e497h2
Filed
Pursuant to Rule 497(h)
Relating to Securities Act File
No. 333-147121
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PROSPECTUS
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December
17, 2007
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Highland
Credit Strategies Fund
11,535,615
Common Shares
Issuable
Upon Exercise of Rights to Subscribe for Such Shares
The Highland Credit Strategies Fund (the Trust) is
issuing transferable rights (Rights) to its common
shareholders of record (Record Date Shareholders) as
of the close of business on December 21, 2007 (the
Record Date), entitling the holders of those Rights
to subscribe for up to an aggregate of 11,535,615 of the
Trusts common shares of beneficial interest (the
Offer). Record Date Shareholders will receive one
Right for each outstanding whole common share held on the Record
Date. The Rights entitle their holders to purchase one new
common share for every three Rights held
(1-for-3).
Record Date Shareholders who fully exercise their Rights will be
entitled to subscribe for additional common shares of the Trust
that may become available with respect to any unexercised
Rights, subject to certain limitations and subject to allotment.
The Trusts outstanding common shares are listed and trade
on the New York Stock Exchange (NYSE) under the
symbol HCF, as will the common shares offered for
subscription in the Offer. The Rights are transferable and will
be admitted for trading on the NYSE under the symbol
HCF.RT during the course of the Offer, which may
afford non-subscribing Record Date Shareholders the opportunity
to sell their Rights for cash value. See The Offer
on page 33 of this prospectus for a complete discussion of
the terms of the Offer. The subscription price (the
Subscription Price) will be determined based upon a
formula equal to 90% of the average of the last reported sale
prices of the Trusts common shares on the NYSE on the
Expiration Date (as defined below) and the four preceding
trading days (the Formula Price). If, however, the
Formula Price is less than 75% of the Trusts net asset
value per share on the Expiration Date, then the Subscription
Price will be 75% of the Trusts net asset value per common
share on that day. The Offer will expire at 5:00 p.m.,
Eastern time, on January 18, 2008, unless extended as
described in this prospectus.
The Trusts net asset value per common share at the close
of business on December 14, 2007 (the last trading date
prior to the date of this prospectus on which the Trust
determined its net asset value) was $18.41 and the last reported
sale price of a common share on the NYSE on that day was $16.31.
Record Date Shareholders who do not fully exercise their Rights
should expect that they will, upon completion of the Offer, own
a smaller proportional interest in the Trust than they owned
prior to the Offer. In addition, because the Subscription Price
per common share may be less than the then current net asset
value per common share, the completion of the Offer will likely
result in an immediate dilution of the net asset value per
common share for all existing shareholders. Such dilution is not
currently determinable because it is not known how many shares
will be subscribed for, what the net asset value or market price
of the common shares will be on the Expiration Date or what the
Subscription Price will be. Such dilution could be substantial.
If such dilution occurs, shareholders will experience a decrease
in the net asset value per common share held by them,
irrespective of whether they exercise all or any portion of
their Rights. The distribution to Record Date Shareholders of
transferable Rights, which may themselves have intrinsic value,
will afford such shareholders the potential of receiving cash
payment upon the sale of the Rights, receipt of which may be
viewed as partial compensation for the economic dilution of
their interests. No assurance can be given that a market for the
Rights will develop, or as to the value, if any, that the Rights
will have. See The OfferInvestment
Considerations.
If you have questions or need further information about the
Offer, please write The Altman Group, the Trusts
information agent for the Offer, at 1200 Wall Street West,
3rd Fl., Lyndhurst, NJ 07071 or call
(800) 370-1749.
Before buying the Trusts common shares through the
exercise of your Rights in the Offer, you should read the
discussion of the material risks of investing in the Trust in
Principal risks of the Trust beginning on
page 63. Certain of these risks are summarized in
Prospectus summaryPrincipal Risks of the Trust
beginning on page 9.
Neither the Securities and Exchange Commission nor any state
securities commission has approved or disapproved of these
securities or determined that this prospectus is truthful or
complete. Any representation to the contrary is a criminal
offense.
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Per
share
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Total(1)
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Estimated subscription
price(2)
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$
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14.68
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$
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169,331,293
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Estimated sales
load(2)(3)
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$
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(0.51
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)
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$
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(5,926,596
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)
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Estimated offering expenses
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$
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(0.04
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)
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$
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(440,000
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)
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Estimated proceeds, after expenses, to the
Trust(2)
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$
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14.13
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$
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162,964,697
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(footnotes
on inside front cover)
UBS
Investment Bank
The Trust is a non-diversified closed-end management investment
company, which was organized under the laws of Delaware on
March 10, 2006. The Trusts investment objectives are
to provide both current income and capital appreciation. The
Trust seeks to achieve its investment objectives by investing
primarily in the following categories of securities and
instruments of corporations and other business entities:
(i) secured and unsecured floating and fixed rate loans;
(ii) bonds and other debt obligations; (iii) debt
obligations of stressed, distressed and bankrupt issuers;
(iv) structured products, including but not limited to,
mortgage-backed and other asset-backed securities and
collateralized debt obligations; and (v) equities. The
Trust seeks to achieve its capital appreciation objective by
investing in category (iii) and (v) obligations and
securities, and to a lesser extent, in category (i), (ii), and
(iv) obligations. Under normal market conditions, at least
80% of the Trusts assets are invested in one or more of
these principal investment categories. Subject only to this
general guideline, Highland Capital Management, L.P., the
Trusts investment adviser (Highland or the
Investment Adviser), has broad discretion to
allocate the Trusts assets among these investment
categories and to change allocations as conditions warrant.
Within the categories of obligations and securities in which the
Trust invests, Highland employs various trading strategies,
including capital structure arbitrage, pair trades and shorting.
See Portfolio Composition for further description of
these strategies. The Trust may also invest in these categories
of obligations and securities through the use of derivatives.
Highland has full discretion regarding the capital markets from
which it can access investment opportunities in accordance with
the investment limitations set forth in this prospectus. A
significant portion of the Trusts assets may be invested
in securities rated below investment grade, which are commonly
referred to as junk securities. Junk securities are
subject to greater risk of loss of principal and interest and
may be less liquid than investment grade securities. Highland
does not anticipate a high correlation between the performance
of the Trusts portfolio and the performance of the
corporate bond and equity markets. The Trusts investment
objectives may be changed without shareholder approval. There
can be no assurance that the Trusts investment objectives
will be achieved. See The Trusts
InvestmentsInvestment Objectives and Policies.
You should read this prospectus, which contains important
information about the Trust, before deciding whether to invest
and retain it for future reference. A Statement of Additional
Information, dated December 17, 2007, containing additional
information about the Trust, has been filed with the Securities
and Exchange Commission (the Commission) and is
incorporated by reference in its entirety into this prospectus.
You can review the table of contents of the Statement of
Additional Information on page 91 of this prospectus. You
may request a free copy of the Statement of Additional
Information, request the Trusts annual and semi-annual
reports, request information about the Trust and make
shareholder inquiries by calling 1-877-665-1287 or by writing to
the Trust at Two Galleria Tower, 13455 Noel Road,
Suite 800, Dallas, Texas 75240. You may also obtain a copy
of the Statement of Additional Information (and other
information regarding the Trust) from the Commissions
Public Reference Room in Washington, D.C. by calling
1-202-942-8090. The Commission charges a fee for copies. The
Trusts annual and semi-annual reports are available, free
of charge, on the Trusts web site
(http://www.highlandfunds.com).
You can obtain the same information, free of charge, from the
Commissions web site
(http://www.sec.gov).
The Trusts common shares do not represent a deposit or
obligation of, and are not guaranteed or endorsed by, any bank
or other insured depository institution, and are not federally
insured by the Federal Deposit Insurance Corporation, the
Federal Reserve Board or any other government agency.
(footnotes from front cover)
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(1) |
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Assumes that all Rights are exercised at the estimated
Subscription Price. |
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(2) |
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Estimated on the basis of 90% of the last reported sale price
of a share of the Trusts common shares on the NYSE on
December 14, 2007. |
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(3) |
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UBS Securities LLC will act as dealer manager for the Offer
(the Dealer Manager). The Trust has agreed to pay
the Dealer Manager a fee for its financial advisory, marketing
and soliciting services equal to 3.50% of the Subscription Price
per common share for each common share issued pursuant to the
exercise of Rights and the over-subscription privilege. The
Dealer Manager will reallow to broker-dealers in the selling
group to be formed and managed by the Dealer Manager selling
fees equal to 2.50% of the Subscription Price per Share for each
Share issued pursuant to the Offer as a result of their selling
efforts. In addition, the Dealer Manager will reallow to other
broker-dealers that have executed and delivered a soliciting
dealer agreement and have solicited the exercise of Rights
solicitation fees equal to 0.50% of the Subscription Price per
Share for each Share issued pursuant to the exercise of Rights
as a result of their soliciting efforts, subject to a maximum
fee based on the number of Shares held by each broker-dealer
through The Depository Trust Company (DTC) on
the Record Date. The fees and expenses of the Offer will be
borne by the Trust and indirectly by all of its shareholders,
including those who do not exercise their Rights. The Trust and
Highland Capital Management, L.P., the Trusts investment
adviser, have each agreed to indemnify the Dealer Manager for or
contribute to losses arising out of certain liabilities,
including liabilities under the Securities Act of 1933, as
amended. |
TABLE OF
CONTENTS
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1
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30
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32
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33
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44
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44
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47
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62
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63
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79
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81
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82
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82
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84
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85
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86
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88
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88
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89
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90
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90
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90
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91
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You should rely only on the information contained or
incorporated by reference in this prospectus. The Trust has not,
and the Dealer Manager has not, authorized any other person to
provide you with different information. If anyone provides you
with different or inconsistent information, you should not rely
on it. The Trust is not, and the Dealer Manager is not, making
an offer to sell these securities in any jurisdiction where the
offer or sale is not permitted. The information contained in
this prospectus is accurate only as of the date of this
prospectus, regardless of the time of delivery of this
prospectus or of any sale of common shares. The Trust will amend
this prospectus if, during the period that this prospectus is
required to be delivered, there are any subsequent material
changes.
i
This is only a summary. This summary may not contain all of the
information that you should consider before investing in the
Trust. You should review the more detailed information contained
in this prospectus and in the Statement of Additional
Information, especially the information set forth under the
heading Principal Risks of the Trust.
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The Trust |
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Highland Credit Strategies Fund is a non-diversified, closed-end
management investment company. The Trust commenced operations on
June 29, 2006, following its initial public offering.
Throughout this prospectus, Highland Credit Strategies Fund is
referred to simply as the Trust. See The
Trust. |
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Purpose of the Offer |
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The Board of Trustees of the Trust (the Board) and
Highland Capital Management, L.P., the Trusts investment
adviser (Highland or the Investment
Adviser), have determined that it would be in the best
interests of the Trust and its shareholders to increase the
assets of the Trust, in order to more fully take advantage of
current and prospective investment opportunities that may enable
the Trust to increase both overall investment yield on its
investments and the opportunity for capital appreciation. Recent
market events and investor sentiment has led to a meaningful
correction across the debt markets, including markets in which
the Trust invests, such as loans and high yield bonds. The Board
and the Investment Adviser believe the current market
environment offers the Trust compelling opportunities to deploy
additional capital to take advantage of attractive investment
opportunities and enhance the Trusts future risk-adjusted
returns. |
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The Board and the Investment Adviser also believe that
increasing the Trusts assets available for investment may
enable the Trust to moderately improve the overall credit
quality of its portfolio, enhance the Trusts market
liquidity, increase future dividend distributions and reduce the
Trusts expense ratio modestly, while achieving other net
benefits to the Trust. The Board and the Investment Adviser
believe that the Offer is currently the most effective way to
raise additional assets for the Trust while offering
shareholders the opportunity to buy additional common shares at
a discounted price. |
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There is no assurance that the Offer will be successful. The
completion of the Offer will likely result in an immediate
dilution of the net asset value per common share for all
existing shareholders, including those who fully exercise their
rights. See The Offer Purpose of the
Offer on page 33. |
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Important Terms of the Offer |
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The Trust is issuing transferable rights (Rights) to
its common shareholders of record (Record Date
Shareholders) as of the close of business on
December 21, 2007 (the Record Date), entitling
the holders of those Rights to subscribe for up to an aggregate
of 11,535,615 of the Trusts common shares (the
Shares) (the Offer). Record Date
Shareholders will receive one Right for each whole common share
of the Trust held on the Record Date. These Rights entitle the
Record Date |
1
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Shareholders to purchase one new Share for every three Rights
held
(1-for-3).
Fractional Shares will not be issued upon the exercise of
Rights; accordingly, Rights may be exercised only in integer
multiples of three, except that any Record Date Shareholder who
is issued fewer than three Rights may subscribe, at the
Subscription Price (defined below), for one full Share. Assuming
the exercise of all Rights, the Offer will result in an
approximately 33.3% increase in the Trusts common shares
outstanding. The Offer is not contingent upon any number of
Rights being exercised. The subscription period commences on
December 21, 2007 and ends at 5:00 p.m., Eastern time,
on January 18, 2008, unless otherwise extended (the
Expiration Date). See The OfferImportant
Terms of the Offer on page 33. |
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The Trust expects to declare a monthly distribution in January
2008. Such distribution will not be payable with respect to
Shares that are issued pursuant to the Offer after the record
date for such dividend. |
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The Trust will bear the expenses of the Offer, which will be
paid from the proceeds of the Offer. These expenses include, but
are not limited to, the expenses of preparing and printing the
prospectus for the Offer and the expenses of Trust counsel and
the Trusts independent registered public accounting firm
in connection with the Offer. |
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Subscription Price |
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The subscription price (the Subscription Price) will
be determined based on a formula equal to 90% of the average of
the last reported sale prices of the Trusts common shares
on the New York Stock Exchange (the NYSE) on the
Expiration Date and the four preceding trading days (the
Formula Price). If, however, the Formula Price is
less than 75% of the net asset value per common share on the
Expiration Date, then the Subscription Price will be 75% of the
Trusts net asset value per common share on that day. See
The OfferThe Subscription Price on
page 34. |
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Over-Subscription Privilege |
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Record Date Shareholders who exercise all the Rights issued to
them (other than those Rights that cannot be exercised because
they represent the right to acquire less than one Share) are
entitled to subscribe for additional Shares at the same
Subscription Price pursuant to the over-subscription privilege,
subject to certain limitations and subject to allotment.
Investors who are not Record Date Shareholders, but who
otherwise acquire Rights to purchase Shares pursuant to the
Offer, are not entitled to subscribe for any Shares pursuant to
the over-subscription privilege. To the extent sufficient Shares
are not available to honor all over-subscription requests,
unsubscribed Shares will be allocated pro rata among those
Record Date Shareholders who over-subscribe based on the number
of common shares of the Trust they owned on the Record Date. See
The OfferOver-Subscription Privilege on
page 35. |
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Sale and Transferability of Rights |
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The Rights will be admitted for trading on the NYSE under the
symbol HCF.RT during the course of the Offer.
Trading in |
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the Rights on the NYSE may be conducted until the close of
trading on the NYSE on the last business day prior to the
Expiration Date. The Trust and UBS Securities LLC, the dealer
manager of the Offer (UBS or the Dealer
Manager), will use their best efforts to ensure that an
adequate trading market for the Rights will exist, although
there is no assurance that a market for the Rights will develop.
Assuming a market exists for the Rights, the Rights may be
purchased and sold through usual brokerage channels or sold
through the Subscription Agent (defined below). |
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Record Date Shareholders who do not wish to exercise any of the
Rights issued to them pursuant to the Offer may instruct the
Subscription Agent to sell any unexercised Rights through or to
the Dealer Manager. Subscription certificates representing the
Rights to be sold through or to the Dealer Manager must be
received by the Subscription Agent by 5:00 p.m., Eastern
time, January 16, 2008 (or, if the subscription period is
extended, by 5:00 p.m., Eastern time, two business days
prior to the extended Expiration Date). |
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Alternatively, the Rights evidenced by a subscription
certificate may be transferred until the Expiration Date in
whole or in part by endorsing the subscription certificate for
transfer in accordance with the accompanying instructions. See
The OfferSale and Transferability of Rights on
page 35. |
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Method for Exercising Rights |
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Rights are evidenced by subscription certificates that will be
mailed to Record Date Shareholders (except as described below
under Requirements for Foreign Shareholders) or, if
their common shares are held by Cede & Co. or any
other depository or nominee, to Cede & Co. or such
other depository or nominee. Rights may be exercised by filling
in and signing the subscription certificate and mailing it in
the envelope provided, or otherwise delivering the completed and
signed subscription certificate to the Subscription Agent,
together with payment at the estimated Subscription Price for
the Shares. Completed subscription certificates and payments
must be received by the Subscription Agent by 5:00 p.m.,
Eastern time, on the Expiration Date at the offices of the
Subscription Agent. Rights also may be exercised by contacting
your broker, banker or trust company, who can arrange, on your
behalf, to guarantee delivery of payment and of a properly
completed and executed subscription certificate. A fee may be
charged for this service by your broker, banker or trust
company. See The OfferMethod for Exercising
Rights on page 37 and The OfferPayment
for Shares on page 40. |
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Requirements for Foreign Shareholders |
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Subscription certificates will not be mailed to Record Date
Shareholders whose addresses are outside the United States (for
these purposes, the United States includes the District of
Columbia and the territories and possessions of the United
States) (Foreign Shareholders). The Subscription
Agent will send a letter via regular mail to Foreign
Shareholders to notify |
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them of the Offer. The Rights of Foreign Shareholders will be
held by the Subscription Agent for their accounts until
instructions are received to exercise the Rights. If
instructions have not been received by 5:00 p.m., Eastern
time, on January 15, 2008, three business days prior to the
Expiration Date (or, if the subscription period is extended, on
or before three business days prior to the extended Expiration
Date), the Rights of Foreign Shareholders will be transferred by
the Subscription Agent to the Dealer Manager, who will either
purchase the Rights or use its best efforts to sell the Rights.
The net proceeds, if any, from sale of those Rights by or to the
Dealer Manager will be remitted to these Foreign Shareholders. |
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Important Dates to Remember
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Record Date:
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December 21, 2007
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Subscription Period:
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December 21, 2007
to January 18, 2008*
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Final Date Rights Will Trade on NYSE:
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January 17, 2008*
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Expiration Date and Pricing Date:
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January 18, 2008*
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Payment for Shares Due or Notices of
Guarantees of Delivery Due:
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January 18, 2008*
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Payment for Guarantees of Delivery Due:
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January 24, 2008*
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Confirmation Mailed to Participants:
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January 28, 2008*
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Final Payment for Shares Due:
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February 11, 2008*
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* Unless the Offer is extended.
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See The OfferPayment for
Shares on page 40.
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Distribution Arrangements |
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UBS will act as Dealer Manager for this Offer. Under the terms
and subject to the conditions contained in the Dealer Manager
Agreement among the Dealer Manager, the Trust and the Investment
Adviser, the Dealer Manager will provide financial structuring
services and marketing assistance in connection with the Offer
and will solicit the exercise of Rights and participation in the
over-subscription privilege. The Trust has agreed to pay the
Dealer Manager a fee for its financial structuring, marketing
and soliciting services equal to 3.50% of the aggregate
Subscription Price for the Shares issued pursuant to the
exercise of Rights and the over-subscription privilege. The fees
paid to the Dealer Manager and other expenses of the Offer will
be borne by the Trust and indirectly by all of its shareholders,
including those who do not exercise the Rights. The Dealer
Manager will reallow a part of its fees to other broker-dealers
who have assisted in soliciting the exercise of Rights. The
Trust and the Investment Adviser have each agreed to indemnify
the Dealer Manager for or contribute to losses arising out of
certain liabilities, including liabilities under the Securities
Act of 1933, as amended (the Securities Act). |
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Prior to the expiration of the Offer, the Dealer Manager may
independently offer for sale Shares it has acquired through
purchasing and exercising the Rights, at prices it sets.
Although |
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the Dealer Manager may realize gains and losses in connection
with purchases and sales of Shares, such offering of Shares is
intended by the Dealer Manager to facilitate the Offer and any
such gains or losses are not expected to be material to the
Dealer Manager. The Dealer Managers fee for its financial
structuring, marketing and soliciting services is independent of
any gains or losses that may be realized by the Dealer Manager
through the purchase and exercise of the Rights and the sale of
Shares. See The OfferDistribution Arrangements
on page 38. |
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Subscription Agent |
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The subscription agent for the Offer is The Colbent Corporation
(the Subscription Agent). |
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Information Agent |
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The information agent for the Offer is The Altman Group (the
Information Agent). If you have questions or need
further information about the Offer, please write the
Information Agent at 1200 Wall Street West, 3rd Fl., Lyndhurst,
NJ 07071 or call
(800) 370-1749. |
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Listing |
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The Trusts outstanding common shares are listed and trade
on the NYSE under the symbol HCF, as will the Shares
offered for subscription in the Offer. The Rights are
transferable and will be admitted for trading on the NYSE under
the symbol HCF.RT during the course of the Offer. |
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Use of Proceeds |
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The net proceeds of the Offer will be invested in accordance
with the Trusts investment objectives and policies set
forth below. Assuming current market conditions, the Trust
estimates that the net proceeds of the Offer will be
substantially invested in accordance with its investment
objectives and policies within one to three months of the
completion of the Offer. Pending such investment, it is
anticipated that the proceeds of the Offer will be invested in
short-term debt securities. The Trust does not expect to use any
part of the proceeds to repay any of its outstanding debt under
the Loan Agreement. Following the completion of the Offer, the
Trust may increase the amount of leverage outstanding. See
Use of Leverage. |
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Certain Effects of the Offer |
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The Investment Adviser will benefit from the Offer because the
investment advisory fee is based on the Trusts average
weekly Managed Assets (as defined below). It is not possible to
state precisely the amount of additional compensation the
Investment Adviser will receive as a result of the Offer because
it is not known how many Shares of the Trust will be subscribed
for and because the proceeds of the Offer will be invested in
additional portfolio securities which will fluctuate in value.
However, assuming (i) all Rights are exercised,
(ii) the Trusts average weekly net asset value during
2008 is $18.41 per share (the net asset value per share on
December 14, 2007) (iii) the Subscription Price is
$14.68 per share (90% of the last reported sale price of
the Trusts common shares on December 14, 2007), and
(iv) assuming, for purposes of this example, the Trust
increases the amount of leverage outstanding while maintaining
approximately the same percentage of total assets attributable
to leverage, and after |
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giving effect to Dealer Manager fees and other offering
expenses, the Investment Adviser would receive additional
advisory fees of approximately $2.2 million for the
calendar year 2008 and would continue to receive additional
advisory fees as a result of the Offer, based on the
Trusts average weekly Managed Assets attributable to the
shares issued in the Offer, thereafter. |
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Investment Objectives and Policies |
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The Trusts investment objectives are to provide both
current income and capital appreciation. The Trust seeks to
achieve its investment objectives by investing primarily in the
following categories of securities and instruments of
corporations and other business entities: (i) secured and
unsecured floating and fixed rate loans; (ii) bonds and
other debt obligations; (iii) debt obligations of stressed,
distressed and bankrupt issuers; (iv) structured products,
including but not limited to, mortgage-backed and other
asset-backed securities and collateralized debt obligations; and
(v) equities. The Trust seeks to achieve its capital
appreciation objective by investing in category (iii) and
(v) obligations and securities, and to a lesser extent, in
category (i), (ii), and (iv) obligations. Under normal
market conditions, at least 80% of the Trusts assets are
invested in one or more of these principal investment
categories. Subject only to this general guideline, Highland has
broad discretion to allocate the Trusts assets among these
investment categories and to change allocations as conditions
warrant. Within the categories of obligations and securities in
which the Trust invests, Highland employs various trading
strategies, including capital structure arbitrage, pair trades
and shorting. See Portfolio Composition for further
description of these strategies. The Trust may also invest in
these categories of obligations and securities through the use
of derivatives. A significant portion of the Trusts assets
may be invested in securities rated below investment grade,
which are commonly referred to as junk securities.
Junk securities are subject to greater risk of loss of principal
and interest and may be less liquid than investment grade
securities. Highland does not anticipate a high correlation
between the performance of the Trusts portfolio and the
performance of the corporate bond and equity markets. The
Trusts investment objectives may be changed without
shareholder approval. There can be no assurance that the
Trusts investment objectives will be achieved. See
Investment Objectives and Policies. |
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Investment Strategies |
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Under normal market conditions, the Trust invests across various
markets in which the Investment Adviser holds significant
investment experience: primarily the leveraged loan, high yield,
structured products and stressed and distressed markets.
Highland makes investment decisions based on quantitative
analysis, which employs sophisticated, data-intensive models to
drive the investment process. Highland has full discretion
regarding the capital markets from which it can access
investment opportunities in accordance with the investment
limitations set forth in this prospectus. |
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Highland uses trading strategies to exploit pricing
inefficiencies across the credit markets, or debt markets, and
within an individual issuers capital structure. Highland
varies the Trusts investments by strategy, industry,
security type and credit market, but reserves the right to
re-position the Trusts portfolio among these criteria
depending on market dynamics, and thus the Trust may experience
high portfolio turnover. Highland manages interest rate,
default, currency and systemic risks through a variety of
trading methods and market tools, including derivative hedging
instruments, as it deems appropriate. |
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This multi-strategy investment program allows Highland to assess
what it considers to be the best opportunities across multiple
markets and to adjust quickly the Trusts trading
strategies and market focus to changing conditions. The
Investment Adviser focuses primarily on the U.S. marketplace,
but may pursue opportunities in the
non-U.S.
credit or securities markets by investing up to 20% of the
Trusts assets in
non-U.S.
credit or securities market investments. |
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The Trust invests and trades in listed and unlisted, public and
private, rated and unrated, debt and equity instruments and
other obligations, including structured debt and equity
instruments as well as financial derivatives. Investments may
include investments in stressed and distressed positions, which
may include publicly-traded debt and equity securities,
obligations which were privately placed with banks, insurance
companies and other lending institutions, trade claims, accounts
receivable and any other form of obligation recognized as a
claim in a bankruptcy or workout process. |
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As part of its investment program, the Trust may invest, from
time to time, in debt or synthetic instruments that are sold in
direct placement transactions between their issuers and their
purchasers and that are neither listed on an exchange, nor
traded over the counter. The Trust may also receive equity or
equity-related securities in connection with a workout
transaction or may invest directly in equity securities. |
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The Trust may employ currency hedges (either in the forward or
options markets) in certain circumstances to reduce currency
risk and may engage in other derivative transactions for hedging
purposes or to enhance total return. The Trust may also lend
securities and engage in short sales of securities. In addition,
the Trust may invest in the securities of companies whose
capital structures are highly leveraged. |
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From time to time, the Investment Adviser may also invest a
portion of the Trusts assets in short-term U.S. Government
obligations, certificates of deposit, commercial paper and other
money market instruments, including repurchase agreements with
respect to such obligations to enable the Trust to make
investments quickly and to serve as collateral with respect to
certain of its investments. A greater percentage of Trust assets
may be invested in such obligations if the Investment Adviser |
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believes that a defensive position is appropriate because of the
outlook for security prices or in order to respond to adverse
market, economic, business or political conditions. From time to
time cash balances in the Trusts brokerage account may be
placed in a money market fund. See Investment Objectives
and PoliciesInvestment Strategies. |
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Use of Leverage |
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As provided in the Investment Company Act of 1940 (the
Investment Company Act) and subject to certain
exceptions, the Trust may issue debt or preferred shares with
the condition that immediately after issuance the value of its
total assets, less certain ordinary course liabilities, exceeds
300% of the amount of the debt outstanding and exceeds 200% of
the sum of the amount of debt and preferred shares outstanding. |
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Thus, the Trust may use leverage in the form of borrowings in an
amount up to
331/3%
of the Trusts total assets (including the proceeds of such
leverage) and may use leverage in the form of preferred shares
in an amount up to 50% of the Trusts total assets
(including the proceeds of such leverage). The total leverage of
the Trust is currently expected to range between 20% and 50% of
the Trusts total assets. The Trust seeks a leverage ratio,
based on a variety of factors including market conditions and
the Investment Advisers market outlook, where the rate of
return, net of applicable Trust expenses, on the Trusts
portfolio investments purchased with leverage exceeds the costs
associated with such leverage. |
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The Trust, as of November 30, 2007, is leveraged through
borrowings from a credit facility in the amount of $227,000,000
or 26.17% of the Trusts total assets (including the
proceeds of such leverage). The Trusts asset coverage
ratio as of November 30, 2007 was 382.2%. See
Principal Risks of the TrustLeverage Risk for
a brief description of the Trusts credit agreement with
The Bank of Nova Scotia. |
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Following the completion of the Offer, the Trust may increase
the amount of leverage outstanding. The Trust may engage in
additional borrowings and/or issue preferred shares in order to
maintain the Trusts desired leverage ratio. However, the
Trust has no present intention to issue preferred shares within
the next twelve months. Leverage creates a greater risk of loss,
as well as a potential for more gain, for the common shares than
if leverage were not used. Interest on borrowings (or dividends
on preferred shares) may be at a fixed or floating rate and
generally will be based on short-term rates. The costs
associated with the Trusts use of leverage, including the
issuance of such leverage and the payment of dividends or
interest on such leverage, will be borne entirely by the holders
of common shares. So long as the rate of return, net of
applicable Trust expenses, on the Trusts portfolio
investments purchased with leverage exceeds the costs associated
with such leverage, the Trust will generate more return or
income than will be needed to pay such costs. In this event, the
excess will be available to pay higher dividends to holders of
common |
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shares. Conversely, if the Trusts return on such assets is
less than the cost of leverage and other Trust expenses, the
return to the holders of the common shares will diminish. Where
leverage is employed, the net asset value and market price of
the common shares and the yield to holders of common shares will
be more volatile. The Trusts leveraging strategy may not
be successful. See Principal Risks of the
TrustLeverage Risk. |
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Principal Risks of the Trust |
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The following is a summary of the principal risks associated
with an investment in the Trusts common shares. Investors
should also refer to Principal Risks of the Trust in
this prospectus for a more detailed explanation of the risks
associated with investing in the Trusts common shares. |
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Investment and Market Discount Risk. An
investment in the Trusts common shares is subject to
investment risk, including the possible loss of the entire
amount that you invest. As with any stock, the price of the
Trusts shares will fluctuate with market conditions and
other factors. If common shares are sold, the price received may
be more or less than the original investment. Common shares are
designed for long-term investors and should not be treated as
trading vehicles. Shares of closed-end management investment
companies frequently trade at a discount to their net asset
value. |
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Interest Rate Risk. Interest rate risk is the
risk that debt securities, and the Trusts net assets, may
decline in value because of changes in interest rates.
Generally, debt securities will decrease in value when interest
rates rise and increase in value when interest rates decline.
This means that the net asset value of the common shares will
fluctuate with interest rate changes and the corresponding
changes in the value of the Trusts debt security holdings. |
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Prepayment Risk. If interest rates fall, the
principal on bonds held by the Trust may be paid earlier than
expected. If this happens, the proceeds from a prepaid security
may be reinvested by the Trust in securities bearing lower
interest rates, resulting in a possible decline in the
Trusts income and distributions to shareholders. The Trust
may invest in pools of mortgages or other assets issued or
guaranteed by private issuers or U.S. government agencies and
instrumentalities. Mortgage-related securities are especially
sensitive to prepayment risk because borrowers often refinance
their mortgages when interest rates drop. |
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Risks of Investing in High-Yield Securities. A
portion of the Trusts investments will consist of
investments that may generally be characterized as
high-yield securities or junk
securities. Such securities are typically rated below
investment grade by one or more nationally recognized
statistical rating organizations or are unrated but of
comparable credit quality to obligations rated below investment
grade, and have greater credit and liquidity risk than more
highly rated obligations. High-yield securities are generally
unsecured and may be |
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subordinate to other obligations of the obligor. The lower
rating of high-yield securities reflects a greater possibility
that adverse changes in the financial condition of the issuer or
in general economic conditions (including, for example, a
substantial period of rising interest rates or declining
earnings) or both may impair the ability of the issuer to make
payment of principal and interest. Many issuers of high-yield
securities are highly leveraged, and their relatively high debt
to equity ratios create increased risks that their operations
might not generate sufficient cash flow to service their
obligations. Overall declines in the below investment grade bond
and other markets may adversely affect such issuers by
inhibiting their ability to refinance their obligations at
maturity. |
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High-yield securities are often issued in connection with
leveraged acquisitions or recapitalizations in which the issuers
incur a substantially higher amount of indebtedness than the
level at which they had previously operated. High-yield
securities that are debt instruments have historically
experienced greater default rates than has been the case for
investment grade securities. The Trust may also invest in equity
securities issued by entities whose obligations are unrated or
are rated below investment grade. |
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The Trust is authorized to invest in obligations of issuers
which are generally trading at significantly higher yields than
had been historically typical of the applicable issuers
obligations. Such investments may include debt obligations that
have a heightened probability of being in covenant or payment
default in the future. Such investments generally are considered
speculative. The repayment of defaulted obligations is subject
to significant uncertainties. Defaulted obligations might be
repaid only after lengthy workout or bankruptcy proceedings,
during which the issuer might not make any interest or other
payments. Typically such workout or bankruptcy proceedings
result in only partial recovery of cash payments or an exchange
of the defaulted security for other debt or equity securities of
the issuer or its affiliates, which may in turn be illiquid or
speculative. |
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High-yield securities purchased by the Trust are subject to
certain additional risks to the extent that such obligations may
be unsecured and subordinated to substantial amounts of senior
indebtedness, all or a significant portion of which may be
secured. Moreover, such obligations purchased by the Trust may
not be protected by financial covenants or limitations upon
additional indebtedness and are unlikely to be secured by
collateral. |
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Illiquidity of Investments. The investments
made by the Trust may be very illiquid, and consequently, the
Trust may not be able to sell such investments at prices that
reflect the Investment Advisers assessment of their fair
value or the amount paid for such investments by the Trust.
Illiquidity may result from the absence of an established market
for the |
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investments as well as legal, contractual or other restrictions
on their resale by the Trust and other factors. Furthermore, the
nature of the Trusts investments, especially those in
financially stressed and distressed companies, may require a
long holding period prior to being able to determine whether the
investment will be profitable or not. There is no limit on the
amount of the Trusts portfolio that can be invested in
illiquid securities. |
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Risks of Investing in Senior Loans. Senior
loans, such as bank loans, are typically at the most senior
level of the capital structure, and are sometimes secured by
specific collateral, including, but not limited to, trademarks,
patents, accounts receivable, inventory, equipment, buildings,
real estate, franchises and common and preferred stock of the
obligor or its affiliates. A portion of the Trusts
investments may consist of loans and participations therein
originated by banks and other financial institutions, typically
referred to as bank loans. The Trusts
investments may include loans of a type generally incurred by
borrowers in connection with highly leveraged transactions,
often to finance internal growth, acquisitions, mergers or stock
purchases, or for other reasons. As a result of the additional
debt incurred by the borrower in the course of the transaction,
the borrowers creditworthiness is often judged by the
rating agencies to be below investment grade. Such loans are
typically private corporate loans which are negotiated by one or
more commercial banks or financial institutions and syndicated
among a group of commercial banks and financial institutions. In
order to induce the lenders to extend credit and to offer a
favorable interest rate, the borrower often provides the lenders
with extensive information about its business which is not
generally available to the public. |
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Bank loans often contain restrictive covenants designed to limit
the activities of the borrower in an effort to protect the right
of lenders to receive timely payments of principal and interest.
Such covenants may include restrictions on dividend payments,
specific mandatory minimum financial ratios, limits on total
debt and other financial tests. Bank loans usually have shorter
terms than subordinated obligations and may require mandatory
prepayments from excess cash flow, asset dispositions and
offerings of debt and/or equity securities. The bank loans and
other debt obligations to be acquired by the Trust are likely to
be below investment grade. |
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The Trust may acquire interests in bank loans and other debt
obligations either directly (by way of sale or assignment) or
indirectly (by way of participation). The purchaser of an
assignment typically succeeds to all the rights and obligations
of the assigning institution and becomes a lender under the
credit agreement with respect to the debt obligation; however,
its rights can be more restricted than those of the assigning
institution, and, in any event, the Trust may not be able
unilaterally to enforce all rights and remedies under the loan
and any associated collateral. A participation interest in a |
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portion of a debt obligation typically results in a contractual
relationship only with the institution participating out the
interest, not with the borrower. In purchasing participations,
the Trust generally will have no right to enforce compliance by
the borrower with either the terms of the loan agreement or any
rights of setoff against the borrower, and the Trust may not
directly benefit from the collateral supporting the debt
obligation in which it has purchased the participation. As a
result, the Trust will be exposed to the credit risk of both the
borrower and the institution selling the participation. |
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Purchasers of bank loans are predominantly commercial banks,
investment trusts and investment banks. As secondary market
trading volumes increase, new bank loans frequently adopt
standardized documentation to facilitate loan trading which
should improve market liquidity. There can be no assurance,
however, that future levels of supply and demand in bank loan
trading will provide an adequate degree of liquidity or that the
current level of liquidity will continue. Because of the
provision to holders of such loans of confidential information
relating to the borrower, the unique and customized nature of
the loan agreement, the limited universe of eligible purchasers
and the private syndication of the loan, bank loans are not as
easily purchased or sold as a publicly traded security, and
historically the trading volume in the bank loan market has been
small relative to the high-yield debt market. |
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Second Lien Loans Risk. Second lien loans are
subject to the same risks associated with investment in senior
loans and non-investment grade securities. However, second lien
loans are second in right of payment to senior loans and
therefore are subject to additional risk that the cash flow of
the borrower and any property securing the loan may be
insufficient to meet scheduled payments after giving effect to
the senior secured obligations of the borrower. Second lien
loans are expected to have greater price volatility than senior
loans and may be less liquid. There is also a possibility that
originators will not be able to sell participations in second
lien loans, which would create greater credit risk exposure. |
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Other Secured Loans Risk. Secured loans other
than senior loans and second lien loans are subject to the same
risks associated with investment in senior loans, second lien
loans and non-investment grade securities. However, such loans
may rank lower in right of payment than any outstanding senior
loans and second lien loans of the borrower and therefore are
subject to additional risk that the cash flow of the borrower
and any property securing the loan may be insufficient to meet
scheduled payments after giving effect to the higher ranking
secured obligations of the borrower. Lower ranking secured loans
are expected to have greater price volatility than senior loans
and second lien loans and may be less liquid. There is also a
possibility that originators will not be able to sell
participations in lower ranking secured loans, which would
create greater credit risk exposure. |
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Unsecured Loans Risk. Unsecured loans are
subject to the same risks associated with investment in senior
loans, second lien loans, other secured loans and non-investment
grade securities. However, because unsecured loans have lower
priority in right of payment to any higher ranking obligations
of the borrower and are not backed by a security interest in any
specific collateral, they are subject to additional risk that
the cash flow of the borrower and available assets may be
insufficient to meet scheduled payments after giving effect to
any higher ranking obligations of the borrower. Unsecured loans
are expected to have greater price volatility than senior loans,
second lien loans and other secured loans and may be less
liquid. There is also a possibility that originators will not be
able to sell participations in unsecured loans, which would
create greater credit risk exposure. |
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Risks of Investing in Obligations of Stressed, Distressed and
Bankrupt Issuers. The Trust is authorized to
invest in the securities and other obligations of stressed,
distressed and bankrupt issuers, including debt obligations that
are in covenant or payment default. There is no limit on the
amount of the Trusts portfolio that can be invested in
stressed, distressed or bankrupt issuers, and the Trust may
invest for purposes of control. Such investments generally trade
significantly below par and are considered speculative. The
repayment of defaulted obligations is subject to significant
uncertainties. Defaulted obligations might be repaid only after
lengthy workout or bankruptcy proceedings, during which the
issuer might not make any interest or other payments. Typically
such workout or bankruptcy proceedings result in only partial
recovery of cash payments or an exchange of the defaulted
obligation for other debt or equity securities of the issuer or
its affiliates, which may in turn be illiquid or speculative. |
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There are a number of significant risks inherent in the
bankruptcy process. First, many events in a bankruptcy are the
product of contested matters and adversary proceedings and are
beyond the control of the creditors. While creditors are
generally given an opportunity to object to significant actions,
there can be no assurance that a bankruptcy court in the
exercise of its broad powers would not approve actions that
would be contrary to the interests of the Trust. Second, a
bankruptcy filing by an issuer may adversely and permanently
affect the issuer. The issuer may lose its market position and
key employees and otherwise become incapable of restoring itself
as a viable entity. If for this or any other reason the
proceeding is converted to a liquidation, the value of the
issuer may not equal the liquidation value that was believed to
exist at the time of the investment. Third, the duration of a
bankruptcy proceeding is difficult to predict. A creditors
return on investment can be adversely affected by delays while
the plan of reorganization is being negotiated, approved by the
creditors and confirmed by the bankruptcy court and until it |
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ultimately becomes effective. Fourth, the administrative costs
in connection with a bankruptcy proceeding are frequently high
and would be paid out of the debtors estate prior to any
return to creditors. For example, if a proceeding involves
protracted or difficult litigation, or turns into a liquidation,
substantial assets may be devoted to administrative costs.
Fifth, bankruptcy law permits the classification of
substantially similar claims in determining the
classification of claims in a reorganization. Because the
standard for classification is vague, there exists the risk that
the Trusts influence with respect to the class of
securities or other obligations it owns can be lost by increases
in the number and amount of claims in that class or by different
classification and treatment. Sixth, in the early stages of the
bankruptcy process it is often difficult to estimate the extent
of, or even to identify, any contingent claims that might be
made. Seventh, especially in the case of investments made prior
to the commencement of bankruptcy proceedings, creditors can
lose their ranking and priority if they exercise
domination and control over a debtor and other
creditors can demonstrate that they have been harmed by such
actions. Eighth, certain claims that have priority by law (for
example, claims for taxes) may be substantial. |
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In any investment involving stressed and distressed debt
obligations, there exists the risk that the transaction
involving such debt obligations will be unsuccessful, take
considerable time or will result in a distribution of cash or a
new security or obligation in exchange for the stressed and
distressed debt obligations, the value of which may be less than
the Trusts purchase price of such debt obligations.
Furthermore, if an anticipated transaction does not occur, the
Trust may be required to sell its investment at a loss. Given
the substantial uncertainties concerning transactions involving
stressed and distressed debt obligations in which the Trust
invests, there is a potential risk of loss by the Trust of its
entire investment in any particular investment. |
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Investments in companies operating in workout modes or under
Chapter 11 of the Bankruptcy Code are also, in certain
circumstances, subject to certain additional liabilities which
may exceed the value of the Trusts original investment in
a company. For example, under certain circumstances, creditors
who have inappropriately exercised control over the management
and policies of a debtor may have their claims subordinated or
disallowed or may be found liable for damages suffered by
parties as a result of such actions. The Investment
Advisers active management style may present a greater
risk in this area than would a more passive approach. In
addition, under certain circumstances, payments to the Trust and
distributions by the Trust or payments on the debt may be
reclaimed if any such payment is later determined to have been a
fraudulent conveyance or a preferential payment. |
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The Investment Adviser on behalf of the Trust may participate on
committees formed by creditors to negotiate with the |
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management of financially troubled companies that may or may not
be in bankruptcy or may negotiate directly with debtors with
respect to restructuring issues. If the Trust does choose to
join a committee, the Trust would likely be only one of many
participants, all of whom would be interested in obtaining an
outcome that is in their individual best interests. There can be
no assurance that the Trust would be successful in obtaining
results most favorable to it in such proceedings, although the
Trust may incur significant legal and other expenses in
attempting to do so. As a result of participation by the Trust
on such committees, the Trust may be deemed to have duties to
other creditors represented by the committees, which might
thereby expose the Trust to liability to such other creditors
who disagree with the Trusts actions. Participation by the
Trust on such committees may cause the Trust to be subject to
certain restrictions on its ability to trade in a particular
investment and may also make the Trust an insider or
an underwriter for purposes of the federal
securities laws. Either circumstance will restrict the
Trusts ability to trade in or acquire additional positions
in a particular investment when it might otherwise desire to do
so. |
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Insolvency Considerations with Respect to Issuers of Debt
Obligations. Various laws enacted for the
protection of creditors may apply to the debt obligations held
by the Trust. The information in this paragraph is applicable
with respect to U.S. issuers subject to United States bankruptcy
laws. Insolvency considerations may differ with respect to other
issuers. If a court in a lawsuit brought by an unpaid creditor
or representative of creditors of an issuer of a debt
obligation, such as a trustee in bankruptcy, were to find that
the issuer did not receive fair consideration or reasonably
equivalent value for incurring the indebtedness constituting the
debt obligation and, after giving effect to such indebtedness,
the issuer (i) was insolvent, (ii) was engaged in a
business for which the remaining assets of such issuer
constituted unreasonably small capital or (iii) intended to
incur, or believed that it would incur, debts beyond its ability
to pay such debts as they mature, such court could determine to
invalidate, in whole or in part, such indebtedness as a
fraudulent conveyance, to subordinate such indebtedness to
existing or future creditors of such issuer, or to recover
amounts previously paid by such issuer in satisfaction of such
indebtedness. |
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The measure of insolvency for purposes of the foregoing will
vary. Generally, an issuer would be considered insolvent at a
particular time if the sum of its debts were then greater than
all of its property at a fair valuation, or if the present fair
saleable value of its assets was then less than the amount that
would be required to pay its probable liabilities on its
existing debts as they became absolute and matured. There can be
no assurance as to what standard a court would apply in order to
determine whether the issuer was insolvent after
giving effect to the incurrence of the indebtedness constituting
the debt obligation |
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or that, regardless of the method of valuation, a court would
not determine that the issuer was insolvent upon
giving effect to such incurrence. In addition, in the event of
the insolvency of an issuer of a debt obligation, payments made
on such debt obligation could be subject to avoidance as a
preference if made within a certain period of time
(which may be as long as one year) before insolvency. Similarly,
a court might apply the doctrine of equitable subordination to
subordinate the claim of a lending institution against an
issuer, to claims of other creditors of the borrower, when the
lending institution, another investor, or any of their
transferees, is found to have engaged in unfair, inequitable, or
fraudulent conduct. In general, if payments on a debt obligation
are avoidable, whether as fraudulent conveyances or preferences,
such payments can be recaptured either from the initial
recipient (such as the Trust) or from subsequent transferees of
such payments (such as the investors in the Trust). To the
extent that any such payments are recaptured from the Trust the
resulting loss will be borne by the investors. However, a court
in a bankruptcy or insolvency proceeding would be able to direct
the recapture of any such payment from such a recipient or
transferee only to the extent that such court has jurisdiction
over such recipient or transferee or its assets. Moreover, it is
likely that avoidable payments could not be recaptured directly
from any such recipient or transferee that has given value in
exchange for its note, in good faith and without knowledge that
the payments were avoidable. Although the Investment Adviser
will seek to avoid conduct that would form the basis for a
successful cause of action based upon fraudulent conveyance,
preference or equitable subordination, these determinations are
made in hindsight, and, in any event, there can be no assurance
as to whether any lending institution or other investor from
which the Trust acquired the debt obligations engaged in any
such conduct (or any other conduct that would subject the debt
obligations and the issuer to insolvency laws) and, if it did,
as to whether such creditor claims could be asserted in a U.S.
court (or in the courts of any other country) against the Trust. |
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Leverage Risk. The Trust currently leverages
through borrowings from a credit facility. The use of leverage,
which can be described as exposure to changes in price at a
ratio greater than the amount of equity invested, through
borrowings, the issuance of preferred shares, or other forms of
market exposure, magnifies both the favorable and unfavorable
effects of price movements in the investments made by the Trust.
Insofar as the Trust continues to employ leverage in its
investment operations, the Trust will be subject to substantial
risks of loss. |
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The Trust currently leverages through borrowings from a credit
facility. The Trust has entered into a revolving credit
agreement with The Bank of Nova Scotia (Scotia) to
borrow up to $300,000,000 (the Loan Agreement). Such
borrowings |
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constitute financial leverage. The Loan Agreement contains
covenants that limit the Trusts ability to, without the
prior consent of Scotia: (i) pay dividends in certain
circumstances, (ii) incur additional debt,
(iii) change its investment objectives, policies and
restrictions as set forth in the Trusts prospectus in
effect when the Loan Agreement became effective or
(iv) adopt or carry out any plan of liquidation,
reorganization, incorporation, recapitalization, merger or
consolidation or sell, transfer or otherwise dispose of all or a
substantial part of its assets. For instance, the Trust agreed
not to purchase assets not contemplated by the investment
policies and restrictions in effect when the Loan Agreement
became effective. Furthermore, the Trust may not incur
additional debt from any other party, except for in limited
circumstances (e.g., in the ordinary course of business).
In addition, the Loan Agreement contains a covenant requiring
asset coverage ratios that may be more stringent than those
required by the Investment Company Act. Such restrictions shall
apply only so long as the Loan Agreement remains in effect. Any
senior security representing indebtedness, as defined in
Section 18(g) of the Investment Company Act, must have
asset coverage of at least 300%. Debt incurred under the Loan
Agreement will be considered a senior security for this purpose. |
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In order to obtain and maintain the required ratings of loans
made under the Loan Agreement or another credit facility, the
Trust must comply with investment quality, diversification and
other guidelines established by Moodys and/or S&P or
the credit facility, respectively. The Trust does not anticipate
that such guidelines will have a material adverse effect on the
Trusts common shareholders or its ability to achieve its
investment objectives. Moodys and S&P receive fees in
connection with their ratings issuances. |
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Common Stock Risk. The Trust may have exposure
to common stocks. Although common stocks have historically
generated higher average total returns than fixed income
securities over the long-term, common stocks also have
historically experienced significantly more volatility in those
returns. Therefore, the Trusts exposure to common stocks
could result in worse performance than would be the case had the
Trust been invested solely in debt securities. An adverse event,
such as an unfavorable earnings report, may depress the value of
a particular common stock held by the Trust. Also, the price of
common stock is sensitive to general movements in the stock
market and a drop in the stock market may depress the price of a
common stock to which the Trust has exposure. Common stock
prices fluctuate for several reasons, including changes in
investors perceptions of the financial condition of an
issuer or the general condition of the relevant stock market, or
when political or economic events affecting the issuers occur.
In addition, common stock prices may be particularly sensitive
to rising interest rates, as the cost of capital rises and
borrowing costs increase. |
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Dividend Risk. Dividends on common stock are
not fixed but are declared at the discretion of an issuers
board of directors. There is no guarantee that the issuers of
the common stocks in which the Trust invests will declare
dividends in the future or that, if declared, the dividends will
remain at current levels or increase over time |
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Small and Mid-Cap Securities Risk. The Trust
may invest in companies with small or medium-sized
capitalizations. Securities issued by small and medium-sized
companies can be more volatile than, and perform differently
from, larger company securities. There may be less trading in a
small or medium companys securities, which means that buy
and sell transactions in those securities could have a larger
impact on the securitys price than is the case with larger
company securities. Small and medium-sized companies may have
fewer business lines; changes in any one line of business,
therefore, may have a greater impact on a small or medium-sized
companys security price than is the case for a larger
company. In addition, small or medium-sized company securities
may not be well known to the investing public. |
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Non-U.S.
Securities Risk. The Trust may invest up to 20%
of its total assets in
non-U.S.
securities, including emerging market securities. Investing in
non-U.S.
securities involves certain risks not involved in domestic
investments, including, but not limited to:
(i) fluctuations in foreign currency exchange rates;
(ii) future foreign economic, financial, political and
social developments; (iii) different legal systems;
(iv) the possible imposition of exchange controls or other
foreign governmental laws or restrictions; (v) lower
trading volume; (vi) much greater price volatility and
illiquidity of certain
non-U.S.
securities markets; (vii) different trading and settlement
practices; (viii) less governmental supervision;
(ix) high and volatile rates of inflation;
(x) fluctuating interest rates; (xi) less publicly
available information; and (xii) different accounting,
auditing and financial recordkeeping standards and requirements. |
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Certain countries in which the Trust may invest, especially
emerging market countries, historically have experienced, and
may continue to experience, high rates of inflation, high
interest rates, exchange rate fluctuations, large amounts of
external debt, balance of payments and trade difficulties and
extreme poverty and unemployment. Many of these countries are
also characterized by political uncertainty and instability.
These risks are especially evident in the Middle East and West
Africa. The cost of servicing external debt will generally be
adversely affected by rising international interest rates
because many external debt obligations bear interest at rates
which are adjusted based upon international interest rates. In
addition, with respect to certain foreign countries, there is a
risk of: (i) the possibility of expropriation or
nationalization of assets; (ii) confiscatory taxation;
(iii) difficulty in obtaining or enforcing a court
judgment; (iv) economic, political or social |
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instability; and (v) diplomatic developments that could
affect investments in those countries. In addition, individual
foreign economies may differ favorably or unfavorably from the
U.S. economy in such respects as: (i) growth of gross
domestic product; (ii) rates of inflation;
(iii) capital reinvestment; (iv) resources;
(v) self-sufficiency; and (vi) balance of payments
position. |
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As a result of these potential risks, Highland may determine
that, notwithstanding otherwise favorable investment criteria,
it may not be practicable or appropriate to invest in a
particular country. The Trust may invest in countries in which
foreign investors, including Highland, have had no or limited
prior experience. |
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Emerging Markets Risk. The Trust may invest up
to 20% of its total assets in securities of issuers based in
emerging markets. Investing in securities of issuers based in
emerging markets entails all of the risks of investing in
securities of
non-U.S.
issuers to a heightened degree. Emerging market countries
generally include every nation in the world except the United
States, Canada, Japan, Australia, New Zealand and most countries
located in Western Europe. These heightened risks include:
(i) greater risks of expropriation, confiscatory taxation,
nationalization, and less social, political and economic
stability; (ii) the smaller size of the markets for such
securities and a lower volume of trading, resulting in lack of
liquidity and in price volatility; and (iii) certain
national policies which may restrict the Trusts investment
opportunities including restrictions on investing in issuers or
industries deemed sensitive to relevant national interests. |
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Foreign Currency Risk. Because the Trust may
invest in securities denominated or quoted in currencies other
than the U.S. dollar, changes in foreign currency exchange rates
may affect the value of securities owned by the Trust, the
unrealized appreciation or depreciation of investments and gains
on and income from investments. Currencies of certain countries
may be volatile and therefore may affect the value of securities
denominated in such currencies, which means that the
Trusts net asset value could decline as a result of
changes in the exchange rates between foreign currencies and the
U.S. dollar. These risks often are heightened for investments in
smaller, emerging capital markets. In addition, the Trust may
enter into foreign currency transactions in an attempt to
enhance total return which may further expose the Trust to the
risks of foreign currency movements and other risks. The use of
foreign currency transactions can result in the Trust incurring
losses as a result of the imposition of exchange controls,
suspension of settlements or the inability of the Trust to
deliver or receive a specified currency. |
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Investments in Unseasoned Companies. The Trust
may invest in the securities of less seasoned companies. These
investments may present greater opportunities for growth, but
also involve |
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greater risks than customarily are associated with investments
in securities of more established companies. Some of the
companies in which the Trust may invest will be
start-up
companies which may have insubstantial operational or earnings
history or may have limited products, markets, financial
resources or management depth. Some may also be emerging
companies at the research and development stage with no products
or technologies to market or approved for marketing. Securities
of emerging companies may lack an active secondary market and
may be subject to more abrupt or erratic price movements than
securities of larger, more established companies or stock market
averages in general. Competitors of certain companies may have
substantially greater financial resources than many of the
companies in which the Trust may invest. |
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Initial Public Offerings Risk. The Trust may
invest in shares of companies through initial public offerings
(IPOs). IPOs and companies that have recently gone
public have the potential to produce substantial gains for the
Trust. However, there is no assurance that the Trust will have
access to profitable IPOs. The investment performance of the
Trust during periods when it is unable to invest significantly
or at all in IPOs may be lower than during periods when the
Trust is able to do so. Securities issued in IPOs are subject to
many of the same risks as investing in companies with smaller
market capitalizations. Securities issued in IPOs have no
trading history, and information about the companies may be
available for limited periods of time. In addition, the prices
of securities sold in IPOs may be highly volatile or may decline
shortly after the IPO. |
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Securities Lending Risk. The Trust may lend
its portfolio securities (up to a maximum of one-third of its
total assets) to banks or dealers which meet the
creditworthiness standards established by the board of trustees
of the Trust. Securities lending is subject to the risk that
loaned securities may not be available to the Trust on a timely
basis and the Trust may, therefore, lose the opportunity to sell
the securities at a desirable price. Any loss in the market
price of securities loaned by the Trust that occurs during the
term of the loan would be borne by the Trust and would adversely
affect the Trusts performance. Also, there may be delays
in recovery, or no recovery, of securities loaned or even a loss
of rights in the collateral provided by the borrower should the
borrower of the securities fail financially while the loan is
outstanding. Although the Trust generally has the ability to
recall loaned securities pursuant to a securities lending
arrangement in the event that a shareholder vote is held, there
is a risk that any delay in recovery of such security will
result in the holder of such security being unable to vote. All
of the aforementioned risks may be greater for
non-U.S.
securities. |
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Risks Associated with Options on
Securities. There are several risks associated
with transactions in options on |
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securities. For example, there are significant differences
between the securities and options markets that could result in
an imperfect correlation between these markets, causing a given
transaction not to achieve its objectives. A decision as to
whether, when and how to use options involves the exercise of
skill and judgment, and even a well conceived transaction may be
unsuccessful to some degree because of market behavior or
unexpected events. |
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As the writer of a covered call option, the Trust foregoes,
during the options life, the opportunity to profit from
increases in the market value of the security covering the call
option above the sum of the premium and the strike price of the
call, but has retained the risk of loss should the price of the
underlying security decline. As the Trust writes covered calls
over more of its portfolio, its ability to benefit from capital
appreciation becomes more limited. The writer of an option has
no control over the time when it may be required to fulfill its
obligation as a writer of the option. Once an option writer has
received an exercise notice, it cannot effect a closing purchase
transaction in order to terminate its obligation under the
option and must deliver the underlying security at the exercise
price. |
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When the Trust writes covered put options, it bears the risk of
loss if the value of the underlying stock declines below the
exercise price minus the put premium. If the option is
exercised, the Trust could incur a loss if it is required to
purchase the stock underlying the put option at a price greater
than the market price of the stock at the time of exercise plus
the put premium the Trust received when it wrote the option.
While the Trusts potential gain in writing a covered put
option is limited to distributions earned on the liquid assets
securing the put option plus the premium received from the
purchaser of the put option, the Trust risks a loss equal to the
entire exercise price of the option minus the put premium. |
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Exchange-Listed Option Risks. There can be no
assurance that a liquid market will exist when the Trust seeks
to close out an option position on an options exchange. Reasons
for the absence of a liquid secondary market on an exchange
include the following: (i) there may be insufficient
trading interest in certain options; (ii) restrictions may
be imposed by an exchange on opening transactions or closing
transactions or both; (iii) trading halts, suspensions or
other restrictions may be imposed with respect to particular
classes or series of options; (iv) unusual or unforeseen
circumstances may interrupt normal operations on an exchange;
(v) the facilities of an exchange or the Options Clearing
Corporation may not at all times be adequate to handle current
trading volume; or (vi) one or more exchanges could, for
economic or other reasons, decide or be compelled at some future
date to discontinue the trading of options (or a particular
class or series of options). If trading were discontinued, the
secondary market on that exchange (or in that class or series of
options) |
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would cease to exist. However, outstanding options on that
exchange that had been issued by the Options Clearing
Corporation as a result of trades on that exchange would
continue to be exercisable in accordance with their terms. If
the Trust were unable to close out a covered call option that it
had written on a security, it would not be able to sell the
underlying security unless the option expired without exercise. |
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The hours of trading for options on an exchange 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. Call options are marked to
market daily and their value will be affected by changes in the
value and dividend rates of the underlying common stocks, an
increase in interest rates, changes in the actual or perceived
volatility of the stock market and the underlying common stocks
and the remaining time to the options expiration.
Additionally, the exercise price of an option may be adjusted
downward before the options expiration as a result of the
occurrence of certain corporate events affecting the underlying
equity security, such as extraordinary dividends, stock splits,
merger or other extraordinary distributions or events. A
reduction in the exercise price of a call option written by the
Trust would reduce the Trusts capital appreciation
potential on the underlying security. |
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Over-the-Counter Option Risk. The Trust may
write (sell) unlisted (OTC or
over-the-counter) options. Options written by the
Trust with respect to
non-U.S.
securities, indices or sectors generally will be OTC options.
OTC options differ from exchange-listed options in that they are
two-party contracts, with exercise price, premium and other
terms negotiated between buyer and seller, and generally do not
have as much market liquidity as exchange-listed options. The
counterparties to these transactions typically will be major
international banks, broker-dealers and financial institutions.
The Trust may be required to treat as illiquid those securities
being used to cover certain written OTC options. The OTC options
written by the Trust will not be issued, guaranteed or cleared
by the Options Clearing Corporation. In addition, the
Trusts ability to terminate the OTC options may be more
limited than with exchange-traded options. Banks, broker-dealers
or other financial institutions participating in such
transaction may fail to settle a transaction in accordance with
the terms of the option as written. In the event of default or
insolvency of the counterparty, the Trust may be unable to
liquidate an OTC option position. |
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Index Option Risk. The Trust may sell index
put and call options from time to time. The purchaser of an
index put option has the right to any depreciation in the value
of the index below the exercise price of the option on or before
the |
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expiration date. The purchaser of an index call option has the
right to any appreciation in the value of the index over the
exercise price of the option on or before the expiration date.
Because the exercise of an index option is settled in cash,
sellers of index call options, such as the Trust, cannot provide
in advance for their potential settlement obligations by
acquiring and holding the underlying securities. The Trust will
lose money if it is required to pay the purchaser of an index
option the difference between the cash value of the index on
which the option was written and the exercise price and such
difference is greater than the premium received by the Trust for
writing the option. The value of index options written by the
Trust, which will be priced daily, will be affected by changes
in the value and dividend rates of the underlying common stocks
in the respective index, changes in the actual or perceived
volatility of the stock market and the remaining time to the
options expiration. The value of the index options also
may be adversely affected if the market for the index options
becomes less liquid or smaller. Distributions paid by the Trust
on its common shares may be derived in part from the net index
option premiums it receives from selling index put and call
options, less the cost of paying settlement amounts to
purchasers of the options that exercise their options. Net index
option premiums can vary widely over the short term and long
term. |
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Asset-Backed Securities Risk. Payment of
interest and repayment of principal on asset-backed securities
may be largely dependent upon the cash flows generated by the
assets backing the securities and, in certain cases, supported
by letters of credit, surety bonds or other credit enhancements.
Asset-backed security values may also be affected by the
creditworthiness of the servicing agent for the pool, the
originator of the loans or receivables or the entities providing
the credit enhancement. In addition, the underlying assets are
subject to prepayments that shorten the securities
weighted average maturity and may lower their return. |
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Mortgage-Backed Securities Risk. A
mortgage-backed security, which represents an interest in a pool
of assets such as mortgage loans, will mature when all the
mortgages in the pool mature or are prepaid. Therefore,
mortgage-backed securities do not have a fixed maturity, and
their expected maturities may vary when interest rates rise or
fall. |
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When interest rates fall, homeowners are more likely to prepay
their mortgage loans. An increased rate of prepayments on the
Trusts mortgage-backed securities will result in an
unforeseen loss of interest income to the Trust as the Trust may
be required to reinvest assets at a lower interest rate. Because
prepayments increase when interest rates fall, the price of
mortgage-backed securities does not increase as much as other
fixed income securities when interest rates fall. |
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When interest rates rise, homeowners are less likely to prepay
their mortgage loans. A decreased rate of prepayments lengthens
the expected maturity of a mortgage-backed security. Therefore,
the prices of mortgage-backed securities may decrease more than
prices of other fixed income securities when interest rates rise. |
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Derivatives Risk. The Trust may engage in
derivative transactions for hedging and speculative purposes or
to enhance total return, including options, futures, swaps,
foreign currency transactions and forward foreign currency
contracts, currency swaps or options on currency and currency
futures (Derivative Transactions). Derivative
Transactions involve risks, including the imperfect correlation
between the value of such instruments and the underlying assets,
the possible default of the other party to the transaction or
illiquidity of the derivative instruments. The ability to
successfully use Derivative Transactions depends on the
Investment Advisers ability to predict pertinent market
movements, which cannot be assured. The use of Derivative
Transactions may result in losses greater than if they had not
been used, may require the Trust to sell or purchase portfolio
securities at inopportune times or for prices other than current
market values, may limit the amount of appreciation the Trust
can realize on an investment or may cause the Trust to hold a
security that it might otherwise sell. The use of foreign
currency transactions can result in the Trusts incurring
losses as a result of the imposition of exchange controls,
suspension of settlements or the inability of the Trust to
deliver or receive a specified currency. Additionally, amounts
paid by the Trust as premiums and cash or other assets held in
margin accounts with respect to Derivative Transactions are not
otherwise available to the Trust for investment purposes. |
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To the extent that the Trust purchases options pursuant to a
hedging strategy, the Trust will be subject to the following
additional risks. If a put or call option purchased by the Trust
is not sold or exercised, the Trust will lose its entire
investment in the option. |
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Where a put or call option on a particular security is purchased
to hedge against price movements in a related security, the
price of the put or call option may move more or less than the
price of the related security. If restrictions on exercise were
imposed, the Trust might be unable to exercise an option it had
purchased. If the Trust were unable to close out an option that
it had purchased on a security, it would have to exercise the
option in order to realize any profit or the option may expire
worthless. |
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Market Risk Generally. The profitability of a
significant portion of the Trusts investment program
depends to a great extent upon correctly assessing the future
course of the price movements of securities and other
investments and the movements of interest rates. There can be no
assurance that the |
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Investment Adviser will be able to predict accurately these
price and interest rate movements. With respect to certain
investment strategies the Trust utilizes, there is a high degree
of market risk. |
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Reinvestment Risk. The Trust reinvests the
cash flows received from a security. The additional income from
such reinvestment, sometimes called
interest-on-interest,
is reliant on the prevailing interest rate levels at the time of
reinvestment. There is a risk that the interest rate at which
interim cash flows can be reinvested will fall. Reinvestment
risk is greater for longer holding periods and for securities
with large, early cash flows such as high-coupon bonds.
Reinvestment risk also applies generally to the reinvestment of
the proceeds the Trust receives upon the maturity or sale of a
portfolio security. |
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Timing Risk. Many agency, corporate and
municipal bonds, and most mortgage-backed securities, contain a
provision that allows the issuer to call all or part
of the issue before the bonds maturity date, often after
five or ten years. The issuer usually retains the right to
refinance the bond in the future if market interest rates
decline below the coupon rate. There are three disadvantages to
the call provision. First, the cash flow pattern of a callable
bond is not known with certainty. Second, because an issuer is
more likely to call the bonds when interest rates have dropped,
the Trust is exposed to reinvestment risk, i.e., the Trust may
have to reinvest at lower interest rates the proceeds received
when the bond is called. Finally, the capital appreciation
potential of a bond will be reduced because the price of a
callable bond may not rise much above the price at which the
issuer may call the bond. |
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Inflation Risk. Inflation risk results from
the variation in the value of cash flows from a security due to
inflation, as measured in terms of purchasing power. For
example, if the Trust purchases a bond in which it can realize a
coupon rate of 5%, but the rate of inflation increases from 2%
to 6%, then the purchasing power of the cash flow has declined.
For all but adjustable bonds or floating rate bonds, the Trust
is exposed to inflation risk because the interest rate the
issuer promises to make is fixed for the life of the security.
To the extent that interest rates reflect the expected inflation
rate, floating rate bonds have a lower level of inflation risk.
In addition, during any periods of rising inflation, dividend
rates of any variable rate preferred stock issued by the Trust
would likely increase, which would tend to further reduce
returns to common shareholders. |
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Arbitrage Risks. The Trust engages in capital
structure arbitrage and other arbitrage strategies. Arbitrage
strategies entail various risks, including the risk that
external events, regulatory approvals and other factors will
impact the consummation of announced corporate events and/or the
prices of certain positions. In addition, hedging is an
important feature of capital structure arbitrage. There is no
guarantee |
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that the Investment Adviser will be able to hedge the
Trusts portfolio in the manner necessary to employ
successfully the Trusts strategy. |
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Short Sales Risk. Short selling involves
selling securities which may or may not be owned and borrowing
the same securities for delivery to the purchaser, with an
obligation to replace the borrowed securities at a later date.
Short selling allows the Trust to profit from declines in market
prices to the extent such decline exceeds the transaction costs
and the costs of borrowing the securities. However, since the
borrowed securities must be replaced by purchases at market
prices in order to close out the short position, any
appreciation in the price of the borrowed securities would
result in a loss. There can be no assurance that the securities
necessary to cover a short position will be available for
purchase. Purchasing securities to close out the short position
can itself cause the price of the securities to rise further,
thereby exacerbating the loss. The Trust may mitigate such
losses by replacing the securities sold short before the market
price has increased significantly. Under adverse market
conditions, the Trust might have difficulty purchasing
securities to meet its short sale delivery obligations, and
might have to sell portfolio securities to raise the capital
necessary to meet its short sale obligations at a time when
fundamental investment considerations would not favor such
sales. Short sales by the Trust that are not made against
the box theoretically involve unlimited loss potential
since the market price of securities sold short may continuously
increase. |
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Risks of Investing in Structured Finance
Securities. A portion of the Trusts
investments may consist of equipment trust certificates,
collateralized mortgage obligations, collateralized bond
obligations, collateralized loan obligations or similar
instruments. Structured finance securities may present risks
similar to those of the other types of debt obligations in which
the Trust may invest and, in fact, such risks may be of greater
significance in the case of structured finance securities.
Moreover, investing in structured finance securities may entail
a variety of unique risks. Among other risks, structured finance
securities may be subject to prepayment risk. In addition, the
performance of a structured finance security will be affected by
a variety of factors, including the securitys priority in
the capital structure of the issuer thereof, the availability of
any credit enhancement, the level and timing of payments and
recoveries on and the characteristics of the underlying
receivables, loans or other assets that are being securitized,
remoteness of those assets from the originator or transferor,
the adequacy of and ability to realize upon any related
collateral and the capability of the servicer of the securitized
assets. |
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Risks of Investing in Preferred
Securities. There are special risks associated
with investing in preferred securities, including: |
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Ø Deferral. Preferred
securities may include provisions that permit the issuer, at its
discretion, to defer distributions for a stated period without
any adverse consequences to the issuer. If the Trust owns a
preferred security that is deferring its distributions, the
Trust may be required to report income for tax purposes although
it has not yet received such income.
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Ø Subordination. Preferred
securities are subordinated to bonds and other debt instruments
in a companys capital structure in terms of priority to
corporate income and liquidation payments, and therefore will be
subject to greater credit risk than more senior debt instruments.
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Ø Liquidity. Preferred
securities may be substantially less liquid than many other
securities, such as common stock or U.S. government securities.
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Ø Limited
Voting Rights. Generally, preferred security
holders have no voting rights with respect to the issuing
company unless preferred dividends have been in arrears for a
specified number of periods, at which time the preferred
security holders may elect a number of directors to the
issuers board. Generally, once all the arrearages have
been paid, the preferred security holders no longer have voting
rights.
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Risks of Investing in Synthetic
Securities. With respect to synthetic securities,
the Trust will usually have a contractual relationship only with
the counterparty of such synthetic securities, and not the
Reference Obligor (as defined below) on the Reference Obligation
(as defined below). The Trust generally will have no right to
directly enforce compliance by the Reference Obligor with the
terms of the Reference Obligation nor any rights of set-off
against the Reference Obligor, nor have any voting rights with
respect to the Reference Obligation. The Trust will not benefit
directly from any collateral supporting the Reference Obligation
or have the benefit of the remedies on default that would
normally be available to a holder of such Reference Obligation.
In addition, in the event of insolvency of its counterparty, the
Trust will be treated as a general creditor of such counterparty
and will not have any claim with respect to the credit risk of
the counterparty as well as that of the Reference Obligor. As a
result, an overabundance of synthetic securities with any one
counterparty subjects the investment to an additional degree of
risk with respect to defaults by such counterparty as well as by
the Reference Obligor. The Investment Adviser may not perform
independent credit analyses of the counterparties or any
entities guaranteeing such counterparties, individually or in
the aggregate. A Reference Obligation is the debt
security or other obligation upon which the synthetic security
is based. A Reference Obligor is the obligor on a
Reference Obligation. There is no maximum amount of Trusts
assets that may be invested in synthetic securities. |
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Valuation Risk. Fair value is defined as the
amount for which assets could be sold in an orderly disposition
over a reasonable period of time, taking into account the nature
of the asset. Fair value pricing, however, involves judgments
that are inherently subjective and inexact, since fair valuation
procedures are used only when it is not possible to be sure what
value should be attributed to a particular asset or when an
event will affect the market price of an asset and to what
extent. As a result, there can be no assurance that fair value
pricing will reflect actual market value, and it is possible
that the fair value determined for a security will be materially
different from the value that actually could be or is realized
upon the sale of that asset. |
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Risks of Non-Diversification and Other Focused
Strategies. While the Investment Adviser invests
in a number of fixed-income and equity instruments issued by
different issuers and employs multiple investment strategies
with respect to the Trusts portfolio, it is possible that
a significant amount of the Trusts investments could be
invested in the instruments of only a few companies or other
issuers or that at any particular point in time one investment
strategy could be more heavily weighted than the others. The
focus of the Trusts portfolio in any one issuer would
subject the Trust to a greater degree of risk with respect to
defaults by such issuer or other adverse events affecting that
issuer, and the focus of the portfolio in any one industry or
group of industries (but not to exceed 25% of the Trusts
total assets) would subject the Trust to a greater degree of
risk with respect to economic downturns relating to such
industry or industries. The focus of the Trusts portfolio
in any one investment strategy would subject the Trust to a
greater degree of risk than if the Trusts portfolio were
varied in its investments with respect to several investment
strategies. |
|
|
|
Market Disruption and Geopolitical Risk. The
aftermath of the war in Iraq and the continuing occupation of
Iraq, instability in the Middle East and terrorist attacks in
the United States and around the world may result in market
volatility and may have long-term effects on the U.S. and
worldwide financial markets and may cause further economic
uncertainties in the United States and worldwide. The Investment
Adviser does not know how long the securities markets may be
affected by these events and cannot predict the effects of the
occupation or similar events in the future on the U.S. economy
and securities markets. |
|
|
|
Risks of Investing in a Trust with Anti-Takeover
Provisions. The Trusts Agreement and
Declaration of Trust includes provisions that could limit the
ability of other entities or persons to acquire control of the
Trust or convert the Trust to open-end status. These provisions
could deprive the holders of common shares of opportunities to
sell their common shares at a premium over the then current
market price of the common shares or at net asset value. |
28
|
|
|
|
|
Key Adviser Personnel Risk. The Trusts
ability to identify and invest in attractive opportunities is
dependent upon Highland, its investment adviser. If one or more
key individuals leaves Highland, Highland may not be able to
hire qualified replacements or may require an extended time to
do so. This situation could prevent the Trust from achieving its
investment objectives. |
|
|
|
Given the risks described above, an investment in the common
shares may not be appropriate for all investors. You should
carefully consider your ability to assume these risks before
making an investment in the Trust. |
|
Investment Adviser and Administrator |
|
Highland is the investment adviser and administrator of the
Trust. As of September 30, 2007, Highland managed
approximately $38 billion in assets on behalf of investors
around the world. In return for its advisory services, Highland
receives an annual fee, payable monthly, in an amount equal to
1.00% of the average weekly value of the Trusts Managed
Assets. In return for its administrative services, Highland
receives an annual fee, payable monthly, in an amount equal to
0.20% of the average weekly value of the Trusts Managed
Assets. Managed Assets means the total assets of the
Trust, including any form of investment leverage, minus all
accrued expenses incurred in the normal course of operations,
but not excluding any liabilities or obligations attributable to
investment leverage obtained through (i) indebtedness of
any type (including, without limitation, borrowing through a
credit facility or the issuance of debt securities),
(ii) the issuance of preferred shares or other similar
preference securities, (iii) the reinvestment of collateral
received for securities loaned in accordance with the
Trusts investment objectives and policies, and/or
(iv) any other means. Highland, at its own expense, has the
authority to engage both a sub-adviser and a sub-administrator,
each of which may be an affiliate of Highland. See
Management of the TrustInvestment Adviser and
Management of the
TrustAdministrator/Sub-Administrator. |
|
|
|
Potential Conflicts of Interest. The Trust
currently employs investment leverage in the form of borrowings
through a credit facility. If the Trust continues to employ
leverage, the Investment Adviser will benefit because the
Trusts Managed Assets will increase with leverage. The
Investment Adviser will also benefit to the extent that the
Trusts Managed Assets increase with reinvested collateral
received on portfolio securities loaned. See Management of
the TrustInvestment Adviser. |
29
Summary
of Trust expenses
The following table is intended to assist investors in
understanding the fees and expenses (annualized) that an
investor in the Trust would bear, directly or indirectly, as a
result of the Offer being fully subscribed and the receipt of
net proceeds from the Offer of approximately $163 million.
|
|
|
|
|
|
|
Percentage of
|
|
|
|
Subscription
Price
|
|
|
|
|
Shareholder Transaction Expenses
|
|
|
|
|
Sales load
|
|
|
3.50
|
%(1)
|
Offering expenses borne by holders of common shares
|
|
|
0.26
|
%(2)
|
Dividend reinvestment and cash purchase plan fees
|
|
|
None
|
(3)
|
|
|
|
|
|
|
|
Percentage of Net
Assets
|
|
|
|
Attributable to
Common Shares
|
|
|
|
(assumes leverage
through
|
|
|
|
borrowings(6))
|
|
|
|
|
Annual Expenses
|
|
|
|
|
Management fees
|
|
|
1.63
|
%(4)
|
Other expenses
|
|
|
0.31
|
%(5)
|
Interest payments on borrowed funds
|
|
|
1.98
|
%
|
Total annual expenses
|
|
|
3.92
|
%
|
EXAMPLE
The following example illustrates the expenses that you would
pay on a $1,000 investment in common shares of the Trust
(including the total sales load of $35 and the other estimated
costs of this offering to be borne by the Trust of $2.60),
assuming (1) that the Offer is fully subscribed and the
Trust receives net proceeds from the Offer of approximately
$163 million, (2) that the Trusts current net
assets do not increase or decrease, (3) that the Trust
borrows approximately $283 million under its credit
facility, (3) that the Trust incurs total annual expenses
of 3.92% of net assets attributable to common shares and
(4) a 5% annual return:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
1 Year
|
|
|
3 Years
|
|
|
5 Years
|
|
|
10 Years
|
|
|
|
|
Total expenses incurred
|
|
$
|
76
|
|
|
$
|
153
|
|
|
$
|
231
|
|
|
$
|
436
|
|
|
|
|
(1) |
|
The Dealer Manager will receive a fee for its financial
structuring, marketing and soliciting services equal to 3.50% of
the aggregate Subscription Price for Shares issued pursuant to
the Offer. The Dealer Manager will reallow to broker-dealers in
the selling group to be formed and managed by the Dealer Manager
selling fees equal to 2.50% of the Subscription Price per Share
for each Share issued pursuant to the Offer as a result of their
selling efforts. In addition, the Dealer Manager will reallow to
other broker-dealers that have executed and delivered a
soliciting dealer agreement and have solicited the exercise of
Rights solicitation fees equal to 0.50% of the Subscription
Price per Share for each Share issued pursuant to the exercise
of Rights as a result of their soliciting efforts, subject to a
maximum fee based on the number of Shares held by each
broker-dealer through The Depository Trust Company
(DTC) on the Record Date. |
|
(2) |
|
The fees and expenses of the Offer will be borne by the Trust
and indirectly by all of its shareholders, including those who
do not exercise their Rights. |
(footnotes continued on
following page)
30
Summary of
Trust expenses
|
|
|
(3) |
|
Common shareholders will be charged a $2.50 service charge
and pay a brokerage commission of $0.05 per share sold if they
direct the Plan Agent (as defined below) to sell common shares
held in a dividend reinvestment account. Each participant in the
Trusts Dividend Reinvestment Plan will pay a pro rata
share of brokerage commissions incurred when dividend
reinvestment occurs in open-market purchases because the Trust
will purchase its shares in the open market when the net asset
value per common share is greater than the market value per
common share. |
|
(4) |
|
Management fees are the investment advisory and
administrative services fees paid to Highland which are computed
based on Managed Assets. Such fees have been converted to net
assets for purposes of the fee table presentation as follows:
management fees, assuming no leverage, divided by (one minus the
Trusts leverage of 26.17% of the Trusts total assets
as of November 30, 2007). |
|
(5) |
|
Other Expenses includes costs associated with the
Trusts short sales on securities, including dividend and
interest expenses associated with securities sold short. When a
cash dividend is declared or interest in payable on a security
for which the Trust holds a short position, the Trust incurs the
obligation to pay an amount equal to that dividend or interest
to the lender of the shorted security. Thus, the estimate for
dividend and interest expenses paid is also based on the
dividend yields or interest payments of securities that would be
sold short as part of anticipated trading practices (which may
involve avoiding dividend or interest expenses with respect to
certain short sale transactions by closing out the position
prior to the underlying issuers ex-dividend or ex-interest
date). Other Expenses includes the dividend and
interest expense that the Trust is expected to incur during the
current fiscal year. |
|
(6) |
|
The Trust may use leverage through borrowings and/or
preferred shares. However, the Trust has no present intention to
issue preferred shares in the next twelve months. |
31
Except when noted, the information in this table is derived from
the Trusts financial statements audited by
PricewaterhouseCoopers LLP, whose report on such financial
statements is contained in the Trusts 2006 Annual Report
and incorporated by reference into the Statement of Additional
Information.
|
|
|
|
|
|
|
|
|
|
|
Six Months
Ended
|
|
|
Period Ended
|
|
|
|
June 30,
|
|
|
December 31,
|
|
Per Share
Operating Performance
|
|
2007
|
|
|
2006(a)
|
|
|
|
|
|
(unaudited)
|
|
|
|
|
|
|
|
Net Asset Value, Beginning of Period
|
|
$
|
20.08
|
|
|
$
|
19.06
|
|
|
|
|
|
|
|
|
|
|
Income from Investment Operations
|
|
|
|
|
|
|
|
|
Net investment income
|
|
|
0.84
|
|
|
|
0.71
|
|
Net realized and unrealized gain on investments
|
|
|
0.43
|
|
|
|
0.91
|
|
Total from investment operations applicable to common
shareholders
|
|
|
1.27
|
|
|
|
1.62
|
|
Less Distributions Declared to Common Shareholders
|
|
|
|
|
|
|
|
|
From net investment income
|
|
|
(0.90
|
)
|
|
|
(0.60
|
)
|
|
|
|
|
|
|
|
|
|
Net Asset Value End of Period
|
|
$
|
20.45
|
|
|
$
|
20.08
|
|
Market Value, End of Period
|
|
$
|
19.80
|
|
|
$
|
21.16
|
|
Market Value Total
Return(b)
|
|
|
6.65
|
%(c)
|
|
|
9.06
|
%(c)
|
|
|
|
|
|
|
|
|
|
Ratios to Average Net Assets/Supplemental Data
|
|
|
|
|
|
|
|
|
Common Share Information at End of Period:
|
|
|
|
|
|
|
|
|
Ratios based on average net assets
|
|
|
|
|
|
|
|
|
Net assets, end of period (in 000s)
|
|
$
|
705,903
|
|
|
$
|
692,964
|
|
Net operating expenses
|
|
|
1.81
|
%
|
|
|
1.53
|
%
|
Interest expenses
|
|
|
2.07
|
%
|
|
|
1.03
|
%
|
Dividend income from short positions
|
|
|
0.16
|
%
|
|
|
N/A
|
|
Net expenses
|
|
|
4.04
|
%
|
|
|
2.56
|
%
|
Net investment income
|
|
|
8.28
|
%
|
|
|
7.64
|
%
|
Ratios based on average Managed Assets
|
|
|
|
|
|
|
|
|
Net assets, end of period (in 000s)
|
|
$
|
705,903
|
|
|
$
|
692,964
|
|
Net operating expenses
|
|
|
1.33
|
%
|
|
|
1.31
|
%
|
Interest expenses
|
|
|
1.52
|
%
|
|
|
0.89
|
%
|
Dividend income from short positions
|
|
|
0.11
|
%
|
|
|
N/A
|
|
Net expenses
|
|
|
2.96
|
%
|
|
|
2.20
|
%
|
Net investment income
|
|
|
6.07
|
%
|
|
|
6.33
|
%
|
Portfolio turnover rate
|
|
|
52.49
|
%(c)
|
|
|
45.95
|
%(c)
|
|
|
|
(a) |
|
The Trust commenced investment operations on June 29,
2006. |
|
(b) |
|
Based on market value per share. Dividends and distributions,
if any, are assumed for purposes of this calculation to be
reinvested at prices obtained under the Trusts dividend
reinvestment plan. |
|
(c) |
|
Not annualized. |
32
PURPOSE OF THE
OFFER
The Board and the Investment Adviser have determined that it
would be in the best interests of the Trust and its shareholders
to increase the assets of the Trust, in order to more fully take
advantage of current and prospective investment opportunities
that may enable the Trust to increase both overall investment
yield on its investments and the opportunity for capital
appreciation. Recent market events and investor sentiment has
led to a meaningful correction across the debt markets,
including markets in which the Trust invests, such as loans and
high yield bonds. The Board and the Investment Adviser believe
the current market environment offers the Trust compelling
opportunities to deploy additional capital to take advantage of
attractive investment opportunities and enhance the Trusts
future risk-adjusted returns.
The Board and the Investment Adviser also believe that
increasing the Trusts assets available for investment may
enable the Trust to moderately improve the overall credit
quality of its portfolio, enhance the Trusts market
liquidity, increase future dividend distributions and reduce the
Trusts expense ratio modestly, while achieving other net
benefits to the Trust. The Board and the Investment Adviser
believe that the Offer is currently the most effective way to
raise additional assets for the Trust while offering
shareholders the opportunity to buy additional common shares at
a discounted price.
There is no assurance that the Offer will be successful. The
completion of the Offer will likely result in an immediate
dilution of the net asset value per common share for all
existing shareholders, including those who fully exercise their
rights.
IMPORTANT TERMS
OF THE OFFER
The Trust is issuing transferable rights (Rights) to
its common shareholders of record (Record Date
Shareholders) as of the close of business on
December 21, 2007 (the Record Date), entitling
the holders of those Rights to subscribe for up to an aggregate
of 11,535,615 the Trusts common shares (the
Shares) (the Offer). Record Date
Shareholders will receive one Right for each whole common share
of the Trust held on the Record Date. These Rights entitle the
Record Date Shareholders to purchase one new Share for every
three Rights held
(1-for-3).
Fractional Shares will not be issued upon the exercise of
Rights; accordingly, Rights may be exercised only in integer
multiples of three, except that any Record Date Shareholder who
is issued fewer than three Rights may subscribe, at the
Subscription Price (defined below), for one full Share. Assuming
the exercise of all Rights, the Offer will result in an
approximately 33.3% increase in the Trusts common shares
outstanding.
Record Date Shareholders who exercise all of the Rights issued
to them (other than those Rights that cannot be exercised
because they represent the right to acquire less than one Share)
are entitled to subscribe for additional Shares at the same
Subscription Price pursuant to the over-subscription privilege,
subject to certain limitations and subject to allotment.
Investors who are not shareholders on the Record Date, but who
otherwise acquire Rights to purchase common shares pursuant to
the Offer, are not entitled to subscribe for any common shares
pursuant to the over-subscription privilege. See
Over-Subscription Privilege below. The distribution
to Record Date Shareholders of transferable Rights may afford
non-participating Record Date Shareholders the opportunity to
sell their Rights for some cash value, receipt of which may be
viewed as partial compensation for any economic dilution of
their interests resulting from the Offer.
The subscription period commences on December 21, 2007 and
ends at 5:00 p.m., Eastern time, on January 18, 2008,
unless otherwise extended (the Expiration Date).
33
For purposes of determining the maximum number of Shares a
shareholder may acquire pursuant to the Offer, broker-dealers,
trust companies, banks or others whose shares are held of record
by Cede & Co., the nominee for the Depository
Trust Company (DTC), or by any other depository
or nominee will be deemed to be the holders of the Rights that
are held by Cede & Co. or such other depository or
nominee on their behalf.
The Rights are transferable and will be admitted for trading on
the NYSE under the symbol HCF.RT during the course
of the Offer. Trading in the Rights on the NYSE is expected to
be conducted until the close of trading on the NYSE on
January 17, 2008 (or if the Offer is extended, until the
last business day prior to the extended Expiration Date). See
Sale and Transferability of Rights. The Shares, once
issued, will be listed on the NYSE under the symbol
HCF. The Rights will be evidenced by subscription
certificates which will be mailed to Record Date Shareholders,
except as discussed below under Requirements for Foreign
Shareholders.
Rights may be exercised by completing a subscription certificate
and delivering it, together with payment of the estimated
Subscription Price, to the Subscription Agent. A Rights holder
will have no right to rescind a purchase after the Subscription
Agent has received a completed subscription certificate together
with payment for the Shares offered pursuant to the Offer,
except as provided under Notice of Net Asset Value
Decline. Rights holders who exercise their Rights will not
know at the time of exercise the Subscription Price of the
Shares being acquired and will be required initially to pay for
both the Shares subscribed for during the subscription period
and, if eligible, any additional Shares subscribed for pursuant
to the over-subscription privilege at the estimated Subscription
Price of $14.68 per Share. For a discussion of the method by
which Rights may be exercised and Shares paid for, see
Method for Exercising Rights and Payment for
Shares.
The Board retained the Dealer Manager to provide the Trust with
financial advisory, marketing and soliciting services relating
to the Offer, including advice with respect to the structure,
timing and terms of the Offer. In determining the structure of
the Offer, the Board considered, among other things, using a
fixed-pricing versus a variable pricing mechanism, the benefits
and drawbacks of conducting a non-transferable versus a
transferable rights offering, the effect on the Trust and its
existing shareholders if the Offer is not fully subscribed, the
dilutive effects on the Trust and its existing shareholder of
the Offer and the experience of the Dealer Manager in conducting
rights offerings. The Board also considered that the Investment
Adviser would benefit from the Offer because the investment
advisory fee paid by the Trust to the Investment Adviser
pursuant to the Investment Advisory Agreement is based on the
Trusts Managed Assets, which would increase as a result of
the Offer. See Certain Effects of the Offer on
page 43.
SUBSCRIPTION
PRICE
The subscription price (the Subscription Price) will
be determined based on a formula equal to 90% of the average of
the last reported sale prices of the Trusts common shares
on the New York Stock Exchange (the NYSE) on the
Expiration Date and the four preceding trading days (the
Formula Price). If, however, the Formula Price is
less than 75% of the net asset value per common share on the
Expiration Date, then the Subscription Price will be 75% of the
Trusts net asset value per common share on that day.
Because the Expiration Date of the subscription period will be
January 18, 2008 (unless we extend the subscription
period), Rights holders will not know the Subscription Price at
the time of exercise and will be required initially to pay for
both the Shares subscribed for pursuant to the primary
subscription and, if eligible, any additional Shares subscribed
for pursuant to the over-subscription privilege at the estimated
Subscription Price of $14.68 per share. See Payment for
Shares. Rights holders who exercise their Rights will have
no right to rescind a purchase after receipt of their completed
subscription certificates together with payment for Shares by
the Subscription Agent, except as provided
34
under Notice of Net Asset Value Decline. The Trust
does not have the right to withdraw the Rights or cancel the
Offer after the Rights have been distributed.
The Trusts net asset value per common share at the close
of business on December 14, 2007 (the last trading date prior to
the date of this prospectus on which the Trust determined its
net asset value) was $18.41 and the last reported sale price of
a share on the NYSE on that day was $16.31.
OVER-SUBSCRIPTION
PRIVILEGE
Record Date Shareholders who exercise all the Rights issued to
them (other than those Rights that cannot be exercised because
they represent the right to acquire less than one Share) are
entitled to subscribe for additional Shares at the same
Subscription Price pursuant to the over-subscription privilege,
subject to certain limitations and subject to allotment.
Investors who are not Record Date Shareholders, but who
otherwise acquire Rights to purchase Shares pursuant to the
Offer, are not entitled to subscribe for any Shares pursuant to
the over-subscription privilege. To the extent sufficient Shares
are not available to honor all over-subscription requests,
unsubscribed Shares will be allocated pro rata among those
Record Date Shareholders who over-subscribe based on the number
of common shares of the Trust they owned on the Record Date. The
allocation process may involve a series of allocations in order
to assure that the total number of Shares available for
over-subscriptions is distributed on a pro rata basis.
Record Date Shareholders who are fully exercising their Rights
during the subscription period should indicate, on the
subscription certificate which they submit with respect to the
exercise of the Rights issued to them, how many Shares they
desire to acquire pursuant to the over-subscription privilege.
Banks, broker-dealers, trustees and other nominee holders of
Rights will be required to certify to the Subscription Agent,
before any over-subscription privilege may be exercised with
respect to any particular beneficial owner, as to the aggregate
number of Rights exercised during the subscription period and
the number of Shares subscribed for pursuant to the
over-subscription privilege by such beneficial owner and that
such beneficial owners primary subscription was exercised
in full. Nominee holder over-subscription forms will be
distributed to banks, brokers, trustees and other nominee
holders of Rights with the subscription certificates.
The Trust will not offer or sell any Shares that are not
subscribed for during the subscription period or pursuant to the
over-subscription privilege.
The Trust has been advised that the Investment Adviser and one
or more of the Trusts trustees or officers may exercise
all of the Rights initially issued to them and may request
additional Shares pursuant to the over-subscription privilege.
An exercise of the over-subscription privilege by such persons
will increase their proportionate voting power and share of the
Trusts assets.
SALE AND
TRANSFERABILITY OF RIGHTS
The Rights will be admitted for trading on the NYSE under the
symbol HCF.RT during the course of the Offer.
Trading in the Rights on the NYSE may be conducted until the
close of trading on the NYSE on the last business day prior to
the Expiration Date. The Trust and the Dealer Manager will use
their best efforts to ensure that an adequate trading market for
the Rights will exist, although there is no assurance that a
market for the Rights will develop. Assuming a market exists for
the Rights, the Rights may be purchased and sold through usual
brokerage channels or sold through the Subscription Agent
(defined below).
Sales through the Subscription Agent and the Dealer
Manager. Record Date Shareholders who do not wish
to exercise any of the Rights issued to them pursuant to the
Offer may instruct the Subscription Agent to sell any
unexercised Rights through or to the Dealer Manager.
Subscription certificates representing the Rights to be sold
through or to the Dealer Manager must be received by the
35
Subscription Agent by 5:00 p.m., Eastern time, on
January 16, 2008 (or, if the subscription period is
extended, by 5:00 p.m., Eastern time, two business days
prior to the extended Expiration Date). Upon the timely receipt
by the Subscription Agent of appropriate instructions to sell
Rights, the Subscription Agent will ask the Dealer Manager
either to purchase them or to use its best efforts to complete
their sale, and the Subscription Agent will remit the proceeds
of the sale to the selling shareholder. If the Rights are sold,
sales of those Rights will be deemed to have been effected at
the weighted average price received by the Dealer Manager on the
day those Rights are sold. The sale price of any Rights sold to
the Dealer Manager will be based upon the then-current market
price for the Rights. The Dealer Manager will also attempt to
sell all Rights which remain unclaimed as a result of
subscription certificates being returned by the postal
authorities to the Subscription Agent as undeliverable as of the
fourth business day prior to the Expiration Date. The
Subscription Agent will hold the proceeds from those sales for
the benefit of those nonclaiming shareholders until the proceeds
are either claimed or revert to the State of Delaware. There can
be no assurance that the Dealer Manager will purchase or be able
to complete the sale of any of those Rights, and neither the
Trust nor the Dealer Manager have guaranteed any minimum sale
price for the Rights. If a Record Date Shareholder does not
utilize the services of the Subscription Agent and chooses to
use another broker-dealer or other financial institution to sell
Rights issued to that shareholder pursuant to the Offer, then
the other broker-dealer or financial institution may charge a
fee to sell the Rights.
Other Transfers. The Rights evidenced by a
subscription certificate may be transferred in whole by
endorsing the subscription certificate for transfer in
accordance with the instructions accompanying the subscription
certificate. A portion of the Rights evidenced by a single
subscription certificate (but not fractional Rights) may be
transferred by delivering to the Subscription Agent a
subscription certificate properly endorsed for transfer, with
instructions to register such portion of the Rights evidenced
thereby in the name of the transferee and to issue a new
subscription certificate to the transferee evidencing the
transferred Rights. If this occurs, a new subscription
certificate evidencing the balance of the Rights, if any, will
be issued to the Record Date Shareholder or, if the Record Date
Shareholder so instructs, to an additional transferee. The
signature on the subscription certificate must correspond with
the name as written upon the face of the subscription
certificate in every particular, without alteration or
enlargement, or any change. A signature guarantee must be
provided by an eligible financial institution as defined in
Rule 17Ad-15
of the Securities Exchange Act of 1934 (the Exchange
Act), subject to the standards and procedures adopted by
the Trust.
Record Date Shareholders wishing to transfer all or a portion of
their Rights should allow at least five business days prior to
the Expiration Date for: (i) the transfer instructions to
be received and processed by the Subscription Agent; (ii) a
new subscription certificate to be issued and transmitted to the
transferee or transferees with respect to transferred Rights and
to the transferor with respect to retained Rights, if any; and
(iii) the Rights evidenced by the new subscription
certificate to be exercised or sold by the recipients of the
subscription certificate. Neither the Trust nor the Subscription
Agent or the Dealer Manager shall have any liability to a
transferee or transferor of Rights if subscription certificates
are not received in time for exercise or sale prior to the
Expiration Date.
Except for the fees charged by the Information Agent,
Subscription Agent and Dealer Manager (which are expected to be
paid from the proceeds of the Offer by the Trust), all
commissions, fees and other expenses (including brokerage
commissions and transfer taxes) incurred or charged in
connection with the purchase, sale or transfer of rights will be
for the account of the transferor of the Rights, and none of
these commissions, fees or expenses will be paid by the Trust,
the Information Agent, the Subscription Agent or the Dealer
Manager. Shareholders who wish to purchase, sell, exercise or
transfer Rights through a broker, bank or other party should
first inquire about any fees and expenses that the shareholder
will incur in connection with the transactions.
36
The Trust anticipates that the Rights will be eligible for
transfer through, and that the exercise of the primary
subscription and the over-subscription may be effected through,
the facilities of DTC or the Subscription Agent until
5:00 p.m., Eastern time, on the Expiration Date.
METHOD FOR
EXERCISING RIGHTS
Rights are evidenced by subscription certificates that will be
mailed to Record Date Shareholders (except as described under
Requirements for Foreign Shareholders below) or, if
a shareholders shares are held by Cede & Co. or
any other depository or nominee on their behalf, to
Cede & Co. or the other depository or nominee. Rights
may be exercised by completing and signing the subscription
certificate and mailing it in the envelope provided, or
otherwise delivering the completed and signed subscription
certificate to the Subscription Agent, together with payment in
full at the estimated Subscription Price for the shares by the
Expiration Date as described under Payment For
Shares. Rights may also be exercised by contacting your
broker, banker or trust company, which can arrange, on your
behalf, to guarantee by the Expiration Date, delivery of payment
and of a properly completed and executed subscription
certificate pursuant to a notice of guaranteed delivery by the
close of business on the third business day after the Expiration
Date. A fee may be charged for this service. Completed
subscription certificates and payments must be received by the
Subscription Agent by 5:00 p.m., Eastern time, on the
Expiration Date (unless delivery of subscription certificate and
payment is effected by means of a notice of guaranteed delivery
as described below under Payment for Shares) at the
offices of the Subscription Agent at the addresses set forth
above under Subscription Agent. Fractional Shares
will not be issued upon exercise of Rights.
Shareholders Who are Record
Owners. Shareholders who are record owners can
choose between either option set forth below under Payment
For Shares. If time is of the essence, option
(2) will permit delivery of the subscription certificate
and payment after the Expiration Date.
Investors Whose Shares are Held by a
Nominee. Shareholders whose shares are held by a
nominee, such as a broker or trustee, must contact that nominee
to exercise their Rights. In that case, the nominee will
complete the subscription certificate on behalf of the investor
and arrange for proper payment by one of the methods set forth
below under Payment For Shares.
Nominees. Nominees, such as brokers, trustees
or depositories for securities, who hold the Trusts common
shares for the account of others should notify the respective
beneficial owners of such shares as soon as possible to
ascertain those beneficial owners intentions and to obtain
instructions with respect to the Rights. If the beneficial owner
so instructs, the nominee should complete the subscription
certificate and submit it to the Subscription Agent with the
proper payment as described below under Payment For
Shares.
Banks, brokers, trustees and other nominee holders of Rights
will be required to certify to the Subscription Agent, before
any over-subscription privilege may be exercised with respect to
any particular beneficial owner on the Record Date, as to the
aggregate number of Rights exercised during the subscription
period and the number of Shares subscribed for pursuant to the
over-subscription privilege by the beneficial owner and that the
beneficial owner exercised all the Rights issued to it pursuant
to the Offer.
REQUIREMENTS FOR
FOREIGN SHAREHOLDERS
Subscription certificates will not be mailed to Record Date
Shareholders whose addresses are outside the United States (for
these purposes, the United States includes the District of
Columbia and the territories and possessions of the United
States) (Foreign Shareholders). The Subscription
Agent will send a letter via regular mail to Foreign
Shareholders to notify them of the Offer. The Rights of Foreign
Shareholders will be held by the Subscription Agent for their
accounts until instructions are received to exercise the Rights.
If instructions have not been received by 5:00 p.m.,
Eastern time, on January 15,
37
2008, three business days prior to the Expiration Date (or, if
the subscription period is extended, on or before three business
days prior to the extended Expiration Date), the Rights of
Foreign Shareholders will be transferred by the Subscription
Agent to the Dealer Manager, who will either purchase the Rights
or use its best efforts to sell the Rights. The net proceeds, if
any, from sale of those Rights by or to the Dealer Manager will
be remitted to these Foreign Shareholders.
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Important Dates
to Remember
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Record Date
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December 21, 2007
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Subscription Period
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December 21, 2007 to
January 18, 2008
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*
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Final Day Rights Will Trade on NYSE
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January 17, 2008
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*
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Expiration Date and Pricing Date
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January 18, 2008
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*
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Payment for Shares Due or Notices of Guarantees of Delivery Due
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January 18, 2008
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*
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Payment for Guarantees of Delivery Due
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January 24, 2008
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*
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Confirmation Mailed to Participants
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January 28, 2008
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*
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Final Payment for Shares Due
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February 11, 2008
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*
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* |
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Unless the Offer is extended. |
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See The OfferPayment for Shares. |
DISTRIBUTION
ARRANGEMENTS
UBS Securities LLC will act as Dealer Manager for this Offer.
Under the terms and subject to the conditions contained in the
Dealer Manager Agreement among the Dealer Manager, the Trust and
the Investment Adviser, the Dealer Manager will provide
financial advisory services and marketing assistance in
connection with the Offer and will solicit the exercise of
Rights and participation in the over-subscription privilege. The
Trust has agreed to pay the Dealer Manager a fee for its
financial advisory, marketing and soliciting services equal to
3.50% of the aggregate Subscription Price for the Shares issued
pursuant to the exercise of Rights and the over-subscription
privilege. The fees paid to the Dealer Manager and other
expenses of the Offer will be borne by the Trust and indirectly
by all of its shareholders, including those who do not exercise
the Rights.
The Dealer Manager will reallow a part of its fees to other
broker-dealers who have assisted in soliciting the exercise of
Rights. The Dealer Manager will reallow to broker-dealers
included in the selling group to be formed and managed by the
Dealer Manager selling fees equal to 2.50% of the Subscription
Price per share for each Share issued pursuant to the Offer as a
result of their selling efforts. In addition, the Dealer Manager
will reallow to other broker-dealers that have executed and
delivered a soliciting dealer agreement and have solicited the
exercise of Rights solicitation fees equal to 0.50% of the
Subscription Price per share for each Share issued pursuant to
exercise of Rights as a result of their soliciting efforts,
subject to a maximum fee based on the number of Shares held by
each broker-dealer through DTC on the Record Date. Fees will be
paid to the broker-dealer designated on the applicable portion
of the subscription certificates or, in the absence of such
designation, to the Dealer Manager.
The Trust and the Investment Adviser have each agreed to
indemnify the Dealer Manager for, or contribute to losses
arising out of, certain liabilities, including liabilities under
the Securities Act. The Dealer Manager Agreement also provides
that the Dealer Manager will not be subject to any liability to
the Trust in rendering the services contemplated by the Dealer
Manager Agreement except for any act of bad faith, willful
misconduct or gross negligence of the Dealer Manager or reckless
disregard by the Dealer Manager of its obligations and duties
under the Dealer Manager Agreement.
Prior to the expiration of the Offer, the Dealer Manager may
independently offer for sale Shares acquired through purchasing
and exercising Rights, at prices it sets. Although the Dealer
Manager may
38
realize gains and losses in connection with such purchases and
sales, such offering of Shares is intended by the Dealer Manager
to facilitate the Offer and any such gains or losses are not
expected to be material to the Dealer Manager. The Dealer
Managers fee for its financial advisory, marketing and
soliciting services is independent of any gains or losses that
may be realized by the Dealer Manager through the purchase and
exercise of Rights.
In the ordinary course of their businesses, the Dealer Manager
and/or its
affiliates may engage in investment banking or financial
transactions with the Trust, the Investment Adviser and their
affiliates.
The principal business address of UBS Securities LLC is 299 Park
Avenue, New York, New York 10171.
SUBSCRIPTION
AGENT
The Colbent Corporation is the Subscription Agent for the Offer.
The Subscription Agent will receive for its administrative,
processing, invoicing and other services a fee estimated to be
approximately $50,000, plus reimbursement for all out-of-pocket
expenses related to the Offer. Questions regarding the
subscription certificates should be directed by mail to The
Colbent Corporation, Attn: Highland Credit Strategies Fund, P.O.
Box 859208, Braintree, MA 02185-9208. Shareholders may
also subscribe for the Offer by contacting their broker dealer,
trust company, bank or other nominee.
Completed subscription certificates must be sent together with
proper payment of the estimated Subscription Price for all
Shares subscribed for in the primary subscription and the
over-subscription privilege (for Record Date Shareholders) to
the Subscription Agent by one of the methods described below.
Alternatively, shareholders may arrange for their financial
institutions to send notices of guaranteed delivery by facsimile
to DTC to be received by the Subscription Agent prior to
5:00 p.m., Eastern time, on the Expiration Date. Facsimiles
should be confirmed by telephone at DTC. The Trust will accept
only properly completed and executed subscription certificates
actually received at any of the addresses listed below, prior to
5:00 p.m., New York City time, on the Expiration Date or by
the close of business on the third business day after the
Expiration Date following timely receipt of a notice of
guaranteed delivery. See Payment for Shares below.
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Subscription
Certificate Delivery Method
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Address/Number
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By Notice of Guaranteed Delivery:
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Contact your broker-dealer, trust company, bank, or other
nominee to notify the Trust of your intent to exercise the
Rights.
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By First Class Mail Only: (No Overnight /Express Mail):
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The Colbent Corporation
Attn: Highland Credit Strategies Fund
P.O. Box 859208
Braintree, MA 02185-9208
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By Hand:
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The Colbent Corporation
Attn: Highland Credit Strategies Fund
161 Bay State Drive
Braintree, MA 02184
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By Express Mail or Overnight Courier:
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The Colbent Corporation
Attn: Highland Credit Strategies Fund
161 Bay State Drive
Braintree, MA 02184
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The Trust will honor only subscription certificates received
by the Subscription Agent on or prior to the Expiration Date at
one of the addresses listed above. Delivery to an address other
than those listed above will not constitute good delivery.
39
INFORMATION
AGENT
The Information Agent for the Offer is The Altman Group. If you
have questions or need further information about the Offer,
please write the Information Agent at 1200 Wall Street West,
3rd Fl.,
Lyndhurst, NJ 07071 or call
(800) 370-1749.
Any questions or requests for assistance concerning the method
of subscribing for Shares or additional copies of this
prospectus or subscription certificates should be directed to
the Information Agent. Shareholders may also contact their
brokers or nominees for information with respect to the Offer.
The Information Agent will receive a fee estimated to be
approximately $18,000 for its services, plus reimbursement for
all out-of-pocket expenses related to the Offer. The fees and
expenses of the Information Agent are included in the fees and
expenses of the Offer and therefore will be borne by the Trust
and indirectly by all of its shareholders, including those who
do not exercise their Rights.
EXPIRATION OF THE
OFFER
The Offer will expire at 5:00 p.m., Eastern time, on
January 18, 2008, unless the Trust extends the Expiration
Date. Rights will expire on the Expiration Date and may not be
exercised after this date. If the Trust extends the Expiration
Date, the Trust will make an announcement as promptly as
practicable. This announcement will be issued no later than
9:00 a.m., Eastern time, on the next business day following
the previously scheduled Expiration Date. Without limiting the
manner in which the Trust may choose to make this announcement,
the Trust will not, unless otherwise required by law, have any
obligation to publish, advertise or otherwise communicate this
announcement other than by making a release to the Dow Jones
News Service or any other means of public announcement as the
Trust may deem proper.
PAYMENT FOR
SHARES
Rights holders who wish to acquire Shares pursuant to the Offer
may choose between the following methods of payment:
(1) A Rights holder can send the subscription
certificate together with payment for the Shares subscribed for
during the subscription period and, if eligible, for any
additional Shares subscribed for pursuant to the
over-subscription privilege to the Subscription Agent based upon
an estimated Subscription Price of $14.68 per Share.
Subscription will be accepted when payment, together with the
executed subscription certificate, is received by the
Subscription Agent at one of the addresses set forth above; the
payment and subscription certificate must be received by the
Subscription Agent by 5:00 p.m., Eastern time, on the
Expiration Date. The Subscription Agent will deposit all checks
received by it for the purchase of Shares into a segregated
interest-bearing account of the Trust (the interest from which
will belong to the Trust) pending proration and distribution of
Shares. A payment pursuant to this method must be in
U.S. dollars by money order or check drawn on a bank
located in the United States, must be payable to Highland
Credit Strategies Fund and must accompany a properly
completed and executed subscription certificate for such
subscription to be accepted.
(2) Alternatively, a subscription will be accepted by
the Subscription Agent if, by 5:00 p.m., Eastern time, on
the Expiration Date, the Subscription Agent has received a
notice of guaranteed delivery by facsimile (telecopy) or
otherwise from a bank, a trust company or NYSE member
guaranteeing delivery of (i) payment of the full
Subscription Price for the Shares subscribed for during the
subscription period and, if eligible, any additional Shares
subscribed for pursuant to the over-subscription privilege and
(ii) a properly completed and executed subscription
certificate. The Subscription Agent will not honor a notice of
guaranteed delivery unless a properly completed and executed
subscription certificate and full payment for the
40
Shares at the estimated Subscription Price are received by the
Subscription Agent by the close of business on the third
business day after the Expiration Date.
On the confirmation date, which will be five business days
following the Expiration Date, a confirmation will be sent by
the Subscription Agent to each Rights holder exercising its
Rights (or, if a Rights holders common shares are held by
DTC or any other depository or nominee, to DTC and that other
depository or nominee) showing (i) the number of Shares of
the Trust acquired during the subscription period, (ii) the
number of Shares, if any, acquired pursuant to the
over-subscription privilege, (iii) the per share and total
purchase price for the Shares and (iv) any additional
amount payable to the Trust by the Rights holder or any excess
to be refunded by the Trust to the Rights holder, in each case
based on the Subscription Price as determined on the Expiration
Date. If any Record Date Shareholder exercises its right to
acquire Shares of the Trust pursuant to the over-subscription
privilege, any excess payment which would otherwise be refunded
to the Record Date Shareholder will be applied by the Trust
toward payment for Shares acquired pursuant to exercise of the
over-subscription privilege. Any additional payment required
from a Rights holder must be received by the Subscription Agent
within ten business days after the confirmation date
(February 11, 2008, unless the Expiration Date is
extended). Any excess payment to be refunded by the Trust to a
Rights holder will be mailed by the Subscription Agent to such
Rights holder as promptly as practicable. All payments by a
Rights holder must be in U.S. dollars by money order or
check drawn on a bank located in the United States and payable
to Highland Credit Strategies Fund.
Whichever of the two methods described above is used, issuance
and delivery of certificates for the Shares subscribed for are
contingent upon actual payment for such Shares.
Rights holders who have exercised their Rights will have no
right to rescind their subscription after receipt of the
completed subscription certificate together with payment for
Shares by the Subscription Agent, except as described under
Notice of Net Asset Value Decline below.
If a Rights holder who acquires Shares during the subscription
period or pursuant to the over-subscription privilege (for
Record Date Shareholders) does not make payment of any amounts
due by the Expiration Date or the date payment is due under a
notice of guaranteed delivery, the Trust reserves the right to
take any or all of the following actions through all appropriate
means: (i) find other Record Date Shareholders for the
subscribed and unpaid for Shares; (ii) apply any payment
actually received by the Trust toward the purchase of the
greatest whole number of Shares which could be acquired by the
Rights holder upon exercise of such Rights acquired during the
subscription period or pursuant to the over-subscription
privilege;
and/or
(iii) exercise any and all other rights or remedies to
which the Trust may be entitled, including, without limitation,
the right to set off against payments actually received by it
with respect to such subscribed Shares.
The method of delivery of completed subscription certificates
and payment of the Subscription Price to the Subscription Agent
will be at the election and risk of exercising Rights holders,
but if sent by mail it is recommended that such forms and
payments be sent by registered mail, properly insured, with
return receipt requested, and that a sufficient number of days
be allowed to ensure delivery to the Subscription Agent and
clearance of payment by 5:00 p.m., Eastern time, on the
Expiration Date. Because uncertified personal checks may take at
least five business days to clear, exercising Rights holders are
strongly urged to pay, or arrange for payment, by means of
certified or cashiers check or money order.
All questions concerning the timeliness, validity, form and
eligibility of any exercise of Rights will be determined by the
Trust, which determinations will be final and binding. The
Trust, in its sole discretion, may waive any defect or
irregularity, or permit a defect or irregularity to be corrected
within such time as it may determine, or reject the purported
exercise of any Right. Subscriptions will not be deemed to have
been received or accepted until substantially all irregularities
have been waived or cured within such time as the Trust
determines in its sole discretion. The Trust will not be under
any duty to
41
give notification of any defect or irregularity in connection
with the submission of subscription certificates or incur any
liability for failure to give such notification.
NOTICE OF NET
ASSET VALUE DECLINE
The Trust has, pursuant to the SECs regulatory
requirements, undertaken to suspend the Offer until the Trust
amends this prospectus if subsequent to December 14, 2007,
the effective date of the Trusts registration statement,
the Trusts net asset value declines more than 10% from the
Trusts net asset value as of that date. In that event, the
Expiration Date will be extended and the Trust will notify
Record Date Shareholders of any such decline and permit Rights
holders to cancel their exercise of Rights.
DELIVERY OF SHARE
CERTIFICATES
Participants in the Trusts dividend reinvestment plan (the
Plan) will have any Shares acquired pursuant to the
Offer credited to their shareholder dividend reinvestment
accounts in the Plan. Shareholders whose shares are held of
record by DTC or by any other depository or nominee on their
behalf or their broker-dealers behalf will have any Shares
acquired during the subscription period credited to the account
of DTC or other depository or nominee. Shares acquired pursuant
to the over-subscription privilege will be certificated and
share certificates representing these Shares will be sent
directly to DTC or other depository or nominee. With respect to
all other shareholders, share certificates for all Shares
acquired pursuant to the Offer will be mailed promptly after
payment for the shares subscribed for has cleared.
U.S. FEDERAL
INCOME TAX CONSEQUENCES
The following is a general summary of the material
U.S. federal income tax consequences of the Offer under the
provisions of the Internal Revenue Code of 1986, as amended (the
Code), and Treasury regulations in effect as of the
date of the prospectus that are generally applicable to Record
Date Shareholders who are United States persons within the
meaning of the Code, and does not address any foreign, state or
local tax consequences. The Code and Treasury regulations are
subject to change or differing interpretations by legislative or
administrative action, which may be retroactive. Record Date
Shareholders and exercising Rights holders should consult their
tax advisors regarding the tax consequences, including
U.S. federal, state, local or foreign tax consequences,
relevant to their particular circumstances.
The value of a Right will not be includible in the income of a
Record Date Shareholder at the time the Right is issued.
The basis of a Right issued to a Record Date Shareholder will be
zero, and the basis of the share with respect to which the Right
was issued (the old share) will remain unchanged, unless either
(a) the fair market value of the Right on the date of
distribution is at least 15% of the fair market value of the old
share, or (b) such shareholder affirmatively elects (in the
manner set out in Treasury regulations under the Code) to
allocate to the Right a portion of the basis of the old share.
If either (a) or (b) applies, such shareholder must
allocate basis between the old share and the Right in proportion
to their fair market values on the date of distribution.
The basis of a Right purchased in the market will generally be
its purchase price.
The holding period of a Right issued to a Record Date
Shareholder will include the holding period of the old share.
No loss will be recognized by a Record Date Shareholder if a
Right distributed to such shareholder expires unexercised
because the basis of the old share may be allocated to a Right
only if the Right is
42
exercised. If a Right that has been purchased in the market
expires unexercised, there will be a recognized loss equal to
the basis of the Right.
Any gain or loss on the sale of a Right will be a capital gain
or loss if the Right is held as a capital asset (which in the
case of Rights issued to Record Date Shareholders will depend on
whether the old share is held as a capital asset), and will be a
long-term capital gain or loss if the holding period is deemed
to exceed one year.
No gain or loss will be recognized by a shareholder upon the
exercise of a Right, and the basis of any Share acquired upon
exercise (the new Share) will equal the sum of the basis, if
any, of the Right and the Subscription Price for the new Share.
The holding period for the new share will begin on the date when
the Right is exercised.
For more information relating to an investment in the Trust, see
Tax Matters below and Tax Matters in the
Statement of Additional Information.
EMPLOYEE PLAN
CONSIDERATIONS
Shareholders whose shares are in employee benefit plans subject
to the Employee Retirement Income Security Act of 1974, as
amended (ERISA) (including corporate savings and
401(k) plans), Keogh or H.R. 10 plans of self-employed
individuals and individual retirement accounts should be aware
that additional contributions of cash to the employee retirement
plan (other than rollover contributions or trustee-to-trustee
transfers from other employee retirement plans) in order to
exercise Rights would be treated as contributions to the
employee retirement plan and, when taken together with
contributions previously made, may result in, among other
things, excise taxes for excess or nondeductible contributions.
In the case of employee retirement plan qualified under
Section 401(a) of the Code and certain other employee
retirement plans, additional cash contributions could cause the
maximum contribution limitations of Section 415 of the Code
or other qualification rules to be violated. In addition, there
may be other adverse tax and ERISA consequences if Rights are
sold or transferred by an employee retirement plan.
Employee retirement plans and other tax exempt entities,
including governmental plans, should also be aware that if they
borrow in order to finance their exercise of Rights, they may
become subject to the tax on unrelated business taxable income
(UBTI) under Section 511 of the Code. If any
portion of an individual retirement account (IRA) is
used as security for a loan, the portion so used is also treated
as distributed to the IRA depositor.
ERISA contains fiduciary responsibility requirements, and ERISA
and the Code contain prohibited transaction rules that may
affect the exercise of Rights. Due to the complexity of these
rules and the penalties for noncompliance, employee retirement
plans should consult with their counsel and other advisers
regarding the consequences of their exercise of Rights under
ERISA and the Code.
CERTAIN EFFECTS
OF THE OFFER
The Investment Adviser will benefit from the Offer because the
investment advisory fee is based on the Trusts average
weekly Managed Assets. It is not possible to state precisely the
amount of additional compensation the Investment Adviser will
receive as a result of the Offer because it is not known how
many Shares of the Trust will be subscribed for and because the
proceeds of the Offer will be invested in additional portfolio
securities which will fluctuate in value. However, assuming
(i) all Rights are exercised, (ii) the Trusts
average weekly net asset value during 2008 is $18.41 per
share (the net asset value per share on December 14, 2007)
(iii) the Subscription Price is $14.68 per share (90%
of the last reported sale price of the Trusts common
shares on December 14, 2007), and (iv) assuming, for
purposes of this example, the Trust increases the amount of
leverage outstanding while maintaining approximately the same
percentage of total assets attributable to leverage, and after
giving effect to Dealer Manager fees and other offering
expenses, the Investment Adviser would receive additional
43
advisory fees of approximately $2.2 million for the
calendar year 2008 and would continue to receive additional
advisory fees as a result of the Offer, based on the
Trusts average weekly Managed Assets attributable to the
shares issued in the Offer, thereafter.
INVESTMENT
CONSIDERATIONS
Upon completion of the Offer, shareholders who do not exercise
their Rights fully will own a smaller proportional interest in
the Trust than would be the case if the Offer had not been made.
In addition, because the Subscription Price per Share will be
less than the then Trusts net asset value per share, the
Offer will likely result in a dilution of the Trusts net
asset value per share for all shareholders, irrespective of
whether they exercise all or any portion of their Rights.
Although it is not possible to state precisely the amount of
such a decrease in value, because it is not known at this time
what the Subscription Price will be, what the net asset value
per share will be at the Expiration Date or what proportion of
Shares will be subscribed for, the dilution could be
substantial. For example, assuming that all Rights are
exercised, that the Trusts net asset value on the
Expiration Date is $18.41 per share (the net asset value
per share on December 14, 2007), and that the Subscription
Price is $14.68 per share (90% of the last reported sale
price of the Trusts common shares on December 14,
2007), the Trusts net asset value per share on this date
would be reduced by approximately $0.18 per share, after
giving affect to Dealer Manager fees and other offering
expenses, estimated at $6,366,596, payable by the Trust. Record
Date Shareholders will experience a decrease in the net asset
value per share held by them, irrespective of whether they
exercise all or any portion of their Rights. The distribution of
transferable Rights, which may themselves have value, will
afford non-participating shareholders the potential of receiving
a cash payment upon the sale of the Rights, receipt of which may
be viewed as partial compensation for the economic dilution of
their interests.
The Trust will invest the net proceeds of any sales of
securities in accordance with the Trusts investment
objectives and policies as stated below. Assuming current market
conditions, the Trust estimates that the net proceeds of the
Offer will be substantially invested in accordance with its
investment objectives and policies within one to three months of
the completion of the Offer. Pending such investment, it is
anticipated that the proceeds of the Offer will be invested in
short-term debt securities. The Trust does not expect to use any
part of the proceeds to repay any of its outstanding debt under
the Loan Agreement. Following the completion of the Offer, the
Trust may increase the amount of leverage outstanding. See
Use of Leverage.
The Trust is a non-diversified, closed-end management investment
company. The Trust was organized as a Delaware statutory trust
on March 10, 2006, pursuant to an Agreement and Declaration
of Trust governed by the laws of the State of Delaware. The
Trust commenced operations on June 29, 2006, following its
initial public offering. The Trusts principal office is
located at Two Galleria Tower, 13455 Noel Road, Suite 800,
Dallas, Texas 75240 and its telephone number is
(877) 665-1287.
44
Investment
objectives and policies
INVESTMENT
OBJECTIVES AND POLICIES
The Trusts investment objectives are to provide both
current income and capital appreciation. The Trust seeks to
achieve its investment objectives by investing primarily in the
following categories of securities and instruments of
corporations and other business entities: (i) secured and
unsecured floating and fixed rate loans; (ii) bonds and
other debt obligations; (iii) debt obligations of stressed,
distressed and bankrupt issuers; (iv) structured products,
including but not limited to, mortgage-backed and other
asset-backed securities and collateralized debt obligations; and
(v) equities. Highland will seek to achieve its capital
appreciation objective by investing in category (iii) and
(v) obligations and securities, and to a lesser extent, in
category (i), (ii), and (iv) obligations. Under normal
market conditions, at least 80% of the Trusts assets are
invested in one or more of these principal investment
categories. Subject only to this general guideline, Highland has
broad discretion to allocate the Trusts assets among these
investment categories and to change allocations as conditions
warrant. In order to pursue most effectively its opportunistic
investment strategy, the Trust will not maintain fixed duration,
maturity or credit quality policies. The Trust may invest in
debt obligations of any credit quality. The Trust may invest
without limitation in securities and obligations of domestic
issuers, but may invest only up to 20% of the assets in
non-U.S. obligors
or issuers.
Within the categories of obligations and securities in which the
Trust invests, Highland also employs various trading strategies,
including capital structure arbitrage, pair trades and shorting.
See Portfolio Composition for further description of
these strategies. The Trust may also invest in these categories
of obligations and securities through the use of derivatives. A
significant portion of the Trusts assets may be invested
in securities rated below investment grade, which are commonly
referred to as junk securities. Junk securities are
subject to greater risk of loss of principal and interest and
may be less liquid than investment grade securities. Highland
does not anticipate a high correlation between the performance
of the Trusts portfolio and the performance of the
corporate bond and equity markets.
The Trusts investment objectives may be changed without
shareholder approval. There can be no assurance that the
Trusts investment objectives will be achieved.
INVESTMENT
STRATEGIES
Under normal market conditions, the Trust invests across various
markets in which Highland holds significant investment
experience: primarily the leveraged loan, high yield, structured
products and stressed and distressed markets. Highland makes
investment decisions based on quantitative analysis, which
employs sophisticated, data-intensive models to drive the
investment process. Highland has full discretion regarding the
capital markets from which it can access investment
opportunities in accordance with the investment limitations set
forth in this prospectus.
The Investment Adviser uses trading strategies to exploit
pricing inefficiencies across the credit markets, or debt
markets, and within an individual issuers capital
structure. Highland varies its investments by strategy,
industry, security type and credit market, but reserves the
right to re-position its portfolio among these criteria
depending on market dynamics, and thus the Trust may experience
high portfolio turnover. The Investment Adviser manages interest
rate, default, currency and systemic risks through a variety of
trading methods and market tools, including derivative hedging
instruments, as it deems appropriate. This multi-strategy
investment program allows the Investment Adviser to assess what
it considers to be the best opportunities across multiple
markets and to adjust quickly the Trusts trading
strategies and market focus to changing conditions. The
Investment Adviser focuses primarily on the
U.S. marketplace, but may pursue opportunities in the
non-U.S. credit
or securities markets by investing up to 20% of the Trusts
assets in
non-U.S. credit
or securities market investments.
45
Investment
objectives and policies
The Investment Adviser may select investments from a wide range
of trading strategies and credit markets in order to vary the
Trusts investments and to optimize the risk-reward
parameters of the Trust. Highland does not intend to invest the
Trusts assets according to pre-determined allocations. The
investment team and other Highland personnel uses a wide range
of resources to identify attractive individual investments and
promising investment strategies for consideration in connection
with investments by the Trust. The following is a description of
the general types of securities in which the Trust may invest.
This description is merely a summary, and the Investment Adviser
has discretion to cause the Trust to invest in other types of
securities and to follow other investment criteria and
guidelines as described herein.
The Trust invests and trades in listed and unlisted, public and
private, rated and unrated, debt and equity instruments and
other obligations, including structured debt and equity
instruments as well as financial derivatives. Investments may
include investments in stressed and distressed positions, which
may include publicly-traded debt and equity securities,
obligations which were privately placed with banks, insurance
companies and other lending institutions, trade claims, accounts
receivable and any other form of obligation recognized as a
claim in a bankruptcy or workout process. The Trust may invest
in securities traded in foreign countries and denominated in
foreign currencies.
As part of its investment program, the Trust may invest, from
time to time, in debt or synthetic instruments that are sold in
direct placement transactions between their issuers and their
purchasers and that are neither listed on an exchange, nor
traded over the counter. The Trust may also receive equity or
equity-related securities in connection with a workout
transaction or may invest directly in equity securities.
The Trust may employ currency hedges (either in the forward or
options markets) in certain circumstances to reduce currency
risk and may engage in other derivative transactions for hedging
purposes or to enhance total return. The Trust may also lend
securities and engage in short sales of securities. The Trust is
currently leveraged through the use of a credit facility and may
continue to use leverage in the future through borrowings or the
issuance of preferred shares. However, the Trust has no present
intention to issue preferred shares within the next twelve
months. In addition, the Trust may invest in the securities of
companies whose capital structures are highly leveraged.
From time to time, the Investment Adviser may also invest a
portion of the Trusts assets in short-term
U.S. Government obligations, certificates of deposit,
commercial paper and other money market instruments, including
repurchase agreements with respect to such obligations to enable
the Trust to make investments quickly and to serve as collateral
with respect to certain of its investments. A greater percentage
of Trust assets may be invested in such obligations if the
Investment Adviser believes that a defensive position is
appropriate because of the outlook for security prices or in
order to respond to adverse market, economic business or
political conditions. From time to time cash balances in the
Trusts brokerage account may be placed in a money market
fund.
For a more complete discussion of the Trusts portfolio
composition, see Portfolio Composition below.
46
The Trusts portfolio will be composed principally of the
following investments. Additional information relating to the
Trusts investment policies and restrictions and the
Trusts portfolio investments is contained in the Statement
of Additional Information.
Senior Loans. Senior loans hold the most
senior position in the capital structure of a business entity,
are typically secured with specific collateral and have a claim
on the general assets of the borrower that is senior to that
held by subordinated debtholders and stockholders of the
borrower. The proceeds of senior loans primarily are used to
finance leveraged buyouts, recapitalizations, mergers,
acquisitions, stock repurchases, and, to a lesser extent, to
finance internal growth and for other corporate purposes. Senior
loans typically have rates of interest which are redetermined
either daily, monthly, quarterly or semi-annually by reference
to a base lending rate, plus a premium. These base lending rates
generally are the London Interbank Offered Rate
(LIBOR), the prime rate offered by one or more major
United States banks (Prime Rate) or the certificate
of deposit (CD) rate or other base lending rates
used by commercial lenders.
Loans and other corporate debt obligations are subject to the
risk of non-payment of scheduled interest or principal. Such
non-payment would result in a reduction of income to the Trust,
a reduction in the value of the investment and a potential
decrease in the net asset value of the Trust. There can be no
assurance that the liquidation of any collateral securing a
senior loan would satisfy a borrowers obligation in the
event of non-payment of scheduled interest or principal
payments, or that such collateral could be readily liquidated.
In the event of bankruptcy of a borrower, the Trust could
experience delays or limitations with respect to its ability to
realize the benefits of the collateral securing a senior loan.
To the extent that a senior loan is collateralized by stock in
the borrower or its subsidiaries, such a stock may lose all or
substantially all of its value in the event of the bankruptcy of
a borrower. Some senior loans are subject to the risk that a
court, pursuant to fraudulent conveyance or other similar laws,
could subordinate senior loans to presently existing or future
indebtedness of the borrower or take other action detrimental to
the holders of senior loans including, in certain circumstances,
invalidating such senior loans or causing interest previously
paid to be refunded to the borrower. If interest were required
to be refunded, it could negatively affect the Trusts
performance. To the extent a senior loan is subordinated in the
capital structure, it will have characteristics similar to other
subordinated debtholders, including a greater risk of nonpayment
of interest or principal.
Many loans in which the Trust invests, and the issuers of such
loans, are not rated by a rating agency, not registered with the
Commission or any state securities commission and not listed on
any national securities exchange. The amount of public
information available with respect to issuers of senior loans
will generally be less extensive than that available for issuers
of registered or exchange listed securities. In evaluating the
creditworthiness of borrowers, the Investment Adviser will
consider, and may rely in part, on analyses performed by others.
The Investment Adviser does not view ratings as the
determinative factor in its investment decisions and relies more
upon its credit analysis abilities than upon ratings. Borrowers
may have outstanding debt obligations that are rated below
investment grade by a rating agency. A high percentage of senior
loans held by the Trust may be rated, if at all, below
investment grade by independent rating agencies. In the event
senior loans are not rated, they are likely to be the equivalent
of below investment grade quality. Debt securities which are
unsecured and rated below investment grade (i.e., Ba and below
by Moodys Investors Service, Inc.
(Moodys) or BB and below by
Standard & Poors Ratings Group, a division of
The McGraw-Hill Companies, Inc. (S&P)) and
comparable unrated bonds, are viewed by the rating agencies as
having speculative characteristics and are commonly known as
junk bonds. A description of the ratings of
corporate bonds by Moodys and S&P included as
Appendix A to the Statement of Additional Information.
Because senior loans are senior in a borrowers capital
structure and are often secured by specific collateral, the
Investment Adviser believes that senior loans have more
favorable loss recovery rates as compared to most other
47
Portfolio
composition
types of below investment grade debt obligations. However, there
can be no assurance that the Trusts actual loss recovery
experience will be consistent with the Investment Advisers
prior experience or that the Trusts senior loans will
achieve any specific loss recovery rates.
No active trading market may exist for many senior loans, and
some senior loans may be subject to restrictions on resale. The
Trust is not limited in the percentage of its assets that may be
invested in senior loans and other securities deemed to be
illiquid. A secondary market may be subject to irregular trading
activity, wide bid/ask spreads and extended trade settlement
periods, which may impair the ability to realize full value on
the disposition of an illiquid senior loan, and cause a material
decline in the Trusts net asset value.
Senior loans generally are arranged through private negotiations
between a borrower and a group of financial institutions
initially represented by an agent who is usually one of the
originating lenders. In larger transactions, it is common to
have several agents. Generally, however, only one such agent has
primary responsibility for ongoing administration of a senior
loan. Agents are typically paid fees by the borrower for their
services. The agent is primarily responsible for negotiating the
credit agreement which establishes the terms and conditions of
the senior loan and the rights of the borrower and the lenders.
The agent is also responsible for monitoring collateral and for
exercising remedies available to the lenders such as foreclosure
upon collateral.
Credit agreements may provide for the termination of the
agents status in the event that it fails to act as
required under the relevant credit agreement, becomes insolvent,
enters FDIC receivership or, if not FDIC insured, enters into
bankruptcy. Should such an agent, lender or assignor with
respect to an assignment inter-positioned between the Trust and
the borrower become insolvent or enter FDIC receivership or
bankruptcy, any interest in the senior loan of such person and
any loan payment held by such person for the benefit of the
Trust should not be included in such persons or
entitys bankruptcy estate. If, however, any such amount
were included in such persons or entitys bankruptcy
estate, the Trust would incur certain costs and delays in
realizing payment or could suffer a loss of principal or
interest. In this event, the Trust could experience a decrease
in net asset value.
The Trusts investments in senior loans may take one of
several forms, including acting as one of the group of lenders
originating a senior loan, purchasing an assignment of a portion
of a senior loan from a third party or acquiring a participation
in a senior loan. When the Trust is a member of the originating
syndicate for a senior loan, it may share in a fee paid to the
syndicate. When the Trust acquires a participation in, or an
assignment of, a senior loan, it may pay a fee to, or forego a
portion of interest payments from, the lender selling the
participation or assignment. The Trust will act as lender, or
purchase an assignment or participation, with respect to a
senior loan only if the agent is determined by the Investment
Adviser to be creditworthy.
When the Trust is one of the original lenders, it will have a
direct contractual relationship with the borrower and can
enforce compliance by the borrower with terms of the credit
agreement. It also may have negotiated rights with respect to
any funds acquired by other lenders through set-off. Original
lenders also negotiate voting and consent rights under the
credit agreement. Actions subject to lender vote or consent
generally require the vote or consent of the majority of the
holders of some specified percentage of the outstanding
principal amount of the senior loan. Certain decisions, such as
reducing the interest rate, or extending the maturity of a
senior loan, or releasing collateral securing a senior loan,
among others, frequently require the unanimous vote or consent
of all lenders affected.
When the Trust is a purchaser of an assignment, it typically
succeeds to all the rights and obligations under the credit
agreement of the assigning lender and becomes a lender under the
credit agreement with the same rights and obligations as the
assigning lender. Assignments are, however, arranged through
private negotiations between potential assignees and potential
assignors, and the rights and
48
Portfolio
composition
obligations acquired by the purchaser of an assignment may be
more limited than those held by the assigning lender.
The Trust may also invest in participations in senior loans. The
rights of the Trust when it acquires a participation are likely
to be more limited than the rights of an original lender or an
investor who acquired an assignment. Participation by the Trust
in a lenders portion of a senior loan typically means that
the Trust has only a contractual relationship with the lender,
not with the borrower. This means that the Trust has the right
to receive payments of principal, interest and any fees to which
it is entitled only from the lender selling the participation
and only upon receipt by the lender of payments from the
borrower.
With a participation, the Trust will have no rights to enforce
compliance by the borrower with the terms of the credit
agreement or any rights with respect to any funds acquired by
other lenders through setoff against the borrower. In addition,
the Trust may not directly benefit from the collateral
supporting the senior loan because it may be treated as a
general creditor of the lender instead of a senior secured
creditor of the borrower. As a result, the Trust may be subject
to delays, expenses and risks that are greater than those that
exist when the Trust is the original lender or holds an
assignment. This means the Trust must assume the credit risk of
both the borrower and the lender selling the participation. The
Trust will consider a purchase of participations only in those
situations where the Investment Adviser considers the
participating lender to be creditworthy.
In the event of a bankruptcy or insolvency of a borrower, the
obligation of the borrower to repay the senior loan may be
subject to certain defenses that can be asserted by such
borrower against the Trust as a result of improper conduct of
the lender selling the participation. A participation in a
senior loan will be deemed to be a senior loan for the purposes
of the Trusts investment objectives and policies.
Investing in senior loans involves investment risk. Some
borrowers default on their senior loan payments. The Trust
attempts to manage this credit risk through multiple different
investments within the portfolio and ongoing analysis and
monitoring of borrowers. The Trust also is subject to market,
liquidity, interest rate and other risks. See Principal
Risks of the Trust.
Second Lien Loans. Second lien loans are loans
made by public and private corporations and other
non-governmental entities and issuers for a variety of purposes.
Second lien loans are second in right of payment to one or more
senior loans of the related borrower. Second lien loans
typically are secured by a second priority security interest or
lien to or on specified collateral securing the borrowers
obligation under the loan and typically have similar protections
and rights as senior loans. Second lien loans are not (and by
their terms cannot) become subordinate in right of payment to
any obligation of the related borrower other than senior loans
of such borrower. Second lien loans, like senior loans,
typically have adjustable floating rate interest payments.
Because second lien loans are second to senior loans, they
present a greater degree of investment risk but often pay
interest at higher rates reflecting this additional risk. Such
investments generally are of below investment grade quality.
Other than their subordinated status, second lien loans have
many characteristics and risks similar to senior loans discussed
above. In addition, second lien loans of below investment grade
quality share many of the risk characteristics of non-investment
grade securities. As in the case of senior loans, the Trust may
purchase interests in second lien loans through assignments or
participations.
Second lien loans are subject to the same risks associated with
investment in senior loans and non-investment grade securities.
Because second lien loans are second in right of payment to one
or more senior loans of the related borrower, they therefore are
subject to additional risk that the cash flow of the borrower
and any property securing the loan may be insufficient to meet
scheduled payments after giving effect to the senior secured
obligations of the borrower. Second lien loans are also expected
to have greater price volatility than senior loans and may be
less liquid. There is also a possibility that
49
Portfolio
composition
originators will not be able to sell participations in second
lien loans, which would create greater credit risk exposure.
Other Secured Loans. Secured loans other than
senior loans and second lien loans are made to public and
private corporations and other non-governmental entities and
issuers for a variety of purposes. Such secured loans may rank
lower in right of payment to one or more senior loans and second
lien loans of the borrower. Such secured loans typically are
secured by a lower priority security interest or lien to or on
specified collateral securing the borrowers obligation
under the loan, and typically have more subordinated protections
and rights than senior loans and second lien loans. Secured
loans may become subordinated in right of payment to more senior
obligations of the borrower issued in the future. Such secured
loans may have fixed or adjustable floating rate interest
payments. Because such secured loans may rank lower as to right
of payment than senior loans and second lien loans of the
borrower, they may present a greater degree of investment risk
than senior loans and second lien loans but often pay interest
at higher rates reflecting this additional risk. Such
investments generally are of below investment grade quality.
Other than their more subordinated status, such investments have
many characteristics and risks similar to senior loans and
second lien loans discussed above. In addition, secured loans of
below investment grade quality share many of the risk
characteristics of non-investment grade securities. As in the
case of senior loans and second lien loans, the Trust may
purchase interests in other secured loans through assignments or
participations. Other secured loans are subject to the same
risks associated with investment in senior loans, second lien
loans and non-investment grade securities. Because such loans,
however, may rank lower in right of payment to senior loans and
second lien loans of the borrower, they may be subject to
additional risk that the cash flow of the borrower and any
property securing the loan may be insufficient to repay the
scheduled payments after giving effect to more senior secured
obligations of the borrower. Such secured loans are also
expected to have greater price volatility than senior loans and
second lien loans and may be less liquid. There is also a
possibility that originators will not be able to sell
participations in other secured loans, which would create
greater credit risk exposure.
Unsecured Loans. Unsecured loans are loans
made to public and private corporations and other
non-governmental entities and issuers for a variety of purposes.
Unsecured loans generally have lower priority in right of
payment compared to holders of secured debt of the borrower.
Unsecured loans are not secured by a security interest or lien
to or on specified collateral securing the borrowers
obligation under the loan. Unsecured loans by their terms may be
or may become subordinate in right of payment to other
obligations of the borrower, including senior loans, second lien
loans and other secured loans. Unsecured loans may have fixed or
adjustable floating rate interest payments. Because unsecured
loans are subordinate to the secured debt of the borrower, they
present a greater degree of investment risk but often pay
interest at higher rates reflecting this additional risk. Such
investments generally are of non-investment grade quality. Other
than their subordinated and unsecured status, such investments
have many characteristics and risks similar to senior loans,
second lien loans and other secured loans discussed above. In
addition, unsecured loans of non-investment grade quality share
many of the risk characteristics of non-investment grade
securities. As in the case of secured loans, the Trust may
purchase interests in unsecured loans through assignments or
participations.
Unsecured loans are subject to the same risks associated with
investment in senior loans, second lien loans, other secured
loans and non-investment grade securities. However, because
unsecured loans rank lower in right of payment to any secured
obligations of the borrower, they may be subject to additional
risk that the cash flow of the borrower and available assets may
be insufficient to meet scheduled payments after giving effect
to the secured obligations of the borrower. Unsecured loans are
also expected to have greater price volatility than secured
loans and may be less liquid. There is also a possibility that
loan originators will not be able to sell participations in
unsecured loans, which would create greater credit risk exposure.
50
Portfolio
composition
Investment Grade Securities. The Trust may
invest in a wide variety of bonds that are rated or determined
by the Investment Adviser to be of investment grade quality of
varying maturities issued by U.S. corporations and other
business entities. Bonds are fixed or variable rate debt
obligations, including bills, notes, debentures, money market
instruments and similar instruments and securities. Bonds
generally are used by corporations and other issuers to borrow
money from investors for a variety of business purposes. The
issuer pays the investor a fixed or variable rate of interest
and normally must repay the amount borrowed on or before
maturity. Certain bonds are perpetual in that they
have no maturity date. Some investment grade securities, such as
zero coupon bonds, do not pay current interest, but are sold at
a discount from their face values. Although more creditworthy
and generally less risky than non-investment grade securities,
investment grade securities are still subject to market and
credit risk. Market risk relates to changes in a securitys
value as a result of interest rate changes generally. Investment
grade securities have varying levels of sensitivity to changes
in interest rates and varying degrees of credit quality. In
general, bond prices rise when interest rates fall, and fall
when interest rates rise. Longer-term bonds and zero coupon
bonds are generally more sensitive to interest rate changes.
Credit risk relates to the ability of the issuer to make
payments of principal and interest. The values of investment
grade securities like those of other debt securities may be
affected by changes in the credit rating or financial condition
of an issuer. Investment grade securities are generally
considered medium-and high-quality securities. Some, however,
may possess speculative characteristics, and may be more
sensitive to economic changes and to changes in the financial
condition of issuers. The market prices of investment grade
securities in the lowest investment grade categories may
fluctuate more than higher-quality securities and may decline
significantly in periods of general or regional economic
difficulty. Like non-investment grade securities, such
investment grade securities in the lowest investment grade
categories may be thinly traded, making them difficult to sell
promptly at an acceptable price.
Other Fixed Income Securities. The Trust also
may purchase unsecured loans, other floating rate or fixed rate
debt securities such as notes, bonds and asset-backed securities
(such as securities issued by special purpose funds investing in
bank loans), investment grade and below investment grade fixed
income debt obligations and money market instruments, such as
commercial paper. The high yield securities in which the Trust
invests are rated Ba or lower by Moodys or BB or lower by
S&P or are unrated but determined by the Investment Adviser
to be of comparable quality. Debt securities rated below
investment grade are commonly referred to as junk
securities and are considered speculative with respect to
the issuers capacity to pay interest and repay principal.
Below investment grade debt securities involve greater risk of
loss, are subject to greater price volatility and are less
liquid, especially during periods of economic uncertainty or
change, than higher rated debt securities. The Trusts
fixed-income securities may have fixed or variable principal
payments and all types of interest rate and dividend payment and
reset terms, including fixed rate, adjustable rate, zero coupon,
contingent, deferred, payment in kind and auction rate features.
The Trust may invest in fixed-income securities with a broad
range of maturities.
The Trust may invest in zero coupon bonds, deferred interest
bonds and bonds or preferred stock on which the interest is
payable-in-kind
(PIK bonds). To the extent the Trust invests in such
instruments, they will not contribute to the Trusts goal
of current income. Zero coupon and deferred interest bonds are
debt obligations which are issued at a significant discount from
face value. While zero coupon bonds do not require the periodic
payment of interest, deferred interest bonds provide for a
period of delay before the regular payment of interest begins.
PIK bonds are debt obligations that provide that the issuer
thereof may, at its option, pay interest on such bonds in cash
or in the form of additional debt obligations. Such investments
may experience greater volatility in market value due to changes
in interest rates. The Trust may be required to accrue income on
these investments for federal income tax purposes and is
required to distribute its net income each year in order to
qualify for the favorable
51
Portfolio
composition
federal income tax treatment potentially available to regulated
investment companies. The Trust may be required to sell
securities to obtain cash needed for income distributions.
Non-Investment Grade Securities. The Trust
invest a significant portion of its assets in securities rated
below investment grade, such as those rated Ba or lower by
Moodys and BB or lower by S&P or securities
comparably rated by other rating agencies or in unrated
securities determined by Highland to be of comparable quality.
Securities rated Ba by Moodys are judged to have
speculative elements, their future cannot be considered as well
assured and often the protection of interest and principal
payments may be very moderate. Securities rated BB by S&P
are regarded as having predominantly speculative characteristics
and, while such obligations have less near-term vulnerability to
default than other speculative grade debt, they face major
ongoing uncertainties or exposure to adverse business, financial
or economic conditions which could lead to inadequate capacity
to meet timely interest and principal payments. Securities rated
C are regarded as having extremely poor prospects of ever
attaining any real investment standing. Securities rated D are
in default and the payment of interest
and/or
repayment of principal is in arrears. The Trust may purchase
securities rated as low as D or unrated securities deemed by
Highland to be of comparable quality. When Highland believes it
to be in the best interests of the Trusts shareholders,
the Trust will reduce its investment in lower grade securities.
Lower grade securities, though high yielding, are characterized
by high risk. They may be subject to certain risks with respect
to the issuing entity and to greater market fluctuations than
certain lower yielding, higher rated securities. The secondary
market for lower grade securities may be less liquid than that
of higher rated securities. Adverse conditions could make it
difficult at times for the Trust to sell certain securities or
could result in lower prices than those used in calculating the
Trusts net asset value.
The prices of debt securities generally are inversely related to
interest rate changes; however, the price volatility caused by
fluctuating interest rates of securities also is inversely
related to the coupon of such securities. Accordingly, lower
grade securities may be relatively less sensitive to interest
rate changes than higher quality securities of comparable
maturity, because of their higher coupon. This higher coupon is
what the investor receives in return for bearing greater credit
risk. The higher credit risk associated with lower grade
securities potentially can have a greater effect on the value of
such securities than may be the case with higher quality issues
of comparable maturity, and will be a substantial factor in the
Trusts relative share price volatility.
Lower grade securities may be particularly susceptible to
economic downturns. It is likely that an economic recession
could disrupt severely the market for such securities and may
have an adverse impact on the value of such securities. In
addition, it is likely that any such economic downturn could
adversely affect the ability of the issuers of such securities
to repay principal and pay interest thereon and increase the
incidence of default for such securities.
The ratings of Moodys and S&P and the other rating
agencies represent their opinions as to the quality of the
obligations which they undertake to rate. Ratings are relative
and subjective and, although ratings may be useful in evaluating
the safety of interest and principal payments, they do not
evaluate the market value risk of such obligations. Although
these ratings may be an initial criterion for selection of
portfolio investments, Highland also will independently evaluate
these securities and the ability of the issuers of such
securities to pay interest and principal. To the extent that the
Trust invests in lower grade securities that have not been rated
by a rating agency, the Trusts ability to achieve its
investment objectives will be more dependent on Highlands
credit analysis than would be the case when the Trust invests in
rated securities.
Asset-Backed Securities. The Trust may invest
a portion of its assets in asset-backed securities. Asset-backed
securities are generally issued as pass-through certificates,
which represent undivided fractional
52
Portfolio
composition
ownership interests in an underlying pool of assets, or as debt
instruments, which are also known as collateralized obligations,
and are generally issued as the debt of a special purpose entity
organized solely for the purpose of owning such assets and
issuing such debt. Asset-backed securities are often backed by a
pool of assets representing the obligations of a number of
different parties. Credit card receivables are generally
unsecured, and the debtors are entitled to the protection of a
number of state and federal consumer credit laws which give
debtors the right to set off certain amounts owed on the credit
cards, thereby reducing the balance due. Most issuers of
automobile receivables permit the servicers to retain possession
of the underlying obligations. If the servicer were to sell
these obligations to another party, there is a risk that the
purchaser would acquire an interest superior to that of the
holders of the related automobile receivables. In addition,
because of the large number of vehicles involved in a typical
issuance and technical requirements under state laws, the
trustee for the holders of the automobile receivables may not
have an effective security interest in all of the obligations
backing such receivables. Therefore, there is a possibility that
recoveries on repossessed collateral may not, in some cases, be
able to support payments on these securities.
Collateralized Loan Obligations and Bond
Obligations. The Trust may invest in certain
asset-backed securities that are securitizing certain financial
assets by issuing securities in the form of negotiable paper
that are issued by a financing company (generally called a
Special Purpose Vehicle or SPV). These securitized
assets are, as a rule, corporate financial assets brought into a
pool according to specific diversification rules. The SPV is a
company founded solely for the purpose of securitizing these
claims and its only asset is the diversified asset pool. On this
basis, marketable securities are issued which, due to the
diversification of the underlying risk, generally represent a
lower level of risk than the original assets. The redemption of
the securities issued by the SPV takes place at maturity out of
the cash flow generated by the collected claims.
A collateralized loan obligation (CLO) is a
structured debt security issued by an SPV that was created to
reapportion the risk and return characteristics of a pool of
assets. The assets, typically senior loans, are used as
collateral supporting the various debt tranches issued by the
SPV. The key feature of the CLO structure is the prioritization
of the cash flows from a pool of debt securities among the
several classes of securities issued by a CLO.
The Trust may also invest in collateralized bond obligations
(CBOs), which are structured debt securities backed
by a diversified pool of high yield, public or private fixed
income securities. These may be fixed pools or may be
market value (or managed) pools of collateral. The
CBO issues debt securities that are typically separated into
tranches representing different degrees of credit quality. The
top tranche of securities has the greatest collateralization and
pays the lowest interest rate. Lower CBO tranches have a lesser
degree of collateralization quality and pay higher interest
rates intended to compensate for the attendant risks. The bottom
tranche specifically receives the residual interest payments
(i.e., money that is left over after the higher tranches have
been paid) rather than a fixed interest rate. The return on the
lower tranches of CBOs is especially sensitive to the rate of
defaults in the collateral pool. Under normal market conditions,
the Trust expects to invest in the lower tranches of CBOs.
Distressed Debt. The Trust is authorized to
invest in the securities and other obligations of distressed and
bankrupt issuers, including debt obligations that are in
covenant or payment default. Such investments generally trade
significantly below par and are considered speculative. The
repayment of defaulted obligations is subject to significant
uncertainties. Defaulted obligations might be repaid only after
lengthy workout or bankruptcy proceedings, during which the
issuer might not make any interest or other payments. Typically
such workout or bankruptcy proceedings result in only partial
recovery of cash payments or an exchange of the defaulted
obligation for other debt or equity securities of the
53
Portfolio
composition
issuer or its affiliates, which may in turn be illiquid or
speculative. The Trust may invest in securities of a company for
purposes of gaining control.
Stressed Debt. The Trust is authorized to
invest in securities and other obligations of stressed issuers.
Stressed issuers are issuers that are not yet deemed distressed
or bankrupt and whose debt securities are trading at a discount
to par, but not yet at distressed levels. An example would be an
issuer that is in technical default of its credit agreement, or
undergoing strategic or operational changes, which results in
market pricing uncertainty.
Credit Default Swaps. To the extent consistent
with Subchapter M of the Internal Revenue Code of 1986, as
amended (the Code), the Trust may enter into credit
default swap agreements. The buyer in a credit
default contract is obligated to pay the seller a
periodic stream of payments over the term of the contract
provided that no event of default on an underlying reference
obligation has occurred. If an event of default occurs, the
seller must pay the buyer the par value (full
notional value) of the reference obligation in exchange for the
reference obligation. The Trust may be either the buyer or
seller in the transaction. If the Trust is a buyer and no event
of default occurs, the Trust loses its investment and recovers
nothing. However, if an event of default occurs, the buyer
receives full notional value for a reference obligation that may
have little or no value. As a seller, the Trust receives income
throughout the term of the contract, which typically is between
six months and three years, provided that there is no default
event.
Credit default swaps involve greater risks than if the Trust had
invested in the reference obligation directly. In addition to
general market risks, credit default swaps are subject to
illiquidity risk, counterparty risk and credit risks. The Trust
will enter into swap agreements only with counterparties that
are rated investment grade quality by at least one nationally
recognized statistical rating organization at the time of
entering into such transaction or whose creditworthiness is
believed by the Investment Adviser to be equivalent to such
rating. A buyer also will lose its investment and recover
nothing should no event of default occur. If an event of default
were to occur, the value of the reference obligation received by
the seller, coupled with the periodic payments previously
received, may be less than the full notional value it pays to
the buyer, resulting in a loss of value to the seller. When the
Trust acts as a seller of a credit default swap agreement it is
exposed to many of the same risks of leverage described under
Principal Risks of the TrustLeverage Risk in
this prospectus since if an event of default occurs the seller
must pay the buyer the full notional value of the reference
obligation.
Senior Loan Based Derivatives. The Trust may
obtain exposure to senior loans and baskets of senior loans
through the use of derivative instruments. Such derivative
instruments have recently become increasingly available. The
Investment Adviser reserves the right to utilize these
instruments and similar instruments that may be available in the
future. For example, the Trust may invest in a derivative
instrument known as the Select Aggregate Market Index
(SAMI), which provides investors with exposure to a
reference basket of senior loans. SAMIs are structured as
floating rate instruments. SAMIs consist of a basket of credit
default swaps whose underlying reference securities are senior
loans. While investing in SAMIs will increase the universe of
floating rate debt securities to which the Trust is exposed,
such investments entail risks that are not typically associated
with investments in other floating rate debt securities. The
liquidity of the market for SAMIs will be subject to liquidity
in the secured loan and credit derivatives markets. Investment
in SAMIs involves many of the risks associated with investments
in derivative instruments discussed generally below. The Trust
may also be subject to the risk that the counterparty in a
derivative transaction will default on its obligations.
Derivative transactions generally involve the risk of loss due
to unanticipated adverse changes in securities prices, interest
rates, the inability to close out a position, imperfect
correlation between a position and the desired hedge, tax
constraints on closing out positions and portfolio management
constraints on
54
Portfolio
composition
securities subject to such transactions. The potential loss on
derivative instruments may be substantially greater than the
initial investment therein.
Credit-Linked Notes. The Trust may invest in
credit-linked notes (CLNs) for risk management
purposes and to vary its portfolio. A CLN is a derivative
instrument. It is a synthetic obligation between two or more
parties where the payment of principal
and/or
interest is based on the performance of some obligation (a
reference obligation). In addition to credit risk of the
reference obligations and interest rate risk, the buyer/seller
of the CLN is subject to counterparty risk.
Common Stocks. The Trust may acquire an
interest in common stocks in various ways, including upon the
default of a senior loan secured by such common stock or by
acquiring common stock for investment. The Trust may also
acquire warrants or other rights to purchase a borrowers
common stock in connection with the making of a senior loan.
Common stocks of a corporation or other entity that entitle the
holder to a pro rata share of the profits, if any, of the
corporation without preference over any other shareholder or
class of shareholders, including holders of such entitys
preferred stocks and other senior equity securities. Common
stock usually carries with it the right to vote and frequently
an exclusive right to do so. In selecting common stocks for
investment, the Trust generally expects to focus primarily on
the securitys dividend paying capacity rather than on its
potential for capital appreciation.
Preferred Stocks. The Trust may invest in
preferred stocks. Preferred stocks are equity securities, but
they have many characteristics of fixed income securities, such
as a fixed dividend payment rate
and/or a
liquidity preference over the issuers common shares.
However, because preferred stocks are equity securities, they
may be more susceptible to risks traditionally associated with
equity investments than the Trusts fixed income securities.
Fixed rate preferred stocks have fixed dividend rates. They can
be perpetual, with no mandatory redemption date, or issued with
a fixed mandatory redemption date. Certain issues of preferred
stocks are convertible into other equity securities. Perpetual
preferred stocks provide a fixed dividend throughout the life of
the issue, with no mandatory retirement provisions, but may be
callable. Sinking fund preferred stocks provide for the
redemption of a portion of the issue on a regularly scheduled
basis with, in most cases, the entire issue being retired at a
future date. The value of fixed rate preferred stocks can be
expected to vary inversely with interest rates.
Adjustable rate preferred stocks have a variable dividend rate
which is determined periodically, typically quarterly, according
to a formula based on a specified premium or discount to the
yield on particular U.S. Treasury securities, typically the
highest base-rate yield of one of three U.S. Treasury
securities: the
90-day
Treasury bill; the
10-year
Treasury note; and either the
20-year or
30-year
Treasury bond or other index. The premium or discount to be
added to or subtracted from this base-rate yield is fixed at the
time of issuance and cannot be changed without the approval of
the holders of the adjustable rate preferred stock. Some
adjustable rate preferred stocks have a maximum and a minimum
rate and in some cases are convertible into common stocks.
Auction rate preferred stocks pay dividends that adjust based on
periodic auctions. Such preferred stocks are similar to
short-term corporate money market instruments in that an auction
rate preferred stockholder has the opportunity to sell the
preferred stock at par in an auction, normally conducted at
least every 49 days, through which buyers set the dividend
rate in a bidding process for the next period. The dividend rate
set in the auction depends on market conditions and the credit
quality of the particular issuer. Typically, the auction rate
preferred stocks dividend rate is limited to a specified
maximum percentage of an external commercial paper index as of
the auction date. Further, the terms of the auction rate
preferred stocks generally provide that they are redeemable by
the issuer at certain times or under certain conditions.
55
Portfolio
composition
Convertible Securities. The Trusts
investment in fixed income securities may include bonds and
preferred stocks that are convertible into the equity securities
of the issuer or a related company. Depending on the
relationship of the conversion price to the market value of the
underlying securities, convertible securities may trade more
like equity securities than debt instruments.
Money Market Instruments. Money market
instruments include short-term U.S. government securities,
U.S. dollar-denominated, high quality commercial paper
(unsecured promissory notes issued by corporations to finance
their short-term credit needs), certificates of deposit,
bankers acceptances and repurchase agreements relating to
any of the foregoing. U.S. government securities include
Treasury notes, bonds and bills, which are direct obligations of
the U.S. government backed by the full faith and credit of
the United States and securities issued by agencies and
instrumentalities of the U.S. government, which may be
guaranteed by the U.S. Treasury, may be supported by the
issuers right to borrow from the U.S. Treasury or may
be backed only by the credit of the federal agency or
instrumentality itself.
U.S. Government
Securities. U.S. government securities in
which the Trust invests include debt obligations of varying
maturities issued by the U.S. Treasury or issued or
guaranteed by an agency or instrumentality of the
U.S. government, including the Federal Housing
Administration, Federal Financing Bank, Farmers Home
Administration, Export-Import Bank of the United States, Small
Business Administration, Government National Mortgage
Association (GNMA), General Services Administration, Central
Bank for Cooperatives, Federal Farm Credit Banks, Federal Home
Loan Banks, Federal Home Loan Mortgage Corporation (FHLMC),
Federal National Mortgage Association (FNMA), Maritime
Administration, Tennessee Valley Authority, District of Columbia
Armory Board, Student Loan Marketing Association, Resolution
Trust Corporation and various institutions that previously
were or currently are part of the Farm Credit System (which has
been undergoing reorganization since 1987). Some
U.S. government securities, such as U.S. Treasury
bills, Treasury notes and Treasury bonds, which differ only in
their interest rates, maturities and times of issuance, are
supported by the full faith and credit of the United States
government. Others are supported by (i) the right of the
issuer to borrow from the U.S. Treasury, such as securities
of the Federal Home Loan Banks; (ii) the discretionary
authority of the U.S. government to purchase the
agencys obligations, such as securities of the FNMA; or
(iii) only the credit of the issuer. No assurance can be
given that the U.S. government will provide financial
support in the future to U.S. government agencies,
authorities or instrumentalities that are not supported by the
full faith and credit of the United States. Securities
guaranteed as to principal and interest by the
U.S. government, its agencies, authorities or
instrumentalities include (i) securities for which the
payment of principal and interest is backed by an irrevocable
letter of credit issued by the U.S. government or any of
its agencies, authorities or instrumentalities; and
(ii) participations in loans made to
non-U.S. governments
or other entities that are so guaranteed. The secondary market
for certain of these participations is limited and therefore may
be regarded as illiquid.
Other Investment Companies. The Trust may
invest in the securities of other investment companies to the
extent that such investments are consistent with the
Trusts investment objectives and principal investment
strategies and permissible under the Investment Company Act.
Under one provision of the Investment Company Act, the Trust may
not acquire the securities of other investment companies if, as
a result, (i) more than 10% of the Trusts total
assets would be invested in securities of other investment
companies, (ii) such purchase would result in more than 3%
of the total outstanding voting securities of any one investment
company being held by the Trust or (iii) more than 5% of
the Trusts total assets would be invested in any one
investment company. Other provisions of the Investment Company
Act are less restrictive provided that the Trust is able to meet
certain conditions. These limitations do not apply to the
acquisition of shares of any investment company in connection
with a merger, consolidation, reorganization or acquisition of
substantially all of the assets of another investment company.
56
Portfolio
composition
The Trust, as a holder of the securities of other investment
companies, will bear its pro rata portion of the other
investment companies expenses, including advisory fees.
These expenses will be in addition to the direct expenses
incurred by the Trust.
Exchange Traded Funds. Subject to the
limitations on investment in other investment companies, the
Trust may invest in exchange traded funds (ETFs).
ETFs, such as SPDRs, NASDAQ 100 Index Trading Stock (QQQs),
iShares and various country index funds, are funds whose shares
are traded on a national exchange. ETFs may be based on
underlying equity or fixed income securities. SPDRs, for
example, seek to provide investment results that generally
correspond to the performance of the component common stocks of
the S&P 500. ETFs do not sell individual shares directly to
investors and only issue their shares in large blocks known as
creation units. The investor purchasing a creation
unit may sell the individual shares on a secondary market.
Therefore, the liquidity of ETFs depends on the adequacy of the
secondary market. There can be no assurance that an ETFs
investment objective will be achieved. ETFs based on an index
may not replicate and maintain exactly the composition and
relative weightings of securities in the index. ETFs are subject
to the risks of investing in the underlying securities. The
Trust, as a holder of the securities of the ETF, will bear its
pro rata portion of the ETFs expenses, including advisory
fees. These expenses are in addition to the direct expenses of
the Trusts own operations.
Zero Coupon Securities. The securities in
which the Trust invests may include zero coupon securities,
which are debt obligations that are issued or purchased at a
significant discount from face value. The discount approximates
the total amount of interest the security will accrue and
compound over the period until maturity or the particular
interest payment date at a rate of interest reflecting the
market rate of the security at the time of issuance. Zero coupon
securities do not require the periodic payment of interest.
These investments benefit the issuer by mitigating its need for
cash to meet debt service but generally require a higher rate of
return to attract investors who are willing to defer receipt of
cash. These investments may experience greater volatility in
market value than securities that make regular payments of
interest. The Trust accrues income on these investments for tax
and accounting purposes, which is distributable to shareholders
and which, because no cash is received at the time of accrual,
may require the liquidation of other portfolio securities to
satisfy the Trusts distribution obligations, in which case
the Trust will forego the purchase of additional income
producing assets with these funds.
Derivative Transactions. In addition to the
credit default swaps and senior loan bond derivatives discussed
above the Trust may, but is not required to, use various
Derivative Transactions described below to earn income,
facilitate portfolio management and mitigate risks. Such
Derivative Transactions are generally accepted under modern
portfolio management and are regularly used by many mutual funds
and other institutional investors. Although the Investment
Adviser seeks to use the practices to further the Trusts
investment objectives, no assurance can be given that these
practices will achieve this result. While the Trust reserves the
ability to use these Derivative Transactions, the Investment
Adviser does not anticipate that Derivative Transactions other
than senior loan bond derivatives will initially be a
significant part of the Trusts investment approach. With
changes in the market or the Investment Advisers strategy,
it is possible that these instruments may be a more significant
part of the Trusts investment approach in the future.
The Trust may purchase and sell derivative instruments such as
exchange-listed and over-the-counter put and call options on
securities, financial futures, equity, fixed-income and interest
rate indices, and other financial instruments, purchase and sell
financial futures contracts and options thereon, enter into
various interest rate transactions such as swaps, caps, floors
or collars and enter into various currency transactions such as
currency forward contracts, currency futures contracts, currency
swaps or options on currency or currency futures or credit
transactions and credit default swaps. The Trust also may
purchase derivative instruments that combine features of these
instruments. The Trust generally seeks to
57
Portfolio
composition
use Derivative Transactions as a portfolio management or hedging
technique to seek to protect against possible adverse changes in
the market value of senior loans or other securities held in or
to be purchased for the Trusts portfolio, protect the
value of the Trusts portfolio, facilitate the sale of
certain securities for investment purposes, manage the effective
interest rate exposure of the Trust, protect against changes in
currency exchange rates, manage the effective maturity or
duration of the Trusts portfolio, or establish positions
in the derivatives markets as a temporary substitute for
purchasing or selling particular securities.
Derivative Transactions have risks, including the imperfect
correlation between the value of such instruments and the
underlying assets, the possible default of the other party to
the transaction or illiquidity of the derivative instruments.
Furthermore, the ability to use successfully Derivative
Transactions depends on the Investment Advisers ability to
predict pertinent market movements, which cannot be assured.
Thus, the use of Derivative Transactions may result in losses
greater than if they had not been used, may require the Trust to
sell or purchase portfolio securities at inopportune times or
for prices other than current market values, may limit the
amount of appreciation the Trust can realize on an investment,
or may cause the Trust to hold a security that it might
otherwise sell. The use of currency transactions can result in
the Trust incurring losses as a result of the imposition of
exchange controls, suspension of settlements or the inability of
the Trust to deliver or receive a specified currency.
Additionally, amounts paid by the Trust as premiums and cash or
other assets held in margin accounts with respect to Derivative
Transactions are not otherwise available to the Trust for
investment purposes.
A more complete discussion of Derivative Transactions and their
risks is contained in the Statement of Additional Information.
Swaps. Swap contracts may be purchased or sold
to obtain investment exposure
and/or to
hedge against fluctuations in securities prices, currencies,
interest rates or market conditions, to change the duration of
the overall portfolio or to mitigate default risk. In a standard
swap transaction, two parties agree to exchange the
returns (or differentials in rates of return) on different
currencies, securities, baskets of currencies or securities,
indices or other instruments, which returns are calculated with
respect to a notional value, i.e., the designated
reference amount of exposure to the underlying instruments. The
Trust intends to enter into swaps primarily on a net basis,
i.e., the two payment streams are netted out, with the Trust
receiving or paying, as the case may be, only the net amount of
the two payments. If the other party to a swap contract
defaults, the Trusts risk of loss will consist of the net
amount of payments that the Trust is contractually entitled to
receive. The net amount of the excess, if any, of the
Trusts obligations over its entitlements will be
maintained in a segregated account by the Trusts
custodian. The Trust will not enter into a swap agreement unless
the claims-paying ability of the other party thereto is
considered to be investment grade by the Investment Adviser. If
there is a default by the other party to such a transaction, the
Trust will have contractual remedies pursuant to the agreements
related to the transaction. Swap instruments are not
exchange-listed securities and may be traded only in the
over-the-counter market.
Interest Rate Swaps. Interest rate swaps
involve the exchange by the Trust with another party of their
respective commitments to pay or receive interest (e.g., an
exchange of fixed rate payments for floating rate payments). The
Trust may use interest rate swaps for risk management purposes
and as a speculative investment.
Total Return Swaps. Total return swaps are
contracts in which one party agrees to make payments of the
total return from the designated underlying asset(s), which may
include securities, baskets of securities, or securities
indices, during the specified period, in return for receiving
payments equal to a fixed or floating rate of interest or the
total return from the other designated underlying asset(s). The
Trust may use total return swaps for risk management purposes
and as a speculative investment.
58
Portfolio
composition
Currency Swaps. Currency swaps involve the
exchange of the two parties respective commitments to pay
or receive fluctuations with respect to a notional amount of two
different currencies (e.g., an exchange of payments with respect
to fluctuations in the value of the U.S. dollar relative to
the Japanese yen). The Trust may enter into currency swap
contracts and baskets thereof for risk management purposes and
as a speculative investment.
Short Sales. The Trust intends to attempt to
limit exposure to a possible market decline in the value of its
portfolio securities through short sales of securities that
Highland believes possess volatility characteristics similar to
those being hedged. In addition, the Trust intends to use short
sales for non-hedging purposes to pursue its investment
objectives. Subject to the requirements of the Investment
Company Act and the Code, the Trust will not make a short sale
if, after giving effect to such sale, the market value of all
securities sold short by the Trust exceeds 25% of the value of
its total assets.
A short sale is a transaction in which the Trust sells a
security it does not own in anticipation that the market price
of that security will decline. When the Trust makes a short
sale, it must borrow the security sold short from a
broker-dealer and deliver it to the buyer upon conclusion of the
sale. The Trust may have to pay a fee to borrow particular
securities and is often obligated to pay over any payments
received on such borrowed securities.
The Trusts obligation to replace the borrowed security
will be secured by collateral deposited with the broker-dealer,
usually cash, U.S. government securities or other liquid
securities. The Trust will also be required to designate on its
books and records similar collateral with its custodian to the
extent, if any, necessary so that the aggregate collateral value
is at all times at least equal to the current market value of
the security sold short. Depending on arrangements made with the
broker-dealer from which it borrowed the security regarding
payment over of any payments received by the Trust on such
security, the Trust may not receive any payments (including
interest) on its collateral deposited with such broker-dealer.
If the price of the security sold short increases between the
time of the short sale and the time the Trust replaces the
borrowed security, the Trust will incur a loss; conversely, if
the price declines, the Trust will realize a gain. Any gain will
be decreased, and any loss increased, by the transaction costs
described above. Although the Trusts gain is limited to
the price at which it sold the security short, its potential
loss is unlimited.
The Trust may also sell a security short if it owns at least an
equal amount of the security sold short or another security
convertible or exchangeable for an equal amount of the security
sold short without payment of further compensation (a short sale
against-the-box). In a short sale against-the-box, the short
seller is exposed to the risk of being forced to deliver stocks
that it holds to close the position if the borrowed stock is
called in by the lender, which would cause gain or loss to be
recognized on the delivered stock. The Trust expects normally to
close its short sales against-the-box by delivering newly
acquired stock.
Purchasing securities to close out the short position can itself
cause the price of the securities to rise further, thereby
exacerbating the loss. Short-selling exposes the Trust to
unlimited risk with respect to that security due to the lack of
an upper limit on the price to which an instrument can rise.
Although the Trust reserves the right to utilize short sales,
and currently intends to utilize short sales, Highland is under
no obligation to utilize short sales at all.
Capital Structure Arbitrage. Capital structure
arbitrage typically involves establishing long and short
positions in securities (or their derivatives) at different
tiers within an issuers capital structure in ratios
designed to maintain a generally neutral overall exposure to the
issuer while exploiting a pricing inefficiency. Some issuers may
also have more than one class of shares or an equivalent vehicle
that trades in a different market (e.g., European equities and
their American Depository Receipt
59
Portfolio
composition
counterparts). This strategy seeks to profit from the disparity
in prices between the various related securities in anticipation
that over time all tiers and classes will become more
efficiently priced relative to one another.
Pair Trades. Pair trades involve the
establishment of a long position in one security and a short
position in another security at the same time. A pair trade
attempts to minimize the effect of larger market trends and
emphasizes the performance of one security relative to another.
Repurchase Agreements. The Trust may invest up
to
331/3%
of its assets in repurchase agreements. It may enter into
repurchase agreements with broker-dealers, member banks of the
Federal Reserve System and other financial institutions.
Repurchase agreements are loans or arrangements under which the
Trust purchases securities and the seller agrees to repurchase
the securities within a specific time and at a specific price.
The repurchase price is generally higher than the Trusts
purchase price, with the difference being income to the Trust.
Under the direction of the board of trustees, the Investment
Adviser reviews and monitors the creditworthiness of any
institution which enters into a repurchase agreement with the
Trust. The counterpartys obligations under the repurchase
agreement are collateralized with U.S. Treasury
and/or
agency obligations with a market value of not less than 100% of
the obligations, valued daily. Collateral is held by the
Trusts custodian in a segregated, safekeeping account for
the benefit of the Trust. Repurchase agreements afford the Trust
an opportunity to earn income on temporarily available cash at
low risk. In the event of commencement of bankruptcy or
insolvency proceedings with respect to the seller of the
security before repurchase of the security under a repurchase
agreement, the Trust may encounter delay and incur costs before
being able to sell the security. Such a delay may involve loss
of interest or a decline in price of the security. If the court
characterizes the transaction as a loan and the Trust has not
perfected a security interest in the security, the Trust may be
required to return the security to the sellers estate and
be treated as an unsecured creditor of the seller. As an
unsecured creditor, the Trust would be at risk of losing some or
all of the principal and interest involved in the transaction.
Lending of Assets. The Trust may lend up to
331/3%
of its assets. It may lend assets to registered broker-dealers
or other institutional investors deemed by the Investment
Adviser to be of good standing under agreements which require
that the loans be secured continuously by collateral in cash,
cash equivalents or U.S. Treasury bills maintained on a
current basis at an amount at least equal to the market value of
the securities loaned. The Trust continues to receive the
equivalent of the interest or dividends paid by the issuer on
the securities loaned as well as the benefit of an increase and
the detriment of any decrease in the market value of the
securities loaned and would also receive compensation based on
investment of the collateral. The Trust would not, however, have
the right to vote any securities having voting rights during the
existence of the loan, but would call the loan in anticipation
of an important vote to be taken among holders of the securities
or of the giving or withholding of consent on a material matter
affecting the investment.
As with other extensions of credit, there are risks of delay in
recovery or even loss of rights in the collateral should the
borrower of the securities fail financially. The Trust will lend
portfolio securities only to firms that have been approved in
advance by the board of trustees, which will monitor the
creditworthiness of any such firms.
Non-U.S. Securities. The
Trust may invest up to 20% of its total assets in
non-U.S. securities,
which may include securities denominated in U.S. dollars or
in
non-U.S. currencies
or multinational currency units. The Trust may invest in
non-U.S. securities
of so-called emerging market issuers. For purposes of the Trust,
a company is deemed to be a
non-U.S. company
if it meets the following tests: (i) such company was not
organized in the United States; (ii) such companys
primary business office is not in the United States;
(iii) the principal trading market for such companys
securities is not located in the United States; (iv) less
than 50% of such companys assets are located in the United
States; or (v) 50%
60
Portfolio
composition
or more of such issuers revenues are derived from outside
the United States.
Non-U.S. securities
markets generally are not as developed or efficient as those in
the United States. Securities of some
non-U.S. issuers
are less liquid and more volatile than securities of comparable
U.S. issuers. Similarly, volume and liquidity in most
non-U.S. securities
markets are less than in the United States and, at times,
volatility of price can be greater than in the United States.
Because evidences of ownership of such securities usually are
held outside the United States, the Trust would be subject to
additional risks if it invested in
non-U.S. securities,
which include possible adverse political and economic
developments, seizure or nationalization of foreign deposits and
adoption of governmental restrictions which might adversely
affect or restrict the payment of principal and interest on the
non-U.S. securities
to investors located outside the country of the issuer, whether
from currency blockage or otherwise.
Since
non-U.S. securities
may be purchased with and payable in foreign currencies, the
value of these assets as measured in U.S. dollars may be
affected favorably or unfavorably by changes in currency rates
and exchange control regulations.
Options. An option on a security is a contract
that gives the holder of the option, in return for a premium,
the right to buy from (in the case of a call) or sell to (in the
case of a put) the writer of the option the security underlying
the option at a specified exercise or strike price.
The writer of an option on a security has the obligation upon
exercise of the option to deliver the underlying security upon
payment of the exercise price or to pay the exercise price upon
delivery of the underlying security. Certain options, known as
American style options may be exercised at any time
during the term of the option. Other options, known as
European style options, may be exercised only on the
expiration date of the option.
If an option written by the Trust expires unexercised, the Trust
realizes on the expiration date a capital gain equal to the
premium received by the Trust at the time the option was
written. If an option purchased by the Trust expires
unexercised, the Trust realizes a capital loss equal to the
premium paid. Prior to the earlier of exercise or expiration, an
exchange-traded option may be closed out by an offsetting
purchase or sale of an option of the same series (type,
underlying security, exercise price and expiration). There can
be no assurance, however, that a closing purchase or sale
transaction can be effected when the Trust desires. The Trust
may sell put or call options it has previously purchased, which
could result in a net gain or loss depending on whether the
amount realized on the sale is more or less than the premium and
other transaction costs paid on the put or call option when
purchased. The Trust will realize a capital gain from a closing
purchase transaction if the cost of the closing option is less
than the premium received from writing the option, or, if it is
more, the Trust will realize a capital loss. If the premium
received from a closing sale transaction is more than the
premium paid to purchase the option, the Trust will realize a
capital gain or, if it is less, the Trust will realize a capital
loss.
Short-Term Debt Securities; Temporary Defensive Position;
Invest-Up
Period. During the period in which the net
proceeds of this offering of common shares are being invested,
during periods in which Highland determines that it is
temporarily unable to follow the Trusts investment
strategy or that it is impractical to do so or pending
re-investment of proceeds received in connection with the sale
of a security, the Trust may deviate from its investment
strategy and invest all or any portion of its assets in cash or
cash equivalents. Highlands determination that it is
temporarily unable to follow the Trusts investment
strategy or that it is impractical to do so will generally occur
only in situations in which a market disruption event has
occurred and where trading in the securities selected through
application of the Trusts investment strategy is extremely
limited or absent. In such a case, shares of the Trust may be
adversely affected and the Trust may not pursue or achieve its
investment objectives.
61
As provided in the Investment Company Act of 1940 (the
Investment Company Act) and subject to certain
exceptions, the Trust may issue debt or preferred shares with
the condition that immediately after issuance the value of its
total assets, less certain ordinary course liabilities, exceed
300% of the amount of the debt outstanding and exceed 200% of
the sum of the amount of debt and preferred shares outstanding.
Thus, the Trust may use leverage in the form of borrowings in an
amount up to
331/3%
of the Trusts total assets (including the proceeds of such
leverage) and may use leverage in the form of preferred shares
in an amount up to 50% of the Trusts total assets
(including the proceeds of such leverage). The total leverage of
the Trust is currently expected to range between 20% and 50% of
the Trusts total assets. The Trust seeks a leverage ratio,
based on a variety of factors including market conditions and
the Investment Advisers market outlook, when the rate of
return, net of applicable Trust expenses, on the Trusts
portfolio investments purchased with leverage exceeds the costs
associated with such leverage.
The Trust, as of November 30, 2007, is leveraged through
borrowings from a credit facility in the amount of $227,000,000
or 26.17% of the Trusts total assets (including the
proceeds of such leverage). The Trusts asset coverage
ratio as of November 30, 2007 was 382.2%. See
Principal Risks of the TrustLeverage Risk for
a brief description of the Trusts credit agreement with
The Bank of Nova Scotia.
Following the completion of the Offer, the Trust may increase
the amount of leverage outstanding. The Trust may engage in
additional borrowings
and/or issue
preferred shares in order to maintain the Trusts desired
leverage ratio. However, the Trust has no present intention to
issue preferred shares in the next twelve months. Leverage
creates a greater risk of loss, as well as a potential for more
gain, for the common shares than if leverage were not used.
Interest on borrowings (or dividends on preferred shares) may be
at a fixed or floating rate and generally will be based on
short-term rates. The costs associated with the Trusts use
of leverage, including the issuance of such leverage and the
payment of dividends or interest on such leverage, will be borne
entirely by the holders of common shares. So long as the rate of
return, net of applicable Trust expenses, on the Trusts
portfolio investments purchased with leverage exceeds the costs
associated with such leverage, the Trust will generate more
return or income than will be needed to pay such costs. In this
event, the excess will be available to pay higher dividends to
holders of common shares. Conversely, if the Trusts return
on such assets is less than the cost of leverage and other Trust
expenses, the return to the holders of the common shares will
diminish. Where leverage is employed, the net asset value and
market price of the common shares and the yield to holders of
common shares will be more volatile. The Trusts leveraging
strategy may not be successful. See Principal Risks of the
TrustLeverage Risk.
Assuming the utilization of leverage in the amount of 26.17% of
the Trusts total assets and an annual interest rate of
5.58% payable on such leverage based on market rates as of the
date of this prospectus, the additional income that the Trust
must earn (net of expenses) in order to cover such leverage is
1.98%. Actual costs of leverage may be higher or lower than that
assumed in the previous example.
62
The following table is designed to illustrate the effect on the
return to a holder of the Trusts common shares of leverage
in the amount of approximately 26.17% of the Trusts total
assets, assuming hypothetical annual returns of the Trusts
portfolio of minus 10% to plus 10%. As the table shows, leverage
generally increases the return to holders of common shares when
portfolio return is positive and greater than the cost of
leverage and decreases the return when the portfolio return is
negative or less than the cost of leverage. The figures
appearing in the table are hypothetical and actual returns may
be greater or less than those appearing in the table.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Assumed portfolio return (net of expenses)
|
|
|
(10
|
)%
|
|
|
(5
|
)%
|
|
|
0
|
%
|
|
|
5
|
%
|
|
|
10
|
%
|
Corresponding common share return assuming 26.17% leverage
|
|
|
(15.52
|
)%
|
|
|
(8.75
|
)%
|
|
|
(1.98
|
)%
|
|
|
4.79
|
%
|
|
|
11.57
|
%
|
Principal
risks of the Trust
INVESTMENT AND
MARKET DISCOUNT RISK
An investment in the Trusts common shares is subject to
investment risk, including the possible loss of the entire
amount that you invest. As with any stock, the price of the
Trusts shares will fluctuate with market conditions and
other factors. If common shares are sold, the price received may
be more or less than the original investment. Shares of
closed-end management investment companies frequently trade at a
discount to their net asset value. The Trusts shares may
trade at a price that is less than the initial offering price.
This risk may be greater for investors who sell their shares in
a relatively short period of time after completion of the
initial offering. Common shares are designed for long-term
investors and should not be treated as trading vehicles.
INTEREST RATE
RISK
Interest rate risk is the risk that debt securities, and the
Trusts net assets, may decline in value because of changes
in interest rates. Generally, debt securities will decrease in
value when interest rates rise and increase in value when
interest rates decline. This means that the net asset value of
the common shares will fluctuate with interest rate changes and
the corresponding changes in the value of the Trusts debt
security holdings.
PREPAYMENT
RISK
If interest rates fall, the principal on bonds held by the Trust
may be paid earlier than expected. If this happens, the proceeds
from a prepaid security may be reinvested by the Trust in
securities bearing lower interest rates, resulting in a possible
decline in the Trusts income and distributions to
shareholders. The Trust may invest in pools of mortgages or
other assets issued or guaranteed by private issuers or
U.S. government agencies and instrumentalities.
Mortgage-related securities are especially sensitive to
prepayment risk because borrowers often refinance their
mortgages when interest rates drop.
RISKS OF
INVESTING IN HIGH-YIELD SECURITIES
A portion of the Trusts investments will consist of
investments that may generally be characterized as
high-yield securities or junk
securities. Such securities are typically rated below
investment grade by one or more nationally recognized
statistical rating organizations or are unrated but of
comparable credit quality to obligations rated below investment
grade, and have greater credit and liquidity risk than more
highly rated obligations. High-yield securities are generally
unsecured and may be subordinate to other obligations of the
obligor. The lower rating of high-yield securities reflects a
greater possibility that adverse changes in the financial
condition of the issuer or in general economic
63
Principal risks
of the Trust
conditions (including, for example, a substantial period of
rising interest rates or declining earnings) or both may impair
the ability of the issuer to make payment of principal and
interest. Many issuers of high-yield securities are highly
leveraged, and their relatively high debt to equity ratios
create increased risks that their operations might not generate
sufficient cash flow to service their obligations. Overall
declines in the below investment grade bond and other markets
may adversely affect such issuers by inhibiting their ability to
refinance their obligations at maturity.
High-yield securities are often issued in connection with
leveraged acquisitions or recapitalizations in which the issuers
incur a substantially higher amount of indebtedness than the
level at which they had previously operated. High-yield
securities that are debt instruments have historically
experienced greater default rates than has been the case for
investment grade securities. The Trust may also invest in equity
securities issued by entities whose obligations are unrated or
are rated below investment grade.
The Trust is authorized to invest in obligations of issuers
which are generally trading at significantly higher yields than
had been historically typical of the applicable issuers
obligations. Such investments may include debt obligations that
have a heightened probability of being in covenant or payment
default in the future. Such investments generally are considered
speculative. The repayment of defaulted obligations is subject
to significant uncertainties. Defaulted obligations might be
repaid only after lengthy workout or bankruptcy proceedings,
during which the issuer might not make any interest or other
payments. Typically such workout or bankruptcy proceedings
result in only partial recovery of cash payments or an exchange
of the defaulted security for other debt or equity securities of
the issuer or its affiliates, which may in turn be illiquid or
speculative.
High-yield securities purchased by the Trust are subject to
certain additional risks to the extent that such obligations may
be unsecured and subordinated to substantial amounts of senior
indebtedness, all or a significant portion of which may be
secured. Moreover, such obligations purchased by the Trust may
not be protected by financial covenants or limitations upon
additional indebtedness and are unlikely to be secured by
collateral.
ILLIQUIDITY OF
INVESTMENTS
The investments made by the Trust may be very illiquid, and
consequently, the Trust may not be able to sell such investments
at prices that reflect the Investment Advisers assessment
of their fair value or the amount paid for such investments by
the Trust. Illiquidity may result from the absence of an
established market for the investments as well as legal,
contractual or other restrictions on their resale by the Trust
and other factors. Furthermore, the nature of the Trusts
investments, especially those in financially stressed and
distressed companies, may require a long holding period prior to
being able to determine whether the investment will be
profitable or not. There is no limit on the amount of the
Trusts portfolio that can be invested in illiquid
securities.
RISKS OF
INVESTING IN SENIOR LOANS
Senior loans are typically at the most senior level of the
capital structure, and are sometimes secured by specific
collateral, including, but not limited to, trademarks, patents,
accounts receivable, inventory, equipment, buildings, real
estate, franchises and common and preferred stock of the obligor
or its affiliates. A portion of the Trusts investments may
consist of loans and participations therein originated by banks
and other financial institutions, typically referred to as
bank loans. The Trusts investments may include
loans of a type generally incurred by borrowers in connection
with highly leveraged transactions, often to finance internal
growth, acquisitions, mergers or stock purchases, or for other
reasons. As a result of the additional debt incurred by the
borrower in the course of the transaction, the borrowers
creditworthiness is often judged by the rating agencies to be
below investment grade. Such loans are typically private
corporate loans which are negotiated by one or more commercial
banks or
64
Principal risks
of the Trust
financial institutions and syndicated among a group of
commercial banks and financial institutions. In order to induce
the lenders to extend credit and to offer a favorable interest
rate, the borrower often provides the lenders with extensive
information about its business which is not generally available
to the public.
Bank loans often contain restrictive covenants designed to limit
the activities of the borrower in an effort to protect the right
of lenders to receive timely payments of principal and interest.
Such covenants may include restrictions on dividend payments,
specific mandatory minimum financial ratios, limits on total
debt and other financial tests. Bank loans usually have shorter
terms than subordinated obligations and may require mandatory
prepayments from excess cash flow, asset dispositions and
offerings of debt
and/or
equity securities. The bank loans and other debt obligations to
be acquired by the Trust are likely to be below investment
grade. For a discussion of the risks associated with below
investment grade investments, see Risks of Investing in
High Yield Securities below.
The Trust may acquire interests in bank loans and other debt
obligations either directly (by way of sale or assignment) or
indirectly (by way of participation). The purchaser of an
assignment typically succeeds to all the rights and obligations
of the assigning institution and becomes a lender under the
credit agreement with respect to the debt obligation; however,
its rights can be more restricted than those of the assigning
institution, and, in any event, the Trust may not be able
unilaterally to enforce all rights and remedies under the loan
and any associated collateral. A participation interest in a
portion of a debt obligation typically results in a contractual
relationship only with the institution participating out the
interest, not with the borrower. In purchasing participations,
the Trust generally will have no right to enforce compliance by
the borrower with neither the terms of the loan agreement nor
any rights of setoff against the borrower, and the Trust may not
directly benefit from the collateral supporting the debt
obligation in which it has purchased the participation. As a
result, the Trust will be exposed to the credit risk of both the
borrower and the institution selling the participation.
Purchasers of bank loans are predominantly commercial banks,
investment funds and investment banks. As secondary market
trading volumes increase, new bank loans frequently adopt
standardized documentation to facilitate loan trading which
should improve market liquidity. There can be no assurance,
however, that future levels of supply and demand in bank loan
trading will provide an adequate degree of liquidity or that the
current level of liquidity will continue. Because of the
provision to holders of such loans of confidential information
relating to the borrower, the unique and customized nature of
the loan agreement, the limited universe of eligible purchasers
and the private syndication of the loan, bank loans are not as
easily purchased or sold as a publicly traded security, and
historically the trading volume in the bank loan market has been
small relative to the high-yield debt market.
SECOND LIEN LOANS
RISK
Second lien loans are subject to the same risks associated with
investment in senior loans and non-investment grade securities.
However, second lien loans are second in right of payment to
senior loans and therefore are subject to additional risk that
the cash flow of the borrower and any property securing the loan
may be insufficient to meet scheduled payments after giving
effect to the senior secured obligations of the borrower. Second
lien loans are expected to have greater price volatility than
senior loans and may be less liquid. There is also a possibility
that originators will not be able to sell participations in
second lien loans, which would create greater credit risk
exposure.
OTHER SECURED
LOANS RISK
Secured loans other than senior loans and second lien loans are
subject to the same risks associated with investment in senior
loans, second lien loans and non-investment grade securities.
However, such loans may rank lower in right of payment than any
outstanding senior loans and second lien loans of the
65
Principal risks
of the Trust
borrower and therefore are subject to additional risk that the
cash flow of the borrower and any property securing the loan may
be insufficient to meet scheduled payments after giving effect
to the higher ranking secured obligations of the borrower. Lower
ranking secured loans are expected to have greater price
volatility than senior loans and second lien loans and may be
less liquid. There is also a possibility that originators will
not be able to sell participations in lower ranking secured
loans, which would create greater credit risk exposure.
UNSECURED LOANS
RISK
Unsecured loans are subject to the same risks associated with
investment in senior loans, second lien loans, other secured
loans and non-investment grade securities. However, because
unsecured loans have lower priority in right of payment to any
higher ranking obligations of the borrower and are not backed by
a security interest in any specific collateral, they are subject
to additional risk that the cash flow of the borrower and
available assets may be insufficient to meet scheduled payments
after giving effect to any higher ranking obligations of the
borrower. Unsecured loans are expected to have greater price
volatility than senior loans, second lien loans and other
secured loans and may be less liquid. There is also a
possibility that originators will not be able to sell
participations in unsecured loans, which would create greater
credit risk exposure.
RISKS OF
INVESTING IN OBLIGATIONS OF STRESSED, DISTRESSED AND BANKRUPT
ISSUERS
The Trust is authorized to invest in the securities and other
obligations of stressed, distressed and bankrupt issuers,
including debt obligations that are in covenant or payment
default. There is no limit on the amount of the Trusts
portfolio that can be invested in stressed, distressed or
bankrupt issuers, and the Trust may invest for purposes of
control. Such investments generally trade significantly below
par and are considered speculative. The repayment of defaulted
obligations is subject to significant uncertainties. Defaulted
obligations might be repaid only after lengthy workout or
bankruptcy proceedings, during which the issuer might not make
any interest or other payments. Typically such workout or
bankruptcy proceedings result in only partial recovery of cash
payments or an exchange of the defaulted obligation for other
debt or equity securities of the issuer or its affiliates, which
may in turn be illiquid or speculative.
There are a number of significant risks inherent in the
bankruptcy process. First, many events in a bankruptcy are the
product of contested matters and adversary proceedings and are
beyond the control of the creditors. While creditors are
generally given an opportunity to object to significant actions,
there can be no assurance that a bankruptcy court in the
exercise of its broad powers would not approve actions that
would be contrary to the interests of the Trust. Second, a
bankruptcy filing by an issuer may adversely and permanently
affect the issuer. The issuer may lose its market position and
key employees and otherwise become incapable of restoring itself
as a viable entity. If for this or any other reason the
proceeding is converted to a liquidation, the value of the
issuer may not equal the liquidation value that was believed to
exist at the time of the investment. Third, the duration of a
bankruptcy proceeding is difficult to predict. A creditors
return on investment can be adversely affected by delays while
the plan of reorganization is being negotiated, approved by the
creditors and confirmed by the bankruptcy court and until it
ultimately becomes effective. Fourth, the administrative costs
in connection with a bankruptcy proceeding are frequently high
and would be paid out of the debtors estate prior to any
return to creditors. For example, if a proceeding involves
protracted or difficult litigation, or turns into a liquidation,
substantial assets may be devoted to administrative costs.
Fifth, bankruptcy law permits the classification of
substantially similar claims in determining the
classification of claims in a reorganization. Because the
standard for classification is vague, there exists the risk that
the Trusts influence with respect to the class of
securities or other obligations it owns can be lost by increases
in the number and amount of claims in that class or by different
classification and
66
Principal risks
of the Trust
treatment. Sixth, in the early stages of the bankruptcy process
it is often difficult to estimate the extent of, or even to
identify, any contingent claims that might be made. Seventh,
especially in the case of investments made prior to the
commencement of bankruptcy proceedings, creditors can lose their
ranking and priority if they exercise domination and
control over a debtor and other creditors can demonstrate
that they have been harmed by such actions. Eighth, certain
claims that have priority by law (for example, claims for taxes)
may be substantial.
In any investment involving stressed and distressed debt
obligations, there exists the risk that the transaction
involving such debt obligations will be unsuccessful, take
considerable time or will result in a distribution of cash or a
new security or obligation in exchange for the stressed and
distressed debt obligations, the value of which may be less than
the Trusts purchase price of such debt obligations.
Furthermore, if an anticipated transaction does not occur, the
Trust may be required to sell its investment at a loss. Given
the substantial uncertainties concerning transactions involving
stressed and distressed debt obligations in which the Trust
invests, there is a potential risk of loss by the Trust of its
entire investment in any particular investment.
Investments in companies operating in workout modes or under
Chapter 11 of the Bankruptcy Code are also, in certain
circumstances, subject to certain additional liabilities which
may exceed the value of the Trusts original investment in
a company. For example, under certain circumstances, creditors
who have inappropriately exercised control over the management
and policies of a debtor may have their claims subordinated or
disallowed or may be found liable for damages suffered by
parties as a result of such actions. The Investment
Advisers active management style may present a greater
risk in this area than would a more passive approach. In
addition, under certain circumstances, payments to the Trust and
distributions by the Trust or payments on the debt may be
reclaimed if any such payment is later determined to have been a
fraudulent conveyance or a preferential payment.
The Investment Adviser on behalf of the Trust may participate on
committees formed by creditors to negotiate with the management
of financially troubled companies that may or may not be in
bankruptcy or may negotiate directly with debtors with respect
to restructuring issues. If the Trust does choose to join a
committee, the Trust would likely be only one of many
participants, all of whom would be interested in obtaining an
outcome that is in their individual best interests. There can be
no assurance that the Trust would be successful in obtaining
results most favorable to it in such proceedings, although the
Trust may incur significant legal and other expenses in
attempting to do so. As a result of participation by the Trust
on such committees, the Trust may be deemed to have duties to
other creditors represented by the committees, which might
thereby expose the Trust to liability to such other creditors
who disagree with the Trusts actions. Participation by the
Trust on such committees may cause the Trust to be subject to
certain restrictions on its ability to trade in a particular
investment and may also make the Trust an insider or
an underwriter for purposes of the federal
securities laws. Either circumstance will restrict the
Trusts ability to trade in or acquire additional positions
in a particular investment when it might otherwise desire to do
so.
INSOLVENCY
CONSIDERATIONS WITH RESPECT TO ISSUERS OF DEBT
OBLIGATIONS
Various laws enacted for the protection of creditors may apply
to the debt obligations held by the Trust. The information in
this paragraph is applicable with respect to U.S. issuers
subject to United States bankruptcy laws. Insolvency
considerations may differ with respect to other issuers. If a
court in a lawsuit brought by an unpaid creditor or
representative of creditors of an issuer of a debt obligation,
such as a trustee in bankruptcy, were to find that the issuer
did not receive fair consideration or reasonably equivalent
value for incurring the indebtedness constituting the debt
obligation and, after giving effect to such indebtedness, the
issuer (i) was insolvent, (ii) was engaged in a
business for which the remaining assets of such issuer
constituted unreasonably small capital or (iii) intended to
incur, or
67
Principal risks
of the Trust
believed that it would incur, debts beyond its ability to pay
such debts as they mature, such court could determine to
invalidate, in whole or in part, such indebtedness as a
fraudulent conveyance, to subordinate such indebtedness to
existing or future creditors of such issuer, or to recover
amounts previously paid by such issuer in satisfaction of such
indebtedness.
The measure of insolvency for purposes of the foregoing will
vary. Generally, an issuer would be considered insolvent at a
particular time if the sum of its debts were then greater than
all of its property at a fair valuation, or if the present fair
saleable value of its assets was then less than the amount that
would be required to pay its probable liabilities on its
existing debts as they became absolute and matured. There can be
no assurance as to what standard a court would apply in order to
determine whether the issuer was insolvent after
giving effect to the incurrence of the indebtedness constituting
the debt obligation or that, regardless of the method of
valuation, a court would not determine that the issuer was
insolvent upon giving effect to such incurrence. In
addition, in the event of the insolvency of an issuer of a debt
obligation, payments made on such debt obligation could be
subject to avoidance as a preference if made within
a certain period of time (which may be as long as one year)
before insolvency. Similarly, a court might apply the doctrine
of equitable subordination to subordinate the claim of a lending
institution against an issuer, to claims of other creditors of
the borrower, when the lending institution, another investor, or
any of their transferees, is found to have engaged in unfair,
inequitable, or fraudulent conduct. In general, if payments on a
debt obligation are avoidable, whether as fraudulent conveyances
or preferences, such payments can be recaptured either from the
initial recipient (such as the Trust) or from subsequent
transferees of such payments (such as the investors in the
Trust). To the extent that any such payments are recaptured from
the Trust the resulting loss will be borne by the investors.
However, a court in a bankruptcy or insolvency proceeding would
be able to direct the recapture of any such payment from such a
recipient or transferee only to the extent that such court has
jurisdiction over such recipient or transferee or its assets.
Moreover, it is likely that avoidable payments could not be
recaptured directly from any such recipient or transferee that
has given value in exchange for its note, in good faith and
without knowledge that the payments were avoidable. Although the
Investment Adviser will seek to avoid conduct that would form
the basis for a successful cause of action based upon fraudulent
conveyance, preference or equitable subordination, these
determinations are made in hindsight, and, in any event, there
can be no assurance as to whether any lending institution or
other investor from which the Trust acquired the debt
obligations engaged in any such conduct (or any other conduct
that would subject the debt obligations and the issuer to
insolvency laws) and, if it did, as to whether such creditor
claims could be asserted in a U.S. court (or in the courts
of any other country) against the Trust.
LEVERAGE
RISK
The Trust currently leverages through borrowings from a credit
facility. The use of leverage, which can be described as
exposure to changes in price at a ratio greater than the amount
of equity invested, either through the issuance of preferred
shares, borrowings or other forms of market exposure, magnifies
both the favorable and unfavorable effects of price movements in
the investments made by the Trust. Insofar as the Trust
continues to employ leverage in its investment operations, the
Trust will be subject to substantial risks of loss.
The Trust currently leverages through borrowings from a credit
facility. The Trust has entered into a revolving credit
agreement with The Bank of Nova Scotia (Scotia) to
borrow up to $300,000,000 (the Loan Agreement). Such
borrowings constitute financial leverage. The Loan Agreement
contains covenants that limits the Trusts ability to,
without the prior consent of Scotia: (i) pay dividends in
certain circumstances, (ii) incur additional debt,
(iii) change its investment objectives, policies and
restrictions as set forth in the Trusts prospectus in
effect when the Loan Agreement became effective or
(iv) adopt or carry out any plan of liquidation,
reorganization, incorporation, recapitalization, merger
68
Principal risks
of the Trust
or consolidation or sell, transfer or otherwise dispose of all
or a substantial part of its assets. For instance, the Trust
agreed not to purchase assets not contemplated by the investment
policies and restrictions in effect when the Loan Agreement
became effective. Furthermore, the Trust may not incur
additional debt from any other party, except for in limited
circumstances (e.g., in the ordinary course of business).
In addition, the Loan Agreement contains a covenant requiring
asset coverage ratios that may be more stringent than those
required by the Investment Company Act. Such restrictions shall
apply only so long as the Loan Agreement remains in effect. Any
senior security representing indebtedness, as defined in
Section 18(g) of the Investment Company Act, must have
asset coverage of at least 300%.
In order to obtain and maintain the required ratings of loans
from the Loan Agreement or another credit facility, the Trust
must comply with investment quality, diversification and other
guidelines established by Moodys
and/or
S&P or the credit facility, respectively. The Trust does
not anticipate that such guidelines will have a material adverse
effect on the Trusts of common shareholders or its ability
to achieve its investment objectives. Moodys and S&P
receive fees in connection with their ratings issuances.
Successful use of a leveraging strategy may depend on the
Investment Advisers ability to predict correctly interest
rates and market movements, and there is no assurance that a
leveraging strategy will be successful during any period in
which it is employed.
COMMON STOCK
RISK
The Trust may have exposure to common stocks. Although common
stocks have historically generated higher average total returns
than fixed income securities over the long-term, common stocks
also have experienced significantly more volatility in those
returns. Therefore, the Trusts exposure to common stocks
could result in worse performance than would be the case had the
Trust been invested solely in debt securities. An adverse event,
such as an unfavorable earnings report, may depress the value of
a particular common stock held by the Trust. Also, the price of
common stock is sensitive to general movements in the stock
market and a drop in the stock market may depress the price of
common stock to which the Trust has exposure. Common stock
prices fluctuate for several reasons, including changes in
investors perceptions of the financial condition of an
issuer or the general condition of the relevant stock market, or
when political or economic events affecting the issuers occur.
In addition, common stock prices may be particularly sensitive
to rising interest rates, as the cost of capital rises and
borrowing costs increase.
DIVIDEND
RISK
Dividends on common stock are not fixed but are declared at the
discretion of an issuers board of directors. There is no
guarantee that the issuers of the common stock in which the
Trust invests will declare dividends in the future or that, if
declared, the dividends will remain at current levels or
increase over time
SMALL AND MID-CAP
SECURITIES RISK
The Trust may invest in companies with small or medium-sized
capitalizations. Securities issued by small and medium-sized
companies can be more volatile than, and perform differently
from, larger company securities. There may be less trading in a
small or medium companys securities, which means that buy
and sell transactions in those securities could have a larger
impact on the securitys price than is the case with larger
company securities. Small and medium-sized companies may have
fewer business lines; changes in any one line of business,
therefore, may have a greater impact on a small or medium-sized
companys security price than is the case for a larger
company. In addition, small or medium-sized company securities
may not be well known to the investing public.
69
Principal risks
of the Trust
NON-U.S.
SECURITIES RISK
The Trust may invest up to 20% of its total assets in
non-U.S. securities,
including emerging market securities. Investing in
non-U.S. securities
involves certain risks not involved in domestic investments,
including, but not limited to: (i) fluctuations in foreign
currency exchange rates; (ii) future foreign economic,
financial, political and social developments;
(iii) different legal systems; (iv) the possible
imposition of exchange controls or other foreign governmental
laws or restrictions; (v) lower trading volume;
(vi) much greater price volatility and illiquidity of
certain
non-U.S. securities
markets; (vii) different trading and settlement practices;
(viii) less governmental supervision; (ix) high and
volatile rates of inflation; (x) fluctuating interest
rates; (xi) less publicly available information; and
(xii) different accounting, auditing and financial
recordkeeping standards and requirements.
Certain countries in which the Trust may invest, especially
emerging market countries, historically have experienced, and
may continue to experience, high rates of inflation, high
interest rates, exchange rate fluctuations, large amounts of
external debt, balance of payments and trade difficulties and
extreme poverty and unemployment. Many of these countries are
also characterized by political uncertainty and instability.
These risks are especially evident in the Middle East and West
Africa. The cost of servicing external debt will generally be
adversely affected by rising international interest rates
because many external debt obligations bear interest at rates
which are adjusted based upon international interest rates. In
addition, with respect to certain foreign countries, there is a
risk of: (i) the possibility of expropriation or
nationalization of assets; (ii) confiscatory taxation;
(iii) difficulty in obtaining or enforcing a court
judgment; (iv) economic, political or social instability;
and (v) diplomatic developments that could affect
investments in those countries. In addition, individual foreign
economies may differ favorably or unfavorably from the
U.S. economy in such respects as: (i) growth of gross
domestic product; (ii) rates of inflation;
(iii) capital reinvestment; (iv) resources;
(v) self-sufficiency; and (vi) balance of payments
position.
As a result of these potential risks, Highland may determine
that, notwithstanding otherwise favorable investment criteria,
it may not be practicable or appropriate to invest in a
particular country. The Trust may invest in countries in which
foreign investors, including Highland, have had no or limited
prior experience.
EMERGING MARKETS
RISK
The Trust may invest up to 20% of its total assets in securities
of issuers based in emerging markets. Investing in securities of
issuers based in underdeveloped emerging markets entails all of
the risks of investing in securities of
non-U.S. issuers
to a heightened degree. Emerging market countries generally
include every nation in the world except the United States,
Canada, Japan, Australia, New Zealand and most countries located
in Western Europe. These heightened risks include:
(i) greater risks of expropriation, confiscatory taxation,
nationalization, and less social, political and economic
stability; (ii) the smaller size of the markets for such
securities and a lower volume of trading, resulting in lack of
liquidity and in price volatility; and (iii) certain
national policies which may restrict the Trusts investment
opportunities including restrictions on investing in issuers or
industries deemed sensitive to relevant national interests.
FOREIGN CURRENCY
RISK
Because the Trust may invest in securities denominated or quoted
in currencies other than the U.S. dollar, changes in
foreign currency exchange rates may affect the value of
securities owned by the Trust, the unrealized appreciation or
depreciation of investments and gains on and income from
investments. Currencies of certain countries may be volatile and
therefore may affect the value of securities denominated in such
currencies, which means that the Trusts net asset value
could decline as
70
Principal risks
of the Trust
a result of changes in the exchange rates between foreign
currencies and the U.S. dollar. These risks often are
heightened for investments in smaller, emerging capital markets.
In addition, the Trust may enter into foreign currency
transactions in an attempt to enhance total return which may
further expose the Trust to the risks of foreign currency
movements and other risks. The use of foreign currency
transactions can result in the Trust incurring losses as a
result of the imposition of exchange controls, suspension of
settlements or the inability of the Trust to deliver or receive
a specified currency.
INVESTMENTS IN
UNSEASONED COMPANIES
The Trust may invest in the securities of less seasoned
companies. These investments may present greater opportunities
for growth, but also involve greater risks than customarily are
associated with investments in securities of more established
companies. Some of the companies in which the Trust may invest
will be
start-up
companies which may have insubstantial operational or earnings
history or may have limited products, markets, financial
resources or management depth. Some may also be emerging
companies at the research and development stage with no products
or technologies to market or approved for marketing. Securities
of emerging companies may lack an active secondary market and
may be subject to more abrupt or erratic price movements than
securities of larger, more established companies or stock market
averages in general. Competitors of certain companies may have
substantially greater financial resources than many of the
companies in which the Trust may invest.
INITIAL PUBLIC
OFFERINGS RISK
The Trust may invest in shares of companies through initial
public offerings (IPOs). IPOs and companies that
have recently gone public have the potential to produce
substantial gains for the Trust. However, there is no assurance
that the Trust will have access to profitable IPOs. The
investment performance of the Trust during periods when it is
unable to invest significantly or at all in IPOs may be lower
than during periods when the Trust is able to do so. Securities
issued in IPOs are subject to many of the same risks as
investing in companies with smaller market capitalizations.
Securities issued in IPOs have no trading history, and
information about the companies may be available for limited
periods of time. In addition, the prices of securities sold in
IPOs may be highly volatile or may decline shortly after the IPO.
SECURITIES
LENDING RISK
The Trust may lend its portfolio securities (up to a maximum of
one-third of its total assets) to banks or dealers which meet
the creditworthiness standards established by the board of
trustees of the Trust. Securities lending is subject to the risk
that loaned securities may not be available to the Trust on a
timely basis and the Trust may, therefore, lose the opportunity
to sell the securities at a desirable price. Any loss in the
market price of securities loaned by the Trust that occurs
during the term of the loan would be borne by the Trust and
would adversely affect the Trusts performance. Also, there
may be delays in recovery, or no recovery, of securities loaned
or even a loss of rights in the collateral should the borrower
of the securities fail financially while the loan is
outstanding. Although the Trust generally has the ability to
recall loaned securities pursuant to a securities lending
arrangement in the event that a shareholder vote is held, there
is a risk that any delay in recovery of such security will
result in the holder of such security being unable to vote. All
of the aforementioned risks may be greater for
non-U.S. securities.
RISKS ASSOCIATED
WITH OPTIONS ON SECURITIES
There are several risks associated with transactions in options
on securities. For example, there are significant differences
between the securities and options markets that could result in
an imperfect
71
Principal risks
of the Trust
correlation between these markets, causing a given transaction
not to achieve its objectives. A decision as to whether, when
and how to use options involves the exercise of skill and
judgment, and even a well conceived transaction may be
unsuccessful to some degree because of market behavior or
unexpected events.
As the writer of a covered call option, the Trust foregoes,
during the options life, the opportunity to profit from
increases in the market value of the security covering the call
option above the sum of the premium and the strike price of the
call, but has retained the risk of loss should the price of the
underlying security decline. As the Trust writes covered calls
over more of its portfolio, its ability to benefit from capital
appreciation becomes more limited. The writer of an option has
no control over the time when it may be required to fulfill its
obligation as a writer of the option. Once an option writer has
received an exercise notice, it cannot effect a closing purchase
transaction in order to terminate its obligation under the
option and must deliver the underlying security at the exercise
price.
When the Trust writes covered put options, it bears the risk of
loss if the value of the underlying stock declines below the
exercise price minus the put premium. If the option is
exercised, the Trust could incur a loss if it is required to
purchase the stock underlying the put option at a price greater
than the market price of the stock at the time of exercise plus
the put premium the Trust received when it wrote the option.
While the Trusts potential gain in writing a covered put
option is limited to distributions earned on the liquid assets
securing the put option plus the premium received from the
purchaser of the put option, the Trust risks a loss equal to the
entire exercise price of the option minus the put premium.
EXCHANGE-LISTED
OPTION RISKS
There can be no assurance that a liquid market will exist when
the Trust seeks to close out an option position on an options
exchange. Reasons for the absence of a liquid secondary market
on an exchange include the following: (i) there may be
insufficient trading interest in certain options;
(ii) restrictions may be imposed by an exchange on opening
transactions or closing transactions or both; (iii) trading
halts, suspensions or other restrictions may be imposed with
respect to particular classes or series of options;
(iv) unusual or unforeseen circumstances may interrupt
normal operations on an exchange; (v) the facilities of an
exchange or the Options Clearing Corporation may not at all
times be adequate to handle current trading volume; or
(vi) one or more exchanges could, for economic or other
reasons, decide or be compelled at some future date to
discontinue the trading of options (or a particular class or
series of options). If trading were discontinued, the secondary
market on that exchange (or in that class or series of options)
would cease to exist. However, outstanding options on that
exchange that had been issued by the Options Clearing
Corporation as a result of trades on that exchange would
continue to be exercisable in accordance with their terms. If
the Trust were unable to close out a covered call option that it
had written on a security, it would not be able to sell the
underlying security unless the option expired without exercise.
The hours of trading for options on an exchange 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. Call options are marked to
market daily and their value will be affected by changes in the
value and dividend rates of the underlying common shares, an
increase in interest rates, changes in the actual or perceived
volatility of the stock market and the underlying common shares
and the remaining time to the options expiration.
Additionally, the exercise price of an option may be adjusted
downward before the options expiration as a result of the
occurrence of certain corporate events affecting the underlying
equity security, such as extraordinary dividends, stock splits,
merger or other extraordinary distributions or events. A
reduction in the exercise price of an option would reduce the
Trusts capital appreciation potential on the underlying
security.
72
Principal risks
of the Trust
OVER-THE-COUNTER
OPTION RISK
The Trust may write (sell) unlisted (OTC or
over-the-counter) options. Options written by the
Trust with respect to
non-U.S. securities,
indices or sectors generally will be OTC options. OTC options
differ from exchange-listed options in that they are two-party
contracts, with exercise price, premium and other terms
negotiated between buyer and seller, and generally do not have
as much market liquidity as exchange-listed options. The
counterparties to these transactions typically will be major
international banks, broker-dealers and financial institutions.
The Trust may be required to treat as illiquid those securities
being used to cover certain written OTC options. The OTC options
written by the Trust will not be issued, guaranteed or cleared
by the Options Clearing Corporation. In addition, the
Trusts ability to terminate the OTC options may be more
limited than with exchange-traded options. Banks, broker-dealers
or other financial institutions participating in such
transaction may fail to settle a transaction in accordance with
the terms of the option as written. In the event of default or
insolvency of the counterparty, the Trust may be unable to
liquidate an OTC option position.
INDEX OPTION
RISK
The Trust may sell index put and call options from time to time.
The purchaser of an index put option has the right to any
depreciation in the value of the index below the exercise price
of the option on or before the expiration date. The purchaser of
an index call option has the right to any appreciation in the
value of the index over the exercise price of the option on or
before the expiration date. Because the exercise of an index
option is settled in cash, sellers of index call options, such
as the Trust, cannot provide in advance for their potential
settlement obligations by acquiring and holding the underlying
securities. The Trust will lose money if it is required to pay
the purchaser of an index option the difference between the cash
value of the index on which the option was written and the
exercise price and such difference is greater than the premium
received by the Trust for writing the option. The value of index
options written by the Trust, which will be priced daily, will
be affected by changes in the value and dividend rates of the
underlying common shares in the respective index, changes in the
actual or perceived volatility of the stock market and the
remaining time to the options expiration. The value of the
index options also may be adversely affected if the market for
the index options becomes less liquid or smaller. Distributions
paid by the Trust on its common shares may be derived in part
from the net index option premiums it receives from selling
index put and call options, less the cost of paying settlement
amounts to purchasers of the options that exercise their
options. Net index option premiums can vary widely over the
short term and long term.
ASSET-BACKED
SECURITIES RISK
Payment of interest and repayment of principal on asset-backed
securities may be largely dependent upon the cash flows
generated by the assets backing the securities and, in certain
cases, supported by letters of credit, surety bonds or other
credit enhancements. Asset-backed security values may also be
affected by the creditworthiness of the servicing agent for the
pool, the originator of the loans or receivables or the entities
providing the credit enhancement. In addition, the underlying
assets are subject to prepayments that shorten the
securities weighted average maturity and may lower their
return.
MORTGAGE-BACKED
SECURITIES RISK
A mortgage-backed security, which represents an interest in a
pool of assets such as mortgage loans, will mature when all the
mortgages in the pool mature or are prepaid. Therefore,
mortgage-backed securities do not have a fixed maturity, and
their expected maturities may vary when interest rates rise or
fall.
73
Principal risks
of the Trust
When interest rates fall, homeowners are more likely to prepay
their mortgage loans. An increased rate of prepayments on the
Trusts mortgage-backed securities will result in an
unforeseen loss of interest income to the Trust as the Trust may
be required to reinvest assets at a lower interest rate. Because
prepayments increase when interest rates fall, the price of
mortgage-backed securities does not increase as much as other
fixed income securities when interest rates fall.
When interest rates rise, homeowners are less likely to prepay
their mortgage loans. A decreased rate of prepayments lengthens
the expected maturity of a mortgage-backed security. Therefore,
the prices of mortgage-backed securities may decrease more than
prices of other fixed income securities when interest rates rise.
DERIVATIVES
RISK
The Trust may engage in derivative transactions for hedging and
speculative purposes or to enhance total return, including
options, futures, swaps, foreign currency transactions and
forward foreign currency contracts, currency swaps or options on
currency and currency futures (Derivative
Transactions). Derivatives allow an investor to hedge or
speculate upon the price movements of a particular security,
financial benchmark currency or index at a fraction of the cost
of investing in the underlying asset. The value of a derivative
depends largely upon price movements in the underlying asset.
Therefore, many of the risks applicable to trading the
underlying asset are also applicable to derivatives of such
asset. However, there are a number of other risks associated
with derivatives trading, including the imperfect correlation
between the value of such instruments and the underlying assets,
the possible default of the other party to the transaction or
illiquidity of the derivative instruments. The ability to
successfully use Derivative Transactions depends on the
Investment Advisers ability to predict pertinent market
movements, which cannot be assured. Because many derivatives are
leveraged, and thus provide significantly more
market exposure than the money paid or deposited when the
transaction is entered into, a relatively small adverse market
movement can not only result in the loss of the entire
investment, but may also expose the Trust to the possibility of
a loss exceeding the original amount invested. The use of
Derivative Transactions may result in losses greater than if
they had not been used, may require the Trust to sell or
purchase portfolio securities at inopportune times or for prices
other than current market values, may limit the amount of
appreciation the Trust can realize on an investment or may cause
the Trust to hold a security that it might otherwise sell. The
use of foreign currency transactions can result in the Trust
incurring losses as a result of the imposition of exchange
controls, suspension of settlements or the inability of the
Trust to deliver or receive a specified currency. Additionally,
amounts paid by the Trust as premiums and cash or other assets
held in margin accounts with respect to Derivative Transactions
are not otherwise available to the Trust for investment purposes.
To the extent that the Trust purchases options pursuant to a
hedging strategy, the Trust will be subject to the following
additional risks. If a put or call option purchased by the Trust
is not sold when it has remaining value, and if the market price
of the underlying security remains equal to or greater than the
exercise price (in the case of a put), or remains less than or
equal to the exercise price (in the case of a call), the Trust
will lose its entire investment in the option.
Where a put or call option on a particular security is purchased
to hedge against price movements in a related security, the
price of the put or call option may move more or less than the
price of the related security. If restrictions on exercise were
imposed, the Trust might be unable to exercise an option it had
purchased. If the Trust were unable to close out an option that
it had purchased on a security, it would have to exercise the
option in order to realize any profit or the option may expire
worthless.
74
Principal risks
of the Trust
MARKET RISK
GENERALLY
The profitability of a significant portion of the Trusts
investment program depends to a great extent upon correctly
assessing the future course of the price movements of securities
and other investments and the movements of interest rates. There
can be no assurance that the Investment Adviser will be able to
predict accurately these price and interest rate movements. With
respect to certain investment strategies the Trust utilizes,
there is a high degree of market risk.
REINVESTMENT
RISK
The Trust reinvests the cash flows received from a security. The
additional income from such reinvestment, sometimes called
interest-on-interest,
is reliant on the prevailing interest rate levels at the time of
reinvestment. There is a risk that the interest rate at which
interim cash flows can be reinvested will fall. Reinvestment
risk is greater for longer holding periods and for securities
with large, early cash flows such as high-coupon bonds.
Reinvestment risk also applies generally to the reinvestment of
the proceeds the Trust receives upon the maturity or sale of a
portfolio security.
TIMING
RISK
Many agency, corporate and municipal bonds, and most
mortgage-backed securities, contain a provision that allows the
issuer to call all or part of the issue before the
bonds maturity date often after 5 or 10 years. The
issuer usually retains the right to refinance the bond in the
future if market interest rates decline below the coupon rate.
There are three disadvantages to the call provision. First, the
cash flow pattern of a callable bond is not known with
certainty. Second, because an issuer is more likely to call the
bonds when interest rates have dropped, the Trust is exposed to
reinvestment risk, i.e., the Trust may have to reinvest
at lower interest rates the proceeds received when the bond is
called. Finally, the capital appreciation potential of a bond
will be reduced because the price of a callable bond may not
rise much above the price at which the issuer may call the bond.
INFLATION
RISK
Inflation risk results from the variation in the value of cash
flows from a security due to inflation, as measured in terms of
purchasing power. For example, if the Trust purchases a bond in
which it can realize a coupon rate of 5%, but the rate of
inflation increases from 2% to 6%, then the purchasing power of
the cash flow has declined. For all but adjustable bonds or
floating rate bonds, the Trust is exposed to inflation risk
because the interest rate the issuer promises to make is fixed
for the life of the security. To the extent that interest rates
reflect the expected inflation rate, floating rate bonds have a
lower level of inflation risk. In addition, during any periods
of rising inflation, dividend rates of any variable rate
preferred share issued by the Trust would likely increase, which
would tend to further reduce returns to common shareholders.
ARBITRAGE
RISKS
The Trust engages in capital structure arbitrage and other
arbitrage strategies. Arbitrage strategies entail various risks,
including the risk that external events, regulatory approvals
and other factors will impact the consummation of announced
corporate events
and/or the
prices of certain positions. In addition, hedging is an
important feature of capital structure arbitrage. There is no
guarantee that the Investment Adviser will be able to hedge the
Trusts portfolio in the manner necessary to employ
successfully the Trusts strategy.
75
Principal risks
of the Trust
SHORT SALES
RISK
Short selling involves selling securities which may or may not
be owned and borrowing the same securities for delivery to the
purchaser, with an obligation to replace the borrowed securities
at a later date. Short selling allows the Trust to profit from
declines in market prices to the extent such decline exceeds the
transaction costs and the costs of borrowing the securities.
However, since the borrowed securities must be replaced by
purchases at market prices in order to close out the short
position, any appreciation in the price of the borrowed
securities would result in a loss. There can be no assurance
that the securities necessary to cover a short position will be
available for purchase. Purchasing securities to close out the
short position can itself cause the price of the securities to
rise further, thereby exacerbating the loss. The Trust may
mitigate such losses by replacing the securities sold short
before the market price has increased significantly. Under
adverse market conditions, the Trust might have difficulty
purchasing securities to meet its short sale delivery
obligations, and might have to sell portfolio securities to
raise the capital necessary to meet its short sale obligations
at a time when fundamental investment considerations would not
favor such sales. Short sales by the Trust that are not made
against the box theoretically involve unlimited loss
potential since the market price of securities sold short may
continuously increase.
RISKS OF
INVESTING IN STRUCTURED FINANCE SECURITIES
A portion of the Trusts investments may consist of
equipment trust certificates, collateralized mortgage
obligations, collateralized bond obligations, collateralized
loan obligations or similar instruments. Structured finance
securities may present risks similar to those of the other types
of debt obligations in which the Trust may invest and, in fact,
such risks may be of greater significance in the case of
structured finance securities. Moreover, investing in structured
finance securities may entail a variety of unique risks. Among
other risks, structured finance securities may be subject to
prepayment risk. In addition, the performance of a structured
finance security will be affected by a variety of factors,
including its priority in the capital structure of the issuer
thereof, the availability of any credit enhancement, the level
and timing of payments and recoveries on and the characteristics
of the underlying receivables, loans or other assets that are
being securitized, remoteness of those assets from the
originator or transferor, the adequacy of and ability to realize
upon any related collateral and the capability of the servicer
of the securitized assets.
RISKS OF
INVESTING IN PREFERRED SECURITIES.
There are special risks associated with investing in preferred
securities, including:
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Deferral. Preferred securities may include
provisions that permit the issuer, at its discretion, to defer
distributions for a stated period without any adverse
consequences to the issuer. If the Trust owns a preferred
security that is deferring its distributions, the Trust may be
required to report income for tax purposes although it has not
yet received such income.
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Subordination. Preferred securities are
subordinated to bonds and other debt instruments in a
companys capital structure in terms of priority to
corporate income and liquidation payments, and therefore will be
subject to greater credit risk than more senior debt instruments.
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Liquidity. Preferred securities may be
substantially less liquid than many other securities, such as
common stock or U.S. government securities.
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Limited Voting Rights. Generally, preferred
security holders have no voting rights with respect to the
issuing company unless preferred dividends have been in arrears
for a specified number of periods, at which time the preferred
security holders may elect a number of trustees to the
issuers
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76
Principal risks
of the Trust
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board. Generally, once all the arrearages have been paid, the
preferred security holders no longer have voting rights.
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RISKS OF
INVESTING IN SWAPS
Investments in swaps involve the exchange with another party of
their respective commitments. Use of swaps subjects the Trust to
risk of default by the counterparty. If there is a default by
the counterparty to such a transaction, there may be contractual
remedies pursuant to the agreements related to the transaction
although contractual remedies may not be sufficient in the event
the counterparty is insolvent. However, the swap market has
grown substantially in recent years with a large number of banks
and investment banking firms acting both as principals and
agents utilizing standardized swap documentation. As a result,
the swap market has become relatively liquid in comparison with
the markets for other similar instruments which are traded in
the interbank market. The Trust may enter into credit default
swaps, currency swaps or other swaps which may be surrogates for
other instruments such as currency forwards or options.
RISKS OF
INVESTING IN SYNTHETIC SECURITIES
With respect to synthetic securities the Trust will usually have
a contractual relationship only with the counterparty of such
synthetic securities, and not the Reference Obligor (as defined
below) on the Reference Obligation (as defined below). The Trust
generally will have no right to directly enforce compliance by
the Reference Obligor with the terms of the Reference Obligation
nor any rights of set-off against the Reference Obligor, nor
have any voting rights with respect to the Reference Obligation.
The Trust will not benefit directly from any collateral
supporting the Reference Obligation or have the benefit of the
remedies on default that would normally be available to a holder
of such Reference Obligation. In addition, in the event of
insolvency of its counterparty, the Trust will be treated as a
general creditor of such counterparty and will not have any
claim with respect to the credit risk of the counterparty as
well as that of the Reference Obligor. As a result, an
overabundance of synthetic securities with any one counterparty
subjects the notes to an additional degree of risk with respect
to defaults by such counterparty as well as by the Reference
Obligor. The Investment Adviser may not perform independent
credit analyses of the counterparties or any entities
guaranteeing such counterparties, individually or in the
aggregate. A Reference Obligation is the debt
security or other obligation upon which the synthetic security
is based. A Reference Obligor is the obligor on a
Reference Obligation. There is no maximum amount of Trusts
assets that may be invested in synthetic securities.
TAX
RISK
The Trust may invest in derivative instruments, such as swaps,
and other instruments, in order to obtain investment exposure to
its principal investment categories or for other purposes. The
Trust intends only to invest in such instruments to an extent
and in a manner consistent with the Trusts qualification
as a regulated investment company for federal income tax
purposes. If the Trust were to fail to qualify as a regulated
investment company in any year, then the Trust would be subject
to federal (and state) income tax on its net income and capital
gains at regular corporate income tax rates (without a deduction
for distributions to shareholders). Trust income distributed to
common shareholders would also be taxable to shareholders as
ordinary dividend income to the extent attributable to the
Trusts earnings and profits. Accordingly, in such event,
the Trusts ability to achieve its investment objectives
would be adversely affected, and common shareholders would be
subject to the risk of diminished investment returns.
77
Principal risks
of the Trust
VALUATION
RISK
Fair value is defined as the amount for which assets could be
sold in an orderly disposition over a reasonable period of time,
taking into account the nature of the asset. Fair value pricing,
however, involves judgments that are inherently subjective and
inexact, since fair valuation procedures are used only when it
is not possible to be sure what value should be attributed to a
particular asset or when an event will affect the market price
of an asset and to what extent. As a result, there can be no
assurance that fair value pricing will reflect actual market
value, and it is possible that the fair value determined for a
security will be materially different from the value that
actually could be or is realized upon the sale of that asset.
RISKS OF
NON-DIVERSIFICATION AND OTHER FOCUSED STRATEGIES
While the Investment Adviser invests in a number of fixed-income
and equity instruments issued by different issuers and employs
multiple investment strategies with respect to the Trusts
portfolio, it is possible that a significant amount of the
Trusts investments could be invested in the instruments of
only a few companies or other issuers or that at any particular
point in time one investment strategy could be more heavily
weighted than the others. The focus of the Trusts
portfolio in any one issuer would subject the Trust to a greater
degree of risk with respect to defaults by such issuer or other
adverse events affecting that issuer, and the focus of the
portfolio in any one industry or group of industries (but not to
the extent of 25% of the Trusts total assets) would
subject the Trust to a greater degree of risk with respect to
economic downturns relating to such industry. The focus of the
Trusts portfolio in any one investment strategy would
subject the Trust to a greater degree of risk than if the
Trusts portfolio were varied in its investments with
respect to several investment strategies.
MARKET DISRUPTION
AND GEOPOLITICAL RISK
The aftermath of the war in Iraq and the continuing occupation
of Iraq, instability in the Middle East and terrorist attacks in
the United States and around the world may result in market
volatility and may have long-term effects on the U.S. and
worldwide financial markets and may cause further economic
uncertainties in the United States and worldwide. The Investment
Adviser does not know how long the securities markets may be
affected by these events and cannot predict the effects of the
occupation or similar events in the future on the
U.S. economy and securities markets.
RISKS OF
INVESTING IN A TRUST WITH ANTI-TAKEOVER PROVISIONS
The Trusts Agreement and Declaration of Trust includes
provisions that could limit the ability of other entities or
persons to acquire control of the Trust or convert the Trust to
open-end status. These provisions could deprive the holders of
common shares of opportunities to sell their common shares at a
premium over the then current market price of the common shares
or at net asset value.
KEY ADVISER
PERSONNEL RISK
The Trusts ability to identify and invest in attractive
opportunities is dependent upon Highland, its investment
adviser. If one or more key individuals leaves Highland,
Highland may not be able to hire qualified replacements or may
require an extended time to do so. This situation could prevent
the Trust from achieving its investment objectives.
Given the risks described above, an investment in the common
shares may not be appropriate for all investors. You should
carefully consider your ability to assume these risks before
making an investment in the Trust.
78
TRUSTEES AND
OFFICERS
The board of trustees is responsible for the overall management
of the Trust, including supervision of the duties performed by
Highland. There are five trustees of the Trust. Four of the
trustees are not interested persons (as defined in
the Investment Company Act) of the Trust. The name and business
address of the trustees and officers of the Trust and their
principal occupations and other affiliations during the past
five years are set forth under Management of the
Trust in the Statement of Additional Information.
INVESTMENT
ADVISER
Highland acts as the Trusts investment adviser. Highland
is located at Two Galleria Tower, 13455 Noel Road,
Suite 800, Dallas, Texas 75240. As of September 30,
2007, the Investment Adviser managed approximately
$38 billion in assets on behalf of investors around the
world. Highland is controlled by James Dondero and Mark Okada,
by virtue of their respective share ownership, and its general
partner, Strand Advisors, Inc. (Strand), of which
Mr. Dondero is the sole stockholder. Messrs. Dondero
and Okada have managed portfolios together since 1990.
Responsibilities. The Investment Adviser
provides the following services to the Trust: (i) furnishes
an investment program for the Trust; (ii) determines,
subject to the overall supervision and review of the board of
trustees, the investments to be purchased, held, sold or
exchanged by the Trust and the portion, if any, of the assets of
the Trust to be held uninvested; (iii) makes changes in the
investments of the Trust; and (iv) votes, exercises
consents and exercises all other rights pertaining to such
investments. Subject to the foregoing, the Investment Adviser,
at its own expense, will have the authority to engage one or
more sub-advisers in connection with the portfolio management of
the Trust, which sub-advisers may be affiliates of the
Investment Adviser; provided, however, that the Investment
Adviser shall remain responsible to the Trust with respect to
its duties and obligations set forth in the investment advisory
agreement.
Compensation. In return for its advisory
services, the Investment Adviser receives an annual fee, payable
monthly, in an amount equal to 1.00% of the average weekly value
of the Trusts Managed Assets (the Advisory
Fee). The accrued fees are payable monthly as promptly as
possible after the end of each month during which the investment
advisory agreement is in effect. The Investment Adviser may
waive a portion of its fees. A discussion regarding the basis
for the approval of the investment advisory agreement by the
Trusts board is available in the Trusts report to
shareholders for the period ending June 30, 2006.
Potential Conflicts of Interest. Since the
Trust employs leverage, the Investment Adviser will benefit
because the Trusts Managed Assets will increase with
leverage. Furthermore, the Investment Adviser will also benefit
to the extent that the Trusts Managed Assets are derived
from the reinvested collateral received on portfolio securities
loaned.
In addition to the Advisory Fee of Highland, the Trust pays all
other costs and expenses of its operations, including, but not
limited to, compensation of its trustees (other than those
affiliated with Highland), custodian, transfer and dividend
disbursing agent expenses, legal fees, listing fees and
expenses, expenses of independent auditors, expenses of
preparing, printing and distributing shareholder reports,
notices, proxy statements and reports to governmental agencies,
and reimbursement of actual expenses of the Investment Adviser
or others for registration and maintenance of the Trusts
registrations with the Commission and other jurisdictions and
taxes, if any.
79
Management of the
Trust
ADMINISTRATOR/SUB-ADMINISTRATOR
Under an administration agreement dated June 29, 2006,
Highland provides administration services to the Trust, provides
executive and other personnel necessary to administer the Trust
and furnishes office space. Highland receives an annual fee,
payable monthly, in an amount equal to 0.20% of the average
weekly value of the Trusts Managed Assets. The accrued
fees are payable monthly as promptly as possible after the end
of each month during which this Agreement is in effect. Highland
may waive a portion of its fees. Under a separate
sub-administration services agreement, dated June 29, 2006,
Highland has delegated certain administrative functions to PFPC
Inc., at an annual rate, payable by Highland, of 0.01% of the
average weekly value of the Trusts Managed Assets.
PORTFOLIO
MANAGERS
The Trusts portfolio managers are Kurtis Plumer, James
Dondero and Mark Okada. Their investment decisions are not
subject to the oversight, approval or ratification of a
committee.
Kurtis Plumer, CFA. Mr. Plumer is a Senior Portfolio
Manager and head of the Multi-Strategies group at Highland where
he is responsible for managing the sourcing, investing and
monitoring process. He has over 15 years of experience in
distressed, high yield bond and leveraged loan products. Prior
to joining Highland in 1999, Mr. Plumer was a distressed
high yield bond trader at Lehman Brothers in New York, where he
managed a $250 million portfolio invested in global
distressed securities. While at Lehman, he also traded emerging
market sovereign bonds. Prior to joining Lehman Brothers,
Mr. Plumer was a corporate finance banker at NationsBanc
Capital Markets, Inc. (now Bank of America Capital Markets,
Inc.) where he focused on M&A and financing transactions
for the banks clients. Mr. Plumer earned a BBA in
Economics and Finance from Baylor University and an MBA in
Strategy and Finance from the Kellogg School at Northwestern
University. Mr. Plumer is a Chartered Financial Analyst.
James Dondero, CFA, CPA, CMA. Mr. Dondero is a
founder and President of Highland. Formerly, Mr. Dondero
served as Chief Investment Officer of Protective Lifes GIC
subsidiary and helped grow the business from concept to over
$2 billion between 1989 and 1993. His portfolio management
experience includes mortgage-backed securities, investment grade
corporates, leveraged bank loans, emerging markets, derivatives,
preferred stocks and common stocks. From 1985 to 1989, he
managed approximately $1 billion in fixed income funds for
American Express. Prior to American Express, he completed his
financial training at Morgan Guaranty Trust Company.
Mr. Dondero is a Beta Gamma Sigma graduate of the
University of Virginia, 1984 with degrees in Accounting and
Finance. Mr. Dondero is a Certified Public Accountant,
Chartered Financial Analyst and a Certified Management
Accountant.
Mark Okada, CFA. Mr. Okada is Executive Vice
President of Strand and the funds in the Highland
Fund Complex. Mr. Okada is a founder and Chief
Investment Officer of Highland and has served as Chief
Investment Officer since 2000. From 1993 to 2000, Mr. Okada
served as Executive Vice President of Highland. He is
responsible for overseeing Highlands investment activities
for its various funds and has over 19 years of experience
in the leveraged finance market. Formerly, Mr. Okada served
as Manager of Fixed Income for Protective Lifes GIC
subsidiary from 1990 to 1993. He was primarily responsible for
the bank loan portfolio and other risk assets. Protective was
one of the first non-bank entrants into the syndicated loan
market. From 1986 to 1990, he served as Vice President for
Hibernia National Bank, managing over $1 billion of
high-yield bank loans. Mr. Okada is an honors graduate of
the University of California Los Angeles with degrees in
Economics and Psychology. He completed his credit training at
Mitsui and is a Chartered Financial Analyst. Mr. Okada is
also Chairman of the Board of Directors of Common Grace
Ministries Inc.
The Statement of Additional Information provides additional
information about the portfolio managers compensation,
other accounts managed by the portfolio managers and the
portfolio managers ownership of securities issued by the
Trust.
80
The net asset value of the common shares of the Trust is
computed based upon the value of the Trusts portfolio
securities and other assets. Net asset value per common share is
determined daily on each day that the New York Stock Exchange is
open for business as of the close of the regular trading session
on the New York Stock Exchange. The Trust calculates net asset
value per common share by subtracting liabilities (including
accrued expenses or dividends) from the total assets of the
Trust (the value of the securities plus cash or other assets,
including interest accrued but not yet received) and dividing
the result by the total number of outstanding common shares of
the Trust.
VALUATIONS
The Trust uses the following valuation methods to determine
either current market value for investments for which market
quotations are available, or if not available, the fair value,
as determined in good faith pursuant to policies and procedures
approved by the board of trustees:
(i) The market value of each security listed or
traded on any recognized securities exchange or automated
quotation system will be the last reported sale price at the
relevant valuation date on the composite tape or on the
principal exchange on which such security is traded. If no sale
is reported on that date, the Investment Adviser utilizes, when
available, pricing quotations from principal market makers. Such
quotations may be obtained from third-party pricing services or
directly from investment brokers and dealers in the secondary
market. Generally, the Trusts loan and bond positions are
not traded on exchanges and consequently are valued based on
market prices received from third-party pricing services or
broker-dealer sources.
(ii) Dividends declared but not yet received, and
rights in respect of securities which are quoted ex-dividend or
ex-rights, will be recorded at the fair value thereof, as
determined by the Investment Adviser, which may (but need not)
be the value so determined on the day such securities are first
quoted ex-dividend or ex-rights.
(iii) Listed options, or over-the-counter options for
which representative brokers quotations are available,
will be valued in the same manner as listed or over-the-counter
securities as hereinabove provided. Premiums for the sale of
such options written by the Trust will be included in the assets
of the Trust, and the market value of such options shall be
included as a liability.
(iv) The Trusts non-marketable investments will
generally be valued in such manner as the Investment Adviser
determines in good faith to reflect their fair values under
procedures established by, and under the general supervision and
responsibility of, the Trusts board of trustees. The
pricing of all assets that are fair valued in this manner will
be subsequently reported to and ratified by the Trusts
board of trustees.
When determining the fair value of an asset, the Investment
Adviser seeks to determine the price that the Trust might
reasonably expect to receive from the current sale of that asset
in an arms-length transaction. Fair value determinations
are based upon all available factors that the Investment Adviser
deems relevant.
81
Subject to market conditions, the Trust expects to declare
dividend on the Trusts common shares on a monthly basis.
The Trust expects to declare a monthly distribution in January
2008. Such distribution will not be payable with respect to
Shares that are issued pursuant to the Offer after the record
date for such dividend. The Trust intends to pay any capital
gain distributions annually.
Various factors will affect the level of the Trusts
current income and current gains, such as its asset mix and the
Trusts use of options. To permit the Trust to maintain
more stable monthly dividends and annual distributions, the
Trust may from time to time distribute less than the entire
amount of income and gains earned in the relevant month or year,
respectively. The undistributed income and gains would be
available to supplement future distributions. As a result, the
distributions paid by the Trust for any particular period may be
more or less than the amount of income and gains actually earned
by the Trust during the applicable period. Undistributed income
and gains will add to the Trusts net asset value and,
correspondingly, distributions from undistributed income and
gains and from capital, if any, will be deducted from the
Trusts net asset value. Shareholders will automatically
have all dividends and distributions reinvested in common shares
issued by the Trust or common shares of the Trust purchased in
the open market in accordance with the Trusts Dividend
Reinvestment Plan unless an election is made to receive cash.
Each participant in the Trusts Dividend Reinvestment Plan
will pay a pro rata portion of brokerage commissions incurred in
connection with open market purchases, and participants
requesting a sale of securities through the plan agent of the
Trusts Dividend Reinvestment Plan are subject to a sales
fee and a brokerage commission. See Dividend Reinvestment
Plan.
Dividend
reinvestment plan
Unless the registered owner of common shares elects to receive
cash by contacting the Plan Agent, all dividends declared for
the common shares of the Trust will be automatically paid in the
form of or, reinvested by PFPC Inc. (the Plan
Agent), agent for shareholders in administering the
Trusts Dividend Reinvestment Plan (the Plan)
in additional common shares of the Trust. If you are a
registered owner of common shares and elect not to participate
in the Plan, you will receive all dividends in cash paid by
check mailed directly to you (or, if the shares are held in
street or other nominee name, then to such nominee) by PFPC
Inc., as dividend disbursing agent. You may elect not to
participate in the Plan and to receive all dividends in cash by
sending written instructions or by contacting PFPC Inc., as
dividend disbursing agent, at the address set forth below.
Participation in the Plan is completely voluntary and may be
terminated or resumed at any time without penalty by contacting
the Plan Agent before the dividend record date; otherwise such
termination or resumption will be effective with respect to any
subsequently declared dividend or other distribution. Some
brokers may automatically elect to receive cash on your behalf
and may re-invest that cash in additional shares of the Trust
for you.
The Plan Agent will open an account for each shareholder under
the Plan in the same name in which such shareholders
shares are registered. Whenever the Trust declares a dividend or
other distribution (together, a dividend) payable in
cash, non-participants in the Plan will receive cash and
participants in the Plan will receive the equivalent in common
shares. The common shares will be acquired by the Plan Agent for
the participants accounts, depending upon the
circumstances described below, either (i) through receipt
of additional unissued but authorized shares from the Trust
(newly issued shares) or (ii) by purchase of
outstanding common shares on the open market (open-market
purchases) on the New York Stock Exchange or elsewhere.
If, on the payment date for any dividend, the market price per
common share plus estimated brokerage commissions is greater
than the net asset value per common share (such condition being
referred to
82
Dividend
reinvestment plan
herein as market premium), the Trust will issue
common shares, including fractions, to the participants in the
amount of the dividend. The number of newly issued common shares
to be credited to each participants account will be
determined by dividing the dollar amount of the dividend by the
net asset value per common share on the payment date; provided
that, if the net asset value per common share is less than 95%
of the market price per common share on the payment date, the
dollar amount of the dividend will be divided by 95% of the
market price per common share on the payment date.
If, on the payment date for any dividend, the net asset value
per common share is greater than the market value per common
share plus estimated brokerage commissions (such condition being
referred to herein as market discount), the Plan
Agent will invest the dividend amount in common shares acquired
on behalf of the participants in open-market purchases.
In the event of a market discount on the payment date for any
dividend, the Plan Agent will have until the last business day
before the next date on which the common shares trade on an
ex-dividend basis or 120 days after the payment
date for such dividend, whichever is sooner (the last
purchase date), to invest the dividend amount in common
shares acquired in open-market purchases. It is contemplated
that the Trust will pay monthly dividends. Therefore, the period
during which open-market purchases can be made will exist only
from the payment date of each dividend through the date before
the
ex-dividend
date of the third month of the quarter. If, before the Plan
Agent has completed its open-market purchases, the market price
of a common share exceeds the net asset value per common share,
the average per common share purchase price paid by the Plan
Agent may exceed the net asset value of the common shares,
resulting in the acquisition of fewer common shares than if the
dividend had been paid in newly issued common shares on the
dividend payment date. Because of the foregoing difficulty with
respect to open market purchases, if the Plan Agent is unable to
invest the full dividend amount in open market purchases during
the purchase period or if the market discount shifts to a market
premium during the purchase period, the Plan Agent may cease
making open-market purchases and may invest the uninvested
portion of the dividend amount in newly issued common shares at
the net asset value per common share at the close of business on
the last purchase date; provided that, if the net asset value
per common share is less than 95% of the market price per common
share on the payment date, the dollar amount of the dividend
will be divided by 95% of the market price per common share on
the payment date.
The Plan Agent maintains all shareholders accounts in the
Plan and furnishes written confirmation of all transactions in
the accounts, including information needed by shareholders for
tax records. Common shares in the account of each Plan
participant will be held by the Plan Agent on behalf of the Plan
participant, and each shareholder proxy will include those
shares purchased or received pursuant to the Plan. The Plan
Agent will forward all proxy solicitation materials to
participants and vote proxies for shares held under the Plan in
accordance with the instructions of the participants.
In the case of shareholders such as banks, brokers or nominees
which hold shares for others who are the beneficial owners, the
Plan Agent will administer the Plan on the basis of the number
of common shares certified from time to time by the record
shareholders name and held for the account of beneficial
owners who participate in the Plan.
There will be no brokerage charges with respect to common shares
issued directly by the Trust. However, each participant will pay
a pro rata share of brokerage commissions incurred in connection
with open-market purchases. The automatic reinvestment of
dividends will not relieve participants of any federal, state or
local income tax that may be payable (or required to be
withheld) on such dividends. Accordingly, any taxable dividend
received by a participant that is reinvested in additional
common shares will be subject to federal (and possibly state and
local) income tax even though such participant will not receive
a corresponding amount of cash with which to pay such taxes. See
Tax Matters. Participants who request a sale of
shares through the Plan Agent are subject to a $2.50 sales fee
and pay a brokerage commission of $0.05 per share sold.
83
Dividend
reinvestment plan
The Trust reserves the right to amend or terminate the Plan.
There is no direct service charge to participants in the Plan;
however, the Trust reserves the right to amend the Plan to
include a service charge payable by the participants.
All correspondence concerning the Plan should be directed to the
Plan Agent at PFPC Inc., 301 Bellevue Parkway, Wilmington,
Delaware 19809; telephone
(877) 665-1287.
Description
of capital structure
COMMON
SHARES
The Trust is a statutory trust organized under the laws of
Delaware pursuant to an Agreement and Declaration of Trust dated
as of March 10, 2006. The Trust is authorized to issue an
unlimited number of common shares of beneficial interest, par
value $0.001 per share. Each common share has one vote and, when
issued and paid for in accordance with the terms of this
offering, will be fully paid and non-assessable, except that the
trustees shall have the power to cause shareholders to pay
expenses of the Trust by setting off charges due from
shareholders from declared but unpaid dividends or distributions
owed the shareholders
and/or by
reducing the number of common shares owned by each respective
shareholder. The Trust currently is not aware of any expenses
that will be paid pursuant to this provision, except to the
extent fees payable under its Dividend Reinvestment Plan are
deemed to be paid pursuant to this provision.
The Trust intends to hold annual meetings of shareholders so
long as the common shares are listed on a national securities
exchange and such meetings are required as a condition to such
listing. All common shares are equal as to dividends, assets and
voting privileges and have no conversion, preemptive or other
subscription rights. The Trust will send annual and semi-annual
reports, including financial statements, to all holders of its
shares.
While the Trust has filed a registration statement to permit the
Trust to offer additional shares from time to time, such
registration statement has not been declared effective and the
Trust has no present intention of offering any additional shares
other than the Shares and common shares issued under the
Trusts Dividend Reinvestment Plan. Any additional
offerings of shares will require approval by the Trusts
board of trustees. Any additional offering of common shares will
be subject to the requirements of the Investment Company Act,
which provides that shares may not be issued at a price below
the then current net asset value, exclusive of sales load,
except in connection with an offering to existing holders of
common shares or with the consent of a majority of the
Trusts outstanding voting securities.
Any additional offerings of common shares would result in
current shareholders owning a smaller proportionate interest in
the Trust than they owned prior to such offering to the extent
that shareholders do not purchase sufficient shares in such
offering to maintain their percentage interest. The Trusts
net asset value would be reduced immediately following an
offering of the shares due to the costs of such offering, which
will be borne entirely by the Trust. The sale of shares by the
Trust (or the perception that such sales may occur) may have an
adverse effect on prices of shares in the secondary market. An
increase in the number of shares available may put downward
pressure on the market price for shares. If the Trust were
unable to invest the proceeds of an additional offering of
shares as intended, the Trusts per share distribution may
decrease and the Trust may not participate in market advances to
the same extent as if such proceeds were fully invested as
planned.
The Trusts common shares are listed on the New York Stock
Exchange under the symbol HCF. Unlike open-end
funds, closed-end funds like the Trust do not continuously offer
shares and do not provide daily redemptions. Rather, if a
shareholder determines to buy additional common shares or sell
shares already held, the shareholder may do so by trading
through a broker on the New York Stock
84
Description of
capital structure
Exchange or otherwise. Shares of closed-end investment companies
frequently trade on an exchange at prices lower than net asset
value. Because the market value of the common shares may be
influenced by such factors as dividend levels (which are in turn
affected by expenses), dividend stability, net asset value,
relative demand for and supply of such shares in the market,
general market and economic conditions and other factors beyond
the control of the Trust, the Trust cannot assure you that
common shares will trade at a price equal to or higher than net
asset value in the future. The common shares are designed
primarily for long-term investors and you should not purchase
the common shares if you intend to sell them soon after
purchase. See the Statement of Additional Information under
Repurchase of Common Shares.
The following table provides information about the Trusts
outstanding shares as of November 30, 2007.
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Amount
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Amount
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Title of
Class
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Authorized
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Outstanding
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Common Shares
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Unlimited
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34,520,549
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OTHER
SHARES
The board of trustees (subject to applicable law and the
Trusts Agreement and Declaration of Trust) may authorize
an offering, without the approval of the holders of common
shares, of other classes of shares, or other classes or series
of shares, as they determine to be necessary, desirable or
appropriate, having such terms, rights, preferences, privileges,
limitations and restrictions as the board of trustees see fit.
The Trust currently does not expect to issue any other classes
of shares, or series of shares, except for the common shares.
CREDIT
FACILITY
The Trust currently leverages through borrowings from a credit
facility. The Trust has entered into a revolving credit
agreement with The Bank of Nova Scotia (Scotia) to
borrow up to $300,000,000 (the Loan Agreement). Such
borrowings constitute financial leverage. The Loan Agreement
contains covenants that limit the Trusts ability to,
without the prior consent of Scotia: (i) pay dividends in
certain circumstances, (ii) incur additional debt,
(iii) change its investment objectives, policies and
restrictions as set forth in the Trusts prospectus in
effect when the Loan Agreement became effective or
(iv) adopt or carry out any plan of liquidation,
reorganization, incorporation, recapitalization, merger or
consolidation or sell, transfer or otherwise dispose of all or a
substantial part of its assets. For instance, the Trust agreed
not to purchase assets not contemplated by the investment
policies and restrictions in effect when the Loan Agreement
became effective. Furthermore, the Trust may not incur
additional debt from any other party, except for in limited
circumstances (e.g., in the ordinary course of business).
In addition, the Loan Agreement contains a covenant requiring
asset coverage ratios that may be more stringent than those
required by the Investment Company Act. Such restrictions shall
apply only so long as the Loan Agreement remains in effect. Any
senior security representing indebtedness, as defined in
Section 18(g) of the Investment Company Act, must have
asset coverage of at least 300%. Debt incurred under the Loan
Agreement will be considered a senior security for this purpose.
Market
and net asset value information
The Trusts common shares are listed on the NYSE under the
symbol HCF. The Trusts common shares commenced
trading on the NYSE in June 2006 and thus have a limited trading
history. The Trust cannot predict whether its shares will trade
in the future at a premium or discount to net asset value.
Issuance of additional common shares may have an adverse effect
on prices in the secondary market for
85
Market and net
asset value information
the Trusts common shares by increasing the number of
shares available, which may put downward pressure on the market
price for the shares.
The following table sets forth, for each of the periods
indicated, the high and low closing market prices of the
Trusts common shares on the NYSE, the corresponding net
asset value per share on such dates and the corresponding
premium/discount to net asset value per share on such dates. See
Net Asset Value for information as to how the
Trusts net asset value is determined.
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Premium/(Discount)
as a %
|
|
|
|
Market
price
|
|
|
Net asset value
per share
|
|
|
of net asset
value
|
|
Quarter
|
|
High
|
|
|
Low
|
|
|
High
|
|
|
Low
|
|
|
High
|
|
|
Low
|
|
|
|
|
2nd Quarter 2006*
|
|
|
20.60
|
|
|
|
20.18
|
|
|
|
19.07
|
|
|
|
19.06
|
|
|
|
8
|
.02
|
%
|
|
|
5
|
.87
|
%
|
3rd Quarter 2006
|
|
|
21.30
|
|
|
|
19.82
|
|
|
|
19.13
|
|
|
|
19.12
|
|
|
|
11
|
.39
|
%
|
|
|
3
|
.62
|
%
|
4th Quarter 2006
|
|
|
21.48
|
|
|
|
20.10
|
|
|
|
20.02
|
|
|
|
19.38
|
|
|
|
7
|
.28
|
%
|
|
|
3
|
.69
|
%
|
1st Quarter 2007
|
|
|
21.69
|
|
|
|
20.37
|
|
|
|
20.34
|
|
|
|
20.33
|
|
|
|
6
|
.63
|
%
|
|
|
0
|
.18
|
%
|
2nd Quarter 2007
|
|
|
21.14
|
|
|
|
19.80
|
|
|
|
20.53
|
|
|
|
20.45
|
|
|
|
2
|
.97
|
%
|
|
|
(3
|
.18
|
)%
|
3rd Quarter 2007
|
|
|
20.17
|
|
|
|
16.25
|
|
|
|
20.63
|
|
|
|
19.18
|
|
|
|
(2
|
.23
|
)%
|
|
|
(15
|
.28
|
)%
|
|
|
|
* |
|
The Trust commenced operations on June 29, 2006 |
Anti-takeover
provisions in the Agreement and Declaration of Trust
The Agreement and Declaration of Trust includes provisions that
could have the effect of limiting the ability of other entities
or persons to acquire control of the Trust or to change the
composition of its board of trustees. This could have the effect
of depriving shareholders of an opportunity to sell their shares
at a premium over prevailing market prices by discouraging a
third party from seeking to obtain control over the Trust. Such
attempts could have the effect of increasing the expenses of the
Trust and disrupting the normal operation of the Trust. The
board of trustees is divided into three classes, with the terms
of one class expiring at each annual meeting of shareholders. At
each annual meeting, one class of trustees is elected to a
three-year term. This provision could delay for up to two years
the replacement of a majority of the board of trustees. A
trustee may be removed from office (for cause, and not without
cause) by the action of a majority of the remaining trustees
followed by a vote of the holders of at least 75% of the shares
then entitled to vote for the election of the respective trustee.
In addition, the Trusts Agreement and Declaration of Trust
requires the favorable vote of a majority of the Trusts
board of trustees followed by the favorable vote of the holders
of at least 75% of the outstanding shares of each affected class
or series of the Trust, voting separately as a class or series,
to approve, adopt or authorize certain transactions with 5% or
greater holders of a class or series of shares and their
associates, unless the transaction has been approved by at least
80% of the trustees, in which case a majority of the
outstanding voting securities (as defined in the
Investment Company Act) of the Trust shall be required. For
purposes of these provisions, a 5% or greater holder of a class
or series of shares (a Principal Shareholder) refers
to any person who, whether directly or indirectly and whether
alone or together with its affiliates and associates,
beneficially owns 5% or more of the outstanding shares of all
outstanding classes or series of shares of beneficial interest
of the Trust.
The 5% holder transactions subject to these special approval
requirements are: the merger or consolidation of the Trust or
any subsidiary of the Trust with or into any Principal
Shareholder; the issuance of any securities of the Trust to any
Principal Shareholder for cash, except pursuant to any automatic
dividend reinvestment plan; the sale, lease or exchange of all
or any substantial part of the
86
Anti-takeover
provisions in the Agreement and Declaration of Trust
assets of the Trust to any Principal Shareholder, except assets
having an aggregate fair market value of less than 2% of the
total assets of the Trust, aggregating for the purpose of such
computation all assets sold, leased or exchanged in any series
of similar transactions within a twelve-month period; or the
sale, lease or exchange to the Trust or any subsidiary of the
Trust, in exchange for securities of the Trust, of any assets of
any Principal Shareholder, except assets having an aggregate
fair market value of less than 2% of the total assets of the
Trust, aggregating for purposes of such computation all assets
sold, leased or exchanged in any series of similar transactions
within a twelve-month period.
To convert the Trust to an open-end investment company, the
Trusts Agreement and Declaration of Trust requires the
favorable vote of a majority of the board of the trustees
followed by the favorable vote of the holders of at least 75% of
the outstanding shares of each affected class or series of
shares of the Trust, voting separately as a class or series,
unless such amendment has been approved by at least 80% of the
trustees, in which case a majority of the outstanding
voting securities (as defined in the Investment Company
Act) of the Trust shall be required. The foregoing vote would
satisfy a separate requirement in the Investment Company Act
that any conversion of the Trust to an open-end investment
company be approved by the shareholders. If approved in the
foregoing manner, conversion of the Trust to an open-end
investment company could not occur until 90 days after the
shareholders meeting at which such conversion was approved
and would also require at least 30 days prior notice
to all shareholders. Following any such conversion, it is
possible that certain of the Trusts investment policies
and strategies would have to be modified to assure sufficient
portfolio liquidity. In the event of conversion, the common
shares would cease to be listed on the New York Stock Exchange
or other national securities exchanges or market systems.
Shareholders of an open-end investment company may require the
company to redeem their shares at any time, except in certain
circumstances as authorized by or under the Investment Company
Act, at their net asset value, less such redemption charge, if
any, as might be in effect at the time of a redemption. The
Trust expects to pay all such redemption requests in cash, but
reserves the right to pay redemption requests in a combination
of cash or securities. If such partial payment in securities
were made, investors may incur brokerage costs in converting
such securities to cash. If the Trust were converted to an
open-end fund, it is likely that new shares would be sold at net
asset value plus a sales load. The board of trustees believes,
however, that the closed-end structure is desirable in light of
the Trusts investment objectives and policies. Therefore,
you should assume that it is not likely that the board of
trustees would vote to convert the Trust to an open-end fund.
For the purposes of calculating a majority of the
outstanding voting securities under the Trusts
Agreement and Declaration of Trust, each class and series of the
Trust shall vote together as a single class, except to the
extent required by the Investment Company Act or the
Trusts Agreement and Declaration of Trust, with respect to
any class or series of shares. If a separate class vote is
required, the applicable proportion of shares of the class or
series, voting as a separate class or series, also will be
required.
The Agreement and Declaration of Trust also provides that the
Trust may be liquidated upon the approval of 80% of the trustees.
The board of trustees has determined that provisions with
respect to the board of trustees and the shareholder voting
requirements described above, which voting requirements are
greater than the minimum requirements under Delaware law or the
Investment Company Act, are in the best interest of shareholders
generally. Reference should be made to the Trusts
Agreement and Declaration of Trust, on file with the Commission
for the full text of these provisions.
87
Closed-end
fund structure
The Trust is a non-diversified, closed-end management investment
company (commonly referred to as a closed-end fund). Closed-end
funds differ from open-end funds (which are generally referred
to as mutual funds) in that closed-end funds generally list
their shares for trading on a stock exchange and do not redeem
their shares at the request of the shareholder. This means that
if you wish to sell your shares of a closed-end fund you must
trade them on the market like any other stock at the prevailing
market price at that time. In a mutual fund, if the shareholder
wishes to sell shares of the fund, the mutual fund will redeem
or buy back the shares at net asset value (less a
redemption fee, if applicable, or contingent deferred sales
charge, if applicable). Also, mutual funds generally offer new
shares on a continuous basis to new investors, and closed-end
funds generally do not. The continuous inflows and outflows of
assets in a mutual fund can make it difficult to manage a mutual
funds investments. By comparison, closed-end funds are
generally able to stay more fully invested in securities that
are consistent with their investment objective and also have
greater flexibility to make certain types of investments and to
use certain investment strategies, such as financial leverage
and investments in illiquid securities.
Shares of closed-end funds frequently trade at a discount to
their net asset value. Because of this possibility and the
recognition that any such discount may not be in the interest of
shareholders, the Trusts board of trustees might consider
from time to time engaging in open-market repurchases, tender
offers for shares or other programs intended to reduce the
discount. We cannot guarantee or assure, however, that the
Trusts board of trustees will decide to engage in any of
these actions. Nor is there any guarantee or assurance that such
actions, if undertaken, would result in the shares trading at a
price equal or close to net asset value per share. The board of
trustees might also consider converting the Trust to an open-end
mutual fund, which would also require a vote of the shareholders
of the Trust.
Repurchase
of common shares
Shares of closed-end investment companies often trade at a
discount to their net asset value, and the Trusts common
shares may also trade at a discount to their net asset value,
although it is possible that they may trade at a premium above
net asset value. The market price of the Trusts common
shares will be determined by such factors as relative demand for
and supply of such common shares in the market, the Trusts
net asset value, general market and economic conditions and
other factors beyond the control of the Trust. See Net
Asset Value. Although the Trusts common shareholders
will not have the right to redeem their common shares, the Trust
may take action to repurchase common shares in the open market
or make tender offers for its common shares. This may have the
effect of reducing any market discount from net asset value.
There is no assurance that, if action is undertaken to
repurchase or tender for common shares, such action will result
in the common shares trading at a price which approximates their
net asset value. Although share repurchases and tenders could
have a favorable effect on the market price of the Trusts
common shares, you should be aware that the acquisition of
common shares by the Trust will decrease the capital of the
Trust and, therefore, may have the effect of increasing the
Trusts expense ratio and decreasing the asset coverage
with respect to any borrowings. Any share repurchases or tender
offers will be made in accordance with requirements of the
Securities Exchange Act of 1934, as amended, the Investment
Company Act and the principal stock exchange on which the common
shares are traded.
88
The following discussion summarizes certain U.S. federal
income tax considerations affecting the Trust and its
shareholders that are U.S. persons as defined for
U.S. federal income tax purposes. For more information,
please see the Statement of Additional Information under
Tax Matters. Because each shareholders tax
situation is unique, ask your tax professional about the tax
consequences to you of an investment in the Trust.
The Trust intends to qualify annually as a regulated investment
company under the Code. Accordingly, the Trust generally will
not be subject to U.S. federal income tax on its net
investment income and net realized capital gains that the Trust
distributes to its shareholders. The Trust expects to pay its
shareholders annually at least 90% of such income.
Distributions paid to both common and preferred shareholders by
the Trust from its net realized long-term capital gains, if any,
that the Trust designates as capital gains dividends
(capital gain dividends) are taxable as long-term
capital gains, regardless of how long you have held your shares.
All other dividends paid to you by the Trust (including
dividends from short-term capital gains) from its current or
accumulated earnings and profits (ordinary income
dividends) are generally subject to tax as ordinary income.
In general, the Trust does not expect that a significant portion
of its ordinary income dividends will be treated as qualified
dividend income, which is eligible for taxation at the rates
applicable to long-term capital gains in the case of individual
shareholders, or that a corporate shareholder will be able to
claim a dividends received deduction with respect to any
significant portion of Trust distributions.
Dividends and other taxable distributions are taxable to you
even if they are reinvested in additional common shares of the
Trust. Dividends and other distributions paid by the Trust are
generally treated as received by you at the time the dividend or
distribution is made. If, however, the Trust pays you a dividend
in January that was declared in the previous October, November
or December and you were the shareholder of record on a
specified date in one of such months, then such dividend will be
treated for tax purposes as being paid by the Trust and received
by you on December 31 of the year in which the dividend was
declared.
The price of common shares purchased at any time may reflect the
amount of a forthcoming distribution. If you purchase common
shares just prior to a distribution, you will receive a
distribution that will be taxable to you even though it
represents in part a return of your invested capital.
The Trust will send you information after the end of each year
setting forth the amount and tax status of any distributions
paid to you by the Trust. Ordinary income dividends and capital
gain dividends may also be subject to state and local taxes.
If you sell or otherwise dispose of common shares of the Trust,
you will generally recognize a gain or loss in an amount equal
to the difference between your tax basis in such shares of the
Trust and the amount you receive in exchange for such shares. If
you hold your common shares as capital assets, any such gain or
loss generally will be long-term capital gain or loss if you
have held such shares for more than one year at the time of sale.
The Trust may be required to withhold, for U.S. federal
backup withholding tax purposes, a portion of the dividends,
distributions and redemption proceeds payable to a non-corporate
shareholder who fails to provide the Trust (or its agent) with
the shareholders correct taxpayer identification number
(in the case of an individual, generally, such individuals
social security number) or to make the required certification,
or who has been notified by the Internal Revenue Service (the
IRS) that such shareholder is subject to backup
withholding. Certain shareholders are exempt from backup
withholding. Backup withholding is not an additional tax and any
amount withheld may be refunded or credited against your
U.S. federal income tax liability, if any, provided that
you furnish the required information to the IRS.
89
The discussions set forth herein and in the Statement of
Additional Information do not constitute tax advice, and you are
urged to consult your own tax advisor to determine the specific
U.S. federal, state, local and foreign tax consequences to
you of investing in the Trust.
Custodian
and transfer agent
The custodian of the assets of the Trust will be PFPC
Trust Company (8800 Tinicum Blvd., 4th Floor,
Philadelphia, PA 19153; telephone
(877) 665-1287).
The custodian will perform custodial, fund accounting and
portfolio accounting services. PFPC Inc. (301 Bellevue Parkway,
Wilmington, Delaware 19809; telephone
(877) 665-1287)
will serve as the Trusts transfer agent with respect to
its common shares.
Certain legal matters in connection with the common shares will
be passed upon for the Trust by Skadden, Arps, Slate,
Meagher & Flom LLP, Chicago, Illinois, and certain
other legal matters will be passed on for the Dealer Manager by
Clifford Chance US LLP, New York, New York. Clifford Chance US
LLP may rely on the opinion of Skadden, Arps, Slate,
Meagher & Flom LLP as to matters of Delaware law.
Privacy
principles of the Trust
The Trust is committed to maintaining the privacy of its
shareholders and to safeguarding their non-public personal
information. The following information is provided to help you
understand what personal information the Trust collects, how the
Trust protects that information and why, in certain cases, the
Trust may share information with select other parties.
Generally, the Trust does not receive any non-public personal
information relating to its shareholders, although certain
non-public personal information of its shareholders may become
available to the Trust. The Trust does not disclose any
non-public personal information about its shareholders or former
shareholders to anyone, except as permitted by law or as is
necessary in order to service shareholder accounts (for example,
to a transfer agent or third party administrator).
The Trust restricts access to non-public personal information
about its shareholders to employees of the Trusts
Investment Adviser and its affiliates with a legitimate business
need for the information. The Trust maintains physical,
electronic and procedural safeguards designed to protect the
non-public personal information of its shareholders.
90
TABLE
OF CONTENTS FOR THE STATEMENT OF ADDITIONAL
INFORMATION
|
|
|
|
|
|
|
Page
|
|
|
Use of Proceeds
|
|
|
B-2
|
|
Investment Restrictions
|
|
|
B-2
|
|
Investment Policies and Techniques
|
|
|
B-3
|
|
Other Investment Policies and Techniques
|
|
|
B-13
|
|
Management of the Trust
|
|
|
B-16
|
|
Portfolio Transactions and Brokerage
|
|
|
B-23
|
|
Repurchase of Common Shares
|
|
|
B-23
|
|
Tax Matters
|
|
|
B-25
|
|
Experts
|
|
|
B-29
|
|
Additional Information
|
|
|
B-29
|
|
Financial Statements
|
|
|
|
|
Appendix A
|
|
|
A-1
|
|
Appendix B
|
|
|
B-1
|
|
Highland
Credit Strategies Fund
11,535,615 Common
Shares
Issuable
Upon Exercise of Rights to
Subscribe
for Such Shares
PROSPECTUS
UBS
Investment Bank
December 17, 2007
Highland Credit Strategies Fund
Statement of Additional Information
Highland Credit
Strategies Fund (the Trust) is a non-diversified, closed-end
management investment company registered under the Investment Company Act with limited operating
history. This Statement of Additional Information registered under the Investment Company Act does
not constitute a prospectus, but should be read in conjunction with the prospectus relating thereto
dated December 17, 2007. This Statement of Additional Information does not include all information
that a prospective investor should consider before purchasing common shares, and investors should
obtain and read the prospectus prior to purchasing such shares. A copy of the prospectus may be
obtained without charge by calling 1-877-665-1287. You may also obtain a copy of the prospectus on
the Securities and Exchange Commissions web site (http://www.sec.gov). Capitalized terms used but
not defined in this Statement of Additional Information have the meanings ascribed to them in the
prospectus.
TABLE OF CONTENTS
|
|
|
|
|
|
|
Page |
|
|
|
|
B-2 |
|
|
|
|
B-2 |
|
|
|
|
B-3 |
|
|
|
|
B-13 |
|
|
|
|
B-16 |
|
|
|
|
B-23 |
|
|
|
|
B-23 |
|
|
|
|
B-25 |
|
|
|
|
B-29 |
|
|
|
|
B-29 |
|
|
|
|
B-29 |
|
|
|
|
A-1 |
|
|
|
|
B-1 |
|
This
Statement of Additional Information is dated December 17, 2007
B-1
USE OF PROCEEDS
Pending investment in securities that meet the Trusts investment objectives and policies, the
net proceeds of the Offer will be invested in short-term debt securities of the type described
under Investment Policies and Techniques Short-Term Debt Securities. We currently
anticipate that the Trust will be able to invest primarily in securities that meet the Trusts
investment objectives and policies within approximately one to three months after the completion of
the Offer.
INVESTMENT RESTRICTIONS
Except as described below, the Trust, as a fundamental policy, may not, without the approval
of the holders of a majority of the outstanding(1) common shares and any preferred shares, if
any, voting together as a single class, and of the holders of a majority of the outstanding
preferred shares, if any, voting as a separate class:
(1) invest 25% or more of the value of its total assets in any single industry or
group of industries;
(2) issue senior securities or borrow money other than as permitted by the Investment
Company Act or pledge its assets other than to secure such issuances or in connection with
hedging transactions, short sales, securities lending, when issued and forward commitment
transactions and similar investment strategies;
(3) make loans of money or property to any person, except through loans of portfolio
securities up to a maximum of 33 1/3% of the Trusts total assets, the purchase of debt
securities, including bank loans (senior loans) and participations therein, or the entry
into repurchase agreements up to a maximum of 33 1/3% of the Trusts total assets;
(4) underwrite the securities of other issuers, except to the extent that, in
connection with the disposition of portfolio securities or the sale of its own securities,
the Trust may be deemed to be an underwriter;
(5) purchase or sell real estate, except that the Trust may invest in securities of
companies that deal in real estate or are engaged in the real estate business, including
real estate investment trusts and real estate operating companies, and instruments secured
by real estate or interests therein and the Trust may acquire, hold and sell real estate
acquired through default, liquidation, or other distributions of an interest in real estate
as a result of the Trusts ownership of such other assets; or
(6) purchase or sell commodities or commodity contracts for any purposes except as,
and to the extent, permitted by applicable law without the Trust becoming subject to
registration with the Commodity Futures Trading Commission (the CFTC) as a
commodity pool.
As currently relevant to the Trust, the Investment Company Act requires an asset coverage of
200% for a closed-end fund issuing preferred shares and 300% for a closed-end fund issuing
borrowings exceeding 5% of the Trusts assets (excluding temporary borrowings).
The Trust will not engage in any activities described under investment restriction number 2
pursuant to which the lenders would be able to foreclose on more than 33 1/3% of the Trusts total
assets.
B-2
(1) |
|
When used with respect to shares of the Trust, majority of the outstanding shares means (i)
67% or more of the shares present at a meeting, if the holders of more than 50% of the shares
are present or represented by proxy, or (ii) more than 50% of the shares, whichever is less. |
The Trust is also subject to the following non-fundamental restrictions and policies, which
may be changed by the board of trustees and without shareholder approval. The Trust may not:
|
(1) |
|
make any short sale of securities except in conformity with applicable
laws, rules and regulations and unless after giving effect to such sale, the market
value of all securities sold short does not exceed 25% of the value of the Trusts
total assets and the Trusts aggregate short sales of a particular class of
securities of an issuer does not exceed 25% of the then outstanding securities of
that class. The Trust may also make short sales against the box without respect
to such limitations. In this type of short sale, at the time of the sale, the Trust
owns or has the immediate and unconditional right to acquire at no additional cost
the identical security; and |
|
|
(2) |
|
purchase securities of open-end or closed-end investment companies
except in compliance with the Investment Company Act or any exemptive relief
obtained thereunder. Under the Investment Company Act, the Trust may invest up to
10% of its total assets in the aggregate in shares of other investment companies
and up to 5% of its total assets in any one investment company, provided the
investment does not represent more than 3% of the voting stock of the acquired
investment company at the time such shares are purchased. As a shareholder in any
investment company, the Trust will bear its ratable share of that investment
companys expenses, and will remain subject to payment of the Advisory Fees and
other expenses with respect to assets so invested. Holders of common shares will
therefore be subject to duplicative expenses to the extent the Trust invests in
other investment companies. In addition, the securities of other investment
companies may be leveraged and will therefore be subject to the risks of leverage.
The net asset value and market value of leveraged shares will be more volatile and
the yield to shareholders will tend to fluctuate more than the yield generated by
unleveraged shares. |
In addition, to comply with the federal tax requirements for qualification as a registered
investment company, the Trusts investments must meet certain diversification requirements. See
Tax Matters.
The percentage limitations applicable to the Trusts portfolio described in the prospectus and
this Statement of Additional Information apply only at the time of investment, except that the
percentage limitation with respect to borrowing applies at all times, and the Trust will not be
required to sell securities due to subsequent changes in the value of securities it owns.
INVESTMENT POLICIES AND TECHNIQUES
The following information supplements the discussion of the Trusts investment objectives,
policies and techniques that are described in the prospectus.
Short-Term Debt Securities
(1) For temporary defensive purposes or to keep cash on hand, the Trust may invest up to 100% of
its total assets in cash equivalents and short-term debt securities. Short-term debt investments
are defined to include, without limitation, the following: U.S. Government securities, including
bills, notes and bonds differing as to maturity and rates of interest that are either issued or
guaranteed by the U.S. Treasury or by
B-3
U.S. Government agencies or instrumentalities. U.S.
Government securities include securities issued by (a) the Federal Housing Administration, Farmers
Home Administration, Export-Import Bank of the United States, Small Business Administration, and
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 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. Consequently, the value of such securities
may fluctuate.
(2) Certificates of deposit issued against funds deposited in a bank or a savings and loan
association. Such certificates are for a definite period of time, earn a specified rate of return,
and are normally negotiable. The issuer of a certificate of deposit agrees to pay the amount
deposited plus interest to the bearer of the certificate on the date specified thereon.
Certificates of deposit purchased by the Trust may not be fully insured by the Federal Deposit
Insurance Corporation.
(3) Repurchase agreements, which involve purchases of debt securities. At the time the Trust
purchases securities pursuant to a repurchase agreement, it simultaneously agrees to resell and
redeliver such securities to the seller, who also simultaneously agrees to buy back the securities
at a fixed price and time. This assures a predetermined yield for the Trust 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 Trust to invest temporarily
available cash. The Trust 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 Trust may invest. Repurchase agreements may be considered loans to the
seller, collateralized by the underlying securities. The risk to the Trust 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 Trust is entitled to sell the underlying collateral. If
the value of the collateral declines after the agreement is entered into, and if the seller
defaults under a repurchase agreement when the value of the underlying collateral is less than the
repurchase price, the Trust could incur a loss of both principal and interest. Highland 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. Highland 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 Trust. If
the seller were to be subject to a federal bankruptcy proceeding, the ability of the Trust to
liquidate the collateral could be delayed or impaired because of certain provisions of the
bankruptcy laws.
(4) Commercial paper, which consists of 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 the Trust and a corporation. There is no secondary
market for such notes. However, they are redeemable by the Trust at any time. Highland will
consider the financial condition of the corporation (e.g., earning power, cash flow and other
liquidity ratios) and will continually monitor the corporations ability to meet all of its
financial obligations, because the Trusts 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 highest categories by a major rating agency and which mature within
one year of the date of purchase or carry a variable or floating rate of interest.
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Equity Securities
The Trust may invest in equity securities including preferred stocks, convertible securities,
warrants and depository receipts.
Preferred Stock. Preferred stock has a preference over common stock in liquidation (and
generally dividends as well) but is subordinated to the liabilities of the issuer in all respects.
As a general rule, the market value of preferred stock with a fixed dividend rate and no conversion
element varies inversely with interest rates and perceived credit risk, while the market price of
convertible preferred stock generally also reflects some element of conversion value. Because
preferred stock is junior to debt securities and other obligations of the issuer, deterioration in
the credit quality of the issuer will cause greater changes in the value of a preferred stock than
in a more senior debt security with similar stated yield characteristics. Unlike interest payments
on debt securities, preferred stock dividends are payable only if declared by the issuers board of
directors. Preferred stock also may be subject to optional or mandatory redemption provisions.
Convertible Securities. A convertible security is a bond, debenture, note, preferred stock or
other security that may be converted into or exchanged for a prescribed amount of common stock or
other equity security of the same or a different issuer within a particular period of time at a
specified price or formula. A convertible security entitles the holder to receive interest paid or
accrued on debt or the dividend paid on preferred stock until the convertible security matures or
is redeemed, converted or exchanged. Before conversion, convertible securities have characteristics
similar to nonconvertible income securities in that they ordinarily provide a stable stream of
income with generally higher yields than those of common stocks of the same or similar issuers, but
lower yields than comparable nonconvertible securities. The value of a convertible security is
influenced by changes in interest rates, with investment value declining as interest rates increase
and increasing as interest rates decline. The credit standing of the issuer and other factors also
may have an effect on the convertible securitys investment value. Convertible securities rank
senior to common stock in a corporations capital structure but are usually subordinated to
comparable nonconvertible securities. Convertible securities may be subject to redemption at the
option of the issuer at a price established in the convertible securitys governing instrument.
Warrants. Warrants, which are privileges issued by corporations enabling the owners to
subscribe to and purchase a specified number of shares of the corporation at a specified price
during a specified period of time. Subscription rights normally have a short life span to
expiration. The purchase of warrants involves the risk that the Trust could lose the purchase value
of a right or warrant if the right to subscribe to additional shares is not exercised prior to the
warrants expiration. Also, the purchase of warrants involves the risk that the effective price
paid for the warrant added to the subscription price of the related security may exceed the value
of the subscribed securitys market price such as when there is no movement in the level of the
underlying security.
Depository Receipts. The Trust may invest in both sponsored and unsponsored American
Depository Receipts (ADRs), European Depository Receipts (EDRs), Global
Depository Receipts (GDRs) and other similar global instruments. ADRs typically are
issued by an American bank or trust company and evidence ownership of underlying securities issued
by a non-U.S. corporation. EDRs, which are sometimes referred to as Continental Depository
Receipts, are receipts issued in Europe, typically by non-U.S. banks and trust companies, that
evidence ownership of either non-U.S. or U.S. underlying securities. GDRs are depository receipts
structured like global debt issues to facilitate trading on an international basis. Unsponsored
ADR, EDR and GDR programs are organized independently and without the
cooperation of the issuer of the underlying securities. As a result, available information
concerning the issuer may not be as current as for sponsored ADRs, EDRs and GDRs, and the prices of
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unsponsored ADRs, EDRs and
GDRs may be more volatile than if such instruments were sponsored by the
issuer. Investments in ADRs, EDRs and GDRs may present additional investment considerations of
non-U.S. securities.
Variable and Floating Rate Instruments
The Trust may purchase rated and unrated variable and floating rate instruments. These
instruments may include variable amount master demand notes that permit the indebtedness thereunder
to vary in addition to providing for periodic adjustments in the interest rate. The Trust may
invest in leveraged inverse floating rate debt instruments (Inverse Floaters). The
interest rate of an Inverse Floater resets in the opposite direction from the market rate of
interest to which it is indexed. An Inverse Floater may be considered to be leveraged to the extent
that its interest rate varies by a magnitude that exceeds the magnitude of the change in the index
rate of interest. The higher degree of leverage inherent in Inverse Floaters is associated with
greater volatility in their market values. Issuers of unrated variable and floating rate
instruments must satisfy the same criteria as set forth above for the Trust. The absence of an
active secondary market with respect to particular variable and floating rate instruments, however,
could make it difficult for the Trust to dispose of a variable or floating rate instrument if the
issuer defaulted on its payment obligation or during periods when the Trust is not entitled to
exercise its demand rights.
With respect to purchasable variable and floating rate instruments, Highland will consider the
earning power, cash flows and liquidity ratios of the issuers and guarantors of such instruments
and, if the instruments are subject to a demand feature, will monitor their financial status to
meet payment on demand. Such instruments may include variable amount master demand notes that
permit the indebtedness thereunder to vary in addition to providing for periodic adjustments in the
interest rate. The absence of an active secondary market with respect to particular variable and
floating rate instruments could make it difficult for the Trust to dispose of a variable or
floating rate note if the issuer defaulted on its payment obligation or during periods that the
Trust is not entitled to exercise its demand rights, and the Trust could, for these or other
reasons, suffer a loss, with respect to such instruments. In determining average-weighted portfolio
maturity, an instrument will be deemed to have a maturity equal to either the period remaining
until the next interest rate adjustment or the time the Trust involved can recover payment of
principal as specified in the instrument, depending on the type of instrument involved.
Derivative Transactions and Risk Management
Consistent with its investment objectives and policies set forth in the prospectus and in
addition to its option strategy, the Trust may also enter into certain risk management
transactions. In particular, the Trust may purchase and sell futures contracts, exchange listed and
over-the-counter put and call options on securities, equity and other indices and futures
contracts, forward foreign currency contracts, and may enter into various interest rate
transactions. Derivative Transactions may be used to attempt to protect against possible changes in
the market value of the Trusts portfolio resulting from fluctuations in the securities markets and
changes in interest rates, to protect the Trusts unrealized gains in the value of its portfolio
securities, to facilitate the sale of such securities for investment purposes and to establish a
position in the securities markets as a temporary substitute for purchasing particular securities.
Any or all of these Derivative Transactions may be used at any time. There is no particular
strategy that requires use of one technique rather than another. Use of any Derivative Transaction
is a function of market conditions. The ability of the Trust to manage them successfully will
depend on Highlands
ability to predict pertinent market movements as well as sufficient correlation among the
instruments, which cannot be assured. The Derivative Transactions that the Trust may use are
described below. Although the Trust recognizes it is not likely that it will use certain of these
strategies in light of its investment policies, it
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nevertheless describes them here because the
Trust may seek to use these strategies in certain circumstances.
Futures Contracts and Options on Futures Contracts. In connection with its Derivative
Transactions and other risk management strategies, the Trust may also enter into contracts for the
purchase or sale for future delivery (futures contracts) of securities, aggregates of securities
or indices or prices thereof, other financial indices and U.S. government debt securities or
options on the above. The Trust will engage in such transactions only for bona fide risk management
and other portfolio management purposes.
Forward Foreign Currency Contracts. The Trust may enter into forward currency contracts to
purchase or sell foreign currencies for a fixed amount of U.S. dollars or another foreign currency.
A forward currency contract involves an obligation to purchase or sell a specific currency at a
future date, which may be any fixed number of days from the date of the forward currency contract
agreed upon by the parties, at a price set at the time the forward currency contract is entered
into. Forward currency contracts are traded directly between currency traders (usually large
commercial banks) and their customers.
The Trust may engage in various forward currency contract strategies:
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The Trust may purchase a forward currency contract to lock in the U.S. dollar price
of a security denominated in a foreign currency that the Trust intends to acquire. The
Trust may sell a forward currency contract to lock in the U.S. dollar equivalent of
the proceeds from the anticipated sale of a security or a dividend or interest payment
denominated in a foreign currency. |
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The Trust may also use forward currency contracts to shift the Trusts exposure to
foreign currency exchange rate changes from one currency to another. For example, if
the Trust owns securities denominated in a foreign currency and Highland believes that
currency will decline relative to another currency, the Trust might enter into a
forward currency contract to sell the appropriate amount of the first foreign currency
with payment to be made in the second currency. |
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The Trust may also purchase forward currency contracts to enhance income when
Highland anticipates that the foreign currency will appreciate in value but securities
denominated in that currency do not present attractive investment opportunities. |
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The Trust may also use forward currency contracts to offset against a decline in
the value of existing investments denominated in a foreign currency. Such a
transaction would tend to offset both positive and negative currency fluctuations, but
would not offset changes in security values caused by other factors. |
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The Trust could also enter into a forward currency contract to sell another
currency expected to perform similarly to the currency in which the Trusts existing
investments are denominated. This type of transaction could offer advantages in terms
of cost, yield or efficiency, but may not offset currency exposure as effectively as a
simple forward currency transaction to sell U.S. dollars. This type of transaction
may result in losses if the currency sold does not perform similarly to the currency in
which the Trusts existing investments are denominated. |
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The Trust may also use forward currency contracts in one currency or a basket of
currencies to attempt to offset against fluctuations in the value of securities
denominated in a different currency if Highland anticipates that there will be a
correlation between the two currencies. |
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The cost to the Trust of engaging in forward currency contracts varies with factors
such as the currency involved, the length of the contract period and the market
conditions then prevailing. Because forward currency contracts are usually entered
into on a principal basis, no fees or commissions are involved. |
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When the Trust enters into a forward currency contract, it relies on the
counterparty to make or take delivery of the underlying currency at the maturity of
the contract. Failure by the counterparty to do so would result in the loss of some or
all of any expected benefit of the transaction. Secondary markets generally do not
exist for forward currency contracts, with the result that closing transactions
generally can be made for forward currency contracts only by negotiating directly with
the counterparty. Thus, there can be no assurance that the Trust will in fact be able
to close out a forward currency contract at a favorable price prior to maturity. In
addition, in the event of insolvency of the counterparty, the Trust might be unable to
close out a forward currency contract. In either event, the Trust would continue to be
subject to market risk with respect to the position, and would continue to be required
to maintain a position in securities denominated in the foreign currency or to
maintain cash or liquid assets in a segregated account. The precise matching of
forward currency contract amounts and the value of the securities involved generally
will not be possible because the value of such securities, measured in the foreign
currency, will change after the forward currency contract has been established. Thus,
the Trust might need to purchase or sell foreign currencies in the spot (cash) market
to the extent such foreign currencies are not covered by forward currency contracts.
The projection of short-term currency market movements is extremely difficult, and the
successful execution of a short-term strategy is highly uncertain. |
Calls on Securities, Indices and Futures Contracts. In addition to its option strategy, in
order to enhance income or reduce fluctuations on net asset value, the Trust may sell or purchase
call options (calls) on securities and indices based upon the prices of futures contracts and
debt or equity securities that are traded on U.S. and non-U.S. securities exchanges and in the
over-the-counter markets. A call option gives the purchaser of the option the right to buy, and
obligates the seller to sell, the underlying security, futures contract or index at the exercise
price at any time or at a specified time during the option period. All such calls sold by the Trust
must be covered as long as the call is outstanding (i.e., the Trust must own the instrument
subject to the call or other securities or assets acceptable for applicable segregation and
coverage requirements). A call sold by the Trust exposes the Trust during the term of the option to
possible loss of opportunity to realize appreciation in the market price of the underlying
security, index or futures contract and may require the Trust to hold an instrument which it might
otherwise have sold. The purchase of a call gives the Trust the right to buy a security, futures
contract or index at a fixed price. Calls on futures on securities must also be covered by assets
or instruments acceptable under applicable segregation and coverage requirements.
Puts on Securities, Indices and Futures Contracts. In addition to its option strategy, the
Trust may purchase put options (puts) that relate to securities (whether or not it holds such
securities in its portfolio), indices or futures contracts. For the same purposes, the Trust may
also sell puts on securities, indices or futures contracts on such securities if the Trusts
contingent obligations on such puts are secured by segregated assets consisting of cash or liquid
debt securities having a value not less than the exercise price. In selling puts, there is a risk
that the Trust may be required to buy the underlying security at a price higher than the current
market price.
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Interest Rate Transactions. Among the Derivative Transactions in which the Trust may enter
into are interest rate swaps and the purchase or sale of interest rate caps and floors. The Trust
expects to enter into these transactions primarily to preserve a return or spread on a particular
investment or portion of its portfolio as a duration management technique or to protect against any
increase in the price of securities the Trust anticipates purchasing at a later date. The Trust
intends to use these transactions for risk management purposes and not as a speculative investment.
The Trust will not sell interest rate caps or floors that it does not own. Interest rate swaps
involve the exchange by the Trust with another party of their respective commitments to pay or
receive interest, e.g., an exchange of floating rate payments for fixed rate payments with respect
to a notional amount of principal. The purchase of an interest rate cap entitles the purchaser, to
the extent that a specified index exceeds a predetermined interest rate, to receive payments of
interest on a notional principal amount from the party selling such interest rate cap. The purchase
of an interest rate floor entitles the purchaser, to the extent that a specified index falls below
a predetermined interest rate, to receive payments of interest on a notional principal amount from
the party selling such interest rate floor.
The Trust may enter into interest rate swaps, caps and floors on either an asset based or
liability-based basis, depending on whether it is offsetting volatility with respect to its assets
or liabilities, and will usually enter into interest rate swaps on a net basis, i.e., the two
payment streams are netted out, with the Trust receiving or paying, as the case may be, only the
net amount of the two payments on the payment dates. Inasmuch as these Derivative Transactions are
incurred into for good faith risk management purposes. Highland and the Trust believe such
obligations do not constitute senior securities, and, accordingly will not treat them as being
subject to its borrowing restrictions. The Trust will accrue the net amount of the excess, if any,
of the Trusts obligations over its entitlements with respect to each interest rate swap on a daily
basis and will designate on its books and records with a custodian an amount of cash or liquid high
grade securities having an aggregate net asset value at all times at least equal to the accrued
excess. The Trust will not enter into any interest rate swap, cap or floor transaction unless the
unsecured senior debt or the claims paying ability of the other party thereto is rated in the
highest rating category of at least one nationally recognized statistical rating organization at
the time of entering into such transaction. If there is a default by the other party to such a
transaction, the Trust will have contractual remedies pursuant to the agreements related to the
transaction. The swap market has grown substantially in recent years with a large number of banks
and investment banking firms acting both as principals and as agents utilizing standardized swap
documentation. Caps and floors are more recent innovations for which standardized documentation has
not yet been developed and, accordingly, they are less liquid than swaps.
Credit Derivatives. The Trust may engage in credit derivative transactions. There are two
broad categories of credit derivatives: default price risk derivatives and market spread
derivatives. Default price risk derivatives are linked to the price of reference securities or
loans after a default by the issuer or borrower, respectively. Market spread derivatives are based
on the
risk that changes in market factors, such as credit spreads, can cause a decline in the value
of a security, loan or index.
There are three basic transactional forms for credit derivatives: swaps, options and
structured instruments. The use of credit derivatives is a highly specialized activity which
involves strategies and risks different from those associated with ordinary portfolio security
transactions. If Highland is incorrect in its forecasts of default risks, market spreads or other
applicable factors, the investment performance of the Trust would diminish compared with what it
would have been if these techniques were not used. Moreover, even if Highland is correct in its
forecasts, there is a risk that a credit derivative position may correlate imperfectly with the
price of the asset or liability being purchased. There is no limit on the amount of credit
derivative transactions that may be entered into by the Trust. The Trusts risk of loss in a credit
derivative transaction varies with the form of the transaction. For example, if the Trust purchases
a default option on a security, and if no default occurs with respect to the security, the Trusts
loss is limited
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to the premium it paid for the default option. In contrast, if there is a default
by the grantor of a default option, the Trusts loss will include both the premium that it paid for
the option and the decline in value of the underlying security that the default option protects.
Below under General Characteristics of Risks of Derivative Transactions is further
information about the characteristics, risks and possible benefits of Derivative Transactions and
the Trusts other policies and limitations (which are not fundamental policies) relating to
investment in futures contracts and options. The principal risks relating to the use of futures
contracts and other Derivative Transactions are: (i) less than perfect correlation between the
prices of the instrument and the market value of the securities in the Trusts portfolio; (ii)
possible lack of a liquid secondary market for closing out a position in such instruments; (iii)
losses resulting from interest rate or other market movements not anticipated by Highland; and (iv)
the obligation to meet additional variation margin or other payment requirements, all of which
could result in the Trust being in a worse position than if such techniques had not been used.
Certain provisions of the Code may restrict or affect the ability of the Trust to engage in
Derivative Transactions. See Tax Matters.
General Characteristics and Risks of Derivative Transactions
In order to manage the risk of its securities portfolio, or to enhance income or gain as
described in the prospectus, the Trust will engage in Derivative Transactions. The Trust will
engage in such activities in the Investment Advisers discretion, and may not necessarily be
engaging in such activities when movements in interest rates that could affect the value of the
assets of the Trust occur. The Trusts ability to pursue certain of these strategies may be limited
by applicable regulations of the CFTC. Certain Derivative Transactions may give rise to taxable
income.
Put and Call Options on Securities and Indices
The Trust may purchase and sell put and call options on securities and indices. A put option
gives the purchaser of the option the right to sell and the writer the obligation to buy the
underlying security at the exercise price during the option period. The Trust may also purchase and
sell options on securities indices (index options). Index options are similar to options on
securities except that, rather than taking or making delivery of securities underlying the option
at a specified price upon exercise, an index option gives the holder the right to receive cash upon
exercise of the option if the level of the securities index upon which the option is based is
greater,
in the case of a call, or less, in the case of a put, than the exercise price of the option.
The purchase of a put option on a security could protect the Trusts holdings in a security or a
number of securities against a substantial decline in the market value. A call option gives the
purchaser of the option the right to buy and the seller the obligation to sell the underlying
security or index at the exercise price during the option period or for a specified period prior to
a fixed date. The purchase of a call option on a security could protect the Trust against an
increase in the price of a security that it intended to purchase in the future. In the case of
either put or call options that it has purchased, if the option expires without being sold or
exercised, the Trust will experience a loss in the amount of the option premium plus any related
commissions. When the Trust sells put and call options, it receives a premium as the seller of the
option. The premium that the Trust receives for selling the option will serve as a partial offset,
in the amount of the option premium, against changes in the value of the securities in its
portfolio. During the term of the option, however, a covered call seller has, in return for the
premium on the option, given up the opportunity for capital appreciation above the exercise price
of the option if the value of the underlying security increases, but has retained the risk of loss
should the price of the underlying security decline. Conversely, a secured put seller retains the
risk of loss should the market value of the underlying security decline below the exercise price of
the option, less the premium received on the sale of the option. The Trust is authorized to
purchase and sell exchange listed options and over-
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the-counter options (OTC Options)
which are privately negotiated with the counterparty. Listed options are issued by the Options
Clearing Corporation (OCC) which guarantees the performance of the obligations of the
parties to such options.
The Trusts ability to close out its position as a purchaser or seller of an exchange listed
put or call option is dependent upon the existence of a liquid secondary market on option
exchanges. Among the possible reasons for the absence of a liquid secondary market on an exchange
are: (i) insufficient trading interest in certain options; (ii) restrictions on transactions
imposed by an exchange; (iii) trading halts, suspensions or other restrictions imposed with respect
to particular classes or series of options or underlying securities; (iv) interruption of the
normal operations on an exchange; (v) inadequacy of the facilities of an exchange or OCC to handle
current trading volume; or (vi) a decision by one or more exchanges to discontinue the trading of
options (or a particular class or series of options), in which event the secondary market on that
exchange (or in that class or series of options) would cease to exist, although outstanding options
on that exchange that had been listed by the OCC as a result of trades on that exchange would
generally continue to be exercisable in accordance with their terms. OTC Options are purchased from
or sold to dealers, financial institutions or other counterparties which have entered into direct
agreements with the Trust. With OTC Options, such variables as expiration date, exercise price and
premium will be agreed upon between the Trust and the counterparty, without the intermediation of a
third party such as the OCC. If the counterparty fails to make or take delivery of the securities
underlying an option it has written, or otherwise settle the transaction in accordance with the
terms of that option as written, the Trust would lose the premium paid for the option as well as
any anticipated benefit of the transaction.
The hours of trading for options on securities may not conform to the hours during which the
underlying securities are traded. To the extent that the option markets close before the markets
for the underlying securities, significant price movements can take place in the underlying markets
that cannot be reflected in the option markets.
Futures Contracts and Related Options
Characteristics. The Trust may sell financial futures contracts or purchase put and call
options on such futures as an offset against anticipated market movements. The sale of a futures
contract creates an obligation by the Trust, as seller, to deliver the specific type of
financial instrument called for in the contract at a specified future time for a specified price.
Options on futures contracts are similar to options on securities except that an option on a
futures contract gives the purchaser the right in return for the premium paid to assume a position
in a futures contract (a long position if the option is a call and a short position if the option
is a put).
Margin Requirements. At the time a futures contract is purchased or sold, the Trust must
allocate cash or securities as a deposit payment (initial margin). It is expected that the
initial margin that the Trust will pay may range from approximately 1% to approximately 5% of the
value of the securities or commodities underlying the contract. In certain circumstances, however,
such as periods of high volatility, the Trust may be required by an exchange to increase the level
of its initial margin payment. Additionally, initial margin requirements may be increased generally
in the future by regulatory action. An outstanding futures contract is valued daily and the payment
in case of variation margin may be required, a process known as marking to the market.
Transactions in listed options and futures are usually settled by entering into an offsetting
transaction, and are subject to the risk that the position may not be able to be closed if no
offsetting transaction can be arranged.
Limitations on Use of Futures and Options on Futures. The Trusts use of futures and options
on futures will in all cases be consistent with applicable regulatory requirements and in
particular the
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rules and regulations of the CFTC. The Trust currently may enter into such
transactions without limit for bona fide strategic purposes, including risk management and duration
management and other portfolio strategies. The Trust may also engage in transactions in futures
contracts or related options for non-strategic purposes to enhance income or gain provided that the
Trust will not enter into a futures contract or related option (except for closing transactions)
for purposes other than bona fide strategic purposes, or risk management including duration
management if, immediately thereafter, the sum of the amount of its initial deposits and premiums
on open contracts and options would exceed 5% of the Trusts liquidation value, i.e., net assets
(taken at current value); provided, however, that in the case of an option that is in-the-money at
the time of the purchase, the in-the-money amount may be excluded in calculating the 5% limitation.
The above policies are non-fundamental and may be changed by the Trusts board of trustees at any
time. Also, when required, an account of cash equivalents designated on the books and records will
be maintained and marked to market on a daily basis in an amount equal to the market value of the
contract.
Segregation and Cover Requirements. Futures contracts, interest rate swaps, caps, floors and
collars, short sales, reverse repurchase agreements and dollar rolls, and listed or OTC options on
securities, indices and futures contracts sold by the Trust are generally subject to earmarking and
coverage requirements of either the CFTC or the SEC, with the result that, if the Trust does not
hold the security or futures contract underlying the instrument, the Trust will be required to
designate on its books and records an ongoing basis, cash, U.S. government securities, or other
liquid high grade debt obligations in an amount at least equal to the Trusts obligations with
respect to such instruments.
Such Amounts Fluctuate as the Obligations Increase or Decrease. The earmarking requirement
can result in the Trust maintaining securities positions it would otherwise liquidate, segregating
assets at a time when it might be disadvantageous to do so or otherwise restrict portfolio
management.
Derivative Transactions Present Certain Risks. With respect to Derivative Transactions and
risk management, the variable degree of correlation between price movements of strategic
instruments and price movements in the position being offset create the possibility that
losses using the strategy may be greater than gains in the value of the Trusts position. The same
is true for such instruments entered into for income or gain. In addition, certain instruments and
markets may not be liquid in all circumstances. As a result, in volatile markets, the Trust may not
be able to close out a transaction without incurring losses substantially greater than the initial
deposit. Although the contemplated use of these instruments predominantly for Derivative
Transactions should tend to minimize the risk of loss due to a decline in the value of the
position, at the same time they tend to limit any potential gain which might result from an
increase in the value of such position. The ability of the Trust to successfully utilize Derivative
Transactions will depend on the Investment Advisers and the sub-advisers ability to predict
pertinent market movements and sufficient correlations, which cannot be assured. Finally, the daily
deposit requirements in futures contracts that the Trust has sold create an on going greater
potential financial risk than do options transactions, where the exposure is limited to the cost of
the initial premium. Losses due to the use of Derivative Transactions will reduce net asset value.
Regulatory Considerations. The Trust has claimed an exclusion from the term commodity pool
operator under the Commodity Exchange Act and, therefore, is not subject to registration or
regulation as a commodity pool operator under the Commodity Exchange Act.
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OTHER INVESTMENT POLICIES AND TECHNIQUES
Restricted and Illiquid Securities
Certain of the Trusts investments may be illiquid. Illiquid securities are subject to legal
or contractual restrictions on disposition or lack an established secondary trading market. The
sale of restricted and illiquid securities often requires more time and results in higher brokerage
charges or dealer discounts and other selling expenses than does the sale of securities eligible
for trading on national securities exchanges or in the over-the-counter markets. Restricted
securities may sell at a price lower than similar securities that are not subject to restrictions
on resale.
When-Issued and Forward Commitment Securities
The Trust may purchase securities on a when-issued basis and may purchase or sell securities
on a forward commitment basis in order to acquire the security or to offset against anticipated
changes in interest rates and prices. When such transactions are negotiated, the price, which is
generally expressed in yield terms, is fixed at the time the commitment is made, but delivery and
payment for the securities take place at a later date. When-issued securities and forward
commitments may be sold prior to the settlement date, but the Trust will enter into when-issued and
forward commitments only with the intention of actually receiving or delivering the securities, as
the case may be. If the Trust disposes of the right to acquire a when-issued security prior to its
acquisition or disposes of its right to deliver or receive against a forward commitment, it might
incur a gain or loss. At the time the Trust enters into a transaction on a when-issued or forward
commitment basis, it will designate on its books and records cash or liquid debt securities equal
to at least the value of the when-issued or forward commitment securities. The value of these
assets will be monitored daily to ensure that their marked to market value will at all times equal
or exceed the corresponding obligations of the Trust. There is always a risk that the securities
may not be delivered and that the Trust may incur a loss. Settlements in the ordinary course, which
may take substantially more than five business days, are not treated by the Trust as when-issued or
forward commitment transactions and accordingly are not subject to the foregoing restrictions.
Pay-In-Kind Bonds
The Trust may invest in Pay-in-kind, or PIK bonds. PIK bonds are bonds which pay interest
through the issuance of additional debt or equity securities. Similar to zero coupon obligations,
PIK bonds also carry additional risk as holders of these types of securities realize no cash until
the cash payment date unless a portion of such securities is sold and, if the issuer defaults, the
Trust may obtain no return at all on its investment. The market price of PIK bonds is affected by
interest rate changes to a greater extent, and therefore tends to be more volatile, than that of
securities which pay interest in cash. Additionally, current federal tax law requires the holder of
certain PIK bonds to accrue income with respect to these securities prior to the receipt of cash
payments. To maintain its qualification as a regulated investment company and avoid liability for
federal income and excise taxes, the Trust may be required to distribute income accrued with
respect to these securities and may have to dispose of portfolio securities under disadvantageous
circumstances in order to generate cash to satisfy these distribution requirements.
Brady Bonds
The Trusts emerging market debt securities may include emerging market governmental debt
obligations commonly referred to as Brady Bonds. Brady Bonds are debt securities, generally
denominated in U.S. dollars, issued under the framework of the Brady Plan, an initiative announced
by U.S. Treasury Secretary Nicholas F. Brady in 1989 as a mechanism for debtor nations (primarily
emerging market countries) to restructure their outstanding external indebtedness (generally,
commercial
B-13
bank debt). Brady Bonds are created through the exchange of existing commercial bank
loans to foreign entities for new obligations in connection with debt restructuring. A significant
amount of the Brady Bonds that the Trust may purchase have no or limited collateralization, and the
Trust will be relying for payment of interest and (except in the case of principal collateralized
Brady Bonds) principal primarily on the willingness and ability of the foreign government to make
payment in accordance with the terms of the Brady Bonds. A substantial portion of the Brady Bonds
and other sovereign debt securities in which the Trust may invest are likely to be acquired at a
discount.
Mezzanine Investments
The Trust may invest in certain high yield securities known as mezzanine investments, which
are subordinated debt securities which are generally issued in private placements in connection
with an equity security (e.g., with attached warrants). Such mezzanine investments may be issued
with or without registration rights. Similar to other high yield securities, maturities of
mezzanine investments are typically seven to ten years, but the expected average life is
significantly shorter at three to five years. Mezzanine investments are usually unsecured and
subordinate to other obligations of the issuer.
Loan Participations and Assignments
The Trust may invest in fixed and floating rate loans (Loans) arranged through private
negotiations between a corporation or foreign government and one or more financial institutions
(Lenders). The Trusts investments in Loans are expected in most instances to be in the form of
participations in Loans (Participations) and assignments of all or a portion of Loans
(Assignments) from third parties. Participations typically will result in the Trust having a
contractual relationship only with the Lender not the borrower. The Trust will have the right to
receive payments of principal, interest and any fees to which it is entitled only from the Lender
selling the Participation and the Trust and only upon receipt by the Lender of the payments by the
borrower. In connection with purchasing Participations, the Trust generally has no direct right to
enforce compliance by the borrower with the terms of the loan agreement relating to the Loan, nor
any rights of set-off against the borrower, and the Trust may not directly benefit from any
collateral supporting the Loan in which is has purchased the Participation. As a result the Trust
will assume the credit risk of both the borrower and the Lender that is selling the Participation.
In the event of the insolvency of the Lender selling a Participation, the Trust may be treated as a
general creditor of the Lender and may not benefit from any set-off between the Lender and the
borrower. The Trust will acquire Participations only if the Lender interpositioned between the
Trust and the borrower is determined by Highland to be creditworthy. When the Trust purchases
Assignments from Lenders, the Trust will acquire direct rights against the borrower on the Loan.
However, since Assignments are arranged through private negotiations between potential assignees
and assignors, the rights and obligations acquired by the Trust as the purchaser of an Assignment
may differ from, and be more limited than, those held by the assigning Lender.
The Trust may have difficulty disposing of Assignments and Participations. Because there is no
liquid market for such securities, the Trust anticipates that such securities could be sold only to
a limited number of institutional investors. The lack of a liquid secondary market will have an
adverse impact on the value of such securities and on the Trusts ability to dispose of particular
Assignments or Participations when necessary to meet the Trusts liquidity needs or in response to
a specific economic event, such as a deterioration in the creditworthiness of the borrower. The
lack of a liquid secondary market for Assignments and Participations also may make it more
difficult for the Trust to assign a value to those securities for purposes of valuing the Trusts
portfolio and calculating its net asset value.
B-14
Structured Investments
The Trust may invest a portion of its assets in interests in entities organized and operated
solely for the purpose of restructuring the investment characteristics of securities. This type of
restructuring involves the deposit with or purchase by an entity, such as a corporation or a trust,
of specified instruments and the issuance by that entity of one or more classes of securities
(Structured Investments) backed by, or representing interests in the underlying instruments. The
cash flow on the underlying instruments may be apportioned among the newly issued Structured
Investments to create securities with different investment characteristics such as varying
maturities, payment priorities and interest rate provisions, and the extent of the payments made
with respect to Structured Investments is dependent on the extent of the cash flow on the
underlying instruments. Because Structured Investments of the type in which the Trust anticipates
it will invest typically involve no credit enhancement, their credit risk generally will be
equivalent to that of the underlying instruments.
The Trust is permitted to invest in a class of Structured Investments that is either
subordinated or not subordinated to the right of payment of another class. Subordinated Structured
Investments typically have higher yields and present greater risks than unsubordinated Structured
Investments.
Certain issuers of Structured Investments may be deemed to be investment companies as
defined in the Investment Company Act. As a result, the Trusts investment in these Structured
Investments may be limited by the restrictions contained in the Investment Company Act. Structured
Investments are typically sold in private placement transaction, and there currently is no active
trading market for Structured Investments.
Project Loans
The Trust may invest in project loans, which are fixed income securities of issuers whose
revenues are primarily derived from mortgage loans to multi-family, nursing home and other real
estate development projects. The principal payments on these mortgage loans will be insured by
agencies and authorities of the U.S. Government.
Zero Coupons and Deferred Payment Obligations
The Trust may invest in zero-coupon bonds, which are normally issued at a significant discount
from face value and do not provide for periodic interest payments. Zero-coupon bonds may experience
greater volatility in market value than similar maturity debt obligations which provide for regular
interest payments. Additionally, current federal tax law requires the holder of certain zero-coupon
bonds to accrue income with respect to these securities prior to the receipt of cash payments. To
maintain its qualification as a regulated investment company and to potentially avoid liability for
federal income and excise taxes, the Trust may be required to distribute income accrued with
respect to these securities and may have to dispose of Trust securities under disadvantageous
circumstances in order to generate cash to satisfy these distribution requirements.
The Trust may invest in Deferred Payment Securities. Deferred Payment Securities are
securities that remain Zero-Coupon Securities until a predetermined date, at which time the stated
coupon rate becomes effective and interest becomes payable at regular intervals. Deferred Payment
Securities are subject to greater fluctuations in value and may have lesser liquidity in the event
of adverse market conditions than comparably rated securities paying cash interest at regular
interest payment periods.
B-15
MANAGEMENT OF THE TRUST
Trustees
The board
of trustees provides broad oversight over the operations and affairs of the Trust
and protects the interests of shareholders. The board of trustees has overall responsibility to
manage and control the business affairs of the Trust, including the complete and exclusive
authority to establish policies regarding the management, conduct and operation of the Trusts
business. The names and ages of the trustees and officers of the Trust, the year each was first
elected or appointed to office, their principal business occupations during the last five years,
the number of funds overseen by each trustee and other directorships or trusteeships they hold are
shown below. The business address of the Trust, Highland and their board members and officers is
Two Galleria Tower, 13455 Noel Road, Suite 800, Dallas, Texas 75240, unless otherwise specified
below.
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Number of Portfolios in |
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Term of Office and |
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Highland Fund Complex |
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Other |
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Position |
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Length of Time |
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Principal Occupation(s) |
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Overseen by |
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Directorships/ |
Name and Age |
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with Trust |
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Served(1) |
|
During Past Five Years |
|
Trustee(2) |
|
Trusteeships Held |
INDEPENDENT TRUSTEES
|
Timothy Hui
(Age 59) |
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Trustee |
|
3 years and Trustee since May 19, 2006 |
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Dean of Educational Resources since July 2006; Assistant
Provost for Graduate Education from July 2004 to June 2006, and Assistant Provost for
Educational Resources from July 2001 to June 2004, Philadelphia Biblical University. |
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10 |
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None |
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Scott Kavanaugh
(Age 46) |
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Trustee |
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3 years and Trustee since May 19, 2006 |
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Private Investor since February 2004. Sales Representative at Round Hill Securities from
March 2003 to January 2004; Executive at Provident Funding Mortgage Corporation, February 2003 to July 2003;
Executive Vice President. Director and CAO, Commercial Capital Bank, January 2000to February 2003; Managing
Principal and Chief Operating Officer, Financial Institutional Partners Mortgage Company and the Managing Principal and
President of Financial Institutional Partners, LLC (an investment banking firm), April 1998 to February 2003. |
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10 |
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None |
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James F. Leary
(Age 77) |
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Trustee |
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3 years and Trustee since May 19, 2006 |
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Managing Director, Benefit Capital Southwest, Inc. (a financial consulting firm) since January 1999. |
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10 |
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Board Member of Capstone Group of Funds (7 portfolios). |
B-16
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Number of Portfolios in |
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Term of Office and |
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Highland Fund Complex |
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Other |
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Position |
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Length of Time |
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Principal Occupation(s) |
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Overseen by |
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Directorships/ |
Name and Age |
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with Trust |
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Served(1) |
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During Past Five Years |
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Trustee(2) |
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Trusteeships Held |
Bryan A. Ward
(Age 52) |
|
Trustee |
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3 years and Trustee since May 19, 2006 |
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Senior Manager since January 2002 and Special Projects Advisor, Accenture, LLP
(consulting firm) with focus on the oil and gas industry, from September 1998 to December 2001. |
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10 |
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None |
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INTERESTED TRUSTEE
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R. Joseph Dougherty (Age 37) |
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Trustee and Chairman of the Board |
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3 years and Trustee since March 10, 2006 |
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Senior Portfolio Manager of the Investment Adviser since 2000.
Director and Senior Vice President of the funds in the Highland Fund Complex. |
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10 |
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None |
OFFICERS
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Term of Office and |
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Principal Occupation(s) During |
Name and Age |
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Position with Trust |
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Length of Time Served |
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Past Five Years |
James D. Dondero
(Age 45)
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Chief Executive
Officer and
President
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Indefinite Term and
Officer since May
19, 2006
|
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President and
Director of Strand
Advisors, Inc.
(Strand), the
General Partner of
the Investment
Adviser. President of
the funds in the
Highland Fund
Complex. |
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Mark Okada
(Age 45)
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Executive Vice
President
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Indefinite Term and
Officer since May
19, 2006
|
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Executive Vice
President of Strand
and the funds in the
Highland Fund
Complex. |
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M. Jason Blackburn
(Age 31)
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Chief Financial
Officer (Principal
Accounting
Officer), Treasurer
and Secretary
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Indefinite Term and
Officer since May
19, 2006
|
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Assistant Controller
of the Investment
Adviser since
November 2001.
Treasurer and
Secretary of the
funds in the Highland
Fund Complex. |
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Michael Colvin
(Age 38)
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Chief Compliance
Officer
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Indefinite Term and
Officer since May
19, 2006
|
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General Counsel and
Chief Compliance
Officer of the
Investment Adviser
since June 2007 and
Chief Compliance
Officer of the funds
in the
Highland Fund Complex
since July 2007.
Shareholder in the
Corporate and
Securities Group at
Greenberg Traurig,
LLP, from January
2007 to June 2007.
Partner from January
2003 to
January 2007 and
Associate from 1995
to 2002 in the
Private Equity
Practice Group at
Weil,
Gotshal & Manges, LLP. |
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(1) |
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After a Trustees initial term, each Trustee is expected to serve a three-year term
concurrent with the class of Trustees with which he serves. Messrs. Leary and Ward, as Class I
Trustees, were re-elected in 2007; Messrs. Hui and Kavanaugh, as Class II Trustees, are
expected to stand for re-election in 2008; and Mr. Dougherty, the sole Class III Trustee, is
expected to stand for re-election in 2009. |
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(2) |
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The Highland Fund Complex consists of all of the registered investment companies advised by
Highland as of the date of this Statement of Additional Information. In addition, each
of the Trustees oversees Highland Distressed Opportunities Fund, Inc., a closed-end company that has
filed an election to be regulated as a business development company under the Investment Company Act. |
|
Compensation of Trustees
The fees
and expenses of the Independent Trustees of the Trust are paid by the Trust. The
trustees who are members of the Highland organization receive no compensation from the Trust. It is
estimated that the Independent Trustees will receive from the Trust the amounts set forth below for
the Trusts calendar year ending December 31, 2007.
B-17
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Total Compensation from |
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Aggregate |
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the Trust |
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Compensation |
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and Highland Fund |
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|
from the Trust |
|
Complex(1) |
Name of Independent Trustees |
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|
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Timothy K. Hui |
|
$ |
7,500 |
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|
$ |
97,500 |
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Scott F. Kavanaugh |
|
$ |
7,500 |
|
|
$ |
97,500 |
|
James F. Leary |
|
$ |
7,500 |
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|
$ |
97,500 |
|
Bryan A. Ward |
|
$ |
7,500 |
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|
$ |
97,500 |
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(1) |
|
Estimates the total compensation to be earned by that person during the calendar year ending
December 31, 2007 from the registered investment companies advised by Highland. |
Share Ownership
The following
table shows the dollar range of equity securities beneficially owned by the
Trusts trustees in the Trust and the aggregate dollar range of equity securities owned by the
Trusts trustees in all funds overseen by the trustee in the Highland Fund Complex as of December
31, 2006.
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Aggregate Dollar Range |
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of Equity Securities |
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Overseen by Trustees |
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Dollar Range of Equity |
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in the Family of |
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Securities in the |
|
Registered Investment |
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|
Trust |
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Companies |
Name of Trustee |
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Interested Trustee |
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R. Joseph Dougherty |
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$ |
0 |
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$100,001 500,000 |
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Independent Trustees |
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Timothy K. Hui |
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$ |
0 |
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$1 10,0000 |
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Scott F. Kavanaugh |
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$ |
0 |
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$50,001 100,000 |
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James F. Leary |
|
$ |
0 |
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$10,001 50,000 |
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Bryan A. Ward |
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$ |
0 |
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$1 10,000 |
|
Committees
In connection
with the board of trustees responsibility for the overall management and
supervision of the Trusts affairs, the trustees meet periodically throughout the year to oversee
the Trusts activities, review contractual arrangements with service providers for the Trust and
review the Trusts performance. To fulfill these duties, the Trust has four committees: an Audit
Committee, a Nominating Committee, a Litigation Committee and a Qualified Legal Compliance
Committee.
The Audit
Committee consists of Timothy Hui, Scott Kavanaugh, James Leary and Bryan Ward. The
Audit Committee acts according to the Audit Committee charter. Scott Kavanaugh has been appointed
as Chairman of the Audit Committee. The Audit Committee is responsible for (i) oversight of the
Trusts accounting and financial reporting processes and the audits of the Trusts financial
statements and (ii) providing assistance to the board of trustees of the Trust in connection with
its oversight of the integrity of the Trusts financial statements, the Trusts compliance with
legal and regulatory requirements and the independent registered public accounting firms
qualifications, independence and performance. The board of trustees of the Trust has determined
that the Trust has one audit committee financial expert serving on its Audit Committee, Mr. Leary,
who is independent for the purpose of the definition of audit committee financial expert as
applicable to the Trust. The Audit Committee met three times during the last fiscal year.
The Nominating
Committees function is to canvass, recruit, interview, solicit and nominate
trustees. The Nominating Committee considers recommendations for nominees from shareholders sent to
the Secretary of the Trust, Two Galleria Tower, 13455 Noel Road, Suite 800, Dallas, Texas 75240. A
nomination submission must include all information relating to the recommended nominee that is
B-18
required to be disclosed in solicitations or proxy statements for the election of trustees, as well
as information sufficient to evaluate the factors listed above. Nomination submissions must be
accompanied by a written consent of the individual to stand for election if nominated by the Board
of trustees and to serve if elected by the shareholders, and such additional information must be
provided regarding the recommended nominee as reasonably requested by the Nominating Committee. The
Nominating Committee is comprised of Messrs. Hui, Kavanaugh, Leary and Ward. The Nominating
Committee did not meet during its first full fiscal year of operation.
The Litigation Committees function is to seek to address any potential conflicts of interest
between or among the Trust and the Investment Adviser in connection with any potential or existing
litigation or other legal proceeding relating to securities held by the Trust and the Investment
Adviser or another client of the Investment Adviser. The Litigation Committee is comprised of
Messrs. Hui, Kavanaugh, Leary and Ward. The Litigation Committee did not meet during its first
full fiscal year of operation.
The Qualified Legal Compliance Committee (the QLCC) is charged with compliance with Rules
205.2(k) and 205.3(c) of the Code of Federal Regulations regarding alternative reporting procedures
for attorneys representing the Trust who appear and practice before the Commission on behalf of the
Trust. The QLCC is comprised of Messrs. Hui, Kavanaugh, Leary and Ward. The QLCC did not meet during its first full fiscal year of operation.
Proxy Voting Policies and Procedures
The board of trustees of the Trust has delegated the voting of proxies for Trust securities to
Highland pursuant to Highlands proxy voting policies and procedures. Under these policies and
procedures, Highland will vote proxies related to Trust securities in the best interests of the
Trust and its shareholders. A copy of Highlands proxy voting policies and procedures is attached
as Appendix B to this Statement of Additional Information. The Trusts proxy voting record for the
most recent 12-month period ending June 30 is available (i) without charge, upon request, by
calling 1-877-665-1287 and (ii) on the Commissions web site (http://www.sec.gov).
Codes of Ethics
The Trust and the Investment Adviser have adopted codes of ethics under Rule 17j-1 of the
Investment Company Act. These codes permit personnel subject to the codes to invest in securities,
including securities that may be purchased or held by the Trust. These codes can be reviewed and
copied at the Commissions Public Reference Room in Washington, D.C. Information on the operation
of the Public Reference Room may be obtained by calling the Commission at 1-202-551-8090. The codes
of ethics are available on the EDGAR Database on the Commissions web site (http://www.sec.gov),
and copies of these codes may be obtained, after paying a duplicating fee, by electronic request at
the following e-mail address: publicinfo@sec.gov, or by writing the Commissions Public Reference
Section, Washington, D.C. 20549-0102.
Administration Services
Pursuant to the Trusts administration services agreement, Highland performs the following
services: (i) prepare monthly security transaction listings; (ii) supply various normal and
customary Trust statistical data as requested on an ongoing basis; (iii) prepare for execution and
file the Trusts federal and state tax returns; prepare a fiscal tax provision in coordination with
the annual audit; prepare an excise tax provision; and prepare all relevant 1099 calculations; (iv)
coordinate contractual relationships and communications between the Trust and its contractual
service providers; (v) coordinate printing of the
B-19
Trusts annual and semi-annual shareholder reports; (vi) prepare income and capital gain
distributions; (vii) prepare the semiannual and annual financial statements; (viii) monitor the
Trusts compliance with Internal Revenue Code, Commission and prospectus requirements; (ix)
prepare, coordinate with the Trusts counsel and coordinate the filing with the Commission:
semi-annual reports on Form N-SAR and Form N-CSR; Form N-Q; and Form N-PX based upon information
provided by the Trust, assist in the preparation of Forms 3, 4 and 5 pursuant to Section 16 of the
Securities Exchange Act of 1934, as amended, and Section 30(f) of the Investment Company Act for
the officers and trustees of the Trust, such filings to be based on information provided by those
persons; (x) assist in the preparation of notices of meetings of shareholders; (xi) assist in
obtaining the fidelity bond and trustees and officers/errors and omissions insurance policies for
the Trust in accordance with the requirements of Rule 17g-1 and 17d-1(d)(7) under the Investment
Company Act as such bond and policies are approved by the Trusts board of trustees; (xii) monitor
the Trusts assets to assure adequate fidelity bond coverage is maintained; (xiii) draft agendas
and resolutions for quarterly and special board meetings; (xiv) coordinate the preparation,
assembly and distribution of board materials; (xv) attend board meetings and draft minutes thereof;
(xvi) maintain the Trusts calendar to assure compliance with various filing and board approval
deadlines; (xvii) furnish the Trust office space in the offices of Highland, or in such other place
or places as may be agreed upon from time to time, and all necessary office facilities, simple
business equipment, supplies, utilities and telephone service for managing the affairs and
investments of the Trust; (xviii) assist the Trust in the handling of SEC examinations and
responses thereto; (xix) perform clerical, bookkeeping and all other administrative services not
provided by the Trusts other service providers; (xx) determine or oversee the determination and
publication of the Trusts net asset value in accordance with the Trusts policy as adopted from
time to time by the Board of Trustees; (xxi) oversee the maintenance by the Trusts custodian and
transfer agent and dividend disbursing agent of certain books and records of the Trust as required
under Rule 31a-1(b)(2)(iv) of the Investment Company Act and maintain (or oversee maintenance by
such other persons as approved by the board of trustees) such other books and records required by
law or for the proper operation of the Trust; (xxii) prepare such information and reports as may be
required by any stock exchange or exchanges on which the Trusts shares are listed; (xxiii)
determine the amounts available for distribution as dividends and distributions to be paid by the
Trust to its shareholders; prepare and arrange for the printing of dividend notices to
shareholders; and provide the Trusts dividend disbursing agent and custodian with such information
as is required for such parties to effect the payment of dividends and distributions and to
implement the Trusts dividend reinvestment plan; (xxiv) serve as liaison between the Trust and
each of its service providers; and (xxv) perform such additional administrative duties relating to
the administration of the Trust as may subsequently be agreed upon in writing between the Trust and
Highland. Highland shall have the authority to engage a sub-administrator in connection with the
administrative services of the Trust, which sub-administrator may be an affiliate of Highland;
provided, however, that Highland shall remain responsible to the Trust with respect to its duties
and obligations set forth in the administration services agreement.
Portfolio Managers
The portfolio managers of the Trust are Kurtis Plumer, James Dondero and Mark Okada.
As of October 31, 2007, Kurtis Plumer managed the following client accounts:
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Number of |
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Assets |
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Accounts |
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Subject to a |
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Assets of |
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Subject to a |
|
Performance |
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Number of |
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Accounts |
|
Performance |
|
Fee |
Type of Account |
|
Accounts |
|
(in millions) |
|
Fee |
|
(in millions) |
Registered Investment Companies |
|
|
2 |
|
|
$ |
978 |
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|
1 |
|
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$ |
87 |
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Other Pooled Investment Vehicles |
|
|
5 |
|
|
$ |
2,532 |
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|
3 |
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$ |
1,947 |
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Other Accounts |
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B-20
As of October 31, 2007, James Dondero managed the following client accounts:
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Number of |
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Assets |
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Accounts |
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Subject to a |
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Assets of |
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Subject to a |
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Performance |
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|
Number of |
|
Accounts |
|
Performance |
|
Fee |
Type of Account |
|
Accounts |
|
(in millions) |
|
Fee |
|
(in millions) |
Registered Investment Companies |
|
|
4 |
|
|
$ |
1,387 |
|
|
|
2 |
|
|
$ |
463 |
|
Other Pooled Investment Vehicles |
|
|
10 |
|
|
$ |
6,282 |
|
|
|
9 |
|
|
$ |
6,277 |
|
Other Accounts |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of October 31, 2007, Mark Okada managed the following client accounts:
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Number of |
|
Assets |
|
|
|
|
|
|
|
|
|
|
Accounts |
|
Subject to a |
|
|
|
|
|
|
Assets of |
|
Subject to a |
|
Performance |
|
|
Number of |
|
Accounts |
|
Performance |
|
Fee |
Type of Account |
|
Accounts |
|
(in millions) |
|
Fee |
|
(in millions) |
Registered Investment Companies |
|
|
14 |
|
|
$ |
9,107 |
|
|
|
|
|
|
|
|
|
Other Pooled Investment Vehicles |
|
|
28 |
|
|
$ |
18,058 |
|
|
|
23 |
|
|
$ |
16,457 |
|
Other Accounts |
|
|
|
|
|
|
|
|
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|
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|
|
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|
The Investment Adviser has built a professional working environment, a firm-wide compliance
culture and compliance procedures and systems designed to protect against potential incentives that
may favor one account over another. The Investment Adviser has adopted policies and procedures that
address the allocation of investment opportunities, execution of portfolio transactions, personal
trading by employees and other potential conflicts of interest that are designed to ensure that all
client accounts are treated equitably over time. Nevertheless, the Investment Adviser furnishes
advisory services to numerous clients in addition to the Trust, and the Investment Adviser may,
consistent with applicable law, make investment recommendations to other clients or accounts
(including accounts which are hedge funds or have performance or higher fees paid to the Investment
Adviser, or in which portfolio managers have a personal interest in the receipt of such fees),
which may be the same as or different from those made to the Trust. In addition, the Investment
Adviser, its affiliates and any officer, director, stockholder or employee may or may not have an
interest in the securities whose purchase and sale the Investment Adviser recommends to the Trust.
Actions with respect to securities of the same kind may be the same as or different from the action
which the Investment Adviser, or any of its affiliates, or any officer, director, stockholder,
employee or any member of their families may take with respect to the same securities. Moreover,
the Investment Adviser may refrain from rendering any advice or services concerning securities of
companies of which any of the Investment Advisers (or its affiliates) officers, directors or
employees are directors or officers, or companies as to which the Investment Adviser or any of its
affiliates or the officers, directors and employees of any of them has any substantial economic
interest or possesses material non-public information. In addition to its various policies and
procedures designed to address these issues, the Investment Adviser includes disclosure regarding
these matters to its clients in both its Form ADV and investment advisory agreements.
The Investment Adviser, its affiliates or their officers and employees serve or may serve as
officers, directors or principals of entities that operate in the same or related lines of business
or of investment funds managed by affiliates of the Investment Adviser. Accordingly, these
individuals may have obligations to investors in those entities or funds or to other clients, the
fulfillment of which might not be in the best interests of the Trust. As a result, the Investment
Adviser will face conflicts in the allocation of investment opportunities to the Trust and other
funds and clients. In order to enable such affiliates to fulfill their fiduciary duties to each of
the clients for which they have responsibility, the Investment Adviser will endeavor to allocate
investment opportunities in a fair and equitable manner
B-21
which may, subject to applicable regulatory constraints, involve pro rata co-investment by the
Trust and such other clients or may involve a rotation of opportunities among the Trust and such
other clients.
While the Investment Adviser does not believe there will be frequent conflicts of interest, if
any, the Investment Adviser and its affiliates have both subjective and objective procedures and
policies in place designed to manage the potential conflicts of interest between the Investment
Advisers fiduciary obligations to the Trust and their similar fiduciary obligations to other
clients so that, for example, investment opportunities are allocated in a fair and equitable manner
among the Trust and such other clients. An investment opportunity that is suitable for multiple
clients of the Investment Adviser and its affiliates may not be capable of being shared among some
or all of such clients due to the limited scale of the opportunity or other factors, including
regulatory restrictions imposed by the Investment Company Act. There can be no assurance that the
Investment Advisers or its affiliates efforts to allocate any particular investment opportunity
fairly among all clients for whom such opportunity is appropriate will result in an allocation of
all or part of such opportunity to the Trust. Not all conflicts of interest can be expected to be
resolved in favor of the Trust.
Under current Commission regulations, the Trust may be prohibited from co-investing with any
unregistered fund managed now or in the future by the Investment Adviser in certain private
placements in which the Investment Adviser negotiates non-pricing terms. The Trust intends to file
for exemptive relief from the Commission to enable it to co-invest with other unregistered funds
managed by the Investment Adviser.
Compensation
The Investment Advisers financial arrangements with its portfolio managers, its competitive
compensation and its career path emphasis at all levels reflect the value senior management places
on key resources. Compensation may include a variety of components and may vary from year to year
based on a number of factors including the relative performance of a portfolio managers underlying
account, the combined performance of the portfolio managers underlying accounts, and the relative
performance of the portfolio managers underlying accounts measured against other employees. The
principal components of compensation include a base salary, a discretionary bonus, various
retirement benefits and one or more of the incentive compensation programs established by the
Investment Adviser such as Option It Plan and the Long-Term Incentive Plan.
Base Compensation. Generally, portfolio managers receive base compensation based on their
seniority and/or their position with the firm, which may include the amount of assets supervised
and other management roles within the firm.
Discretionary Compensation. In addition to base compensation, portfolio managers may receive
discretionary compensation, which can be a substantial portion of total compensation. Discretionary
compensation can include a discretionary cash bonus as well as one or more of the following:
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|
|
Option It Plan. The purpose of this plan is to attract and retain the
highest quality employees for positions of substantial responsibility, and to
provide additional incentives to a select group of management or highly
compensated employees of Highland so as to promote the success of the Highland. |
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|
|
Long Term Incentive Plan. The purpose of this plan is to create positive
morale and teamwork, to attract and retain key talent, and to encourage the
achievement of common goals. This plan seeks to reward participating employees
based on the increased value of Highland through the use of Long-Term Incentive
Units. |
B-22
Senior portfolio managers who perform additional management functions may receive additional
compensation in these other capacities. Compensation is structured such that key professionals
benefit from remaining with the firm.
Securities Ownership of Portfolio Managers
As of October 31, 2007, Mr. Dondero and Mr. Okada
owned between $50,001 - $100,000 and over $100,000 of the Trusts common shares, respectively.
PORTFOLIO TRANSACTIONS AND BROKERAGE
In placing portfolio transactions for the Trust, the Investment Adviser will give primary
consideration to securing the most favorable price and efficient execution. Consistent with this
policy, the Investment Adviser may consider the financial responsibility, research and investment
information and other services provided by brokers or dealers who may effect or be a party to any
such transaction or other transactions to which other clients of the Investment Adviser may be a
party. Neither the Trust nor the Investment Adviser has adopted a formula for allocation of the
Trusts investment transaction business. The Investment Adviser has access to supplemental
investment and market research and security and economic analysis provided by brokers who may
execute brokerage transactions at a higher cost to the Trust than would otherwise result when
allocating brokerage transactions to other brokers on the basis of seeking the most favorable price
and efficient execution. The Investment Adviser, therefore, is authorized to place orders for the
purchase and sale of securities for the Trust with such brokers, subject to review by the Trusts
board of trustees from time to time with respect to the extent and continuation of this practice.
The services provided by such brokers may be useful or beneficial to the Investment Adviser in
connection with its services to other clients.
On occasions when the Investment Adviser deems the purchase or sale of a security to be in the
best interest of the Trust as well as other clients, the Investment Adviser, to the extent
permitted by applicable laws and regulations, may, but shall be under no obligation to, aggregate
the securities to be so sold or purchased in order to obtain the most favorable price or lower
brokerage commissions and efficient execution. In such event, allocation of the securities so
purchased or sold, as well as the expenses incurred in the transaction, will be made by the
Investment Adviser in the manner it considers to be the most equitable and consistent with its
fiduciary obligations to the Trust and to such other clients.
REPURCHASE OF COMMON SHARES
The Trust is a closed-end management investment company and as such its shareholders will not
have the right to cause the Trust to redeem their shares. Instead, the Trusts common shares will
trade in the open market at a price that will be a function of several factors, including dividend
levels (which are in turn affected by expenses), net asset value, call protection, dividend
stability, relative demand for and supply of such shares in the market, general market and economic
conditions and other factors. Because shares of a closed-end investment company may frequently
trade at prices lower than net asset value, the Trusts board of trustees may consider action that
might be taken to reduce or eliminate any material discount from net asset value in respect of
common shares, which may include the repurchase of such shares in the open market or in private
transactions, the making of a tender offer for such shares, or the conversion of the Trust to an
open-end investment company. The board of trustees may decide not to take any of these actions. In
addition, there can be no assurance that share repurchases or tender offers, if undertaken, will
reduce market discount.
Notwithstanding the foregoing, at any time when there are outstanding borrowings, the Trust
may not purchase, redeem or otherwise acquire any of its common shares unless (i) all accrued
preferred shares dividends have been paid and (ii) at the time of such purchase, redemption or
acquisition, the net
B-23
asset value of the Trusts portfolio (determined after deducting the acquisition price of the
common shares) is at least 200% of the liquidation value of the outstanding borrowings. Any service
fees incurred in connection with any tender offer made by the Trust will be borne by the Trust and
will not reduce the stated consideration to be paid to tendering shareholders.
Subject to its investment restrictions, the Trust may borrow to finance the repurchase of
shares or to make a tender offer. Interest on any borrowings to finance share repurchase
transactions or the accumulation of cash by the Trust in anticipation of share repurchases or
tenders will reduce the Trusts net income. Any share repurchase, tender offer or borrowing that
might be approved by the Trusts board of trustees would have to comply with the Securities
Exchange Act of 1934, as amended, the Investment Company Act and the rules and regulations
thereunder.
Although the decision to take action in response to a discount from net asset value will be
made by the board of trustees at the time it considers such issue, it is the boards present
policy, which may be changed by the board of trustees, not to authorize repurchases of common
shares or a tender offer for such shares if: (1) such transactions, if consummated, would (a)
result in the delisting of the common shares from the New York Stock Exchange, or (b) impair the
Trusts status as a regulated investment company under the Code (which would make the Trust a
taxable entity, causing the Trusts income to be taxed at the corporate level in addition to the
taxation of shareholders who receive dividends from the Trust), or as a registered closed-end
investment company under the Investment Company Act; (2) the Trust would not be able to liquidate
portfolio securities in an orderly manner and consistent with the Trusts investment objectives and
policies in order to repurchase shares; or (3) there is, in the boards judgment, any (a) material
legal action or proceeding instituted or threatened challenging such transactions or otherwise
materially adversely affecting the Trust, (b) general suspension of or limitation on prices for
trading securities on the New York Stock Exchange, (c) declaration of a banking moratorium by
federal or state authorities or any suspension of payment by U.S. or New York banks, (d) material
limitation affecting the Trust or the issuers of its portfolio securities by federal or state
authorities on the extension of credit by lending institutions or on the exchange of foreign
currency, (e) commencement of war, armed hostilities or other international or national calamity
directly or indirectly involving the United States or (f) other event or condition which would have
a material adverse effect (including any adverse tax effect) on the Trust or its shareholders if
shares were repurchased. The board of trustees may in the future modify these conditions in light
of experience.
The repurchase by the Trust of its shares at prices below net asset value will result in an
increase in the net asset value of those shares that remain outstanding. However, there can be no
assurance that share repurchases or tender offers at or below net asset value will result in the
Trusts shares trading at a price equal to their net asset value. Nevertheless, the fact that the
Trusts shares may be the subject of repurchase or tender offers from time to time, or that the
Trust may be converted to an open-end investment company, may reduce any spread between market
price and net asset value that might otherwise exist.
Before deciding whether to take any action if the common shares trade below net asset value,
the Trusts board of trustees would likely consider all relevant factors, including the extent and
duration of the discount, the liquidity of the Trusts portfolio, the impact of any action that
might be taken on the Trust or its shareholders and market considerations. Based on these
considerations, even if the Trusts shares should trade at a discount, the board of trustees may
determine that, in the interest of the Trust and its shareholders, no action should be taken.
B-24
TAX MATTERS
The following discussion summarizes certain U.S. federal income tax considerations affecting
the Trust and the purchase, ownership and disposition of the Trusts common and preferred shares by
shareholders that are U.S. persons, as defined for U.S. federal income tax purposes. This
discussion is based upon current provisions of the Internal Revenue Code of 1986, as amended (the
Code), the regulations promulgated thereunder and judicial and administrative authorities, all of
which are subject to change or differing interpretations by the courts or the Internal Revenue
Service (the IRS), possibly with retroactive effect. No attempt is made to present a detailed
explanation of all U.S. federal tax concerns affecting the Trust and its shareholders (including
non-U.S. Shareholders owning large positions in the Trust and others subject to special treatment
under U.S. federal income tax law).
The discussions set forth herein and in the prospectus do not constitute tax advice, and you
are urged to consult with your own tax advisor to determine the specific U.S. federal, state, local
and foreign tax consequences to you of investing in the Trust.
Taxation of the Trust
The Trust intends to elect to be treated and to qualify annually as a regulated investment
company under Subchapter M of the Code. Accordingly, the Trust must, among other things, meet the
following requirements regarding the source of its income and the diversification of its assets:
(i) The Trust must derive in each taxable year at least 90% of its gross income from the
following sources: (a) dividends, interest (including tax-exempt interest), payments with respect
to certain securities loans, gains from the sale or other disposition of stock, securities or
foreign currencies, or other income (including but not limited to gains from options, futures and
forward contracts) derived with respect to its business of investing in such stock, securities or
foreign currencies; and (b) interests in qualified publicly traded partnerships (as defined in
the Code).
(ii) The Trust must diversify its holdings so that, at the end of each quarter of each taxable
year: (a) at least 50% of the value of the Trusts total assets is represented by cash and cash
items, U.S. government securities, the securities of other regulated investment companies and other
securities, with such other securities limited, in respect of any one issuer, to an amount not
greater than 5% of the value of the Trusts total assets and not more than 10% of the outstanding
voting securities of such issuer and (b) not more than 25% of the value of the Trusts total assets
is invested in the securities (other than U.S. government securities and the securities of other
regulated investment companies) of: (I) any one issuer, (II) any two or more issuers that the Trust
controls (by owning 20% or more of their voting power) and that are determined to be engaged in the
same business or similar or related trades or businesses or (III) any one or more qualified
publicly traded partnerships (as defined in the Code).
As a regulated investment company, the Trust generally will not be subject to U.S. federal
income tax on income and gains that the Trust distributes to its shareholders, provided that it
distributes each taxable year at least the sum of: (i) 90% of the Trusts investment company
taxable income (which includes, among other items, dividends, interest and the excess of any net
short-term capital gain over net long-term capital loss and other taxable income, other than any
net long-term capital gain, reduced by deductible expenses) determined without regard to the
deduction for dividends paid and (ii) 90% of the Trusts net tax-exempt interest (the excess of its
gross tax-exempt interest over certain disallowed deductions). The Trust intends to distribute
substantially all of such income each year. The Trust will be subject to U.S. federal income tax at
regular corporate rates on any taxable income or gains that it does not distribute to its
shareholders.
B-25
The Code imposes a 4% nondeductible excise tax on the Trust to the extent the Trust does not
distribute by the end of any calendar year at least the sum of: (i) 98% of its ordinary income (not
taking into account any capital gain or loss) for the calendar year and (ii) 98% of its capital
gain in excess of its capital loss (adjusted for certain ordinary losses) for a one-year period
generally ending on October 31 of the calendar year (unless an election is made to use the Trusts
fiscal year). In addition, the minimum amounts that must be distributed in any year to avoid the
excise tax will be increased or decreased to reflect any under-distribution or over-distribution,
as the case may be, from the previous year. While the Trust intends to distribute any income and
capital gain in the manner necessary to minimize imposition of the 4% excise tax, there can be no
assurance that sufficient amounts of the Trusts taxable income and capital gain will be
distributed to avoid entirely the imposition of the excise tax. In that event, the Trust will be
liable for the excise tax only on the amount by which it does not meet the foregoing distribution
requirement.
If, for any taxable year, the Trust does not qualify as a regulated investment company, all of
its taxable income (including its net capital gain) will be subject to tax at regular corporate
rates without any deduction for distributions to shareholders, and such distributions will be
taxable to the shareholders as ordinary dividends to the extent of the Trusts current or
accumulated earnings and profits. Provided that shareholders satisfy certain holding period and
other requirements with respect to their common shares, such dividends would be eligible (i) to be
treated as qualified dividend income in the case of shareholders taxed as individuals and (ii) for
the dividends received deduction in the case of shareholders taxed as corporations. The Trust may
be required to recognize unrealized gains, pay taxes and make distributions (which may be subject
to interest charges) before requalifying for taxation as a regulated investment company. If the
Trust fails to qualify as a regulated investment company in any year, it must pay out its earnings
and profits accumulated in that year in order to qualify again as a regulated investment company.
If the Trust fails to qualify as a regulated investment company for a period greater than one
taxable year, the Trust may be required to recognize and pay tax on any net built-in gains with
respect to certain of its assets (i.e., the excess of the aggregate gains, including items of
income, over aggregate losses that would have been realized with respect to such assets if the
Trust had been liquidated) or, alternatively, to elect to be subject to taxation on such built-in
gain recognized for a period of ten years, in order to qualify as a regulated investment company in
a subsequent year.
Taxation of the Trusts Investments
Certain of the Trusts investment practices are subject to special and complex U.S. federal
income tax provisions that may, among other things: (i) treat dividends that would otherwise
constitute qualified dividend income as non-qualified dividend income, (ii) treat dividends that
would otherwise be eligible for the corporate dividends received deduction as ineligible for such
treatment, (iii) disallow, suspend or otherwise limit the allowance of certain losses or
deductions, (iv) convert lower-taxed, long-term capital gain into higher-taxed, short-term capital
gain or ordinary income, (v) convert an ordinary loss or deduction into a capital loss (the
deductibility of which is more limited), (vi) cause the Trust to recognize income or gain without a
corresponding receipt of cash, (vii) adversely affect the time as to when a purchase or sale of
stocks or securities is deemed to occur, (viii) adversely alter the characterization of certain
complex financial transactions or (ix) produce income that will not qualify as good income for
purposes of the 90% annual gross income requirement described above. These U.S. federal income tax
provisions could therefore affect the amount, timing and character of distributions to
shareholders. The Trust intends to monitor its transactions and may make certain tax elections and
may be required to dispose of securities or borrow money to mitigate the effect of these provisions
and prevent disqualification of the Trust as a regulated investment company.
If the Trust purchases shares in certain foreign investment entities, called passive foreign
investment companies (PFICs), the Trust may be subject to U.S. federal income tax on a portion of
any
B-26
excess distribution or gain from the disposition of such shares. Additional charges in the
nature of interest may be imposed on the Trust in respect of deferred taxes arising from such
distributions or gains. Elections may be available to the Trust to mitigate the effect of this tax,
but such elections generally accelerate the recognition of income without the receipt of cash.
Dividends paid by PFICs will not be qualified dividend income.
If the Trust invests in the shares of a PFIC, or any other investment that produces income
that is not matched by a corresponding cash distribution to the Trust, such as investments in debt
securities that have original issue discount, the Trust could be required to recognize income that
it has not yet received. Any such income would be treated as income earned by the Trust and
therefore would be subject to the distribution requirements of the Code. This might prevent the
Trust from distributing 90% of its net investment income as is required in order to avoid
Trust-level U.S. federal income taxation on all of its income, or might prevent the Trust from
distributing enough ordinary income and capital gain net income to avoid completely the imposition
of the excise tax. To avoid this result, the Trust may be required to borrow money or dispose of
securities to be able to make required distributions to the shareholders.
Dividend, interest and other income received by the Trust from investments outside the United
States may be subject to withholding and other taxes imposed by foreign countries. Tax treaties
between the United States and other countries may reduce or eliminate such taxes. The Trust does
not expect that it will be eligible to elect to treat any foreign taxes it pays as paid by its
shareholders, who therefore will not be entitled to credits for such taxes on their own tax
returns. Foreign taxes paid by a Trust will reduce the return from the Trusts investments.
Taxation of Shareholders
The Trust will determine either to distribute or to retain for reinvestment all or part of its
net capital gain. If any such gain is retained, the Trust will be subject to corporate income tax
(currently at a maximum rate of 35%) on such retained amount. In that event, the Trust expects to
designate the retained amount as undistributed capital gain in a notice to its shareholders, each
of whom: (i) will be required to include in income for U.S. federal income tax purposes as
long-term capital gain its share of such undistributed amounts, (ii) will be entitled to credit its
proportionate share of the tax paid by the Trust against its U.S. federal income tax liability and
to claim refunds to the extent that the credit exceeds such liability and (iii) will increase its
basis in its common shares of the Trust by an amount equal to 65% of the amount of undistributed
capital gain included in such shareholders gross income.
Distributions paid to you by the Trust from its net realized long-term capital gains, if any,
that the Trust designates as capital gains dividends (capital gain dividends) are taxable as
long-term capital gains, regardless of how long you have held your common shares. All other
dividends paid to you by the Trust (including dividends from short-term capital gains) from its
current or accumulated earnings and profits (ordinary income dividends) are generally subject to
tax as ordinary income. The Trust does not expect that a corporate shareholder will be able to
claim a dividends received deduction with respect to any significant portion of the Trust
distributions.
Special rules apply, however, to ordinary income dividends paid to individuals with
respect to taxable years beginning on or before December 31, 2010. If you are an individual,
any such ordinary income dividend that you receive from the Trust generally will be eligible
for taxation at the rates applicable to long-term capital gains to the extent that: (i) the
ordinary income dividend is attributable to qualified dividend income (i.e., generally
dividends paid by U.S. corporations and certain foreign corporations) received by the Trust,
(ii) the Trust satisfies certain holding period and other requirements with respect to the
stock on which such qualified dividend income was paid and (iii) you satisfy certain holding
period and other requirements with respect to your common shares. Ordinary income dividends
B-27
subject to these special rules are not actually treated as capital gains, however, and thus will
not be included in the computation of your net capital gain and generally cannot be used to offset
any capital losses. In general, you may include as qualified dividend income only that portion of
the dividends that may be and are so designated by the Trust as qualified dividend income; however,
the Trust does not expect that a significant portion of its ordinary income dividends will be
treated as qualified dividend income.
Any distributions that you receive that are in excess of the Trusts current or accumulated
earnings and profits will be treated as a tax-free return of capital to the extent of your adjusted
tax basis in your common shares, and thereafter as capital gain from the sale of common shares. The
amount of any Trust distribution that is treated as a tax-free return of capital will reduce your
adjusted tax basis in your common shares, thereby increasing your potential gain or reducing your
potential loss on any subsequent sale or other disposition of your common shares.
For holders of common shares that participate in the Trusts Automatic Dividend Reinvestment
Plan, dividends and other taxable distributions are taxable to you even if they are reinvested in
additional common shares of the Trust. Dividends and other distributions paid by the Trust are
generally treated under the Code as received by you at the time the dividend or distribution is
made. If, however, the Trust pays you a dividend in January that was declared in the previous
October, November or December and you were the shareholder of record on a specified date in one of
such months, then such dividend will be treated for tax purposes as being paid by the Trust and
received by you on December 31 of the year in which the dividend was declared.
The price of common shares purchased at any time may reflect the amount of a forthcoming
distribution. If you purchase common shares just prior to a distribution, you will receive a
distribution that will be taxable to you even though it represents in part a return of your
invested capital.
The Trust will send you information after the end of each year setting forth the amount and
tax status of any distributions paid to you by the Trust. Ordinary income dividends and capital
gain dividends may also be subject to state and local taxes.
If you sell or otherwise dispose of common shares of the Trust, you will generally recognize a
gain or loss in an amount equal to the difference between your adjusted tax basis in such common
shares of the Trust and the amount you receive upon disposition of such common shares. If you hold
your common shares as capital assets, any such gain or loss will be long-term capital gain or loss
if you have held such common shares for more than one year at the time of sale. Any loss upon the
sale or exchange of common shares held for six months or less will be treated as long-term capital
loss to the extent of any capital gain dividends received (including amounts credited as an
undistributed capital gain dividend) by you with respect to such common shares. Any loss you
realize on a sale or exchange of common shares will be disallowed if you acquire other common
shares (whether through the automatic reinvestment of dividends or otherwise) within a 61-day
period beginning 30 days before and ending 30 days after your sale or exchange of the common
shares. In such case, your tax basis in the common shares acquired will be adjusted to reflect the
disallowed loss.
Current U.S. federal income tax laws tax both long-term and short-term capital gain of
corporations at the rates applicable to ordinary income. For non-corporate taxpayers, short-term
capital gain is currently taxed at rates applicable to ordinary income (currently at a maximum of
35%) while long-term capital gain generally is taxed at a maximum rate of 15% with respect to
taxable years beginning on or before December 31, 2010 (20% thereafter, unless changed by future
legislation).
B-28
Shareholders
may be entitled to offset their capital gain dividends with capital loss. The
Code contains a number of statutory provisions affecting the circumstances under which capital loss
may be offset against capital gain and limiting the use of loss from certain investments and
activities. Accordingly, shareholders that have capital losses are urged to consult their tax
advisors.
The Trust
may be required to withhold, for U.S. federal backup withholding tax purposes, a
portion of the dividends, distributions and redemption proceeds payable to a shareholder who fails
to provide the Trust (or its agent) with the shareholders correct taxpayer identification number
(in the case of an individual, generally, such individuals social security number) or to make the
required certification, or who has been notified by the IRS that such shareholder is subject to
backup withholding. Corporate shareholders and certain other shareholders are exempt from backup
withholding. Backup withholding is not an additional tax and any amount withheld may be refunded or
credited against your U.S. federal income tax liability, if any, provided that you furnish the
required information to the IRS.
EXPERTS
PricewaterhouseCoopers LLP, located at 2001 Ross Avenue, Suite 1800, Dallas, Texas
75201, provides accounting and auditing services to the Trust.
ADDITIONAL INFORMATION
A Registration
Statement on Form N-2, including amendments thereto, relating to the shares
offered hereby, has been filed by the Trust with the Commission, Washington, D.C. The prospectus
and this Statement of Additional Information do not contain all of the information set forth in the
Registration Statement, including any exhibits and schedules thereto. For further information with
respect to the Trust and the Shares offered hereby, reference is made to the Registration
Statement. Statements contained in the prospectus and this Statement of Additional Information as
to the contents of any contract or other document referred to are not necessarily complete and in
each instance reference is made to the copy of such contract or other document filed as an exhibit
to the Registration Statement, each such statement being qualified in all respects by such
reference. A copy of the Registration Statement may be inspected without charge at the Commissions
principal office in Washington, D.C., and copies of all or any part thereof may be obtained from
the Commission upon the payment of certain fees prescribed by the Commission.
FINANCIAL STATEMENTS
The
Trusts financial statements appearing in the Trusts
annual shareholder report for the period ended December 31, 2006
are incorporated by reference in this Statement of Additional
Information and have been so incorporated in reliance upon the report
of PricewaterhouseCoopers LLP, independent registered public
accounting firm for the Trust. The
Trusts unaudited financial statements appearing in the Trusts semi-annual shareholder
report for the period ended June 30, 2007 are incorporated by reference in this Statement of
Additional Information. The annual and semi-annual (unaudited) shareholder reports are available
upon request and without charge by writing to the Trust at Two Galleria Tower, 13455 Noel Road,
Suite 800, Dallas, Texas 75240 or by calling (877) 665-1287.
B-29
APPENDIX A
A Standard & Poors issue credit rating is a current opinion of the creditworthiness of an
obligor with respect to a specific financial obligation, a specific class of financial obligations,
or a specific financial program (including ratings on medium-term note programs and commercial
paper programs). It takes into consideration the creditworthiness of guarantors, insurers, or other
forms of credit enhancement on the obligation and takes into account the currency in which the
obligation is denominated. The issue credit rating is not a recommendation to purchase, sell, or
hold a financial obligation, inasmuch as it does not comment as to market price or suitability for
a particular investor.
Issue credit ratings are based on current information furnished by the obligors or obtained by
Standard & Poors from other sources it considers reliable. Standard & Poors does not perform an
audit in connection with any credit rating and may, on occasion, rely on unaudited financial
information. Credit ratings may be changed, suspended, or withdrawn as a result of changes in, or
unavailability of, such information, or based on other circumstances.
Issue credit ratings can be either long-term or short-term. Short-term ratings are generally
assigned to those obligations considered short-term in the relevant market. In the U.S., for
example, that means obligations with an original maturity of no more than 365 days, including
commercial paper, are considered short-term. Short-term ratings are also used to indicate the
creditworthiness of an obligor with respect to put features on long-term obligations. The result is
a dual rating, in which the short-term rating addresses the put feature, in addition to the usual
long-term rating. Medium-term notes are assigned long-term ratings.
Long-Term Issue Credit Ratings
Issue credit ratings are based, in varying degrees, on the following considerations:
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Likelihood of paymentcapacity and willingness of the obligor to meet its financial
commitment on an obligation in accordance with the terms of the obligation; |
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Nature of and provisions of the obligation; and |
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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. |
The issue rating definitions are expressed in terms of default risk. As such, they pertain to
senior obligations of an entity. Junior obligations are typically rated lower than senior
obligations, to reflect the lower priority in bankruptcy, as noted above. (Such differentiation
applies when an entity has both senior and subordinated obligations, secured and unsecured
obligations, or operating company and holding company obligations.) Accordingly, in the case of
junior debt, the rating may not conform exactly with the category definition.
AAA
An obligation rated AAA has the highest rating assigned by Standard & Poors. The obligors
capacity to meet its financial commitment on the obligation is extremely strong.
A-1
AA
An obligation rated AA differs from the highest-rated obligations only to a small degree.
The obligors capacity to meet its financial commitment on the obligation is very strong.
A
An obligation rated A is somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions than obligations in higher-rated categories. However, the
obligors capacity to meet its financial commitment on the obligation is still strong.
BBB
An obligation rated BBB exhibits adequate protection parameters. However, adverse economic
conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor
to meet its financial commitment on the obligation.
BB, B, CCC, CC, and C
Obligations rated BB, B, CCC, CC, and C are regarded as having significant
speculative characteristics. BB indicates the least degree of speculation and C the highest.
While such obligations will likely have some quality and protective characteristics, these may be
outweighed by large uncertainties or major exposures to adverse conditions.
An obligation rated BB is less vulnerable to nonpayment than other speculative issues.
However, it faces major ongoing uncertainties or exposure to adverse business, financial, or
economic conditions which could lead to the obligors inadequate capacity to meet its financial
commitment on the obligation.
B
An obligation rated B is more vulnerable to nonpayment than obligations rated BB, but the
obligor currently has the capacity to meet its financial commitment on the obligation. Adverse
business, financial, or economic conditions will likely impair the obligors capacity or
willingness to meet its financial commitment on the obligation.
CCC
An obligation rated CCC is currently vulnerable to nonpayment, and is dependent upon
favorable business, financial, and economic conditions for the obligor to meet its financial
commitment on the obligation. In the event of adverse business, financial, or economic conditions,
the obligor is not likely to have the capacity to meet its financial commitment on the obligation.
CC
An obligation rated CC is currently highly vulnerable to nonpayment.
C
A subordinated debt or preferred stock obligation rated C is currently highly vulnerable to
nonpayment. The C rating may be used to cover a situation where a bankruptcy petition has been
filed or similar action taken, but payments on this obligation are being continued. A C also will
be assigned to a preferred stock issue in arrears on dividends or sinking fund payments, but that
is currently paying.
A-2
D
An obligation rated D is in payment default. The D rating category is used when payments
on an obligation are not made on the date due even if the applicable grace period has not expired,
unless Standard & Poors believes that such payments will be made during such grace period. The D
rating also will be used upon the filing of a bankruptcy petition or the taking of a similar action
if payments on an obligation are jeopardized.
Plus (+) or minus ()
The ratings from AA to CCC may be modified by the addition of a plus (+) or minus ()
sign to show relative standing within the major rating categories.
NR
This indicates that no rating has been requested, that there is insufficient information on
which to base a rating, or that Standard & Poors does not rate a particular obligation as a matter
of policy.
Short-Term Issue Credit Ratings
A-1
A short-term obligation rated A-1 is rated in the highest category by Standard & Poors. The
obligors capacity to meet its financial commitment on the obligation is strong. Within this
category, certain obligations are designated with a plus sign (+). This indicates that the
obligors capacity to meet its financial commitment on these obligations is extremely strong.
A-2
A short-term obligation rated A-2 is somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions than obligations in higher rating categories.
However, the obligors capacity to meet its financial commitment on the obligation is satisfactory.
A-3
A short-term obligation rated A-3 exhibits adequate protection parameters. However, adverse
economic conditions or changing circumstances are more likely to lead to a weakened capacity of the
obligor to meet its financial commitment on the obligation.
B
A short-term obligation rated B is regarded as having significant speculative
characteristics. Ratings of B-1, B-2, and B-3 may be assigned to indicate finer distinctions
within the B category. The obligor currently has the capacity to meet its financial
commitment on the obligation; however, it faces major ongoing uncertainties which could lead to the
obligors inadequate capacity to meet its financial commitment on the obligation.
B-1
A short-term obligation rated B-1 is regarded as having significant speculative
characteristics, but the obligor has a relatively stronger capacity to meet its financial
commitments over the short-term compared to other speculative-grade obligors.
A-3
B-2
A short-term obligation rated B-2 is regarded as having significant speculative
characteristics, and the obligor has an average speculative-grade capacity to meet its financial
commitments over the short-term compared to other speculative-grade obligors.
B-3
A short-term obligation rated B-3 is regarded as having significant speculative
characteristics, and the obligor has a relatively weaker capacity to meet its financial commitments
over the short-term compared to other speculative-grade obligors.
C
A short-term obligation rated C is currently vulnerable to nonpayment and is dependent upon
favorable business, financial, and economic conditions for the obligor to meet its financial
commitment on the obligation.
D
A short-term obligation rated D is in payment default. The D rating category is used when
payments on an obligation are not made on the date due even if the applicable grace period has not
expired, unless Standard & Poors believes that such payments will be made during such grace
period. The D rating also will be used upon the filing of a bankruptcy petition or the taking of
a similar action if payments on an obligation are jeopardized.
Active Qualifiers (Currently applied and/or outstanding)
i
This subscript is used for issues in which the credit factors, terms, or both, that determine
the likelihood of receipt of payment of interest are different from the credit factors, terms or
both that determine the likelihood of receipt of principal on the obligation. The i subscript
indicates that the rating addresses the interest portion of the obligation only. The i subscript
will always be used in conjunction with the p subscript, which addresses likelihood of
receipt of principal. For example, a rated obligation could be assigned ratings of AAAp NRi
indicating that the principal portion is rated AAA and the interest portion of the obligation is
not rated.
L
Ratings qualified with L apply only to amounts invested up to federal deposit insurance
limits.
A-4
P
This subscript is used for issues in which the credit factors, the terms, or both, that
determine the likelihood of receipt of payment of principal are different from the credit factors,
terms or both that determine the likelihood of receipt of interest on the obligation. The p
subscript indicates that the rating addresses the principal portion of the obligation only. The p
subscript will always be used in conjunction with the i subscript, which addresses likelihood of
receipt of interest. For example, a rated obligation could be assigned ratings of AAAp N.R.i
indicating that the principal portion is rated AAA and the interest portion of the obligation is
not rated.
pi
Ratings with a pi subscript are based on an analysis of an issuers published financial
information, as well as additional information in the public domain. They do not, however, reflect
in-depth meetings with an issuers management and are therefore based on less comprehensive
information than ratings without a pi subscript. Ratings with a pi subscript are reviewed
annually based on a new years financial statements, but may be reviewed on an interim basis if a
major event occurs that may affect the issuers credit quality.
pr
The letters pr indicate that the rating is provisional. A provisional rating assumes the
successful completion of the project financed by the debt being rated and indicates that payment of
debt service requirements is largely or entirely dependent upon the successful, timely completion
of the project. This rating, however, while addressing credit quality subsequent to completion of
the project, makes no comment on the likelihood of or the risk of default upon failure of such
completion. The investor should exercise his own judgment with respect to such likelihood and risk.
Preliminary
Preliminary ratings are assigned to issues, including financial programs, in the following
circumstances.
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Preliminary ratings may be assigned to obligations, most commonly structured and
project finance issues, pending receipt of final documentation and legal opinions.
Assignment of a final rating is conditional on the receipt and approval by Standard &
Poors of appropriate documentation. Changes in the information provided to Standard &
Poors could result in the assignment of a different rating. In addition, Standard &
Poor s reserves the right not to issue a final rating. |
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Preliminary ratings are assigned to Rule 415 Shelf Registrations. As specific
issues, with defined terms, are offered from the master registration, a final rating
may be assigned to them in accordance with Standard & Poors policies. The final rating
may differ from the preliminary rating. |
t
This symbol indicates termination structures that are designed to honor their contracts to
full maturity or, should certain events occur, to terminate and cash settle all their contracts
before their final maturity date.
A-5
Inactive Qualifiers (No longer applied or outstanding)
*
This symbol indicated continuance of the ratings is contingent upon Standard & Poor s receipt
of an executed copy of the escrow agreement or closing documentation confirming investments and
cash flows. Discontinued use in August 1998.
c
This qualifier was used to provide additional information to investors that the bank may
terminate its obligation to purchase tendered bonds if the long-term credit rating of the issuer is
below an investment-grade level and/or the issuers bonds are deemed taxable. Discontinued use in
January 2001.
q
A q subscript indicates that the rating is based solely on quantitative analysis of publicly
available information. Discontinued use in April 2001.
r
The r modifier was assigned to securities containing extraordinary risks, particularly
market risks, that are not covered in the credit rating. The absence of an r modifier should not
be taken as an indication that an obligation will not exhibit extraordinary non-credit related
risks. Standard & Poors discontinued the use of the r modifier for most obligations in June 2000
and for the balance of obligations (mainly structured finance transactions) in November 2002.
Moodys Investors Service, Inc.A brief description of the applicable Moodys Investors
Service, Inc. (Moodys) rating symbols and their meanings (as published by Moodys) follows:
Long-Term Obligation Ratings
Moodys long-term obligation ratings are opinions of the relative credit risk of a fixed
income obligations with an original maturity of one year or more. They address the possibility that
a financial obligation will not be honored as promised. Such ratings reflect both the likelihood of
default and any financial loss suffered in the event of default.
Moodys Long-Term Rating Definitions:
Aaa
Obligations rated Aaa are judged to be of the highest quality, with minimal credit risk.
Aa
Obligations rated Aa are judged to be of high quality and are subject to very low credit risk.
A
Obligations rated A are considered upper medium-grade and are subject to low credit risk.
A-6
Baa
Obligations rated Baa are subject to moderate credit risk. They are considered medium-grade
and as such may possess certain speculative characteristics.
Ba
Obligations rated Ba are judged to have speculative elements and are subject to substantial
credit risk.
B
Obligations rated B are considered speculative and are subject to high credit risk.
Caa
Obligations rated Caa are judged to be of poor standing and are subject to very high credit
risk.
Ca
Obligations rated Ca are highly speculative and are likely in, or very near, default, with
some prospect of recovery of principal and interest.
C
Obligations rated C are the lowest rated class of bonds and are typically in default, with
little prospect for recovery of principal or interest.
Note: Moodys appends numerical modifiers 1, 2, and 3 to each generic rating classification
from Aa through Caa. The modifier 1 indicates that the obligation ranks in the higher end of its
generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates
a ranking in the lower end of that generic rating category.
Medium-Term Note Ratings
Moodys assigns long-term ratings to individual debt securities issued from medium-term note
(MTN) programs, in addition to indicating ratings to MTN programs themselves. Notes issued under
MTN programs with such indicated ratings are rated at issuance at the rating applicable to all parí
passu notes issued under the same program, at the programs relevant indicated rating, provided
such notes do not exhibit any of the characteristics listed below:
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Notes containing features that link interest or principal to the credit performance
of any third party or parties (i.e., credit-linked notes); |
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Notes allowing for negative coupons, or negative principal |
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Notes containing any provision that could obligate the investor to make any
additional payments |
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Notes containing provisions that subordinate the claim. |
A-7
For notes with any of these characteristics, the rating of the individual note may differ from
the indicated rating of the program.
For credit-linked securities, Moodys policy is to look through to the credit risk of the
underlying obligor. Moodys policy with respect to non-credit linked obligations is to rate the
issuers ability to meet the contract as stated, regardless of potential losses to investors as a
result of non-credit developments. In other words, as long as the obligation has debt standing in
the event of bankruptcy, we will assign the appropriate debt class level rating to the instrument.
Market participants must determine whether any particular note is rated, and if so, at what
rating level. Moodys encourages market participants to contact Moodys Ratings Desks or visit
www.moodys.com directly if they have questions regarding ratings for specific notes issued under a
medium-term note program. Unrated notes issued under an MTN program may be assigned an NR (not
rated) symbol.
Short-Term Ratings:
Moodys short-term ratings are opinions of the ability of issuers to honor short-term
financial obligations. Ratings may be assigned to issuers, short-term programs or to individual
short-term debt instruments. Such obligations generally have an original maturity not exceeding
thirteen months, unless explicitly noted.
Moodys employs the following designations to indicate the relative repayment ability of rated
issuers:
P-1
Issuers (or supporting institutions) rated Prime-1 have a superior ability to repay short-term
debt obligations.
P-2
Issuers (or supporting institutions) rated Prime-2 have a strong ability to repay short-term
debt obligations.
P-3
Issuers (or supporting institutions) rated Prime-3 have an acceptable ability to repay
short-term obligations.
NP
Issuers (or supporting institutions) rated Not Prime do not fall within any of the Prime
rating categories.
Note: Canadian issuers rated P-1 or P-2 have their short-term ratings enhanced by the senior
most long-term rating of the issuer, its guarantor or support provider.
A-8
APPENDIX B
PROXY VOTING POLICIES AND PROCEDURES
B-1
HIGHLAND CAPITAL MANAGEMENT, L.P.
PROXY VOTING POLICY
1. Application; General Principles
1.1 This proxy voting policy (the Policy) applies to securities held in Client accounts as
to which the above-captioned investment adviser (the Company) has voting authority, directly or
indirectly. Indirect voting authority exists where the Companys voting authority is implied by a
general delegation of investment authority without reservation of proxy voting authority.
1.2 The Company shall vote proxies in respect of securities owned by or on behalf of a Client
in the Clients best economic interests and without regard to the interests of the Company or any
other Client of the Company.
2. Voting; Procedures
2.1 Monitoring. A settlement designee of the Company shall have responsibility for
monitoring portfolios managed by the Company for securities subject to a proxy vote. Upon the
receipt of a proxy notice related to a security held in a portfolio managed by the Company, the
settlement designee shall forward all relevant information to the portfolio manager(s) with
responsibility for the security.
2.2 Voting.
2.2.1. Upon receipt of notice from the settlement designee, the portfolio manager(s) with
responsibility for purchasing the security subject to a proxy vote shall evaluate the subject
matter of the proxy and cause the proxy to be voted on behalf of the Client. In determining how to
vote a particular proxy, the portfolio manager (s) shall consider, among other things, the
interests of each Client account as it relates to the subject matter of the proxy, any potential
conflict of interest the Company may have in voting the proxy on behalf of the Client and the
procedures set forth in this Policy.
2.2.2 If a proxy relates to a security held in a registered investment company or business
development company (Retail Fund) portfolio, the portfolio manager(s) shall notify the Compliance
Department and a designee from the Retail Funds group. Proxies for securities held in the Retail
Funds will be voted by the designee from the Retail Funds group in a manner consistent with the
best interests of the applicable Retail Fund and a record of each vote will be reported to the
Retail Funds Board of Directors in accordance with the procedures set forth in Section 4 of this
Policy.
2.3 Conflicts of Interest. If the portfolio manager(s) determine that the Company may
have a potential material conflict of interest (as defined in Section 3 of this Policy) in voting a
particular proxy, the portfolio manager(s) shall contact the Companys Compliance Department prior
to causing the proxy to be voted.
2.3.1. For a security held by a Retail Fund, the Company shall disclose the conflict
and the determination of the manner in which it proposes to vote to the Retail Funds Board
of Directors. The Companys determination shall take into account only the interests of the
Retail Fund, and the Compliance Department shall document the basis for the decision and
furnish the documentation to the Board of Directors.
B-2
2.3.2. For a security held by an unregistered investment company, such as a hedge fund
and structured products (Non-Retail Funds), where a material conflict of interest has been
identified the Company may resolve the conflict by following the recommendation of a
disinterested third party or by abstaining from voting.
2.4 Non-Votes. The Company may determine not to vote proxies in respect of securities
of any issuer if it determines it would be in its Clients overall best interests not to vote.
Such determination may apply in respect of all Client holdings of the securities or only certain
specified Clients, as the Company deems appropriate under the circumstances. As examples, the
portfolio manager(s) may determine: (a) not to recall securities on loan if, in its judgment, the
negative consequences to Clients of disrupting the securities lending program would outweigh the
benefits of voting in the particular instance or (b) not to vote certain foreign securities
positions if, in its judgment, the expense and administrative inconvenience outweighs the benefits
to Clients of voting the securities.
2.5 Recordkeeping. Following the submission of a proxy vote, the applicable portfolio
manager(s) shall submit a report of the vote to a settlement designee of the Company. Records of
proxy votes by the Company shall be maintained in accordance with Section 4 of this Policy.
2.6 Certification. On a quarterly basis, each portfolio manager shall certify to the
Compliance Department that they have complied with this Policy in connection with proxy votes
during the period.
3. Conflicts of Interest
3.1 Voting the securities of an issuer where the following relationships or circumstances
exist are deemed to give rise to a material conflict of interest for purposes of this Policy:
3.1.1 The issuer is a Client of the Company accounting for more than 5% of the
Companys annual revenues.
3.1.2 The issuer is an entity that reasonably could be expected to pay the Company more
than $1 million through the end of the Companys next two full fiscal years.
3.1.3 The issuer is an entity in which a Covered Person (as defined in the Retail
Funds and the Companys Policies and Procedures Designed to Detect and Prevent Insider
Trading and to Comply with Rule 17j-1 of the Investment Company Act of 1940, as amended
(each, a Code of Ethics)) has a beneficial interest contrary to the position held by the
Company on behalf of Clients.
3.1.4 The issuer is an entity in which an officer or partner of the Company or a
relative1 of any such person is or was an officer, director or employee, or such
person or relative otherwise has received more than $150,000 in fees, compensation and other
payment from the issuer during the Companys last three fiscal years; provided,
however, that the Compliance Department may deem such a relationship not to be a
material conflict of interest if the Company representative serves as an officer or director
of the issuer at the direction of the Company for purposes of seeking control over the
issuer.
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For the purposes of this Policy, relative includes
the following family members: spouse, minor children or stepchildren or
children or stepchildren sharing the persons home. |
B-3
3.1.5 The matter under consideration could reasonably be expected to result in a
material financial benefit to the Company through the end of the Companys next two full
fiscal years (for example, a vote to increase an investment advisory fee for a Retail Fund
advised by the Company or an affiliate).
3.1.6 Another Client or prospective Client of the Company, directly or indirectly,
conditions future engagement of the Company on voting proxies in respect of any Clients
securities on a particular matter in a particular way.
3.1.7 The Company holds various classes and types of equity and debt securities of the
same issuer contemporaneously in different Client portfolios.
3.1.8 Any other circumstance where the Companys duty to serve its Clients interests,
typically referred to as its duty of loyalty, could be compromised.
3.2 Notwithstanding the foregoing, a conflict of interest described in Section 3.1 shall not
be considered material for the purposes of this Policy in respect of a specific vote or
circumstance if:
3.2.1 The securities in respect of which the Company has the power to vote account for
less than 1% of the issuers outstanding voting securities, but only if: (i) such
securities do not represent one of the 10 largest holdings of such issuers outstanding
voting securities and (ii) such securities do not represent more than 2% of the Clients
holdings with the Company.
3.2.2 The matter to be voted on relates to a restructuring of the terms of existing
securities or the issuance of new securities or a similar matter arising out of the holding
of securities, other than common equity, in the context of a bankruptcy or threatened
bankruptcy of the issuer.
4. Recordkeeping and Retention
4.1 The Company shall retain records relating to the voting of proxies, including:
4.1.1 Copies of this Policy and any amendments thereto.
4.1.2 A copy of each proxy statement that the Company receives regarding Client
securities.
4.1.3 Records of each vote cast by the Company on behalf of Clients.
4.1.4 A copy of any documents created by the Company that were material to making a
decision how to vote or that memorializes the basis for that decision.
4.1.5 A copy of each written request for information on how the Company voted proxies
on behalf of the Client, and a copy of any written response by the Company to any (oral or
written) request for information on how the Company voted.
4.2 These records shall be maintained and preserved in an easily accessible place for a period
of not less than five years from the end of the Companys fiscal year during which the last entry
was made in the records, the first two years in an appropriate office of the Company.
B-4
4.3 The Company may rely on proxy statements filed on the SECs EDGAR system or on proxy
statements and records of votes cast by the Company maintained by a third party, such as a proxy
voting service (provided the Company had obtained an undertaking from the third party to provide a
copy of the proxy statement or record promptly on request).
4.4 Records relating to the voting of proxies for securities held by the Retail Funds will be
reported periodically to the Retail Funds Boards of Directors and, with respect to Retail Funds
other than business development companies, to the SEC on an annual basis pursuant to Form N-PX.
B-5