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STATEMENT OF ADDITIONAL INFORMATION
STRONG ASSET ALLOCATION FUND II
P.O. Box 2936
Milwaukee, Wisconsin 53201
Telephone: 1-414-359-1400
Toll-Free: 1-800-368-3863
Strong Asset Allocation Fund II (the "Fund") is a diversified series of
the Strong Variable Insurance Funds, Inc. (the "Corporation"), an open-end
management investment company designed to provide an investment vehicle for
variable annuity and variable life insurance contracts of certain insurance
companies. Shares in the Fund are only offered and sold to the separate
accounts of such insurance companies. The Fund is described herein and in the
Prospectus for the Fund dated July 14, 1995.
This Statement of Additional Information is not a prospectus and should be
read in conjunction with the Prospectus for the Fund dated July 14, 1995 and
the prospectus for the separate account of the specific insurance product.
Requests for copies of the Fund's Prospectus may be made by calling one of
the numbers listed above.
This Statement of Additional Information is dated July 14, 1995,
as supplemented on October 20, 1995.
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STRONG ASSET ALLOCATION FUND II
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TABLE OF CONTENTS PAGE
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INVESTMENT RESTRICTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
INVESTMENT POLICIES AND TECHNIQUES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Derivative Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Short Sales Against the Box . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Lending of Portfolio Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Warrants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Debt Obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
High-Yield (High-Risk) Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Mortgage- and Asset-Backed Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
When-Issued Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Illiquid Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Foreign Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Sovereign Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Depositary Receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Foreign Investment Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Repurchase Agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Borrowing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Mortgage Dollar Rolls and Reverse Repurchase Agreements . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Variable- or Floating-Rate Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Small Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
DIRECTORS AND OFFICERS OF THE CORPORATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
PRINCIPAL SHAREHOLDERS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
INVESTMENT ADVISOR AND DISTRIBUTOR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
PORTFOLIO TRANSACTIONS AND BROKERAGE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
CUSTODIAN . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
TRANSFER AGENT AND DIVIDEND-DISBURSING AGENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
ADMINISTRATIVE SERVICES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
TAXES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
DETERMINATION OF NET ASSET VALUE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
FUND ORGANIZATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
PERFORMANCE INFORMATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
GENERAL INFORMATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
PORTFOLIO MANAGEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
INDEPENDENT ACCOUNTANTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
LEGAL COUNSEL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
APPENDIX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-1
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No person has been authorized to give any information or to make any
representations other than those contained in this Statement of Additional
Information and the Prospectus dated July 14, 1995 and, if given or made, such
information or representations may not be relied upon as having been authorized
by the Fund.
This Statement of Additional Information does not constitute an offer
to sell securities.
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INVESTMENT RESTRICTIONS
The investment objective of the Fund is to seek high total return
consistent with reasonable risk over the long term. The Fund's investment
objective and policies are described in detail in the Prospectus under the
caption "Investment Objective and Policies." The following are the Fund's
fundamental investment limitations which cannot be changed without shareholder
approval.
The Fund:
1. May not with respect to 75% of its total assets, purchase the securities
of any issuer (except securities issued or guaranteed by the U.S.
government or its agencies or instrumentalities) if, as a result, (i) more
than 5% of the Fund's total assets would be invested in the securities of
that issuer, or (ii) the Fund would hold more than 10% of the outstanding
voting securities of that issuer.
2. May (i) borrow money from banks and (ii) make other investments or engage
in other transactions permissible under the Investment Company Act of 1940
(the "1940 Act") which may involve a borrowing, provided that the
combination of (i) and (ii) shall not exceed 33 1/3% of the value of the
Fund's total assets (including the amount borrowed), less the Fund's
liabilities (other than borrowings), except that the Fund may borrow up to
an additional 5% of its total assets (not including the amount borrowed)
from a bank for temporary or emergency purposes (but not for leverage or
the purchase of investments). The Fund may also borrow money from the
other Strong Funds or other persons to the extent permitted by applicable
law.
3. May not issue senior securities, except as permitted under the 1940 Act.
4. May not act as an underwriter of another issuer's securities, except to
the extent that the Fund may be deemed to be an underwriter within the
meaning of the Securities Act of 1933 in connection with the purchase and
sale of portfolio securities.
5. May not purchase or sell physical commodities unless acquired as a result
of ownership of securities or other instruments (but this shall not
prevent the Fund from purchasing or selling options, futures contracts, or
other derivative instruments, or from investing in securities or other
instruments backed by physical commodities).
6. May not make loans if, as a result, more than 33 1/3% of the Fund's total
assets would be lent to other persons, except through (i) purchases of
debt securities or other debt instruments, or (ii) engaging in repurchase
agreements.
7. May not purchase the securities of any issuer if, as a result, more than
25% of the Fund's total assets would be invested in the securities of
issuers, the principal business activities of which are in the same
industry.
8. May not purchase or sell real estate unless acquired as a result of
ownership of securities or other instruments (but this shall not prohibit
the Fund from purchasing or selling securities or other instruments backed
by real estate or of issuers engaged in real estate activities).
9. May, notwithstanding any other fundamental investment policy or
restriction, invest all of its assets in the securities of a single
open-end management investment company with substantially the same
fundamental investment objective, policies, and restrictions as the Fund.
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The following are the Fund's non-fundamental operating policies which may be
changed by the Board of Directors of the Corporation without shareholder
approval.
The Fund may not:
1. Sell securities short, unless the Fund owns or has the right to obtain
securities equivalent in kind and amount to the securities sold short, or
unless it covers such short sale as required by the current rules and
positions of the Securities and Exchange Commission or its staff, and
provided that transactions in options, futures contracts, options on
futures contracts, or other derivative instruments are not deemed to
constitute selling securities short.
2. Purchase securities on margin, except that the Fund may obtain such
short-term credits as are necessary for the clearance of transactions; and
provided that margin deposits in connection with futures contracts,
options on futures contracts, or other derivative instruments shall not
constitute purchasing securities on margin.
3. Invest in illiquid securities if, as a result of such investment, more
than 15% of its net assets would be invested in illiquid securities, or
such other amounts as may be permitted under the 1940 Act.
4. Purchase securities of other investment companies except in compliance
with the 1940 Act and applicable state law.
5. Invest all of its assets in the securities of a single open-end investment
management company with substantially the same fundamental investment
objective, restrictions and policies as the Fund.
6. Purchase the securities of any issuer (other than securities issued or
guaranteed by domestic or foreign governments or political subdivisions
thereof) if, as a result, more than 5% of its total assets would be
invested in the securities of issuers that, including predecessor or
unconditional guarantors, have a record of less than three years of
continuous operation. This policy does not apply to securities of pooled
investment vehicles or mortgage or asset-backed securities.
7. Invest in direct interests in oil, gas, or other mineral exploration
programs or leases; however, the Fund may invest in the securities of
issuers that engage in these activities.
8. Engage in futures or options on futures transactions which are
impermissible pursuant to Rule 4.5 under the Commodity Exchange Act and,
in accordance with Rule 4.5, will use futures or options on futures
transactions solely for bona fide hedging transactions (within the meaning
of the Commodity Exchange Act), provided, however, that the Fund may, in
addition to bona fide hedging transactions, use futures and options on
futures transactions if the aggregate initial margin and premiums required
to establish such positions, less the amount by which any such options
positions are in the money (within the meaning of the Commodity Exchange
Act), do not exceed 5% of the Fund's net assets.
In addition, (i) the aggregate value of securities underlying call options
on securities written by the Fund or obligations underlying put options on
securities written by the Fund determined as of the date the options are
written will not exceed 50% of the Fund's net assets; (ii) the aggregate
premiums paid on all options purchased by the Fund and which are being
held will not exceed 20% of the Fund's net assets; (iii) the Fund will not
purchase put or call options, other than hedging positions, if, as a
result thereof, more than 5% of its total assets would be so invested; and
(iv) the aggregate margin deposits required on all futures and options on
futures transactions being held will not exceed 5% of the Fund's total
assets.
9. Pledge, mortgage or hypothecate any assets owned by the Fund except as may
be necessary in connection with permissible borrowings or investments and
then such pledging, mortgaging, or hypothecating may not exceed 33 1/3% of
the Fund's total assets at the time of the borrowing or investment.
10. Purchase or retain the securities of any issuer if any officer or director
of the Fund or its investment advisor beneficially owns more than 1/2 of
1% of the securities of such issuer and such officers and directors
together own beneficially more than 5% of the securities of such issuer.
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11. Purchase warrants, valued at the lower of cost or market value, in excess
of 5% of the Fund's net assets. Included in that amount, but not to
exceed 2% of the Fund's net assets, may be warrants that are not listed on
any stock exchange. Warrants acquired by the Fund in units or attached to
securities are not subject to these restrictions.
12. Borrow money except (i) from banks or (ii) through reverse repurchase
agreements or mortgage dollar rolls, and will not purchase securities when
bank borrowings exceed 5% of its total assets.
13. Make any loans other than loans of portfolio securities, except through
(i) purchases of debt securities or other debt instruments, or (ii)
engaging in repurchase agreements.
Except for the fundamental investment limitations listed above and the
Fund's investment objective, the other investment policies described in the
Prospectus and this Statement of Additional Information are not fundamental and
may be changed with approval of the Corporation's Board of Directors.
INVESTMENT POLICIES AND TECHNIQUES
The following information supplements the discussion of the Fund's
investment objective, policies, and techniques that are described in detail in
the Prospectus under the captions "Investment Objective and Policies" and
"Implementation of Policies and Risks."
DERIVATIVE INSTRUMENTS
GENERAL DESCRIPTION. As discussed in the Prospectus, the Fund may use
a variety of derivative instruments, including options, futures contracts
(sometimes referred to as "futures"), options on futures contracts, forward
currency contracts and swap agreements for any lawful purpose consistent with
the Fund's investment objective, such as to hedge the Fund's portfolio, manage
risk, or attempt to enhance returns, but not for speculation.
The use of these instruments is subject to applicable regulations of the
Securities and Exchange Commission (the "SEC"), the several options and futures
exchanges upon which they may be traded, the Commodity Futures Trading
Commission (the "CFTC") and various state regulatory authorities. In addition,
the Fund's ability to use these instruments will be limited by tax
considerations.
In addition to the products, strategies and risks described below and in
the Prospectus, the Advisor may discover additional derivative instruments and
other hedging techniques. These new opportunities may become available as the
Advisor develops new techniques or as regulatory authorities broaden the range
of permitted transactions. The Advisor may utilize these opportunities to the
extent that they are consistent with the Fund's investment objective and
permitted by the Fund's investment limitations and applicable regulatory
authorities.
SPECIAL RISKS OF THESE INSTRUMENTS. The use of derivative instruments
involves special considerations and risks as described below. Risks pertaining
to particular instruments are described in the sections that follow.
(1) Successful use of most of these instruments depends upon the
Advisor's ability to predict movements of the overall securities and currency
markets, which requires different skills than predicting changes in the prices
of individual securities. While the Advisor is experienced in the use of these
instruments, there can be no assurance that any particular strategy adopted
will succeed.
(2) There might be imperfect correlation, or even no correlation,
between price movements of an instrument and price movements of investments
being hedged. For example, if the value of an instrument used in a short hedge
(such as writing a call option, buying a put option, or selling a futures
contract) increased by less than the decline in value of the hedged investment,
the hedge would not be fully successful. Such a lack of correlation might
occur due to factors unrelated to the value of the investments being hedged,
such as speculative or other pressures on the markets in which these
instruments are traded. The effectiveness of hedges using instruments on
indices will depend on the degree of correlation between price movements in the
index and price movements in the investments being hedged.
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(3) Hedging strategies, if successful, can reduce risk of loss by
wholly or partially offsetting the negative effect of unfavorable price
movements in the investments being hedged. However, hedging strategies can
also reduce opportunity for gain by offsetting the positive effect of favorable
price movements in the hedged investments. For example, if the Fund entered
into a short hedge because the Advisor projected a decline in the price of a
security in the Fund's portfolio, and the price of that security increased
instead, the gain from that increase might be wholly or partially offset by a
decline in the price of the instrument. Moreover, if the price of the
instrument declined by more than the increase in the price of the security, the
Fund could suffer a loss.
(4) As described below, the Fund might be required to maintain
assets as "cover," maintain segregated accounts, or make margin payments when
it takes positions in these instruments involving obligations to third parties
(i.e., instruments other than purchased options). If the Fund were unable to
close out its positions in such instruments, it might be required to continue
to maintain such assets or accounts or make such payments until the position
expired or matured. The requirements might impair the Fund's ability to sell a
portfolio security or make an investment at a time when it would otherwise be
favorable to do so, or require that the Fund sell a portfolio security at a
disadvantageous time. The Fund's ability to close out a position in an
instrument prior to expiration or maturity depends on the existence of a liquid
secondary market or, in the absence of such a market, the ability and
willingness of the other party to the transaction ("counter party") to enter
into a transaction closing out the position. Therefore, there is no assurance
that any hedging position can be closed out at a time and price that is
favorable to the Fund.
For a discussion of the federal income tax treatment of the Fund's
derivative instruments, see "Taxes -- Derivative Instruments" below.
GENERAL LIMITATIONS ON CERTAIN DERIVATIVE TRANSACTIONS. The Fund has
filed a notice of eligibility for exclusion from the definition of the term
"commodity pool operator" with the CFTC and the National Futures Association,
which regulate trading in the futures markets. Pursuant to Rule 4.5 of the
regulations under the Commodity Exchange Act (the "CEA"), the notice of
eligibility includes representations that the Fund will use futures contracts
and related options solely for bona fide hedging purposes within the meaning of
CFTC regulations, provided that the Fund may hold other positions in futures
contracts, and related options that do not qualify as a bona fide hedging
position if the aggregate initial margin deposits and premiums required to
establish these positions, less the amount by which any such options positions
are "in the money," do not exceed 5% of the Fund's net assets. Adoption of
these guidelines does not limit the percentage of the Fund's assets at risk to
5%.
In addition, (i) the aggregate value of securities underlying call options
on securities written by the Fund or obligations underlying put options on
securities written by the Fund determined as of the date the options are
written will not exceed 50% of the Fund's net assets; (ii) the aggregate
premiums paid on all options purchased by the Fund and which are being held
will not exceed 20% of the Fund's net assets; (iii) the Fund will not purchase
put or call options, other than hedging positions, if, as a result thereof,
more than 5% of its total assets would be so invested; and (iv) the aggregate
margin deposits required on all futures and options on futures transactions
being held will not exceed 5% of the Fund's total assets.
The foregoing limitations are not fundamental policies of the Fund and may
be changed by the Corporation's Board of Directors without shareholder approval
as regulatory agencies permit.
Transactions using options (other than purchased options), forward
currency contracts, and swaps expose the Fund to counter-party risk. To the
extent required by SEC guidelines, the Fund will not enter into any such
transactions unless it owns either (1) an offsetting ("covered") position in
securities, currencies, or other options, futures, or forward currency
contracts or (2) cash and liquid high grade debt obligations with a value
sufficient at all times to cover its potential obligations to the extent not
covered as provided in (1) above. The Fund will also segregate such assets
with respect to futures contracts and its net obligations under swap
agreements. See "Swap Agreements" below. Assets used as cover or held in a
segregated account cannot be sold while the position in the corresponding
option, futures contract, or forward currency contract is open, unless they are
replaced with similar assets. As a result, the commitment of a large portion
of the Fund's assets to segregated accounts as a cover could impede portfolio
management or the Fund's ability to meet redemption requests or other current
obligations.
In some cases, the Fund may be required to maintain or limit exposure to a
specified percentage of its assets to a particular asset class or foreign
country. In such cases, when the Fund uses a derivative instrument to increase
or decrease exposure to an asset class or foreign country and is required by
applicable SEC guidelines to set aside liquid assets in a segregated account to
secure its obligations under the derivative instruments, the Advisor will
measure compliance with the applicable percentage by reference to the
nature of the economic exposure created through the use of the derivative
instrument and not by reference to the nature of the exposure arising from the
liquid assets set aside in the segregated account (unless another
interpretation is specified by applicable regulatory requirements).
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OPTIONS. The Fund may purchase and write put and call options on
securities, on indices and on foreign currencies and enter into closing
transactions with respect to such options to terminate an existing position.
The purchase of call options serves as a long hedge, and the purchase of put
options serves as a short hedge. Writing put or call options can enable the
Fund to enhance income by reason of the premiums paid by the purchaser of such
options. Writing call options serves as a limited short hedge because declines
in the value of the hedged investment would be offset to the extent of the
premium received for writing the option. However, if the security appreciates
to a price higher than the exercise price of the call option, it can be
expected that the option will be exercised and the Fund will be obligated to
sell the security at less than its market value or will be obligated to
purchase the security at a price greater than that at which the security must
be sold under the option. All or a portion of any assets used as cover for OTC
options written by the Fund would be considered illiquid to the extent
described under "Investment Policies and Techniques--Illiquid Securities."
Writing put options serves as a limited long hedge because increases in the
value of the hedged investment would be offset to the extent of the premium
received for writing the option. However, if the security depreciates to a
price lower than the exercise price of the put option, it can be expected that
the put option will be exercised and the Fund will be obligated to purchase the
security at more than its market value.
The value of an option position will reflect, among other things, the
historical price volatility of the underlying investment, the current market
value of the underlying investment, the time remaining until expiration, the
relationship of the exercise price to the market price of the underlying
investment, and general market conditions. Options used by the Fund may
include European-style options. This means that the option is only exercisable
at its expiration. This is in contrast to American-style options which are
exercisable at any time prior to the expiration date of the option. Options
that expire unexercised have no value.
The Fund may effectively terminate its right or obligation under an option
by entering into a closing transaction. For example, the Fund may terminate
its obligation under a call or put option that it had written by purchasing an
identical call or put option; this is known as a closing purchase transaction.
Conversely, the Fund may terminate a position in a put or call option it had
purchased by writing an identical put or call option; this is known as a
closing sale transaction. Closing transactions permit the Fund to realize the
profit or limit the loss on an option position prior to its exercise or
expiration.
The Fund may purchase or write both exchange-traded and OTC options.
Exchange-traded options are issued by a clearing organization affiliated with
the exchange on which the option is listed that, in effect, guarantees
completion of every exchange-traded option transaction. OTC options are
contracts between the Fund and the other party to the transaction ("counter
party") (usually a securities dealer or a bank) with no clearing organization
guarantee. Thus, when the Fund purchases or writes an OTC option, it relies on
the counter party to make or take delivery of the underlying investment upon
exercise of the option. Failure by the counter party to do so would result in
the loss of any premium paid by the Fund as well as the loss of any expected
benefit of the transaction.
The Fund's ability to establish and close out positions in exchange-listed
options depends on the existence of a liquid market. The Fund intends to
purchase or write only those exchange-traded options for which there appears to
be a liquid secondary market. However, there can be no assurance that such a
market will exist at any, particular time. Closing transactions can be made
for OTC options only by negotiating directly with the counter party, or by a
transaction in the secondary market if any such market exists. Although the
Fund will enter into OTC options only with counter parties that are expected to
be capable of entering into closing transactions with the Fund, there is no
assurance that the Fund will in fact be able to close out an OTC option at a
favorable price prior to expiration. In the event of insolvency of the counter
party, the Fund might be unable to close out an OTC option position at any time
prior to its expiration.
If the Fund were unable to effect a closing transaction for an option it
had purchased, it would have to exercise the option to realize any profit. The
inability to enter into a closing purchase transaction for a covered call
option written by the Fund could cause material losses because the Fund would
be unable to sell the investment used as cover for the written option until the
option expires or is exercised.
The Fund may purchase and write put and call options on indices in much
the same manner as the options discussed above, except the index options may
serve as a hedge against overall fluctuations in the securities markets in
general.
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The writing and purchasing of options is a highly specialized activity
that involves investment techniques and risks different from those associated
with ordinary portfolio securities transactions. Imperfect correlation between
the options and securities markets may detract from the effectiveness of
attempted hedging.
SPREAD TRANSACTIONS. The Fund may purchase covered spread options from
securities dealers. Such covered spread options are not presently
exchange-listed or exchange-traded. The purchase of a spread option gives the
Fund the right to put, or sell, a security that it owns at a fixed dollar
spread or fixed yield spread in relationship to another security that the Fund
does not own, but which is used as a benchmark. The risk to the Fund in
purchasing covered spread options is the cost of the premium paid for the
spread option and any transaction costs. In addition, there is no assurance
that closing transactions will be available. The purchase of spread options
will be used to protect the Fund against adverse changes in prevailing credit
quality spreads, i.e., the yield spread between high quality and lower quality
securities. Such protection is only provided during the life of the spread
option.
FUTURES CONTRACTS. The Fund may enter into futures contracts, including
interest rate, index, and currency futures. The Fund may also purchase
put and call options, and write covered put and call options, on futures in
which it is allowed to invest. The purchase of futures or call options thereon
can serve as a long hedge, and the sale of futures or the purchase of put
options thereon can serve as a short hedge. Writing covered call options on
futures contracts can serve as a limited short hedge, and writing covered put
options on futures contracts can serve as a limited long hedge, using a
strategy similar to that used for writing covered options in securities. The
Fund's hedging may include purchases of futures as an offset against the effect
of expected increases in currency exchange rates and securities prices and
sales of futures as an offset against the effect of expected declines in
currency exchange rates and securities prices. The Fund's futures transactions
may be entered into for any lawful purpose consistent with the Fund's
investment objective, such as hedging purposes, risk management, or to enhance
returns, but not for speculation. The Fund may also write put options on
futures contracts while at the same time purchasing call options on the same
futures contracts in order to create synthetically a long futures contract
position. Such options would have the same strike prices and expiration dates.
The Fund will engage in this strategy only when the Advisor believes it is more
advantageous to the Fund than is purchasing the futures contract.
To the extent required by regulatory authorities, the Fund only enters
into futures contracts that are traded on national futures exchanges and are
standardized as to maturity date and underlying financial instrument. Futures
exchanges and trading are regulated under the CEA by the CFTC. Although
techniques other than sales and purchases of futures contracts could be used to
reduce the Fund's exposure to market, currency, or interest rate fluctuations,
the Fund may be able to hedge its exposure more effectively and perhaps at a
lower cost through using futures contracts.
A futures contract is an agreement pursuant to which the parties agree to
take or make delivery of an amount of cash equal to the difference between the
value of the index at the close of the last trading day of the contract and the
price at which the index futures contract was originally written. An interest
rate futures contract provides for the future sale by one party and purchase by
another party of a specified amount of a specific financial instrument (e.g.,
debt security) or currency for a specified price at a designated date, time,
and place. A foreign currency contract is a bilateral agreement pursuant to
which one party agrees to make and the other party agrees to accept delivery of
a specified type of currency at a specified future time and at a specified
price. Transaction costs are incurred when a futures contract is bought or
sold and margin deposits must be maintained. A futures contract may be
satisfied by delivery or purchase, as the case may be, of the instrument, the
currency or by payment of the change in the cash value of the index. More
commonly, futures contracts are closed out prior to delivery by entering into
an offsetting transaction in a matching futures contract. Although the value
of an index might be a function of the value of certain specified securities,
no physical delivery of those securities is made. If the offsetting purchase
price is less than the original sale price, the Fund realizes a gain; if it is
more, the Fund realizes a loss. Conversely, if the offsetting sale price is
more than the original purchase price, the Fund realizes a gain; if it is less,
the Fund realizes a loss. The transaction costs must also be included in these
calculations. There can be no assurance, however, that the Fund will be able
to enter into an offsetting transaction with respect to a particular futures
contract at a particular time. If the Fund is not able to enter into an
offsetting transaction, the Fund will continue to be required to maintain the
margin deposits on the futures contract.
No price is paid by the Fund upon entering into a futures contract.
Instead, at the inception of a futures contract, the Fund is required to
deposit in a segregated account with its custodian, in the name of the futures
broker through whom the transaction was effected, "initial margin" consisting
of cash, U.S. government securities or other liquid, high grade debt
obligations, in an amount generally equal to 10% or less of the contract value.
High grade securities include securities rated "A" or better by an NRSRO.
Margin must also be deposited when writing a call
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or put option on a futures contract, in accordance with applicable exchange
rules. Unlike margin in securities transactions, initial margin on futures
contracts does not represent a borrowing, but rather is in the nature of a
performance bond or good-faith deposit that is returned to the Fund at the
termination of the transaction if all contractual obligations have been
satisfied. Under certain circumstances, such as periods of high volatility,
the Fund may be required by an exchange to increase the level of its initial
margin payment, and initial margin requirements might be increased generally in
the future by regulatory action.
Subsequent "variation margin" payments are made to and from the futures
broker daily as the value of the futures position varies, a process known as
"marking to market." Variation margin does not involve borrowing, but rather
represents a daily settlement of the Fund's obligations to or from a futures
broker. When the Fund purchases an option on a future, the premium paid plus
transaction costs is all that is at risk. In contrast, when the Fund purchases
or sells a futures contract or writes a call or put option thereon, it is
subject to daily variation margin calls that could be substantial in the event
of adverse price movements. If the Fund has insufficient cash to meet daily
variation margin requirements, it might need to sell securities at a time when
such sales are disadvantageous. Purchasers and sellers of futures positions
and options on futures can enter into offsetting closing transactions by
selling or purchasing, respectively, an instrument identical to the instrument
held or written. Positions in futures and options on futures may be closed
only on an exchange or board of trade that provides a secondary market. The
Fund intends to enter into futures transactions only on exchanges or boards of
trade where there appears to be a liquid secondary market. However, there can
be no assurance that such a market will exist for a particular contract at a
particular time.
Under certain circumstances, futures exchanges may establish daily limits
on the amount that the price of a future or option on a futures contract can
vary from the previous day's settlement price; once that limit is reached, no
trades may be made that day at a price beyond the limit. Daily price limits do
not limit potential losses because prices could move to the daily limit for
several consecutive days with little or no trading, thereby preventing
liquidation of unfavorable positions.
If the Fund were unable to liquidate a futures or option on a futures
contract position due to the absence of a liquid secondary market or the
imposition of price limits, it could incur substantial losses. The Fund would
continue to be subject to market risk with respect to the position. In
addition, except in the case of purchased options, the Fund would continue to
be required to make daily variation margin payments and might be required to
maintain the position being hedged by the future or option or to maintain cash
or securities in a segregated account.
Certain characteristics of the futures market might increase the risk that
movements in the prices of futures contracts or options on futures contracts
might not correlate perfectly with movements in the prices of the investments
being hedged. For example, all participants in the futures and options on
futures contracts markets are subject to daily variation margin calls and might
be compelled to liquidate futures or options on futures contracts positions
whose prices are moving unfavorably to avoid being subject to further calls.
These liquidations could increase price volatility of the instruments and
distort the normal price relationship between the futures or options and the
investments being hedged. Also, because initial margin deposit requirements in
the futures markets are less onerous than margin requirements in the securities
markets, there might be increased participation by speculators in the futures
markets. This participation also might cause temporary price distortions. In
addition, activities of large traders in both the futures and securities
markets involving arbitrage, "program trading" and other investment strategies
might result in temporary price distortions.
FOREIGN CURRENCY-RELATED DERIVATIVE STRATEGIES-SPECIAL CONSIDERATIONS.
The Fund may purchase and sell foreign currency on a spot basis, and may use
currency-related derivatives instruments such as options on foreign currencies,
futures on foreign currencies, options on futures on foreign currencies and
forward currency contracts (i.e., an obligation to purchase or sell a specific
currency at a specified future date, which may be any fixed number of days from
the contract date agreed upon by the parties, at a price set at the time the
contract is entered into). The Fund may use these instruments for hedging or
any other lawful purpose consistent with its investment objective, including
transaction hedging, anticipatory hedging, cross hedging, proxy hedging, and
position hedging. The Fund's use of currency-related derivative instruments
will be directly related to the Fund's current or anticipated portfolio
securities, and the Fund may engage in transactions in currency-related
derivative instruments as a means to protect against some or all of the effects
of adverse changes in foreign currency exchange rates on its portfolio
investments. In general, if the currency in which a portfolio investment is
denominated appreciates against the U.S. dollar, the dollar value of the
security will increase. Conversely, a decline in the exchange rate of the
currency would adversely affect the value of the portfolio investment expressed
in U.S. dollars.
For example, the Fund might use currency-related derivative instruments to
"lock in" a U.S. dollar price for a portfolio investment, thereby enabling the
Fund to protect itself against a possible loss resulting from an adverse change
in the relationship between the U.S. dollar and the subject foreign currency
during the period between the date the security is purchased or sold and the
date on which payment is made or received. The Fund also might use
currency-related derivative instruments when the Advisor believes that one
currency may experience a substantial movement against another currency,
including the U.S. dollar, and it may use currency-related derivative
instruments to sell or buy the amount of the former foreign currency,
approximating the value of some or all of the Fund's portfolio securities
denominated in such foreign currency. Alternatively, where appropriate, the
Fund may use currency-related derivative instruments to hedge all or part of
its foreign currency exposure through the use of a basket of currencies or a
proxy currency where such currency or currencies act as an effective proxy for
other currencies. The use of this basket hedging technique may be more
efficient and economical than using separate currency-related derivative
instruments for each currency exposure held by the Fund. Furthermore,
currency-related derivative instruments may be used for short hedges - for
example, the Fund may sell a forward currency contract to lock in the U.S.
dollar equivalent of the proceeds from the anticipated sale of a security
denominated in a foreign currency.
In addition, the Fund may use a currency-related derivative instrument to
shift exposure to foreign currency fluctuations from one foreign country to
another foreign country where the Advisor believes that the foreign currency
exposure purchased will appreciate relative to the U.S. dollar and thus better
protect the Fund against the expected decline in the foreign currency exposure
sold. For example, if the Fund owns securities denominated in a foreign
currency and the Advisor believes that currency will decline, it might enter
into a forward contract to sell an appropriate amount of the first foreign
currency, with payment to be made in a second foreign currency that the Advisor
believes would better protect the Fund against the decline in the first
security than would a U.S. dollar exposure. Hedging transactions that use two
foreign currencies are sometimes referred to as "cross hedges." The effective
use of currency-related derivative instruments by the Fund in a cross hedge is
dependent upon a correlation between price movements of the two currency
instruments and the underlying security involved, and the use of two currencies
magnifies the risk that movements in the price of one instrument may not
correlate or may correlate unfavorably with the foreign currency being hedged.
Such a lack of correlation might occur due to factors unrelated to the value of
the currency instruments used or investments being hedged, such as speculative
or other pressures on the markets in which these instruments are traded.
The Fund also might seek to hedge against changes in the value of a
particular currency when no hedging instruments on that currency are available
or such hedging instruments are more expensive than certain other hedging
instruments. In such cases, the Fund may hedge against price movements in that
currency by entering into transactions using currency-related derivative
instruments on another foreign currency or a basket of currencies, the values
of which the Advisor believes will have a high degree of positive correlation
to the value of the currency being hedged. The risk that movements in the price
of the hedging instrument will not correlate perfectly with movements in the
price of the currency being hedged is magnified when this strategy is used.
The use of currency-related derivative instruments by the Fund involves a
number of risks. The value of currency-related derivative instruments depends
on the value of the underlying currency relative to the U.S. dollar. Because
foreign currency transactions occurring in the interbank market might involve
substantially larger amounts than those involved in the use of such derivative
instruments, the Fund could be disadvantaged by having to deal in the odd lot
market (generally consisting of transactions of less than $1 million) for the
underlying foreign currencies at prices that are less favorable than for round
lots (generally consisting of transactions of greater than $1 million).
There is no systematic reporting of last sale information for foreign
currencies or any regulatory requirement that quotations available through
dealers or other market sources be firm or revised on a timely basis. Quotation
information generally is representative of very large transactions in the
interbank market and thus might not reflect odd-lot transactions where rates
might be less favorable. The interbank market in foreign currencies is a
global, round-the-clock market. To the extent the U.S. options or futures
markets are closed while the markets for the underlying currencies remain open,
significant price and rate movements might take place in the underlying markets
that cannot be reflected in the markets for the derivative instruments until
they re-open.
Settlement of transactions in currency-related derivative instruments
might be required to take place within the country issuing the underlying
currency. Thus, the Fund might be required to accept or make delivery of the
underlying foreign currency in accordance with any U.S. or foreign regulations
regarding the maintenance of foreign banking arrangements by U.S. residents
and might be required to pay any fees, taxes and charges associated with such
delivery assessed in the issuing country.
When the Fund engages in a transaction in a currency-related derivative
instrument, it relies on the counterparty to make or take delivery of
the underlying currency at the maturity of the contract or otherwise complete
the contract. In other words, the Fund will be subject to the risk that a loss
may be sustained by the Fund as a result of the failure of the counterparty to
comply with the terms of the transaction. The counterparty risk for
exchange-traded instruments is generally less than for privately-negotiated or
OTC currency instruments, since generally a clearing agency, which is the
issuer or counterparty to each instrument, provides a guarantee of performance.
For privately-negotiated instruments, there is no similar clearing agency
guarantee. In all transactions, the Fund will bear the risk that the
counterparty will default, and this could result in a loss of the expected
benefit of the transaction and possibly other losses to the Fund. The Fund will
enter into transactions in currency-related derivative instruments only with
counterparties that the Advisor reasonably believes are capable of performing
under the contract.
Purchasers and sellers of currency-related derivative instruments may
enter into offsetting closing transactions by selling or purchasing,
respectively, an instrument identical to the instrument purchased or sold.
Secondary markets generally do not exist for forward currency contracts, with
the result that closing transactions generally can be made for forward currency
contracts only by negotiating directly with the counterparty. Thus, there can
be no assurance that the Fund will in fact be able to close out a forward
currency contract (or any other currency-related derivative instrument) at a
time and price favorable to the Fund. In addition, in the event of insolvency
of the counterparty, the Fund might be unable to close out a forward currency
contact at any time prior to maturity. In the case of an exchange-traded
instrument, the Fund will be able to close the position out only on an exchange
which provides a market for the instruments. The ability to establish and
close out positions on an exchange is subject to the maintenance of a liquid
market, and there can be no assurance that a liquid market will exist for any
instrument at any specific time. In the case of a privately-negotiated
instrument, the Fund will be able to realize the value of the instrument only
by entering into a closing transaction with the issuer or finding a third party
buyer for the instrument. While the Fund will enter into privately-negotiated
transactions only with entities who are expected to be capable of entering into
a closing transaction, there can be no assurance that the Fund will in fact be
able to enter into such closing transactions.
The precise matching of currency-related derivative instrument amounts and
the value of the portfolio securities involved generally will not be possible
because the value of such securities, measured in the foreign currency, will
change after the currency-related derivative instrument position has been
established. Thus, the Fund might need to purchase or sell foreign currencies
in the spot (cash) market. The projection of short-term currency market
movements is extremely difficult, and the successful execution of a short-term
hedging strategy is highly uncertain.
Permissible foreign currency options will include options traded primarily
in the OTC market. Although options on foreign currencies are traded
primarily in the OTC market, the Fund will normally purchase or sell OTC
options on foreign currency only when the Advisor reasonably believes a liquid
secondary market will exist for a particular option at any specific time.
There will be a cost to the Fund of engaging in transactions in
currency-related derivative instruments that will vary with factors such as the
contract or currency involved, the length of the contract period and the market
conditions then prevailing. The Fund may have to pay a fee or commission or, in
cases where the instruments are entered into on a principal basis, foreign
exchange dealers or other counterparties will realize a profit based on the
difference ("spread") between the prices at which they are buying and selling
various currencies. Thus, for example, a dealer may offer to sell a foreign
currency to the Fund at one rate, while offering a lesser rate of exchange
should the Fund desire to resell that currency to the dealer.
When required by SEC guidelines, the Fund will set aside permissible
liquid assets in segregated accounts or otherwise cover its potential
obligations under currency-related derivatives instruments. To the extent the
Fund's assets are so set aside, they cannot be sold while the corresponding
currency position is open, unless they are replaced with similar assets. As a
result, if a large portion of the Fund's assets are so set aside, this could
impede portfolio management or the Fund's ability to meet redemption requests
or other current obligations.
The Advisor's decision to engage in a transaction in a particular
currency-related derivative instrument will reflect the Advisor's judgment that
the transaction will provide value to the Fund and its shareholders and is
consistent with the Fund's objectives and policies. In making such a judgment,
the Advisor will analyze the benefits and risks of the transaction and weigh
them in the context of the Fund's entire portfolio and objectives. The
effectiveness of any transaction in a currency-related derivative instrument is
dependent on a variety of factors, including the Advisor's skill in analyzing
and predicting currency values and upon a correlation between price movements
of the currency instrument and the underlying security. There might be
imperfect correlation, or even no correlation, between price movements of an
instrument and price movements of investments being hedged. Such a lack of
correlation might occur due to factors unrelated to the value of the
investments being hedged, such as speculative or other pressures on the markets
in which these instruments are traded. In addition, the Fund's use of
currency-related derivative instruments is always subject to the risk that the
currency in question could be devalued by the foreign government. In such a
case, any long currency positions would decline in value and could adversely
affect any hedging position maintained by the Fund.
The Fund's dealing in currency-related derivative instruments will
generally be limited to the transactions described above. However, the Fund
reserves the right to use currency-related derivatives instruments for
different purposes and under different circumstances. Of course, the Fund is
not required to use currency-related derivatives instruments and will not do so
unless deemed appropriate by the Advisor. It also should be realized that use
of these instruments does not eliminate, or protect against, price movements in
the Fund's securities that are attributable to other (i.e., non-currency
related) causes. Morever, while the use of currency-related derivatives
instruments may reduce the risk of loss due to a decline in the value of a
hedged currency, at the same time the use of these instruments tends to limit
any potential gain which may result from an increase in the value of the that
currency.
SWAP AGREEMENTS. The Fund may enter into interest rate, securities index
and currency exchange rate swap agreements for any lawful purpose consistent
with the Fund's investment objective, such as for the purpose of attempting to
obtain or preserve a particular desired return or spread at a lower cost to the
Fund than if the Fund had invested directly in an instrument that yielded that
desired return or spread. The Fund also may enter into swaps in order to
protect against an increase in the price of, or the currency exchange rate
applicable to, securities that the Fund anticipates purchasing at a later date.
Swap agreements are two-party contracts entered into primarily by institutional
investors for periods ranging from a few weeks to several years. In a standard
"swap" transaction, two parties agree to exchange the returns (or differentials
in rates of return) earned or realized on particular predetermined investments
or instruments. The gross returns to be exchanged or "swapped" between the
parties are calculated with respect to a "notional amount," i.e., the return on
or increase in value of a particular dollar amount invested at a particular
interest rate, in a particular foreign currency, or in a "basket" of securities
representing a particular index. Swap agreements may include interest rate
caps, under which, in return for a premium,
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one party agrees to make payments to the other to the extent that interest
rates exceed a specified rate, or "cap;" interest rate floors, under which, in
return for a premium, one party agrees to make payments to the other to the
extent that interest rates fall below a specified level, or "floor"; and
interest rate collars, under which a party sells a cap and purchases a floor,
or vice versa, in an attempt to protect itself against interest rate movements
exceeding given minimum or maximum levels.
The "notional amount" of the swap agreement is only the agreed upon basis
for calculating the obligations that the parties to a swap agreement have
agreed to exchange. Under most swap agreements entered into by the Fund, the
obligations of the parties would be exchanged on a "net basis." Consequently,
the Fund's obligations (or rights) under a swap agreement will generally be
equal only to the net amount to be paid or received under the agreement based
on the relative values of the positions held by each party to the agreement
(the "net amount"). The Fund's obligations under a swap agreement will be
accrued daily (offset against amounts owed to the Fund) and any accrued but
unpaid net amounts owed to a swap counterparty will be covered by the
maintenance of a segregated account consisting of cash, or liquid high grade
debt obligations.
Whether the Fund's use of swap agreements will be successful in furthering
its investment objective will depend on the Advisor's ability to predict
correctly whether certain types of investments are likely to produce greater
returns than other investments. Swap agreements may be considered to be
illiquid. Moreover, the Fund bears the risk of loss of the amount expected to
be received under a swap agreement in the event of the default or bankruptcy of
a swap agreement counterparty. Certain restrictions imposed on the Fund by
the Internal Revenue Code may limit the Fund's ability to use swap agreements.
The swaps market is largely unregulated.
The Fund will enter into swap agreements only with banks and recognized
securities dealers believed by the Advisor to present minimal credit risks in
accordance with guidelines established by the Fund's Board of Directors. If
there is a default by the other party to such a transaction, the Fund will have
to rely on its contractual remedies (which may be limited by bankruptcy,
insolvency or similar laws) pursuant to the agreements related to the
transaction.
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SHORT SALES AGAINST THE BOX
The Fund may sell securities short against the box to hedge unrealized
gains on portfolio securities. Selling securities short against the box
involves selling a security that the Fund owns or has the right to acquire, for
delivery at a specified date in the future. If the Fund sells securities short
against the box, it may protect unrealized gains, but will lose the opportunity
to profit on such securities if the price rises.
LENDING OF PORTFOLIO SECURITIES
The Fund is authorized to lend up to 33 1/3% of the total value of its
portfolio securities to broker-dealers or institutional investors that the
Advisor deems qualified, but only when the borrower maintains with the Fund's
custodian bank collateral either in cash or money market instruments in an
amount at least equal to the market value of the securities loaned, plus
accrued interest and dividends, determined on a daily basis and adjusted
accordingly. However, the Fund does not presently intend to engage in such
lending. In determining whether to lend securities to a particular
broker-dealer or institutional investor, the Advisor will consider, and during
the period of the loan will monitor, all relevant facts and circumstances,
including the creditworthiness of the borrower. The Fund will retain authority
to terminate any loans at any time. The Fund may pay reasonable administrative
and custodial fees in connection with a loan and may pay a negotiated portion
of the interest earned on the cash or money market instruments held as
collateral to the borrower or placing broker. The Fund will receive reasonable
interest on the loan or a flat fee from the borrower and amounts equivalent to
any dividends, interest or other distributions on the securities loaned. The
Fund will retain record ownership of loaned securities to exercise beneficial
rights, such as voting and subscription rights and rights to dividends,
interest or other distributions, when retaining such rights is considered to be
in the Fund's interest.
WARRANTS
The Fund may acquire warrants. Warrants are securities giving the holder
the right, but not the obligation, to buy the stock of an issuer at a given
price (generally higher than the value of the stock at the time of issuance)
during a specified period or perpetually. Warrants may be acquired separately
or in connection with the acquisition of securities. The Fund will not
purchase warrants, valued at the lower of cost or market value, in excess of 5%
of the Fund's net assets. Included in that amount, but not to exceed 2% of the
Fund's net assets, may be warrants that are not listed on any stock exchange.
Warrants acquired by the Fund in units or attached to securities are not
subject to these restrictions. Warrants do not carry with them the right to
dividends or voting rights with respect to the securities that they entitle
their holder to purchase, and they do not represent any rights in the assets of
the issuer. As a result, warrants may be considered more speculative than
certain other types of investments. In addition, the value of a warrant does
not necessarily change with the value of the underlying securities, and a
warrant ceases to have value if it is not exercised prior to its expiration
date.
DEBT OBLIGATIONS
The Fund may invest a portion of its assets in debt obligations, including
U.S. government securities, commercial paper, banker's acceptances,
certificates of deposit, and time deposits. Issuers of debt obligations have a
contractual obligation to pay interest at a specified rate on specified dates
and to repay principal on a specified maturity date. Certain debt obligations
(usually intermediate- and long-term bonds) have provisions that allow the
issuer to redeem or "call" a bond before its maturity. Issuers are most likely
to call such securities during periods of falling interest rates.
PRICE VOLATILITY. The market value of debt obligations is affected by
changes in prevailing interest rates. The market value of a debt obligation
generally reacts inversely to interest-rate changes, meaning, when prevailing
interest rates decline, an obligation's price usually rises, and when
prevailing interest rates rise, an obligation's price usually declines. A fund
portfolio consisting primarily of debt obligations will react similarly to
changes in interest rates.
MATURITY. In general, the longer the maturity of a debt obligation, the
higher its yield and the greater its sensitivity to changes in interest rates.
Conversely, the shorter the maturity, the lower the yield but the greater the
price stability. Commercial paper is generally considered the shortest form of
debt obligation. The term "bond" generally refers to securities with
maturities
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longer than two years. Bonds with maturities of three years or less are
considered short-term, bonds with maturities between three and seven years are
considered intermediate-term, and bonds with maturities greater than seven
years are considered long-term.
CREDIT QUALITY. The values of debt obligations may also be affected by
changes in the credit rating or financial condition of their issuers.
Generally, the lower the quality rating of a security, the higher the degree of
risk as to the payment of interest and return of principal. To compensate
investors for taking on such increased risk, those issuers deemed to be less
creditworthy generally must offer their investors higher interest rates than do
issuers with better credit ratings.
In conducting its credit research and analysis, the Advisor considers both
qualitative and quantitative factors to evaluate the creditworthiness of
individual issuers. The Advisor also relies, in part, on credit ratings
compiled by a number of NRSROs. See the Appendix for additional information.
TEMPORARY DEFENSIVE POSITION. When the Advisor determines that market
conditions warrant a temporary defensive position, the Fund may invest without
limitation in cash and short-term fixed income securities, including U.S.
government securities, commercial paper, banker's acceptances, certificates of
deposit, and time deposits.
HIGH-YIELD (HIGH-RISK) SECURITIES
IN GENERAL. The Fund has the authority to invest up to, but not
including, 35% of its assets in non-investment grade debt obligations.
Non-investment grade debt obligations (hereinafter referred to as
"lower-quality securities") include (i) bonds rated as low as C by Moody's
Investors Service, Inc. ("Moody's"), Standard & Poor's Ratings Group ("S&P"),
or Fitch Investors Service, Inc. ("Fitch") or CCC by Duff & Phelps, Inc.
("D&P"); (ii) commercial paper rated as low as C by S&P, Not Prime by Moody's,
or Fitch 4 by Fitch; and (iii) unrated debt obligations of comparable quality.
Lower-quality securities, while generally offering higher yields than
investment-grade securities with similar maturities, involve greater risks,
including the possibility of default or bankruptcy. They are regarded as
predominantly speculative with respect to the issuer's capacity to pay interest
and repay principal. The special risk considerations in connection with such
investments are discussed below. Refer to the Appendix of this Statement of
Additional Information for a discussion of securities ratings.
EFFECT OF INTEREST RATES AND ECONOMIC CHANGES. The lower-quality
securities market is relatively new, and its growth paralleled a long economic
expansion. As a result, it is not clear how this market may withstand a
prolonged recession or economic downturn. Such a prolonged economic downturn
could severely disrupt the market for and adversely affect the value of such
securities.
All interest-bearing securities typically experience appreciation when
interest rates decline and depreciation when interest rates rise. The market
values of lower-quality securities tend to reflect individual corporate
developments to a greater extent than do higher rated securities, which react
primarily to fluctuations in the general level of interest rates.
Lower-quality securities also tend to be more sensitive to economic conditions
than are higher rated securities. As a result, they generally involve more
credit risks than securities in the higher rated categories. During an
economic downturn or a sustained period of rising interest rates, highly
leveraged issuers of lower-quality securities may experience financial stress
and may not have sufficient revenues to meet their payment obligations. The
issuer's ability to service its debt obligations may also be adversely affected
by specific corporate developments, the issuer's inability to meet specific
projected business forecasts, or the unavailability of additional financing.
The risk of loss due to default by an issuer of lower-quality securities is
significantly greater than issuers of higher rated securities because such
securities are generally unsecured and are often subordinated to other
creditors. Further, if the issuer of a lower-quality security defaulted, the
Fund might incur additional expenses to seek recovery. Periods of economic
uncertainty and changes would also generally result in increased volatility in
the market prices of lower-quality securities and thus in the Fund's net asset
value.
As previously stated, the value of such a security will decrease in a
rising interest rate market and accordingly, so will the Fund's net asset
value. If the Fund experiences unexpected net redemptions in such a market, it
may be forced to liquidate a portion of its portfolio securities without regard
to their investment merits. Due to the limited liquidity of lower-quality
securities (discussed below) the Fund may be forced to liquidate these
securities at a substantial discount. Any such liquidation would reduce the
Fund's asset base over which expenses could be allocated and could result in a
reduced rate of return for the Fund.
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PAYMENT EXPECTATIONS. Lower-quality securities typically contain
redemption, call, or prepayment provisions which permit the issuer of such
securities containing such provisions to, at their discretion, redeem the
securities. During periods of falling interest rates, issuers of lower-quality
securities are likely to redeem or prepay the securities and refinance them
with debt securities with a lower interest rate. To the extent an issuer is
able to refinance the securities, or otherwise redeem them, the Fund may have
to replace the securities with a lower yielding security, which would result in
a lower return for the Fund.
CREDIT RATINGS. Credit ratings issued by credit-rating agencies
evaluate the safety of principal and interest payments of rated securities.
They do not, however, evaluate the market value risk of lower rated securities
and, therefore, may not fully reflect the true risks of an investment. In
addition, credit-rating agencies may or may not make timely changes in a rating
to reflect changes in the economy or in the condition of the issuer that affect
the market value of the security. Consequently, credit ratings are used only
as a preliminary indicator of investment quality. Investments in lower rated
obligations will be more dependent on the Advisor's credit analysis than would
be the case with investments in investment grade debt obligations. The Advisor
employs its own credit research and analysis, which includes a study of
existing debt, capital structure, ability to service debt and to pay dividends,
the issuer's sensitivity to economic conditions, its operating history, and the
current trend of earnings. The Advisor continually monitors the investments in
the Fund's portfolio and carefully evaluates whether to dispose of or to retain
lower rated securities whose credit ratings or credit quality may have changed.
LIQUIDITY AND VALUATION. The Fund may have difficulty disposing of
certain lower-quality securities because there may be a thin trading market for
such securities. Because not all dealers maintain markets in all lower-quality
securities, there is no established retail secondary market for many of these
securities. The Fund anticipates that such securities could be sold only to a
limited number of dealers or institutional investors. To the extent a
secondary trading market does exist, it is generally not as liquid as the
secondary market for higher rated securities. The lack of a liquid secondary
market may have an adverse impact on the market price of the security. As a
result, the Fund's asset value and the Fund's ability to dispose of particular
securities, when necessary to meet the Fund's liquidity needs or in response to
a specific economic event, may be impacted. The lack of a liquid secondary
market for certain securities may also make it more difficult for the Fund to
obtain accurate market quotations for purposes of valuing the Fund's portfolio.
Market quotations are generally available on many lower-quality securities only
from a limited number of dealers and may not necessarily represent firm bids of
such dealers or prices for actual sales. During periods of thin trading, the
spread between bid and asked prices is likely to increase significantly. In
addition, adverse publicity and investor perceptions, whether or not based on
fundamental analysis, may decrease the values and liquidity of lower rated
securities, especially in a thinly traded market.
RECENT AND PROPOSED LEGISLATION. Recent legislation has been adopted, and
from time to time, proposals have been discussed, regarding new legislation
designed to limit the use of certain lower-quality securities by certain
issuers. An example of legislation is a recent law which requires federally
insured savings and loan associations to divest their investments in these
securities over time. It is not currently possible to determine the impact of
the recent legislation or the proposed legislation on the lower-quality
securities market. However, it is anticipated that if additional legislation
is enacted or proposed, it could have a material affect on the value of these
securities and the existence of a secondary trading market for the securities.
MORTGAGE- AND ASSET-BACKED SECURITIES
Mortgage-backed securities represent direct or indirect participations in,
or are secured by and payable from, mortgage loans secured by real property,
and include single- and multi-class pass-through securities and collateralized
mortgage obligations. Such securities may be issued or guaranteed by U.S.
government agencies or instrumentalities, such as the Government National
Mortgage Association and the Federal National Mortgage Association, or by
private issuers, generally originators and investors in mortgage loans,
including savings associations, mortgage bankers, commercial banks, investment
bankers, and special purpose entities (collectively, "private lenders").
Mortgage-backed securities issued by private lenders may be supported by pools
of mortgage loans or other mortgage-backed securities that are guaranteed,
directly or indirectly, by the U.S. government or one of its agencies or
instrumentalities, or they may be issued without any governmental guarantee of
the underlying mortgage assets but with some form of non-governmental credit
enhancement.
Asset-backed securities have structural characteristics similar to
mortgage-backed securities. However, the underlying assets are not first lien
mortgage loans or interests therein, but include assets such as motor vehicle
installment sales contracts,
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other installment loan contracts, home equity loans, leases of various types of
property, and receivables from credit card or other revolving credit
arrangements. Payments or distributions of principal and interest on
asset-backed securities may be supported by non-governmental credit
enhancements similar to those utilized in connection with mortgage-backed
securities.
The yield characteristics of mortgage- and asset-backed securities differ
from those of traditional debt obligations. Among the principal differences
are that interest and principal payments are made more frequently on
mortgage- and asset-backed securities, usually monthly, and that principal may
be prepaid at any time because the underlying mortgage loans or other assets
generally may be prepaid at any time. As a result, if the Fund purchases these
securities at a premium, a prepayment rate that is faster than expected will
reduce yield to maturity, while a prepayment rate that is slower than expected
will have the opposite effect of increasing the yield to maturity. Conversely,
if the Fund purchases these securities at a discount, a prepayment rate that is
faster than expected will increase yield to maturity, while a prepayment rate
that is slower than expected will reduce yield to maturity. Amounts available
for reinvestment by the Fund are likely to be greater during a period of
declining interest rates and, as a result, are likely to be reinvested at lower
interest rates than during a period of rising interest rates. Accelerated
prepayments on securities purchased by the Fund at a premium also impose a risk
of loss of principal because the premium may not have been fully amortized at
the time the principal is prepaid in full. The market for privately issued
mortgage- and asset-backed securities is smaller and less liquid than the
market for government-sponsored mortgage-backed securities.
The Fund may invest in stripped mortgage- or asset-backed securities,
which receive differing proportions of the interest and principal payments from
the underlying assets. The market value of such securities generally is more
sensitive to changes in prepayment and interest rates than is the case with
traditional mortgage- and asset-backed securities, and in some cases such
market value may be extremely volatile. With respect to certain stripped
securities, such as interest only and principal only classes, a rate of
prepayment that is faster or slower than anticipated may result in the Fund
failing to recover all or a portion of its investment, even though the
securities are rated investment grade.
WHEN-ISSUED SECURITIES
The Fund may invest without limitation in when-issued and delayed delivery
securities (collectively "When-Issued Securities"). The price of such
securities, which may be expressed in yield terms, is fixed at the time the
commitment to purchase is made, but delivery and payment for the When-Issued
Securities take place at a later date. Normally, the settlement date occurs
within one month of the purchase. During the period between purchase and
settlement, no payment is made by the Fund to the issuer and no interest
accrues to the Fund. Forward commitments involve a risk of loss if the value of
the security to be purchased declines prior to the settlement date, which risk
is in addition to the risk of decline in value of the Fund's other assets.
While When-Issued Securities may be sold prior to the settlement date, the Fund
intends to purchase such securities with the purpose of actually acquiring them
unless a sale appears desirable for investment reasons. At the time the Fund
makes the commitment to purchase a security on a when-issued basis, it will
record the transaction and reflect the value of the security in determining its
net asset value. The Fund does not believe that its net asset value or income
will be adversely affected by its purchases of securities on a when-issued
basis.
The Fund will maintain cash and marketable securities equal in value to
commitments for When-Issued Securities. Such segregated securities either will
mature or, if necessary, be sold on or before the settlement date. When the
time comes to pay for When-Issued Securities, the Fund will meet its obligation
from then-available cash flow, sale of the securities held in the separate
account, described above, sale of other securities or, although it would not
normally expect to do so, from the sale of the When-Issued Securities
themselves (which may have a market value greater or less than the respective
Fund's payment obligation).
ILLIQUID SECURITIES
The Fund may invest in illiquid securities (i.e., securities that are not
readily marketable). However, the Fund will not acquire illiquid securities
if, as a result, they would comprise more than 15% of the value of the Fund's
net assets (or such other amounts as may be permitted under the 1940 Act). The
Board of Directors of the Corporation or its delegate has the ultimate
authority to determine, to the extent permissible under the federal securities
laws, which securities are illiquid for purposes of this limitation. Certain
securities exempt from registration or issued in transactions exempt from
registration under the Securities Act of 1933, as
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amended (the "Securities Act"), including securities that may be resold
pursuant to Rule 144A under the Securities Act or Section 4(2) commercial
paper, may be considered liquid. The Board of Directors has delegated to the
Advisor the day-to-day determination of the liquidity of a security, although
it has retained oversight and ultimate responsibility for such determinations.
Although no definitive liquidity criteria are used, the Corporation's Board of
Directors has directed the Advisor to look to such factors as (i) the nature of
the market for a security (including the institutional private resale market),
(ii) the terms of certain securities or other instruments allowing for the
disposition to a third party or the issuer thereof (e.g., certain repurchase
obligations and demand instruments), (iii) the availability of market
quotations (e.g., for securities quoted in the PORTAL system), and (iv) other
permissible relevant factors.
Restricted securities may be sold only in privately negotiated
transactions or in a public offering with respect to which a registration
statement is in effect under the Securities Act. Where registration is
required, the Fund may be obligated to pay all or part of the registration
expenses and a considerable period may elapse between the time of the decision
to sell and the time the Fund may be permitted to sell a security under an
effective registration statement. If, during such a period, adverse market
conditions were to develop, the Fund might obtain a less favorable price than
prevailed when it decided to sell. Restricted securities will be priced at
fair value as determined in good faith by the Corporation's Board of Directors.
If through the appreciation of restricted securities or the depreciation of
unrestricted securities, the Fund should be in a position where more than 15%
of the value of its net assets are invested in illiquid securities, including
restricted securities which are not readily marketable, the Fund will take such
steps as are deemed advisable, if any, to protect liquidity.
The Fund may sell OTC options and, in connection therewith, segregate
assets or cover its obligations with respect to OTC options written by the
Fund. The assets used as cover for OTC options written by the Fund will be
considered illiquid unless the OTC options are sold to qualified dealers who
agree that the Fund may repurchase any OTC option it writes at a maximum price
to be calculated by a formula set forth in the option agreement. The cover for
an OTC option written subject to this procedure would be considered illiquid
only to the extent that the maximum repurchase price under the formula exceeds
the intrinsic value of the option.
Notwithstanding the above, the Advisor intends, as a matter of internal
policy, to limit the Fund's investments in illiquid securities to 10% of its
net assets.
FOREIGN SECURITIES
The Fund may invest without limitation in foreign securities. Many of the
foreign securities held by the Fund will not be registered with the SEC, nor
will the issuers thereof be subject to SEC reporting requirements.
Accordingly, there may be less publicly available information concerning
foreign issuers of securities held by the Fund than is available concerning
U.S. companies. Disclosure and regulatory standards in many respects are less
stringent in emerging market countries than in the U.S. and other major
markets. There also may be a lower level of monitoring and regulation of
emerging markets and the activities of investors in such markets, and
enforcement of existing regulations may be extremely limited. Foreign
companies, and in particular, companies in smaller and emerging capital markets
are not generally subject to uniform accounting, auditing and financial
reporting standards or to other regulatory requirements comparable to those
applicable to U.S. companies. The Fund's net investment income and capital
gains from its foreign investment activities may be subject to non-U.S.
withholding taxes.
The costs attributable to foreign investing that the Fund must bear
frequently are higher than those attributable to domestic investing; this is
particularly true with respect to emerging capital markets. For example, the
cost of maintaining custody of foreign securities exceeds custodian costs for
domestic securities, and transaction and settlement costs of foreign investing
also frequently are higher than those attributable to domestic investing.
Costs associated with the exchange of currencies also make foreign investing
more expensive than domestic investing. Investment income on certain foreign
securities in which the Fund may invest may be subject to foreign withholding
or other government taxes that could reduce the return of these securities.
Tax treaties between the United States and foreign countries, however, may
reduce or eliminate the amount of foreign tax to which the Fund would be
subject.
Foreign markets also have different clearance and settlement procedures,
and in certain markets there have been times when settlements have failed to
keep pace with the volume of securities transactions, making it difficult to
conduct such transactions. Delays in settlement could result in temporary
periods when assets of the Fund are uninvested and no return is
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earned thereon. The inability of the Fund to make intended security purchases
due to settlement problems could cause the Fund to miss attractive investment
opportunities. Inability to dispose of a portfolio security due to settlement
problems could result either in losses to the Fund due to subsequent declines
in the value of such portfolio security or, if the Fund has entered into a
contract to sell the security, could result in possible liability to the
purchaser.
SOVEREIGN DEBT
Sovereign debt differs from debt obligations issued by private entities in
that, generally, remedies for defaults must be pursued in the courts of the
defaulting party. Legal recourse is therefore limited. Political conditions,
especially a sovereign entity's willingness to meet the terms of its debt
obligations, are of considerable significance. Also, there can be no assurance
that the holders of commercial bank loans to the same sovereign entity may not
contest payments to the holders of sovereign debt in the event of default under
commercial bank loan agreements.
A sovereign debtor's willingness or ability to repay principal and pay
interest in a timely manner may be affected by, among other factors, its cash
flow situation, the extent of its foreign reserves, the availability of
sufficient foreign exchange on the date a payment is due, the relative size of
the debt service burden to the economy as a whole, the sovereign debtor's
policy toward principal international lenders and the political constraints to
which a sovereign debtor may be subject. A country whose exports are
concentrated in a few commodities could be vulnerable to a decline in the
international price of such commodities. Increased protectionism on the part
of a country's trading partners, or political changes in those countries, could
also adversely affect its exports. Such events could diminish a country's
trade account surplus, if any, or the credit standing of a particular local
government or agency. Another factor bearing on the ability of a country to
repay sovereign debt is the level of the country's international reserves.
Fluctuations in the level of these reserves can affect the amount of foreign
exchange readily available for external debt payments and, thus, could have a
bearing on the capacity of the country to make payments on its sovereign debt.
To the extent that a country has a current account deficit (generally when
exports of merchandise and services are less than the country's imports of
merchandise and services plus net transfers (e.g., gifts of currency and goods)
to foreigners), it will need to depend on loans from foreign governments,
multilateral organizations or private commercial banks, aid payments from
foreign governments and inflows of foreign investment. The access of a country
to these forms of external funding may not be certain, and a withdrawal of
external funding could adversely affect the capacity of a government to make
payments on its obligations. In addition, the cost of servicing debt
obligations can be affected by a change in international interest rates since
the majority of these obligations carry interest rates that are adjusted
periodically based upon international rates.
With respect to sovereign debt of emerging market issuers, investors
should be aware that certain emerging market countries are among the largest
debtors to commercial banks and foreign governments. At times certain emerging
market countries have declared moratoria on the payment of principal and
interest on external debt.
Certain emerging market countries have experienced difficulty in servicing
their sovereign debt on a timely basis which led to defaults on certain
obligations and the restructuring of certain indebtedness. Restructuring
arrangements have included, among other things, reducing and rescheduling
interest and principal payments by negotiating new or amended credit agreements
or converting outstanding principal and unpaid interest to Brady Bonds
(discussed below), and obtaining new credit to finance interest payments.
Holders of sovereign debt, including the Fund, may be requested to participate
in the rescheduling of such debt and to extend further loans to sovereign
debtors. The interests of holders of sovereign debt could be adversely
affected in the course of restructuring arrangements or by certain other
factors referred to below. Furthermore, some of the participants in the
secondary market for sovereign debt may also be directly involved in
negotiating the terms of these arrangements and may therefore have access to
information not available to other market participants. Obligations arising
from past restructuring agreements may affect the economic performance and
political and social stability of certain issuers of sovereign debt. There is
no bankruptcy proceeding by which sovereign debt on which a sovereign has
defaulted may be collected in whole or in part.
Foreign investment in certain sovereign debt is restricted or controlled
to varying degrees. These restrictions or controls may at times limit or
preclude foreign investment in such sovereign debt and increase the costs and
expenses of the Fund. Certain countries in which the Fund will invest require
governmental approval prior to investments by foreign persons, limit the amount
of investment by foreign persons in a particular issuer, limit the investment
by foreign persons only to a specific class of securities of an issuer that may
have less advantageous rights than the classes available for purchase by
domiciliaries of the countries, or
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impose additional taxes on foreign investors. Certain issuers may require
governmental approval for the repatriation of investment income, capital or the
proceeds of sales of securities by foreign investors. In addition, if a
deterioration occurs in a country's balance of payments, the country could
impose temporary restrictions on foreign capital remittances. The Fund could
be adversely affected by delays in, or a refusal to grant, any required
governmental approval for repatriation of capital, as well as by the
application to the Fund of any restrictions on investments. Investing in local
markets may require the Fund to adopt special procedures, seek local government
approvals or take other actions, each of which may involve additional costs to
the Fund.
The sovereign debt in which the Fund may invest includes Brady Bonds,
which are securities issued under the framework of the Brady Plan, an
initiative announced by former U.S. Treasury Secretary Nicholas F. Brady in
1989 as a mechanism for debtor nations to restructure their outstanding
external commercial bank indebtedness. In restructuring its external debt
under the Brady Plan framework, a debtor nation negotiates with its existing
bank lenders as well as multilateral institutions such as the International
Monetary Fund ("IMF"). The Brady Plan framework, as it has developed,
contemplates the exchange of commercial bank debt for newly issued Brady Bonds.
Brady Bonds may also be issued in respect of new money being advanced by
existing lenders in connection with the debt restructuring. The World Bank and
the IMF support the restructuring by providing funds pursuant to loan
agreements or other arrangements which enable the debtor nation to
collateralize the new Brady Bonds or to repurchase outstanding bank debt at a
discount.
There can be no assurance that the circumstances regarding the issuance of
Brady Bonds by these countries will not change. Investors should recognize
that Brady Bonds have been issued only recently, and accordingly do not have a
long payment history. Agreements implemented under the Brady Plan to date are
designed to achieve debt and debt-service reduction through specific options
negotiated by a debtor nation with its creditors. As a result, the financial
packages offered by each country differ. The types of options have included
the exchange of outstanding commercial bank debt for bonds issued at 100% of
face value of such debt, which carry a below-market stated rate of interest
(generally known as par bonds), bonds issued at a discount from the face value
of such debt (generally known as discount bonds), bonds bearing an interest
rate which increases over time, and bonds issued in exchange for the
advancement of new money by existing lenders. Regardless of the stated face
amount and stated interest rate of the various types of Brady Bonds, the Fund
will purchase Brady Bonds in secondary markets, as described below, in which
the price and yield to the investor reflect market conditions at the time of
purchase.
Certain Brady Bonds have been collateralized as to principal due at
maturity by U.S. Treasury zero coupon bonds with maturities equal to the final
maturity of such Brady Bonds. Collateral purchases are financed by the IMF,
the World Bank, and the debtor nations' reserves. In the event of a default
with respect to collateralized Brady Bonds as a result of which the payment
obligations of the issuer are accelerated, the U.S. Treasury zero coupon
obligations held as collateral for the payment of principal will not be
distributed to investors, nor will such obligations be sold and the proceeds
distributed. The collateral will be held by the collateral agent to the
scheduled maturity of the defaulted Brady Bonds, which will continue to be
outstanding, at which time the face amount of the collateral will equal the
principal payments which would have then been due on the Brady Bonds in the
normal course. In addition, interest payments on certain types of Brady Bonds
may be collateralized by cash or high grade securities in amounts that
typically represent between 12 and 18 months of interest accruals on these
instruments with the balance of the interest accruals being uncollateralized.
Brady Bonds are often viewed as having several valuation components: (1) the
collateralized repayment of principal, if any, at final maturity, (2) the
collateralized interest payments, if any, (3) the uncollateralized interest
payments, and (4) any uncollateralized repayment of principal at maturity
(these uncollateralized amounts constitute the "residual risk"). In light of
the residual risk of Brady Bonds and, among other factors, the history of
defaults with respect to commercial bank loans by public and private entities
of countries issuing Brady Bonds, investments in Brady Bonds are to be viewed
as speculative. The Fund may purchase Brady Bonds with no or limited
collateralization, and will be relying for payment of interest and (except in
the case of principal collateralized Brady Bonds) principal primarily on the
willingness and ability of the foreign government to make payment in accordance
with the terms of the Brady Bonds. Brady Bonds issued to date are purchased
and sold in secondary markets through U.S. securities dealers and other
financial institutions and are generally maintained through European
transnational securities depositories.
DEPOSITARY RECEIPTS
As indicated in the Prospectus, the Fund may invest in foreign securities
by purchasing depositary receipts, including American Depositary Receipts
("ADRs") and European Depositary Receipts ("EDRs"), or other securities
convertible into securities or issuers based in foreign countries. These
securities may not necessarily be denominated in the same currency as the
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securities into which they may be converted. Generally, ADRs, in registered
form, are denominated in U.S. dollars and are designed for use in the U.S.
securities markets, while EDRs, in bearer form, may be denominated in other
currencies and are designed for use in European securities markets. ADRs are
receipts typically issued by a U.S. bank or trust company evidencing ownership
of the underlying securities. EDRs are European receipts evidencing a similar
arrangement. For purposes of the Fund's investment policies, ADRs and EDRs are
deemed to have the same classification as the underlying securities they
represent. Thus, an ADR or EDR representing ownership of common stock will be
treated as common stock.
ADR facilities may be established as either "unsponsored" or "sponsored."
While ADRs issued under these two types of facilities are in some respects
similar, there are distinctions between them relating to the rights and
obligations of ADR holders and the practices of market participants. A
depositary may establish an unsponsored facility without participation by (or
even necessarily the acquiescence of) the issuer of the deposited securities,
although typically the depositary requests a letter of non-objection from such
issuer prior to the establishment of the facility. Holders of unsponsored ADRs
generally bear all the costs of such facilities. The depositary usually
charges fees upon the deposit and withdrawal of the deposited securities, the
conversion of dividends into U.S. dollars, the disposition of non-cash
distributions, and the performance of other services. The depositary of an
unsponsored facility frequently is under no obligation to distribute
shareholder communications received from the issuer of the deposited securities
or to pass through voting rights to ADR holders in respect of the deposited
securities. Sponsored ADR facilities are created in generally the same manner
as unsponsored facilities, except that the issuer of the deposited securities
enters into a deposit agreement with the depositary. The deposit agreement
sets out the rights and responsibilities of the issuer, the depositary and the
ADR holders. With sponsored facilities, the issuer of the deposited securities
generally will bear some of the costs relating to the facility (such as
dividend payment fees of the depositary), although ADR holders continue to bear
certain other costs (such as deposit and withdrawal fees). Under the terms of
most sponsored arrangements, depositories agree to distribute notices of
shareholder meetings and voting instructions, and to provide shareholder
communications and other information to the ADR holders at the request of the
issuer of the deposited securities.
FOREIGN INVESTMENT COMPANIES
Some of the countries in which the Fund invests may not permit direct
investment by outside investors. Investments in such countries may only be
permitted through foreign government-approved or -authorized investment
vehicles, which may include other investment companies. Investing through such
vehicles may involve frequent or layered fees or expenses and may also be
subject to limitation under the 1940 Act. Under the 1940 Act, a Fund may
invest up to 10% of its assets in shares of investment companies and up to 5%
of its assets in any one investment company as long as the investment does not
represent more than 3% of the voting stock of the acquired investment company.
REPURCHASE AGREEMENTS
The Fund may invest in repurchase agreements with certain banks or
non-bank dealers. In a repurchase agreement, the Fund buys a security at one
price, and at the time of sale, the seller agrees to repurchase the obligation
at a mutually agreed upon time and price (usually within seven days). The
repurchase agreement, thereby, determines the yield during the purchaser's
holding period, while the seller's obligation to repurchase is secured by the
value of the underlying security. If the value of such securities is less than
the repurchase price, plus any agreed-upon additional amount, the other party
to the agreement will be required to provide additional collateral so that at
all times the collateral is at least equal to the repurchase price, plus any
agreed-upon additional amount. The Advisor will monitor, on an ongoing basis,
the value of the underlying securities to ensure that the value always equals
or exceeds the repurchase price plus accrued interest. Repurchase agreements
could involve certain risks in the event of a default or insolvency of the
other party to the agreement, including possible delays or restrictions upon
the Fund's ability to dispose of the underlying securities. Although no
definitive creditworthiness criteria are used, the Advisor reviews the
creditworthiness of the banks and non-bank dealers with which the Fund enters
into repurchase agreements to evaluate those risks. The Fund may, under certain
circumstances, deem repurchase agreements collateralized by U.S. government
securities to be investments in U.S. government securities.
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BORROWING
The Fund may borrow money from banks, limited by the Fund's fundamental
investment restriction to 33 1/3% of its total assets, and may engage in
mortgage dollar roll transactions and reverse repurchase agreements which may
be considered a form of borrowing. (See "Mortgage Dollar Rolls and Reverse
Repurchase Agreements" below.) In addition, the Fund may borrow up to an
additional 5% of its total assets from banks for temporary or emergency
purposes. The Fund will not purchase securities when bank borrowings exceed 5%
of the Fund's total assets.
MORTGAGE DOLLAR ROLLS AND REVERSE REPURCHASE AGREEMENTS
The Fund may engage in reverse repurchase agreements to facilitate
portfolio liquidity, a practice common in the mutual fund industry, or for
arbitrage transactions discussed below. In a reverse repurchase agreement, the
Fund would sell a security and enter into an agreement to repurchase the
security at a specified future date and price. The Fund generally retains the
right to interest and principal payments on the security. Since the Fund
receives cash upon entering into a reverse repurchase agreement, it may be
considered a borrowing. When required by guidelines of the SEC, the Fund will
set aside permissible liquid assets in a segregated account to secure its
obligations to repurchase the security.
The Fund may also enter into mortgage dollar rolls, in which the Fund
would sell mortgage-backed securities for delivery in the current month and
simultaneously contract to purchase substantially similar securities on a
specified future date. While the Fund would forego principal and interest paid
on the mortgage-backed securities during the roll period, the Fund would be
compensated by the difference between the current sales price and the lower
price for the future purchase as well as by any interest earned on the proceeds
of the initial sale. The Fund also could be compensated through the receipt of
fee income equivalent to a lower forward price. At the time the Fund would
enter into a mortgage dollar roll, it would set aside permissible liquid assets
in a segregated account to secure its obligation for the forward commitment to
buy mortgage-backed securities. Mortgage dollar roll transactions may be
considered a borrowing by the Fund.
The mortgage dollar rolls and reverse repurchase agreements entered into
by the Fund may be used as arbitrage transactions in which the Fund will
maintain an offsetting position in investment grade debt obligations or
repurchase agreements that mature on or before the settlement date on the
related mortgage dollar roll or reverse repurchase agreement. Since the Fund
will receive interest on the securities or repurchase agreements in which it
invests the transaction proceeds, such transactions may involve leverage.
However, since such securities or repurchase agreements will be high quality
and will mature on or before the settlement date of the mortgage dollar roll or
reverse repurchase agreement, the Advisor believes that such arbitrage
transactions do not present the risks to the Fund that are associated with
other types of leverage.
VARIABLE- OR FLOATING-RATE SECURITIES
The Fund may invest in securities which offer a variable- or floating-rate
of interest. Variable-rate securities provide for automatic establishment of a
new interest rate at fixed intervals (e.g., daily, monthly, semi-annually,
etc.). Floating-rate securities provide for automatic adjustment of the
interest rate whenever some specified interest rate index changes. The
interest rate on variable- or floating-rate securities is ordinarily determined
by reference to or is a percentage of a bank's prime rate, the 90-day U.S.
Treasury bill rate, the rate of return on commercial paper, bank certificates
of deposit, an index of short-term interest rates, or some other objective
measure.
Variable- or floating-rate securities frequently include a demand feature
entitling the holder to sell the securities to the issuer at par. In many
cases, the demand feature can be exercised at any time on 7 days' notice; in
other cases, the demand feature is exercisable at any time on 30 days' notice
or on similar notice at intervals of not more than one year. Some securities,
which do not have variable or floating interest rates, may be accompanied by
puts producing similar results and price characteristics. When considering the
maturity of any instrument which may be sold or put to the issuer or a third
party, the Fund may consider that instrument's maturity to be shorter than its
stated maturity.
Variable-rate demand notes include master demand notes, which are
obligations that permit the Fund to invest fluctuating amounts that may change
daily without penalty, pursuant to direct arrangements between the Fund, as
lender, and the borrower. The interest rates on these notes fluctuate from
time to time. The issuer of such obligations normally has a
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corresponding right, after a given period, to prepay in its discretion the
outstanding principal amount of the obligations plus accrued interest upon a
specified number of days' notice to the holders of such obligations. The
interest rate on a floating-rate demand obligation is based on a known lending
rate, such as a bank's prime rate, and is adjusted automatically each time such
rate is adjusted. The interest rate on a variable-rate demand obligation is
adjusted automatically at specified intervals. Frequently, such obligations
are secured by letters of credit or other credit support arrangements provided
by banks. Because these obligations are direct-lending arrangements between the
lender and borrower, it is not contemplated that such instruments will
generally be traded. There generally is not an established secondary market
for these obligations, although they are redeemable at face value.
Accordingly, where these obligations are not secured by letters of credit or
other credit support arrangements, the Fund's right to redeem is dependent on
the ability of the borrower to pay principal and interest on demand. Such
obligations frequently are not rated by credit rating agencies and, if not so
rated, the Fund may invest in them only if the Fund's Advisor determines that,
at the time of investment, the obligations are of comparable quality to the
other obligations in which the Fund may invest. The Advisor, on behalf of the
Fund, will consider on an ongoing basis the creditworthiness of the issuers of
the floating- and variable-rate demand obligations in the Fund's portfolio.
The Fund will not invest more than 15% of its net assets in variable- and
floating-rate demand obligations that are not readily marketable (a variable-
or floating-rate demand obligation that may be disposed of on not more than
seven days notice will be deemed readily marketable and will not be subject to
this limitation). (See "Illiquid Securities" and "Investment Restrictions.")
In addition, each variable- or floating-rate obligation must meet the credit
quality requirements applicable to all the Fund's investments at the time of
purchase. When determining whether such an obligation meets the Fund's credit
quality requirements, the Fund may look to the credit quality of the financial
guarantor providing a letter of credit or other credit support arrangement.
SMALL COMPANIES
The Fund may, from time to time, invest a substantial portion of its
assets in small companies. While smaller companies generally have the
potential for rapid growth, investments in smaller companies often involve
greater risks than investments in larger, more established companies because
smaller companies may lack the management experience, financial resources,
product diversification, and competitive strengths of larger companies. In
addition, in many instances the securities of smaller companies are traded only
over-the-counter or on a regional securities exchange, and the frequency and
volume of their trading is substantially less than is typical of larger
companies. Therefore, the securities of smaller companies may be subject to
greater and more abrupt price fluctuations. When making large sales, the Fund
may have to sell portfolio holdings at discounts from quoted prices or may have
to make a series of small sales over an extended period of time due to the
trading volume of smaller company securities. Investors should be aware that,
based on the foregoing factors, an investment in the Fund may be subject to
greater price fluctuations than an investment in a fund that invests primarily
in larger, more established companies. The Advisor's research efforts may also
play a greater role in selecting securities for the Fund than in a fund that
invests in larger, more established companies.
DIRECTORS AND OFFICERS OF THE CORPORATION
Directors and officers of the Corporation, together with information as to
their principal business occupations during the past five years, and other
information are shown below. Each director who is deemed an "interested
person," as defined in the 1940 Act, is indicated by an asterisk. Each officer
and director holds the same positions with the following registered investment
companies: Strong Advantage Fund, Inc.; Strong American Utilities Fund, Inc.;
Strong Asia Pacific Fund, Inc.; Strong Asset Allocation Fund, Inc.; Strong
Common Stock Fund, Inc.; Strong Corporate Bond Fund, Inc.; Strong Discovery
Fund, Inc.; Strong Government Securities Fund, Inc.; Strong Growth Fund, Inc.;
Strong Heritage Reserve Series, Inc.; Strong High-Yield Municipal Bond Fund,
Inc.; Strong Insured Municipal Bond Fund, Inc.; Strong International Bond Fund,
Inc.; Strong International Stock Fund, Inc.; Strong Money Market Fund, Inc.;
Strong Municipal Bond Fund, Inc.; Strong Municipal Money Market Fund, Inc.;
Strong Opportunity Fund, Inc.; Strong Short-Term Bond Fund, Inc.; Strong
Short-Term Global Bond Fund, Inc.; Strong Short-Term Municipal Bond Fund, Inc.;
Strong Total Return Fund, Inc.; and Strong U.S. Treasury Money Fund,
Inc. (collectively, the "Strong Funds"); and Strong Institutional Funds, Inc.;
and Strong Special Fund II, Inc.
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<PAGE> 21
*Richard S. Strong (DOB 5/12/42), Chairman of the Board and Director of
the Corporation.
Prior to August 1985, Mr. Strong was Chief Executive Officer of the
Advisor, which he founded in 1974. Since August 1985, Mr. Strong has been a
Security Analyst and Portfolio Manager of the Advisor. In October 1991, Mr.
Strong also became the Chairman of the Advisor. Mr. Strong is a director of
the Advisor. Since October 1993, Mr. Strong has been Chairman and a director
of Strong Holdings, Inc.; a Wisconsin corporation and subsidiary of the Advisor
("Holdings"), and the Fund's underwriter, Strong Funds Distributors, Inc.; a
Wisconsin corporation and subsidiary of Holdings ("Distributor"). Since
January 1994, Mr. Strong has been Chairman and a director of Heritage Reserve
Development Corporation, a Wisconsin corporation and subsidiary of Holdings;
and since February 1994, Mr. Strong has been a member of the Managing Boards of
Fussville Real Estate Holdings L.L.C., a Wisconsin Limited Liability Company
and subsidiary of the Advisor, and Fussville Development L.L.C. a Wisconsin
Limited Liability Company and subsidiary of the Advisor, and certain of its
subsidiaries. Mr. Strong has served as a director of the Corporation since
incorporation in December 1990 and Chairman of the Board of the Corporation
since January 1992. Mr. Strong has been in the investment management business
since 1967.
Marvin E. Nevins (DOB 7/9/18), Director of the Corporation.
Private Investor. From 1945 to 1980, Mr. Nevins was Chairman of Wisconsin
Centrifugal Inc.; a foundry. From July 1983 to December 1986, he was Chairman
of General Casting Corp., Waukesha, Wisconsin, a foundry. Mr. Nevins is a
former Chairman of the Wisconsin Association of Manufacturers & Commerce. He
was also a regent of the Milwaukee School of Engineering and a member of the
Board of Trustees of the Medical College of Wisconsin. Mr. Nevins has served
as a director of the Corporation since incorporation in December 1990.
Willie D. Davis (DOB 7/24/34), Director of the Corporation.
Mr. Davis has been director of Alliance Bank Since 1980, Sara Lee
Corporation (a food/consumer products company) since 1983, KMart Corporation (a
discount consumer products company) since 1985, YMCA Metropolitan - Los Angeles
since 1985, Dow Chemical Company since 1988, MGM Grand, Inc. (an
entertainment/hotel company) since 1990, WICOR, Inc. (a utility company) since
1990, Johnson Controls, Inc. (an industrial company) since 1992, L.A. Gear (a
footwear/sportswear company) since 1992, and Rally's Hamburger, Inc. since
1994. Mr. Davis has been a trustee of the University of Chicago since 1980,
Marquette University since 1988, and Occidental College since 1990. Since
1977, Mr. Davis has been President and Chief Executive Officer of All Pro
Broadcasting, Inc. Mr. Davis was a director of the Fireman's Fund (an
insurance company) from 1975 until 1990. Mr. Davis has served as a director of
the Corporation since July 1994.
*John Dragisic (DOB 11/26/40), Vice Chairman and Director of the
Corporation.
Mr. Dragisic has been Vice Chairman and a director of the Advisor and a
director of Holdings and Distributor since July 1994. Mr. Dragisic previously
served as a director of the Fund from 1992 and 1994. Mr. Dragisic was the
President and Chief Executive Officer of Grunau Company, Inc. (a mechanical
contracting and engineering firm), Milwaukee, Wisconsin from 1987 until July
1994. From 1981 to 1987, he was an Executive Vice President with Grunau
Company, Inc. From 1969 until 1973, Mr. Dragisic worked for the InterAmerican
Development Bank. Mr. Dragisic received his Ph.D. in Economics in 1971 from
the University of Wisconsin - Madison and his B.A. degree in Economics in 1962
from Lake Forest College. Mr. Dragisic has served as Vice Chairman of the
Corporation since July 1994 and director of the Corporation since April 1995.
Stanley Kritzik (DOB 1/9/30), Director of the Corporation.
Mr. Kritzik has been a Partner of Metropolitan Associates since 1962, a
Director of Aurora Health Care since 1987, and Health Network Ventures, Inc.
since 1992. He has served as a director of the Corporation since April 1995.
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<PAGE> 22
William F. Vogt (DOB 7/19/47), Director of the Corporation.
Mr. Vogt has been the President of Vogt Management Consulting, Inc. since
1990. From 1982 until 1990, he served as Executive Director of University
Physicians of the University of Colorado. Mr. Vogt is the Past President of
the Medical Group Management Association and a Fellow of the American College
of Medical Practice Executives. He has served as a director of the Corporation
since April 1995.
Lawrence A. Totsky (DOB 5/6/59), C.P.A., Vice President of the Corporation.
Mr. Totsky has been Senior Vice President of the Advisor since December
1994. Mr. Totsky acted as the Advisor's Manager of Shareholder Accounting and
Compliance from June 1987 to June 1991 when he was named Director of Mutual
Fund Administration. Mr. Totsky has been a Vice President of the Corporation
since May 1993.
Thomas P. Lemke (DOB 7/30/54), Vice President of the Corporation.
Mr. Lemke has been Senior Vice President, Secretary, and General Counsel
of the Advisor since September 1994. For two years prior to joining the
Advisor, Mr. Lemke acted as Resident Counsel for Funds Management at J.P.
Morgan & Co., Inc. From February 1989 until April 1992, Mr. Lemke acted as
Associate General Counsel to Sanford C. Bernstein Co., Inc. For two years
prior to that, Mr. Lemke was Of Counsel at the Washington, D.C. law firm of Tew
Jorden & Schulte, a successor of Finley, Kumble Wagner. From August 1979 until
December 1986, Mr. Lemke worked at the Securities and Exchange Commission, most
notably as the Chief Counsel to the Division of Investment Management (November
1984 - December 1986), and as Special Counsel to the Office of Insurance
Products, Division of Investment Management (April 1982 - October 1984). Mr.
Lemke has been a Vice President of the Corporation since October 1994.
Ann E. Oglanian (DOB 12/7/61), Secretary of the Corporation.
Ms. Oglanian has been an Associate Counsel of the Advisor since January
1992. Ms. Oglanian acted as Associate Counsel for the Chicago-based investment
management firm, Kemper Financial Services, Inc.; from June 1988 until December
1991. Ms. Oglanian has been the Secretary of the Corporation since May 1994.
Ronald A. Neville (DOB 5/21/47), C.P.A., Treasurer of the Corporation.
Mr. Neville has been the Senior Vice President and Chief Financial Officer
of the Advisor since January 1995. For fourteen years prior to that, Mr.
Neville worked at Twentieth Century Companies, Inc., most notably as Senior
Vice President and Chief Financial Officer (1988 until December 1994). Mr.
Neville received his M.B.A. in 1972 from the University of Missouri - Kansas
City and his B.A. degree in Business Administration and Economics in 1969 from
Drury College. Mr. Neville has been the Treasurer of the Corporation since
April 1995.
Except for Messrs. Nevins, Davis, Kritzik and Vogt, the address of all of
the above persons is P.O. Box 2936, Milwaukee, Wisconsin 53201. Mr. Nevins'
address is 6075 Pelican Bay Boulevard, Naples, Florida 33963. Mr. Davis'
address is 161 North La Brea, Inglewood, California 90301. Mr. Kritzik's
address is 1123 North Astor Street, P.O. Box 92547, Milwaukee, Wisconsin
53202-0547. Mr. Vogt's address is 2830 Third Street Avenue, Denver, Colorado
80206.
The mutual fund complex that is managed by the Advisor, which is
composed of 26 open-end management investment companies consisting of 31 mutual
funds, of which the Fund is a part, in the aggregate, pays each Director who is
not a director, officer, or employee of the Advisor, or any affiliated company
(a "disinterested director") an annual fee of $50,000, plus $100 per Board
meeting for each mutual fund or series thereof. In addition, each disinterested
director is reimbursed by the mutual funds for travel and other expenses
incurred in connection with attendance at such meetings. Other officers and
directors of the mutual funds receive no compensation or expense reimbursement
from the mutual funds.
As of July 14, 1995, the officers and directors of the Corporation did not
own any of the Fund's shares.
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<PAGE> 23
PRINCIPAL SHAREHOLDERS
As of July 14, 1995, no one owned of record or beneficially any shares
of the Fund.
INVESTMENT ADVISOR AND DISTRIBUTOR
The Advisor to the Fund is Strong Capital Management, Inc. Mr. Richard
S. Strong controls the Advisor. Mr. Strong is the Chairman and a director of
the Advisor, Mr. Dragisic is the Vice Chairman and a director of the Advisor,
Mr. Totsky is a Senior Vice President of the Advisor, Mr. Lemke is a Senior
Vice President, Secretary and General Counsel of the Advisor, Mr. Neville is a
Senior Vice President and Chief Financial Officer of the Advisor, and Ms.
Oglanian is an Associate Counsel of the Advisor. A brief description of the
Fund's investment advisory agreement ("Advisory Agreement") is set forth in
the Prospectus under "Management."
The Fund's Advisory Agreement is dated July 10, 1995, and will remain in
effect as to the Fund for a period of two years. The Advisory Agreement was
approved by the Fund's initial shareholder on its first day of operations.
Thereafter, the Advisory Agreement is required to be approved annually by the
Board of Directors of the Corporation or by vote of a majority of the Fund's
outstanding voting securities (as defined in the 1940 Act). In either case,
each annual renewal must also be approved by the vote of a majority of the
Corporation's directors who are not parties to the Advisory Agreement or
interested persons of any such party, cast in person at a meeting called for
the purpose of voting on such approval. The Advisory Agreement is terminable,
without penalty, on 60 days' written notice by the Board of Directors of the
Corporation, by vote of a majority of the Fund's outstanding voting securities,
or by the Advisor. In addition, the Advisory Agreement will terminate
automatically in the event of its assignment.
Under the terms of the Advisory Agreement, the Advisor manages the Fund's
investments subject to the supervision of the Corporation's Board of Directors.
The Advisor is responsible for investment decisions and supplies investment
research and portfolio management. At its expense, the Advisor provides office
space and all necessary office facilities, equipment, and personnel for
servicing the investments of the Fund. The Advisor places all orders for the
purchase and sale of the Fund's securities at its expense.
Except for expenses assumed by the Advisor as set forth above or by the
Distributor as described below with respect to the distribution of the Fund's
shares, the Fund is responsible for all its other expenses, including, without
limitation, interest charges, taxes, brokerage commissions, and similar
expenses; expenses of issue, sale, repurchase, or redemption of shares;
expenses of registering or qualifying shares for sale; expenses for printing
and distribution costs of prospectuses and quarterly financial statements
mailed to existing shareholders; charges of custodians, transfer agent fees
(including the printing and mailing of reports and notices to shareholders),
fees of registrars, fees for auditing and legal services, fees for clerical
services related to recordkeeping and shareholder relations, the cost of stock
certificates and fees for directors who are not "interested persons" of the
Advisor; and its allocable share of the Corporation's expenses.
As compensation for its services, the Fund pays to the Advisor a monthly
management fee at the annual rate of .85% of the first $35,000,000 of the Fund's
average daily net asset value and at the annual rate of .80% of the Fund's
average daily net asset value in excess of $35,000,000. (See "Additional
Information - Calculation of Net Asset Value" in the Prospectus.) From time to
time, the Advisor may voluntarily waive all or a portion of its management fee
for the Fund.
The Advisory Agreement requires the Advisor to reimburse the Fund in the
event that the expenses and charges payable by the Fund in any fiscal year,
including the management fee but excluding taxes, interest, brokerage
commissions, and similar fees and to the extent permitted extraordinary
expenses, exceed that percentage of the average net asset value of the Fund for
such year. Such excess is determined by valuations made as of the close of each
business day of the year, which is the most restrictive percentage provided by
the state laws of the various states in which the Fund's shares are qualified
for sale; or if the states in which the Fund's shares are qualified for sale
impose no restrictions, the Advisor shall reimburse the Fund in the event the
expenses and charges payable by the Fund in any fiscal year (as described
above) exceed 2%. The most restrictive percentage limitation
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<PAGE> 24
currently applicable to the Fund is 2.5% of its average daily net assets up to
$30,000,000, 2% on the next $70,000,000 of its average daily net assets and
1.5% of its average daily net assets in excess of $100,000,000. Reimbursement
of expenses in excess of the applicable limitation will be made on a monthly
basis and will be paid to the Fund by reduction of the Advisor's fee, subject
to later adjustment month by month for the remainder of the Fund's fiscal year.
The Advisor may from time to time absorb expenses for the Fund in addition to
the reimbursement of expenses in excess of applicable limitations.
On July 12, 1994, the SEC filed an administrative action (Order) against
the Advisor, Mr. Strong, and another employee of the Advisor in connection with
conduct that occurred between 1987 and early 1990. In re Strong/Corneliuson
Capital Management, Inc.; et al. Admin. Proc. File No. 3-8411. The proceeding
was settled by consent without admitting or denying the allegations in the
Order. The Order alleged that the Advisor and Mr. Strong aided and abetted
violations of Section 17(a) of the 1940 Act by effecting trades between mutual
funds, and between mutual funds and Harbour Investments Ltd. ("Harbour"),
without complying with the exemptive provisions of SEC Rule 17a-7 or otherwise
obtaining an exemption. It further alleged that the Advisor violated, and Mr.
Strong aided and abetted violations of, the disclosure provisions of the 1940
Act and the Investment Advisers Act of 1940 by misrepresenting the Advisor's
policy on personal trading and by failing to disclose trading by Harbour, an
entity in which principals of the Advisor owned between 18 and 25 percent of
the voting stock. As part of the settlement, the respondents agreed to a
censure and a cease and desist order and the Advisor agreed to various
undertakings, including adoption of certain procedures and a limitation for six
months on accepting certain types of new advisory clients.
The staff of the U.S. Department of Labor (the "Staff") has contacted the
Advisor regarding alleged cross-trading of securities between 1987 and early
1990 involving various customer accounts subject to the Employee Retirement
Security Act of 1974 ("ERISA") and managed by the Advisor. The Advisor has
informed the Staff of the basis for its position that the trades complied with
ERISA and that, in any event, any alleged noncompliance was not the cause of
any losses to the accounts. The Staff has stated that it disagrees with the
Advisor's positions, although to date it has not filed any action against the
Advisor. At this time, the Advisor is negotiating with the Staff regarding a
possible resolution of the matter, but it cannot presently determine whether
the matter will be settled or litigated or, if it is settled or litigated, how
it ultimately will be resolved. However, management presently believes, based
on current knowledge and the Advisor's insurance coverage, that the ultimate
resolution of this matter should not have a material adverse effect on the
Advisor's financial position.
The Advisor has adopted a Code of Ethics (the "Code") which governs the
personal trading activities of all "Access Persons" of the Advisor. Access
Persons include every director and officer of the Advisor and the investment
companies managed by the Advisor, including the Fund, as well as certain
employees of the Advisor who have access to information relating to the
purchase or sale of securities by the Advisor on behalf of accounts managed by
it. The Code is based upon the principal that such Access Persons have a
fiduciary duty to place the interests of the Advisor's clients ahead of their
own.
The Code requires Access Persons (other than Access Persons who are
independent directors of the investment companies managed by the Advisor,
including the Fund) to, among other things, preclear their securities
transactions (with limited exceptions, such as transactions in shares of mutual
funds, direct obligations of the U.S. government and certain options on
broad-based securities market indexes) and to execute such transactions through
the Advisor's trading department. The Code, which applies to all Access Persons
(other than Access Persons who are independent directors of the investment
companies managed by the Advisor, including the Fund), includes a ban on
acquiring any securities in an initial public offering, other than a new
offering of a registered open-end investment company, and a prohibition from
profiting on short-term trading in securities. In addition, no Access Person
may purchase or sell any security which, at the time, is being purchased or
sold, or to the knowledge of the Access Person, is being considered for
purchase or sale, by the Advisor on behalf of any mutual fund or other account
managed by it. Finally, the Code provides for trading "black out" periods
which prohibit trading by Access Persons who are portfolio managers within
seven calendar days of trading in the same securities by any mutual fund or
other account managed by the portfolio manager.
Under a Distribution Agreement dated July 10, 1995 with the Corporation
(the "Distribution Agreement"), Strong Funds Distributors, Inc.
("Distributor"), a subsidiary of the Advisor, acts as underwriter of the Fund's
shares. The Distribution Agreement provides that the Distributor will use its
best efforts to distribute the Fund's shares. Shares are only offered and sold
to the separate accounts of certain insurance companies. Since the Fund is a
"no-load" fund, no sales commissions are charged on the purchase of Fund
shares. Certain sales charges may apply to the variable annuity or life
insurance contract, which should be described in the prospectus of the
insurance company's separate account. The Distribution Agreement further
provides that the Distributor will bear the additional costs of printing
prospectuses and shareholder reports which are used for selling purposes, as
well as advertising and other costs attributable to the distribution of the
Fund's shares. The Distributor is an indirect subsidiary of the Advisor and
controlled by the Advisor and Richard S. Strong. The Distribution Agreement is
subject to the same termination and renewal provisions as are described above
with respect to the Advisory Agreement.
PORTFOLIO TRANSACTIONS AND BROKERAGE
The Advisor is responsible for decisions to buy and sell securities for
the Fund and for the placement of the Fund's investment business and the
negotiation of the commissions to be paid on such transactions. It is the
policy of the Advisor to seek the best execution at the best security price
available with respect to each transaction, in light of the overall quality of
brokerage and research services provided to the Advisor or the Fund. In
over-the-counter transactions, orders are placed directly with a principal
market maker unless it is believed that a better price and execution can be
obtained using a broker. The best price to the Fund means the best net price
without regard to the mix between purchase or sale price and commission, if
any. In selecting broker-dealers and in negotiating commissions, the Advisor
considers a variety of factors, including best price and execution, the full
range of brokerage services provided by the broker, as well as its capital
strength and stability, and the quality of the research and research services
provided by the broker. Brokerage will not be allocated based on the sale of
any shares of the Strong Funds.
Section 28(e) of the Securities Exchange Act of 1934 ("Section 28(e)")
permits an investment advisor, under certain circumstances, to cause an account
to pay a broker or dealer a commission for effecting a transaction in excess of
the amount of
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<PAGE> 25
commission another broker or dealer would have charged for effecting the
transaction in recognition of the value of the brokerage and research services
provided by the broker or dealer. Brokerage and research services include (a)
furnishing advice as to the value of securities, the advisability of investing
in, purchasing or selling securities, and the availability of securities or
purchasers or sellers of securities; (b) furnishing analyses and reports
concerning issuers, industries, securities, economic factors and trends,
portfolio strategy, and the performance of accounts; and (c) effecting
securities transactions and performing functions incidental thereto (such as
clearance, settlement, and custody).
In carrying out the provisions of the Advisory Agreement, the Advisor
may cause the Fund to pay a broker, which provides brokerage and research
services to the Advisor, a commission for effecting a securities transaction in
excess of the amount another broker would have charged for effecting the
transaction. The Advisor believes it is important to its investment
decision-making process to have access to independent research. The Advisory
Agreement provides that such higher commissions will not be paid by the Fund
unless (a) the Advisor determines in good faith that the amount is reasonable
in relation to the services in terms of the particular transaction or in terms
of the Advisor's overall responsibilities with respect to the accounts as to
which it exercises investment discretion; (b) such payment is made in
compliance with the provisions of Section 28(e), other applicable state and
federal laws, and the Advisory Agreement; and (c) in the opinion of the
Advisor, the total commissions paid by the Fund will be reasonable in relation
to the benefits to the Fund over the long term. The investment management fee
paid by the Fund under the Advisory Agreement is not reduced as a result of the
Advisor's receipt of research services.
Generally, research services provided by brokers may include information
on the economy, industries, groups of securities, individual companies,
statistical information, accounting and tax law interpretations, political
developments, legal developments affecting portfolio securities, technical
market action, pricing and appraisal services, credit analysis, risk
measurement analysis, performance analysis, and analysis of corporate
responsibility issues. Such research services are received primarily in the
form of written reports, telephone contacts, and personal meetings with
security analysts. In addition, such research services may be provided in the
form of access to various computer-generated data, computer hardware and
software, and meetings arranged with corporate and industry spokespersons,
economists, academicians, and government representatives. In some cases,
research services are generated by third parties but are provided to the
Advisor by or through brokers. Such brokers may pay for all or a portion of
computer hardware and software costs relating to the pricing of securities.
Where the Advisor itself receives both administrative benefits and
research and brokerage services from the services provided by brokers, it makes
a good faith allocation between the administrative benefits and the research
and brokerage services, and will pay for any administrative benefits with cash.
In making good faith allocations of costs between administrative benefits and
research and brokerage services, a conflict of interest may exist by reason of
the Advisor's allocation of the costs of such benefits and services between
those that primarily benefit the Advisor and those that primarily benefit the
Fund and other advisory clients.
From time to time, the Advisor may purchase securities for the Fund in a
fixed price offering. In these situations, the seller may be a member of the
selling group that will, in addition to selling the securities to the Fund and
other advisory clients, provide the Advisor with research. The National
Association of Securities Dealers has adopted rules expressly permitting these
types of arrangements under certain circumstances. Generally, the seller will
provide research "credits" in these situations at a rate that is higher than
that which is available for typical secondary market transactions. These
arrangements may not fall within the safe harbor of Section 28(e).
Each year, the Advisor considers the amount and nature of research and
research services provided by brokers, as well as the extent to which such
services are relied upon, and attempts to allocate a portion of the brokerage
business of the Fund and other advisory clients on the basis of that
consideration. In addition, brokers may suggest a level of business they would
like to receive in order to continue to provide such services. The actual
brokerage business received by a broker may be more or less than the suggested
allocations, depending upon the Advisor's evaluation of all applicable
considerations.
During its last fiscal year, the Advisor had an arrangement with various
brokers whereby, in consideration of the providing of research services, the
Advisor allocated brokerage to those firms, provided that their brokerage and
research services were satisfactory to the Advisor and their execution
capabilities were compatible with the Advisor's policy of seeking best
execution at the best security price available, as discussed above.
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<PAGE> 26
The Advisor may direct the purchase of securities on behalf of the Fund
and other advisory clients in secondary market transactions, in public
offerings directly from an underwriter, or in privately negotiated transactions
with an issuer. When the Advisor believes the circumstances so warrant,
securities purchased in public offerings may be resold shortly after
acquisition in the immediate aftermarket for the security in order to take
advantage of price appreciation from the public offering price or for other
reasons. Short-term trading of securities acquired in public offerings, or
otherwise, may result in higher portfolio turnover and associated brokerage
expenses.
The Advisor places portfolio transactions for other advisory accounts,
including other mutual funds managed by the Advisor. Research services
furnished by firms through which the Fund effects its securities transactions
may be used by the Advisor in servicing all of its accounts; not all of such
services may be used by the Advisor in connection with the Fund. In the
opinion of the Advisor, it is not possible to measure separately the benefits
from research services to each of the accounts (including the Fund) managed by
the Advisor. Because the volume and nature of the trading activities of the
accounts are not uniform, the amount of commissions in excess of those charged
by another broker paid by each account for brokerage and research services will
vary. However, in the opinion of the Advisor, such costs to the Fund will not
be disproportionate to the benefits received by the Fund on a continuing basis.
The Advisor seeks to allocate portfolio transactions equitably whenever
concurrent decisions are made to purchase or sell securities by the Fund and
another advisory account. In some cases, this procedure could have an adverse
effect on the price or the amount of securities available to the Fund. In
making such allocations between the Fund and other advisory accounts, the main
factors considered by the Advisor are the respective investment objectives, the
relative size of portfolio holdings of the same or comparable securities, the
availability of cash for investment, the size of investment commitments
generally held, and the opinions of the persons responsible for recommending
the investment.
The Corporation has entered into agreements with the Advisor and each of
Salomon and PaineWebber (collectively, the "Brokers"), in which the Brokers
have agreed to pay directly to vendors certain investment management and other
related expenses incurred and otherwise payable by the Fund ("Expense
Agreements"). In accordance with the Expense Agreements, the Advisor directs
the delivery to the Brokers of invoices determined by the Fund to be
appropriate for payment by the Brokers. The Brokers pay the invoices with the
proceeds of certain commissions received from the Fund. The Expense Agreements
provide that a percentage of commissions received from the Fund for completed
agency transactions in certain securities for the Fund, designated by the
Advisor as directed commissions subject to the Expense Agreements, shall be
used by the Brokers to pay the invoices. In all cases, such credits have been
immaterial in amount. The Advisor believes that this practice has not resulted
in any increase in the level of commissions paid by the Fund. Investment
management and other related expenses include those payable by the Fund, as
described under "Investment Advisor and Distributor" in this Statement of
Additional Information.
CUSTODIAN
As custodian of the Fund's assets, Firstar Trust Company, P.O. Box 761,
Milwaukee, Wisconsin 53201, has custody of all securities and cash of the Fund,
delivers and receives payment for securities sold, receives and pays for
securities purchased, collects income from investments, and performs other
duties, all as directed by officers of the Corporation. The custodian is in no
way responsible for any of the investment policies or decisions of the Fund.
TRANSFER AGENT AND DIVIDEND-DISBURSING AGENT
The Advisor acts as transfer agent and dividend-disbursing agent for
the Fund at no cost.
ADMINISTRATIVE SERVICES
From time to time the Fund and/or the Advisor may enter into
arrangements under which certain administrative services may be performed by
the insurance companies that purchase shares in the Fund. These administrative
services may include, among other things, responding to ministerial inquiries
concerning the Fund's investment objective, investment program, policies and
performance, transmitting, on behalf of the Fund, proxy statements, annual
reports, updated prospectuses, and other communications regarding the Fund, and
providing only related services as the Fund or its shareholders may reasonably
request. Depending on the arrangements, the Fund and/or Advisor may compensate
such insurance companies or their agents directly or indirectly for the
administrative services. To the extent the Fund compensates the insurance
company for these services, the Fund will pay the insurance company an annual
fee that will vary depending upon the number of contract holders that utilize
the Fund as the funding medium for their contracts. The insurance company may
impose other account or service charges. See the prospectus for the separate
account of the insurance company for additional information regarding such
charges.
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<PAGE> 27
TAXES
GENERAL
As indicated under "Additional Information - Distributions and Taxes" in
the Prospectus, the Fund intends to continue to qualify annually for treatment
as a regulated investment company ("RIC") under the Internal Revenue Code of
1986, as amended (the "Code"). This qualification does not involve government
supervision of the Fund's management practices or policies.
In order to qualify for treatment as a RIC under the Code, the Fund must
distribute to its shareholders for each taxable year at least 90% of its
investment company taxable income (consisting generally of net investment
income, net short-term capital gain, and net gains from certain foreign
currency transactions) ("Distribution Requirement") and must meet several
additional requirements. Among these requirements are the following: (1) the
Fund must derive at least 90% of its gross income each taxable year from
dividends, interest, payments with respect to securities loans, and gains from
the sale or other disposition of securities or foreign currencies, or other
income (including gains from options, futures, or forward contracts) derived
with respect to its business of investing in securities or those currencies
("Income Requirement"); (2) the Fund must derive less than 30% of its gross
income each taxable year from the sale or other disposition of securities, or
any of the following, that were held for less than three months - options or
futures (other than those on foreign currencies), or foreign currencies (or
options, futures, or forward contracts thereon) that are not directly related
to the Fund's principal business or investing in securities (or options and
futures with respect to securities) ("30% Limitation"); (3) at the close of
each quarter of the Fund's taxable year, at least 50% of the value of its total
assets must be represented by cash and cash items, U.S. government securities,
securities of other RICs, and other securities, with these other securities
limited, in respect of any one issuer, to an amount that does not exceed 5% of
the value of the Fund's total assets and that does not represent more than 10%
of the issuer's outstanding voting securities; and (4) at the close of each
quarter of the Fund's taxable year, not more than 25% of the value of its total
assets may be invested in securities (other than U.S. government securities or
the securities of other RICs) of any one issuer.
If Fund shares are sold at a loss after being held for six months or less,
the loss will be treated as long-term, instead of short-term, capital loss to
the extent of any capital gain distributions received on those shares.
In addition, the Fund must satisfy the diversification requirements of
Section 817(h) of the Code. In general, for the Fund to meet these investment
diversification requirements, Treasury regulations require that no more than
55% of the total value of the assets of the Fund may be represented by any one
investment, no more than 70% by two investments, no more than 80% by three
investments and no more than 90% by four investments. Generally, for purposes
of the regulations, all securities of the same issuer are treated as a single
investment. With respect to the United States Government securities (including
any security that is issued, guaranteed or insured by the United States or an
instrumentality of the United States), each governmental agency or
instrumentality is treated as a separate issuer. Compliance with the
regulations is tested on the last day of each calendar year quarter. There is
a 30-day period after the end of each calendar year quarter in which to cure
any non-compliance with these requirements.
FOREIGN TRANSACTIONS
Interest and dividends received by the Fund may be subject to income,
withholding, or other taxes imposed by foreign countries and U.S. possessions
that would reduce the yield on its securities. Tax conventions between certain
countries and the United States may reduce or eliminate these foreign taxes,
however, and many foreign countries do not impose taxes on capital gains in
respect of investments by foreign investors.
The Fund maintains its accounts and calculates its income in U.S. dollars.
In general, gain or loss (1) from the disposition of foreign currencies and
forward currency contracts, (2) from the disposition of
foreign-currency-denominated debt securities that are attributable to
fluctuations in exchange rates between the date the securities are acquired and
their disposition date, and (3) attributable to fluctuations in exchange rates
between the time the Fund accrues interest or other receivables or expenses or
other liabilities denominated in a foreign currency and the time the Fund
actually collects those receivables or pays those liabilities, will be treated
as ordinary income or loss. A foreign-currency-denominated debt security
acquired by the Fund may bear interest at a high normal rate that takes into
account expected decreases in the value of the principal amount of the security
due to anticipated currency devaluations; in that case, the Fund would be
required to include the interest in income as it
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<PAGE> 28
accrues but generally would realize a currency loss with respect to the
principal only when the principal was received (through disposition or upon
maturity).
The Fund may invest in the stock of "passive foreign investment companies"
("PFICs"). A PFIC is a foreign corporation that, in general, meets either of
the following tests: (1) at least 75% of its gross income is passive or (2) an
average of at least 50% of its assets produce, or are held for the production
of, passive income. Under certain circumstances, the Fund will be subject to
federal income tax on a portion of any "excess distribution" received on the
stock or of any gain on disposition of the stock (collectively, "PFIC income"),
plus interest thereon, even if the Fund distributes the PFIC income to its
shareholders. The balance of the PFIC income will be included in the Fund's
investment company taxable income and, accordingly, will not be taxable to it
to the extent that income is distributed to its shareholders. If the Fund
invests in a PFIC and elects to treat the PFIC as a "qualified electing fund,"
then in lieu of the foregoing tax and interest obligation, the Fund will be
required to include in income each year its pro rata share of the qualified
electing fund's annual ordinary earnings and net capital gain (the excess of
net long-term capital gain over net short-term capital loss) -- which probably
would have to be distributed to its shareholders to satisfy the Distribution
Requirement -- even if those earnings and gain were not received by the Fund.
In most instances it will be very difficult, if not impossible, to make this
election because of certain requirements thereof.
The "Tax Simplification and Technical Corrections Bill of 1993," passed in
May 1994 by the House of Representatives would substantially modify the
taxation of U.S. shareholders of foreign corporations, including eliminating
the provisions described above dealing with PFICs and replacing them (and other
provisions) with a regulatory scheme involving entities called "passive foreign
corporations." Three similar bills were passed by Congress in 1991 and 1992 and
were vetoed. It is unclear at this time whether, and in what form, the
proposed modifications may be enacted into law.
Pursuant to proposed regulations, open-end RICs such as the Fund would be
entitled to elect to "mark-to-market" their stock in certain PFICs.
"Marking-to-market," in this context, means recognizing as gain for each
taxable year the excess, as of the end of that year, of the fair market value
of each such PFIC's stock over the adjusted basis in that stock (including
mark-to-market gain for each prior year for which an election was in effect).
DERIVATIVE INSTRUMENTS
The use of derivatives strategies, such as purchasing and selling
(writing) options and futures and entering into forward currency contracts,
involves complex rules that will determine for income tax purposes the
character and timing of recognition of the gains and losses the Fund realizes
in connection therewith. Gains from the disposition of foreign currencies
(except certain gains therefrom that may be excluded by future regulations),
and income from transactions in options, futures, and forward currency
contracts derived by the Fund with respect to its business of investing in
securities or foreign currencies, will qualify as permissible income under the
Income Requirement. However, income from the disposition of options and
futures (other than those on foreign currencies) will be subject to the 30%
Limitation if they are held for less than three months. Income from the
disposition of foreign currencies, and options, futures, and forward contracts
on foreign currencies, that are not directly related to the Fund's principal
business of investing in securities (or options and futures with respect to
securities) also will be subject to the 30% Limitation if they are held for
less than three months.
If the Fund satisfies certain requirements, any increase in value of a
position that is part of a "designated hedge" will be offset by any decrease in
value (whether realized or not) of the offsetting hedging position during the
period of the hedge for purposes of determining whether the Fund satisfies the
30% Limitation. Thus, only the net gain (if any) from the designated hedge
will be included in gross income for purposes of that limitation. The Fund
intends that, when it engages in hedging strategies, the hedging transactions
will qualify for this treatment, but at the present time it is not clear
whether this treatment will be available for all of the Fund's hedging
transactions. To the extent this treatment is not available or is not elected
by the Fund, it may be forced to defer the closing out of certain options,
futures, or forward currency contracts beyond the time when it otherwise would
be advantageous to do so, in order for the Fund to continue to qualify as a
RIC.
For federal income tax purposes, the Fund is required to recognize as
income for each taxable year its net unrealized gains and losses on options,
futures, and forward currency contracts that are subject to section 1256 of the
Code ("Section 1256 Contracts") and are held by the Fund as of the end of the
year, as well as gains and losses on Section 1256 Contracts actually realized
during the year. Except for Section 1256 Contracts that are part of a "mixed
straddle" and with respect to which the Fund makes a certain election, any gain
or loss recognized with respect to Section 1256 Contracts is considered to be
60% long-term
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<PAGE> 29
capital gain or loss and 40% short-term capital gain or loss, without regard to
the holding period of the Section 1256 Contract. Unrealized gains on Section
1256 Contracts that have been held by the Fund for less than three months as of
the end of its taxable year, and that are recognized for federal income tax
purposes as described above, will not be considered gains on investments held
for less than three months for purposes of the 30% Limitation.
ZERO-COUPON, STEP-COUPON, AND PAY-IN-KIND SECURITIES
The Fund may acquire zero-coupon, step-coupon, or other securities issued
with original issue discount. As a holder of those securities, the Fund must
include in its income the original issue discount that accrues on the
securities during the taxable year, even if the Fund receives no corresponding
payment on the securities during the year. Similarly, the Fund must include in
its income securities it receives as "interest" on pay-in-kind securities.
Because the Fund annually must distribute substantially all of its investment
company taxable income, including any original issue discount and other
non-cash income, to satisfy the Distribution Requirement, it may be required in
a particular year to distribute as a dividend an amount that is greater than
the total amount of cash it actually receives. Those distributions may be made
from the proceeds on sales of portfolio securities, if necessary. The Fund may
realize capital gains or losses from those sales, which would increase or
decrease its investment company taxable income or net capital gain, or both.
In addition, any such gains may be realized on the disposition of securities
held for less than three months. Because of the 30% Limitation, any such gains
would reduce the Fund's ability to sell other securities, or certain options,
futures, or forward currency contracts, held for less that three months that
it might wish to sell in the ordinary course of its portfolio management.
The foregoing federal tax discussion as well as the tax discussion
contained within the Prospectus under "Additional Information - Distributions
and Taxes" is intended to provide you with an overview of the impact of federal
income tax provisions on the Fund or its shareholders. These tax
provisions are subject to change by legislative or administrative action at the
federal, state, or local level, and any changes may be applied retroactively.
Any such action that limits or restricts the Fund's current ability to
pass-through earnings without taxation at the Fund level, or otherwise
materially changes the Fund's tax treatment, could adversely affect the value
of a shareholder's investment in the Fund. Because the Fund's taxes are a
complex matter, you should consult your tax adviser for more detailed
information concerning the taxation of the Fund and the federal, state, and
local tax consequences to shareholders of an investment in the Fund.
DETERMINATION OF NET ASSET VALUE
A more complete discussion of the Fund's determination of net asset value
is contained in the Prospectus. Generally, the net asset value of the Fund
will be determined as of the close of trading on each day the New York Stock
Exchange (the "NYSE") is open for trading. The NYSE is open for trading Monday
through Friday except New Year's Day, Presidents' Day, Good Friday, Memorial
Day, Independence Day, Labor Day, Thanksgiving Day, and Christmas Day.
Additionally, if any of the aforementioned holidays falls on a Saturday, the
NYSE will not be open for trading on the preceding Friday, and when any such
holiday falls on a Sunday, the NYSE will not be open for trading on the
succeeding Monday, unless unusual business conditions exist, such as the ending
of a monthly or the yearly accounting period.
FUND ORGANIZATION
The Fund is a series of Strong Variable Insurance Funds, Inc., a Wisconsin
corporation (the "Corporation"). The Corporation (formerly known as Strong
Discovery Fund II, Inc., formerly known as Strong D Fund, Inc.) was organized
on December 28, 1990 and is authorized to issue 10,000,000,000 shares of common
stock and series and classes of series of shares of common stock, with a par
value of $.00001 per share. The Corporation is authorized to issue 300,000,000
shares of common stock of the Fund. Each share of the Corporation has one
vote, and all shares of a series participate equally in dividends and other
capital gains distributions and in the residual assets of that Fund in the
event of liquidation. Fractional shares have the same rights proportionately as
do full shares. Shares of the Corporation have no preemptive, conversion, or
subscription rights. The Corporation currently has six series of common
stock outstanding. The assets belonging to each series of shares is held
separately by a custodian, and in effect each series is a separate fund. All
holders of shares of the Corporation would vote on each matter presented to
shareholders for action except with respect to any matter which affects only
one or more series or classes, in which case only the shares of the affected
series or class shall be entitled to vote. Because of current federal
securities law requirements the Corporation expects that its shareholders will
offer to owners of variable annuity and variable life insurance contracts the
opportunity to instruct them as to how shares allocable to their contracts will
be voted with respect to certain matters, such as approval of changes to the
investment advisory agreement. The Wisconsin Business Corporation Law permits
registered investment companies, such as the series of the Corporation, to
operate without an annual meeting of shareholders under specified circumstances
if an annual meeting is not required by the 1940 Act. The Corporation has
adopted the appropriate provisions in its Bylaws and may, at its discretion,
not hold an annual meeting in any year in which the election of directors is
not required to be acted on by shareholders under the 1940 Act.
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<PAGE> 30
The Corporation's Bylaws allow for a director to be removed by its
shareholders with or without cause, only at a meeting called for the purpose of
removing the director. Upon the written request of the holders of shares
entitled to not less than ten percent (10%) of all the votes entitled to be
cast at such meeting, the Secretary of the Corporation shall promptly call a
special meeting of shareholders for the purpose of voting upon the question of
removal of any director. The Secretary shall inform such shareholders of the
reasonable estimated costs of preparing and mailing the notice of the meeting,
and upon payment to the Corporation of such costs, the Corporation shall give
not less than ten nor more than sixty days notice of the special
meeting.
PERFORMANCE INFORMATION
As described under "Additional Information - Performance Information" in
the Prospectus, the Fund's historical performance or return may be shown in the
form of "average annual total return," "total return," and "cumulative total
return." From time to time, the Advisor may voluntarily waive all or a portion
of its management fee and/or absorb certain expenses for the Fund. Total
returns contained in advertisements include the effect of deducting the Fund's
expenses, but may not include charges and expenses attributable to any
particular insurance product. Since shares may only be purchased by the
separate accounts of certain insurance companies, contracts owners should
carefully review the prospectus of the separate account for information on fees
and expenses. Excluding such fees and expenses from the Fund's total return
quotations has the effect of increasing the performance quoted.
AVERAGE ANNUAL TOTAL RETURN
The Fund's average annual total return quotation is computed in accordance
with a standardized method prescribed by rules of the SEC. The average annual
total return for the Fund for a specific period is found by first taking a
hypothetical $10,000 investment ("initial investment") in the Fund's shares on
the first day of the period and computing the "redeemable value" of that
investment at the end of the period. The redeemable value is then divided by
the initial investment, and this quotient is taken to the Nth root (N
representing the number of years in the period) and one is subtracted from the
result, which is then expressed as a percentage. The calculation assumes that
all income and capital gains dividends paid by the Fund have been reinvested at
net asset value on the reinvestment dates during the period.
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<PAGE> 31
TOTAL RETURN
Calculation of the Fund's total return is not subject to a standardized
formula. Total return performance for a specific period is calculated by first
taking an investment (assumed below to be $10,000) ("initial investment") in
the Fund's shares on the first day of the period and computing the "ending
value" of that investment at the end of the period. The total return
percentage is then determined by subtracting the initial investment from the
ending value and dividing the remainder by the initial investment and
expressing the result as a percentage. The calculation assumes that all income
and capital gains dividends paid by the Fund have been reinvested at net asset
value on the reinvestment dates during the period. Total return may also be
shown as the increased dollar value of the hypothetical investment over the
period.
CUMULATIVE TOTAL RETURN
Cumulative total return represents the simple change in value of our
investment over a stated period and may be quoted as a percentage or as a
dollar amount. Total returns and cumulative total returns may be broken down
into their components of income and capital (including capital gains and
changes in share price) in order to illustrate the relationship between these
factors and their contributions to total return.
The Fund's performance figures are based upon historical results and do
not represent future performance. The Fund's shares are sold at net asset
value per share. The Fund's returns and net asset value will fluctuate and
shares are redeemable at the then current net asset value of the Fund, which
may be more or less than original cost. Factors affecting the Fund's
performance include general market conditions, operating expenses and
investment management. Any additional fees charged by a dealer or other
financial services firm would reduce the returns described in this section.
COMPARISONS
(1) U.S. TREASURY BILLS, NOTES, OR BONDS
Investors may also wish to compare the performance of the Fund to that of
United States Treasury bills, notes, or bonds, which are issued by the U.S.
government, because such instruments represent alternative income producing
products. Treasury obligations are issued in selected denominations. Rates of
Treasury obligations are fixed at the time of issuance and payment of principal
and interest is backed by the full faith and credit of the United States
Treasury. The market value of such instruments will generally fluctuate
inversely with interest rates prior to maturity and will equal par value at
maturity.
(2) CERTIFICATES OF DEPOSIT
Investors may wish to compare the Fund's performance to that of
certificates of deposit offered by banks and other depositary institutions.
Certificates of deposit represent an alternative income producing product.
Certificates of deposit may offer fixed or variable interest rates and
principal is guaranteed and may be insured. Withdrawal of the deposits prior to
maturity normally will be subject to a penalty. Rates offered by banks and
other depositary institutions are subject to change at any time specified by
the issuing institution.
(3) MONEY MARKET FUNDS
Investors may also want to compare performance of the Fund to that of
money market funds. Money market fund yields will fluctuate and an investment
in money market fund shares is neither insured nor guaranteed by the U.S.
government, but share values usually remain stable.
(4) LIPPER ANALYTICAL SERVICES, INC. ("LIPPER") AND OTHER INDEPENDENT RANKING
ORGANIZATIONS
From time to time, in marketing and other fund literature, the Fund's
performance may be compared to the performance of other mutual funds in general
or to the performance of particular types of mutual funds, with similar
investment goals, as tracked by independent organizations. Among these
organizations, Lipper, a widely used independent research firm which ranks
mutual funds by overall performance, investment objectives, and assets, may be
cited. Lipper performance figures are based on changes in net asset value,
with all income and capital gain dividends reinvested. Such calculations do
not include the effect of any sales charges imposed by other funds. The Fund
will be compared to Lipper's appropriate fund category, that is, by fund
objective and portfolio holdings.
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<PAGE> 32
(5) MORNINGSTAR, INC.
The Fund's performance may also be compared to the performance of other
mutual funds by Morningstar, Inc. which rates funds on the basis of historical
risk and total return. Morningstar's ratings range from five stars (highest)
to one star (lowest) and represent Morningstar's assessment of the historical
risk level and total return of the Fund as a weighted average for 3, 5, and 10
year periods. Ratings are not absolute and do not represent future results.
(6) VARDS REPORT
The Fund's performance may also be compared to the performance of other
variable annuity products in general or to the performance of particular types
of variable annuity products, with similar investment goals, as tracked by the
VARDS Report (Variable Annuity Research and Data Service Report) produced by
Financial Planning Resources, Inc. The VARDS Report is a monthly performance
analysis of the variable annuity industry.
(7) INDEPENDENT SOURCES
Evaluations of Fund performance made by independent sources may also be
used in advertisements concerning the Fund, including reprints of, or
selections from, editorials or articles about the Fund, especially those with
similar objectives. Sources for Fund performance information and articles
about the Fund may include publications such as Money, Forbes, Kiplinger's,
Smart Money, Morningstar, Inc., Financial World, Business Week, U.S. News and
World Report, The Wall Street Journal, Barron's, and a variety of investment
newsletters.
(8) INDICES
The Fund may compare its performance to a wide variety of
indices including the following:
(a) The Consumer Price Index
(b) Dow Jones Average of 30 Industrials
(c) Standard & Poor's 500 Stock Index
(d) NASDAQ Over-the-Counter Composite Index
(e) Russell 2000 Small Stock Index
(f) Russell 3000 Stock Index
(g) Salomon Brothers 3-month Treasury Bill Index
(h) Salomon Brothers Broad Investment-Grade Bond Index
(i) Lehman Brothers Aggregate Bond Index
(j) Lehman Brothers Intermediate Government/Corporate Bond Index
(k) A blended index consisting of: Standard & Poor's 500 Stock
Index (40% weighted), Salomon Brothers Broad Investment Grade
Bond Index (40% weighted), and Salomon Brothers 3-Month
Treasury Bill Index (20% weighted).
There are differences and similarities between the investments that the
Fund may purchase and the investments measured by the indices which are noted
herein.
(9) HISTORICAL ASSET CLASS RETURNS
From time to time, marketing materials may portray the historical returns
of various asset classes. Such presentations will typically compare the
average annual rates of return of inflation, U.S. Treasury bills, bonds, common
stocks, and small stocks. There are important differences between each of these
investments that should be considered in viewing any such comparison. The
market value of stocks will fluctuate with market conditions, and small-stock
prices generally will fluctuate more than large-stock prices. Stocks are
generally more volatile than bonds. In return for this volatility, stocks have
generally performed better than bonds or cash over time. Bond prices
generally will fluctuate inversely with interest rates and other market
conditions, and the prices of bonds with longer maturities generally will
fluctuate more than those of shorter-maturity bonds. Interest rates for bonds
may be fixed at the time of issuance, and payment of principal and interest may
be guaranteed by the issuer and, in the case of U.S. Treasury obligations,
backed by the full faith and credit of the U.S. Treasury.
(10) STRONG VARIABLE INSURANCE FUNDS
The Strong Variable Insurance Funds offer a range of investment
options. All of the members of the Strong Variable Insurance Funds and their
investment objectives are listed below. The Funds are listed in ascending order
of risk and return, as determined by the Funds' Advisor.
<TABLE>
<CAPTION>
FUND NAME INVESTMENT OBJECTIVE
- --------------------------------------------------------------------------------------------------------------
<S> <C>
Strong Advantage Fund II Current income with a very low degree of
share-price fluctuation.
- --------------------------------------------------------------------------------------------------------------
Strong Government Securities Fund II Total return by investing for a high level of current income
with a moderate degree of share-price fluctuation.
- --------------------------------------------------------------------------------------------------------------
Strong Asset Allocation Fund II High total return consistent with reasonable risk over the
long term.
- --------------------------------------------------------------------------------------------------------------
Strong Special Fund II Capital growth.
- --------------------------------------------------------------------------------------------------------------
Strong Growth Fund II Capital growth.
- --------------------------------------------------------------------------------------------------------------
Strong Discovery Fund II Capital growth.
- --------------------------------------------------------------------------------------------------------------
Strong International Stock Fund II Capital growth.
- --------------------------------------------------------------------------------------------------------------
</TABLE>
Each Fund may from time to time be compared to the other Funds in
the Strong Variable Insurance Funds based on a risk/reward spectrum. In
general, the amount of risk associated with any investment product is
commensurate with that product's potential level of reward. The Strong Variable
Insurance Funds' risk/reward continuum or any Fund's position on the continuum
may be described or diagrammed in marketing materials. The Strong Variable
Insurance Funds' risk/reward continuum positions the risk and reward potential
of each Fund relative to the other Strong Variable Insurance Funds, but is not
intended to position any Fund relative to other mutual funds or investment
products. Marketing materials may also discuss the relationship between risk and
reward as it relates to an individual investor's portfolio. Financial goals vary
from person to person. You may choose one or more of the Strong Variable
Insurance Funds to help you reach your financial goals.
The Advisor also serves as advisor to the Strong Family of Funds, which
is a retail fund complex composed of 26 open-end management investment
companies.
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<PAGE> 33
ADDITIONAL FUND INFORMATION
(1) PORTFOLIO CHARACTERISTICS
In order to present a more complete picture of a Fund's portfolio,
marketing materials may include various actual or estimated portfolio
characteristics, including but not limited to median market capitalizations,
earnings per share, alphas, betas, price/earnings ratios, returns on equity,
dividend yields, capitalization ranges, growth rates, price/book ratios, top
holdings, sector breakdowns, asset allocations, quality breakdowns, and
breakdowns by geographic region.
(2) MEASURES OF VOLATILITY AND RELATIVE PERFORMANCE
Occasionally statistics may be used to specify Fund volatility or risk.
The general premise is that greater volatility connotes greater risk undertaken
in achieving performance. Measures of volatility or risk are generally used to
compare the Fund's net asset value or performance relative to a market index.
One measure of volatility is beta. Beta is the volatility of a fund relative
to the total market as represented by the Standard & Poor's 500 Stock Index. A
beta of more than 1.00 indicates volatility greater than the market, and a beta
of less than 1.00 indicates volatility less than the market. Another measure
of volatility or risk is standard deviation. Standard deviation is a
statistical tool that measures the degree to which a fund's performance has
varied from its average performance during a particular time period.
Standard deviation is calculated using the following formula:
2
Standard deviation = the square root of +(x - x )
i m
-------------
n-1
where + = "the sum of",
x = each individual return during the time period,
i
x = the average return over the time period, and
m
n = the number of individual returns during the time period.
Statistics may also be used to discuss a Fund's relative performance. One
such measure is alpha. Alpha measures the actual return of a fund compared to
the expected return of a fund given its risk (as measured by beta). The
expected return is based on how the market as a whole performed, and how the
particular fund has historically performed against the market. Specifically,
alpha is the actual return less the expected return. The expected return is
computed by multiplying the advance or decline in a market representation by
the fund's beta. A positive alpha quantifies the value that the fund manager
has added, and a negative alpha quantifies the value that the fund manager has
lost.
Other measures of volatility and relative performance may be used as
appropriate. However, all such measures will fluctuate and do not represent
future results.
GENERAL INFORMATION
BUSINESS PHILOSOPHY
The Advisor is an independent, Midwestern-based investment advisor, owned
by professionals active in its management. Recognizing that investors are the
focus of its business, the Advisor strives for excellence both in investment
management and in the service provided to investors. This commitment affects
many aspects of the business, including professional staffing, product
development, investment management, and service delivery. Through its
commitment to excellence, the Advisor intends to benefit investors and to
encourage them to think of Strong Funds as their mutual fund family.
The increasing complexity of the capital markets requires specialized
skills and processes for each asset class and style. Therefore, the Advisor
believes that active management should produce greater returns than a passively
managed index. The Advisor has brought together a group of top-flight
investment professionals with diverse product expertise, and each concentrates
on their investment specialty. The Advisor believes that people are the firm's
most important asset. For this reason, continuity of professionals is critical
to the firm's long-term success.
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INVESTMENT ENVIRONMENT
Discussions of economic, social, and political conditions and their impact
on the Fund may be used in advertisements and sales materials. Such factors
that may impact the Fund include, but are not limited to, changes in interest
rates, political developments, the competitive environment, consumer behavior,
industry trends, technological advances, macroeconomic trends, and the supply
and demand of various financial instruments. In addition, marketing materials
may cite the portfolio management's views or interpretations of such factors.
EIGHT BASIC PRINCIPLES FOR SUCCESSFUL MUTUAL FUND INVESTING
These common sense rules are followed by many successful investors. They
make sense for beginners, too. If you have a question on these principles, or
would like to discuss them with us, please contact us at 1-800-368-3863.
1. Have a plan - even a simple plan can help you take control of your
financial future. Review your plan once a year, or if your circumstances
change.
2. Start investing as soon as possible. Make time a valuable ally. Let it put
the power of compounding to work for you, while helping to reduce your
potential investment risk.
3. Diversify your portfolio. By investing in different asset classes -
stocks, bonds, and cash - you help protect against poor performance in one
type of investment while including investments most likely to help you
achieve your important goals.
4. Invest regularly. Investing is a process, not a one-time event. By
investing regularly over the long term, you reduce the impact of short-
term market gyrations, and you attend to your long-term plan before you're
tempted to spend those assets on short-term needs.
5. Maintain a long-term perspective. For most individuals, the best
discipline is staying invested as market conditions change. Reactive,
emotional investment decisions are all too often a source of regret - and
principal loss.
6. Consider stocks to help achieve major long-term goals. Over time, stocks
have provided the more powerful returns needed to help the value of your
investments stay well ahead of inflation.
7. Keep a comfortable amount of cash in your portfolio. To meet current
needs, including emergencies, use a money market fund or a bank account -
not your long-term investment assets.
8. Know what you're buying. Make sure you understand the potential risks and
rewards associated with each of your investments. Ask questions...request
information...make up your own mind. And choose a fund company that helps
you make informed investment decisions.
PORTFOLIO MANAGEMENT
Each portfolio manager works with a team of analysts, traders, and
administrative personnel. From time to time, marketing materials may discuss
various members of the team, including their education, investment experience,
and other credentials.
The Advisor believes that active management is the best way to achieve the
Fund's objective. This policy is based on the fundamental belief that economic
and financial conditions create favorable and unfavorable investment periods
(or seasons) and that these different seasons require different investment
approaches. During favorable investment periods, the Fund seeks to generate
real (inflation plus) growth, and its portfolio may be more heavily weighted in
equities. During uncertain periods, income and capital preservation may be
emphasized, and the Fund's portfolio may be more heavily weighted in bonds or
short-term securities. Through their understanding and willingness to change
with investment cycles or periods, the co-managers of the Fund seek to achieve
the Fund's objectives throughout the seasons of investment.
The Fund's co-managers intend to employ an investment strategy which will
permit it to participate in a rising market in equities with less risk and
volatility and more income than a fund which concentrates its investments in
stocks. On the other
34
<PAGE> 35
hand, since the Fund's portfolio will generally have significant holdings in
equities, it will be subject to greater volatility and produce less income than
a fund which concentrates its investments solely in bonds or money market
instruments.
In allocating the Fund's assets among equities, bonds, and short-term
securities, the team's lead portfolio manager will employ top-down fundamental
analysis in evaluating the attractiveness of the three asset components on the
basis of economic trends such as inflation, growth of corporate profits and
Federal Reserve Board policies in conjunction with measures of market valuation
such as price-earnings ratios, dividend yields and real interest rates. The
relative weights of the Fund's three asset components are adjusted gradually,
perhaps as often as several times a year, rather than making dramatic
reallocations in anticipation of a major shift in the attractiveness of one
asset category over another. Therefore, the Fund should be viewed as a
long-term investment suitable for investors with an investment horizon of five
years or more. In light of the nature of the Fund and its long-term investment
horizon, it may be most appropriate for persons attempting to achieve long-term
goals such as accumulating funds for retirement, college tuition or a better
life for one's family.
INDEPENDENT ACCOUNTANTS
Coopers & Lybrand L.L.P., 411 East Wisconsin Avenue, Milwaukee, Wisconsin
53202, have been selected as the independent accountants for the Fund,
providing audit services and assistance and consultation with respect to the
preparation of filings with the SEC.
LEGAL COUNSEL
Godfrey & Kahn, S.C., 780 North Water Street, Milwaukee, Wisconsin 53202,
acts as outside legal counsel for the Fund.
35
<PAGE> 36
APPENDIX
BOND RATINGS
STANDARD & POOR'S DEBT RATINGS
A Standard & Poor's corporate or municipal debt rating is a current
assessment of the creditworthiness of an obligor with respect to a specific
obligation. This assessment may take into consideration obligors such as
guarantors, insurers, or lessees.
The debt rating is not a recommendation to purchase, sell, or hold a
security, inasmuch as it does not comment as to market price or suitability for
a particular investor.
The ratings are based on current information furnished by the issuer or
obtained by S&P from other sources it considers reliable. S&P does not perform
an audit in connection with any rating and may, on occasion, rely on unaudited
financial information. The ratings may be changed, suspended, or withdrawn as
a result of changes in, or unavailability of, such information, or for other
circumstances.
The ratings are based, in varying degrees,
on the following considerations:
1. Likelihood of default -- capacity and willingness of the
obligor as to the timely payment of interest and repayment
of principal in accordance with the terms of the
obligation.
2. Nature of and provisions of the obligation.
3. Protection afforded by, and relative position of, the
obligation in the event of bankruptcy, reorganization, or
other arrangement under the laws of bankruptcy and other
laws affecting creditors' rights.
INVESTMENT GRADE
AAA Debt rated 'AAA' has the highest rating assigned by Standard & Poor's.
Capacity to pay interest and repay principal is extremely strong.
AA Debt rated 'AA' has a very strong capacity to pay interest and repay
principal and differs from the highest rated issues only in small degree.
A Debt rated 'A' has a strong capacity to pay interest and repay principal
although it is somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions than debt in higher rated categories.
BBB Debt rated 'BBB' is regarded as having an adequate capacity to pay
interest and repay principal. Whereas it normally exhibits adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal for
debt in this category than in higher rated categories.
SPECULATIVE GRADE
Debt rated 'BB', 'B', 'CCC', 'CC' and 'C' is regarded as having
predominantly speculative characteristics with respect to capacity to pay
interest and repay principal. 'BB' indicates the least degree of speculation
and 'C' the highest. While such debt will likely have some quality and
protective characteristics, these are outweighed by large uncertainties or
major risk exposures to adverse conditions.
BB Debt rated 'BB' has less near-term vulnerability to default than other
speculative issues. However, it faces major ongoing uncertainties or exposure
to adverse business, financial, or economic conditions which could lead to
inadequate capacity to meet timely interest and principal payments. The 'BB'
rating category is also used for debt subordinated to senior debt that is
assigned an actual or implied 'BBB-' rating.
A-1
<PAGE> 37
B Debt rated 'B' has a greater vulnerability to default but currently has
the capacity to meet interest payments and principal repayments. Adverse
business, financial, or economic conditions will likely impair capacity or
willingness to pay interest and repay principal. The 'B' rating category is
also used for debt subordinated to senior debt that is assigned an actual or
implied 'BB' or 'BB-' rating.
CCC Debt rated 'CCC' has a currently identifiable vulnerability to
default, and is dependent upon favorable business, financial, and economic
conditions to meet timely payment of interest and repayment of principal. In
the event of adverse business, financial, or economic conditions, it is not
likely to have the capacity to pay interest and repay principal. The 'CCC'
rating category is also used for debt subordinated to senior debt that is
assigned an actual or implied 'B' or 'B-' rating.
CC Debt rated 'CC' typically is applied to debt subordinated to senior
debt that is assigned an actual or implied 'CCC' rating.
C Debt rated 'C' typically is applied to debt subordinated to senior debt
which is assigned an actual or implied 'CCC-' debt rating. The 'C' rating may
be used to cover a situation where a bankruptcy petition has been filed, but
debt service payments are continued.
CI The rating 'CI' is reserved for income bonds on which no interest is
being paid.
D Debt rated 'D' is in payment default. The 'D' rating category is used
when interest payments or principal payments are not made on the date due even
if the applicable grace period has not expired, unless S&P believes that such
payments will be made during such grade period. The 'D' rating also will be
used upon the filing of a bankruptcy petition if debt service payments are
jeopardized.
MOODY'S LONG-TERM DEBT RATINGS
Aaa - Bonds which are rated Aaa are judged to be of the best quality.
They carry the smallest degree of investment risk and are generally referred to
as "gilt edged". Interest payments are protected by a large or by an
exceptionally stable margin and principal is secure. While the various
protective elements are likely to change, such changes as can be visualized are
most unlikely to impair the fundamentally strong position of such issues.
Aa - Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are generally known
as high grade bonds. They are rated lower than the best bonds because margins
of protection may not be as large as in Aaa securities or fluctuation of
protective elements may be of greater amplitude or there may be other elements
present which make the long-term risk appear somewhat larger than in Aaa
securities.
A - Bonds which are rated A possess many favorable investment attributes
and are to be considered as upper-medium grade obligations. Factors giving
security to principal and interest are considered adequate, but elements may be
present which suggest a susceptibility to impairment some time in the future.
Baa - Bonds which are rated Baa are considered as medium-grade obligations
(i.e., they are neither highly protected nor poorly secured). Interest
payments and principal security appear adequate for the present but certain
protective elements may be lacking or may be characteristically unreliable over
any great length of time. Such Bonds lack outstanding investment
characteristics and in fact have speculative characteristics as well.
Ba - Bonds which are rated Ba are judged to have speculative elements;
their future cannot be considered as well-assured. Often the protection of
interest and principal payments may be very moderate, and thereby not well
safeguarded during both good and bad times over the future. Uncertainty of
position characterizes Bonds in this class.
B - Bonds which are rated B generally lack characteristics of the
desirable investment. Assurance of interest and principal payments or of
maintenance of other terms of the contract over any long period of time may be
small.
A-2
<PAGE> 38
Caa - Bonds which are rated Caa are of poor standing. Such issues may be
in default or there may be present elements of danger with respect to principal
or interest.
Ca - Bonds which are rated Ca represent obligations which are speculative
in a high degree. Such issues are often in default or have other marked
shortcomings.
C - Bonds which are rated C are the lowest rated class of bonds, and
issues so rated can be regarded as having extremely poor prospects of ever
attaining any real investment standing.
FITCH INVESTORS SERVICE, INC. BOND RATINGS
Fitch investment grade bond ratings provide a guide to investors in
determining the credit risk associated with a particular security. The ratings
represent Fitch's assessment of the issuer's ability to meet the obligations of
a specific debt issue or class of debt in a timely manner.
The rating takes into consideration special features of the issue, its
relationship to other obligations of the issuer, the current and prospective
financial condition and operating performance of the issuer and any guarantor,
as well as the economic and political environment that might affect the
issuer's future financial strength and credit quality.
Fitch ratings do not reflect any credit enhancement that may be provided
by insurance policies or financial guaranties unless otherwise indicated.
Bonds that have the same rating are of similar but not necessarily
identical credit quality since the rating categories do not fully reflect small
differences in the degrees of credit risk.
Fitch ratings are not recommendations to buy, sell, or hold any security.
Ratings do not comment on the adequacy of market price, the suitability of any
security for a particular investor, or the tax-exempt nature or taxability of
payments made in respect of any security.
Fitch ratings are based on information obtained from issuers, other
obligors, underwriters, their experts, and other sources Fitch believes to be
reliable. Fitch does not audit or verify the truth or accuracy of such
information. Ratings may be changed, suspended, or withdrawn as a result of
changes in, or the unavailability of, information or for other reasons.
AAA Bonds considered to be investment grade and of the highest credit
quality. The obligor has an exceptionally strong ability to pay
interest and repay principal, which is unlikely to be affected by
reasonably foreseeable events.
AA Bonds considered to be investment grade and of very high credit
quality. The obligor's ability to pay interest and repay principal
is very strong, although not quite as strong as bonds rated 'AAA'.
Because bonds rated in the 'AAA' and 'AA' categories are not
significantly vulnerable to foreseeable future developments,
short-term debt of the issuers is generally rated 'F-1+'.
A Bonds considered to be investment grade and of high credit quality.
The obligor's ability to pay interest and repay principal is
considered to be strong, but may be more vulnerable to adverse
changes in economic conditions and circumstances than bonds with
higher ratings.
BBB Bonds considered to be investment grade and of satisfactory credit
quality. The obligor's ability to pay interest and repay principal
is considered to be adequate. Adverse changes in economic
conditions and circumstances, however, are more likely to have
adverse impact on these bonds, and therefore impair timely payment.
The likelihood that the ratings of these bonds will fall below
investment grade is higher than for bonds with higher ratings.
A-3
<PAGE> 39
Fitch speculative grade bond ratings provide a guide to investors in
determining the credit risk associated with a particular security. The ratings
('BB' to 'C') represent Fitch's assessment of the likelihood of timely payment
of principal and interest in accordance with the terms of obligation for bond
issues not in default. For defaulted bonds, the rating ('DDD' to 'D') is an
assessment of the ultimate recovery value through reorganization or
liquidation.
The rating takes into consideration special features of the issue, its
relationship to other obligations of the issuer, the current and prospective
financial condition and operating performance of the issuer and any guarantor,
as well as the economic and political environment that might affect the
issuer's future financial strength.
Bonds that have the same rating are of similar but not necessarily
identical credit quality since the rating categories cannot fully reflect the
differences in the degrees of credit risk. Moreover, the character of the risk
factor varies from industry to industry and between corporate, health care and
municipal obligations.
BB Bonds are considered speculative. The obligor's ability to pay
interest and repay principal may be affected over time by adverse
economic changes. However, business and financial alternatives
can be identified which could assist the obligor in satisfying
its debt service requirements.
B Bonds are considered highly speculative. While bonds in this
class are currently meeting debt service requirements, the
probability of continued timely payment of principal and interest
reflects the obligor's limited margin of safety and the need for
reasonable business and economic activity throughout the life of
the issue.
CCC Bonds have certain identifiable characteristics which, if not
remedied, may lead to default. The ability to meet obligations
requires an advantageous business and economic environment.
CC Bonds are minimally protected. Default in payment of interest
and/or principal seems probable over time.
C Bonds are in imminent default in payment of interest or principal.
DDD, DD,
and D Bonds are in default on interest and/or principal payments.
Such bonds are extremely speculative and should be valued on
the basis of their ultimate recovery value in liquidation or
reorganization of the obligor. 'DDD' represents the highest
potential for recovery of these bonds, and 'D' represents the
lowest potential for recovery.
DUFF & PHELPS, INC. LONG-TERM DEBT RATINGS
These ratings represent a summary opinion of the issuer's long-term
fundamental quality. Rating determination is based on qualitative and
quantitative factors which may vary according to the basic economic and
financial characteristics of each industry and each issuer. Important
considerations are vulnerability to economic cycles as well as risks related to
such factors as competition, government action, regulation, technological
obsolescence, demand shifts, cost structure, and management depth and
expertise. The projected viability of the obligor at the trough of the cycle
is a critical determination.
Each rating also takes into account the legal form of the security, (e.g.,
first mortgage bonds, subordinated debt, preferred stock, etc.). The extent of
rating dispersion among the various classes of securities is determined by
several factors including relative weightings of the different security classes
in the capital structure, the overall credit strength of the issuer, and the
nature of covenant protection. Review of indenture restrictions is important
to the analysis of a company's operating and financial constraints.
The Credit Rating Committee formally reviews all ratings once per quarter
(more frequently, if necessary). Ratings of 'BBB-' and higher fall within the
definition of investment grade securities, as defined by bank and insurance
supervisory authorities.
A-4
<PAGE> 40
<TABLE>
<CAPTION>
RATING SCALE DEFINITION
<S> <C>
- -----------------------------------------------------------------------------------------------------------
AAA Highest credit quality. The risk factors are negligible, being only slightly more
than for risk-free U.S. Treasury debt.
- -----------------------------------------------------------------------------------------------------------
AA+ High credit quality. Protection factors are strong. Risk is modest, but may
AA vary slightly from time to time because of economic conditions.
AA-
- -----------------------------------------------------------------------------------------------------------
A+ Protection factors are average but adequate. However, risk factors are more
A variable and greater in periods of economic stress.
A-
- -----------------------------------------------------------------------------------------------------------
BBB+ Below average protection factors but still considered sufficient for prudent
BBB investment. Considerable variability in risk during economic cycles.
BBB-
- -----------------------------------------------------------------------------------------------------------
BB+ Below investment grade but deemed likely to meet obligations when due.
BB Present or prospective financial protection factors fluctuate according to
BB- industry conditions or company fortunes. Overall quality may move up or
down frequently within this category.
- -----------------------------------------------------------------------------------------------------------
B+ Below investment grade and possessing risk that obligations will not be met
B when due. Financial protection factors will fluctuate widely according to
B- economic cycles, industry conditions and/or company fortunes. Potential
exists for frequent changes in the rating within this category or into a higher
or lower rating grade.
- -----------------------------------------------------------------------------------------------------------
CCC Well below investment grade securities. Considerable uncertainty exists as to
timely payment of principal, interest or preferred dividends.
Protection factors are narrow and risk can be substantial with unfavorable
economic/industry conditions, and/or with unfavorable company developments.
- -----------------------------------------------------------------------------------------------------------
DD Defaulted debt obligations. Issuer failed to meet scheduled principal and/or
interest payments.
DP Preferred stock with dividend arrearages.
- -----------------------------------------------------------------------------------------------------------
</TABLE>
A-5
<PAGE> 41
SHORT-TERM RATINGS
STANDARD & POOR'S COMMERCIAL PAPER RATINGS
A Standard & Poor's commercial paper rating is a current assessment of
the likelihood of timely payment of debt considered short-term in the relevant
market.
Ratings graded into several categories, ranging from 'A-1' for the
highest quality obligations to 'D' for the lowest. These categories are as
follows:
A-1 This highest category indicates that the degree of safety regarding
timely payment is strong. Those issues determined to possess extremely strong
safety characteristics are denoted with a plus sign (+) designation.
A-2 Capacity for timely payment on issues with this designation is
satisfactory. However, the relative degree of safety is not as high as for
issues designated 'A-1'.
A-3 Issues carrying this designation have adequate capacity for timely
payment. They are, however, more vulnerable to the adverse effects of changes
in circumstances than obligations carrying the higher designations.
B Issues rated 'B' are regarded as having only speculative capacity for
timely payment.
C This rating is assigned to short-term debt obligations with doubtful
capacity for payment.
D Debt rated 'D' is in payment default. The 'D' rating category is used
when interest payments or principal payments are not made on the date due, even
if the applicable grace period has not expired, unless S&P believes that such
payments will be made during such grace period.
MOODY'S COMMERCIAL PAPER RATINGS
The term "commercial paper" as used by Moody's means promissory
obligations not having an original maturity in excess of nine months. Moody's
makes no representation as to whether such commercial paper is by any other
definition "commercial paper" or is exempt from registration under the
Securities Act of 1933, as amended.
Moody's commercial paper ratings are opinions of the ability of issuers
to repay punctually promissory obligations not having an original maturity in
excess of nine months. Moody's makes no representation that such obligations
are exempt from registration under the Securities Act of 1933, nor does it
represent that any specific note is a valid obligation of a rated issuer or
issued in conformity with any applicable law. Moody's employs the following
three designations, all judged to be investment grade, to indicate the relative
repayment capacity of rated issuers:
Issuers rated PRIME-1 (for related supporting institutions) have a
superior capacity for repayment of short-term promissory obligations. Prime-1
repayment capacity will normally be evidenced by the following characteristics:
(i) leading market positions in well established industries, (ii) high rates of
return on funds employed, (iii) conservative capitalization structures with
moderate reliance on debt and ample asset protection, (iv) broad margins in
earnings coverage of fixed financial charges and high internal cash generation,
and (v) well established access to a range of financial markets and assured
sources of alternate liquidity.
Issuers rated PRIME-2 (or related supporting institutions) have a strong
capacity for repayment of short-term promissory obligations. This will
normally be evidenced by many of the characteristics cited above, but to a
lesser degree. Earnings trends and coverage ratios, while sound, will be more
subject to variation. Capitalization characteristics, while still appropriate,
may be more affected by external conditions. Ample alternate liquidity is
maintained.
A-6
<PAGE> 42
Issuers rated PRIME-3 (or related supporting institutions) have an
acceptable capacity for repayment of short-term promissory obligations. The
effect of industry characteristics and market composition may be more
pronounced. Variability in earnings and profitability may result in changes in
the level of debt protection measurements and the requirement for relatively
high financial leverage. Adequate alternate liquidity is maintained.
Issuers rated NOT PRIME do not fall within any of the Prime rating
categories.
FITCH INVESTORS SERVICE, INC. SHORT-TERM RATINGS
Fitch's short-term ratings apply to debt obligations that are payable on
demand or have original maturities of generally up to three years, including
commercial paper, certificates of deposit, medium-term notes, and municipal and
investment notes.
The short-term rating places greater emphasis than a long-term rating on
the existence of liquidity necessary to meet the issuer's obligations in a
timely manner.
F-1+ (Exceptionally Strong Credit Quality) Issues assigned this rating
are regarded as having the strongest degree of assurance for timely
payment.
F-1 (Very Strong Credit Quality) Issues assigned this rating reflect an
assurance of timely payment only slightly less in degree than issues
rated 'F-1+'.
F-2 (Good Credit Quality) Issues assigned this rating have a
satisfactory degree of assurance for timely payment but the margin
of safety is not as great as for issues assigned 'F-1+' and 'F-1'
ratings.
F-3 (Fair Credit Quality) Issues assigned this rating have
characteristics suggesting that the degree of assurance for timely
payment is adequate, however, near-term adverse changes could cause
these securities to be rated below investment grade.
F-S (Weak Credit Quality) Issues assigned this rating have
characteristics suggesting a minimal degree of assurance for timely
payment and are vulnerable to near-term adverse changes in financial
and economic conditions.
D (Default) Issues assigned this rating are in actual or imminent
payment default.
LOC The symbol LOC indicates that the rating is based on a letter of
credit issued by a commercial bank.
DUFF & PHELPS, INC. SHORT-TERM DEBT RATINGS
Duff & Phelps' short-term ratings are consistent with the rating criteria
utilized by money market participants. The ratings apply to all obligations
with maturities of under one year, including commercial paper, the uninsured
portion of certificates of deposit, unsecured bank loans, master notes, bankers
acceptances, irrevocable letters of credit, and current maturities of long-term
debt. Asset-backed commercial paper is also rated according to this scale.
Emphasis is placed on liquidity which we define as not only cash from
operations, but also access to alternative sources of funds including trade
credit, bank lines, and the capital markets. An important consideration is the
level of an obligor's reliance on short-term funds on an ongoing basis.
A-7
<PAGE> 43
Rating Scale: Definition
Duff 1+ Highest certainty of timely payment. Short-term liquidity,
including internal operating factors and/or access to
alternative sources of funds, is outstanding, and safety is
just below risk-free U.S. Treasury short-term obligations.
Duff 1 Very high certainty of timely payment. Liquidity factors are
excellent and supported by good fundamental protection
factors. Risk factors are minor.
Duff 1- High certainty of timely payment. Liquidity factors are
strong and supported by good fundamental protection factors.
Risk factors are very small.
Good Grade
Duff 2 Good certainty of timely payment. Liquidity factors and
company fundamentals are sound. Although ongoing funding
needs may enlarge total financing requirements, access to
capital markets is good. Risk factors are small.
Satisfactory Grade
Duff 3 Satisfactory liquidity and other protection factors qualify
issue as to investment grade. Risk factors are larger and
subject to more variation. Nevertheless, timely payment is
expected.
Non-investment Grade
Duff 4 Speculative investment characteristics. Liquidity is not
sufficient to insure against disruption in debt service.
Operating factors and market access may be subject to a high
degree of variation.
Default
Duff 5 Issuer failed to meet scheduled principal and/or
interest payments.
A-8
