain the security in the Fund as an investment. The Trust
reserves the right to amend or terminate this practice at any time.
NET ASSET VALUE
The net asset value per share of each Fund (other than the Money Market
Fund) is determined by the Trust daily as of the close of regular trading on the
New York Stock Exchange (currently 4:00 p.m., Eastern time) on each day when the
New York Stock Exchange is open for trading. The net asset value per share of
the Money Market Fund is also determined at noon on such days.
Portfolio securities of the Money Market Fund are valued at their amortized
cost, which does not take into account unrealized securities gains or losses.
While this method provides certainty in valuation, it may result in periods
during which value, as determined by amortized cost, is higher or lower than the
price the Money Market Fund would receive if it sold the instrument. During
periods of declining interest rates, the quoted yield on shares of the Money
Market Fund may tend to be higher than a like computation made by a fund with
identical investments utilizing a method of valuation based upon market prices
and estimates of market prices for all of its portfolio instruments. Thus, if
the use of amortized cost by the Money Market Fund resulted in a lower aggregate
portfolio value on a particular day, a prospective investor in the Money Market
Fund would be able to obtain a somewhat higher yield if he or she purchased
shares of the Money Market Fund on that day, than would result from investment
in a fund utilizing solely market values, and existing investors in the Money
Market Fund would receive less investment income. The converse would apply in a
period of rising interest rates.
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<PAGE>
Portfolio securities of each other Fund are valued (a) by appraising common
and preferred stocks which are traded on the New York Stock Exchange at the last
sale price on that Exchange on the day as of which assets are valued or, if no
sale occurs, at the mean between the closing bid price and asked price, (b) by
appraising other common and preferred stocks as nearly as possible in the manner
described in clause (a) if traded on any other exchange, including the National
Association of Securities Dealers National Market System and foreign securities
exchanges, (c) by appraising over-the-counter common and preferred stocks quoted
on the National Association of Securities Dealers NASDAQ system (but not listed
on the National Market System) at the closing bid price supplied through such
system, (d) by appraising over-the-counter common and preferred stocks not
quoted on the NASDAQ system and securities listed or traded on certain foreign
exchanges whose operations are similar to the U.S over-the-counter market at
prices supplied by a pricing agent selected by the Adviser if those prices are
deemed by the Adviser to be representative of market values at the first close
of business of the New York Stock Exchange, (e) by appraising debt securities at
prices supplied by a pricing agent selected by the Adviser, which prices reflect
broker-dealer-supplied valuations and electronic data processing techniques if
those prices are deemed by the Adviser to be representative of market values at
the first close of business of the New York Stock Exchange, (f) by appraising
exchange-traded options and futures contracts at the last posted settlement
price on the market where any such option or futures contract is principally
traded and (g) by appraising all other securities and other assets, including
over-the-counter common and preferred stocks not quoted on the NASDAQ system,
securities listed or traded on certain foreign exchanges whose operations are
similar to the U.S. over-the-counter market and debt securities for which prices
are supplied by a pricing agent but are not deemed by the Adviser to be
representative of market values, but excluding money market instruments with a
remaining maturity of 60 days or less and including restricted securities and
securities for which no market quotation is available, at fair value in
accordance with procedures approved by and determined in good faith by the
Trustees, although the actual calculation may be done by others. Money market
instruments held by the Funds with a remaining maturity of 60 days or less will
be valued by the amortized cost method unless such method does not represent
fair value. Forward foreign currency exchange contracts held by the Funds are
valued at their respective fair market values determined on the basis of the
mean between the last current bid and asked prices based on dealer or exchange
quotations.
Portfolio securities traded on more than one U.S. national securities
exchange or foreign securities exchange are valued at
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<PAGE>
the last sale price on the business day as of which such value is being
determined at the close of the exchange representing the principal market for
such securities. The value of all assets and liabilities expressed in foreign
currencies will be converted into U.S. dollar values at the mean between the
buying and selling rates of such currencies against U.S. dollars last quoted by
any major bank or broker-dealer. If such quotations are not available, the rate
of exchange will be determined in accordance with policies established by the
Trustees. The Trust recognizes dividend income and other distributions on the
ex-dividend date, except that certain dividends from foreign securities are
recognized as soon as the Trust is informed after the ex-dividend date.
Trading in securities on European and Far Eastern securities exchanges and
over-the-counter markets is normally completed well before the close of business
on each business day in New York (i.e., a day on which the New York Stock
---
Exchange is open for trading). In addition, European or Far Eastern securities
trading generally in a particular country or countries may not take place on all
business days in New York. Furthermore, trading takes place in Japanese markets
on certain Saturdays and in various foreign markets on days which are not
business days in New York and on which the Funds' net asset values are not
calculated. Such calculation of net asset value does not take place
contemporaneously with the determination of the prices of the majority of the
portfolio securities used in such calculation.
Events affecting the values of portfolio securities that occur between the
time their prices are determined and the close of the New York Stock Exchange
will not be reflected in the Funds' calculation of net asset values unless the
Adviser deems that the particular event would materially affect net asset value,
in which case an adjustment will be made.
Because the Guarantee regarding the Equity Index Fund is payable to
shareholders directly (and not payable to the Equity Index Fund), and because it
represents only a contingent liability rather than an agreement to pay a
definite amount on the Guarantee Date, the Trustees believe that the Guarantee
should have no impact in determining the Equity Index Fund's net asset value.
The proceeds received by each Fund for each issue or sale of its shares,
and all net investment income, realized and unrealized gain and proceeds
thereof, subject only to the rights of creditors, will be specifically allocated
to such Fund and constitute the underlying assets of that Fund. The underlying
assets of each Fund will be segregated on the books of account,
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<PAGE>
and will be charged with the liabilities in respect to such Fund and with a
share of the general liabilities of the Trust. Expenses with respect to any two
or more Funds will be allocated in proportion to the net asset values of the
respective Funds except where allocations of direct expenses can otherwise be
fairly made.
To the extent that any newly organized fund or class of shares receives, on
or before December 31, any seed capital, the net asset value of such fund(s) or
class(es) will be calculated as of December 31.
SHAREHOLDER INVESTMENT ACCOUNT
A Shareholder Investment Account is established for each investor in the
Funds, under which a record of the shares of each Fund held is maintained by the
Transfer Agent. If a share certificate is desired, it must be requested in
writing for each transaction. There is no charge to the investor for issuance
of a certificate. Whenever a transaction takes place in a Fund (other than the
Money Market Fund), the shareholder will be mailed a confirmation showing the
transaction. Shareholders will be sent a quarterly statement showing the status
of the Account. In addition, shareholders will be sent a monthly statement for
each month in which a transaction occurs.
SHAREHOLDER SERVICING AGENT
The Glass-Steagall Act prohibits national banks from engaging in the
business of underwriting, selling or distributing securities. There is
currently no precedent prohibiting banks from performing shareholder servicing
and recordkeeping functions. Changes in federal or state statutes and
regulations pertaining to the permissible activities of banks and their
affiliates or subsidiaries, as well as further judicial or administrative
decisions or interpretations of those provisions, could prevent a bank from
continuing to perform all or a part of such services. If a bank were prohibited
from so acting, the Trustees would consider what actions, if any, would be
necessary to continue to provide efficient and effective shareholder services.
It is not expected that shareholders would suffer any adverse financial
consequences as a result of any of these occurrences.
PURCHASES, REDEMPTION AND REPURCHASE
LETTER OF INTENT ("LOI")
The LOI is a non-binding obligation on the Qualified Purchaser to purchase
the full amount indicated; however, on the
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<PAGE>
initial purchase, if required (or, on subsequent purchases if necessary), 5% of
the dollar amount specified in the LOI will be held in escrow by the Transfer
Agent in shares registered in the shareholder's name in order to assure payment
of the proper sales charge. If total purchases pursuant to the LOI (less any
dispositions and exclusive of any distribution on such shares automatically
reinvested) are less than the amount specified, the investor will be requested
to remit to the Distributor an amount equal to the difference between the sales
charge paid and the sales charge applicable to the aggregate purchases actually
made. If not remitted within 20 days after written request, an appropriate
number of escrowed shares will be redeemed in order to realize the difference.
SUSPENSION OF REDEMPTIONS
The Trust may suspend the right of redemption of shares of any Fund and may
postpone payment for any period: (i) during which the New York Stock Exchange
is closed other than customary weekend and holiday closings or during which
trading on the New York Stock Exchange is restricted; (ii) when the SEC
determines that a state of emergency exists which may make payment or transfer
not reasonably practicable; (iii) as the SEC may by order permit for the
protection of the security holders of the Trust; or (iv) at any other time when
the Trust may, under applicable laws and regulations, suspend payment on the
redemption or repurchase of its shares.
TAX-DEFERRED RETIREMENT PLANS
CASH OR DEFERRED PROFIT SHARING PLANS UNDER SECTION 401(K) FOR CORPORATIONS AND
SELF-EMPLOYED INDIVIDUALS
Shares of a Fund, except the California Tax Free Fund, New York Tax Free
Fund and Tax Free Bond Fund, may also be purchased as an investment under a
specimen cash or deferred profit sharing plan intended to qualify under Section
401(k) of the Code (a "401(k) Plan") adopted by a corporation, a self-employed
individual (including sole proprietors and partnerships), or other organization.
All Funds, except the California Tax Free Fund, New York Tax Free Fund and Tax
Free Bond Fund, may be used as funding vehicles for qualified retirement plans
including 401(k) plans, which may be administered by third-party administrator
organizations. NYLIFE Distributors does not sponsor or administer such
qualified plans at this time.
INDIVIDUAL RETIREMENT ACCOUNT ("IRA")
Shares of a Fund, except the California Tax Free Fund, New York Tax Free
Fund and Tax Free Bond Fund, may also be purchased
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<PAGE>
as an underlying investment for an IRA made available by NYLIFE Distributors.
An individual may contribute as much as $2,000 of his or her earned income
to an IRA. A married individual filing a joint return may also contribute to an
IRA for a nonworking spouse. For tax years beginning after 1996, the maximum
deduction allowed for a contribution to a spousal IRA is the lesser of (i)
$2,000 or (ii) the sum of (a) the compensation includible in the working
spouse's gross income plus (b) any compensation includible in the gross income
of the nonworking spouse, reduced by the amount of the deduction taken by the
working spouse. The maximum deduction for a IRA contribution by a married
couple is $4,000.
An individual who has not attained age 70-1/2 may make an IRA contribution
which is deductible for federal income tax purposes only if (i) neither the
individual nor his or her spouse (unless filing separate returns and living
apart at all times during the taxable year) is an active participant in an
employer's retirement plan, or (ii) the individual (and his or her spouse, if
applicable) has an adjusted gross income below a certain level ($40,000 for
married individuals filing a joint return, with a phase-out of the deduction for
adjusted gross income between $40,000 and $50,000; $25,000 for a single
individual, with a phase-out for adjusted gross income between $25,000 and
$35,000). However, an individual not permitted to make a deductible
contribution to an IRA may nonetheless make nondeductible contributions up to
the maximum contribution limit for that year. The deductibility of IRA
contributions under state law varies from state to state.
Distributions from IRAs (to the extent they are not treated as a tax-free
return of nondeductible contributions) are taxable under federal income tax laws
as ordinary income. There are special rules for determining how withdrawals are
to be taxed if an IRA contains both deductible and nondeductible amounts. In
general, all IRAs are aggregated and treated as one IRA, all withdrawals are
treated as one withdrawal, and then a proportionate amount of the withdrawal
will be deemed to be made from nondeductible contributions; amounts treated as a
return of nondeductible contributions will not be taxable. Certain early
withdrawals are subject to an additional excise tax. There are also special
rules governing when IRA distributions must begin and the minimum amount of such
distributions; failure to comply with these rules can result in the imposition
of an excise tax.
All income and capital gains deriving from IRA investments in the Fund are
reinvested and compound tax-deferred until distributed from the IRA. The
combination of annual
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<PAGE>
contributions which may be deductible and tax-deferred
compounding can lead to substantial retirement savings.
403(B)(7) TAX SHELTERED ACCOUNT
Shares of a Fund, except the California Tax Free Fund, New York Tax Free
Fund and Tax Free Bond Fund, may also be purchased as the underlying investment
for tax sheltered custodial accounts made available by NYLIFE Distributors. In
general, employees of tax-exempt organizations described in Section 501(c)(3) of
the Code (such as hospitals, churches, religious, scientific, or literary
organizations and educational institutions) or a public school system are
eligible to participate in a 403(b) plan.
GENERAL INFORMATION
Shares of a Fund, except the California Tax Free Fund, New York Tax Free
Fund and Tax Free Bond Fund, may also be a permitted investment under profit
sharing, pension, and other retirement plans, IRAs, and tax-deferred annuities
other than those offered by the Fund depending on the provisions of the relevant
plan. Third-party administrative services, available for some corporate plans,
may limit or delay the processing of transactions.
The custodial agreements and forms provided by the Funds' Custodian and
Transfer Agent designate New York Life Trust Company as custodian for IRAs and
403(b) plans (unless another trustee or custodian is designated by the
individual or group establishing the plan) and contain specific information
about the plans. Each plan provides that dividends and distributions will be
reinvested automatically. For further details with respect to any plan,
including fees charged by New York Life Trust Company, tax consequences and
redemption information, see the specific documents for that plan.
The federal tax laws applicable to retirement plans, IRAs and 403(b) plans
are extremely complex and change from time to time. Therefore, an investor
should consult with his or her own professional tax adviser before establishing
any of the tax-deferred retirement plans described above.
CALCULATION OF PERFORMANCE QUOTATIONS
From time to time, quotations of the Money Market Fund's "yield" and
"effective yield" may be included in advertisements or communications to
shareholders. These performance figures are calculated in the following manner:
B-137
<PAGE>
A. Yield -- the net annualized yield based on a specified seven-
-----
calendar day period calculated at simple interest rates. Yield is
calculated by determining the net change, exclusive of capital changes, in
the value of a hypothetical preexisting account having a balance of one
share at the beginning of the period, subtracting a hypothetical charge
reflecting deductions from shareholder accounts, and dividing the
difference by the value of the account at the beginning of the base period
to obtain the base period return. The yield is annualized by multiplying
the base period return by 365/7. The yield figure is stated to the nearest
hundredth of one percent. The yield of the Class A and Class B shares of
the Money Market Fund for the seven-day period ended December 31, 1996 was
5.12% and 5.12%, respectively.
B. Effective Yield -- the net annualized yield for a specified seven-
---------------
calendar day period assuming a reinvestment of dividends (compounding).
Effective yield is calculated by the same method as yield except the yield
figure is compounded by adding one, raising the sum to a power equal to 365
divided by 7, and subtracting one from the result, according to the
following formula: Effective Yield = [(Base Period Return + 1) /365/7/] -
1. The effective yield of the Class A and Class B shares of the Money
Market Fund for the seven-day period ended December 31, 1996 was 5.25% and
5.25%, respectively.
The yield and effective yield of the Money Market Fund reflect the
reduction of certain fees otherwise payable and voluntary expense
limitations. Had there been no reduction of fees or expense limitations,
the yield and effective yield of the Money Market Fund would have been
5.05% and 5.17%, respectively, for Class A shares and 5.05% and 5.17%,
respectively, for Class B shares for the seven-day period ended December
31, 1996.
As described above, yield and effective yield are based on historical
earnings and are not intended to indicate future performance. The "effective
yield" will be slightly higher than the "yield" because of the compounding
effect of the assumed reinvestment of dividends. Yield and effective yield will
vary based on changes in market conditions and the level of expenses.
From time to time a Fund, other than the Money Market Fund, may publish its
yield and/or average annual total return in advertisements and communications to
shareholders. Total return and yield are computed separately for Class A and
Class B shares. The average annual total return of each Fund is determined for
a
B-138
<PAGE>
particular period by calculating the actual dollar amount of the investment
return on a $1,000 investment in the Fund made at the maximum public offering
price at the beginning of the period, and then calculating the annual compounded
rate of return which would produce that amount. Total return for a period of
one year is equal to the actual return of the Fund during that period. This
calculation assumes a complete redemption of the investment and the deduction of
the maximum contingent deferred sales charge at the end of the period in the
case of Class B shares. In the case of Class A shares, the calculation assumes
the maximum sales charge is deducted from the initial $1,000 purchase order. It
also assumes that all dividends and distributions are reinvested at net asset
value on the reinvestment dates during the period. The performance information
shown below for the period ended December 31, 1996 provides performance figures
for both Class A and Class B shares of the Funds, except in the case of the
Equity Index Fund which offers only one class of shares, Class A shares.
In considering any average annual total return quotation, investors should
remember that the maximum initial sales charge reflected in each quotation for
Class A shares is a one-time fee which will have its greatest impact during the
early stages of an investor's investment in the Fund. The actual performance of
your investment will be affected less by this charge the longer you retain your
investment in the Fund.
Quotations of each Fund's average annual total return will be calculated
according to the following SEC formula:
P(1+T)/n /= ERV
where:
P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years
ERV = ending redeemable value of a hypothetical $1,000 payment made at the
beginning of the 1, 5 or 10-year periods at the end of the 1, 5, or
10-year periods (or fractional portion thereof)
Each Fund may quote total rates of return in addition to its average annual
total return. Such quotations are computed in the same manner as the average
annual compounded rate, except that such quotations will be based on a Fund's
actual return for a specified period as opposed to its average return over 1, 5,
and 10-year periods. In considering any total rate of return quotation,
investors should remember that the maximum initial
B-139
<PAGE>
sales charge reflected in each quotation for Class A shares is a one-time fee
which will have its greatest impact during the early stages of an investor's
investment in the Fund. The actual performance of your investment will be
affected less by this charge the longer you retain your investment in the Fund.
The average annual total returns of the Class A shares of the following
Funds for the one-year and, as applicable, five-year periods ended December 31,
1996 and the period from inception to December 31, 1996 were as follows:*
<TABLE>
<CAPTION>
Five Average
Year Years Annual
Ended Ended Total Inception
Fund 12/31/96 12/31/96 Return(a) Date
---- -------- -------- --------- ---------
<S> <C> <C> <C> <C>
California Tax Free Fund...... -1.22% 5.63% 5.76% 10/01/91
Capital Appreciation Fund(b).. 12.61% 13.76% 14.06% 5/01/86
Convertible Fund(b)........... 5.96% 12.73% 9.86% 5/01/86
Equity Index Fund............. 18.38% 13.36% 15.60% 12/20/90
Government Fund(b)............ -2.62% 3.89% 6.30% 5/01/86
High Yield Corporate
Bond Fund(b)................. 11.09% 14.95% 10.33% 5/01/86
International Bond Fund(b).... 8.77% -- 11.82% 9/13/94
International Equity Fund(b).. 3.75% -- 2.85% 9/13/94
New York Tax Free Fund........ -1.58% 5.86% 5.98% 10/01/91
Strategic Income Fund......... -- -- -- 2/28/97
Tax Free Bond Fund(b)......... -1.03% 5.06% 5.93% 5/01/86
Total Return Fund(b).......... 7.00% 8.99% 11.88% 12/29/87
Value Fund(b)................. 15.14% 14.95% 11.86% 5/01/86
</TABLE>
- -----------------
* Assumes the deduction of the maximum applicable initial sales charge.
(a) From inception to 12/31/96.
(b) Performance figures for the Fund's Class A shares, first offered to the
public on January 3, 1995, include the historical performance of the Fund's
Class B shares for the period from inception through December 31, 1994.
Performance data for the two classes after this date vary based on
differences in their expense structures.
The average annual total returns of the Class B shares of the following
Funds for the one-year and, as applicable, five-year periods ended December 31,
1996, were as follows:
B-140
<PAGE>
<TABLE>
<CAPTION>
Five Average
Year Years Annual
Ended Ended Total Inception
Fund 12/31/96 12/31/96 Return(a) Date
---- -------- -------- ------ ---------
<S> <C> <C> <C> <C>
California Tax Free Fund(b).. -1.90% 6.18% 6.43% 10/01/91
Capital Appreciation Fund.... 13.56% 14.60% 14.56% 5/01/86
Convertible Fund............. 6.39% 13.50% 10.32% 5/01/86
Government Fund.............. -3.75% 4.24% 6.63% 5/01/86
High Yield Corporate
Bond Fund................... 10.58% 15.53% 10.69% 5/01/86
International Bond Fund...... 8.13% -- 12.34% 9/13/94
International Equity Fund.... 4.05% -- 3.43% 9/13/94
New York Tax Free Fund(b).... -2.14% 6.43% 6.67% 10/01/91
Strategic Income Fund........ -- -- -- 2/28/97
Tax Free Bond Fund........... -1.67% 5.63% 6.35% 5/01/86
Total Return Fund............ 7.73% 9.74% 12.46% 12/29/87
Value Fund................... 16.11% 15.77% 12.33% 5/01/86
</TABLE>
- ----------
* Assumes a complete redemption at the end of each year and the deduction of
the maximum applicable contingent deferred sales charge.
(a) From inception to 12/31/96.
(b) Performance figures for the Fund's Class B shares, first offered to the
public on January 3, 1995, include the historical performance of the Fund's
Class A shares for the period from inception through December 31, 1994.
Performance data for the two classes after this date vary based on
differences in their expense structures.
The average annual total returns of the Class A shares of the following
Funds without deducting the applicable initial sales charge is as follows:
<TABLE>
<CAPTION>
Five Average
Year Years Annual
Ended Ended Total Inception
Fund 12/31/96 12/31/96 Return(a) Date
---- -------- -------- ------ ---------
<S> <C> <C> <C> <C>
California Tax Free Fund...... 3.44% 6.61% 6.69% 10/01/91
Capital Appreciation Fund(b).. 19.16% 15.06% 14.66% 5/01/86
Convertible Fund(b)........... 12.13% 14.02% 10.44% 5/01/86
Equity Index Fund............. 22.04% 14.05% 16.19% 12/20/90
Government Fund(b)............ 1.97% 4.85% 6.76% 5/01/86
High Yield Corporate
Bond Fund(b)................. 16.33% 16.01% 10.80% 5/01/86
International Bond Fund(b).... 13.90% -- 14.07% 9/13/94
International Equity Fund(b).. 9.78% -- 5.40% 9/13/94
New York Tax Free Fund........ 3.06% 6.84% 6.91% 10/01/91
Strategic Income Fund......... -- -- -- 2/28/97
Tax Free Bond Fund(b)......... 3.63% 6.04% 6.39% 5/01/86
Total Return Fund(b).......... 13.22% 10.23% 12.59% 12/29/87
Value Fund(b)................. 21.84% 16.26% 12.45% 5/01/86
</TABLE>
- ----------
(a) From inception to 12/31/96.
(b) Performance figures for the Fund's Class A shares, first offered to the
public on January 3, 1995, include the historical performance of the Fund's
Class B shares for the period from inception through December 31, 1994.
Performance data for the two classes after this date vary based on
differences in their expense structures.
The average annual total returns of the Class B shares of the following
Funds without deducting the applicable contingent deferred sales charge is as
follows:
B-141
<PAGE>
<TABLE>
<CAPTION>
Five Average
Year Years Annual
Ended Ended Total Inception
Fund 12/31/96 12/31/96 Return(a) Date
---- -------- -------- ------ ---------
<S> <C> <C> <C> <C>
California Tax Free Fund(b).. 3.10% 6.49% 6.58% 10/01/91
Capital Appreciation Fund.... 18.56% 14.83% 14.56% 5/01/86
Convertible Fund............. 11.39% 13.74% 10.32% 5/01/86
Government Fund.............. 1.25% 4.58% 6.63% 5/01/86
High Yield Corporate
Bond Fund................... 15.58% 15.75% 10.69% 5/01/86
International Bond Fund...... 13.13% -- 13.46% 9/13/94
International Equity Fund.... 9.05% -- 4.67% 9/13/94
New York Tax Free Fund(b).... 2.86% 6.74% 6.82% 10/01/91
Strategic Income Fund........ -- -- -- 2/28/97
Tax Free Bond Fund........... 3.33% 5.95% 6.35% 5/01/86
Total Return Fund............ 12.73% 10.02% 12.46% 12/29/87
Value Fund................... 21.11% 15.99% 12.33% 5/01/86
</TABLE>
- ----------
(a) From inception to 12/31/96.
(b) Performance figures for the Fund's Class B shares, first offered to the
public on January 3, 1995, include the historical performance of the Fund's
Class A shares for the period from inception through December 31, 1994.
Performance data for the two classes after this date vary based on
differences in their expense structures.
The performance data quoted represents historical performance and the
investment return and principal value of an investment will fluctuate so that an
investor's shares, when redeemed, may be worth more or less than their original
cost.
The yield of each Fund, except the Money Market Fund, is computed by
dividing its net investment income (determined in accordance with the following
SEC formula) earned during a recent 30-day period by the product of the average
daily number of shares outstanding and entitled to receive dividends during the
period and the maximum offering price per share on the last day of the period.
The results are compounded on a bond equivalent (semiannual) basis and then they
are annualized. Yield will be calculated using the following SEC formula:
Yield = 2[(a-b +1)/6/ -1]
---
cd
where:
a = 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
B-142
<PAGE>
This yield figure does not reflect the deduction of any contingent deferred
sales charges which are imposed upon certain redemptions at the rates set forth
under "Redemptions and Repurchases" in the Prospectus.
For the 30-day period ended December 31, 1996, the yield of each of the
following Funds was:
<TABLE>
<CAPTION>
30-Day
Period Ended
December 31,
1996
------------
Fund Class A Class B
---- ------- -------
<S> <C> <C>
California Tax Free Fund........ 4.86% 4.81%
Government Fund................. 5.66% 5.38%
High Yield Corporate Bond Fund.. 7.38% 7.13%
International Bond Fund......... 3.57% 3.19%
New York Tax Free Fund.......... 4.73% 4.68%
Tax Free Bond Fund.............. 5.47% 5.52%
</TABLE>
The California Tax Free Fund, New York Tax Free Fund and Tax Free Bond Fund
may publish its tax equivalent yield in advertisements and communications to
shareholders. The tax equivalent yield is calculated by determining the rate of
return that would have to be achieved on a fully taxable investment to produce
the after-tax equivalent of the Fund's yield, assuming certain tax brackets for
a Fund shareholder.
For the 30-day period ended December 31, 1996, the Federal income tax
equivalent yield for the California Tax Free Fund, New York Tax Free Fund or Tax
Free Bond Fund was as shown in the following table.*+
B-143
<PAGE>
<TABLE>
<CAPTION>
To Equal a 5.50% Tax
If Free Return, a Taxable
Your Federal Investment Would Have to
Marginal Tax Earn Without Fee Reduction
Rate is: or Expense Limit
------------ ---------------------------
<S> <C>
15.00% 6.47%
28.00% 7.64%
31.00% 7.97%
36.00% 8.59%
39.60% 9.11%
</TABLE>
- ----------
* This table reflects application of the regular Federal income tax only;
other taxes may be applicable with respect to a particular shareholder.
Such taxes could change the information shown. Tax rates are subject to
change. Investors in the California and New York Tax Free Funds should in
particular note that the chart does not reflect any state and local taxes
that may be deductible in computing Federal income tax liability.
+ This table is for illustrative purposes only; investors should consult
their tax advisers with respect to the tax implications of an investment in
a Fund that invests primarily in securities, the interest on which is
exempt from regular Federal income tax.
A Fund may also include its current dividend rate in its prospectus, in
supplemental sales literature, or in communications to shareholders. The
current dividend rate of each Fund for a particular period is calculated by
annualizing total distributions per share from net investment income (including
equalization credits, excluding realized short-term capital gains and premiums
from writing options) during this period and dividing this amount by the maximum
offering price per share on the last day of the period. The current dividend
rate does not reflect all components of a Fund's performance including (i)
realized and unrealized capital gains and losses, which are reflected in
calculations of a Fund's total return, or (ii) the amortized discount and
premium on debt obligations in income using the current market value of the
obligations, as is currently required for yield calculations. In addition, the
current dividend rate does not take into account the imposition of any
contingent deferred sales charge on the redemption of Fund
B-144
<PAGE>
shares. Any performance figure which does not take into account the contingent
deferred sales charge would be reduced to the extent such charge is imposed upon
a redemption.
Investors should note that the investment results of a Fund will fluctuate
over time, and any presentation of a Fund's yield, current dividend rate, total
return or tax-equivalent yield of any prior period should not be considered as a
representation of what an investment may earn or what an investor's yield,
current dividend rate, total return or tax-equivalent yield may be in any future
period.
In addition, advertising for a Fund may indicate that investors may
consider diversifying their investment portfolios in order to seek protection of
the value of their assets against inflation. From time to time, advertising
materials for a Fund may refer to or discuss current or past business,
political, economic or financial conditions, including events as they relate to
those conditions, such as any U.S. monetary or fiscal policies and the current
rate of inflation. In addition, from time to time, advertising materials for a
Fund may include information concerning retirement and investing for retirement
and may refer to the approximate number of then-current Fund shareholders,
shareholder accounts and Fund assets.
From time to time, advertising and sales literature for a Fund may discuss
the investment philosophy, personnel and assets under management of the Fund's
investment adviser, and other pertinent facts relating to the management of the
Fund by the adviser.
From time to time any of the Funds may publish an indication of its past
performance as measured by independent sources such as Lipper Analytical
Services, Incorporated, Weisenberger Investment Companies Service, Donoghue's
Money Fund Report, Spot Market Prices, Barron's, BusinessWeek, Kipplinger's
-------- ------------ ------------
Personal Finance, Financial World, Forbes, Money, Morningstar, Personal
- ---------------- --------------- ------ ----- ----------- --------
Investor, Sylvia Porter's Personal Finance, and The Wall Street Journal.
- -------- --------------- ---------------- -----------------------
In addition, performance information for a Fund may be compared, in
advertisements, sales literature, and reports to shareholders, to: (i)
unmanaged indexes, such as the Standard & Poor's 500 Composite Stock Price
Index, the Salomon Brothers Broad Investment Grade Bond Index, the Morgan
Stanley Capital International indexes; the Dow Jones Industrial Average,
Donoghue Money Market Institutional Averages, the Merrill Lynch 1 to 3 Year
Treasury Index, the Salomon Brothers World Government Benchmark Bond Index, the
Salomon Brothers non-U.S. Dollar World Government Bond Index, the Lehman
Brothers Municipal Bond Index and the Lehman Brothers Government Corporate
Index; (ii) other
B-145
<PAGE>
groups of mutual funds tracked by Morningstar Inc. or Lipper Analytical
Services, widely used independent research firms which rank mutual funds by
overall performance, investment objectives and assets, or tracked by other
services, companies, publications or persons who rank mutual funds on overall
performance or other criteria; and (iii) the Consumer Price Index (measure for
inflation) and other measures of the performance of the economy to assess the
real rate of return from an investment in the Funds. Unmanaged indexes may
assume the reinvestment of dividends but generally do not reflect deductions for
administrative and management costs and expenses.
From time to time, advertisements for the Funds may include general
information about the services and products offered by the Funds, MainStay
Institutional Funds Inc. and New York Life Insurance Company and its
subsidiaries. For example, such advertisements may include statistical
information about those entities including, but not limited to, the number of
current shareholder accounts, the amount of assets under management, sales
information, the distribution channels through which the entities' products are
available, marketing efforts and statements about this information by the
entities' officers, directors and employees.
TAX STATUS
TAXATION OF THE FUNDS
Each Fund intends to be treated as a regulated investment company ("RIC")
under Subchapter M of the Code. Such qualification does not involve supervision
of management or investment practices or policies by any governmental agency or
bureau.
As a regulated investment company required under Subchapter M of the Code
to distribute at least 90% of its taxable net investment income and net short-
term capital gain in excess of net long-term capital losses (and at least 90%
of net tax-exempt interest income), each Fund generally will not be subject to
federal income or excise tax on any of its net investment income or net realized
capital gains which are timely distributed to shareholders. Provided that a
Fund qualifies as a regulated investment company, it generally will not be
subject to any excise or income taxes in Massachusetts. A Fund's investments,
if any, in REMIC residual interests (as explained previously in this SAI) or in
Passive Foreign Investment Companies, as explained below, may cause the Fund to
become liable for certain taxes. Investors that are tax-exempt organizations
should carefully consider whether distributions of a Fund's earnings will be
subject to tax in their hands.
B-146
<PAGE>
Each Fund, other than the Equity Index Fund (which offers only one class of
shares) has received a ruling from the IRS to the effect that differing
distributions between the classes of its shares will not result in a Fund's
dividends and other distributions being regarded as "preferential dividends"
under the Code. Generally, a preferential dividend is a dividend which a Fund
cannot treat as having been distributed for purposes of (i) determining whether
the Fund qualifies as a regulated investment company for federal tax purposes,
and (ii) determining the Fund's tax liability.
CHARACTER OF DISTRIBUTIONS TO SHAREHOLDERS -- GENERAL
Assuming a Fund qualifies as a RIC, distributions of taxable net investment
income and net short-term capital gains in excess of net long-term capital
losses will be treated as ordinary income in the hands of shareholders. If a
Fund's investment income is derived exclusively from interest rather than
dividends, no portion of such distributions will be eligible for the dividends-
received deduction available to corporations. If a portion of a Fund's net
investment income is derived from dividends from domestic corporations, then a
portion of such distributions may be eligible for the corporate dividends-
received deduction. The dividends-received deduction is reduced to the extent
shares of a Fund are treated as debt-financed under the Code and is eliminated
if such shares are deemed to have been held for less than 46 days. In addition,
the entire dividend (including the deducted portion) is includable in the
corporate shareholder's alternative minimum taxable income. Finally, if such
dividends are large enough to constitute "extraordinary dividends" under Section
1059 of the Code, the shareholder's basis in its shares could be reduced by all
or a portion of the amount of the dividends that qualifies for the dividends-
received deduction.
Distributions of the excess of net long-term capital gain over net short-
term capital loss are taxable to shareholders as long-term capital gain, if such
distributions are designated as capital gain dividends, regardless of the length
of time the shares of a Fund have been held by such shareholders. Such
distributions are not eligible for the corporate dividends-received deduction.
Any loss realized upon the redemption of shares within six months from the date
of their purchase will be treated as a long-term capital loss to the extent of
any capital gain dividends received with respect to such shares during that six-
month period. A loss realized upon a redemption of shares of a Fund within 30
days before or after a purchase of shares of the same Fund (whether by
reinvestment of distributions or otherwise) may be disallowed in whole or in
part.
B-147
<PAGE>
If any net long-term capital gains in excess of net short-term capital
losses are retained by a Fund for reinvestment, requiring federal income taxes
to be paid thereon by that Fund, the Fund intends to elect to treat such capital
gains as having been distributed to shareholders. As a result, such amounts
will be taxable as long-term capital gains in the hands of the shareholders.
Shareholders will be able to claim their proportionate share of the federal
income taxes paid by the Fund on such gains as a credit against their own
federal income tax liabilities and will be entitled to increase the adjusted tax
basis of the relevant Fund shares by the difference between their pro-rata share
of such gains and their tax credit.
Except for distributions by the Money Market Fund, distributions by a Fund
result in a reduction in the net asset value of a Fund's shares. Should a
distribution reduce the net asset value below a shareholder's cost basis, such
distribution nevertheless would be taxable to the shareholder (except to the
extent the distribution is an exempt interest dividend as described below) as
ordinary income or capital gain as described above, even though, from an
investment standpoint, it may constitute a partial return of investment. In
particular, investors should be careful to consider the tax implications of
buying shares just prior to a distribution. The price of shares purchased at
that time includes the amount of the forthcoming distribution. Those investors
purchasing shares just prior to a distribution will then receive a partial
return of their investment upon such distribution, which may nevertheless be
taxable to them.
Distributions of taxable net investment income and net realized capital
gains will be taxable as described above, whether received in shares or in cash.
Any distributions that are not from a Fund's net investment income or net
capital gain may be characterized as a return of capital to shareholders or, in
some cases, as capital gain. Shareholders electing to receive distributions in
the form of additional shares will have a cost basis for federal income tax
purposes in each share so received equal to the net asset value of such share on
the reinvestment date.
CHARACTER OF DISTRIBUTIONS TO SHAREHOLDERS -- THE TAX-FREE FUNDS
Subchapter M permits the character of tax-exempt interest distributed by a
regulated investment company to "flow through" as tax-exempt interest to its
shareholders, provided that 50% or more of the value of its assets at the end of
each quarter of its taxable year is invested in state, municipal or other
obligations the interest on which is exempt under Section 103(a) of the Code.
Each of the California Tax Free Fund, New York Tax Free Fund and
B-148
<PAGE>
Tax Free Bond Fund (collectively, the "Tax Free Funds") intend to satisfy the
50% requirement in order to permit their distributions of tax-exempt interest to
be treated as such for regular Federal income tax purposes in the hands of their
shareholders. Exempt-interest dividends must be taken into account by
individual shareholders in determining whether their total incomes are large
enough to result in taxation of up to 85% of their social security benefits and
certain railroad retirement benefits. None of the income distributions of such
Fund will be eligible for the deduction for dividends received by corporations.
Although a significant portion of the distributions by the Tax Free Funds
generally is expected to be exempt from federal taxes, each of these Funds may
under certain circumstances invest in obligations the interest from which is
fully taxable, or, although exempt from the regular federal income tax, is
subject to the alternative minimum tax. Similarly, gains from the sale or
exchange of obligations the interest on which is exempt from regular Federal
income tax will constitute taxable income to those Funds. In addition, a sale
of shares in such Fund (including a redemption of such shares and an exchange of
shares between two mutual funds) will be a taxable event, and may result in a
taxable gain or loss to a shareholder. Accordingly, it is possible that a
significant portion of the distributions of these Funds will constitute taxable
rather than tax-exempt income in the hands of a shareholder. Furthermore,
investors should be aware that tax laws may change, and issuers may fail to
follow applicable laws, causing a tax-exempt item to become taxable.
Exempt-interest dividends from the Tax Free Funds; ordinary dividends from
the Tax Free Funds, if any; capital gains distributions from the Tax Free Funds
and any capital gains or losses realized from the sale or exchange of shares may
be subject to state and local taxes. However, the portion of a distribution of
the Funds' tax-exempt income that is attributable to state and municipal
securities issued within the shareholder's own state may not be subject, at
least in some states, to state or local taxes.
Distributions derived from interest on certain private activity bonds which
is exempt from regular federal income tax are treated as a tax preference item
and may subject individual or corporate shareholders to liability (or increased
liability) for the alternative minimum tax. In addition, because a portion of
the difference between adjusted current earnings, as defined in the Code, and
alternative minimum taxable income is an addition to the alternative minimum tax
base, all distributions derived from interest which is exempt from regular
federal income tax are included in adjusted current earnings and may subject
B-149
<PAGE>
corporate shareholders to or increase their liability for the alternative
minimum tax. In addition, a deductible "environmental tax" of 0.12% is imposed
on a corporation's modified alternative minimum taxable income in excess of $2
million. The environmental tax will be imposed even if the corporation is not
required to pay an alternative minimum tax because the corporation's regular
income tax liability exceeds its minimum tax liability. To the extent that
exempt-interest dividends paid by a Fund are included in alternative minimum
taxable income, corporate shareholders may be subject to the environmental tax.
DISCOUNT
Certain of the bonds purchased by the Funds, such as zero coupon bonds, may
be treated as bonds that were originally issued at a discount. Original issue
discount represents interest for federal income tax purposes and can generally
be defined as the difference between the price at which a security was issued
and its stated redemption price at maturity. Original issue discount, although
no cash is actually received by a Fund until the maturity of the bond, is
treated for federal income tax purposes as income earned by a Fund over the term
of the bond, and therefore is subject to the distribution requirements of the
Code. The annual amount of income earned on such a bond by a Fund generally is
determined on the basis of a constant yield to maturity which takes into account
the semiannual compounding of accrued interest.
In addition, some of the bonds may be purchased by a Fund at a discount
which exceeds the original issue discount on such bonds, if any. This
additional discount represents market discount for federal income tax purposes.
The gain realized on the disposition of any bond having market discount,
generally will be treated as taxable ordinary income to the extent it does not
exceed the accrued market discount on such bond (unless a Fund elects to include
market discount in income in tax years to which it is attributable). Realized
accrued market discount on obligations that pay tax-exempt interest is
nonetheless taxable. Generally, market discount accrues on a daily basis for
each day the bond is held by a Fund at a constant rate over the time remaining
to the bond's maturity. In the case of any debt security having a fixed
maturity date of not more than one year from date of issue, the gain realized on
disposition will be treated as short-term capital gain.
USERS OF BOND-FINANCED FACILITIES
Section 147(a) of the Code prohibits exemption from taxation of interest on
certain governmental obligations to persons who
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are "substantial users" (or persons related thereto) of facilities financed
thereby. No investigation as to the users of the facilities financed by bonds
in the portfolios of the Tax Free Funds has been made by these Funds. Persons
who may be "substantial users" (or "related persons" of substantial users) of
facilities financed by private activity bonds should consult their tax advisers
before purchasing shares of a Fund since the acquisition of shares of the Tax
Free Bond Fund, California Tax Free Fund or New York Tax Free Fund may result in
adverse tax consequences to them.
EXCISE TAX
The Funds are potentially subject to a 4% nondeductible excise tax on
amounts required to be but not distributed under a prescribed formula. The
formula generally requires payment to shareholders during a calendar year of
distributions representing at least 98% of each Fund's ordinary income for the
calendar year and at least 98% of the excess of its capital gains over capital
losses realized during the one-year period ending October 31 during such year.
The Funds have adjusted their distribution policies to minimize any adverse
impact from this tax or eliminate its application.
TAXATION OF OPTIONS, FUTURES AND SIMILAR INSTRUMENTS
Many of the options, futures contracts and forward contracts entered into
by a Fund will be classified as "Section 1256 contracts." Generally, gains or
losses on Section 1256 contracts are considered 60% long-term and 40% short-term
capital gains or losses ("60/40"). Also, certain Section 1256 contracts held by
a Fund are "marked-to-market" at the times required pursuant to the Code with
the result that unrealized gains or losses are treated as though they were
realized and the resulting gain or loss generally is treated as 60/40 gain or
loss, except for foreign currency gain or loss on such contracts, which
generally is ordinary in character.
Gains from hedging transactions generally are taxable so distributions of
such gains generally will be taxable to shareholders. Generally, the hedging
transactions and certain other transactions in options, futures and forward
contracts undertaken by a Fund may result in "straddles" for federal income tax
purposes. The straddle rules may affect the character of gains (or losses)
realized by a Fund. In addition, losses realized by a Fund on positions that
are part of a straddle may be deferred under the straddle rules rather than
being taken into account in the taxable year in which such losses are realized.
Because only a few regulations implementing the straddle rules have been
promulgated, the tax consequences of transactions in
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options, futures and forward contracts to a Fund are not entirely clear. The
hedging transactions in which a Fund engages may increase the amount of short-
term capital gain realized by a Fund which is taxed as ordinary income when
distributed to shareholders.
A Fund may make one or more of the elections available under the Code which
are applicable to straddles. If a Fund makes any of the elections, the amount,
character and timing of the recognition of gains or losses from the affected
straddle positions will be determined under rules that vary according to the
election(s) made. The rules applicable under certain of the elections operate
to accelerate the recognition of gains or losses from the affected straddle
positions.
Because application of the straddle rules may affect the character of gains
or losses, defer losses and/or accelerate the recognition of gains or losses
from the affected straddle positions, the amount which must be distributed to
shareholders and which will be taxed to shareholders as ordinary income or long-
term capital gain, may be increased or decreased substantially as compared to a
Fund that did not engage in such hedging transactions.
The 30% limit on gains from the disposition of certain assets held less
than three months and the diversification requirements applicable to a Fund's
status as a regulated investment company may limit the extent to which a Fund
will be able to engage in transactions in options, futures contracts or forward
contracts.
Regarding the Tax Free Bond Fund, the California Tax Free Fund and New York
Tax Free Fund, gains from certain transactions, including, for example,
transactions in options, futures, and other instruments, and from obligations
the interest on which is not exempt from Federal income tax, will be taxable
income to those Funds. The requirements relating to those Funds' qualification
as a regulated investment company and those Funds' investment policies may limit
the extent to which each Fund will be able to engage in transactions in options
and futures contracts.
Regarding the International Bond Fund, International Equity Fund and
Strategic Income Fund, rules governing the tax aspects of swap agreements are in
a developing stage and are not entirely clear in certain respects. Accordingly,
while the Funds intend to account for such transactions in a manner they deem to
be appropriate, the IRS might not accept such treatment. If it did not, the
status of a Fund as a regulated investment company might be affected. The Funds
intend to monitor developments in this
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area. Certain requirements that must be met under the Code in order for a Fund
to qualify as a regulated investment company may limit the extent to which a
Fund will be able to engage in swap agreements.
PASSIVE FOREIGN INVESTMENT COMPANIES
Certain of the Funds may invest in shares of foreign corporations which may
be classified under the Code as passive foreign investment companies ("PFICs").
In general, a foreign corporation is classified as a PFIC if at least one-half
of its assets constitute investment-type assets or 75% or more of its gross
income is investment-type income. If a Fund receives a so-called "excess
distribution" with respect to PFIC stock, the Fund itself may be subject to a
tax on a portion of the excess distribution, whether or not the corresponding
income is distributed by the Fund to Shareholders. In general, under the PFIC
rules, an excess distribution is treated as having been realized ratably over
the period during which the Fund held the PFIC shares. The Fund itself will be
subject to tax on the portion, if any, of an excess distribution that is so
allocated to prior Fund taxable years and an interest factor will be added to
the tax, as if the tax had been payable in such prior taxable years. Certain
distributions from a PFIC as well as gain from the sale of PFIC shares are
treated as excess distributions. Excess distributions are characterized as
ordinary income even though, absent application of the PFIC rules, certain
excess distributions might have been classified as capital gain.
A Fund may be eligible to elect alternative tax treatment with respect to
PFIC shares. Under an election that currently is available in some
circumstances, a Fund generally would be required to include in its gross income
its share of the earnings of a PFIC on a current basis, regardless of whether
distributions are received from the PFIC in a given year. If this election were
made, the special rules, discussed above, relating to the taxation of excess
distributions, would not apply. In addition, another election may be available
that would involve marking-to-market a Fund's PFIC shares at the end of each
taxable year (and on certain other dates prescribed in the Code), with the
result that unrealized gains are treated as though they were realized. If this
election were made, tax at the fund level under the PFIC rules would generally
be eliminated, but a Fund could, in limited circumstances, incur nondeductible
interest charges. Other elections may become available that would affect the
tax treatment of PFIC shares held by the Fund. The Fund's intention to qualify
annually as a regulated investment company may limit its elections with respect
to PFIC shares.
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Because the application of the PFIC rules may affect, among other things,
the character of gains, the amount of gain or loss and the timing of the
recognition of income with respect to PFIC shares, as well as subject the Fund
itself to tax on certain income from PFIC shares, the amount that must be
distributed to shareholders, and which will be taxed to shareholders as ordinary
income or long-term capital gain, may be increased or decreased substantially as
compared to a Fund that did not invest in PFIC shares.
FOREIGN CURRENCY GAINS AND LOSSES
Under the Code, gains or losses attributable to fluctuations in exchange
rates which occur between the time a Fund accrues income or other receivables or
accrues expenses or other liabilities denominated in a foreign currency and the
time a Fund actually collects such receivables or pays such liabilities
generally are treated as ordinary income or ordinary loss. Similarly, on the
disposition of debt securities denominated in a foreign currency and on the
disposition of certain options, futures, forward and other contracts, gain or
loss attributable to fluctuations in the value of foreign currency between the
date of acquisition of the security or contract and the date of disposition also
are treated as ordinary gain or loss. These gains or losses, referred to under
the Code as "Section 988" gains or losses, may increase or decrease the amount
of a Fund's net investment income to be distributed to its shareholders. If
Section 988 losses exceed other investment company taxable income (which
includes, among other items, dividends, interest and the excess, if any, of net
short-term capital gains over net long-term capital losses) during the taxable
year, a Fund would not be able to make any ordinary dividend distributions, and
distributions made before the losses were realized would be recharacterized as a
return of capital to shareholders or, in some cases, as capital gain, rather
than as an ordinary dividend.
COMMODITY INVESTMENTS
A regulated investment company is required under the Code to derive at
least 90% of its gross income from certain qualifying sources and to have, at
the close of each quarter of the taxable year, at least 50% of the market value
of its assets represented by cash, U.S. government securities, the securities of
other regulated investment companies and other securities, with such other
securities of any one issuer limited for the purposes of this calculation to an
amount not greater than 5% of the value of the Fund's total assets and 10% of
the outstanding voting securities of such issuer. In addition, not more than
25% of the value of a Fund's total assets may be invested in the securities of
any one issuer (other than U.S. government securities or the
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securities of other regulated investment companies). Qualifying income
includes, inter alia, interest, dividends, and gain from the sale of stock or
----------
securities, but it does not include gain from the sale of commodities such as
gold and other precious metals.
DISPOSITIONS OF FUND SHARES
Upon redemption, sale or exchange of shares of a Fund, a shareholder will
realize a taxable gain or loss, depending on whether the gross proceeds are more
or less than the shareholder's tax basis for the shares. Such gain or loss
generally will be a capital gain or loss if the shares of a Fund were capital
assets in the hands of the shareholder, and generally will be long- or short-
term, depending on the length of time the shares of the Fund were held. A loss
realized by a shareholder on the redemption, sale or exchange of shares of a
Fund with respect to which capital gain dividends have been paid will, to the
extent of such capital gain dividends, be treated as long-term capital loss if
such shares have been held by the shareholder for six months or less at the time
of their disposition. Furthermore, a loss realized by a shareholder on the
redemption, sale or exchange of shares of a Fund with respect to which exempt-
interest dividends have been paid will, to the extent of such exempt-interest
dividends, be disallowed if such shares have been held by the shareholder for
six months or less at the time of their disposition. A loss realized on a
redemption, sale or exchange also will be disallowed to the extent the shares
disposed of are replaced (whether through reinvestment of distributions, or
otherwise) within a period of 61 days beginning 30 days before and ending 30
days after the shares are disposed of. In such a case, the basis of the shares
acquired will be adjusted to reflect the disallowed loss.
Shareholders should be aware that redeeming shares of a Fund after tax-
exempt interest has been accrued by the Fund but before that income has been
declared as a dividend may be disadvantageous. This is because the gain, if
any, on the redemption will be taxable, even though such gains may be
attributable in part to the accrued tax-exempt interest which, if distributed to
the shareholder as a dividend rather than as redemption proceeds, might have
qualified as an exempt-interest dividend.
Under certain circumstances, the sales charge incurred in acquiring shares
of either Fund may not be taken into account in determining the gain or loss on
the disposition of those shares. This rule applies where shares of a Fund are
exchanged within 90 days after the date they were purchased and new shares are
acquired without a sales charge or at a reduced sales charge. In that case, the
gain or loss recognized on the exchange will be
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determined by excluding from the tax basis of the shares exchanged all or a
portion of the sales charge incurred in acquiring those shares. This exclusion
applies to the extent that the otherwise applicable sales charge with respect to
the newly acquired shares is reduced as a result of having incurred a sales
charge initially. The portion of the sales charge affected by this rule will be
treated as a sales charge paid for the new shares.
TAX REPORTING REQUIREMENTS
All distributions, whether received in shares or cash, must be reported by
each shareholder on his or her federal income tax return. Shareholders are also
required to report tax-exempt interest. Dividends declared and payable to
shareholders of record on a specified date in October, November or December, if
any, will be deemed to have been received by shareholders on December 31 if paid
during January of the following year. Redemptions of shares, including
exchanges for shares of another Fund, may result in tax consequences (gain or
loss) to the shareholder and generally are also subject to these reporting
requirements. Each shareholder should consult his or her own tax adviser to
determine the tax status of a Fund distribution in his or her own state and
locality.
Under the federal income tax law, a Fund will be required to report to the
IRS all distributions of income (other than exempt-interest dividends) and
capital gains as well as gross proceeds from the redemption or exchange of Fund
shares (other than shares of the Money Market Fund), except in the case of
certain exempt shareholders. Under the backup withholding provisions of Section
3406 of the Code, all such taxable distributions and proceeds from the
redemption or exchange of a Fund's shares may be subject to withholding of
federal income tax at the rate of 31% in the case of nonexempt shareholders who
fail to furnish a Fund with their taxpayer identification number and with
required certifications regarding their status under the federal income tax law
or if the IRS or a broker notifies a Fund that the number furnished by the
shareholder is incorrect. In addition, both the Fund and the shareholder are
potentially subject to a $50 penalty imposed by the IRS if a correct, certified
taxpayer identification number is not furnished and used on required information
returns. If the withholding provisions are applicable, any such distributions
and proceeds, whether taken in cash or reinvested in shares, will be reduced by
the amounts required to be withheld. Backup withholding is not an additional
tax and any amounts withheld are creditable against the shareholder's U.S.
Federal tax liability. Investors may wish to consult their tax advisers about
the applicability of the backup withholding provisions.
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FOREIGN TAXES
Investment income and gains received by a Fund from sources outside the
United States may be subject to foreign taxes which were withheld at the
source. Since the percentage of each Fund's total assets (with the exception of
the International Bond Fund and International Equity Fund) which will be
invested in foreign stocks and securities will not be more than 50%, any foreign
tax credits or deductions associated with such foreign taxes will not be
available for use by its shareholders. The effective rate of foreign taxes to
which a Fund will be subject depends on the specific countries in which each
Fund's assets will be invested and the extent of the assets invested in each
such country and, therefore, cannot be determined in advance.
The International Bond Fund and the International Equity Fund may qualify
for and make the election permitted under Section 853 of the Code so that
shareholders will be able to claim a credit or deduction on their federal income
tax returns for, and will be required to treat as part of the amounts
distributed to them, their pro rata portion of qualified taxes paid by the Fund
to foreign countries (which taxes relate primarily to investment income). The
U.S. shareholders of a Fund may claim a foreign tax credit or deduction by
reason of the Fund's election under Section 853 of the Code, provided that more
than 50% of the value of the total assets of the Fund at the close of the
taxable year consists of securities of foreign corporations. The foreign tax
credit and deduction available to shareholders is subject to certain limitations
imposed by the Code. Also, under Section 63 of the Code, no deduction for
foreign taxes may be claimed by shareholders who do not itemize deductions on
their federal income tax returns, although any such shareholder may claim a
credit for foreign taxes and in any event will be treated as having taxable
income in respect to the shareholder's pro rata share of foreign taxes paid by
the Fund. It should also be noted that a tax-exempt shareholder, like other
shareholders, will be required to treat as part of the amounts distributed its
pro rata portion of the income taxes paid by the Fund to foreign countries.
However, that income will generally be exempt from taxation by virtue of such
shareholder's tax-exempt status, and such a shareholder will not be entitled to
either a tax credit or a deduction with respect to such income. The foreign tax
credit generally may offset only up to 90% of the alternative minimum tax in any
given year. Foreign taxes generally are not deductible in computing alternative
minimum taxable income.
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STATE AND LOCAL TAXES - GENERAL
The state and local tax treatment of distributions received from a Fund and
any special tax considerations associated with foreign investments of a Fund
should be examined by shareholders with regard to their own tax situations.
Shareholders of the Tax Free Bond Fund, the California Tax Free Fund and
New York Tax Free Fund may be subject to state and local taxes on distributions
from the Fund, including distributions which are exempt from federal income
taxes. Some states exempt from the state personal income tax distributions from
a Fund derived from interest on obligations issued by the U.S. government or by
such state or its municipalities or political subdivisions. Each investor
should consult his or her own tax adviser to determine the tax status of
distributions from the Funds in his or her own state and locality.
Opinions relating to the validity of municipal securities and the exemption
of interest thereon from federal income tax are rendered by bond counsel to the
issuers. The Tax Free Bond Fund, California Tax Free Fund and New York Tax Free
Fund, the Adviser and its affiliates, and the Funds' counsel make no review of
proceedings relating to the issuance of state or municipal securities or the
bases of such opinions.
Due to the lack of adequate supply of certain types of tax-exempt
obligations, and other reasons, various instruments are being marketed which are
not "pure" state and local obligations, but which are thought to generate
interest excludable from taxable income under Code section 103. While a Fund
may invest in such instruments, it does not guarantee the tax-exempt status of
the income earned thereon or from any other investment. Thus, for example, were
a Fund to invest in an instrument thought to give rise to tax-exempt interest
but such interest ultimately were determined to be taxable, the Fund might have
invested more than 20% of its assets in taxable instruments. In addition, it is
possible in such circumstances that a Fund will not have met the 50% investment
threshold, described above, necessary for it to pay exempt-interest dividends.
EXPLANATION OF FUND DISTRIBUTIONS
Each distribution is accompanied by a brief explanation of the form and
character of the distribution. In January of each year, each Fund will issue to
each shareholder a statement of the federal income tax status of all
distributions, including, in the case of the Tax Free Bond Fund, the California
Tax Free Fund and New York Tax Free Fund, a statement of the percentage of the
prior calendar year's distributions which the Fund has designated
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as tax-exempt, the percentage of such tax-exempt distributions treated as a
tax-preference item for purposes of the alternative minimum tax, and in, the
case of the Tax Free Bond Fund, the source on a state-by-state basis of all
distributions.
ADDITIONAL INFORMATION REGARDING THE EQUITY INDEX FUND
Distributions of investment company taxable income generally are taxable to
shareholders as ordinary income. As a result of the Guarantee, distributions
from the Fund may not be eligible for the dividends-received deduction available
to corporations. Distributions of net capital gains, if any, designated by the
Fund as capital gain dividends are taxable to shareholders as long-term capital
gain, regardless of the length of time the Fund's shares have been held by a
shareholder, and are not eligible for the dividends-received deduction. All
distributions are taxable to the shareholder whether reinvested in additional
shares or received in cash. Shareholders will be notified annually as to the
Federal tax status of distributions.
In addition, although not considered likely, it is possible that
shareholders could be regarded for tax purposes as receiving a constructive
distribution(s) (which could be taxable) from the Fund to the extent that the
Guarantee is deemed to have value.
It is anticipated that capital gain or loss from the disposition of shares
will be eligible for treatment as long-term or short-term capital gain or loss
depending upon the shareholder's actual holding period for the shares.
Investors should be aware that, under recent IRS regulations, as a result of the
Guarantee, a shareholder's holding period for Fund shares might be deemed not to
commence until the Guarantee is paid or expires. In that event, the capital
gain or loss on the disposition of Fund shares would be short-term capital gain
or loss until such time as the shares have been held continuously by the
shareholder for the requisite long-term holding period (currently more than one
year for Federal income tax purposes) after the expiration or payment of the
Guarantee. The holding period for shares received from reinvestment of
dividends and distributions will commence no earlier than the reinvestment date
but could be delayed as described previously in this paragraph as a result of
the Guarantee. If reverse stock splits are done, a share may have a split
holding period reflecting the fact that part of the share represents a
reinvested dividend or distribution.
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ADDITIONAL INFORMATION REGARDING THE CALIFORNIA TAX FREE FUND AND NEW YORK TAX
FREE FUND
Under California law, a mutual fund which qualifies as a regulated
investment company must have at least 50% of its total assets in obligations
exempt from California personal income tax at the end of each quarter of its
taxable year in order to be eligible to pay dividends which will be exempt from
California personal income tax. Generally, shareholders who are California
residents will not incur California personal income tax on the amount of exempt-
interest dividends received by them from the California Tax Free Fund and
derived from California state and local issues, whether taken in cash or
reinvested in additional shares. However, other taxes, such as the franchise
tax may apply. Shareholders will normally be subject to California personal
income tax on dividends paid from interest income derived from taxable
securities and from securities issued by states other than California and its
subsidiaries and on distributions of capital gains.
Deductions for interest on indebtedness incurred or continued by a
shareholder to purchase or carry shares of the Fund may be disallowed in whole
or in part for California personal income tax purposes.
Exempt-interest dividends paid by the New York Tax Free Fund from interest
on qualifying New York bonds generally are exempt from New York State and New
York City personal income taxes, but not corporate franchise taxes. Dividends
and distributions of the Fund derived from taxable income and capital gains are
not exempt from New York State and New York City taxes. Deductions for interest
on indebtedness incurred or continued by a shareholder to purchase or carry
shares of the Fund may be disallowed in whole or in part for New York State or
New York City personal income tax purposes.
Dividends from the California Tax Free Fund or New York Tax Free Fund
(including exempt-interest dividends), capital gains distributions from a Fund,
and any capital gains or losses realized from the sale or exchange of shares may
be subject to state and local taxes (as well as Federal taxes). However, the
portion of a distribution of a Fund's tax-exempt income that is attributable to
state and municipal securities issued within the shareholder's own state
generally will not be subject to state or local taxes. Individuals are often
exempt from state and local personal income taxes on distributions of tax-exempt
interest income derived from obligations of issuers located in the state in
which they reside when these distributions are received directly from these
issuers, but are usually subject to such taxes on income derived from
obligations of issuers located in
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other jurisdictions. Shareholders are urged to consult their tax advisers with
specific reference to their own federal, state and local tax situations.
ANNUAL STATEMENTS
Each shareholder of the California Tax Free Fund will be sent after the
close of the calendar year an annual statement as to the federal income tax and
California state personal income tax status of his or her dividends and
distributions from the Fund for the prior calendar year. Any dividends
attributable to interest on municipal obligations that are not California
municipal securities will be taxable as ordinary dividends for California state
personal income tax purposes even if such dividends are excluded from gross
income for federal income tax purposes. These statements will also designate
the amount of exempt-interest dividends that is a specific preference item for
purposes of the federal individual and corporate alternative minimum taxes.
Each shareholder also will receive, if appropriate, various written notices
after the close of the Fund's prior taxable year as to the federal income tax
status of his or her dividends and distributions which were received from the
Fund during the Fund's prior taxable year. Shareholders should consult their
tax advisers as to any other state and local taxes that may apply to these
dividends and distributions. The dollar amount of dividends excluded or exempt
from federal income taxation or California state personal income taxation, if
any, will vary for each shareholder depending upon the size and duration of each
shareholder's investment in the Fund.
Each shareholder of the New York Tax Free Fund will be sent after the close
of the calendar year an annual statement as to the federal income tax and New
York State and New York City personal income tax status of his or her dividends
and distributions from the Fund for the prior calendar year. These statements
will also designate the amount of exempt-interest dividends that is a specified
preference item for purposes of the federal individual and corporate alternative
minimum taxes. Each shareholder also will receive, if appropriate, various
written notices after the close of the Fund's prior taxable year as to the
federal income tax status of his or her dividends and distributions which were
received from the Fund during the Fund's prior taxable year. Shareholders
should consult their tax advisers as to any other state and local taxes that may
apply to these dividends and distributions. The dollar amounts of dividends
excluded or exempt from federal income taxation or New York State and City
personal income taxation and the dollar amount subject to federal income
taxation or New York State and City personal income taxation, if any, will vary
for each
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shareholder depending upon the size and duration of each shareholder's
investment in the Fund.
GENERAL INFORMATION
The foregoing discussion generally relates to U.S. federal income tax law
as applicable to U.S. persons (i.e., U.S. citizens and residents and U.S.
domestic corporations, partnerships, trusts and estates). Each shareholder who
is not a U.S. person should consult his or her tax adviser regarding the U.S.
and non-U.S. tax consequences of ownership of shares of a Fund, including the
possibility that such a shareholder may be subject to a U.S. withholding tax at
a rate of 30% (or at a lower rate under an applicable U.S. income tax treaty) on
amounts constituting ordinary income to him or her.
This discussion of the federal income tax treatment of each Fund and its
shareholders is based on the federal income tax law in effect as of the date of
this SAI.
ORGANIZATION AND CAPITALIZATION
GENERAL
The Funds are separate series of an open-end investment company, The
MainStay Funds ("Trust"), established under the laws of The Commonwealth of
Massachusetts by a Declaration of Trust dated January 9, 1986, as amended. The
Tax Free Bond Fund was originally formed as the MacKay-Shields MainStay Tax Free
Bond Fund pursuant to a Declaration of Trust on January 9, 1986 and became a
series of the Trust pursuant to a reorganization which occurred on May 29, 1987.
The Total Return Fund commenced operations on December 29, 1987. The Equity
Index Fund commenced operations on December 20, 1990. The California Tax Free
Fund and New York Tax Free Fund commenced operations on October 1, 1991. The
International Bond Fund and International Equity Fund commenced operations on
September 13, 1994. The Strategic Income Fund commenced operations on February
28, 1997. The organizational expenses of the Fund will be amortized and
deferred over a period not to exceed 60 months. The Declaration of Trust and
By-laws authorize the Trustees to establish additional series or "Funds" as well
as additional classes of shares.
VOTING RIGHTS
Shares entitle their holders to one vote per share; however, separate votes
will be taken by each Fund or class on matters affecting an individual Fund or a
particular class of shares issued by a Fund. Shares have noncumulative voting
rights, which
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means that holders of more than 50% of the shares voting for the election of
Trustees can elect all Trustees and, in such event, the holders of the remaining
shares voting for the election of Trustees will not be able to elect any person
or persons as Trustees. Shares have no preemptive or subscription rights and
are transferable.
SHAREHOLDER AND TRUSTEE LIABILITY
Under Massachusetts law, shareholders of such a trust may, under certain
circumstances, be held personally liable as partners for the obligations of the
trust. The Declaration of Trust contains an express disclaimer of shareholder
liability for acts or obligations of the Trust. Notice of such disclaimer will
normally be given in each agreement, obligation or instrument entered into or
executed by the Trust or the Trustees. The Declaration of Trust provides for
indemnification by the relevant Fund for any loss suffered by a shareholder as a
result of an obligation of the Fund. The Declaration of Trust also provides
that the Trust shall, upon request, assume the defense of any claim made against
any shareholder for any act or obligation of the Trust and satisfy any judgment
thereon. Thus, the risk of a shareholder incurring financial loss on account of
shareholder liability is limited to circumstances in which a Fund would be
unable to meet its obligations. The Trustees believe that, in view of the
above, the risk of personal liability of shareholders is remote.
The Declaration of Trust further provides that the Trustees will not be
liable for errors of judgment or mistakes of fact or law, but nothing in the
Declaration of Trust protects a Trustee against any liability to which he or she
would otherwise be subject by reason of willful misfeasance, bad faith, gross
negligence or reckless disregard of the duties involved in the conduct of his or
her office.
OTHER INFORMATION
INDEPENDENT ACCOUNTANTS
Price Waterhouse LLP, 1177 Avenue of the Americas, New York, New York,
10036, has been selected as independent public accountants of the Trust. The
Funds' Annual Reports, which are incorporated by reference in this SAI (included
in the case of the Equity Index Fund) have been so incorporated or included in
reliance on the reports of Price Waterhouse, independent public accountants,
given on the authority of said firm as experts in auditing and accounting.
B-163
<PAGE>
LEGAL COUNSEL
Dechert Price & Rhoads, 1500 K Street, N.W., Washington, D.C. 20005, passes
upon certain legal matters in connection with the shares offered by the Trust,
and also acts as counsel to the Trust.
SHARE OWNERSHIP OF THE FUNDS
The following table sets forth information concerning beneficial and record
ownership, as of April 1, 1997, of the Funds' shares by each person who
beneficially or of record owns more than five percent of the voting securities
of any Fund:
<TABLE>
<CAPTION>
Shares Percentage of
Name and Address Beneficially Outstanding
Name of Fund of Shareholder Owned (1) Shares Owned
- ------------ ------------------- -------------- ----------------
<S> <C> <C> <C>
California NYLIFE Distributors Inc.(2) 271,121 (Class A) 15.3% (Class A)
Tax Free Fund 260 Cherry Hill Road 12 (Class B) 0% (Class B)
Parsippany, NJ 07054
New York Tax NYLIFE Distributors Inc.(2) 499,488 (Class A) 34.7% (Class A)
Free Fund 260 Cherry Hill Road 12 (Class B) 0% (Class B)
Parsippany, NJ 07054
International NYLIFE Distributors Inc.(2) 750,163 (Class A) 70.8% (Class A)
Bond Fund 260 Cherry Hill Road 12 (Class B) 0% (Class B)
Parsippany, NJ 07054
International NYLIFE Distributors Inc.(2) 625,100 (Class A) 41.1% (Class A)
Equity Fund 260 Cherry Hill Road 11 (Class B) 0% (Class B)
Parsippany, NJ 07054
Strategic NYLIFE Distributors Inc. 10 (Class A) 0% (Class A)
Income 260 Cherry Hill Road 500,010 (Class B) 51.3% (Class B)
Fund Parsippany, NJ 07054
Strategic New York Life Insurance 2,000,000 (Class A) 81.6% (Class A)
Income Company General Account 0 (Class B) 0% (Class B)
Fund 51 Madison Avenue
New York, NY 10010
</TABLE>
- ----------
(1) This information, not being within the knowledge of the Trust, has been
furnished by each of the above persons. Beneficial ownership is as defined
under Section 13(d) of the Securities Exchange Act of 1934. Fractional
Shares have been omitted.
(2) Mr. George Daoust, in connection with his position with NYLIFE
Distributors, has the power to vote all of the shares shown in the above
table owned by NYLIFE Distributors. Mr. Daoust disclaims beneficial
ownership of such shares.
NYLIFE Distributors Inc. is a corporation organized under the laws of
Delaware. NYLIFE Distributors Inc. is a wholly owned subsidiary of NYLIFE Inc.,
and an indirect wholly owned subsidiary of New York Life Insurance Company.
B-164
<PAGE>
CODE OF ETHICS
The Trust has adopted a Code of Ethics governing personal trading
activities of all Trustees, officers of the Trust and persons who, in connection
with their regular functions, play a role in the recommendation of any purchase
or sale of a security by the Trust or obtain information pertaining to such
purchase or sale or who have the power to influence the management or policies
of the Trust or an Investment Adviser unless such power is the result of their
position with the Trust or Investment Adviser. Such persons are generally
required to preclear all security transactions with the Trust's Compliance
Officer or his designee and to report all transactions on a regular basis. The
Trust has developed procedures for administration of the Code.
FINANCIAL STATEMENTS
The financial statements of the Capital Appreciation Fund, California Tax
Free Fund, New York Tax Free Fund, Value Fund, Convertible Fund, Total Return
Fund, High Yield Corporate Bond Fund, Government Fund (formerly the Government
Plus Fund), Tax Free Bond Fund (formerly the MacKay-Shields MainStay Tax Free
Bond Fund), International Bond Fund, International Equity Fund, Equity Index
Fund and the Money Market Fund, including the Portfolio of Investments as of
December 31, 1996, the Statement of Assets and Liabilities as of December 31,
1996, the Statement of Operations for the year ended December 31, 1996, the
Statement of Changes in Net Assets for the years ended December 31, 1996 and
1995, the Notes to the Financial Statements and the Reports of Independent
Accountants, all of which are included in the 1996 Annual Reports to the
Shareholders are hereby incorporated by reference into this Statement of
Additional Information.
An audited financial statement for NYLIFE Inc. as of December 31, 1996, is
included in this Statement of Additional Information.
B-165
<PAGE>
[LOGO]
NYLIFE INC. AND SUBSIDIARIES
(affiliates of
New York Life Insurance Company)
CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1996 AND 1995
<PAGE>
1177 Avenue of the Americas Telephone 212 596 7000
New York, NY 10036 Facsimile 212 596 8910
[LOGO]
PRICE WATERHOUSE LLP
April 15, 1997
To the Board of Directors and
Stockholder of NYLIFE Inc.
REPORT OF INDEPENDENT ACCOUNTANTS
- ---------------------------------
We have audited the accompanying statutory basis consolidated statement of
financial position of NYLIFE Inc. and its subsidiaries (affiliates of New York
Life Insurance Company) as of December 31, 1996 and 1995, and the related
statutory basis consolidated statements of operations, of changes in
stockholder's equity and of cash flows for each of the three years in the period
ended December 31, 1996. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
As described in Note 2, these financial statements were prepared in conformity
with accounting practices prescribed or permitted by the New York State
Insurance Department for valuing companies owned by an insurer, which is a
comprehensive basis of accounting other than generally accepted accounting
principles. The effects on the financial statements of the variances between
such practices and generally accepted accounting principles are described in
Note 2.
In our opinion, except for the effects of the matters described in the preceding
paragraph, the financial statements referred to above present fairly, in all
material respects, the financial position of NYLIFE Inc. and its subsidiaries at
December 31, 1996 and 1995, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 1996, in
conformity with generally accepted accounting principles.
<PAGE>
To the Board of Directors and
Stockholder of NYLIFE Inc.
Page 2
April 15, 1997
Also, in our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of NYLIFE Inc. and its
subsidiaries at December 31, 1996 and 1995, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 1996, on the basis of the accounting described in Note 2.
As described in Note 1, on January 1, 1996, New York Life Insurance Company
combined certain of its group life and health indemnity insurance operations
with a subsidiary of the Company. The combination has been treated as a
transaction between entities under common control and, accordingly, the
consolidated financial statements presented herein for periods prior to January
1, 1996 have been restated to reflect the combination as if it had occurred on
January 1, 1994.
/s/ Price Waterhouse LLP
<PAGE>
NYLIFE INC. AND SUBSIDIARIES
----------------------------
(affiliates of New York Life Insurance Company)
CONSOLIDATED STATEMENT OF FINANCIAL POSITION
--------------------------------------------
<TABLE>
<CAPTION>
December 31,
-----------------------------
(Restated)
1996 1995
---- ----
(in thousands)
ASSETS
------
<S> <C> <C>
Cash and cash equivalents $ 369,810 $ 302,780
Short-term investments 25 9,925
Premiums and accounts receivable less allowance for doubtful
accounts of $4,042 and $5,642, respectively 477,317 303,843
Liquidation advance recoverable 64,431 -
Interest and other receivables 60,318 74,580
Deferred distribution costs (net of accumulated amortization
of $229,711 and $172,254, respectively) 224,752 174,055
Investments:
Common stocks 7,042 5,520
Available for sale - bonds 200,442 611,644
Held to maturity - bonds 2,311 33,763
Insurance operations - bonds 32,411 29,201
Mortgage loans 6,769 116,963
Real estate 100,374 108,664
MainStay funds at fair value 47,263 33,762
Security alarm monitoring contracts held for sale 38,455 -
Security alarm monitoring contracts (net of accumulated amortization
of $22,499) - 48,425
Other investments and advances to affiliates 106,831 114,433
Statutory valuation of subsidiary in excess of GAAP net equity 99,527 406,834
Fixed assets (net of accumulated depreciation of $25,235 and
$59,044, respectively) 89,371 72,925
Income taxes receivable 11,345 2,412
Receivable from New York Life Insurance Company - 82,172
Net deferred tax asset and other assets 126,282 241,699
---------- ----------
Total assets $2,065,076 $2,773,600
========== ==========
LIABILITIES and STOCKHOLDER'S EQUITY
------------------------------------
Accrued HMO claims payable $ 229,802 $ 290,734
Policy and claim reserves - accident and health 127,722 225,000
Policy and claim reserves - life 67,657 95,885
Policyholder account balances and deposit funds - 304,214
Dividends payable to policyholders 30,100 28,926
Payable to New York Life Insurance Company 47,699 -
Accrued expenses and other payables 152,684 204,021
Payable on reinsurance assumed 26,507 -
Medical group risk sharing and unearned premiums 54,270 53,626
Notes payable 183,196 141,081
Net deferred tax liability and other liabilities 147,236 133,882
Accrued costs for liquidation of Limited Partnerships 10,404 137,000
---------- ----------
Total liabilities 1,077,277 1,614,369
---------- ----------
Minority interest 89,533 26,252
Stockholder's equity:
Common stock, par value $.10 per share (20,000 shares authorized,
3,850 shares issued and outstanding) and additional paid-in capital 1,066,921 946,546
Accumulated deficit (270,817) (240,623)
Investment valuation account 99,527 406,834
Net unrealized (losses) gains on available for sale investments (net of
taxes of $(764) and $8,832, respectively) (1,215) 19,099
Cumulative translation adjustment 3,850 1,123
---------- ----------
Total stockholder's equity 898,266 1,132,979
---------- ----------
Total liabilities and stockholder's equity $2,065,076 $2,773,600
========== ==========
The accompanying notes are an integral part of these financial statments
</TABLE>
<PAGE>
NYLIFE INC. AND SUBSIDIARIES
----------------------------
(affiliates of New York Life Insurance Company)
CONSOLIDATED STATEMENT OF OPERATIONS
------------------------------------
<TABLE>
<CAPTION>
For the Years ended December 31,
-------------------------------
(Restated)
----------
1996 1995 1994
---- ---- ----
(in thousands)
<S> <C> <C> <C>
Revenues:
Premium revenue - net $2,363,290 $2,146,107 $1,989,309
Initial premiums on reinsurance assumed 478,145 - -
Fee income 988,957 762,149 541,101
Interest and dividend income 57,187 111,048 167,071
Commission income 95,858 50,378 26,068
Net realized and unrealized (losses) gains on investments (2,869) (7,418) 43,928
Realized gain on sale of interest in subsidiary 121,741 - 34,574
Equity in (loss) earnings of affiliates (699) 155 1,769
Gain on issuance of additional shares by public subsidiary 21,633 - -
Other income 20,936 12,282 3,708
---------- ---------- ----------
Total revenues 4,144,179 3,074,701 2,807,528
---------- ---------- ----------
Expenses:
HMO claims and capitation costs 1,402,025 1,184,977 1,034,071
Health, disability and death benefit claims 567,394 567,989 544,850
Cost of prescription sales 618,022 437,223 299,285
Initial reserve transfer on reinsurance assumed 478,147 - -
Increase in policy reserves - life 11,748 14,237 58,126
Employee compensation 339,974 286,811 259,850
Depreciation and amortization 112,794 103,779 70,764
Administrative charge from New York Life Insurance Company 64,605 40,848 41,956
Impairment of intangible asset 28,830 - -
Interest 15,594 29,784 46,719
Professional fees 38,407 32,822 26,792
Selling expenses 123,413 118,637 162,001
Rent expense 34,943 32,848 28,315
Interest crediting expense - 17,472 13,642
Administrative and other expenses 152,937 186,050 146,061
Provision for liquidation of Limited Partnerships - 137,000 -
---------- ---------- -----------
Total expenses 3,988,833 3,190,477 2,732,432
---------- ---------- -----------
Income (loss) before income taxes and minority
interest 155,346 (115,776) 75,096
Income tax expense (benefit) 76,325 (24,441) 22,435
---------- ---------- -----------
Income (loss) before minority interest 79,021 (91,335) 52,661
Minority interest 14,188 4,598 4,189
----------- ----------- -----------
Net income (loss) $ 64,833 $ (95,933) $ 48,472
=========== ============ ===========
The accompanying notes are an integral part of these financial statements.
</TABLE>
<PAGE>
NYLIFE INC. AND SUBSIDIARIES
----------------------------
(affiliates of New York Life Insurance Company)
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDER'S EQUITY
---------------------------------------------------------
For the years ended December 31, 1996, 1995 (Restated) and 1994 (Restated)
<TABLE>
<CAPTION>
Common Net Unrealized
Stock & Gains (Losses)
Additional Investment on Available Cumulative Total
Paid-In Accumulated Valuation for Sale Translation Stockholder's
Capital Deficit Account Investments Adjustment Equity
---------- ----------- ---------- -------------- ----------- -------------
(in thousands)
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1993
as previously reported $482,390 $(122,303) $180,818 $ - $3,880 $544,785
Effect of business combination
(Note 1) - 55,376 - - - 55,376
---------- ----------- ---------- ----------- --------- -----------
Balance at December 31, 1993
as restated 482,390 (66,927) 180,818 - 3,880 600,161
Capital contributions 127,913 - - - - 127,913
Return of capital (11,230) - - - - (11,230)
Dividends - (72,946) - - (72,946)
Cumulative translation
adjustment - - - - (1,917) (1,917)
Statutory valuation of subsidiary
in excess of GAAP net equity - - 108,895 - - 108,895
Other equity adjustments - (10,768) (10,768)
Net unrealized losses on available
for sale investments - - - (26,213) - (26,213)
Net income - 48,472 - - - 48,472
---------- ---------- ------------ ------------ --------- ----------
Balance at December 31, 1994 599,073 (102,169) 289,713 (26,213) 1,963 762,367
Capital contributions 347,473 - - - - 347,473
Dividends - (41,900) - - - (41,900)
Cumulative translation adjustment - - - - (840) (840)
Statutory valuation of subsidiary
in excess of GAAP net equity - - 117,121 - - 117,121
Other equity adjustments - (621) - - - (621)
Net unrealized gains on available
for sale investments - - - 45,312 - 45,312
Net loss - (95,933) - - - (95,933)
---------- ---------- ------------ --------- ---------- ----------
Balance at December 31, 1995 946,546 (240,623) 406,834 19,099 1,123 1,132,979
Effect of business combination
(Note 1) - (88,130) - (17,375) - (105,505)
Capital contributions 120,375 - - - - 120,375
Change in prior year's retained
earnings - (7,102) - - - (7,102)
Cumulative translation adjustment - - - - 2,727 2,727
Statutory valuation of subsidiary
in excess of GAAP net equity - - (307,307) - - (307,307)
Other equity adjustments - 205 - - - 205
Net unrealized losses on available
for sale investments - - - (2,939) - (2,939)
Net income - 64,833 - - - 64,833
---------- ---------- ----------- ----------- ---------- -----------
Balance at December 31, 1996 $1,066,921 $(270,817) $ 99,527 $ (1,215) $ 3,850 $ 898,266
========== ========== ======== ========= ======= =========
The accompanying notes are an integral part of these financial statements.
</TABLE>
<PAGE>
NYLIFE INC. AND SUBSIDIARIES
----------------------------
(affiliates of New York Life Insurance Company)
CONSOLIDATED STATEMENT OF CASH FLOWS
------------------------------------
Increase in Cash and Cash Equivalents
<TABLE>
<CAPTION>
For the Years ended December 31,
--------------------------------
(Restated)
1996 1995 1994
---- ---- ----
(in thousands)
<S> <C> <C> <C>
Cash flow from operating activities:
Net income (loss) $ 64,833 $ (95,933) $ 48,472
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 112,794 104,679 70,889
Impairment of intangible assets 28,830 - -
Insurance reserves 11,748 24,370 69,912
Gain on sale of shares of subsidiary (121,741) - (27,788)
Net realized and unrealized losses (gains) 2,869 9,870 (43,608)
Equity in loss (earnings) of affiliates 699 (155) (1,769)
Provision for deferred income tax expense (benefit) 87,295 (41,969) (494)
Minority interest 14,188 4,598 4,189
Gain on issuance of additional shares by public subsidiary (21,633) - -
Other 1,467 50 5,821
Change in assets and liabilities:
(Decrease) increase in bank overdrafts - (53,538) 53,538
Increase in premiums and accounts receivable (206,586) (95,884) (11,628)
(Increase) decrease in interest and other receivables (67,627) 3,632 (2,750)
Increase in liquidation advance recoverable (64,431) - -
Increase in deferred distribution costs and other assets (141,565) (93,479) (89,960)
Increase in accrued expenses and other payables 170,133 11,457 74,458
(Decrease) increase in accrued costs for liquidation of Limited
Partnership (126,596) 137,000 -
Increase (decrease) in payable to New York Life Insurance Company 28,970 (19,266) 12,249
Increase (decrease) in policy and claim reserves 143,096 (6,194) 1,707
Increase (decrease) in interest payable 211 (3,218) (9)
(Increase) decrease in income taxes receivable (57,330) 307 (30,551)
---------- ----------- ----------
Net cash (used in) provided by operating activities (140,376) (113,673) 132,678
---------- ----------- ----------
Cash flow from investing activities:
Capital expenditures (51,450) (44,854) (30,669)
Proceeds from sale of investments 209,383 857,479 1,252,103
Purchase of investments (229,664) (534,761) (1,381,194)
Sale of interest in subsidiaries, net of cash sold 138,497 - 34,574
Acquisition of subsidiaries, net of cash acquired (14,843) (15,765) (59,934)
Payments received on investments 46,423 6,992 45,231
Other 3,552 3,121 (3,373)
---------- --------- ------------
Net cash provided by (used in) investing activities $ 101,898 $ 272,212 $ (143,262)
---------- --------- ------------
The accompanying notes are an integral part of these financial statements.
</TABLE>
<PAGE>
NYLIFE INC. AND SUBSIDIARIES
----------------------------
(affiliates of New York Life Insurance Company)
CONSOLIDATED STATEMENT OF CASH FLOWS (cont.)
--------------------------------------------
Increase in Cash and Cash Equivalents
<TABLE>
<CAPTION>
For the Years ended Daecember 31,
---------------------------------
(Restated)
----------
1996 1995 1994
---- ---- ----
(in thousands)
<S> <C> <C> <C>
Cash flow from financing activities:
Capital contributions $97,784 $160,752 $114,226
Dividends paid (35,250) (32,584) (23,002)
Borrowings net of repayments under line of credit agreements 53,378 20,342 (72,896)
Payments applied against capital leases (779) (1,107) (1,251)
Proceeds from issuance of debt - 24,521 104,730
Principal repayment of debt (12,536) (310,644) (32,251)
Proceeds from issuance of shares by public subsidiary 52,592 - (3,499)
Other (Note 16) (52,839) 21,309 (36,459)
-------- --------- --------
Net cash provided by (used in) financing activities 102,350 (117,411) 49,598
-------- --------- --------
Effect of exchange rates on cash 3,158 (339) 4,997
-------- --------- --------
Net increase in cash and cash equivalents 67,030 40,789 44,011
Cash and cash equivalents at beginning of period 302,780 261,991 217,980
-------- --------- --------
Cash and cash equivalents at end of period $369,810 $ 302,780 $261,991
======== ========= ========
The accompanying notes are an integral part of these financial statements.
</TABLE>
<PAGE>
NYLIFE INC. AND SUBSIDIARIES
----------------------------
(AFFILIATES OF NEW YORK LIFE INSURANCE COMPANY)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
------------------------------------------
DECEMBER 31, 1996, 1995 AND 1994
NOTE 1 - ORGANIZATION AND DESCRIPTION OF BUSINESS
- -------------------------------------------------
The accompanying financial statements reflect the consolidation of NYLIFE Inc.
("NYLIFE" or the "Company"), a wholly-owned subsidiary of New York Life
Insurance Company ("New York Life"), and its subsidiaries, each of which is
wholly-owned, except as noted:
Aegis Technologies, Inc. ("Aegis"), 94% owned
Eagle Strategies Corp. ("Eagle")
Greystone Realty Corporation ("Greystone")
MacKay-Shields Financial Corporation ("MacKay-Shields")
Monitor Capital Advisors, Inc.
MSC Holding, Inc. ("MSC"), 85% owned
New York Life Benefit Services Company, Inc. ("Benefit Services")
New York Life Capital Corporation ("Capital Corp.")
New York Life International Investment Inc. ("NYL International")
NYL Management Limited, formerly Quorum Capital Management
Monetary Research Limited ("MRL")
New York Life Irrevocable Trust of 1996 ("Trust")
New York Life Settlement Corporation ("NYLSET")
New York Life Worldwide Holding, Inc. ("Worldwide")
NYLCO, Inc.
NYLICO, Inc. ("NYLICO")
NYLIFE Administration Corp. ("NYLACOR")
NYL Trust Company ("NYL Trust")
NYLIFE Depositary Corporation ("Depositary")
NYLIFE Distributors Inc. ("NYLIFE Distributors")
NYLIFE Equity Inc. ("NYLIFE Equity")
NYLIFE Funding Inc. ("NYLIFE Funding")
NYLIFE HealthCare Management Inc. ("NYLIFE HealthCare"),
NYLCare Health Plans ("NYLCare"), formerly Sanus Corp. Health
Systems Express Scripts Inc. ("ESI"), 46% owned
NYLIFE Realty Inc. ("NYLIFE Realty")
NYLIFE Refinery Inc. ("NYLIFE Refinery")
NYLIFE Resources Inc. ("NYLIFE Resources")
NYLIFE Securities Inc. ("NYLIFE Securities")
NYLIFE SFD Holding, Inc.("SFD Holding"), formerly NAFCO, Inc. Auto
Funding II, LP, formerly NAFCO Auto Funding, LP
NYLINK Insurance Agency Corporation ("NYLINK")
NYLTemps Inc.
NYLIFE Inc., through its subsidiaries, offers health insurance, managed care and
related products and services, life insurance in certain international markets
and investment management, mutual fund, securities brokerage and pension
products and services. Through its health care related subsidiaries, primarily
NYLCare and ESI, the company develops and manages health maintenance
organizations ("HMOs"), markets mail order prescriptions and provides pharmacy
claims processing
<PAGE>
-2-
services and offers indemnity health insurance products and ancillary coverages
such as group life and disability insurance. HMO's are established under the
individual practice association model and provide comprehensive health care to
their members for a fixed monthly fee. Although indemnity products are offered
throughout the United States through the Company's group sales offices, HMO's
are centered in Texas, Washington, D.C., New York, New Jersey and Illinois.
International operations are conducted through Worldwide, which markets life
insurance and related products and services through joint ventures and equity
investments in Hong Kong, Korea, Indonesia, Mexico, Argentina, Bermuda and the
United Kingdom. Asset management operations primarily consist of institutional
asset management and mutual fund related products and services offered through
MacKay-Shields and the Mainstay Funds. Securities brokerage and mutual fund
distribution and administration services are conducted through NYLIFE Securities
and NYLIFE Distributors and pension and 401(k) products and services are offered
through Benefit Services and NYL Trust.
BUSINESS COMBINATION:
NYLCare was established on January 1, 1996 when New York Life combined certain
of its existing group life and health indemnity insurance operations with those
of Sanus Corp. Health Systems, an indirect wholly-owned managed care subsidiary
of New York Life, and renamed the company. Concurrently, New York Life also
transferred its ownership in New York Life and Health Insurance Company
(NYLHIC), a wholly-owned life insurance subsidiary, to NYLCare.
Also on January 1, 1996, NYLHIC entered into a modified coinsurance agreement
through which it assumed the risk on 90% of New York Life's group life and
health indemnity insurance business. Under the terms of the agreement, NYLHIC
assumes the risk for group life and health policies issued by New York Life;
however, New York Life retains the claim and policy reserves as well as the
related assets. The group life and health indemnity business will continue to be
written by New York Life and reinsured to NYLHIC until approval is granted by
various state insurance departments for NYLHIC to directly market such business.
For purposes of these financial statements, the combination has been treated as
a transaction between entities under common control and, accordingly, financial
statements presented for periods prior to January 1, 1996 have been restated to
include the assets, liabilities and operations of New York Life's group life and
health indemnity business during these periods. The approximate effects of
restatement are as follows: an increase in net income of $14,175,000 and
$18,579,000 for the years ended December 31, 1995 and 1994, respectively, and an
increase in total assets of $877,013,000 and an increase in stockholder's equity
of $105,505,000 as of December 31, 1995.
NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES
- ----------------------------------------
The accompanying statutory basis consolidated financial statements have been
prepared on the basis of accounting practices prescribed or permitted by the New
York State Insurance Department for valuing common stocks of subsidiaries (New
York statutory basis of accounting), which is a comprehensive basis of
accounting other than generally accepted accounting principles ("GAAP").
Prior to 1996 the New York statutory basis of accounting was considered GAAP for
mutual life insurance companies and their wholly-owned subsidiaries.
Accordingly, the Company's life insurance operations, which were presented on
the New York statutory basis of accounting, were
<PAGE>
-3-
described as presented in accordance with GAAP. However, in April 1995, the
Financial Accounting Standards Board issued Interpretation No. 40,
"Applicability of Generally Accepted Accounting Principles to Mutual Life
Insurance and Other Enterprises", which established a different definition of
GAAP for mutual life insurance companies and their subsidiaries. Under this
Interpretation, financial statements for mutual life insurance companies and
their subsidiaries, which are presented on the statutory basis of accounting,
can no longer be characterized as in conformity with GAAP.
The New York statutory basis of accounting for insurance subsidiaries varies
from those prepared under GAAP primarily as follows: (1) the costs relating to
acquiring business, principally commissions and certain policy issuance
expenses, are charged to income in the year incurred, whereas under GAAP, they
would be deferred and amortized over the periods benefited; (2) policy reserves
are based on different assumptions than under GAAP and dividends on
participating policies are provided when approved by the Board of Directors,
whereas under GAAP, they are provided when credited to the policies; (3) policy
reserves are recorded net of reinsurance, whereas under GAAP, such amounts are
reported gross; (4) the excess of purchase price over statutory net assets
acquired is charged to stockholder's equity in the year of acquisition, whereas
under GAAP, an intangible asset is established and amortized over a period of 15
to 25 years; (5) investments in bonds are generally carried at amortized cost,
whereas under GAAP, investments in bonds which are considered available for sale
or held for trading are generally carried at market value, with changes in
market value charged against equity or reflected in earnings; (6) certain assets
are considered 'non-admitted' and excluded from the statement of financial
position, whereas they are included under GAAP; (7) joint ventures and minority
stock investments are stated at the value of their underlying statutory net
assets, whereas under GAAP, such investments are stated on the equity basis; and
(8) deferred federal income taxes are not provided for as they are under GAAP.
In addition, goodwill arising from the purchase of non-insurance subsidiaries is
amortized over a period not to exceed ten years. Under GAAP, this goodwill would
be amortized over a period of 15 to 25 years. In 1993, New York Life received
authorization from the New York State Insurance Department to adopt approximate
market value as the carrying value for its investment in Express Scripts Inc., a
publicly traded 46% owned subsidiary of NYLIFE HealthCare. This practice is not
recognized under GAAP.
The approximate effects on the financial statements of the variances between the
practices described in the preceding paragraphs and generally accepted
accounting principles are as follows: a decrease in net income of $17,000,000,
$2,000,000 and $46,000,000 for the years ending December 31, 1996, 1995 and
1994, respectively, and an increase in total assets of $4,000,000 and a decrease
in total assets of $300,000,000, and a decrease in stockholder's equity of
$4,000,000 and $320,000,000 as of December 31, 1996 and 1995, respectively.
The consolidated statement of operations reflects the activities of purchased
subsidiaries from the acquisition date through the respective year-end date.
Intercompany accounts and transactions have been eliminated.
FEE INCOME:
The Company through its subsidiaries receives fees for services provided under
agreements with its clients. The Company accrues fee income when earned.
Additionally, the Company derives monitoring revenues from customer payments for
alarm monitoring services. The Company recognizes revenue as the monitoring
services are provided.
<PAGE>
-4-
FOREIGN CURRENCY TRANSLATION:
Assets and liabilities denominated in foreign currency have been translated into
U.S. dollars at the respective year end exchange rates. Operating results are
translated at the average exchange rates for the year. Foreign currency
translation gains and losses are credited or charged directly to the Cumulative
Translation Adjustment account in stockholder's equity. The change in the
Cumulative Translation Adjustment account is due to the current year effect of
the translation adjustment. Foreign currency transaction gains and losses are
included in net income.
CASH AND CASH EQUIVALENTS:
Cash equivalents are short-term, highly liquid investments that are readily
convertible to known amounts of cash and have original maturities at purchase of
three months or less. The carrying value of cash and cash equivalents
approximates fair value.
ACCOUNTS RECEIVABLE:
The carrying value of accounts receivable at December 31, 1996 and 1995
approximates fair value.
DEFERRED DISTRIBUTION COSTS:
Deferred distribution costs relate to commission expenses and certain other
costs related to the distribution of MainStay Funds which have a contingent
deferred sales charge, and are deferred and amortized over a six year period on
a straight-line basis, adjusted for related contingent deferred sales charge
income earned.
INVESTMENTS:
Short-term investments are carried at cost which approximates fair value. Common
stocks are stated at market value. At December 31, 1996 and 1995, bonds, other
than those associated with insurance operations, are either classified as held
to maturity and are reported at amortized cost or classified as available for
sale and are reported at estimated fair value, with unrealized gains and losses
reported as a separate component of stockholder's equity, net of deferred tax.
The investment in the MainStay Funds is primarily held by NYLIFE Securities and
NYLIFE Distributors, broker-dealers, and in accordance with specialized
accounting practices in their industry, is recorded at fair value, with
unrealized gains and losses included in income.
Mortgage loans are generally stated at the aggregate principal balance due,
except when in management's opinion collection of the loan is doubtful, in which
case the loan is written down to the appraised value of the underlying property.
Such writedowns are recorded as net losses on investments. Interest income is
recorded on the accrual basis, except where collection is 90 days past due or is
considered uncertain. Real estate acquired through foreclosure is valued at the
lower of the mortgage loan carrying value or the appraised (fair market) value
of the property at the time of foreclosure plus certain directly related
expenses. Any excess of the carrying value of the loan over the appraised value
is recorded as a realized loss. Prior to December 30, 1996, alarm monitoring
contracts were recorded at cost net of accumulated amortization. Effective on
this date, such contracts are recorded at the lower of carrying value or fair
value less cost to sell and the amortization of the contracts has been
discontinued (see Note 4). Investments in limited partnerships are generally
accounted for under the equity method of accounting. Under this method, net
earnings or losses are included in income currently.
FAIR VALUES OF FINANCIAL INSTRUMENTS:
Fair values of various assets and liabilities are included throughout the notes
to financial statements. Specifically, fair value disclosure of bonds, mortgage
loans, real estate and the investment in the
<PAGE>
-5-
MainStay Funds is reported in Note 6, and fair value disclosure of notes payable
is reported in Note 9. Fair values of bonds and the investment in the MainStay
Funds are based on published or quoted market values, respectively. Fair value
of mortgage loans is estimated based on discounted cash flow analyses prepared
for each loan using interest rates approximating the current rates for new
mortgages with similar remaining maturities.
FIXED ASSETS:
Fixed assets are recorded at cost and are depreciated over the estimated useful
lives of the assets, generally 3 to 10 years, using the double-declining balance
and straight-line methods of depreciation.
INTANGIBLE ASSETS:
Intangible assets primarily consist of goodwill arising from acquisitions.
Goodwill, which represents the cost in excess of the value assigned to net
assets acquired in connection with acquisitions, is being amortized over 10
years, unless deemed to be impaired, in which case it is written off to the
extent considered unrecoverable (see Note 4).
PREMIUM REVENUE RECOGNITION:
Premium revenue for indemnity health insurance and managed health care and other
ancillary coverage is recorded as income over the premium paying period of the
policies. Revenue on premiums collected in advance is deferred.
Revenues from dispensing prescription and non-prescription medical products from
ESI's mail service pharmacies are recorded upon shipment. Revenue from sales of
prescription drugs by pharmacies in ESI's nationwide network and pharmacy claims
processing revenues are recognized when the claims are processed. When ESI has
an independent contractual obligation to pay its network pharmacy providers for
benefits provided to members of its clients' pharmacy benefit plans, ESI
includes payments from plan sponsors for these benefits as prescription sales
and fees and payments to these pharmacy providers in cost of prescription sales.
If ESI is only administering the plan sponsors' network pharmacy contracts, ESI
records fees derived from ESI's contracts with plan sponsors as net revenue.
CLAIMS, BENEFITS AND CAPITATION COSTS:
Claims and benefits include estimates of payments to be made on individual
claims for medical and ancillary services and for death benefits. The cost of
claims incurred but not reported is estimated using actuarial techniques based
on current membership statistics, current utilization and historical claims data
and trends. These estimates are continually reviewed and revised as changes in
these factors occur and revisions are reflected in the current year's statement
of income. Capitation costs represent monthly charges paid to participating
physicians as compensation for providing continuing medical care.
COST OF PRESCRIPTION SALES:
Costs of prescription sales includes product costs, pharmacy claims payments and
other direct costs associated with dispensing prescription and non-prescription
medical products and claims processing operations, offset by fees received from
pharmaceutical manufacturers in connection with ESI's drug purchasing and
formulary management programs.
POLICYHOLDER ACCOUNT BALANCES AND DEPOSIT FUNDS:
Policyholders' account balances for investment-type contracts and dividends and
policy proceeds deposited with the Company are equal to the policy account
values. The policy account values
<PAGE>
-6-
represent an accumulation of gross premium payments plus credited interest less
expense and mortality charges and withdrawals. Dividends and policy proceeds
deposited with the Company consist of dividend accumulations and supplementary
contracts without life contingencies. The statement value for these liabilities
approximates fair value.
DIVIDENDS PAYABLE TO POLICYHOLDERS:
The liability for dividends payable to policyowners consists principally of
dividends earned as of the statement date. The allocation of dividends is
determined by means of formulas which reflect the relative contribution of each
group of policies to the results of operations.
ACCRUED EXPENSES AND OTHER PAYABLES:
The carrying value of accrued expenses and other payables at December 31, 1996
and 1995 approximates fair value.
MEDICAL GROUPS' RISK SHARING:
NYLCare compensates primary care physicians on a capitation basis. NYLCare has
in place an incentive program whereby primary care physicians are eligible to
receive a bonus based on quality and cost utilization criteria. An accrual is
made for the estimate of the amount of bonus which will be paid to medical care
providers based upon quality cost utilization criteria.
NYLCare also has risk contracts with provider groups covering certain medical
services. To the extent medical expenses differ from budget, NYLCare and the
providers share any savings or deficit as defined in the contracts.
NOTE 3 - BUSINESS RISKS AND UNCERTAINTIES:
- -----------------------------------------
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenue and expenses during the reporting period. Actual
results could differ from those estimates.
At December 31, 1996, the Company's investments were comprised of common stock,
bonds, real estate properties and mortgage loans. Significant changes in
prevailing interest rates and geographic conditions may adversely affect the
timing and amount of cash flows on such investments, as well as their related
values. In addition, the value of these investments is often derived from an
appraisal, an estimate or opinion of value. A significant decline in the market
value of these investments could have an adverse affect on the Company's balance
sheet.
During 1993, New York Life received authorization from the New York State
Insurance Department to adopt approximate market value as the carrying value for
its investment in ESI. Accordingly, the Company recorded adjustments of
$99,527,000 and $406,834,000 for the statutory valuation of ESI in excess of its
GAAP net equity at December 31, 1996 and 1995, respectively. These adjustments
are included as a component of stockholder's equity. Based upon the market value
of ESI's common stock at April 11, 1997, the amount of the statutory valuation
of subsidiary in excess of GAAP net equity was approximately $94,036,000. A
significant decline in the value of this stock could have an adverse effect on
the Company's stockholder's equity.
<PAGE>
-7-
As providers of life and health insurance products, the operating results of
certain subsidiaries in any given period depend upon estimates of policy
reserves required to provide for future policyholder benefits. The development
of policy reserves for the products of these companies requires management to
make estimates and assumptions regarding mortality, morbidity, health care
costs, lapses, expenses and investment experience. Such estimates, including
provisions for incurred but not reported claims, are primarily based on
historical experience and, at times, the specific requirements of local
insurance regulators. Actual results could differ from these estimates.
Management monitors actual experience, and, where circumstances warrant, revises
its assumptions and the related estimates of policy reserves and claim
liabilities.
As substantially all of the net assets of Worldwide's subsidiaries are held in
foreign countries, there is a potential for adverse impact on net assets arising
from economic and political changes in these countries.
NOTE 4 - CHANGES IN ACCOUNTING PRINCIPLES
- -----------------------------------------
NYLCARE:
During 1995, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard No. 121 ("SFAS 121"), "Accounting for the
Impairment of Long-lived Assets to be Disposed Of," which is effective for the
fiscal years beginning after December 15, 1995. SFAS 121 establishes accounting
standards for the impairment of long-lived assets, certain identifiable
intangibles and goodwill related to those assets to be held and used and for
long-lived assets and certain identifiable intangibles to be disposed of.
In connection with the adoption of SFAS 121 in 1996, NYLCare determined that
continuing operating losses of certain subsidiaries which perform administrative
services for physician groups, were indicators of potential impairment. The
estimated undiscounted cash flows anticipated from these subsidiaries indicated
that a write-down of the goodwill related to these subsidiaries was required
under SFAS 121. As a result of the above, approximately $28,830,000 of goodwill
and other intangibles was written off in 1996.
SFD HOLDING AND DEPOSITARY:
On December 30, 1996, Westinghouse Electric Corporation ("Westinghouse") (the
servicer of the security alarm contracts) sold its security alarm business to
WestSec Inc. As part of this transaction, NYLIFE Structured Asset Management
Company Ltd. ("SAMCO", a subsidiary of SFD Holding - 83% and Depositary -17%),
Westinghouse, WestSec Inc. and an affiliate of WestSec Inc. entered into a
Consent, Assignment, Assumption, and Modification Agreement ("the Consent
Agreement"). In connection with the Consent Agreement, WestSec has committed to
purchase, and SAMCO has committed to sell, the security alarm contracts ("the
Contracts") securing each series of notes used to finance the acquisition of the
Contracts at fixed dates in the future for a determinable price. In accordance
with SFAS 121, SAMCO has reported such Contracts at the lower of carrying amount
or fair value less cost to sell and has discontinued amortization of the
Contracts effective December 30, 1996.
ESI
CONTRACTUAL AGREEMENTS:
ESI enters into corporate alliances with certain of its clients whereby shares
of ESI's class A common stock are awarded as advance discounts to the client.
Prior to December 15, 1995, the stock is valued utilizing the quoted market
value at the date the agreement is consummated if the number
<PAGE>
-8-
of shares to be issued is known. If the number of shares to be issued is
contingent upon the occurrence of future events, the stock is valued utilizing
the quoted market value at the date the contingency is satisfied and the number
of shares is determinable. The value of the shares of stock awarded as advance
discounts is recorded as a deferred cost and included in other assets. The
deferred cost is recognized in selling, administrative and other expenses over
the period of the contract.
In October 1995, the Financial Accounting Standards Board issued Statement 123,
"Accounting for Stock-Based Compensation" ("SFAS 123"), effective for all stock
issued to non-employees subsequent to December 15, 1995. SFAS 123 requires that
all stock issued to non-employees be accounted for based on the fair value of
the consideration received or the fair value of the equity instruments issued
instead of the intrinsic value method utilized for stock issued or to be issued
under alliances entered into prior to December 15, 1995. ESI has adopted SFAS
123 as it relates to stock issued under alliances consummated subsequent to
December 15, 1995, based on fair value at the date the agreement is consummated.
ACCOUNTING FOR STOCK-BASED COMPENSATION:
ESI accounts for employee stock options in accordance with Accounting Principles
Board No. 25 (APB 25), "Accounting for Stock Issued to Employees." Under APB 25,
ESI applies the intrinsic value method of accounting and, therefore, does not
recognize compensation expense for options granted, because options are only
granted at a price equal to market value at the time of grant. SFAS 123
prescribes the recognition of compensation expense based on the fair value of
options determined on the grant date. However, SFAS 123 grants an exception that
allows companies currently applying APB 25 to continue using that method. ESI
has, therefore, elected to continue applying the intrinsic value method under
APB 25.
NOTE 5 - ACQUISITIONS AND DISPOSITIONS
- --------------------------------------
NYLIFE HEALTHCARE:
During 1996 and 1995, NYLIFE Inc. paid $7,076,000 and $10,800,000, respectively,
to the three original Founders of NYLIFE HealthCare to purchase their remaining
NYLIFE HealthCare shares in accordance with their Termination, Severance and
Stock Buyback Agreements. Subsequent to the purchase of these shares, NYLIFE's
ownership of NYLIFE HealthCare increased to 100%.
During 1995 and 1994, NYLCare completed four acquisitions for cash, as described
below. Each transaction was accounted for as a purchase and accordingly, the
purchase price was allocated to the fair values of assets acquired and
liabilities assumed. The remaining excess of the purchase price over such fair
values was allocated to goodwill. The operating results of each acquisition have
been included in consolidated net income of the Company from the date of
acquisition.
In July 1995, NYLCare acquired the minority shareholder's interest in
Lonestar Holding Company for approximately $4,100,000 in cash. As a
result of the transaction, the Houston HMO became a wholly-owned
subsidiary of NYLCare. Goodwill related to the purchase of
approximately $2,700,000 is being amortized over an estimated useful
life of 10 years.
In November 1994, NYLCare purchased 100% of the outstanding stock of
The Ethix Corporation, which included 13% owned by NYLIFE, for a
purchase price of approximately $32,900,000. The fair values of
assets acquired and liabilities assumed were $25,800,000
<PAGE>
-9-
and $16,200,000, respectively. Goodwill of approximately $23,300,000
related to the purchase is being amortized over an estimated useful
life of 10 years. The acquisition agreement provides for additional
consideration to be paid based on membership increases over the five
year period ending November 1999. No such amounts were incurred
through 1996.
In June 1994, NYLCare acquired certain assets and assumed certain
liabilities of two partnerships which performed administrative
services for a physician group in the New York City metropolitan
area. Cash paid totaled $10,000,000 plus the assumption of an excess
of the fair value of liabilities over assets acquired of $17,200,000.
Goodwill associated with the acquisition of $27,200,000 is being
amortized over an estimated useful life of 10 years.
In May 1994, NYLCare purchased the remaining 12% minority interest in
Avanti Health Systems. The entire purchase price of $10,000,000 was
allocated to goodwill, which was being amortized over an estimated
useful life of 10 years, but was written off in 1996 under SFAS 121.
In April 1996, ESI completed a public offering of 1,150,000 shares of Class A
common stock and received $52,592,000 in net proceeds. NYLIFE HealthCare
recognized a pre-tax gain of $21,633,000, representing the difference between
NYLIFE HealthCare's interest in the net assets of ESI immediately after the
public offering and the historical book value of its investment in ESI. As part
of the same stock offering, NYLIFE HealthCare converted 2,990,000 shares of ESI
Class B Common Stock to Class A Common Stock. Net proceeds from the sale totaled
$138,497,000 and a pre-tax gain of approximately $121,741,000 was recognized. As
a result of these transactions, NYLIFE HealthCare's ownership of ESI decreased
from 70% to 46% and its voting stock from 96% to 90%.
WORLDWIDE HOLDING
UNITED KINGDOM:
On December 22, 1994, New York Life UK Limited ("NYLUK"), a wholly-owned
subsidiary of New York Life Worldwide Holding, Inc., sold 68.75% of the common
stock of its wholly-owned subsidiary, Windsor Life Assurance Company Ltd., to
outside investors. Also during December, 1994, NYLUK and the new stockholders of
Windsor Life exchanged all of their common stock of Windsor Life for common
stock of Life Assurance Holding Corporation Limited ("LAHC"), a new holding
company. NYLUK is party to the Warranty Indemnity Deed (guaranteed by Worldwide)
relating to the sale of the common stock of Windsor Life. Under the terms of
this deed, NYLUK has undertaken to indemnify the outside investors against
liabilities, costs and expenses incurred with regard to specified matters. Any
claims under the deed require NYLUK to subscribe for deferred shares in LAHC at
par value. Management believes that adequate provision has been made for
potential claims that may arise.
The total income, total benefits and expenses and realized gains on investments
of Windsor Life presented in the Consolidated Statement of Operations during
1994 amounted to $212,326,000, $259,151,000 and $58,617,000, respectively.
Dividend income earned by NYLUK on it's investment in LAHC during the year ended
December 31, 1996, amounted to $3,673,000.
<PAGE>
-10-
NYL BENEFIT SERVICES COMPANY, INC.
Effective June 6, 1994, NYLIFE acquired Benefit Services, a provider of
consulting, administrative, actuarial, communications and investment advisory
services for employee benefit plan sponsors, with an initial cash payment of
$8,000,000, plus a series of future cash payments, exercisable from the fifth to
tenth year. The future cash payments are based on the joint assets of New York
Life and its affiliates related to the Company's 401(k) Complete product.
Approximately $6,640,000 of the original purchase price plus $1,800,000 of the
estimated future cash payments has been allocated to goodwill, which is being
amortized over an estimated useful life of 10 years.
MSC HOLDING, INC.
During 1995, the assets of the Health and Investment Divisions were sold to
Meritech, a subsidiary of Summit Technologies and Melson Technologies, an
indirect subsidiary of Aegon Insurance, respectively. Meritech purchased the
Health Division assets for approximately $750,000 which included contracts,
licenses, equipment and various receivables. Melson Technologies purchased the
Investment Division assets for a contingent purchase price of $3,500,000.
$1,000,000 of the purchase price is guaranteed and is expected to be received by
MSC within three years. As of December 31, 1996, $77,000 has been received. The
remaining $2,500,000 is contingent upon the amount of licensing fees the buyers
receive over the next 10 years relating to the SMS Investment System, which is
currently under development. A total gain of approximately $1,695,000 was
recognized on these transactions.
NEW YORK LIFE CAPITAL CORP.
New York Life Capital Corp. was incorporated in Delaware in June 1995. Capital
Corp's activities will primarily consist of issuing commercial paper and
borrowing from other sources for the purpose of making loans to New York Life
and its affiliates. Capital Corp. has not yet commenced operations.
NYLINK INSURANCE AGENCY CORPORATION
NYLINK Insurance Agency Corporation was incorporated in Delaware in November
1996. NYLINK's activities will primarily consist of the facilitation of sales of
non-proprietary insurance products by New York Life registered representatives.
NYLINK has not yet commenced operations.
NYL TRUST COMPANY
NYL Trust was incorporated in New York on February 2, 1995 as a limited purpose
trust company chartered by the New York State Banking Department to act as a
fiduciary for pension, profit sharing and other employee benefit plans. NYL
Trust's responsibilities include acting as a trustee or custodian for 401(k)
plans and Individual Retirement Accounts.
NYL MANAGEMENT LTD.
On June 18, 1996, Quorum Capital Management Ltd. ("Quorum") transferred its
assets and business operations to Westdeutsche LandesBank (West LB) for
approximately $1,125,000. A gain of approximately $969,000 has been recognized
on this transaction. Quorum subsequently changed its name to NYL Management Ltd.
and substantially ceased on-going operations.
AUTO FUNDING II, LP
NAFCO Auto Funding L.P. ("Funding") was organized as a limited partnership in
1993. Depositary was the general partner and SFD Holding was the limited
partner. On August 15, 1996, Funding assigned all of its financial assets and
liabilities to Auto Funding II L.P. ("Funding II"), a limited partnership with
an ownership structure identical to Funding. Subsequent to the assignment of
assets
<PAGE>
-11-
to Funding II, Depositary and SFD Holding sold their interests in Funding to an
unaffiliated third party. Consideration for the sale of Funding included
$200,000 in cash and $2,000,000 of 6% cumulative preferred stock and 10% of the
common stock of NAFCO Holding Company, Inc., a subsidiary of the purchaser. The
cumulative preferred stock is redeemable under various circumstances, but in any
event within 10 years.
NYLIFE EQUITY AND NYLIFE REALTY
In 1995, New York Life, NYLIFE, and certain other affiliated and unaffiliated
entities, entered into a Stipulation of Settlement (the "Settlement Agreement")
of a class action lawsuit related to the sale of units in, and the operation of,
the Company's proprietary limited partnership programs. In connection with the
Settlement Agreement, New York Life announced a plan to dissolve the partnership
programs (the "Plan"), contingent upon the consent of the Limited Partnership
Investors (the "Investors"). In 1995, NYLIFE recorded a provision of
$137,000,000 to reflect the estimated costs of discontinuing the partnership
operations and certain claims in connection therewith, including settlement of
the class action lawsuit. Both the Settlement Agreement and the Plan were
approved during 1996.
Pursuant to the Plan, NYLIFE Equity and NYLIFE Realty, as liquidators, have
commenced the process of winding up the partnership programs. Substantially all
of the property interests of the partnership programs were sold prior to
December 31, 1996. As of December 31, 1996, pursuant to the Settlement
Agreement, NYLIFE has advanced $174,000,000 to the Investors and has paid
$35,397,000 to other unaffiliated entities for costs of the liquidation,
primarily from proceeds from a $200,000,000 line of credit with New York Life.
In exchange for advances received under the Settlement Agreement, each Investor
granted a security interest to NYLIFE (up to the amount of advances) in any
future distributions from liquidation of the partnerships. Through December 31,
1996, the Company has recovered $18,734,000 from liquidating dividends and has a
liquidation advance recoverable of $64,431,000 as of December 31, 1996.
NEW YORK LIFE IRREVOCABLE TRUST
On February 13, 1996, The New York Life Irrevocable Trust of 1996, (the "Trust")
was created to hold the stock of NYLSET. NYLIFE, as Grantor of the Trust,
transferred its 100% ownership of NYLSET to the Trust, making NYLIFE the
beneficiary.
AEGIS TECHNOLOGIES
In December 1995, the Aegis Technologies' Board of Directors approved a plan to
close the business and dissolve Aegis in the event a suitable buyer could not be
found. On March 5, 1996, the decision to dissolve Aegis and its subsidiary,
Personal Financial Assistant Financial Centers was announced.
The assets were liquidated and a loss of $5,420,000 was recognized.
NYLIFE RESOURCES
In December 1993, NYLIFE Resources became a limited partner in the Ancon
Partnership Limited ("Ancon"). The partnership was formed to acquire, explore,
develop, and operate oil and gas properties.
<PAGE>
-12-
In December 1996, NYLIFE Resources, along with New York Life and New York Life
Insurance and Annuity Corporation (a wholly owned subsidiary of New York Life)
entered into a purchase and sale agreement with American Exploration Company,
the general partner. NYLIFE Resources sold its remaining 11.23% in Ancon for
$1,813,000 in cash. The estimated investment value was $2,173,000, resulting in
a loss of $360,000.
NOTE 6 - INVESTMENTS
- --------------------
COMMON STOCK:
The common stock portfolio, which is stated at market value, primarily consists
of securities issued in the United Kingdom which are denominated in British
Pounds Sterling at December 31, 1996 and 1995.
BONDS:
At December 31, 1996, the maturity distribution of bonds was as follows (in
thousands):
<TABLE>
<CAPTION>
Available for Sale Held to Maturity Life Insurance Operations
------------------ ---------------- -------------------------
Amortized Estimated Amortized Estimated Statement Estimated
Cost Fair Value Cost Fair Value Value Fair Value
--------- ---------- --------- ---------- --------- ----------
<S> <C> <C> <C> <C> <C> <C>
Due in one year or less $ 39,797 $ 39,830 $ - $ - $ 716 $ 716
Due in years two through five 85,322 85,670 - - 6,572 6,703
Due in years six through ten 59,969 58,908 - - 17,595 19,107
Due after ten years 13,088 12,399 2,311 2,431 7,528 8,274
--------- --------- --------- --------- --------- ----------
Sub-total 198,176 196,807 2,311 2,431 32,411 34,800
Asset-backed securities 3,658 3,635 - - - -
--------- ---------- --------- --------- -------- ---------
Total $201,834 $200,442 $ 2,311 $ 2,431 $ 32,411 $ 34,800
======== ======== ========= ========= ======== =========
</TABLE>
At December 31, 1996 and 1995, the distribution of unrealized gains and losses
on bonds was as follows (in thousands):
DECEMBER 31, 1996
<TABLE>
<CAPTION>
Amortized Unrealized Unrealized Estimated
Available for sale Cost Gains Losses Fair Value
- ------------------ --------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
U.S. Treasury and other
U.S. Governmental Agencies $ 97,430 $ 256 $ 880 $ 96,806
Commercial paper and Corporate notes 99,983 682 1,450 99,215
Other 4,223 - - 4,223
Certificates of deposit 198 - - 198
-------- ------ ------- --------
Total $201,834 $ 938 $ 2,330 $200,442
======== ====== ======= ========
<CAPTION>
Amortized Unrealized Unrealized Estimated
Held to maturity Cost Gains Losses Fair Value
- ---------------- --------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
U.S. Treasury and other
U.S. Governmental Agencies $2,311 $ 120 $ - $2,431
====== ======= ============ ======
</TABLE>
<PAGE>
-13-
<TABLE>
<CAPTION>
Statement Unrealized Unrealized Estimated
Insurance Operations: Value Gains Losses Fair Value
- -------------------- --------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Foreign Governments $ 10,782 $ 1,281 $ - $12,063
Corporate 15,520 951 190 16,281
Other 6,109 384 37 6,456
-------- ---------- --------- -------
Total $ 32,411 $ 2,616 $ 227 $34,800
======== ========== ========= =======
<CAPTION>
DECEMBER 31, 1995
Amortized Unrealized Unrealized Estimated
Available for sale Cost Gains Losses Fair Value
- ------------------ --------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
U.S. Treasury and other
U.S. Governmental Agencies $318,830 $12,101 $ 224 $ 330,707
Commercial paper and Corporate notes 265,170 16,455 1,039 280,586
Certificates of deposit 337 14 - 351
-------- ------- ------ ---------
Total $584,337 $28,570 $1,263 $611,644\
======== ======= ====== =========
<CAPTION>
Amortized Unrealized Unrealized Estimated
Held to Maturity Cost Gains Losses Fair Value
- ------------------ --------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Commercial paper and Corporate notes $33,763 $3,397 $ - $37,160
======= ====== ========== =======
<CAPTION>
Statement Unrealized Unrealized Estimated
Insurance Operations: Value Gains Losses Fair Value
- ------------------ --------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Foreign Governments $ 12,240 $ 869 $ 4 $ 13,105
Corporate 16,961 1,548 358 18,151
-------- ---------- -------- ---------
Total $ 29,201 $ 2,417 $ 362 $ 31,256
======== ========== ======== =========
</TABLE>
Proceeds from investments in bonds sold, matured, or repaid were $182,786,000,
$624,801,000, and $651,365,000 for 1996, 1995 and 1994, respectively. Realized
gains from investments in bonds sold, matured, or repaid were $705,000,
$10,164,000 and $6,551,000 for 1996, 1995 and 1994, respectively, and realized
losses were $12,000, $3,844,000 and $3,796,000 for 1996, 1995 and 1994
respectively.
Investment in bonds include $65,610,000 and $58,585,000 of restricted securities
on deposit to meet statutory solvency requirements, for 1996 and 1995,
respectively.
<PAGE>
-14-
MORTGAGE LOANS:
At December 31, 1996 and 1995 the geographic diversification of the mortgage
loan portfolio was as follows (in millions):
1996 1995
---- ----
United States:
Pacific $6.8 $33.8
Central - 20.8
Middle Atlantic - 36.6
South Atlantic - 20.2
New England - .5
Mountain - 2.8
Other - 2.3
---- ------
Total $6.8 $117.0
==== ======
Mortgage loans are secured by first liens on all properties. The mortgage loan
portfolio consisted of one loan at December 31, 1996 is summarized below (in
thousands):
Statement
Property Type State Loan Period Interest Rate Value
- ------------- ----- ----------- ------------- ---------
Shopping Center CA 1993 - 1998 8.750% $6,769
The fair value of the mortgage loan portfolio was $6,769,000 and $116,488,000 at
December 31, 1996 and 1995, respectively, estimated based on discounted cash
flow analyses prepared for each loan using interest rates approximating the
current rates for new mortgages with similar remaining maturities. Fair values
do not necessarily represent the values for which these loans could have been
sold at December 31, 1996 or 1995; therefore, care should be exercised in
drawing any conclusions from these fair values.
Write downs related to declines in the appraised value of properties underlying
mortgage loans totaled $0 and $9,335,000 in 1996 and 1995, respectively.
During 1996, Funding foreclosed on two mortgage loans and collected a prepayment
on one mortgage loan. Funding recorded a realized loss of $929,000 as a result
of these transactions.
During 1995, fourteen loans were sold to New York Life (see note 11).
<PAGE>
-15-
REAL ESTATE:
At December 31, 1996 and 1995, real estate included the following properties
which were acquired through foreclosure (in millions):
Carrying Value
Year ----------------
Property Type State Acquired 1996 1995
- ------------- ----- -------- ---- ----
Office MD 1991 $75.8 $ 74.5
Shopping Center FL 1991 3.5 -
Office NY 1992 18.8 17.6
Office TX 1933 - 3.0
Office MI 1994 - 4.0
Office CT 1994 - 5.0
Office NJ 1995 - 2.5
----- -------
Total $98.1 $106.6
----- ===== ======
At December 31, 1996 and 1995, real estate also included $2,300,000 and
$2,100,000 associated with Worldwide operations.
During 1996, Funding foreclosed on two delinquent mortgage loans and transferred
them at their appraisal value to real estate. Funding recorded a realized gain
of $773,000 as a result of these transactions.
In January 1995, a previously acquired apartment property was sold to New York
Life for cash (see Note 11).
MAINSTAY FUNDS:
At December 31, 1996 the total investment in the MainStay Funds includes
investments in individual funds as follows (in thousands):
Fund Cost Fair Value
- ------------------------ ---- -----------
California Tax Free $ 3,867 $ 3,751
Capital Appreciation 56 137
Convertible 81 115
Corporate Bond 539 521
Equity Index 122 234
Institutional Growth 1,124 1,106
International Equity 8,428 8,806
International Bond 8,578 9,353
High Yield Corporate Bond 91 112
Short-Term Bond 15,859 15,130
New York Tax Free 6,232 6,049
Total Return 55 90
Value 1,830 1,859
------- --------
Total 1996 $46,862 $47,263
======= =======
Total 1995 $33,084 $33,762
======= =======
<PAGE>
-16-
SECURITY ALARM CONTRACTS:
At December 31, 1996, the carrying amount of security alarm monitoring contracts
held for sale includes Contracts collateralizing Series A, B and C Notes (see
Note 7) as follows (in thousands):
Series A Series B Series C Total
Carrying amount $9,112 $3,711 $25,632 $38,455
Investment in security alarm monitoring contracts at December 31, 1995 includes
Contracts collateralizing Series A, B and C Notes as follows (in thousands):
<TABLE>
<CAPTION>
Series A Series B Series C Total
-------- -------- -------- -----
<S> <C> <C> <C> <C>
Investment in security alarm monitoring contracts $23,000 $8,665 $44,604 $76,269
Less: Purchase Price Refunds 2,234 890 2,221 5,345
Accumulated Amortization 9,322 3,187 9,990 22,499
------------ ------- --------- --------
Net investment $11,444 $4,588 $32,393 $48,425
============ ====== ======= =======
</TABLE>
Prior to the reclassification of the Contracts as held for sale effective
December 30, 1996, the Contracts were being amortized over an estimated life of
12 years, as adjusted for attrited Contracts. Amortization expense for the
period January 1, 1996 to December 30, 1996 for Series A, B and C Contracts was
$9,924,000. Amortization expense for the years ended 1995 and 1994 was
$10,292,000 and $7,573,000, respectively.
TIME DEPOSITS:
Time deposits, included in cash and cash equivalents, at December 31, 1996 and
1995 amounted to $11,889,000 and $8,155,000, respectively.
OTHER INVESTMENTS:
Other investments include interests in limited partnerships which consist
primarily of an oil refinery and oil and gas producing properties valued at
$32,403,000 and $38,966,000 at December 31, 1996 and 1995, respectively.
As described in Note 5, in connection with the Settlement Agreement, the
Investors approved a plan to dissolve the partnership programs in which NYLIFE
Equity and NYLIFE Realty have interests in. Substantially all of the property
interests of these partnership programs have been sold prior to December 31,
1996. Accordingly, NYLIFE Equity's and NYLIFE Realty's interests in the
partnership programs at December 31, 1996 are comprised principally of cash
received from the sales and other miscellaneous assets and liabilities.
<PAGE>
-17-
NOTE 7 - FIXED ASSETS
- ---------------------
At December 31, 1996 and 1995 fixed assets, at cost, are comprised of the
following (in thousands):
1996 1995
---- ----
Furniture $ 7,825 $ 22,021
Equipment 73,481 41,737
Computer hardware 7,725 30,315
Computer software 7,275 7,646
Leasehold improvements 5,687 19,084
Other 12,613 11,166
-------- --------
114,606 131,969
Less accumulated depreciation and amortization 25,235 59,044
-------- --------
Total $ 89,371 $ 72,925
======== ========
NOTE 8 - POLICY AND CLAIM RESERVES - ACCIDENT AND HEALTH
- --------------------------------------------------------
Activity in the liability for policy and claim reserves for accident and health
insurance for 1996 and 1995 is summarized as follows (in millions):
<TABLE>
<CAPTION>
1996 1995
---- ----
<S> <C> <C>
Gross balance at January 1 $225 $199
Effect of business combination (Note 1) (225) -
---- ----
Gross balance at January 1, as adjusted - $199
---- ----
Gross incurred related to:
Current year 459 465
Prior years - 6
Initial transfer for reserves under the modco reinsurance
agreement 478 -
----- ----
Total gross incurred 937 471
----- ----
Gross paid related to:
Current year 331 342
Prior years - 103
Retransfer of reserves under the modco reinsurance
agreement 478 -
----- ----
Total gross paid 809 445
----- ----
Gross balance at December 31 $ 128 $225
===== ====
</TABLE>
On January 1, 1996, in accordance with the terms of the initial settlement of
the modified coinsurance agreement, New York Life transferred $478,149,000 to
NYLHIC representing reserves and an equal amount of premiums on existing
business. NYLHIC immediately retransferred the reserves back to New York Life.
As a result of the above transactions, NYLHIC recorded premiums assumed and an
increase in policy reserves on the initial settlement of $478,149,000 in the
statement of operations.
<PAGE>
-18-
The modified coinsurance reserve retained by New York Life related to the
reinsured group life and health indemnity business is $498,255,000 at December
31, 1996.
NOTE 9 - NOTES PAYABLE
- ----------------------
Notes payable, generally carried at the unpaid principal balance, consisted of
the following at December 31, 1996 and 1995 (in thousands):
<TABLE>
<CAPTION>
1996 1995
---------- -------
<S> <C> <C>
Worldwide-Loan from Windsor Life $ 6,103 $ 6,434
Series A and B, Floating Rate Secured Five Year Notes 17,146 20,628
Series C 9% Fixed Rate Secured Five Year Notes 26,596 32,218
Loans payable to New York Life 113,220 59,842
Bank borrowings and revolving line of credit with financial institutions 14,222 15,732
Other (including current portion) 5,909 6,227
-------- --------
$183,196 $141,081
======== ========
</TABLE>
The carrying value of notes payable approximates fair value.
The $17,146,000 of Series A and B Floating Rate Secured Five Year Notes are
collateralized by security alarm monitoring contracts, and pay interest
quarterly at a per annum floating rate based on the minimum denomination
five-year certificate of deposit average rate as reported by Bank Rate Monitor.
Principal is paid down on a quarterly basis. At December 31, 1996, the rate on
these Notes was 9%. In addition, $1,720,000 of these notes are payable during
1997.
The $26,596,000 of Series C 9% Fixed Rate Secured Five Year Notes are
collateralized by security alarm monitoring contracts, and pay interest
quarterly at the fixed rate. Principal is paid down on a quarterly basis. In
addition, $2,250,000 of these notes are payable during 1997.
In January 1995, NYLIFE entered into a credit agreement, expiring January 1,
1997, with New York Life whereby NYLIFE can borrow up to an aggregate principal
amount of $200,000,000 at any one time. This agreement and any loans made shall
be automatically extended and renewed for additional one year periods, unless
either NYLIFE or New York Life notifies the other of its desire to terminate the
agreement. At December 31, 1996 the total principal borrowed under this
agreement was $91,131,000. Interest expense amounted to $2,598,000.
On November 1, 1993, SFD Holding entered into a loan agreement with New York
Life. The agreement allows SFD Holding to borrow money pursuant to one or more
master notes (individually, a "Master Note", collectively, "Master Notes") each
of which will not exceed one year in maturity and for amounts, in aggregate, not
to exceed $35,000,000 at any one time. Interest on any Master Note borrowings
accrues at the rate which is the annual simple interest equivalent (computed on
the actual daily principal balance based on a 360 day year of 12 30-day months)
of 225 basis points above the one month LIBOR published in the Wall Street
Journal on the 15th day of the proceeding calendar month (or if such day is not
a day on which such newspaper is published, the next succeeding day of such
publication). In 1995, the loan agreement between SFD Holding and New York Life
was amended to accommodate the acquisition of prime auto loans. The amendment
provides for the following: (i) an increase in the maximum borrowings to
$70,000,000, (ii) an interest rate of 200 basis points above the one month LIBOR
for borrowings related to prime auto
<PAGE>
-19-
loan acquisitions, and (iii) a change in the monthly interest payment date to
the 20th of each month. During 1996 and 1995, SFD Holding made interest payments
totaling $2,805,000 and $2,636,000, respectively, to New York Life pursuant to
the Master Notes. At December 31, 1996 and 1995, the amounts outstanding under
the Master Notes are $22,089,000 and $32,484,000, respectively. Accrued interest
at December 31, 1996 and 1995 is $145,000 and $278,000, respectively.
On December 11, 1992, SFD Holding entered into a revolving credit agreement (the
"Credit Agreement") with Barclays Bank PLC ("Barclays"). The Credit Agreement
allows SFD Holding to borrow an aggregate principal amount not to exceed
$15,000,000 at any one time. Interest on any borrowing accrues at a rate equal
to either (i) the rate of interest per annum declared by Barclays as its prime
rate in effect at its branch in New York City or (ii) LIBOR plus 1%. During 1996
and 1995, SFD Holding recorded interest expense of approximately $980,000 and
$138,000, respectively, to Barclays pursuant to the Credit Agreement. At
December 31, 1996, borrowings under the credit agreement are $13,700,000. At
December 31, 1995, borrowings under the credit agreement were $15,000,000. All
borrowings under the credit agreement are guaranteed by NYLIFE.
Along with New York Life, Capital Corp. is party to a credit agreement with a
consortium of banks. The credit agreement consists of a $150,000,000, 364 day
revolving credit facility ("Facility A"), and a $350,000,000, 5 year revolving
credit facility ("Facility B"). Annual facility fees are .04% and .06%, for
Facility A and B, respectively, and borrowing rates are capped at spreads of
.16% and .14% over LIBOR, respectively. In addition, the credit agreement
contains various covenants pertaining to allowable activities of Capital Corp.
Neither Capital Corp. nor New York Life have utilized the credit facility to
date.
ESI maintains two $25,000,000 unsecured lines of credit with two separate
financial institutions. One agreement will expire on May 29, 1997 and the other
on October 30, 1997. Terms of both lines are essentially the same and are as
follows: interest is charged on the principal amount outstanding at a rate equal
to any of the following options which ESI, at its option shall select: (i) the
bank's "prime rate", (ii) a floating rate equal to the Bank's cost of funds rate
plus 50 basis points, or (iii) a fixed rate for periods of 30, 60, 90 or 180
days equal to the LIBOR rate plus 50 basis points. Fees under these agreements
on any unused portion are charged at ten hundredths of one percent per year. At
December 31, 1996 and 1995, ESI had no outstanding borrowings under these
agreements, nor did it borrow any amounts under these agreements during 1996.
NYLCare had a loan agreement with New York Life under which NYLCare borrowed
amounts as mutually agreed. Under the provisions of this agreement, interest was
payable at the end of each calendar quarter at a rate of 1% over the prime rate
as announced by a specified New York money center bank. The applicable interest
rates during 1995 ranged from 9.5% to 10.0% and 1994 ranged from 7.0% to 9.5%.
NYLCare borrowed $4,000,000 during 1995 and $57,889,000 during 1994, primarily
to finance acquisitions. Effective December 31, 1995 the loan balance, along
with accrued interest, in the total amount of $82,898,000 was contributed to
NYLCare as additional paid-in-capital and the loan agreement, which was to
mature on October 1, 1997, was terminated. Interest expense on such borrowings
during 1995 was $7,854,000.
On May 15, 1995, NYLIFE Funding repaid the principal and remaining interest on
9.25% Guaranteed Notes which totaled $300,000,000 and $9,250,000, respectively.
<PAGE>
-20-
NOTE 10 - REINSURANCE
- ---------------------
MODIFIED COINSURANCE:
As described in Note 1, in 1996, NYLHIC entered into a modified coinsurance
reinsurance agreement with New York Life, whereby 90% of New York Life's group
life and health indemnity insurance business was reinsured with NYLHIC. In 1996,
NYLHIC assumed $613,632,000 in premiums under this agreement. In addition, in
1996 NYLHIC recorded a commission and expense allowance of $142,725,000, a modco
reserve adjustment of $13,135,000, and benefit payments of $507,055,000 under
this agreement. Settlement on the net amount due is made 90 days after the end
of each quarter. At December 31, 1996, premiums receivable were $191,922,000,
claims payable were $143,096,000, commission and expense allowances payable were
$34,191,000, dividends payable were $27,777,000 and payable on reinsurance
assumed was $26,507,000.
OTHER REINSURANCE:
Certain subsidiaries enter into reinsurance agreements in the normal course of
their insurance business. Reinsurance on certain individual lives is ceded to
reduce the risk on any one life. These subsidiaries remain liable for the
reinsurance ceded, if the reinsurer fails to meet its obligations. Premiums
ceded by these subsidiaries for the years ended December 31, 1996, 1995 and 1994
in connection with reinsurance agreements totaled $29,434,000, $3,201,000 and
$75,971,000, respectively. Policy reserves are recorded net of reinsurance
receivables of $7,709,000 and $649,000 at December 31, 1996 and 1995,
respectively.
NOTE 11 - RELATED PARTY TRANSACTIONS
- ------------------------------------
NYLIFE and several of its subsidiaries are party to a service agreement with New
York Life, whereby New York Life provides services to NYLIFE and such
subsidiaries, including office space, legal, accounting, administrative,
personnel and other services for which NYLIFE and its subsidiaries are billed.
NYLIFE and its subsidiaries are charged for these services based upon (a) actual
costs incurred, where they are separately identifiable and (b) allocation of
costs incurred by New York Life developed through analyses of time spent on
matters relating to NYLIFE and its subsidiaries.
Investment management fees of $40,864,000, $35,089,000, and $32,684,000 were
received from New York Life and certain of its affiliates during the years ended
December 31, 1996, 1995 and 1994, respectively.
Certain subsidiaries earned premiums and fees related to health care services
provided to New York Life of $14,447,000, $14,301,000 and $14,137,000 in 1996,
1995 and 1994, respectively.
During 1995, one of NYLCare's HMO subsidiaries paid hospital service claims of
approximately $7,000,000, respectively, to its minority shareholders.
NYLACOR has eight offices which market the New York Life long-term care product.
Beginning in 1995, all the expenses incurred by New York Life sales agents to
market the New York Life long-term care product are paid by NYLACOR and
reimbursed by New York Life. These expenses and the associated reimbursements
totaled $5,859,000 and $3,266,000, respectively, for the year ended December 31,
1996 and 1995.
<PAGE>
-21-
At December 31, 1996 and 1995, New York Life owned approximately 3.5% and 8.7%,
respectively, of the outstanding common stock of American Exploration Company
("American"), the parent of NYLIFE Equity's co-general partner (American
Exploration Production Company) and had invested approximately $18,954,000 in
partnerships it managed in 1995. During 1996, such investments were sold to
American. In addition, New York Life provided a $40,000,000 bridge facility for
American through February 1995 to finance the consolidation of its institutional
oil and gas limited partnerships.
As distributor, NYLIFE Distributors has entered into agreements with the
MainStay Funds, pursuant to Rule 12b-1 under the Investment Act of 1940, to
compensate it for the distribution expenses it incurs. Although the plans are
required to be approved annually by the Trustees of the board of NYLIFE
Distributors, the management of NYLIFE Distributors believes that such annual
approval will continue indefinitely. Distribution fee income for 1996 was
$36,826,000. At December 31, 1996 and 1995 receivables from the MainStay Funds
approximated $8,539,000 and $6,493,000, respectively for distribution, services
and administration fees.
NYLIFE Securities earned commission revenue of approximately $61,438,000,
$29,910,000 and $16,855,000 on transactions with affiliates during 1996, 1995
and 1994, respectively.
At December 31, 1995, Greystone had an intercompany payable to New York Life of
$3,387,000 which requires minimum annual installments of $250,000 until the
balance of the account is liquidated. Greystone paid installments of $750,000
and $1,279,000 in 1996 and 1995, respectively.
Such liability is non-interest bearing.
During 1995, NYLIFE Funding sold fourteen mortgage loans and one foreclosed
property with a total statement value of $119,314,000 to New York Life and
received a capital infusion of $115,000,000 from New York Life through NYLIFE.
The cash received in these two transactions was used to repay the principal and
interest obligations on the 9.25% Guaranteed Notes.
<PAGE>
-22-
NOTE 12 - FOREIGN OPERATIONS
- ----------------------------
NYLIFE subsidiaries conduct insurance and investment management operations in
the United Kingdom, Argentina, Bermuda, Hong Kong, Japan, Korea, Indonesia and
Mexico. The assets, liabilities, and net income of these foreign operations at
December 31, 1996 and 1995 and for the years then ended are as follows (in
thousands):
CONSOLIDATED SUBSIDIARIES:
1996 1995
---- ----
Assets $128,526 $90,614
Liabilities 98,180 70,326
Revenue 43,760 29,854
Net Loss (20,735) (14,384)
NON-CONSOLIDATED SUBSIDIARIES
1996 1995
---- ----
Assets $3,961,499 $3,261,163
Liabilities 3,807,416 3,178,398
Revenue 330,529 352,057
Net Income 25,852 3,231
The cumulative translation adjustment for 1996 is $3,850,000.
NOTE 13 - INCOME TAXES
- ----------------------
NYLIFE and its subsidiaries are members of an affiliated group which joins in
the filing of a consolidated federal income tax return with New York Life. The
consolidated income tax provision or benefit is allocated among the members of
the group in accordance with a tax allocation agreement. The tax allocation
agreement provides that each member of the group is allocated its share of the
consolidated tax provision or benefit determined generally on a separate return
basis, but may, where applicable, recognize the tax benefits of net operating
losses or capital losses utilizable in the consolidated group. Estimated
payments for taxes are made between the members of the consolidated group during
the year. State, local, and foreign tax returns are filed separately. The income
tax receivable included $14,481,000 and $5,141,000 due from New York Life as of
December 31, 1996 and 1995, respectively pursuant to the tax allocation
agreement.
<PAGE>
-23-
The components of income tax expense (benefit) for each year are as follows:
1996 1995 1994
------ ------ ------
(in thousands)
Current
Federal $ (20,135) $ 9,119 $12,275
State 8,973 8,771 8,366
Foreign 190 (363) 2,570
------- -------- -------
Total Current (10,972) 17,527 23,211
------- -------- -------
Deferred
Federal 86,686 (41,370) 3,040
State 611 (598) (3,816)
------- ------- -------
Total Deferred 87,297 (41,968) (776)
------- ------- -------
Total $76,325 $(24,441) $22,435
======= ======== =======
Total income tax expense (benefit) is different from the amount computed using
the statutory federal tax rate of 35% in 1996, 1995 and 1994 for the following
reasons:
<TABLE>
<CAPTION>
1996 1995 1994
---- ---- ----
(in thousands)
<S> <C> <C> <C>
Income tax expense (benefit) at statutory rate $54,371 $ (40,522) $26,284
Tax exempt investment income and capital gains (216) (231) (136)
State and local taxes, net of federal income tax benefit 6,256 5,288 2,952
Amortization of goodwill 6,155 6,219 913
Net foreign taxes 183 (1,904) (2,642)
Equity in non-consolidated affiliates 6,447 4,518 (6,100)
Non-deductible losses with respect to foreign operations 349 1,378 -
Undistributed earnings of subsidiaries 1,237 896 634
Issuance of additional shares by public subsidiary 2,689 - -
Provision to return reconciliation 217 (1,126) (23)
Other (1,363) 1,043 553
------- --------- -------
Total income tax expense (benefit) $76,325 $ (24,441) $22,435
======= ======== =======
</TABLE>
<PAGE>
-24-
The net deferred tax asset (liability) as of December 31, 1996 and 1995,
respectively is attributable to the following temporary differences (in
thousands):
<TABLE>
<CAPTION>
1996 1995
---- ----
<S> <C> <C>
Deferred tax asset:
Non-deductible reserves $ 14,389 $ 71,022
Net operating losses 4,448 6,244
Deferred compensation 13,417 17,267
Impairments 2,133 5,787
Investments in affiliates and partnerships 652 735
Leasehold improvements 2,607 1,935
Deferred rent 2,365 2,943
Depreciation 912 1,046
Unrealized investment losses 764 -
Employee benefits 4,867 -
Deferred tax on sale of shares of subsidiary stock 2,614 -
Other 2,212 1,519
-------- ---------
Gross deferred tax asset 51,380 108,498
Deferred tax liability:
Deferred distribution costs (78,663) (60,919)
Unrealized appreciation of subsidiary (11,456) (1,713)
Investments in affiliates and partnerships (5,204) (6,736)
Depreciation (1,729) (1,363)
Unrealized net appreciation (9,102) (7,780)
Software development costs - (322)
Unrealized investment gains - (8,832)
Forgiveness of subsidiary loan (4,340) -
Other (492) (615)
--------- --------
Gross deferred tax (liability) (110,986) (88,280)
Valuation allowance (4,445) (6,236)
--------- --------
Net deferred tax (liability) asset $ (64,051) $ 13,982
========= ========
</TABLE>
The December 31, 1995 valuation allowance principally relates to foreign net
operating losses, the utilization of which is subject to limitations in the
United Kingdom, and net operating loss limitations.
NOTE 14 - COMMITMENTS AND CONTINGENCIES
- ---------------------------------------
LEASES:
The subsidiaries lease office space, a telephone system, and certain computer
and office equipment under agreements with various expiration dates. The leases
contain provisions for payment of real estate taxes, building maintenance,
electricity, and other escalations.
<PAGE>
-25-
Future minimum lease payments under capital and noncancelable operating leases
with original or remaining lease terms in excess of one year at December 31,
1996, are as follows (in thousands):
<TABLE>
<CAPTION>
Capital Leases Operating Leases
-------------- ----------------
<S> <C>
1997 $ 816 $ 27,959
1998 1,127 26,856
1999 1,206 25,817
2000 1,290 23,358
2001 1,380 19,880
2002 & thereafter 1,100 71,182
--------- --------
Total 6,919 195,052
--------- --------
Less future sublease rental receipts - 3,293
--------- --------
Present value of future minimum lease payments 6,919 191,759
--------- --------
Less amount due in one year 816 -
--------- --------
Total $ 6,103 $191,759
========= ========
</TABLE>
Assets recorded under capital leases and the related accumulated depreciation
are listed below. Amortization of these assets is included in depreciation and
amortization expense (in thousands):
December 31,
------------------------------
1996 1995
---- ----
Assets recorded under leases $12,286 $12,871
Accumulated depreciation (1,910) (2,794)
-------- --------
Total $10,376 $10,077
======= =======
Rent expense for the years ended December 31, 1996, 1995 and 1994 was
approximately $34,943,000, $32,848,000 and $28,315,000, respectively.
Windsor Construction Company Limited, a wholly owned subsidiary of NYLUK,
entered into two contracts with Balfour Beatty Limited on January 11, 1994, for
the construction of phases II and III of NYLUK's head office development in the
United Kingdom amounting to $3,945,000 for Phase II and $4,190,000 for Phase
III. The contract for Phase II must begin by January 8, 1997, and the contract
for Phase III must begin by December 31, 1999.
New York Life has a guarantee, dated December 19, 1995, on behalf of NYLCare for
the rents due by NYLCare to its landlord, Olympia & York OLP Company. New York
Life will only be responsible upon the occurrences of certain events. The total
remaining amount of rental payments for the five year lease is $20,000,000.
<PAGE>
-26-
INTEGRATION COSTS:
During 1995, NYLCare recorded a pretax charge of $10,000,000 relating to
expenses incurred for the integration of NYLCare operations and certain of New
York Life's group operations. Such costs related primarily to consulting, public
relations and relocation charges. A remaining liability of $5,000,000 is
included in accounts payable and accrued expenses as of December 31, 1995 and
the related charge was included in selling, administrative and other costs for
1995.
OTHER:
During 1990, NYLIFE entered into an agreement to provide a guarantee for the
benefit of the shareholders of the MainStay Equity Index Fund. The guarantee
provides that if, after ten years from date of purchase, the net asset value,
with all dividend and capital gains distributions reinvested, is less than the
original offering price, NYLIFE will reimburse the shareholders for their loss
of principal and restore the net asset value to the original offering price,
including the return of any front-end sales charge. If shares are redeemed prior
to or after the one day guarantee date, the investor loses the benefit of the
guarantee with respect to those shares.
New York Life and NYLIFE have an indemnification agreement dated September 29,
1995, on behalf of MacKay-Shields. Under this agreement, New York Life and
NYLIFE have agreed to indemnify a client of MacKay-Shields for any actions,
omissions, or liabilities that MacKay-Shields is unable to satisfy under an
investment management agreement, pursuant to which MacKay-Shields acts as an
investment manager for $431,000,000 of the clients assets.
The Company and its subsidiaries are also defendants in other individual and
alleged class actions arising from its operations. Most of these actions seek
substantial or unspecified compensatory and punitive damages. The Company is
also from time to time involved as a party in various governmental,
administrative and investigative proceedings and inquiries. Given the uncertain
nature of litigation and regulatory inquiries, the outcome of the above and
other actions pending against the Company cannot be predicted. The Company
nevertheless believes that the ultimate outcome of all pending litigation should
not have a material adverse effect on the Company's financial position; however,
it is possible that settlements or adverse determinations in one or more actions
or other proceedings in the future could have a material adverse effect on the
Company's operating results for a given year.
Additionally, certain subsidiaries are subject to minimum net worth restrictions
pursuant to regulatory requirements and the terms of limited partnership and
debt agreements. At December 31, 1996 and 1995, the net worth of these
subsidiaries exceeded the related requirements.
For the year ended December 31, 1996, approximately 79% of ESI's pharmaceutical
purchases were through one wholesaler. ESI believes that other alternative
sources are readily available.
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NOTE 15 - EMPLOYEE BENEFIT PLANS
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LONG TERM PERFORMANCE PLAN:
MacKay-Shields adopted Long-Term Performance Plans ("the Plans") in 1988 and
1995. These Plans grant awards calculated based upon the attainment of specific
goals as set forth in each plan.
Payments under the 1988 plan commenced in 1996 and extend through 2000. In
accordance with the provisions of the 1988 Plan, participants are also entitled
to income on the unpaid amount of their award. For certain individuals, a
portion of this amount may be adjusted based upon the investment performance of
certain registered investment companies managed by MacKay-Shields. In 1996
MacKay-Shields recorded dividend and interest income in the amount of $1,678,000
on the cash and investments segregated to fund the Plan obligation.
Awards under the 1995 Plan are based on cumulative growth during the 1995 to
1997 time period, and are payable commencing in 1999 and extending through 2001.
An accrual was recorded as a liability based on asset growth through December
31, 1996.
The Plan is long-term in nature and requires participants to enter into
multi-year employment contracts.
OTHER:
Certain subsidiaries sponsor defined contribution retirement, 401(k) and profit
sharing plans for employees. Contributions to these plans during 1996, 1995 and
1994 totalled $9,011,000, $1,794,000 and $548,000, respectively.
NOTE 16 - SUPPLEMENTAL CASH FLOW INFORMATION
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SUPPLEMENTAL NON-CASH ACTIVITY:
The terms of the modified coinsurance agreement between NYLHIC and New York Life
(see Note 1) effective January 1, 1996, specify that NYLHIC assumes the risk for
group life and health policies issued by New York Life; however, New York Life
retains the claim and policy reserves as well as the related assets. As such,
the assets and liabilities of New York Life's group life and health operations
included in the Company's restated consolidated statement of financial position
at December 31, 1995 are not reflected in the Company's December 31, 1996
accounts. The change in the related assets and liabilities between 1995 and 1996
had no impact on the Company's 1996 cash flows other than a reduction in
reported cash balances of $50,140,000 reflected as other financing activities.
New York Life made net non-cash capital contributions of $21,798,000 and
$82,898,000, respectively, during 1996 and 1995.
OTHER:
Net cash paid for income tax expense was $50,245,000, $16,234,000 and
$26,752,000 during 1996, 1995 and 1994, respectively.
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Interest paid during 1996, 1995 and 1994 was $15,075,000, $18,931,000 and
$43,675,000, respectively.
NYLUK sold 68.75% of the common stock of Windsor Life, effective December 22,
1994, for $77,596,000. The statement value of the cash and cash equivalents of
Windsor Life at the date of sale was $43,022,000.
NOTE 17 - SUBSEQUENT EVENTS
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On February 15, 1997 SAMCO distributed $2,886,000 to the Series A, B and C note
holders, which included interest, quarterly principal repayment and additional
principal repayment.
On February 20, 1997, SFD Holding borrowed $12,833,000 under the Master Note
Agreement with New York Life. Those funds were used to repay all amounts then
outstanding under the Credit Agreement with Barclays Bank PLC. Concurrent with
the repayment, the Credit Agreement was terminated.
On March 4, 1997, MainStay Shareholder Services Inc. ("MSS") was created to
assume certain shareholder servicing functions currently handled by NYLIFE
Distributors. MSS was funded with a $2,000,000 cash contribution and $973,000 of
furniture and equipment. Operations have not yet commenced.
As of April 11, 1997, NYLIFE has received $29,000,000 of cash contributions from
New York Life.
