STATEMENT OF ADDITIONAL INFORMATION
ICAP FUNDS, INC.
ICAP Discretionary Equity Portfolio
ICAP Equity Portfolio
225 West Wacker Drive, Suite 2400
Chicago, Illinois 60606
1-800-645-2457
This Statement of Additional Information is not a prospectus
and should be read in conjunction with the Prospectus of ICAP
Funds, Inc. (the "Company"), dated December 31, 1994. Requests
for copies of the Prospectus should be made by writing to the
Company at the address listed above; or by calling 1-800-645-2457.
This Statement of Additional Information is dated December 31, 1994, as
supplemented through November 27, 1995.
<PAGE>
ICAP FUNDS, INC.
TABLE OF CONTENTS
Page No.
INVESTMENT RESTRICTIONS . . . . . . . . . . . . . . . . . . . . . . . . . 4
INVESTMENT POLICIES AND TECHNIQUES . . . . . . . . . . . . . . . . . . . 6
Illiquid Securities . . . . . . . . . . . . . . . . . . . . . . . . . 6
Short-Term Fixed Income Securities . . . . . . . . . . . . . . . . . . 6
Short Sales Against the Box . . . . . . . . . . . . . . . . . . . . . 8
Warrants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
When-Issued Securities . . . . . . . . . . . . . . . . . . . . . . . . 8
Unseasoned Companies . . . . . . . . . . . . . . . . . . . . . . . . . 9
Non-Investment Grade Debt Securities "Junk Bonds" . . . . . . . . . . 9
Hedging Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . 11
General Description of Hedging Strategies . . . . . . . . . . . . . 11
General Limitations on Futures and Options Transactions . . . . . . 11
Asset Coverage for Futures and Options Positions . . . . . . . . . 11
Stock Index Options . . . . . . . . . . . . . . . . . . . . . . . . 12
Certain Considerations Regarding Options . . . . . . . . . . . . . 12
Federal Tax Treatment of Options . . . . . . . . . . . . . . . . . 13
Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . 13
Options on Futures . . . . . . . . . . . . . . . . . . . . . . . . 15
Federal Tax Treatment of Futures Contracts . . . . . . . . . . . . 16
DIRECTORS AND OFFICERS . . . . . . . . . . . . . . . . . . . . . . . . .16
PRINCIPAL SHAREHOLDERS . . . . . . . . . . . . . . . . . . . . . . . . .18
INVESTMENT ADVISER . . . . . . . . . . . . . . . . . . . . . . . . . . .19
PORTFOLIO TRANSACTIONS AND BROKERAGE . . . . . . . . . . . . . . . . . .20
CUSTODIAN . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22
TRANSFER AGENT AND DIVIDEND-DISBURSING AGENT . . . . . . . . . . . . . .22
TAXES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22
DETERMINATION OF NET ASSET VALUE . . . . . . . . . . . . . . . . . . . .22
SHAREHOLDER MEETINGS . . . . . . . . . . . . . . . . . . . . . . . . . .23
<PAGE>
PERFORMANCE INFORMATION . . . . . . . . . . . . . . . . . . . . . . . . .24
INDEPENDENT ACCOUNTANTS . . . . . . . . . . . . . . . . . . . . . . . . .25
FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . . . . . . . . . .26
APPENDIX A - BOND RATINGS . . . . . . . . . . . . . . . . . . . . . . . .A-1
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 December 31, 1994, and if given or made,
such information or representations may not be relied upon as having been
authorized by the Company.
This Statement of Additional Information does not constitute an offer to
sell securities.
<PAGE>
INVESTMENT RESTRICTIONS
The investment objective of both the ICAP Discretionary Equity Portfolio
(the "Discretionary Equity Portfolio") and the ICAP Equity Portfolio (the
"Equity Portfolio") (hereinafter collectively referred to as the "Portfolios")
is to seek a superior total return with only a moderate degree of risk. This
investment objective is relative to and measured against the Standard & Poor's
500 ("S&P 500"). The investment objective and policies of each Portfolio are
described in detail in the Prospectus under the captions "DISCRETIONARY EQUITY
PORTFOLIO" and "EQUITY PORTFOLIO." The following is a complete list of each
Portfolio's fundamental investment limitations which cannot be changed without
shareholder approval.
Neither Portfolio may:
1. With respect to 75% of its total assets, purchase securities
of any issuer (except securities issued or guaranteed by the U.S.
government or any agency or instrumentality thereof) if, as a result,
(i) more than 5% of the Portfolio's total assets would be invested in
the securities of that issuer, or (ii) the Portfolio would hold more
than 10% of the outstanding voting securities of that issuer.
2. Borrow money, except that the Portfolio may (i) borrow money
from banks for temporary or emergency purposes (but not for leverage or
the purchase of investments) and (ii) make other investments or engage
in other transactions permissible under the Investment Company Act of
1940 which may involve a borrowing, provided that the combination of (i)
and (ii) shall not exceed 33 1/3% of the value of the Portfolio's total
assets (including the amount borrowed), less the Portfolio's liabilities
(other than borrowings).
3. Act as an underwriter of another issuer's securities, except
to the extent that the Portfolio 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.
4. Make loans to other persons, except through (i) the purchase
of debt securities permissible under the Portfolio's investment
policies, (ii) repurchase agreements, or (iii) the lending of portfolio
securities, provided that no such loan of portfolio securities may be
made by the Portfolio if, as a result, the aggregate of such loans would
exceed 33 1/3% of the value of the Portfolio's total assets.
5. Purchase or sell physical commodities unless acquired as a
result of ownership of securities or other instruments (but this shall
not prevent the Portfolio from purchasing or selling options, futures
contracts, or other derivative instruments, or from investing in
securities or other instruments backed by physical commodities).
6. Purchase or sell real estate unless acquired as a result of
ownership of securities or other instruments (but this shall not
prohibit the Portfolio from purchasing or selling securities or other
instruments backed by real estate or of issuers engaged in real estate
activities).
7. Issue senior securities, except as permitted under the
Investment Company Act of 1940.
8. Purchase the securities of any issuer if, as a result, more
than 25% of the Portfolio's total assets would be invested in the
securities of issuers whose principal business activities are in the
same industry.
<PAGE>
With the exception of the investment restriction set out in item 2
above, if a percentage restriction is adhered to at the time of investment, a
later increase in percentage resulting from a change in market value of the
investment or the total assets will not constitute a violation of that
restriction.
The following investment policies may be changed by the Board of
Directors of the Company (the "Board of Directors") without shareholder
approval.
Neither Portfolio may:
1. Sell securities short, unless the Portfolio owns or has the
right to obtain securities equivalent in kind and amount to the
securities sold short, and provided that transactions in options,
futures 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 Portfolio 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. Pledge, mortgage or hypothecate any assets owned by the
Portfolio 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 Portfolio's total assets at
the time of the borrowing or investment.
4. 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
predecessors 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.
5. Invest in illiquid securities if, as a result of such
investment, more than 5% of the Portfolio's net assets would be invested
in illiquid securities.
6. Purchase securities of open-end or closed-end investment
companies except in compliance with the Investment Company Act and
applicable state law.
7. Enter into futures contracts or related options if more than
30% of the Portfolio's net assets would be represented by futures
contracts or more than 5% of the Portfolio's net assets would be
committed to initial margin deposits and premiums on futures contracts
and related options.
8. Invest in direct interests in oil, gas or other mineral
exploration programs or leases; however, the Portfolio may invest in the
securities of issuers that engage in these activities.
9. Purchase securities when borrowings exceed 5% of its total
assets.
<PAGE>
INVESTMENT POLICIES AND TECHNIQUES
The following information supplements the discussion of the Portfolios'
investment objectives, policies, and techniques that are described in the
Prospectus under the captions "DISCRETIONARY EQUITY PORTFOLIO," "EQUITY
PORTFOLIO," and "INVESTMENT TECHNIQUES AND RISKS."
Illiquid Securities
The Portfolios may invest in illiquid securities (i.e., securities that
are not readily marketable). For purposes of this restriction, illiquid
securities include, but are not limited to, restricted securities (securities
the disposition of which is restricted under the federal securities laws),
securities which may be resold pursuant to Rule 144A under the Securities Act
of 1933, as amended (the "Securities Act"), and repurchase agreements with
maturities in excess of seven days. However, neither Portfolio will acquire
illiquid securities if, as a result, such securities would comprise more than
5% of the value of the Portfolio's net assets. The Board of Directors or its
delegate has the ultimate authority to determine, to the extent permissible
under the federal securities laws, which securities are liquid or illiquid for
purposes of this 5% limitation. The Board of Directors has delegated to
Institutional Capital Corporation ("ICAP") the day-to-day determination of the
liquidity of any security, although it has retained oversight and ultimate
responsibility for such determinations. Although no definitive liquidity
criteria are used, the Board of Directors has directed ICAP 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, a Portfolio 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 Portfolio may be permitted to sell a security under
an effective registration statement. If, during such a period, adverse market
conditions were to develop, the Portfolio might obtain a less favorable price
than that which prevailed when it decided to sell. Restricted securities will
be priced at fair value as determined in good faith by the Board of Directors.
If, through the appreciation of restricted securities or the depreciation of
unrestricted securities, a Portfolio should be in a position where more than
5% of the value of its net assets are invested in illiquid securities,
including restricted securities which are not readily marketable, the affected
Portfolio will take such steps as is deemed advisable, if any, to protect
liquidity.
Short-Term Fixed Income Securities
The Discretionary Equity Portfolio may invest up to 35% of its total
assets and, for defensive, temporary purposes up to 100% of its total assets,
in short-term fixed income securities, defined below. The Equity Portfolio
intends to be fully invested at all times and accordingly will only hold
short-term fixed income securities to meet anticipated redemption requests and
pay expenses which, in any case, generally will not exceed 5% of its total
assets. The Equity Portfoio may, however, temporarily exceed this 5%
limitation, but only in circumstances pending investment and only for short
periods of time. Short-term fixed income securities are defined to include
without limitation, the following:
1. U.S. government securities, including bills, notes and bonds
differing as to maturity and rates of interest, which are either issued
or guaranteed by the U.S. Treasury or by U.S. government agencies or
instrumentalities. U.S. government agency securities include securities
issued by (a) the Federal Housing Administration, Farmers Home
Administration, Export-Import Bank of the United States, Small
<PAGE>
Business
Administration, and the Government National Mortgage Association, whose
securities are supported by the full faith and credit of the United
States; (b) the Federal Home Loan Banks, Federal Intermediate Credit
Banks, and the Tennessee Valley Authority, whose securities are
supported by the right of the agency to borrow from the U.S. Treasury;
(c) the Federal National Mortgage Association, whose securities are
supported by the discretionary authority of the U.S. government to
purchase certain obligations of the agency or instrumentality; and (d)
the Student Loan Marketing Association, whose securities are supported
only by its credit. While the U.S. government provides financial
support to such U.S. government-sponsored agencies or instrumentalities,
no assurance can be given that it always will do so since it is not so
obligated by law. The U.S. government, its agencies, and
instrumentalities do not guarantee the market value of their securities,
and consequently, the value of such securities may fluctuate.
2. Certificates of Deposit issued against funds deposited in a
bank or savings and loan association. Such certificates are for a
definite period of time, earn a specified rate of return, and are
normally negotiable. If such certificates of deposit are non-
negotiable, they will be considered illiquid securities and be subject
to the Portfolios' 5% restriction on investments in illiquid securities.
Pursuant to the certificate of deposit, the issuer agrees to pay the
amount deposited plus interest to the bearer of the certificate on the
date specified thereon. Under current FDIC regulations, the maximum
insurance payable as to any one certificate of deposit is $100,000;
therefore, certificates of deposit purchased by a Portfolio may not be
fully insured.
3. Bankers' acceptances which are short-term credit instruments
used to finance commercial transactions. Generally, an acceptance is a
time draft drawn on a bank by an exporter or an importer to obtain a
stated amount of funds to pay for specific merchandise. The draft is
then "accepted" by a bank that, in effect, unconditionally guarantees to
pay the face value of the instrument on its maturity date. The
acceptance may then be held by the accepting bank as an asset or it may
be sold in the secondary market at the going rate of interest for a
specific maturity.
4. Repurchase agreements which involve purchases of debt
securities. In such an action, at the time a Portfolio purchases the
security, it simultaneously agrees to resell and redeliver the security
to the seller, who also simultaneously agrees to buy back the security
at a fixed price and time. This assures a predetermined yield for the
Portfolio during its holding period since the resale price is always
greater than the purchase price and reflects an agreed-upon market rate.
Such actions afford an opportunity for the Portfolio to invest
temporarily available cash. The Portfolios may enter into repurchase
agreements only with respect to obligations of the U.S. government, its
agencies or instrumentalities; certificates of deposit; or bankers
acceptances in which the Portfolios may invest. Repurchase agreements
may be considered loans to the seller, collateralized by the underlying
securities. The risk to the Portfolios is limited to the ability of the
seller to pay the agreed-upon sum on the repurchase date; in the event
of default, the repurchase agreement provides that the affected
Portfolio is entitled to sell the underlying collateral. If the value
of the collateral declines after the agreement is entered into, however,
and if the seller defaults under a repurchase agreement when the value
of the underlying collateral is less than the repurchase price, the
Portfolio could incur a loss of both principal and interest. ICAP
monitors the value of the collateral at the time the action is entered
into and at all times during the term of the repurchase agreement. ICAP
does so in an effort to determine that the value of the collateral
always equals or exceeds the agreed-upon repurchase price to be paid to
the Portfolio. If the seller were to be subject to a federal bankruptcy
proceeding, the ability of a Portfolio to liquidate the collateral could
be delayed or impaired because of certain provisions of the bankruptcy
laws.
<PAGE>
5. Bank time deposits, which are monies kept on deposit with
banks or savings and loan associations for a stated period of time at a
fixed rate of interest. There may be penalties for the early withdrawal
of such time deposits, in which case the yields of these investments
will be reduced.
6. Commercial paper, which are short-term unsecured promissory
notes, including variable rate master demand notes issued by
corporations to finance their current operations. Master demand notes
are direct lending arrangements between a Portfolio and a corporation.
There is no secondary market for the notes. However, they are
redeemable by the Portfolios at any time. ICAP will consider the
financial condition of the corporation (e.g., earning power, cash flow,
and other liquidity ratios) and will continuously monitor the
corporation's ability to meet all of its financial obligations, because
a Portfolio's liquidity might be impaired if the corporation were unable
to pay principal and interest on demand. Investments in commercial
paper will be limited to commercial paper rated in the two highest
categories by a major rating agency or unrated commercial paper which
is, in the opinion of ICAP, of comparable quality.
Short Sales Against the Box
When ICAP believes that the price of a particular security held by a
Portfolio may decline, it may make "short sales against the box" to hedge the
unrealized gain on such security. Selling short against the box involves
selling a security which the Portfolio owns for delivery at a specified date
in the future. Each Portfolio will limit its transactions in short sales
against the box to 5% of its net assets. In addition, each Portfolio will
limit its transactions such that the value of the securities of any issuer in
which it is short will not exceed the lesser of 2% of the value of the
Portfolio's net assets or 2% of the securities of any class of the issuer.
If, for example, a Portfolio bought 100 shares of ABC at $40 per share in
January and the price appreciates to $50 in March, the Portfolio might "sell
short" the 100 shares at $50 for delivery the following July. Thereafter, if
the price of the stock declines to $45, it will realize the full $1,000 gain
rather than the $500 gain it would have received had it sold the stock in the
market. On the other hand, if the price appreciates to $55 per share, the
Portfolio would be required to sell at $50 and thus receive a $1,000 gain
rather than the $1,500 gain it would have received had it sold the stock in
the market. The Portfolios may also be required to pay a premium for short
sales which would partially offset any gain.
Warrants
Each Portfolio may invest in warrants if, after giving effect thereto,
not more than 5% of its net assets will be invested in warrants other than
warrants acquired in units or attached to other securities. Of such 5%, not
more than 2% of its assets at the time of purchase may be invested in warrants
that are not listed on the New York Stock Exchange or the American Stock
Exchange. Investing in warrants is purely speculative in that they have no
voting rights, pay no dividends, and have no rights with respect to the assets
of the corporation issuing them. Warrants basically are options to purchase
equity securities at a specific price for a specific period of time. They do
not represent ownership of the securities but only the right to buy them.
Warrants are issued by the issuer of the security, which may be purchased on
their exercise. The prices of warrants do not necessarily parallel the prices
of the underlying securities.
When-Issued Securities
The Portfolios may from time to time purchase securities on a "when-
issued" basis. The price of securities purchased on a when-issued basis is
fixed at the time the commitment to purchase is made, but delivery and payment
for the securities take place at a later date. Normally, the settlement date
occurs within 45 days of the purchase. During the period between the purchase
and settlement, no payment is made by the Portfolios to the issuer and no
<PAGE>
interest is accrued on debt securities or dividend income is earned on equity
securities. 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 Portfolios' other assets.
While when-issued securities may be sold prior to the settlement date, the
Portfolios intend to purchase such securities with the purpose of actually
acquiring them. At the time a Portfolio 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 Portfolios
do not believe that net asset value will be adversely affected by purchases of
securities on a when-issued basis.
The Portfolios will maintain cash, U.S. government securities and high
grade liquid debt 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, each Portfolio will meet its obligations 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 Portfolio's payment
obligation).
Unseasoned Companies
Neither Portfolio may invest more than 5% of its net assets in
unseasoned companies. While smaller companies generally have potential for
rapid growth, they often involve higher risks because they lack the management
experience, financial resources, product diversification, and competitive
strengths of larger corporations. In addition, in many instances, the
securities of smaller companies are traded only over-the-counter or on
regional securities exchanges, 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 wider price fluctuations.
When making large sales, the Portfolios may have to sell portfolio holdings of
small companies at discounts from quoted prices or may have to make a series
of smaller sales over an extended period of time due to the trading volume in
smaller company securities.
Non-Investment Grade Debt Securities "Junk Bonds"
The Portfolios may invest up to 5% of their assets in junk bonds. Junk
bonds 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 investments in these securities
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 junk bond market is
relatively new and its growth has paralleled a long economic expansion. As a
result, it is not clear how this market may withstand a prolonged recession or
economic downturn. Such an 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 junk bond 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. Junk bond
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 junk bond securities may experience financial stress and may not
have sufficient revenues to meet their payment obligations. The risk of loss
due to default by an issuer of these securities is significantly greater than
issuers of higher-rated
<PAGE>
securities because such securities are generally
unsecured and are often subordinated to other creditors. Further, if the
issuer of a junk bond security defaulted, a Portfolio 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 these
securities and thus in a Portfolio's net asset value.
As previously stated, the value of a junk bond security will generally
decrease in a rising interest rate market, and accordingly so will a
Portfolio's net asset value. If a Portfolio 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 junk bond securities, a Portfolio may be forced to
liquidate these securities at a substantial discount. Any such liquidation
would reduce a Portfolio's asset base over which expenses could be allocated
and could result in a reduced rate of return for the Portfolio.
Payment Expectations. Junk bond securities typically contain
redemption, call or prepayment provisions which permit the issuer of such
securities containing such provisions to redeem the securities at its
discretion. During periods of falling interest rates, issuers of these
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, a Portfolio may
have to replace the securities with a lower yielding security, which could
result in a lower return for the Portfolio.
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 junk bond 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 junk bond securities will be more dependent on ICAP's credit analysis than
would be the case with investments in investment-grade debt securities. ICAP
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. ICAP continually monitors each
Portfolios' investments and carefully evaluates whether to dispose of or to
retain junk bond securities whose credit ratings or credit quality may have
changed.
Liquidity and Valuation. A Portfolio may have difficulty disposing of
certain junk bond securities because there may be a thin trading market for
such securities. Because not all dealers maintain markets in all junk bond
securities there is no established retail secondary market for many of these
securities. The Portfolios anticipate 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. The
lack of a liquid secondary market for certain securities may also make it more
difficult for a Portfolio to obtain accurate market quotations for purposes of
valuing the Portfolio. Market quotations are generally available on many junk
bond issues 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 junk bond securities, especially in a thinly traded
market.
New 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 junk bond 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 junk bond securities market.
However, it is anticipated that if
<PAGE>
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.
Hedging Strategies
General Description of Hedging Strategies
The Portfolios may engage in hedging activities. ICAP may cause the
Portfolios to utilize a variety of financial instruments, including options,
futures contracts (sometimes referred to as "futures") and options on futures
contracts to attempt to hedge a Portfolio's holdings.
Hedging instruments on securities generally are used to hedge against
price movements in one or more particular securities positions that a
Portfolio owns or intends to acquire. Hedging instruments on stock indices,
in contrast, generally are used to hedge against price movements in broad
equity market sectors in which a Portfolio has invested or expects to invest.
The use of hedging instruments is subject to applicable regulations of the
Securities and Exchange Commission (the "SEC"), the several options and
futures exchanges upon which they are traded, the Commodity Futures Trading
Commission (the "CFTC") and various state regulatory authorities. In
addition, a Portfolio's ability to use hedging instruments will be limited by
tax considerations.
General Limitations on Futures and Options Transactions
The Company 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 Section 4.5 of the regulations under the Commodity Exchange Act
(the "CEA"), the notice of eligibility for the Portfolios includes the
representation that the Portfolios will use futures contracts and related
options solely for bona fide hedging purposes within the meaning of CFTC
regulations, provided that the Portfolios may hold other positions in futures
contracts and related options that do not fall within the definition of bona
fide hedging transactions (i.e., for speculative purposes) if aggregate
initial margins and premiums paid do not exceed 5% of the net asset value of
the respective Portfolios. In addition, neither Portfolio will enter into
futures contracts and options transactions if more than 30% of its net assets
would be committed to such instruments.
The foregoing limitations are not fundamental policies of the Portfolios
and may be changed without shareholder approval as regulatory agencies permit.
Various exchanges and regulatory authorities have undertaken reviews of
options and futures trading in light of market volatility. Among the possible
actions that have been presented are proposals to adopt new or more stringent
daily price fluctuation limits for futures and options transactions and
proposals to increase the margin requirements for various types of futures
transactions.
Asset Coverage for Futures and Options Positions
Each Portfolio will comply with the regulatory requirements of the SEC
and the CFTC with respect to coverage of options and futures positions by
registered investment companies and, if the guidelines so require, will set
aside cash, U.S. government securities, high grade liquid debt securities
and/or other liquid assets permitted by the SEC and CFTC in a segregated
custodial account in the amount prescribed. Securities held in a segregated
account cannot be sold while the futures or options position is outstanding,
unless replaced with other permissible assets, and will be marked-to-market
daily.
<PAGE>
Stock Index Options
Each Portfolio may (i) purchase stock index options for any purpose,
(ii) sell stock index options in order to close out existing positions, and/or
(iii) write covered options on stock indexes for hedging purposes. Stock
index options are put options and call options on various stock indexes. In
most respects, they are identical to listed options on common stocks. The
primary difference between stock options and index options occurs when index
options are exercised. In the case of stock options, the underlying security,
common stock, is delivered. However, upon the exercise of an index option,
settlement does not occur by delivery of the securities comprising the index.
The option holder who exercises the index option receives an amount of cash if
the closing level of the stock index upon which the option is based is greater
than, in the case of a call, or less than, in the case of a put, the exercise
price of the option. This amount of cash is equal to the difference between
the closing price of the stock index and the exercise price of the option
expressed in dollars times a specified multiple.
A stock index fluctuates with changes in the market values of the stocks
included in the index. For example, some stock index options are based on a
broad market index, such as the Standard & Poor's 500 or the Value Line
Composite Index or a narrower market index, such as the Standard & Poor's 100.
Indexes may also be based on an industry or market segment, such as the AMEX
Oil and Gas Index or the Computer and Business Equipment Index. Options on
stock indexes are currently traded on the following exchanges: the Chicago
Board Options Exchange, the New York Stock Exchange, the American Stock
Exchange, the Pacific Stock Exchange, and the Philadelphia Stock Exchange.
A Portfolio's use of stock index options is subject to certain risks.
Successful use by the Portfolios of options on stock indexes will be subject
to the ability of the ICAP to correctly predict movements in the directions of
the stock market. This requires different skills and techniques than
predicting changes in the prices of individual securities. In addition, a
Portfolio's ability to effectively hedge all or a portion of the securities in
its portfolio, in anticipation of or during a market decline through
transactions in put options on stock indexes, depends on the degree to which
price movements in the underlying index correlate with the price movements of
the securities held by a Portfolio. Inasmuch as a Portfolio's securities will
not duplicate the components of an index, the correlation will not be perfect.
Consequently, each Portfolio will bear the risk that the prices of its
securities being hedged will not move in the same amount as the prices of its
put options on the stock indexes. It is also possible that there may be a
negative correlation between the index and a Portfolio's securities which
would result in a loss on both such securities and the options on stock
indexes acquired by the Portfolio.
The hours of trading for options may not conform to the hours during
which the underlying securities are traded. To the extent that the options
markets close before the markets for the underlying securities, significant
price and rate movements can take place in the underlying markets that cannot
be reflected in the options markets. The purchase of options is a highly
specialized activity which involves investment techniques and risks different
from those associated with ordinary portfolio securities transactions. The
purchase of stock index options involves the risk that the premium and
transaction costs paid by a Portfolio in purchasing an option will be lost as
a result of unanticipated movements in prices of the securities comprising the
stock index on which the option is based.
Certain Considerations Regarding Options
There is no assurance that a liquid secondary market on an options
exchange will exist for any particular option, or at any particular time, and
for some options no secondary market on an exchange or elsewhere may exist.
If a Portfolio is unable to close out a call option on securities that it has
written before the option is exercised, the Portfolio may be required to
purchase the optioned securities in order to satisfy its obligation under the
option to deliver such securities. If a Portfolio is unable to effect a
closing sale transaction with respect to options on
<PAGE>
securities that it has
purchased, it would have to exercise the option in order to realize any profit
and would incur transaction costs upon the purchase and sale of the underlying
securities.
The writing and purchasing of options is a highly specialized activity
which 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. Options transactions may result in significantly higher
transaction costs and portfolio turnover for the Portfolios.
Federal Tax Treatment of Options
Certain option transactions have special tax results for the Portfolios.
Expiration of a call option written by a Portfolio will result in short-term
capital gain. If the call option is exercised, the Portfolio will realize a
gain or loss from the sale of the security covering the call option and, in
determining such gain or loss, the option premium will be included in the
proceeds of the sale.
If a Portfolio writes options other than "qualified covered call
options," as defined in Section 1092 of the Internal Revenue Code of 1986, as
amended (the "Code"), or purchases puts, any losses on such options trans-
actions, to the extent they do not exceed the unrealized gains on the
securities covering the options, may be subject to deferral until the
securities covering the options have been sold.
In the case of transactions involving "nonequity options," as defined in
Code Section 1256, the Portfolios will treat any gain or loss arising from the
lapse, closing out or exercise of such positions as 60% long-term and 40%
short-term capital gain or loss as required by Section 1256 of the Code. In
addition, such positions must be marked-to-market as of the last business day
of the year, and gain or loss must be recognized for federal income tax
purposes in accordance with the 60%/40% rule discussed above even though the
position has not been terminated. A "nonequity option" includes an option
with respect to any group of stocks or a stock index if there is in effect a
designation by the CFTC of a contract market for a contract based on such
group of stocks or indexes. For example, options involving stock indexes such
as the Standard & Poor's 500 and 100 indexes would be "nonequity options"
within the meaning of Code Section 1256.
Futures Contracts
The Portfolios may enter into futures contracts (hereinafter referred to
as "Futures" or "Futures Contracts"), including index Futures as a hedge
against movements in the equity markets, in order to establish more definitely
the effective return on securities held or intended to be acquired by the
Portfolios or for other purposes permissible under the CEA. Each Portfolio's
hedging may include sales of Futures as an offset against the effect of
expected declines in stock prices and purchases of Futures as an offset
against the effect of expected increases in stock prices. The Portfolios will
not enter into Futures Contracts which are prohibited under the CEA and will,
to the extent required by regulatory authorities, enter only into Futures
Contracts that are traded on national futures exchanges and are standardized
as to maturity date and underlying financial instrument. The principal
interest rate Futures exchanges in the United States are the Board of Trade of
the City of Chicago and the Chicago Mercantile Exchange. Futures exchanges
and trading are regulated under the CEA by the CFTC.
An index 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. 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 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
<PAGE>
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, a gain will be realized; if it is more, a
loss will be realized. Conversely, if the offsetting sale price is more than
the original purchase price, a gain will be realized; if it is less, a loss
will be realized. The transaction costs must also be included in these
calculations. There can be no assurance, however, that the Portfolios will be
able to enter into an offsetting transaction with respect to a particular
Futures Contract at a particular time. If the Portfolios are not able to
enter into an offsetting transaction, the Portfolios will continue to be
required to maintain the margin deposits on the Futures Contract.
A public market exists in Futures Contracts covering a number of
indexes, including, but not limited to, the Standard & Poor's 500 Index, the
Standard & Poor's 100 Index, the NASDAQ 100 Index, the Value Line Composite
Index and the New York Stock Exchange Composite Index.
Margin is the amount of funds that must be deposited by each Portfolio
with its custodian in a segregated account in the name of the futures
commission merchant in order to initiate Futures trading and to maintain the
Portfolio's open positions in Futures Contracts. A margin deposit is intended
to ensure the Portfolio's performance of the Futures Contract. The margin
required for a particular Futures Contract is set by the exchange on which the
Futures Contract is traded and may be significantly modified from time to time
by the exchange during the term of the Futures Contract. Futures Contracts
are customarily purchased and sold on margins that may range upward from less
than 5% of the value of the Futures Contract being traded.
If the price of an open Futures Contract changes (by increase in the
case of a sale or by decrease in the case of a purchase) so that the loss on
the Futures Contract reaches a point at which the margin on deposit does not
satisfy margin requirements, the broker will require an increase in the
margin. However, if the value of a position increases because of favorable
price changes in the Futures Contract so that the margin deposit exceeds the
required margin, the broker will pay the excess to the Portfolio. In
computing daily net asset value, each Portfolio will mark to market the
current value of its open Futures Contracts. The Portfolios expect to earn
interest income on their margin deposits.
Because of the low margin deposits required, Futures trading involves an
extremely high degree of leverage. As a result, a relatively small price
movement in a Futures Contract may result in immediate and substantial loss,
as well as gain, to the investor. For example, if at the time of purchase,
10% of the value of the Futures Contract is deposited as margin, a subsequent
10% decrease in the value of the Futures Contract would result in a total loss
of the margin deposit, before any deduction for the transaction costs, if the
account were then closed out. A 15% decrease would result in a loss equal to
150% of the original margin deposit, if the Futures Contract were closed out.
Thus, a purchase or sale of a Futures Contract may result in losses in excess
of the amount initially invested in the Futures Contract. However, a
Portfolio would presumably have sustained comparable losses if, instead of the
Futures Contract, it had invested in the underlying financial instrument and
sold it after the decline.
Most United States Futures exchanges limit the amount of fluctuation
permitted in Futures Contract prices during a single trading day. The daily
limit establishes the maximum amount that the price of a Futures Contract may
vary either up or down from the previous day's settlement price at the end of
a trading session. Once the daily limit has been reached in a particular type
of Futures Contract, no trades may be made on that day at a price beyond that
limit. The daily limit governs only price movement during a particular
trading day and therefore does not limit potential losses, because the limit
may prevent the liquidation of unfavorable positions. Futures Contract prices
have occasionally moved to the daily limit for several consecutive trading
days with little or no trading, thereby preventing prompt liquidation of
Futures positions and subjecting some Futures traders to substantial losses.
<PAGE>
There can be no assurance that a liquid market will exist at a time when
the Portfolios seek to close out a Futures position. The Portfolios would
continue to be required to meet margin requirements until the position is
closed, possibly resulting in a decline in the Portfolios' net asset value.
In addition, many of the contracts discussed above are relatively new
instruments without a significant trading history. As a result, there can be
no assurance that an active secondary market will develop or continue to
exist.
Options on Futures
The Portfolios may also purchase or write put and call options on
Futures Contracts and enter into closing transactions with respect to such
options to terminate an existing position. A futures option gives the holder
the right, in return for the premium paid, to assume a long position (call) or
short position (put) in a Futures Contract at a specified exercise price prior
to the expiration of the option. Upon exercise of a call option, the holder
acquires a long position in the Futures Contract and the writer is assigned
the opposite short position. In the case of a put option, the opposite is
true. Prior to exercise or expiration, a futures option may be closed out by
an offsetting purchase or sale of a futures option of the same series.
The Portfolios may use options on Futures Contracts in connection with
hedging strategies. Generally, these strategies would be employed under the
same market and market sector conditions in which the Portfolios use put and
call options on securities or indexes. The purchase of put options on Futures
Contracts is analogous to the purchase of puts on securities or indexes so as
to hedge the Portfolios' securities holdings against the risk of declining
market prices. The writing of a call option or the purchasing of a put option
on a Futures Contract constitutes a partial hedge against declining prices of
the securities which are deliverable upon exercise of the Futures Contract.
If the futures price at expiration of a written call option is below the
exercise price, the Portfolio will retain the full amount of the option
premium which provides a partial hedge against any decline that may have
occurred in the Portfolio's holdings of securities. If the futures price when
the option is exercised is above the exercise price, however, the Portfolio
will incur a loss, which may be offset, in whole or in part, by the increase
in the value of the securities held by the Portfolio that were being hedged.
Writing a put option or purchasing a call option on a Futures Contract serves
as a partial hedge against an increase in the value of the securities the
Portfolio intends to acquire.
As with investments in Futures Contracts, each Portfolio is required to
deposit and maintain margin with respect to put and call options on Futures
Contracts written by it. Such margin deposits will vary depending on the
nature of the underlying Futures Contract (and the related initial margin
requirements), the current market value of the option, and other futures
positions held by the Portfolio. The Portfolios will set aside in a
segregated account at the Portfolios' custodian liquid assets, such as cash,
U.S. government securities or other high grade liquid debt obligations equal
in value to the amount due on the underlying obligation. Such segregated
assets will be marked to market daily, and additional assets will be placed in
the segregated account whenever the total value of the segregated account
falls below the amount due on the underlying obligation.
The risks associated with the use of options on Futures Contracts
include the risk that a Portfolio may close out its position as a writer of an
option only if a liquid secondary market exists for such options, which cannot
be assured. The Portfolios' successful use of options on Futures Contracts
depends on ICAP's ability to correctly predict the movement in prices of
Futures Contracts and the underlying instruments, which may prove to be
incorrect. In addition, there may be imperfect correlation between the
instruments being hedged and the Futures Contract subject to the option. For
additional information, see "Futures Contracts."
<PAGE>
Federal Tax Treatment of Futures Contracts
For federal income tax purposes, each Portfolio is required to recognize
as income for each taxable year its net unrealized gains and losses on Futures
Contracts as of the end of the year, as well as gains and losses actually
realized during the year. Except for transactions in Futures Contracts that
are classified as part of a "mixed straddle" under Code Section 1256, any gain
or loss recognized with respect to a Futures Contract is considered to be 60%
long-term capital gain or loss and 40% short-term capital gain or loss,
without regard to the holding period of the Futures Contract. In the case of
a Futures transaction not classified as a "mixed straddle," the recognition of
losses may be deferred to a later taxable year.
Sales of Futures Contracts that are intended to hedge against a change
in the value of securities held by a Portfolio may affect the holding period
of such securities and, consequently, the nature of the gain or loss on such
securities upon disposition.
Each Portfolio intends to operate as a "Regulated Investment Company"
under Subchapter M of the Code, and therefore will not be liable for federal
income taxes to the extent earnings are timely distributed. In addition, as a
result of being a Regulated Investment Company, net capital gain that the
Portfolios distribute to shareholders will retain their original capital gain
character in the shareholders' individual tax returns.
In order for each Portfolio to qualify for federal income tax treatment
as a Regulated Investment Company, at least 90% of the gross income of each
Portfolio for a taxable year must be derived from qualifying income; i.e.,
dividends, interest, income derived from loans of securities and gains from
the sale of securities, and other income (including gains on options and
futures contracts) derived with respect to the Portfolio's business of
investing in stock or securities. In addition, gains realized on the sale or
other disposition of securities or Futures Contracts held for less than three
months must be limited to less than 30% of the Portfolio's annual gross
income. It is anticipated that any net gain realized from the closing out of
Futures Contracts will be considered gain from the sale of securities and
therefore be qualifying income for purposes of the 90% requirement. For
purposes of applying these tests, any increase in value on a position that is
part of a designated hedge will be offset by any decrease in value (whether or
not realized) on any other position that is part of such hedge. It is
anticipated that unrealized gains on Futures Contracts which have been open
for less than three months as of the end of a Portfolio's fiscal year and
which are recognized for tax purposes will not be considered gains on
securities held less than three months for purposes of the 30% test.
The Portfolios will distribute to shareholders annually any net capital
gains which have been recognized for federal income tax purposes (including
unrealized gains at the end of the Portfolio's fiscal year) on Futures
transactions. Such distributions will be combined with distributions of
capital gains realized on the Portfolios' other investments and shareholders
will be advised of the nature of the payments.
DIRECTORS AND OFFICERS
The directors and officers of the Company, together with information as
to their principal business occupations during the last five years, and other
information, are shown below. Each director who is deemed an "interested
person," as defined in the Investment Company Act of 1940 ("Investment Company
Act"), is indicated by an asterisk.
*Robert H. Lyon, President and a Director of the Company.
Mr. Lyon joined ICAP in 1988 and has been the President, Chief
Investment Officer, and a Director of ICAP since 1992. For the seven
years prior to joining ICAP, Mr. Lyon was an Executive Vice President
and Director of Research with Fred Alger Management in New York. Mr.
Lyon graduated from Northwestern University with a B.A. in economics and
received his M.B.A. from the Wharton School of Finance. Mr. Lyon has
served as President and a Director of the Company since its inception in
December 1994.
*Pamela H. Conroy, Vice President, Treasurer and a Director of the Company.
Ms. Conroy has been the Senior Vice President of ICAP since joining the
Company in August of 1994. Her responsibilities include accounting,
systems, communication and product development. Prior to joining ICAP,
Ms. Conroy worked at the Northern Trust where she served as a Vice
President and worked in a variety of capacities in the investments and
securities processing areas over a nine year period. Ms. Conroy earned
a B.A. from the University of Illinois and an M.M. from the Kellogg
School of Management. Ms. Conroy has served as Vice President,
Treasurer and a Director of the Company since its inception in December
1994.
[/R]
*Donald D. Niemann, Vice President, Secretary and a Director of the Company.
Mr. Niemann was an original co-founder of ICAP and has served as an
Executive Vice President and a Director of ICAP since March 1993. His
responsibilities at ICAP include stock research, selection and proxy
analysis. Mr. Niemann received a B.A. in history from Princeton
University and an M.B.A. from Harvard University. He is a Chartered
Financial Analyst (CFA). Mr. Niemann has served as Vice President and
Secretary of the Company since its inception in December 1994, and as a
Director of the Company since July 1995.
*Gary S. Maurer, a Director of the Company.
Mr. Maurer, who joined ICAP in 1972, has served as Executive Vice
President and a Director of ICAP since March of 1993. His
responsibilities include oversight of quantitative research, as well as
performance measurement and analysis. In addition, Mr. Maurer is the
director of ICAP's client service effort. Mr. Maurer received a B.A. in
economics from Cornell University and an M.B.A. from the University of
Chicago. Mr. Maurer has served as a Director of the Company since its
inception in December 1994.
*Barbara A. Chiesa, a Director of the Company.
Ms. Chiesa, who joined ICAP in 1981 currently serves as Vice President
for Trading and is a Director of ICAP. Previously, Ms. Chiesa served as
an investment officer and trader at Harris Trust & Savings Bank. Prior
to that, Ms. Chiesa served as an equity trader at First Wisconsin Trust.
She studied accounting at the University of Wisconsin. Ms. Chiesa has
served as a Director of the Company since its inception in December
1994.
Dr. James A. Gentry, a Director of the Company.
Dr. Gentry, who joined the faculty at the University of Illinois in
1966, is a Professor of Finance of the College of Commerce and Business
Administration at the University. Since joining the University, Dr.
Gentry has served as Associate Dean of the College of Commerce and
Business Administration and has
<PAGE>
authored numerous articles and chapters
in books. Currently, he teaches courses in advanced financial
management and an honors course that provides outstanding undergraduate
students with the opportunity to interact with leading corporate
executives. Dr. Gentry received an A.B. from Indiana State University,
and an M.B.A. and D.B.A. from Indiana University. Dr. Gentry has
served as a Director of the Company since its inception in December
1994.
Harold W. Nations, a Director of the Company.
Mr. Nations is a partner with the law firm of Shefsky & Froelich in
Chicago, Illinois. He has been with Shefsky & Froelich since March,
1991. For the seven years prior thereto, Mr. Nations was an associate
with the firm of Skadden, Arps, Slate, Meagher, & Flom. Mr. Nations has
served as a Director of the Company since its inception in December
1994.
Joseph A. Hays, a Director of the Company.
Mr. Hays has been Vice President/Corporate Relations for the Tribune
Company, a diverse media company, since April 1983. Mr. Hays received a
B.S. in journalism from Utah State University and a Bachelor of Law from
Indiana University. Mr. Hays has served as a Director of the Company
since July 1995.
Except for Dr. James A. Gentry, Mr. Harold W. Nations, and Mr. Joseph
Hays, the address of all of the above persons is Institutional Capital
Corporation, 225 West Wacker Drive, Suite 2400, Chicago, Illinois 60606. Dr.
Gentry's address is the University of Illinois, 419 Commerce West, 1206 South
6th Street, Champaign, Illinois 61820-6271. Mr. Nations address is 323
Rosewood Avenue, Winnetka, Illinois, 60093. Mr. Hays' address is 1110 North
Lake Shore Drive, Apartment 24-South, Chicago, Illinois 60611.
As of June 30, 1995, officers and directors of the Company did not
beneficially own any shares of common stock of the Discretionary Equity
Portfolio; however, as of that date, such officers and directors did own 8,355
shares of common stock of the Equity Portfolio, which was .72% of the Equity
Portfolio's then outstanding shares. Directors and officers of the Company
who are also officers, directors, employees, or shareholders of ICAP do not
receive any remuneration from either of the Portfolios for serving as
directors or officers. All other directors receive $2,000 worth of shares of
common stock in the Portfolio or Portfolios of their choice for each board
meeting each such director attends.
PRINCIPAL SHAREHOLDERS
As of June 30, 1995, the following persons owned of record or are known
by the Company to own of record or beneficially more than 5% of the Company's
outstanding shares:
Name and Address Portfolio No. Shares Percentage
Clark & Co. Discretionary 41,781 5.84%
235 West Schrock Road Equity
Westerville, OH 43081
Seattle First National Bank Discretionary 427,741 59.74%
P.O. Box 94627 Equity
Pasadena, CA 91109-4127
<PAGE>
Marshall & Ilsley Trust Discretionary 239,107 33.39%
1000 N. Water Street Equity
Milwaukee, WI 53202
Cameron S. Avery & Lawrence Equity 118,650 10.21%
Howe & Howard Jessen &
Donald S. Perkins
c/o Cameron S. Avery
Bell Boyd & Lloyd
Three First National Plaza
#3200
Chicago, IL 60602
Santa Barbara Bank and Trust Equity 101,876 8.76%
P.O. Box 2340
Santa Barbara, CA 93120-2340
Bank of America Equity 58,970 5.07%
P.O. Box 94627
Pasadena, CA 91109-4627
Northern Trust Company Equity 298,005 25.64%
P.O. Box 92956
Chicago, IL 60675
Keystone District Council of Equity 127,551 10.97%
Carpenters Pension Trust
524 South 22nd Street
Harrisburg, PA 17104
Chicago Symphony Orchestra Equity 171,845 14.78%
Pension Trust
220 South Michigan Avenue
Chicago, IL 60604
Wadsworth Atheneum Equity 215,863 18.57%
600 Main Street
Hartford, CT 06103-2990
Shareholders with a controlling interest could effect the outcome of
proxy voting or the direction of management of the Company.
INVESTMENT ADVISER
Institutional Capital Corporation ("ICAP") is the investment adviser to
the Portfolios. Mr. Lyon controls ICAP and is the President, Chief Investment
Officer, and a director of ICAP. Ms. Conroy is the Senior Vice President of
ICAP, and both Mr. Maurer and Mr. Niemann are Executive Vice Presidents and
Directors of ICAP. Mr. Lyon owns 51% of ICAP. A brief description of the
Portfolios' investment advisory agreement is set forth in the Prospectus under
"MANAGEMENT."
<PAGE>
The Portfolios' advisory agreement is dated December 30, 1994 (the
"Advisory Agreement"). The Advisory Agreement has an initial term of one year
and thereafter is required to be approved annually by the Board of Directors
of the Company or by vote of a majority of each of the Portfolio's outstanding
voting securities (as defined in the Investment Company Act). Each annual
renewal must also be approved by the vote of a majority of the Company'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 was approved by the vote of a
majority of the Company's directors who are not parties to the Advisory
Agreement or interested persons of any such party on December 6, 1994 and by
the initial shareholders of each Portfolio on December 14, 1994. The Advisory
Agreement is terminable without penalty, on 60 days' written notice by the
Board of Directors of the Company, by vote of a majority of each of the
Portfolio's outstanding voting securities, or by ICAP, and will terminate
automatically in the event of its assignment.
Under the terms of the Advisory Agreement, ICAP manages the Portfolios'
investments, subject to the supervision of the Company's Board of Directors.
ICAP is responsible for investment decisions and supplies investment research
and portfolio management. At its expense, ICAP provides office space and all
necessary office facilities, equipment and personnel for servicing the
investments of the Portfolios.
As compensation for its services, each Portfolio pays to ICAP a monthly
advisory fee at the annual rate of .80% of the average daily net asset value
of the respective Portfolio. See "DETERMINATION OF NET ASSET VALUE" in the
Prospectus. From time to time, ICAP may voluntarily waive all or a portion of
its management fee for the Portfolios. In fact, ICAP has agreed to waive its
management fee and/or reimburse each Portfolio's operating expenses to the
extent necessary to ensure that neither Portfolio's total operating expenses
exceed .80% of the respective Portfolio's average daily net assets for each
Portfolio's first 12 months of operation. The organizational expenses of each
Portfolio were advanced by ICAP and will be reimbursed by the Portfolios over
a period of not more than 60 months. The organizational expenses were
approximately $31,982 for the Discretionary Equity Portfolio and $31,981 for
the Equity Portfolio.
The Advisory Agreement requires ICAP to reimburse the Portfolios in the
event that the expenses and charges payable by the Portfolios in any fiscal
year, including the advisory fee but excluding taxes, interest, brokerage
commissions, and similar fees, exceed those set forth in any statutory or
regulatory formula prescribed by any state in which shares of the Portfolios
are registered. Such excess is determined by valuations made as of the close
of each business day of the year. The most restrictive percentage limitation
currently applicable to the Portfolios will be 2 1/2% of each Portfolio's
average net asset value up to $30,000,000, 2% on the next $70,000,000 of each
Portfolio's average net asset value and 1 1/2% of each Portfolio's average net
asset value 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 Portfolios by reduction of ICAP's fee, subject to later adjustment, month
by month, for the remainder of the Portfolios' fiscal year. ICAP may from
time to time voluntarily absorb expenses for the Portfolios in addition to the
reimbursement of expenses in excess of applicable limitations.
PORTFOLIO TRANSACTIONS AND BROKERAGE
ICAP is responsible for decisions to buy and sell securities for the
Portfolios and for the placement of the Portfolios' securities business, the
negotiation of the commissions to be paid on such transactions and the
allocation of portfolio brokerage and principal business. It is the policy of
ICAP 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 ICAP or the Portfolios. The best price to the
Portfolios means the best net price without regard to the mix between purchase
or sale price and commission, if any. Purchases may be made from
underwriters, dealers, and, on occasion, the issuers. Commissions will be
paid on the Portfolios' futures and options transactions, if any.
<PAGE>
The
purchase price of portfolio securities purchased from an underwriter or dealer
may include underwriting commissions and dealer spreads. The Portfolios may
pay mark-ups on principal transactions. In selecting broker-dealers and in
negotiating commissions, ICAP considers the firm's reliability, the quality of
its execution services on a continuing basis and its financial condition.
Brokerage will not be allocated based on the sale of a Portfolio's shares.
Section 28(e) of the Securities Exchange Act of 1934 ("Section 28(e)")
permits an investment adviser, under certain circumstances, to cause an
account to pay a broker or dealer who supplies brokerage and research services
a commission for effecting a transaction in excess of the amount of commission
another broker or dealer would have charged for effecting the transaction.
Brokerage and research services include (a) furnishing advice as to the value
of securities, the advisability of investing, 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 selecting brokers, ICAP considers investment and market information
and other research, such as economic, securities and performance measurement
research, provided by such brokers, and the quality and reliability of
brokerage services, including execution capability, performance, and financial
responsibility. Accordingly, the commissions charged by any such broker may
be greater than the amount another firm might charge if ICAP determines in
good faith that the amount of such commissions is reasonable in relation to
the value of the research information and brokerage services provided by such
broker to the Portfolios. ICAP believes that the research information
received in this manner provides the Portfolios with benefits by supplementing
the research otherwise available to the Portfolios. The Advisory Agreement
provides that such higher commissions will not be paid by the Portfolios
unless (a) ICAP determines in good faith that the amount is reasonable in
relation to the services in terms of the particular transaction or in terms of
ICAP'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 ICAP, the total commissions
paid by the Portfolios will be reasonable in relation to the benefits to the
Portfolios over the long term. The investment advisory fees paid by the
Portfolios under the Advisory Agreement are not reduced as a result of ICAP's
receipt of research services.
ICAP places portfolio transactions for other advisory accounts managed
by ICAP. Research services furnished by firms through which the Portfolios
effect their securities transactions may be used by ICAP in servicing all of
its accounts; not all of such services may be used by ICAP in connection with
the Portfolios. ICAP believes it is not possible to measure separately the
benefits from research services to each of the accounts (including the
Portfolios) managed by it. 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, ICAP believes such costs to the
Portfolios will not be disproportionate to the benefits received by the
Portfolios on a continuing basis. ICAP seeks to allocate portfolio
transactions equitably whenever concurrent decisions are made to purchase or
sell securities by the Portfolios 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 Portfolios. In making such allocations between
the Portfolio and other advisory accounts, the main factors considered by ICAP
are the respective investment objectives, the relative size of portfolio
holdings of the same or comparable securities, the availability of cash for
investment and the size of investment commitments generally held.
Each Portfolio anticipates that its portfolio turnover rate will not
exceed 150%, and is expected to be between 100 and 125%. The annual portfolio
turnover rate indicates changes in each Portfolio's securities holdings; for
instance, a rate of 100% would result if all the securities in a portfolio
(excluding securities whose maturities
<PAGE>
at acquisition were one year or less)
at the beginning of an annual period had been replaced by the end of the
period. The turnover rate may vary from year to year, as well as within a
year, and may be affected by portfolio sales necessary to meet cash
requirements for redemptions of the Portfolios' shares.
CUSTODIAN
As custodian of the Portfolios' assets, United Missouri Bank, n.a. has
custody of all securities and cash of each Portfolio, 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
the officers of the Company.
TRANSFER AGENT AND DIVIDEND-DISBURSING AGENT
Sunstone Financial Group, Inc. ("Sunstone") acts as transfer agent and
dividend-disbursing agent for the Portfolios. Sunstone is compensated based
on an annual fee per open account of $12.00, plus out-of-pocket expenses such
as postage and printing expenses in connection with shareholder
communications. Sunstone also receives an annual fee per closed account of
$2.50.
TAXES
Each Portfolio will be treated as a separate entity for Federal income
tax purposes since the Tax Reform Act of 1986 requires that all portfolios of
a series fund be treated as separate taxpayers. As indicated under
"DIVIDENDS, CAPITAL GAINS DISTRIBUTIONS, AND TAX STATUS" in the Prospectus,
each Portfolio intends to qualify annually as a "regulated investment company"
under the Code. This qualification does not involve government supervision of
the Portfolios' management practices or policies.
A dividend or capital gains distribution received shortly after the
purchase of shares reduces the net asset value of shares by the amount of the
dividend or distribution and, although in effect a return of capital, will be
subject to income taxes. Net gains on sales of securities when realized and
distributed are taxable as capital gains. If the net asset value of shares
were reduced below a shareholder's cost by distribution of gains realized on
sales of securities, such distribution would be a return of investment
although taxable as stated above.
DETERMINATION OF NET ASSET VALUE
As set forth in the Prospectus under the same caption, the net asset
value of each of the Portfolios will be determined as of the close of trading
on each day the New York Stock Exchange is open for trading. The Portfolios
do not determine net asset value on days the New York Stock Exchange is closed
and at other times described in the Prospectus. The New York Stock Exchange
is closed on New Year's Day, President's 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
New York Stock Exchange will not be open for trading on the preceding Friday
and when such holiday falls on a Sunday, the New York Stock Exchange 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.
<PAGE>
SHAREHOLDER MEETINGS
Maryland law permits registered investment companies, such as the
Company, to operate without an annual meeting of shareholders under specified
circumstances if an annual meeting is not required by the Investment Company
Act. The Company 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
Investment Company Act.
The Company's Bylaws also contain procedures for the removal of
directors by shareholders of the Company. At any meeting of shareholders,
duly called and at which a quorum is present, the shareholders may, by the
affirmative vote of the holders of a majority of the votes entitled to be cast
thereon, remove any director or directors from office and may elect a
successor or successors to fill any resulting vacancies for the unexpired
terms of removed directors.
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 Company shall promptly call a special meeting of
shareholders for the purpose of voting upon the question of removal of any
director. Whenever ten or more shareholders of record who have been such for
at least six months preceding the date of application, and who hold in the
aggregate either shares having a net asset value of at least $25,000 or at
least one percent (1%) of the total outstanding shares, whichever is less,
shall apply to the Company's Secretary in writing, stating that they wish to
communicate with other shareholders with a view to obtaining signatures to a
request for a meeting as described above and accompanied by a form of
communication and request which they wish to transmit, the Secretary shall
within five business days after such application either: (1) afford to such
applicants access to a list of the names and addresses of all shareholders as
recorded on the books of the Company; or (2) inform such applicants as to the
approximate number of shareholders of record and the approximate cost of
mailing to them the proposed communication and form of request.
If the Secretary elects to follow the course specified in clause (2) of
the last sentence of the preceding paragraph, the Secretary, upon the written
request of such applicants, accompanied by a tender of the material to be
mailed and of the reasonable expenses of mailing, shall, with reasonable
promptness, mail such material to all shareholders of record at their
addresses as recorded on the books unless within five business days after such
tender the Secretary shall mail to such applicants and file with the SEC,
together with a copy of the material to be mailed, a written statement signed
by at least a majority of the Board of Directors to the effect that, in their
opinion, either such material contains untrue statements of fact or omits to
state facts necessary to make the statements contained therein not misleading,
or would be in violation of applicable law, and specifying the basis of such
opinion.
After opportunity for hearing upon the objections specified in the
written statement so filed, the SEC may, and if demanded by the Board of
Directors or by such applicants shall, enter an order either sustaining one or
more of such objections or refusing to sustain any of them. If the SEC shall
enter an order refusing to sustain any of such objections, or if, after the
entry of an order sustaining one or more of such objections, the SEC shall
find, after notice and opportunity for hearing, that all objections so
sustained have been met, and shall enter an order so declaring, the Secretary
shall mail copies of such material to all shareholders with reasonable
promptness after the entry of such order and the renewal of such tender.
<PAGE>
PERFORMANCE INFORMATION
As described in the "COMPARISON OF INVESTMENT RESULTS" section of the
Portfolios' Prospectus, the Portfolios' historical performance or return may
be shown in the form of various performance figures. The Portfolios'
performance figures are based upon historical results and are not necessarily
representative of future performance. Factors affecting the Portfolios'
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.
Total Return
The average annual total return of each Portfolio is computed by finding
the average annual compounded rates of return over the periods that would
equate the initial amount invested to the ending redeemable value, according
to the following formula:
P(1+T)n = ERV
P = a hypothetical initial payment of $1,000.
T = average annual total return.
n = number of years.
ERV = ending redeemable value of a hypothetical $1,000
payment made at the beginning of the stated periods at
the end of the stated periods.
Performance for a specific period is calculated by first taking an investment
(assumed to be $1,000) ("initial investment") in a Portfolio'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 a
Portfolio have been reinvested at the net asset value of the Portfolio 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 represents the simple change in value of an
investment over a stated period and may be quoted as a percentage or as a
dollar amount. 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.
Volatility
Occasionally statistics may be used to specify a Portfolio's volatility
or risk. Measures of volatility or risk are generally used to compare a
Portfolio'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
used to measure variability of net asset value or total return around an
average, over a specified period of time. The premise is that greater
volatility connotes greater risk undertaken in achieving performance.
<PAGE>
Comparisons
From time to time, in marketing and other Portfolio literature, the
Portfolios' 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 Analytical Services, Inc. ("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 gains dividends reinvested. Such calculations do not include the
effect of any sales charges imposed by other funds. The Portfolios will be
compared to Lipper's appropriate fund category, that is, by fund objective and
portfolio holdings.
The Portfolios' performance may also be compared to the performance of
other mutual funds by Morningstar, Inc., which ranks funds on the basis of
historical risk and total return. Morningstar's rankings range from five
stars (highest) to one star (lowest) and represent Morningstar's assessment of
the historical risk level and total return of a fund as a weighted average for
3, 5, and 10 year periods. Rankings are not absolute or necessarily
predictive of future performance.
Evaluations of Portfolio performance made by independent sources may
also be used in advertisements concerning the Portfolios, including reprints
of or selections from, editorials or articles about the Portfolios. Sources
for Portfolio performance and articles about the Portfolios may include
publications such as Money, Forbes, Kiplinger's, Financial World, Business
Week, U.S. News and World Report, the Wall Street Journal, Barron's and a
variety of investment newsletters.
The Portfolios may compare their performance to a wide variety of
indices and measures of inflation including the Standard & Poor's Index of 500
Stocks and the NASDAQ Over-the-Counter Composite Index. There are differences
and similarities between the investments that the Portfolios may purchase for
their respective portfolios and the investments measured by these indices.
Investors may want to compare the Portfolios' performance to that of
certificates of deposit offered by banks and other depository institutions.
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 depository institutions are subject to change at any time specified by
the issuing institution. Investors may also want to compare performance of
the Portfolios to that of money market funds. Money market fund yields will
fluctuate and shares are not insured, but share values usually remain stable.
INDEPENDENT ACCOUNTANTS
Coopers & Lybrand L.L.P. have been selected as the independent
accountants for the Portfolios.
<PAGE>
FINANCIAL STATEMENTS
The following audited financial statements of the Company are contained
herein:
(a) Report of Independent Accountants.
(b) Statement of Assets and Liabilities.
(c) Notes to Statement of Assets and Liabilities.
The following unaudited financial statements of each of the Portfolios
for the period from January 1, 1995 to June 30, 1995 are also contained
herein:
(a) Schedules of Investments in Securities.
(b) Statements of Assets and Liabilities.
(c) Statements of Operations.
(d) Statements of Changes in Net Assets.
(e) Financial Highlights.
(f) Notes to Financial Statements.
<PAGE>
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.
<PAGE>
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.
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
ebt 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
<PAGE>
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.
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.
<PAGE>
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.
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
<PAGE>
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, and
DD, 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.
Rating Scale Definition
AAA Highest credit quality. The risk factors are negligible,
being only slightly more
than for risk-free U.S. Treasury debt.
AA+ High credit quality. Protection factors are strong. Risk
AA is modest, but may
AA- vary slightly from time to time because of economic
conditions.
<PAGE>
A+ Protection factors are average but adequate. However, risk
A factors are more
A- variable and greater in periods of economic stress.
BBB+ Below average protection factors but still considered
BBB sufficient for prudent
BBB- investment. Considerable variability in risk during
economic cycles.
BB+ Below investment grade but deemed likely to meet obligations
BB when due.
BB- Present or prospective financial protection factors
fluctuate according to
industry conditions or company fortunes. Overall quality
may move up or
down frequently within this category.
B+ Below investment grade and possessing risk that obligations
B will not be met
B- when due. Financial protection factors will fluctuate
widely according to
economic cycles, industry conditions and/or company
fortunes. Potential
exists for frequent changes in the rating within this
category or into a higher
or lower rating grade.
CCC Well below investment grade securities. Considerable
uncertainty exists as to
timely payment of principal, interest or preferred
dividends.
Protection factors are narrow and risk can be substantial
with unfavorable
economic/industry conditions, and/or with unfavorable
company developments.
DD Defaulted debt obligations. Issuer failed to meet scheduled
principal and/or interest payments.
DP Preferred stock with dividend arrearages.
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.
<PAGE>
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 (or 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.
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.
<PAGE>
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 is defined 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.
<PAGE>
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.
