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STATEMENT OF ADDITIONAL INFORMATION
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FLAG INVESTORS INTERMEDIATE-TERM INCOME FUND, INC.
135 E. Baltimore Street
Baltimore, Maryland 21202
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THIS STATEMENT OF ADDITIONAL INFORMATION IS NOT A
PROSPECTUS. IT SHOULD BE READ IN CONJUNCTION WITH A
PROSPECTUS, WHICH MAY BE OBTAINED FROM ANY
PARTICIPATING DEALER OR SHAREHOLDER SERVICING AGENT
OR BY WRITING ALEX. BROWN & SONS INCORPORATED, 135
EAST BALTIMORE STREET, BALTIMORE, MARYLAND 21202, OR
BY CALLING (800) 767-FLAG.
Statement of Additional Information Dated: May 1, 1996
Relating to the Prospectuses Dated:
May 1, 1996 relating to the Class A Shares
and the Institutional Shares
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TABLE OF CONTENTS
Page
1. General Information and History............................... 1
2. Investment Objectives and Policies............................ 1
3. Valuation of Shares and Redemption............................ 6
4. Federal Tax Treatment of Dividends and Distributions.......... 7
5. Management of the Fund........................................ 9
6. Investment Advisory and Other Services........................ 13
7. Distribution of Fund Shares................................... 15
8. Brokerage..................................................... 18
9. Capital Stock................................................. 20
10. Reports....................................................... 20
11. Custodian, Transfer Agent, Accounting Services ............... 20
12. Independent Auditors ......................................... 21
13. Performance Information....................................... 21
14. Control Persons and Principal Holders of Securities........... 24
15. Financial Statements.......................................... 25
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1. GENERAL INFORMATION AND HISTORY
Flag Investors Intermediate-Term Income Fund, Inc. (the "Fund") is an
open-end management investment company. Under the rules and regulations of the
Securities and Exchange Commission (the "SEC"), all mutual funds are required to
furnish prospective investors with certain information concerning the activities
of the company being considered for investment. The Fund currently offers two
classes of shares: Flag Investors Intermediate-Term Income Fund Class A Shares
(the "Class A Shares") and Flag Investors Intermediate-Term Income Fund
Institutional Shares (the "Institutional Shares") (collectively, the "Shares").
The Class A Shares were formerly known as the Flag Investors Shares.
There are two separate prospectuses for the Fund's Shares: one for the
Class A Shares and one for the Institutional Shares. Each prospectus contains
important information concerning the class of Shares offered thereby and the
Fund and may be obtained without charge from Alex. Brown & Sons Incorporated
("Alex. Brown"), 135 East Baltimore Street, Baltimore, Maryland 21202
(telephone: (800) 767-FLAG) or, from Participating Dealers that offer Shares to
prospective investors. Prospectuses for the Class A Shares may also be obtained
from Shareholder Servicing Agents. As used herein, the term "Prospectus"
describes information common to the prospectuses of the two classes of the
Fund's shares, unless the term "Prospectus" is modified by the appropriate class
designation. As used herein, the "Fund" refers to Flag Investors
Intermediate-Term Income Fund, Inc. and specific references to either class of
the Fund's Shares will be made using the name of such class. Some of the
information required to be in this Statement of Additional Information is also
included in the Fund's current Prospectuses. To avoid unnecessary repetition,
references are made to related sections of the Prospectuses. In addition, the
Prospectuses and this Statement of Additional Information omit certain
information about the Fund and its business that is contained in the
Registration Statement respecting the Fund and its Shares filed with the SEC.
Copies of the Registration Statement as filed, including such omitted items, may
be obtained from the SEC by paying the charges prescribed under its rules and
regulations.
The Fund was incorporated under the laws of the State of Maryland on
April 16, 1990. The Fund filed a registration statement with the SEC registering
itself as an open-end diversified management investment company under the
Investment Company Act of 1940, as amended (the "Investment Company Act"), and
its Shares under the Securities Act of 1933, as amended, and commenced
operations on May 13, 1991. The Fund has offered the Institutional Shares since
November 2, 1995. Such shares are offered only to certain eligible institutions
and to clients of investment advisory affiliates of Alex. Brown.
Under a license agreement dated May 10, 1991 between the Fund and Alex.
Brown Incorporated, Alex. Brown Incorporated licenses to the Fund the "Flag
Investors" name and logo but retains the rights to the name and logo, including
the right to permit other investment companies to use them.
2. INVESTMENT OBJECTIVES AND POLICIES
The Fund is designed to provide a high level of current income
consistent with preservation of principal within an intermediate-term maturity
structure. As described in the Prospectus, the Fund will attempt to achieve its
objective by investing in high quality debt obligations, primarily securities
issued or guaranteed by the U.S. Government or its agencies or
instrumentalities, corporate bonds, collateralized mortgage obligations and
other asset backed securities. There can be no assurance that the Fund's
investment objective will be achieved.
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Mortgage-Backed Securities
As indicated in the Prospectus, the Fund may invest in mortgage-backed
securities representing ownership interests in a pool of mortgage loans which
securities are issued or guaranteed by the Government National Mortgage
Association ("GNMA"), the Federal Home Loan Mortgage Corporation ("FHLMC") or
the Federal National Mortgage Association ("FNMA").
GNMA Certificates.
GNMA Certificates are mortgage-backed securities which evidence an
undivided ownership interest in a pool of mortgage loans. Principal and interest
is paid back monthly by the borrower over the term of the underlying loans. The
National Housing Act authorizes GNMA to guarantee the timely payment of
principal and interest on securities backed by a pool of mortgages insured by
the Federal Housing Administration or the Farmers' Home Administration or
guaranteed by the Veterans Administration. The GNMA guarantee is backed by the
full faith and credit of the U.S. Government. The GNMA is also empowered to
borrow without limitation from the U.S. Treasury if necessary to make any
payments required under its guarantees.
The average life of a GNMA Certificate is likely to be substantially
less than the original maturity of the mortgage pools underlying the securities.
Prepayments of principal by mortgagors and mortgage foreclosures will usually
result in the return of the greater part of principal investment substantially
before maturity of the mortgages in the pool. Because prepayment rates of
individual mortgage pools vary, it is not possible to predict accurately the
average life of a particular issue of GNMA Certificates. However, statistics
published by the FHA indicate that the average life of single-family home
mortgage loans with 25 to 30 year maturities (the type of mortgage underlying
most GNMA Certificates) is approximately 12 years. It is customary, therefore,
to treat GNMA Certificates as 30-year mortgage-backed securities which prepay in
full in the twelfth year.
FHLMC and FNMA Certificates.
The FHLMC is a corporate instrumentality of the U.S. Government and was
created in 1970 for the purpose of increasing the availability of mortgage
credit for residential housing through the development of a nationwide secondary
market in conventional residential mortgages. The FHLMC issues Participation
Certificates which represent a pro rata share of all interest and principal
payments made and owed on the underlying pool (which consists of mortgages from
FHLMC's national portfolio). The FHLMC guarantees the timely payment of interest
and ultimate collection of principal. FHLMC Participation Certificates are
assumed to be prepaid in full in the twelfth year.
The FNMA is a government-sponsored corporation owned by private
stockholders that was established in 1938 to create a secondary market in
mortgages issued by the FHA. FNMA Certificates resemble GNMA Certificates in
that each Certificate represents a pro rata share of all interest and principal
payments made and owed on the underlying pool. FNMA guarantees timely payment of
interest on FNMA Certificates and full return of principal. FNMA Certificates
are assumed to be prepaid in full in the twelfth year.
Risk of foreclosure of the underlying mortgages is greater with FHLMC
and FNMA securities because, unlike GNMA securities, FHLMC and FNMA securities
are not backed by the full faith and credit of the U.S. Government.
Interests in such mortgage-backed securities differ from other forms of
debt securities, which typically provide for periodic payment of interest in
fixed amounts with principal payments at maturity or specified call dates.
Mortgage-backed securities provide monthly payments to the certificate holders,
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consisting of both interest and principal payments, which in effect
"pass-through" the monthly interest and principal payments made on the
underlying mortgage loans. Although the underlying mortgage loans are for
specified periods of time (such as 20 or 30 years), borrowers can repay their
loans sooner and the certificate holders would receive any such prepayment of
principal in addition to the principal that is part of the monthly payment. A
borrower is more likely to prepay a mortgage which bears a relatively high rate
of interest. Accordingly, during periods of declining interest rates, prepayment
of mortgages underlying mortgage-backed securities can be expected to
accelerate. Because prepayment of the underlying mortgages may vary, it is not
possible to predict accurately the average life or realized yield of a
particular issue of pass-through certificates. When the prepayments of principal
are included in the monthly payments to the Fund as a certificate holder, the
Fund reinvests the prepaid amounts in securities, the yield of which reflects
interest rates prevailing at the time. Prepayments of mortgages which underlie
securities purchased at a premium could result in capital losses.
Changes in market yields will affect the value of securities issued or
guaranteed by the U.S. Government or its agencies or instrumentalities
(including mortgage-backed securities) because the price of fixed income
securities generally increases when interest rates decline and decreases when
interest rates rise. Prices of longer term securities generally increase or
decrease more sharply in response to interest rate changes than those of shorter
term securities. In addition, prepayments of principal on mortgage pass-through
securities may make it difficult to fix interest rates for a specified period of
time. To the extent that mortgage-backed securities are purchased at prices that
differ from par, such prepayments (which are received at par) may make up a
significant portion of the pass-through total return.
Collateralized Mortgage Obligations
As indicated in the Prospectus, the Fund may invest in collateralized
mortgage obligations ("CMOs") which are collateralized by mortgage-backed
securities issued by GNMA, FHLMC or FNMA (collectively, "Mortgage Assets") and
which are rated AAA by Standard & Poor's Ratings Group ("S&P") or Aaa by Moody's
Investors Service, Inc. ("Moody's") or are determined to be of comparable
quality by the Fund's investment advisor.
In a CMO, a series of bonds or certificates is issued in multiple
classes. Each class of CMOs, often referred to as a "tranche", is issued at a
specific fixed or floating coupon rate and has a stated maturity or final
distribution date. Principal prepayments on the Mortgage Assets may cause the
CMOs to be retired substantially earlier than their stated maturities or final
distribution dates. Interest is paid or accrues on all classes of the CMOs on a
monthly, quarterly or semi-annual basis. Payments of principal of and interest
on the Mortgage Assets are commonly applied to the classes of a series of the
CMO in the order of their respective stated maturities or final distribution
dates, so that no payment of principal will be made on any class of a CMO until
all other classes having an earlier stated maturity or final distribution date
have been paid in full. Because CMOs are collateralized by mortgage-backed
securities, they are subject to similar risks and uncertainties associated with
the prepayment of principal and the ability to accurately predict yield
described above with respect to mortgage-backed securities.
Asset Backed Securities
The Fund may also invest in securities backed by assets other than
mortgages, including company receivables, truck and auto loans, leases, and
credit card receivables, which securities are rated AAA by S&P or Aaa by
Moody's, or if not rated, are determined by the Advisor to be of comparable
quality. Through the use of trusts and special purpose corporations, these types
of assets are being securitized in pass-through structures similar to the
mortgage pass-through structure or in pay-through structures similar to the CMO
structure, both as described above. In general, the collateral supporting
asset-backed securities is of shorter maturity than mortgage loans and is less
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likely to experience substantial prepayments. However, asset-backed securities
do not generally have the benefit of the same security interest in the related
collateral as either mortgage-backed securities or CMOs, and may therefore
present certain risks not associated with such other securities. If the
asset-backed security is issued in a pay-through structure similar to a CMO, the
cash flow generated by the underlying assets is applied to make required
payments on the securities and to pay related administrative expenses. The
residual in an asset-backed security pay-through structure represents the
interest in any excess cash flow remaining after making the foregoing payments,
and will depend on, among other things, the characteristics of the underlying
assets, the coupon rates on the securities, prevailing interest rates, the
amount of administrative expenses and the actual prepayment experience on the
underlying assets.
Other Investment Practices
In addition, the Fund may enter into repurchase agreements and make
purchases of when-issued securities as described below.
Repurchase Agreements.
The Fund may enter into repurchase agreements with financial
institutions, such as banks and broker-dealers, deemed to be creditworthy by the
Fund's Board of Directors under criteria established with the guidance of the
Fund's investment advisor, Investment Company Capital Corp. ("ICC" or the
"Advisor"). A repurchase agreement is a short-term investment in which the
purchaser (i.e., the Fund) acquires ownership of a debt security and the seller
agrees to repurchase the obligation at a future time and set price, usually not
more than seven days from the date of purchase, thereby determining the yield
during the purchaser's holding period. The value of underlying securities will
be at least equal at all times to the total amount of the repurchase obligation,
including the interest factor. The Fund makes payment for such securities only
upon physical delivery or evidence of book entry transfer to the account of a
custodian or bank acting as agent. The underlying securities, which in the case
of the Fund are securities of the U.S. Treasury only, may have maturity dates
exceeding one year. The Fund does not bear the risk of a decline in value of the
underlying securities unless the seller defaults under its repurchase
obligation. In the event of a bankruptcy or other default of a seller of a
repurchase agreement, the Fund could experience both delays in liquidating the
underlying securities and loss including (a) possible decline in the value of
the underlying security while the Fund seeks to enforce its rights thereto, (b)
possible subnormal levels of income and lack of access to income during this
period and (c) expenses of enforcing its rights.
Foreign Currency Exchange Transactions.
The Fund may conduct its foreign currency exchange transactions through
forward contracts to purchase or sell foreign currencies. A forward foreign
currency exchange contract involves an obligation to purchase or sell a
specified currency at a future date (which may be any fixed number of days from
the date the contract is entered into by the parties) at the price set at the
time of the contract. These contracts are traded directly between currency
traders (usually large commercial banks) and their customers.
The Fund may use such forward contracts only under two circumstances:
first, if the Advisor believes that the Fund should fix the U.S. dollar price of
the foreign security when the Fund enters into a contract for the purchase or
sale, at a future date, of a security denominated in a foreign currency; and
second, if the Advisor believes that the Fund should hedge against risk of loss
in the value of its portfolio securities denominated in foreign currencies, the
Fund may enter into a forward contract to purchase or sell an amount of the
foreign currency approximating the value of some or all of the Fund's portfolio
securities denominated in such foreign currency.
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Investment Restrictions
The Fund's investment program is subject to a number of investment
restrictions which reflect self-imposed standards as well as federal and state
regulatory limitations. The investment restrictions recited below are in
addition to those described in the Fund's Prospectus, and are matters of
fundamental policy and may not be changed without the affirmative vote of a
majority of the outstanding Shares. Accordingly, the Fund will not:
1. Invest in real estate or mortgages on real estate;
2. Purchase or sell commodities or commodities contracts or futures
contracts;
3. Act as an underwriter of securities within the meaning of the U.S.
federal securities laws except insofar as it might be deemed to be an
underwriter upon disposition of certain portfolio securities acquired within the
limitation on purchases of restricted securities;
4. Issue senior securities;
5. Make loans, except that the Fund may purchase or hold debt
instruments in accordance with its investment objectives and policies;
6. Effect short sales of securities;
7. Purchase securities on margin (but the Fund may obtain such
short-term credits as may be necessary for the clearance of transactions);
8. Purchase participations or other direct interests in oil, gas or
other mineral exploration or development programs; or
9. Invest more than 10% of the value of its net assets in illiquid
securities, including repurchase agreements with remaining maturities in excess
of seven days.
The following are investment restrictions that may be changed by a vote
of the majority of the Board of Directors. The Fund will not:
1. Purchase any securities of unseasoned issuers which have been in
operation directly or through predecessors for less than three years;
2. Invest in shares of any other investment company registered under the
Investment Company Act, other than in connection with a merger, consolidation,
reorganization or acquisition of assets;
3. Purchase or retain the securities of any issuer if to the knowledge
of the Fund any officer or Director of the Fund or its investment advisor owns
beneficially more than .5% of the outstanding securities of such issuer and
together they own beneficially more than 5% of the securities of such issuer;
4. Invest in companies for the purpose of exercising management or
control;
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5. Purchase or sell puts or calls or any combination thereof;
6. Invest in real estate limited partnerships or oil, gas or mineral
leases; or
7. Purchase warrants.
The percentage limitations contained in these restrictions apply at the
time of purchase of securities.
3. VALUATION OF SHARES AND REDEMPTION
Valuation of Shares
The net asset value per Share is determined once daily as of 4:00 p.m.
(Eastern Time) each day on which the New York Stock Exchange is open for
business ("Business Day"). The New York Stock Exchange is open for business on
all weekdays except for the following holidays: New Year's Day, Presidents' Day,
Good Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving Day and
Christmas Day.
Net asset value per Share of a class is calculated by valuing all assets
held by the Fund, deducting liabilities attributable to all Shares and any
liabilities attributable to the specific class, and dividing the resulting
amount by the number of then outstanding Shares of the class. For this purpose,
portfolio securities will be given their market value where feasible. Portfolio
securities that are actively traded in the over-the-counter market, including
listed securities for which the primary market is believed by the Advisor to be
over-the-counter, are valued at the quoted bid prices provided by principal
market makers. If a portfolio security is traded primarily on a national
exchange on the valuation date, the last quoted sale price will generally be
used. Securities or other assets for which market quotations are not readily
available are valued at their fair market value as determined in good faith
under procedures established from time to time and monitored by the Fund's Board
of Directors. Such procedures may include (i) the use of an independent pricing
service which uses prices based upon yields or prices of securities of
comparable quality, coupon, maturity and type, (ii) indications as to values
from dealers, (iii) and general market conditions. Debt obligations with
maturities of 60 days or less will be valued at amortized cost, which
constitutes fair value as determined by the Fund's Board of Directors.
Redemption
The Fund may suspend the right of redemption or postpone the date of
payment during any period when (a) trading on the New York Stock Exchange is
restricted by applicable rules and regulations of the SEC; (b) the New York
Stock Exchange is closed for other than customary weekend and holiday closings;
(c) the SEC has by order permitted such suspension; or (d) an emergency exists
as determined by the SEC so that valuation of the net assets of the Fund is not
reasonably practicable.
Under normal circumstances, the Fund will redeem Class A Shares by check
and Institutional Shares by wire transfer of funds, as described in the
Prospectus relating to each class of Shares. However, if the Board of Directors
determines that it would be in the best interests of the remaining shareholders
to make payment of the redemption price in whole or in part by a distribution in
kind of securities from the portfolio of the Fund in lieu of cash, in conformity
with applicable rules of the SEC, the Fund will make such distributions in kind.
If Shares are redeemed in kind, the redeeming shareholder will incur brokerage
costs in later converting the assets into cash. The method of valuing portfolio
securities is described under "Valuation of Shares" and such valuation will be
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made as of the same time the redemption price is determined. The Fund has
elected to be governed by Rule 18f-1 under the Investment Company Act pursuant
to which the Fund is obligated to redeem Shares solely in cash up to the lesser
of $250,000 or 1% of the net asset value of the Fund during any 90-day period
for any one shareholder.
4. FEDERAL TAX TREATMENT OF DIVIDENDS AND DISTRIBUTIONS
The following is only a summary of certain additional tax considerations
generally affecting the Fund and its shareholders that are not described in the
Fund's Prospectus. No attempt is made to present a detailed explanation of the
tax treatment of the Fund or its shareholders, and the discussion here and in
the Fund's Prospectus is not intended as a substitute for careful tax planning.
The following general discussion of certain federal income tax
consequences is based on the Internal Revenue Code of 1986, as amended (the
"Code") and the regulations issued thereunder as in effect on the date of this
Prospectus. New legislation as well as administrative changes or court
decisions, may significantly change the conclusions expressed herein, and may
have a retroactive effect with respect to the transactions contemplated herein.
The Fund intends to continue to qualify as a regulated investment
company ("RIC") under Subchapter M of the Code. However, to qualify as a RIC for
any taxable year, the Fund must (1) derive at least 90% of its gross income from
dividends, interest, certain payments with respect to securities loans and gains
from the sale or other disposition of stock, securities or foreign currencies
and other income (including, but not limited to gains from options, futures or
forward contracts) derived with respect to its business of investing in such
stock, securities or currencies (the "Income Requirement") and (2) derive less
than 30% of its gross income (exclusive of certain gains from designated hedging
transactions that are offset by unrealized losses on offsetting positions) from
gains on the sale or other disposition of any of the following investments if
such investments are held for less than three months (the "Short-Short Gain
Test"): (a) stock or securities (as defined in Section 2(a)(36) of the
Investment Company Act); (b) options, futures or forward contracts (other than
options, futures, or forward contracts on foreign currencies), and (c) foreign
currencies (or options, futures, or forward contracts on foreign currencies) but
only if such currencies (or options, futures, or forward contracts on foreign
currencies) are not directly related to the regulated investment company's
principal business of investing in stock or securities (or options and futures
with respect to stocks or securities). The Short-Short Gain Test will not
prevent the Fund from disposing of investments at a loss, since the recognition
of a loss before the expiration of the three-month holding period is
disregarded.
In addition, at the close of each quarter of the Fund's taxable year, at
least 50% of the value of its assets must consist of cash and cash items, U.S.
government securities, securities of other RICs, and securities of other issuers
(as to which the Fund has not invested more than 5% of the value of its total
assets in securities of such issuer and as to which the Fund does not hold more
than 10% of the outstanding voting securities of such issuer), and no more than
25% of the value of its total assets may be invested in the securities of any
one issuer (other than U.S. government securities and securities of other
regulated investment companies), or in two or more issuers which the Fund
controls and which are engaged in the same, similar or related trades or
businesses (the "Asset Diversification Test"). Generally, the Fund will not lose
its status as a RIC if it fails to meet the Asset Diversification Test solely as
a result of a fluctuation in value of portfolio assets not attributable to a
purchase.
Under Subchapter M, the Fund is exempt from federal income tax on its
net investment income and net capital gains which it distributes to
shareholders, provided generally that it distributes at least 90% of its
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investment company taxable income (net investment income and the excess of net
short term capital gains over net long term capital loss) for the year (the
"Distribution Requirement") and complies with the other requirements of the Code
described above. The Distribution Requirement for any year may be waived if a
regulated investment company establishes to the satisfaction of the Internal
Revenue Service that it is unable to satisfy the Distribution Requirement by
reason of distributions previously made for the purpose of avoiding liability
for federal excise tax (discussed below). Distributions of investment company
taxable income will generally be taxable to shareholders as ordinary income,
regardless of whether such distributions are paid in cash or are reinvested in
Shares.
For purposes of the Distribution Requirement (as well as for other
purposes), the Fund will be required to treat as interest income any recognized
market discount on debt obligations which it holds. Generally, market discount
is the amount by which the stated redemption price of a bond exceeds the amount
paid by a purchaser of the bond (most common where the value of a bond decreases
after original issue as a result of a decline in the creditworthiness of the
issuer or an increase in prevailing interest rates). Generally, upon the
disposition of a bond bearing market discount or receipt of any principal
payment with respect to such a bond, market discount is recognized by treating a
portion of the proceeds as interest income. The application of these rules (and
the rules regarding original issue discount) to debt obligations held by the
Fund could affect (i) the amount and timing of distributions to shareholders and
(ii) the ability of the Fund to satisfy the Distribution Requirement.
The Fund may either retain or distribute to shareholders its excess of
net long-term capital gains over net short-term capital losses ("net capital
gain"). If such gains are distributed as capital gains, they are taxable to
shareholders as long-term capital gains, regardless of the length of time the
shareholder has held the Shares. Conversely, if the Fund elects to retain its
net capital gains, it will be taxed thereon at the applicable corporate capital
gains tax rate. In this event, it is expected that the Fund also will elect to
have shareholders treated as having received a distribution of such gains, with
the result that they will be required to report such gains on their returns as
long-term capital gains, will receive a tax credit for their allocable share of
capital gains tax paid by the Fund on the gains, and will increase the tax basis
for their Shares by an amount equal to 65 percent of the deemed distribution.
Generally, gains or losses on the sale or exchange of a Share will be
capital gains or losses which will be long-term if the Share is held for more
than one year. However, if a shareholder realizes a loss on the sale, exchange
or redemption of a Share held for six months or less and has previously received
a capital gains distribution with respect to the Share (or any undistributed net
capital gains of the Fund with respect to such Share are included in determining
the shareholder's long-term capital gains), the shareholder must treat the loss
as a long-term capital loss to the extent of the amount of the prior capital
gains distribution (or any undistributed net capital gains of the Fund which
have been included in determining such investor's long-term capital gains). In
addition, any loss realized on a sale or other disposition of Shares will be
disallowed to the extent an investor repurchases (or enters into a contract or
option to repurchase) Shares within a period of 61 days (beginning 30 days
before and ending 30 days after the disposition of the Shares). Investors should
particularly note that this loss disallowance rule will apply to Shares received
through the reinvestment of dividends during the 61-day period.
Investors should be careful to consider the tax implications of
purchasing Shares just prior to the ex-dividend date of any ordinary income
dividend or capital gains distribution. Those purchasing just prior to an
ordinary income dividend or capital gains distribution will be taxable on the
entire amount of the dividend received, even though the net asset value per
Share on the date of such purchase reflected the amount of such distribution.
If for any taxable year, the Fund does not qualify as a RIC, all of its
taxable income will be subject to tax at regular corporate rates without any
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deduction for distributions to shareholders, and such distributions will
generally be taxable as ordinary dividends to the extent of the Fund's current
and accumulated earnings and profits. However, in the case of corporate
shareholders, such distributions will generally be eligible for the 70%
dividends received deduction for "qualifying dividends."
The Fund will be required in certain cases to withhold and remit tax to
the United States Treasury on distributions payable to any shareholder who (1)
has provided the Fund either an incorrect tax identification number or no number
at all, (2) who is subject to backup withholding by the Internal Revenue Service
for failure to properly report payments of interest or dividends, or (3) who has
failed to certify to the Fund that such shareholder is not subject to backup
withholding.
The Fund will provide a statement annually to shareholders as to the
federal tax status of distributions paid (or deemed to be paid) by the Fund
during the year.
The Code imposes a nondeductible 4% federal excise tax on RICs that do
not distribute in each calendar year an amount equal to 98% of their ordinary
income for the calendar year plus 98% of their capital gains net income (the
excess of short and long-term capital gains over short and long-term capital
losses) for the one-year period ending on October 31 of such calendar year. The
balance of such income must be distributed during the next calendar year. For
the foregoing purposes, an investment company is treated as having distributed
any amount on which it is subject to income tax for any taxable year ending in
such calendar year.
The Fund intends to make sufficient distributions of its ordinary income
and capital gains net income prior to the end of each calendar year to avoid
liability for excise tax. However, investors should note that the Fund may in
certain circumstances be required to liquidate portfolio investments in order to
make sufficient distributions to avoid excise tax liability, and, in addition,
that the liquidation of such investments in such circumstances may affect the
ability of the Fund to satisfy the Short-Short Gain Test.
Rules of state and local taxation of dividend and capital gains
distributions from regulated investment companies often differ from the rules
for federal income taxation described above. Shareholders are urged to consult
their tax advisers as to the consequences of these and other state and local tax
rules affecting an investment in the Fund and also as to the application of the
rules set forth above to a shareholder's particular circumstances.
5. MANAGEMENT OF THE FUND
Directors and Officers
The Directors and executive officers of the Fund, their respective dates
of birth and their principal occupations during the last five years are set
forth below. Unless otherwise indicated, the address of each Director and
executive officer is 135 East Baltimore Street, Baltimore, Maryland 21202.
*RICHARD T. HALE, Chairman and Director (7/17/45)
Managing Director, Alex. Brown & Sons Incorporated; Chartered Financial
Analyst.
*W. JAMES PRICE, Director (10/6/24)
6885 North Ocean Boulevard, Apartment #306, Ocean Ridge, Florida
33435-3342. Director, Boca Research, Inc. (computer peripherals);
Managing Director Emeritus, Alex. Brown & Sons Incorporated; Formerly,
Director, CSX Corporation (transportation) and PHH Corporation (business
services).
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<PAGE>
JAMES J. CUNNANE, Director (3/11/38)
CBC Capital, 264 Carlyle Lake Drive, St. Louis, Missouri 63141. Managing
Director, CBC Capital (merchant banking), 1993-Present; Formerly, Senior
Vice President and Chief Financial Officer, General Dynamics Corporation
(defense), 1989-1993 and Director, The Arch Fund (registered investment
company).
JOHN F. KROEGER, Director (8/11/24)
37 Pippins Way, Morristown, New Jersey 07960. Director/Trustee, AIM
Funds; Formerly, Consultant, Wendell & Stockel Associates, Inc.
(consulting firm) and General Manager, Shell Oil Company.
LOUIS E. LEVY, Director (11/16/32)
26 Farmstead Road, Short Hills, New Jersey 07078. Director,
Kimberly-Clark Corporation (personal consumer products) and Household
International (finance and banking); Chairman of the Quality Control
Inquiry Committee, American Institute of Certified Public Accountants;
Formerly, Trustee, Merrill Lynch Funds for Institutions, 1991-1993;
Adjunct Professor, Columbia University-Graduate School of Business,
1991-1992; Partner, KPMG Peat Marwick, retired 1990.
EUGENE J. MCDONALD, Director (7/14/32)
Duke Management Company, Erwin Square, Suite 1000, 2200 West Main
Street, Durham, North Carolina 27705. President, Duke Management Company
(investments); Executive Vice President, Duke University (education,
research and healthcare).
HARRY WOOLF, Director (8/12/23)
Institute for Advanced Study, South Olden Lane, Princeton, New Jersey
08540. Professor-at-Large Emeritus, Institute for Advanced Study;
Director, ATL and Spacelabs Medical Corp. (medical equipment) and Family
Health International (non-profit research and education); Trustee, Reed
College (education); Director, Research America (non-profit medical
research); Formerly, Trustee, Rockefeller Foundation and Director,
Merrill Lynch Cluster C Funds (registered investment companies).
M. ELLIOTT RANDOLPH, President (1/10/42)
Principal, Alex. Brown & Sons Incorporated, 1991 - Present; Principal,
Monument Capital Management, Inc., 1988-1991; Senior Vice President and
Chief Investment Officer, First National Bank of Maryland, 1976-1988.
PAUL D. CORBIN, Executive Vice President (7/24/52)
Principal, Alex. Brown & Sons Incorporated, 1991 - Present; Senior Vice
President, First National Bank of Maryland, 1985-1991.
EDWARD J. VEILLEUX, Vice President (8/26/43)
Principal, Alex. Brown & Sons Incorporated; President, Investment
Company Capital Corp., (registered investment advisor); Vice President,
Armata Financial Corp. (registered broker-dealer).
GARY V. FEARNOW, Vice President (12/6/44)
Managing Director, Alex. Brown & Sons Incorporated and Manager, Special
Products Department, Alex. Brown & Sons Incorporated.
BRIAN C. NELSON, Vice President and Secretary (7/31/59)
Vice President, Alex. Brown & Sons Incorporated, Investment Company
Capital Corp. (registered investment advisor) and Armata Financial Corp.
(registered broker-dealer).
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<PAGE>
MONICA M. HAUSNER, Vice President (10/26/61)
Vice President, Fixed Income Management Department, Alex. Brown & Sons
Incorporated, March 1992-Present; Formerly, Assistant Vice President,
First National Bank of Maryland, 1984-1992.
JOSEPH A. FINELLI, Treasurer (1/24/57)
Vice President, Alex. Brown & Sons Incorporated, September 1995-Present;
Formerly, Vice President and Treasurer, The Delaware Group of Funds
(registered investment companies) and Vice President, Delaware
Management Company Inc., 1980-August 1995.
LAURIE D. DePRINE, Assistant Secretary (1/1/66)
Asset Management Department, Alex. Brown & Sons Incorporated,
1991-Present; Formerly, Student 1989-1991.
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* Messrs. Hale and Price are Directors who are "interested persons", as defined
in the Investment Company Act.
Directors and officers of the Fund are also directors and officers of
some or all of the other investment companies managed, administered, advised or
distributed by Alex. Brown or its affiliates. There are currently 12 funds in
the Flag Investors/ISI Funds and Alex. Brown Cash Reserve Fund, Inc. fund
complex (the "Fund Complex"). Mr. Price serves as a Director of seven funds in
the Fund Complex. Mr. Hale serves as President and Director of one fund, and
Director of each of the other funds in the Fund Complex. Messrs. Cunnane,
Kroeger, Levy, McDonald and Woolf serve as Directors of each fund in the Fund
Complex. Mr. Veilleux serves as Executive Vice President of one fund and as Vice
President of each of the other funds in the Fund Complex. Mr. Nelson serves as
Vice President and Secretary, Mr. Finelli serves as Treasurer and Ms. DePrine
serves as Assistant Secretary, respectively, of each fund in the Fund Complex.
Mr. Randolph serves as President of two funds and Vice President of one fund in
the Fund Complex. Mr. Corbin serves as Vice President of three funds and Mr.
Fearnow serves as Vice President of 10 funds in the Fund Complex. Ms. Hausner
serves as Vice President of three funds in the Fund Complex.
Some of the Directors of the Fund are customers of, and have had normal
brokerage transactions with, Alex. Brown in the ordinary course of business. All
such transactions were made on substantially the same terms as those prevailing
at the time for comparable transactions with unrelated persons. Additional
transactions may be expected to take place in the future.
Officers of the Fund receive no direct remuneration in such capacity
from the Fund. Officers and Directors of the Fund who are officers or directors
of Alex. Brown may be considered to have received remuneration indirectly. As
compensation for his services as Director, each Director who is not an
"interested person" of the Fund (as defined in the Investment Company Act) (a
"Non-Interested Director") receives an aggregate annual fee (plus reimbursement
for reasonable out-of-pocket expenses incurred in connection with his attendance
at Board and committee meetings) from all Flag Investors/ISI Funds and Alex.
Brown Cash Reserve Fund, Inc. for which he serves. In addition, the Chairman of
the Fund Complex's Audit Committee receives an aggregate annual fee from the
Fund Complex. Payment of such fees and expenses are allocated among all such
funds described above in direct proportion to their relative net assets. For the
fiscal year ended December 31, 1995, Non-Interested Directors' fees attributable
to the assets of the Fund totalled approximately $5,000. The following table
shows aggregate compensation paid to each of the Fund's Directors by the Fund
and the Fund Complex, respectively, in the fiscal year ended December 31, 1995.
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<PAGE>
COMPENSATION TABLE
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------------------------
Name of Person, Position Aggregate Compensation Total Compensation
From the Fund in the From the Fund
Fiscal Year Ended and Fund Complex
December 31, 1995 Paid to Directors
in the Fiscal Year
Ended December 31, 1995
- ------------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
*Richard T. Hale, Director $0 $0
*W. James Price, Chairman $0 $0
James J. Cunnane, Director $640.31(2) $39,000 for service on 13
Boards(1) in the Fund Complex
N. Bruce Hannay, Director** $640.31(2) $39,000 for service on 13
Boards(1) in the Fund Complex
John F. Kroeger, Director $725.91(2) $44,425 for service on 13
Boards(1) in the Fund Complex
Louis E. Levy, Director $640.31(2) $39,000 for service on 13
Boards(1) in the Fund Complex
Eugene J. McDonald, Director $640.31(2) $39,000 for service on 13
Boards(1) in the Fund Complex
Harry Woolf, Director $640.31(2) $39,000 for service on 13
Boards(1) in the Fund Complex
</TABLE>
- -----------
* A Director who is an "interested person" as defined in the Investment
Company Act.
** Retired, effective January 31, 1996.
1 One fund ceased operations on May 17, 1995.
2 Of the amounts paid to Messrs. Cunnane, Hannay, Kroeger, Levy, McDonald
and Woolf, $640.31, $454.73, $0, $0, $640.31 and $640.31, respectively,
was deferred pursuant to a deferred compensation plan.
The Fund Complex has adopted a Retirement Plan (the "Retirement Plan")
for Directors who are not employees of the Fund, the Fund's Advisor or their
respective affiliates (the "Participants"). After completion of six years of
service, each Participant will be entitled to receive an annual retirement
benefit equal to a percentage of the fee earned in his last year of service.
Upon retirement, each Participant will receive annually 10% of such fee for each
year that he served after completion of the first five years, up to a maximum
annual benefit of 50% of the fee earned by him in his last year of service. The
fee will be paid quarterly, for life, by each Fund for which he serves. The
Retirement Plan is unfunded and unvested. Messrs. Kroeger and Woolf have
qualified but have not yet received benefits. The Fund has two Participants, a
Director who retired effective December 31, 1994, and a Director who retired
effective January 31, 1996, each of whom has qualified for the Retirement Plan
and will be paid a quarterly fee of $4,875 by the Fund Complex for the rest of
his life. Such fee is allocated to each fund in the Fund Complex based upon the
relative net assets of such fund to the Fund Complex.
Beginning in December, 1994, any Director who receives fees from the
Fund is permitted to defer a minimum of 50%, or up to all, of his annual
compensation pursuant to a Deferred Compensation Plan. Messrs. Cunnane, Hannay,
Kroeger, Levy, McDonald and Woolf have each executed a Deferred Compensation
Agreement. Currently, the deferring Directors may select various Flag and Alex.
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<PAGE>
Brown Funds in which all or part of their deferral account shall be deemed to be
invested. Distributions from the deferring Directors' deferral accounts will be
paid in cash, in generally equal quarterly installments over a period of five
years.
Code of Ethics
The Board of Directors of the Fund has adopted a Code of Ethics pursuant
to Rule 17j-1 under the Investment Company Act. The Code of Ethics significantly
restricts the personal investing activities of all employees of ICC and the
directors and officers of Alex. Brown. As described below, the Code of Ethics
imposes additional, more onerous, restrictions on the Fund's investment
personnel, including the portfolio managers and employees who execute or help
execute a portfolio manager's decisions or who obtain contemporaneous
information regarding the purchase or sale of a security by the Fund.
The Code of Ethics requires that all employees of ICC, any director or
officer of Alex. Brown, and all Directors, preclear personal securities
investments (with certain exceptions, such as non-volitional purchases or
purchases which are part of an automatic dividend reinvestment plan). The
preclearance requirement and associated procedures are designed to identify any
substantive prohibition or limitation applicable to the proposed investment. The
substantive restrictions applicable to investment personnel include a ban on
acquiring any securities in an initial public offering, a prohibition from
profiting on short-term trading in securities and preclearance of the
acquisition of securities in private placements. Furthermore, the Code of Ethics
provides for trading "blackout periods" that prohibit trading by investment
personnel and certain other employees within periods of trading by the Fund in
the same security.
6. INVESTMENT ADVISORY AND OTHER SERVICES
On May 9, 1991, the sole shareholder of the Fund approved an Investment
Advisory Agreement between the Fund and ICC. ICC is a wholly-owned subsidiary of
Alex. Brown Financial Corporation and an indirect subsidiary of Alex. Brown
Incorporated. ICC is also the investment advisor to Flag Investors Telephone
Income Fund, Inc., Flag Investors Value Builder Fund, Inc., Flag Investors
Equity Partners Fund, Inc., Alex. Brown Cash Reserve Fund, Inc., Flag Investors
International Fund, Inc., Flag Investors Emerging Growth Fund, Inc., Flag
Investors Maryland Intermediate Tax Free Income Fund, Inc. and Flag Investors
Real Estate Securities Fund, Inc. which are distributed by Alex. Brown, the
Fund's distributor.
Under the Investment Advisory Agreement, ICC obtains and evaluates
economic, statistical and financial information to formulate and implement
investment policies for the Fund. Any investment program undertaken by ICC will
at all times be subject to policies and control of the Fund's Board of
Directors. ICC will provide the Fund with office space for managing its affairs,
with the services of required executive personnel and with certain clerical and
bookkeeping services and facilities. These services are provided by ICC without
reimbursement by the Fund for any costs. ICC shall not be liable to the Fund or
its shareholders for any act or omission by ICC or any losses sustained by the
Fund or its shareholders, except in the case of willful misfeasance, bad faith,
gross negligence, or reckless disregard of duty. As compensation for its
services, ICC receives an annual fee from the Fund, payable monthly, at the
annual rate of .35% of the first $1 billion of the Fund's average daily net
assets, .30% of the Fund's average daily net assets in excess of $1 billion but
not exceeding $1.5 billion and .25% of the Fund's average daily net assets
exceeding $1.5 billion. ICC has voluntarily agreed to reduce its annual fee, if
necessary, or to make payments to the Fund to the extent required so that the
Fund's annual expenses do not exceed .70% of the Class A Shares' average daily
net assets and .45% of the Institutional Shares' average daily net assets. As
compensation for investment advisory services for the fiscal years ended
December 31, 1995, December 31, 1994 and December 31, 1993, ICC received fees of
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<PAGE>
$252,372, $357,585 and $332,862 and from such amounts waived fees of $162,943,
$141,214 and $145,696, respectively. Absent such waivers for the fiscal years
ended December 31, 1995, December 31, 1994 and December 31, 1993, the Fund's
Total Operating Expenses would have been .93%, .84% and .85%, respectively, of
the Class A Shares' average daily net assets. The services of ICC to the Fund
are not exclusive and ICC is free to render similar services to others.
ICC has also agreed to reduce its aggregate fees on a monthly basis for
any fiscal year to the extent required so that the amount of the ordinary
expenses of the Fund (excluding brokerage commissions, interest, taxes and
extraordinary expenses such as legal claims, liabilities, litigation costs and
indemnification related thereto) paid or incurred by the Fund for such fiscal
year does not exceed the expense limitations applicable to the Fund imposed by
the securities laws or regulations of the states in which the Shares are
registered or qualified for sale, as such limitations may be raised or lowered
from time to time. Currently, the most restrictive of such expense limitations
requires the Advisor to reduce its fees to the extent required so that ordinary
expenses of the Fund (excluding brokerage commissions, interest, taxes and
extraordinary expenses such as legal claims, liabilities, litigation costs and
indemnification related thereto) do not exceed 2.5% of the first $30 million of
the Fund's average daily net assets, 2.0% of the next $70 million of the Fund's
average daily net assets and 1.5% of the Fund's average daily net assets in
excess of $100 million. In addition, if required to do so by any applicable
state securities laws or regulations, ICC will reimburse the Fund to the extent
required to prevent the expense limitations of any state law or regulation from
being exceeded. No such reimbursements were required in the fiscal year ended
December 31, 1995.
The Investment Advisory Agreement will continue in effect from year to
year thereafter if such continuance is specifically approved at least annually
by the Fund's Board of Directors, including a majority of the Non-Interested
Directors who have no direct or indirect financial interest in such agreement,
by votes cast in person at a meeting called for such purpose, or by a vote of a
majority of the outstanding Shares (as defined under "Capital Stock"). The
Investment Advisory Agreement was approved in the foregoing manner by the Fund's
Board of Directors most recently on September 25, 1995 and by a majority of the
outstanding Shares on July 31, 1992. The Fund or ICC may terminate the
Investment Advisory Agreement on sixty days' written notice without penalty. The
Investment Advisory Agreement will terminate automatically in the event of
assignment (as defined in the Investment Company Act).
In addition to its services as investment advisor, ICC also provides
accounting services to the Fund and serves as the Fund's transfer and dividend
disbursing agent. (See "Custodian, Transfer Agent, Accounting Services.")
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<PAGE>
7. DISTRIBUTION OF FUND SHARES
Alex. Brown serves as the distributor of the Fund's Shares pursuant to
two separate Distribution Agreements, one for the Class A Shares (the "Class A
Distribution Agreement") and one for the Institutional Shares (the
"Institutional Distribution Agreement") (collectively, the "Distribution
Agreements").
The Class A Shares
The Class A Distribution Agreement provides that Alex. Brown has the
exclusive right to distribute Class A Shares either directly or through other
broker-dealers. The Distribution Agreement further provides that Alex. Brown
will: (a) solicit and receive orders for the purchase of Class A Shares; (b)
accept or reject such orders on behalf of the Fund in accordance with the Fund's
currently effective Prospectus and transmit such orders as are accepted to the
Fund's transfer agent as promptly as possible; (c) receive requests for
redemptions and transmit such redemption requests to the Fund's transfer agent
as promptly as possible; and (d) respond to inquiries from shareholders
concerning the status of their accounts and the operations of the Fund. Alex.
Brown has not undertaken to sell any specific number of Class A Shares. The
Class A Shares Distribution Agreement further provides that, in connection with
the distribution of Shares, Alex. Brown will be responsible for all of the
promotional expenses. The services provided by Alex. Brown to the Fund are not
exclusive, and Alex. Brown is free to provide similar services to others. Alex.
Brown shall not be liable to the Fund or its shareholders for any act or
omission by Alex. Brown or any losses sustained by the Fund or its shareholders
except in the case of willful misfeasance, bad faith, gross negligence or
reckless disregard of duty.
Alex. Brown and certain broker-dealers ("Participating Dealers") have
entered into Sub-Distribution Agreements under which such broker-dealers have
agreed to process investor purchase and redemption orders and respond to
inquiries from shareholders concerning the status of their accounts and the
operations of the Fund.
As compensation for providing distribution services for the Class A
Shares as described above, Alex. Brown receives an annual fee, paid monthly,
equal to .25% of the average daily net assets of the Class A Shares. Alex. Brown
expects to allocate most of its annual fee to its investment representatives and
up to all of its fee to Participating Dealers. For the fiscal years ended
December 31, 1995, December 31, 1994 and December 31, 1993, Alex. Brown received
distribution fees of $179,666, $255,418 and $237,758, respectively, and paid
from such fees $170,797, $239,042 and $138,839, respectively, as compensation to
its investment representatives and $7,344, $4,457 and $2,596, respectively, as
compensation to Participating Dealers. No compensation was paid to financial
institutions in any fiscal period. In addition, in the fiscal year ended
December 31, 1995, Alex. Brown incurred expenses of $0 for advertising and
$17,107 for printing and mailing prospectuses to prospective investors in the
Fund's Shares.
Pursuant to Rule 12b-1 under the Investment Company Act, which provides
that investment companies may pay distribution expenses, directly or indirectly,
only pursuant to a plan adopted by the investment company's board of directors
and approved by its shareholders, the Fund has adopted a Plan of Distribution
for the Fund's Class A Shares (the "Class A Plan"). Under the Class A Plan, the
Fund pays a fee to Alex. Brown for distribution and other shareholder servicing
assistance as set forth in the Class A Distribution Agreement, and Alex. Brown
is authorized to make payments out of its fee to its investment representatives
and to participating broker-dealers. The Class A Distribution Agreement,
including the Class A Plan and a form of Sub-Distribution Agreement, was
approved by the sole shareholder of the Fund on May 9, 1991, by a majority of
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<PAGE>
the outstanding Shares of the Fund on July 31, 1992, and most recently by the
Fund's Board of Directors, including a majority of the Non-Interested Directors,
on September 25, 1995. The Class A Distribution Agreement and the Class A Plan
encompassed therein will remain in effect from year to year thereafter, if
specifically approved at least annually by the Fund's Board of Directors and by
the affirmative vote of a majority of the Non-Interested Directors by votes cast
in person at a meeting called for such purpose.
In approving the Class A Plan, the Directors concluded, in the exercise
of reasonable business judgment, that there was a reasonable likelihood that the
Class A Plan would benefit the Fund and its shareholders. The Class A Plan will
be renewed only if the Directors make a similar determination in each subsequent
year. The Class A Plan may not be amended to increase materially the fee to be
paid pursuant to the Class A Distribution Agreement without the approval of the
shareholders of the Fund. The Class A Plan may be terminated at any time and the
Class A Distribution Agreement may be terminated at any time upon sixty days'
notice, in either case without penalty, by the vote of a majority of the Fund's
Non-Interested Directors or by a vote of a majority of the outstanding Shares
(as defined under "Capital Stock"). Any Sub-Distribution Agreement may be
terminated in the same manner at any time. The Class A Distribution Agreement
and any Sub-Distribution Agreement shall automatically terminate in the event of
assignment.
During the continuance of the Class A Plan, the Fund's Board of
Directors will be provided for their review, at least quarterly, a written
report concerning the payments made under the Class A Plan to Alex. Brown
pursuant to the Class A Distribution Agreement and to broker-dealers pursuant to
Sub-Distribution Agreements. Such reports shall be made by the persons
authorized to make such payments. In addition, during the continuance of the
Class A Plan, the selection and nomination of the Fund's Non-Interested
Directors shall be committed to the discretion of the Non-Interested Directors
then in office.
In addition, with respect to the Class A Shares, the Fund may enter into
Shareholder Servicing Agreements with certain financial institutions, such as
banks, to act as Shareholder Servicing Agents, pursuant to which Alex. Brown
will allocate a portion of its distribution fee as compensation for such
financial institutions' ongoing shareholder services. Although banking laws and
regulations prohibit banks from distributing shares of open-end investment
companies such as the Fund, according to interpretations by various bank
regulatory authorities, financial institutions are not prohibited from acting in
other capacities for investment companies, such as the shareholder servicing
capacities described above. Should future legislative, judicial or
administrative action prohibit or restrict the activities of the Shareholder
Servicing Agents in connection with the Shareholder Servicing Agreements, the
Fund may be required to alter materially or discontinue its arrangements with
the Shareholder Servicing Agents. Such financial institutions may impose
separate fees in connection with these services and investors should review the
Prospectus and this Statement of Additional Information in conjunction with any
such institution's fee schedule. In addition, state securities laws on this
issue may differ from the interpretations of federal law expressed herein, and
banks and financial institutions may be required to register as dealers pursuant
to state law.
Under the Class A Plan, amounts allocated to Participating Dealers and
Shareholder Servicing Agents may not exceed amounts payable to Alex. Brown under
the Class A Plan. Payments under the Class A Plan are made as described above
regardless of Alex. Brown's actual cost of providing distribution services and
may be used to pay Alex. Brown's overhead expenses. If the cost of providing
distribution services to the Fund in connection with the sale of the Class A
Shares is less than .25% of the Fund's average daily net assets for any period,
the unexpended portion of the distribution fee may be retained by Alex. Brown.
The Class A Plan does not provide for any charges to the Fund for excess amounts
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<PAGE>
expended by Alex. Brown and, if the Class A Plan is terminated in accordance
with its terms, the obligation of the Fund to make payments to Alex. Brown
pursuant to the Class A Plan will cease and the Fund will not be required to
make any payments past the date the related Class A Distribution Agreement
terminates.
In the fiscal years ended December 31, 1995, December 31, 1994 and
December 31, 1993, Alex. Brown received sales commissions on the Class A Shares
of $11,196, $134,543 and $281,443 and from such amounts retained $11,088,
$132,337 and $278,516 for each such year, respectively.
The Institutional Shares
The Institutional Distribution Agreement provides that Alex. Brown has
the exclusive right to distribute the Institutional Shares, either directly or
through Participating Dealers, and further provides that Alex. Brown will
solicit and receive orders for the purchase of Institutional Shares, accept or
reject such orders on behalf of the Fund in accordance with the Fund's currently
effective Prospectus for the Institutional Shares and transmit such orders as
are accepted to the Fund's transfer agent as promptly as possible, receive
requests for redemption and transmit such redemption requests to the Fund's
transfer agent as promptly as possible, respond to inquiries from the Fund's
shareholders concerning the status of their accounts with the Fund, maintain
such accounts, books and records as may be required by law or be deemed
appropriate by the Fund's Board of Directors, and take all actions deemed
necessary to carry into effect the distribution of the Institutional Shares.
Alex. Brown has not undertaken to sell any specific number of Institutional
Shares. The Institutional Distribution Agreement further provides that, in
connection with the distribution of Institutional Shares, Alex. Brown will be
responsible for all of the promotional expenses. The services provided by Alex.
Brown to the Fund are not exclusive, and Alex. Brown is free to provide similar
services to others. Alex. Brown shall not be liable to the Fund or its
shareholders for any act or omission by Alex. Brown or any losses sustained by
the Fund or its shareholders, except in the case of willful misfeasance, bad
faith, gross negligence or reckless disregard of duty.
Alex. Brown receives no compensation for distributing the Institutional
Shares.
Alex. Brown and Participating Dealers have entered into Sub-Distribution
Agreements under which such Participating Dealers have agreed to process
investor purchase and redemption orders and respond to inquiries from
shareholders concerning the status of their accounts and the operations of the
Fund.
The Institutional Distribution Agreement was approved by the Fund's
Board of Directors on September 25, 1995 and by the sole shareholder of the
class on October 31, 1995. It has an initial term of two years and will remain
in effect from year to year thereafter, if specifically approved at least
annually by the Fund's Board of Directors and by the affirmative vote of a
majority of the Non- Interested Directors by votes cast at a meeting called for
such purpose. It may be terminated at any time upon sixty days' written notice,
without penalty, by the vote of a majority of the Fund's Non-Interested
Directors or by a vote of a majority of the outstanding Institutional Shares (as
defined under Capital Stock). The Institutional Distribution Agreement and any
Sub-Distribution Agreement shall automatically terminate in the event of
assignment.
General Information
The Fund will pay all costs associated with its organization and
registration under the Securities Act of 1933 and the Investment Company Act.
Except as described elsewhere, the Fund pays or causes to be paid all continuing
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<PAGE>
expenses of the Fund, including, without limitation: investment advisory and
distribution fees; the charges and expenses of any registrar, any custodian or
depository appointed by the Fund for the safekeeping of cash, portfolio
securities and other property, and any transfer, dividend or accounting agent or
agents appointed by the Fund; brokers' commissions chargeable to the Fund in
connection with portfolio securities transactions to which the Fund is a party;
all taxes, including securities issuance and transfer taxes, and fees payable by
the Fund to federal, state or other governmental agencies; the costs and
expenses of engraving or printing of certificates representing Shares; all costs
and expenses in connection with the registration and maintenance of registration
of the Fund and its Shares with the SEC and various states and other
jurisdictions (including filing fees, legal fees and disbursements of counsel);
the costs and expenses of printing, including typesetting and distributing
prospectuses and statements of additional information of the Fund and
supplements thereto to the Fund's shareholders; all expenses of shareholders'
and Directors' meetings and of preparing, printing and mailing proxy statements
and reports to shareholders; fees and travel expenses of Directors and Director
members of any advisory board or committee; all expenses incident to the payment
of any dividend, distribution, withdrawal or redemption, whether in Shares or in
cash; charges and expenses of any outside service used for pricing of the
Shares; fees and expenses of legal counsel, including counsel to the
Non-Interested Directors, and of independent auditors, in connection with any
matter relating to the Fund; a portion of membership dues of industry
associations; interest payable on Fund borrowings; postage; insurance premiums
on property or personnel (including officers and Directors) of the Fund which
inure to its benefit; extraordinary expenses (including, but not limited to,
legal claims and liabilities and litigation costs and any indemnification
related thereto); and all other charges and costs of the Fund's operation unless
otherwise explicitly assumed by Alex. Brown or ICC.
The address of Alex. Brown is 135 East Baltimore Street, Baltimore,
Maryland 21202.
8. BROKERAGE
ICC is responsible for decisions to buy and sell securities for the
Fund, for the broker-dealer selection and for negotiation of commission rates.
Purchases and sales of securities on a securities exchange are effected through
broker-dealers who charge a commission for their services. ICC may direct
purchase and sale orders to any broker-dealer, including, to the extent and in
the manner permitted by applicable law, Alex. Brown.
In over-the-counter transactions, orders are placed directly with a
principal market maker and such purchases normally include a mark up over the
bid to the broker-dealer based on the spread between the bid and asked price for
the security. Purchases from underwriters of portfolio securities include a
commission or concession paid by the issuer to the underwriter. On occasion,
certain money market instruments may be purchased directly from an issuer
without payment of a commission or concession. The Fund will not deal with Alex.
Brown in any transaction in which Alex. Brown acts as a principal; that is, an
order will not be placed with Alex. Brown if execution of the trade involves
Alex. Brown serving as a principal with respect to any part of the Fund's order,
nor will the Fund buy or sell over-the-counter securities with Alex. Brown
acting as market maker.
If Alex. Brown is participating in an underwriting or selling group, the
Fund may not buy portfolio securities from the group except in accordance with
rules of the SEC. The Fund believes that the limitation will not affect its
ability to carry out its present investment objective.
ICC's primary consideration in effecting securities transactions is to
obtain best price and execution of orders on an overall basis. As described
below, however, ICC may, in its discretion, effect brokerage transactions with
broker-dealers that furnish statistical, research or other information or
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<PAGE>
services which are deemed by ICC to be beneficial to the Fund's investment
program. Certain research services furnished by broker-dealers may be useful to
ICC with clients other than the Fund. Similarly, any research services received
by ICC through placement of portfolio transactions of other clients may be of
value to ICC in fulfilling its obligations to the Fund. No specific value can be
determined for research and statistical services furnished without cost to ICC
by a broker-dealer. ICC is of the opinion that because the material must be
analyzed and reviewed by its staff, its receipt does not tend to reduce
expenses, but may be beneficial in supplementing ICC's research and analysis.
Therefore, it may tend to benefit the Fund by improving ICC's investment advice.
ICC's policy is to pay a broker-dealer higher commissions for particular
transactions than might be charged if a different broker-dealer had been chosen
when, in ICC's opinion, this policy furthers the overall objective of obtaining
best price and execution. Subject to periodic review by the Fund's Board of
Directors, ICC is also authorized to pay broker-dealers other than Alex. Brown
higher commissions on brokerage transactions for the Fund in order to secure
research and investment services described above. The allocation of orders among
broker-dealers and the commission rates paid by the Fund will be reviewed
periodically by the Board of Directors. For the fiscal years ended December 31,
1995, December 31, 1994 and December 31, 1993, ICC directed no brokerage
transactions to broker-dealers and paid no related commissions because of
research services provided to the Fund.
Subject to the above considerations, the Board of Directors has
authorized the Fund to effect portfolio transactions, on an agency basis,
through Alex. Brown. At the time of such authorization certain policies and
procedures incorporating the standards of Rule 17e-1 under the Investment
Company Act which requires that the commissions paid Alex. Brown must be
"reasonable and fair compared to the commission, fee or other remuneration
received or to be received by other brokers in connection with comparable
transactions involving similar securities during a comparable period of time."
Rule 17e-1 also contains requirements for the review of such transactions by the
Board of Directors and requires ICC to furnish reports and to maintain records
in connection with such reviews. The Distribution Agreements between Alex. Brown
and the Fund do not provide for any reduction in the distribution fee to be
received by Alex. Brown from the Fund as a result of profits resulting from
brokerage commissions on transactions of the Fund effected through Alex. Brown.
For the fiscal years ended December 31, 1995, December 31, 1994 and December 31,
1993, the Fund paid no brokerage commissions to Alex. Brown. The Fund is
required to identify any securities of its "regular brokers or dealers" (as such
term is defined in the Investment Company Act) which the Fund has acquired
during its most recent fiscal year. As of December 31, 1995, the Fund held a
5.70% repurchase agreement issued by Goldman Sachs & Co. valued at $1,806,000.
Goldman Sachs & Co. is a "regular broker or dealer" of the Fund.
ICC manages other investment accounts. It is possible that, at times,
identical securities will be acceptable for the Fund and one or more of such
other accounts; however, the position of each account in the securities of the
same issuer may vary and the length of time that each account may choose to hold
its investment in such securities may likewise vary. The timing and amount of
purchase by each account will also be determined by its cash position. If the
purchase or sale of securities consistent with the investment policies of the
Fund or one or more of these accounts is considered at or about the same time,
transactions in such securities will be allocated among the accounts in a manner
deemed equitable by ICC. ICC may combine such transactions, in accordance with
applicable laws and regulations, in order to obtain the best net price and most
favorable execution. Such simultaneous transactions, however, could adversely
affect the ability of the Fund to obtain or dispose of the full amount of a
security which it seeks to purchase or sell.
-19-
<PAGE>
9. CAPITAL STOCK
The Fund is authorized to issue fifty-five million Shares of common
stock, par value $.001 per share. The Board of Directors may increase or
decrease the number of authorized Shares without shareholder approval.
The Fund's Articles of Incorporation provide for the establishment of
separate series and separate classes of Shares by the Directors at any time
without shareholder approval. The Fund currently has one Series and the Board
has designated three classes of shares: Flag Investors Intermediate-Term Income
Fund Class A Shares, Flag Investors Intermediate-Term Income Fund Class B
Shares, and Flag Investors Intermediate-Term Income Fund Institutional Shares.
The Institutional Shares are offered only to certain eligible institutions and
to clients of investment advisory affiliates of Alex. Brown. The Class B Shares
are not currently being offered. Shares of the Fund, regardless of series or
class would have equal rights with respect to voting, except that with respect
to any matter affecting the rights of the holders of a particular series or
class, the holders of each series or class would vote separately. In general,
each series would be managed separately and shareholders of each series would
have an undivided interest in the net assets of that series. For tax purposes,
the series would be treated as separate entities. Generally, each class of
Shares would be identical to every other class in a particular series and
expenses of the Fund (other than 12b-1 and any applicable service fees) would be
prorated between all classes of a series based upon the relative net assets of
each class. Any matters affecting any class exclusively will be voted on by the
holders of such class.
Shareholders of the Fund do not have cumulative voting rights, and
therefore the holders of more than 50% of the outstanding Shares voting together
for election of Directors may elect all the members of the Board of Directors of
the Fund. In such event, the remaining holders cannot elect any members of the
Board of Directors of the Fund. There are no preemptive, conversion or exchange
rights applicable to any of the Shares. The issued and outstanding Shares are
fully paid and non-assessable. In the event of liquidation or dissolution of the
Fund, each Share is entitled to its portion of the Fund's assets (or the assets
allocated to a separate series of shares if there is more than one series) after
all debts and expenses have been paid.
As used in this Statement of Additional Information the term "majority
of the outstanding Shares" means the vote of the lesser of (i) 67% or more of
the Shares present at a meeting, if the holders of more than 50% of the
outstanding Shares are present or represented by proxy, or (ii) more than 50% of
the outstanding Shares.
10. REPORTS
The Fund furnishes shareholders with semi-annual reports containing
information about the Fund and its operations, including a list of investments
held in the Fund's portfolio and financial statements. The annual financial
statements are audited by the Fund's independent auditors.
11. CUSTODIAN, TRANSFER AGENT, ACCOUNTING SERVICES
PNC Bank, National Association ("PNC Bank"), with offices at Airport
Business Park, 200 Stevens Drive, Lester, Pennsylvania, 19113, has been retained
to act as custodian of the Fund's investments. PNC Bank receives such
compensation from the Fund for its services as custodian as may be agreed to
from time to time by PNC Bank and the Fund. Investment Company Capital Corp.,
-20-
<PAGE>
135 East Baltimore Street, Baltimore, Maryland 21202, serves as the Fund's
transfer and dividend disbursing agent and provides certain accounting services
to the Fund under a Master Services Agreement between the Fund and ICC. As
compensation for providing dividend and transfer agency services, the Fund pays
ICC up to $10.62 per account per year, plus reimbursement for out-of-pocket
expenses incurred in connection therewith. For the fiscal year ended December
31, 1995, such fees totalled $24,999.
As compensation for providing accounting services, ICC receives an
annual fee, calculated daily and paid monthly, as shown below.
Average Net Assets Incremental Fee
------------------ ---------------
$ 0 - $ 10,000,000 $15,000 (fixed fee)
$ 10,000,001 - $ 24,999,999 .080%
$ 25,000,000 - $ 50,000,000 .077%
$ 50,000,001 - $ 75,000,000 .050%
$ 75,000,001 - $ 99,999,999 .030%
$100,000,000 - $ 500,000,000 .020%
$500,000,001 - $1,000,000,000 .008%
over $1,000,000,000 .003%
In addition, the Fund will reimburse ICC for the following out-of-pocket
expenses incurred in connection with ICC's provision of accounting services
under the Master Services Agreement: express delivery service, independent
pricing and storage. For the fiscal year ended December 31, 1995, ICC received
accounting fees of $57,172.
ICC also serves as the Fund's investment advisor.
12. INDEPENDENT AUDITORS
The annual financial statements of the Fund are audited by Deloitte &
Touche LLP. Deloitte & Touche LLP has offices at 117 Campus Drive, Princeton,
New Jersey 08540.
13. PERFORMANCE INFORMATION
For purposes of quoting and comparing the performance of the Fund to
that of other open-end diversified management investment companies and to stock
or other relevant indices in advertisements or in certain reports to
shareholders, performance will generally be stated both in terms of total return
and in terms of yield. However, the Fund may also from time to time state the
performance of the Fund solely in terms of total return.
Total Return Calculations
The total return quotations, under the rules of the SEC, must be
calculated according to the following formula:
-21-
<PAGE>
n
P(1 + T) = ERV
Where: P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years (1, 5 or 10)
ERV = ending redeemable value at the end of the 1, 5, or 10 year
periods (or fractional portion thereof) of a hypothetical $1,000
payment made at the beginning of the 1, 5 or 10 year periods.
Under the foregoing formula, the time periods used in advertising will be based
on rolling calendar quarters, updated to the last day of the most recent quarter
prior to submission of the advertising for publication, and will cover one,
five, and ten year periods or a shorter period dating from the effectiveness of
the Fund's registration statement (or the later commencement of operations of a
Series or class). During its first year of operations, the Fund may, in lieu of
annualizing its total return, use an aggregate total return calculated in the
same manner. In calculating the ending redeemable value, the maximum sales load
(1.50% for the Class A Shares) is deducted from the initial $1,000 payment and
all dividends and distributions by the Fund are assumed to have been reinvested
at net asset value as described in the Prospectuses on the reinvestment dates
during the period. "T" in the formula above is calculated by finding the average
annual compounded rate of return over the period that would equate an assumed
initial payment of $1,000 to the ending redeemable value. Any sales loads that
might in the future be made applicable at the time to reinvestments would be
included as would any recurring account charges that might be imposed by the
Fund. The Institutional Shares are sold without a sales load.
The Fund may also from time to time include in such advertising total
return figures that are not calculated according to the formula set forth above
to compare more accurately the Fund's performance with other measures of
investment return. For example, in comparing the Fund's total return with data
published by Lipper Analytical Services, Inc., CDA/Weisenberger or Morningstar
Inc., or with the performance of Lehman Brothers Government Corporate Bond
Index, Lehman Brothers Government Intermediate-Term Bond Index or Salomon
Brothers Broad Investment Grade Index, the Fund calculates its aggregate and
average annual total return for the specified periods of time by assuming the
investment of $10,000 in Shares and assuming the reinvestment of each dividend
or other distribution at net asset value on the reinvestment date.
For this alternative computation, the Fund assumes that the $10,000
invested in Shares is net of all sales charges (as distinguished from the
computation required by the SEC where the $1,000 payment is reduced by sales
charges before being invested in Shares). The Fund will, however, disclose the
maximum sales charges and will also disclose that the performance data do not
reflect sales charges and that inclusion of sales charges would reduce the
performance quoted. Such alternative total return information will be given no
greater prominence in such advertising than the information prescribed under SEC
rules, and all advertisements containing performance data will include a legend
disclosing that such performance data represent past performance and that 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.
Calculated according to the SEC rules for the one-year period ended
December 31, 1995, the ending redeemable value of a hypothetical $1,000 payment
for Class A Shares was $1,138, resulting in a total return for such shares equal
-22-
<PAGE>
to 13.77%. For the period from effectiveness of the Fund's registration
statement on May 13, 1991 to the end of the Fund's most recent fiscal year on
December 31, 1995, the ending redeemable value of a hypothetical $1,000 payment
for Class A Shares was $1,391 resulting in an average annual total return for
such shares equal to 7.38%.
Calculated according to the SEC rules for the period from November 2,
1995 (commencement of offering of the Institutional Shares) through December 31,
1995, the ending redeemable value of a hypothetical $1,000 payment for
Institutional Shares was $1,025, resulting in an aggregate total return for such
shares equal to 2.50%.
Calculated according to the alternative computation which assumes no
sales charges and reinvestment of all distributions, for the one-year period
ended December 31, 1995, the ending redeemable value of a hypothetical $10,000
investment in Class A Shares was $11,543, resulting in a total return for such
shares equal to 15.43%. For the period from effectiveness of the Fund's
registration statement on May 13, 1991 to the end of the Fund's most recent
fiscal year on December 31, 1995, the ending redeemable value of a hypothetical
$10,000 investment in Class A Shares was $14,112, resulting in an average annual
total return for such shares equal to 7.21%.
Calculated according to the alternative computation for the period from
November 2, 1995 (commencement of offering of the Institutional Shares) through
December 31, 1995, the ending redeemable value of a hypothetical $10,000
investment in Institutional Shares was $10,250, resulting in an aggregate total
return for such Shares equal to 2.50%.
Yield Calculations
The Fund's yield for the Class A Shares and the Institutional Shares for
the 30 day period ended December 31, 1995 was 6.27% and 6.30%, respectively, and
was computed in the manner discussed below. The yield of the Fund is calculated
by dividing the net investment income per Share earned by the Fund during a
30-day (or one month) period by the maximum offering price per share on the last
day of the period and annualizing the result on a semi-annual basis by adding
one to the quotient, raising the sum to the power of six, subtracting one from
the result and then doubling the difference. The Fund's yield calculations
assume a maximum sales charge of 1.50% for the Class A Shares and no sales
charge for the Institutional Shares. The Fund's net investment income per Share
earned during the period is based on the average daily number of Shares
outstanding during the period entitled to receive dividends and includes
dividends and interest earned during the period minus expenses accrued for the
period, net of reimbursements.
Except as noted below, for the purpose of determining net investment
income earned during the period, interest earned on debt obligations held by the
Fund is calculated by computing the yield to maturity of each obligation based
on the market value of the obligation (including actual accrued interest) at the
close of business on the last business day of each month, or, with respect to
obligations purchased during the month, based on the purchase price (plus actual
accrued interest), dividing the result by 360 and multiplying the quotient by
the market value of the obligation (including actual accrued interest) in order
to determine the interest income on the obligation for each day of the
subsequent month that the obligation is held by the Fund. For purposes of this
calculation, it is assumed that each month contains 30 days. The maturity of an
obligation with a call provision is the next call date on which the obligation
reasonably may be expected to be called or, if none, the maturity date.
-23-
<PAGE>
Undeclared earned income will be subtracted from the net asset value per
share. Undeclared earned income is net investment income which, at the end of
the base period, has not been declared as a dividend, but is reasonably expected
to be and is declared as a dividend shortly thereafter.
The Fund's annual portfolio turnover rate (the lesser of the value of
the purchases or sales for the year divided by the average monthly market value
of the portfolio during the year, excluding U.S. Government securities and
securities with maturities of one year or less) may vary from year to year, as
well as within a year, depending on market conditions. The Fund's portfolio
turnover rate for the fiscal years ended December 31, 1995 and December 31, 1994
was 46% and 50%. A high level of portfolio turnover may generate relatively high
transaction costs and may increase the amount of taxes payable by the Fund's
shareholders.
14. CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES
As of April 2, 1996 to Fund management's knowledge, the following
persons owned of record or beneficially 5% or more of the Fund's outstanding
Shares.
Name and Address % Ownership
---------------- -----------
Class A Shares
--------------
OLICOM A/S 16.07%
ATTN: Jorgen Nielsen
Nybrovej 114
DK-2800
Lyngby, Denmark
Alex. Brown & Sons Incorporated 73.56%*
135 E. Baltimore Street
Baltimore, MD 21202
Institutional Shares
--------------------
Lauer & Co. Cust. 24.24%
BAT Customers
c/o Glenmede Income Collection Dept.
1650 Market St., Ste. 1200
Philadelphia, PA 19103-7301
Lauer & Co. FBO Alex. Brown Cap. 8.07%
Advisory & Tr. Irvin L. Small
#BS7116209 c/o Glenmede Trust Co.
Suite 1200
One Liberty Place
1650 Market Street
Philadelphia, PA 19103-7391
-24-
<PAGE>
Alex. Brown & Sons Incorporated 5.70%*
FBO 201-83722-15
P.O. Box 1346
Baltimore, MD 21203-1346
Alex. Brown & Sons Incorporated 6.10%*
FBO 201-86313-13
P.O. Box 1346
Baltimore, MD 21203-1346
Alex. Brown & Sons Incorporated 7.50%*
FBO 201-81960-10
P.O. Box 1346
Baltimore, MD 21203-1346
Alex. Brown & Sons Incorporated 8.44%*
FBO 201-86541-17
P.O. Box 1346
Baltimore, MD 21203-1346
Alex. Brown & Sons Incorporated 19.18%*
135 E. Baltimore Street
Baltimore, MD 21202
------------
* As of such date Alex. Brown owned beneficially less than
1% of such Shares.
As of April 2, 1996, Directors and officers as a group owned
less than 1% of the Fund's total outstanding Shares.
15. FINANCIAL STATEMENTS
(See next page.)
-25-
<PAGE>
FLAG INVESTORS
INTERMEDIATE-TERM INCOME FUND
Statement of Net Assets December 31, 1995
<TABLE>
<CAPTION>
S&P Par Value
Security Rating(1) (000) (Note A)
<S> <C> <C> <C>
CORPORATE BONDS -- 26.1%
Banc One Columbus
7.375%, 12/1/02 AA- $1,000 $ 1,092,500
Banc One Credit Card Master Trust
6.30%, 10/15/02 AAA 3,000 3,067,500
Bear Stearns Co.
6.625%, 1/15/04 A 3,000 3,041,250
Countrywide Funding
8.25%, 7/15/02 A- 3,250 3,599,375
Fund America Enterprise
7.75%, 2/1/03 BBB+ 3,000 3,142,500
Pacific Gas & Electric
6.25%, 3/1/04 A 2,000 2,002,500
Societe Nationale Elf Aquitaine
7.75%, 5/1/99 AA- 2,000 2,125,000
----------
Total Corporate Bonds (Cost $17,483,844) 18,070,625
----------
U.S. GOVERNMENT AGENCY SECURITIES -- 20.1%
Federal Home Loan Banks Board -- 4.4%
7.151%, 9/13/05 (callable 9/13/97) AAA 3,000 3,086,310
Federal Home Loan Mortgage Corp. -- 2.1%
Pool #G10049, 8.00%, 10/1/07 AAA 1,393 1,444,393
Federal National Mortgage Assoc. -- 5.9%
Multi-Class Mortgage Certificates
Pool #326570, 7.00%, 2/1/08 AAA 3,997 4,074,315
Government National Mortgage Assoc. -- 6.0%
Multi-Class Mortgage Certificates
Pool #194615, 8.00%, Due 3/15/17 AAA 166 172,545
Pool #204405, 8.00%, Due 4/15/17 AAA 184 191,503
Pool #371200, 8.00%, Due 12/15/23 AAA 1,618 1,687,303
Pool #371206, 8.00%, Due 12/15/23 AAA 2,019 2,105,216
Guaranteed Export Trust -- 1.7%
8.187%, 12/15/04 AAA 1,060 1,148,055
----------
Total U.S. Government Agency Securities (Cost $13,700,276) 13,909,640
----------
U.S. TREASURY SECURITIES -- 16.6%
U.S. Treasury Notes
4.75%, 9/30/98 AAA 4,000 3,952,120
5.50%, 4/15/00 AAA 2,500 2,521,550
5.75%, 8/15/03 AAA 5,000 5,067,200
----------
Total U.S. Treasury Securities (Cost $11,205,039) 11,540,870
----------
</TABLE>
-26-
<PAGE>
FLAG INVESTORS
INTERMEDIATE-TERM INCOME FUND
Statement of Net Assets (concluded) December 31, 1995
<TABLE>
<CAPTION>
S&P Par Value
Security Rating(1) (000) (Note A)
<S> <C> <C> <C>
ASSET-BACKED SECURITIES -- 11.3%
Premier Auto Trust, 94-1-A3, 4.75%, 2/2/00 AAA $ 944 $ 937,160
Discover Credit Card, 93-A-A, 6.25%, 8/16/00 AAA 3,000 3,052,620
Sears Credit Account Master Trust, II 95-2-A, 8.10%, 6/15/04 AAA 3,500 3,808,770
----------
Total Asset-Backed Securities (Cost $7,481,229) 7,798,550
COLLATERALIZED MORTGAGE OBLIGATIONS -- 22.8%
Federal Home Loan Mortgage Corp. -- 11.9%
Multi-Class Mortgage Certificates
Series 21-H, 5.85%, 1/25/19 AAA 4,000 3,941,361
Series 1163-I, 6.95%, 12/15/20 AAA 600 610,782
Series 106-F, 8.50%, 12/15/20 AAA 3,562 3,670,704
Federal National Mortgage Assoc. -- 10.8%
Multi-Class Mortgage Certificates
Series 1988-18-B, 9.40%, 7/25/03 AAA 237 248,636
Series 1992-149-D, 12.00%, 4/25/19 AAA 2,068 2,139,593
Series 1991-11-G, 7.00%, 11/25/19 AAA 3,052 3,069,546
Series 1995-W-1--A2, 8.20%, 4/25/25 AAA 2,000 2,058,200
Goldman Sachs Trust Series 3 -- 0.1%
Remic, Series 3 E-4, 8.00%, 5/27/15 AAA 66 67,321
----------
Total Collateralized Mortgage Obligations (Cost $15,609,443) 15,806,143
----------
REPURCHASE AGREEMENT -- 2.6%
Goldman Sachs & Co., 5.70%
Dated 12/29/95, to be repurchased on 1/2/96, collateralized
by U.S. Treasury Bonds with a market value of $1,834,529.
(Cost $1,806,000) NR* 1,806 1,806,000
---------
Total Investment in Securities -- 99.5%
(Cost $67,285,831)** 68,931,828
Other Assets in Excess of Liabilities, Net -- 0.5% 369,866
----------
Net Assets -- 100.0% $69,301,694
==========
Net Asset Value Per:
Class A Share ($67,115,974 / 6,406,450 shares outstanding) $10.48
=====
Institutional Share ($2,185,720 / 206,585 shares outstanding) $10.58
=====
Maximum Offering Price Per:
Class A Share ($10.48 / .985) $10.64
=====
Institutional Share $10.58
=====
</TABLE>
(1) The Standard & Poor's rating indicated is believed to be the most
recent rating available as of December 31, 1995.
* Not rated.
** Also aggregate cost for federal tax purposes.
See accompanying Notes to Financial Statements.
-27-
<PAGE>
FLAG INVESTORS
INTERMEDIATE-TERM INCOME FUND
Statement of Operations For the Year Ended December 31, 1995
INVESTMENT INCOME (NOTE A):
Interest $ 4,829,563
-----------
EXPENSES:
Investment advisory fee (Note B) 252,372
Distribution fee (Note B) 179,666
Accounting fee (Note B) 57,172
Printing and postage 32,168
Custodian fees 25,999
Transfer agent fees (Note B) 24,999
Legal 24,999
Audit 23,999
Registration fees 19,998
Organizational expense (Note A) 9,092
Miscellaneous 8,500
Directors' fees 5,000
Insurance 3,680
-----------
Total expenses 667,644
Less: Fees waived (Note B) (162,943)
-----------
Net expenses 504,701
-----------
Net investment income 4,324,862
-----------
REALIZED AND UNREALIZED GAIN/(LOSS) ON INVESTMENTS (NOTE A):
Net realized loss from securities transactions (1,018,416)
Change in unrealized appreciation of investments 7,179,328
Change in unrealized appreciation of assets and liabilities
denominated in foreign currency 1,216
-----------
Net gain on investments 6,162,128
-----------
NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS $10,486,990
===========
See accompanying Notes to Financial Statements.
-28-
<PAGE>
FLAG INVESTORS
INTERMEDIATE-TERM INCOME FUND
Statement of Changes in Net Assets
<TABLE>
<CAPTION>
For the Year Ended December 31,
1995 1994
<S> <C> <C>
INCREASE/(DECREASE) IN NET ASSETS:
OPERATIONS:
Net investment income $ 4,324,862 $ 5,692,067
Net loss from security transactions (1,018,416) (2,533,036)
Change in unrealized appreciation/(depreciation)
of investments 7,179,328 (6,950,668)
Change in unrealized appreciation/(depreciation) of assets
and liabilities denominated in foreign currency 1,216 --
---------- ------------
Net increase/(decrease) in net assets
resulting from operations 10,486,990 (3,791,637)
---------- ------------
DIVIDENDS TO SHAREHOLDERS FROM:
Net investment income:
Flag Investors Class A Shares (4,208,250) (5,690,349)
Flag Investors Institutional Shares (7,962) --
Return of capital:
Flag Investors Class A Shares -- (324,493)
Flag Investors Institutional Shares -- --
---------- ------------
Total distributions (4,216,212) (6,014,842)
---------- ------------
CAPITAL SHARE TRANSACTIONS (NOTE C):
Proceeds from sale of shares 4,986,795 18,470,875
Value of shares issued in reinvestment of dividends 2,635,861 4,067,306
Cost of shares repurchased (23,380,739) (46,462,862)
---------- ------------
Decrease in net assets derived from
capital share transactions (15,758,083) (23,924,681)
---------- ------------
Total decrease in net assets (9,487,305) (33,731,160)
NET ASSETS:
Beginning of year 78,788,999 112,520,159
---------- ------------
End of year $69,301,694 $ 78,788,999
========== ============
</TABLE>
See accompanying Notes to Financial Statements.
-29-
<PAGE>
FLAG INVESTORS
INTERMEDIATE-TERM INCOME FUND
FINANCIAL HIGHLIGHTS -- FLAG INVESTORS CLASS A SHARES
(For a share outstanding throughout each period)
<TABLE>
<CAPTION>
For the Period
May 13, 1991*
For the Year Ended December 31, through
1995 1994 1993 1992 Dec. 31, 1991
<S> <C> <C> <C> <C> <C>
PER SHARE OPERATING PERFORMANCE:
Net asset value at beginning of period $ 9.62 $ 10.57 $ 10.37 $ 10.54 $ 10.00
------- ------- -------- ------- -------
INCOME FROM INVESTMENT OPERATIONS:
Net investment income 0.62 0.57 0.57 0.63 0.32
Net realized and unrealized gain/(loss)
on investments 0.84 (0.92) 0.34 (0.05) 0.64
------- ------- -------- ------- -------
Total from Investment Operations 1.46 (0.35) 0.91 0.58 0.96
------- ------- -------- ------- -------
LESS DISTRIBUTIONS:
Dividends from net investment
income and short-term gains (0.60) (0.57) (0.69) (0.75) (0.42)
Return of capital -- (0.03) -- -- --
Distributions from net realized
long-term gains -- -- (0.02) -- --
------- ------- -------- ------- -------
Total distributions (0.60) (0.60) (0.71) (0.75) (0.42)
------- ------- -------- ------- -------
Net asset value at end of period $ 10.48 $ 9.62 $ 10.57 $ 10.37 $ 10.54
======= ======= ======== ======= =======
TOTAL RETURN(1) 15.43% (3.32)% 8.98% 5.68% 9.79%
RATIOS TO AVERAGE NET ASSETS:
Expenses(2) 0.70% 0.70% 0.70% 0.70% 0.70%**
Net investment income(3) 6.00% 5.57% 5.43% 6.01% 5.97%**
SUPPLEMENTAL DATA:
Net assets at end of period (000) $67,116 $78,789 $112,520 $78,706 $64,327
Portfolio turnover rate 46% 50% 86% 107% 46%
</TABLE>
* Commencement of operations.
** Annualized.
(1) Total return excludes the effect of sales loads.
(2) Without the waiver of advisory fees (Note B), the ratio of expenses
to average net assets would have been 0.93%, 0.84%, 0.85%, 0.87% and
1.73% (annualized) for the years ended December 31, 1995, 1994, 1993,
1992, and for the period ended December 31, 1991, respectively.
(3) Without the waiver of advisory fees (Note B), the ratio of net
investment income to average net assets would have been 5.77%,
5.43%, 5.28%, 5.83% and 4.94% (annualized) for the years ended
December 31, 1995, 1994, 1993, 1992, and for the period ended
December 31, 1991, respectively.
See accompanying Notes to Financial Statements.
-30-
<PAGE>
FLAG INVESTORS
INTERMEDIATE-TERM INCOME FUND
FINANCIAL HIGHLIGHTS -- INSTITUTIONAL SHARES
(For a share outstanding during the period)
For the Period
November 2, 1995*
through
December 31, 1995
PER SHARE OPERATING PERFORMANCE:
Net asset value at beginning of period $ 10.42
-------
INCOME FROM INVESTMENT OPERATIONS:
Net investment income 0.09
Net realized and unrealized gain on investments 0.12
-------
Total from Investment Operations 0.21
-------
Less Distributions:
Dividends from net investment income and
short-term capital gains (0.05)
-------
Net asset value at end of period $ 10.58
=======
Total Return 12.47%**
Ratios to Average Net Assets:
Expenses(1) 0.47%**
Net investment income(2) 6.52%**
Supplemental Data:
Net assets at end of period (000) $ 2,186
Portfolio turnover rate 46%
* Commencement of operations.
** Annualized.
(1) Without the waiver of advisory fees (Note B), the ratio of expenses
to average net assets would have been 0.72% (annualized) for the
period ending December 31, 1995.
(2) Without the waiver of advisory fees (Note B), the ratio of net
investment income to average net assets would have been 6.27%
(annualized) for the period ending December 31, 1995.
See accompanying Notes to Financial Statements.
-31-
<PAGE>
FLAG INVESTORS
INTERMEDIATE-TERM INCOME FUND
NOTES TO FINANCIAL STATEMENTS
A. SIGNIFICANT ACCOUNTING POLICIES - Flag Investors Intermediate-Term Income
Fund, Inc. (the "Fund") is registered under the Investment Company Act of 1940
as an open-end, diversified management investment company designed to provide a
high level of current income consistent with preservation of capital within an
intermediate-term maturity structure. The Fund commenced operations on May 13,
1991, consisting of Class A Shares, which are subject to a maximum front-end
sales charge of 1.50% and a 0.25% distribution fee. On November 2, 1995, the
Fund began offering Institutional Shares, which are not subject to a front-end
sales charge or a distribution fee. 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 revenues and expenses
during the reporting period. Actual results could differ from those estimates.
The following is a summary of significant accounting policies followed by the
Fund.
SECURITY VALUATION - Debt securities are valued on the basis of quotations
provided by a pricing service, which uses information with respect to
transactions on bonds, quotations from bond dealers, market transactions in
comparable securities and various relationships between securities in
determining value. Portfolio securities that are listed on a national securities
exchange are valued on the basis of their last sale price or, in the absence of
recorded sales, at the average of readily available closing bid and asked
prices. Securities or other assets for which market quotations are not readily
available are valued at their fair value so determined in good faith by the
investment advisor under procedures established and monitored by the Board of
Directors. Short-term obligations with maturities of 60 days or less are valued
at amortized cost which approximates market.
FEDERAL INCOME TAX - No provision is made for federal income taxes as it is the
Fund's intention to continue to qualify as a regulated investment company under
Subchapter M of the Internal Revenue Code and to make requisite distributions to
the shareholders that will be sufficient to relieve it from all or substantially
all federal income and excise taxes. The Fund's policy is to distribute to
shareholders substantially all of its taxable net investment income on a monthly
basis and net realized long-term capital gains annually, if any.
OTHER - Security transactions are accounted for on the trade date and the cost
of investments sold or redeemed is determined by use of the specific
identification method for both financial reporting and income tax purposes.
Interest income is recorded on an accrual basis and includes amortization of
premiums and accretion of discounts.
Costs incurred by the Fund in connection with its organization, registration and
the initial public offering of shares have been deferred and are being amortized
on the straight-line method over a five-year period beginning on the date on
which the Fund commenced its investment activities.
B. INVESTMENT ADVISORY FEES, TRANSACTIONS WITH AFFILIATES AND OTHER FEES -
Investment Company Capital Corp. ("ICC"), a subsidiary of Alex. Brown & Sons
Incorporated ("Alex. Brown"), serves as the Fund's investment advisor. As
compensation for its advisory services, ICC receives from the Fund an annual
fee, calculated daily and paid monthly, at an annual rate of 0.35% of the first
$1 billion of the Fund's average daily net assets; 0.30% of the Fund's average
daily net assets in excess of $1 billion but not exceeding $1.5 bil-
-32-
<PAGE>
FLAG INVESTORS
INTERMEDIATE-TERM INCOME FUND
NOTES TO FINANCIAL STATEMENTS (continued)
lion; and 0.25% of the Fund's average daily net assets in excess of $1.5
billion.
ICC has agreed to reduce its aggregate fees so that ordinary expenses of the
Fund for any fiscal year do not exceed 0.70% of the Fund's average daily net
assets. For the year ended December 31, 1995, ICC waived fees of $162,943.
As compensation for its transfer agent services, ICC receives from the Fund a
per account fee, calculated and paid monthly. ICC received $24,999 for transfer
agent services for the year ended December 31, 1995.
As compensation for its accounting services, ICC receives from the Fund an
annual fee, calculated daily and paid monthly, from the Fund's average daily net
assets. ICC received $57,172 for accounting services for the year ended December
31, 1995.
As compensation for providing distribution services, ICC receives from the Fund
an annual fee, calculated daily and paid monthly, at an annual rate equal to
0.25% of the Fund's average daily net assets of Class A Shares. For the year
ended December 31, 1995, distribution fees aggregated $179,666.
Flag Investors/ISI Fund complex has adopted a retirement plan for eligible
Directors. The pension expense as of the year ended December 31, 1995 was not
material.
C. CAPITAL SHARE TRANSACTIONS - The Fund is authorized to issue up to 55 million
shares of capital stock (45 million Class A, 5 million Institutional, 2 million
Class B and 3 million undesignated), par value $.001 per share, all of which are
designated as common stock. Transactions in shares of the Fund were as follows:
Flag Investors Class A Shares
-------------------------------
For the Year Ended December 31,
1995 1994
--------- ----------
Shares sold 267,783 1,793,782
Shares issued to
shareholders on
reinvestment of
dividends 261,580 404,005
Shares redeemed (2,317,104) (4,649,437)
---------- ----------
Net decrease in shares
outstanding (1,787,741) (2,451,650)
========== ==========
Proceeds from sale
of shares $ 2,690,780 $18,470,875
Value of reinvested
dividends 2,635,861 4,067,306
Cost of shares
redeemed (23,241,599) (46,462,862)
---------- ----------
Net decrease from
capital share
transactions $(17,914,958) $(23,924,681)
========== ==========
-33-
<PAGE>
FLAG INVESTORS
INTERMEDIATE-TERM INCOME FUND
NOTES TO FINANCIAL STATEMENTS (concluded)
Institutional Shares
--------------------------------
For the Period November 2, 1995*
through December 31, 1995
--------------------------------
Shares sold 219,797
Shares issued to
shareholders on
reinvestment of
dividends --
Shares redeemed (13,212)
-----------
Net increase in shares
outstanding 206,585
===========
Proceeds from sale
of shares $2,296,015
Value of reinvested
dividends --
Cost of shares
redeemed (139,140)
----------
Net increase from
capital share
transactions $2,156,875
==========
* Commencement of operations.
D. INVESTMENT TRANSACTIONS - Purchases and sales of investment securities, other
than short-term obligations, aggregated $31,389,840 and $42,317,826,
respectively, for the year ended December 31, 1995.
At December 31, 1995, aggregate gross unrealized appreciation for all
securities in which there is an excess of value over tax cost was $1,747,187,
and aggregate gross unrealized depreciation for all securities in which there is
an excess of tax cost over value was $101,190.
E. CAPITAL LOSS CARRYFORWARD - At December 31, 1995, there was a tax capital
loss carryforward of $3,494,748, of which $383,359 expires in 2002 and
$3,111,389 expires in 2003. This carryforward will be used to offset future net
capital gains, if any.
F. NET ASSETS - At December 31, 1995, net assets consisted of:
Paid-in capital:
Flag Investors Class A Shares $69,160,420
Flag Investors Institutional Shares 2,156,875
Accumulated net realized loss from
security transactions (3,514,478)
Unrealized appreciation of
investments 1,645,997
Overdistribution of net investment
income (147,120)
-----------
$69,301,694
===========
-34-
<PAGE>
FLAG INVESTORS
INTERMEDIATE-TERM INCOME FUND
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Shareholders, Flag
Investors Intermediate-Term Income Fund, Inc.:
We have audited the accompanying statement of net assets of Flag Investors
Intermediate-Term Income Fund, Inc. as of December 31, 1995, the related
statements of operations for the year then ended and changes in net assets for
each of the years in the two-year period then ended, and the financial
highlights for each of the years in the four-year period then ended and the
period May 13, 1991 (commencement of operations) to December 31, 1991. These
financial statements and financial highlights are the responsibility of the
Fund's management. Our responsibility is to express an opinion on these
financial statements and financial highlights based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements and the financial
highlights are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. Our procedures included confirmation of securities owned at December
31, 1995 by correspondence with the custodian. An audit also includes assessing
the accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Flag Investors
Intermediate-Term Income Fund, Inc. as of December 31, 1995, the results of its
operations, the changes in its net assets, and the financial highlights for the
respective stated periods in conformity with generally accepted accounting
principles.
DELOITTE & TOUCHE LLP
Princeton, New Jersey
January 26, 1996
-35-
