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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM N-CSR
CERTIFIED SHAREHOLDER REPORT OF REGISTERED
MANAGEMENT INVESTMENT COMPANIES
Investment Company Act file number: 811-21769
HIGHLAND SPECIAL SITUATIONS FUND
(Exact name of registrant as specified in charter)
200 Crescent Court
Suite 700
Dallas, Texas 75201
(Address of principal executive offices) (Zip code)
Highland Capital Management Fund Advisors, L.P.
200 Crescent Court
Suite 700
Dallas, Texas 75201
(Name and Address of Agent for Service)
Registrant’s telephone number, including area code: (877) 665-1287
Date of fiscal year end: June 30
Date of reporting period: June 30, 2014
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Item 1: Reports to Stockholders.
A copy of the Report to Shareholders transmitted to shareholders pursuant to Rule 30e-1 under the Investment Company Act of 1940 is attached herewith.
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Annual Report
June 30, 2014
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Highland Special Situations Fund
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Economic and market conditions change frequently.
There is no assurance that the trends described in this report will continue or commence.
A prospectus must precede or accompany this report. Please read the prospectus carefully before you invest.
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PORTFOLIO MANAGER COMMENTARY (unaudited)
Highland Special Situations Fund |
Dear Shareholders:
We are pleased to provide you with our report for Highland Special Situations Fund (the “Fund”) for the period ended June 30, 2014. On June 30, 2014 the net asset value of the Fund was $6.21 per share, as compared to $6.04 on December 31, 2013. During the six-month period ended June 30, 2014, the Fund did not declare any distributions to common shareholders.
THE FUND’S INVESTMENTS:
The total return, for the six-month period ended June 30, 2014, was 2.81%.
Respectively submitted,
Fund Management
1 Annual Report
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Highland Special Situations Fund |
Objective
Highland Special Situations Fund (the “Fund”) seeks to achieve high total returns while minimizing losses.
Net Assets as of June 30, 2014
$2.7 million
Portfolio Data as of June 30, 2014
The information below provides a snapshot of the Fund at the end of the reporting period. The Fund is actively managed and the composition of its portfolio will change over time.
Quality Breakdown as of 06/30/14 (%)(1) | ||||
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D | 98.6 | |||
Not Rated | 1.4 |
Sector Classifications as of 06/30/2014 (%)(1) | ||||
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Common Stocks | 21.7 | |||
U.S. Senior Loans | 5.7 | |||
Corporate Bonds & Notes | 0.1 | |||
Other Investments and Assets & Liabilities(2)
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| 72.5
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Top Holdings as of 06/30/2014 (%)(1)(2)
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Metro-Goldwyn-Mayer, Inc., Class A | 18.4 | |||
Texas Competitive Electric Holdings Co. LLC | 5.7 | |||
Genesys Ventures IA, LP | 1.7 | |||
Pendrell Corp. | 1.6 | |||
Celtic Pharma Phinco BV, PIK
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| 0.1
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(1) | Quality is calculated as a percentage of total senior loans and corporate bonds & notes. Sectors and holdings are calculated as a percentage of total net assets. The quality ratings reflected were issued by Standard & Poors, a nationally recognized statistical rating organization. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest). Quality ratings reflect the credit quality of the underlying bonds in the Fund’s portfolio and not that of the Fund itself. Quality Ratings are subject to change. |
(2) | Includes the Fund’s investments of cash collateral received in connection with securities lending in the amount of $43,556. |
(3) | Excludes the Fund’s investment in an investment company purchased with cash collateral from securities lending. |
2 Annual Report
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June 30, 2014
A guide to understanding the Fund’s financial statements
Investment Portfolio | The Investment Portfolio details the Fund’s holdings and their market value as of the last day of the reporting period. Portfolio holdings are organized by type of asset and industry to demonstrate areas of concentration and diversification. | |
Statement of Assets and Liabilities | This statement details the Fund’s assets, liabilities, net assets and share price for each share class as of the last day of the reporting period. Net assets are calculated by subtracting all of the Fund’s liabilities (including any unpaid expenses) from the total of the Fund’s investment and non-investment assets. The net asset value per share for each class is calculated by dividing net assets allocated to that share class by the number of shares outstanding in that class as of the last day of the reporting period. | |
Statement of Operations | This statement reports income earned by the Fund and the expenses incurred by the Fund during the reporting period. The Statement of Operations also shows any net gain or loss the Fund realized on the sales of its holdings during the period as well as any unrealized gains or losses recognized over the period. The total of these results represents the Fund’s net increase or decrease in net assets from operations. | |
Statement of Changes in Net Assets | This statement details how the Fund’s net assets were affected by its operating results, distributions to shareholders and shareholder transactions (e.g., subscriptions, redemptions and distribution reinvestments) during the reporting period. The Statement of Changes in Net Assets also details changes in the number of shares outstanding. | |
Statement of Cash Flows | This statement reports net cash and foreign currency, excluding restricted cash, provided or used by operating, investing and financing activities and the net effect of those flows on cash and foreign currency during the period. | |
Financial Highlights | ||
The Financial Highlights demonstrate how the Fund’s net asset value per share was affected by the Fund’s operating results. The Financial Highlights also disclose the classes’ performance and certain key ratios (e.g., net expenses and net investment income as a percentage of average net assets). | ||
Notes to Financial Statements | ||
These notes disclose the organizational background of the Fund, certain of its significant accounting policies (including those surrounding security valuation, income recognition and distributions to shareholders), federal tax information, fees and compensation paid to affiliates and significant risks and contingencies. |
3 Annual Report |
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As of June 30, 2014 | Highland Special Situations Fund |
Principal Amount ($)
| Value ($) | |||||
U.S. Senior Loans (a)(b) - 5.7% | ||||||
UTILITY - 5.7% | ||||||
190,310 | Texas Competitive Electric Holdings Co. LLC | 156,212 | ||||
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Total U.S. Senior Loans (Cost $173,061) | 156,212 | |||||
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Corporate Bonds & Notes (b)(c) - 0.1% | ||||||
HEALTHCARE EQUIPMENT & SERVICES - 0.1% | ||||||
317,987 | Celtic Pharma Phinco BV, PIK | 2,201 | ||||
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Total Corporate Bonds & Notes (Cost $212,561) | 2,201 | |||||
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Shares
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Common Stocks (d) - 21.7% | ||||||
COMMERCIAL & PROFESSIONAL SERVICES - 1.6% | ||||||
24,889 | Pendrell Corp. (e) | 43,804 | ||||
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HEALTHCARE EQUIPMENT & SERVICES - 1.7% | ||||||
141,000 | Genesys Ventures IA, LP (f) | 46,206 | ||||
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MEDIA - 18.4% | ||||||
6,363 | Metro-Goldwyn-Mayer, Inc., Class A | 499,228 | ||||
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Total Common Stocks (Cost $255,982) | 589,238 | |||||
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Investment Companies (g) - 1.6% | ||||||
43,556 | State Street Navigator Prime Securities Lending Portfolio | 43,556 | ||||
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Total Investment Companies (Cost $43,556) | 43,556 | |||||
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Total Investments - 29.1%
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| 791,207
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Other Assets & Liabilities, Net - 70.9% | 1,930,157 | |||||
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Net Assets applicable to Common Shareholders - 100.0% | 2,721,364 | |||||
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(a) | Senior loans (also called bank loans, leveraged loans, or floating rate loans) in which the Fund invests generally pay interest at rates which are periodically determined by reference to a base lending rate plus a spread (unless otherwise identified, all senior loans carry a variable rate of interest). These base lending rates are generally (i) the Prime Rate offered by one or more major United States banks, (ii) the lending rate offered by one or more European banks such as the London Interbank Offered Rate (“LIBOR”) or (iii) the Certificate of Deposit rate. Rate shown represents the weighted average rate at June 30, 2014. Senior loans, while exempt from registration under the Securities Act of 1933 (the “1933 Act”), contain certain restrictions on resale and cannot be sold publicly. Senior secured floating rate loans often require prepayments from excess cash flow or permit the borrower to repay at its election. The degree to which borrowers repay, whether as a contractual requirement or at their election, cannot be predicted with accuracy. As a result, the actual remaining maturity may be substantially less than the stated maturity shown. |
(b) | The issuer is, or is in danger of being, in default of its payment obligation. Income is not being accrued. |
(c) | Securities exempt from registration under Rule 144A of the 1933 Act. These securities may only be resold in transaction exempt from registration to qualified institutional buyers. At June 30, 2014, these securities amounted to $2,201 or 0.1% of net assets. |
(d) | Non-income producing security. |
(e) | Securities (or a portion of securities) on loan. As of June 30, 2014, the market value of securities loaned was $43,804. The loaned securities were secured with cash collateral of $43,556. Collateral is calculated based on prior day’s prices. See Note 3. |
(f) | Represents fair value as determined by the Fund’s Board of Trustees (the “Board”), or its designee in good faith, pursuant to the policies and procedures approved by the Board. Securities with a total aggregate value of $48,407, or 1.7% of net assets, were fair valued under the Fund’s valuation procedures as of June 30, 2014. |
(g) | Represents investments of cash collateral received in connection with securities lending. |
(h) | Cost for U.S. federal income tax purposes is $690,785. |
Glossary: | ||
PIK | Payment-in-Kind |
4 See accompanying Notes to Financial Statements.
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STATEMENT OF ASSETS AND LIABILITIES
As of June 30, 2014 | Highland Special Situations Fund |
($) | ||||
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Assets: | ||||
Investments, at value (cost $685,160)(a) | 791,207 | |||
Cash | 1,952,914 | |||
Receivable for: | ||||
Interest receivable | 968 | |||
Expense reimbursement due from Investment Advisor | 40,909 | |||
Prepaid expenses and other assets | 34 | |||
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Total assets | 2,786,032 | |||
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Liabilities: | ||||
Payable upon receipt of securities loaned (Note 3) | 43,556 | |||
Payable for: | ||||
Audit and tax payable | 19,088 | |||
Trustees’ fees (Note 5) | 156 | |||
Accrued expenses and other liabilities | 1,868 | |||
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Total liabilities | 64,668 | |||
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Net Assets Applicable to Common Shares | 2,721,364 | |||
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Composition of Net Assets: | ||||
Par value of common shares (Note 1) | 438 | |||
Paid-in capital in excess of par value of common shares | 11,581,718 | |||
Accumulated net investment loss | (17,028) | |||
Accumulated net realized loss from investments | (8,949,811) | |||
Net unrealized appreciation on investments | 106,047 | |||
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Net Assets Applicable to Common Shares | 2,721,364 | |||
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Common Shares | ||||
Net assets | 2,721,364 | |||
Shares outstanding (unlimited authorization) | 438,178 | |||
Net asset value per share (net assets/shares outstanding) | 6.21 |
(a) Includes market value of securities on loan of $43,804.
5 See accompanying Notes to Financial Statements.
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For the Six Months Ended June 30, 2014 | Highland Special Situations Fund |
($) | ||||
Investment Income | ||||
Interest | 5,581 | |||
Securities lending income (Note 3) | 25 | |||
Other income | 38 | |||
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Total investment income | 5,644 | |||
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Expenses: | ||||
Investment management fees (Note 5) | 21,010 | |||
Transfer agent fees | 61 | |||
Trustees’ fees (Note 5) | 85 | |||
Accounting services fees | 1,722 | |||
Audit fees | 23,435 | |||
Legal fees | 2,444 | |||
Insurance | 79 | |||
Reports to shareholders | 1,578 | |||
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Total expenses | 50,414 | |||
Fees waived/reimbursed by Investment Adviser (Note 5) | (26,496) | |||
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Net expenses | 23,918 | |||
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Net investment loss | (18,274) | |||
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Net Realized and Unrealized Gain/(Loss) on Investments | ||||
Net realized gain on investments | 47,956 | |||
Net change in unrealized appreciation on investments | 44,717 | |||
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Net realized and unrealized gain on investments | 92,673 | |||
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Net increase in net assets from operations | 74,399 | |||
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6 See accompanying Notes to Financial Statements.
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STATEMENTS OF CHANGES IN NET ASSETS
Highland Special Situations Fund |
Six Months Ended June 30, 2014 ($) | Year Ended December 31, 2013 ($) | |||||||||
From Operations | ||||||||||
Net investment income (loss) | (18,274) | 6,637 | ||||||||
Net realized gain on investments | 47,956 | 33,960 | ||||||||
Net change in unrealized appreciation on investments | 44,717 | 169,623 | ||||||||
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Net increase in net assets from operations | 74,399 | 210,220 | ||||||||
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Share Transactions from Common Shares | ||||||||||
Subscriptions | 1,831,274 | — | ||||||||
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Net increase from share transactions from common shares | 1,831,274 | — | ||||||||
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Total increase in net assets from common shares | 1,905,673 | 210,220 | ||||||||
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Net Assets Applicable to Common Shares | ||||||||||
Beginning of period | 815,691 | 605,471 | ||||||||
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End of period (including accumulated net investment income (loss) of $(17,028) and $5,850, respectively) | 2,721,364 | 815,691 | ||||||||
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Change in Common Shares | ||||||||||
Subscriptions | 303,191 | — | ||||||||
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Net increase in common shares | 303,191 | — | ||||||||
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7 See accompanying Notes to Financial Statements.
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For the Six Months Ended June 30, 2014 | Highland Special Situations Fund |
($) | |||||||||||
Cash Flows Provided by Operating Activities | |||||||||||
Net increase in net assets from operations | 74,399 | ||||||||||
Adjustments to Reconcile Net Increase in Net Assets from Operations to Net Cash Provided by Operating Activities | |||||||||||
Proceeds from disposition of investment securities | 47,956 | ||||||||||
Net amortization of discount | (2,608) | ||||||||||
Net realized gain on investments from unaffiliated issuers | (47,956) | ||||||||||
Net change in unrealized appreciation on investments | (44,717) | ||||||||||
Net change in short-term investments | 5,624 | ||||||||||
Increase in receivable for expense reimbursement | (5,486) | ||||||||||
Decrease in interest receivable | 523 | ||||||||||
Decrease in prepaid expenses and other assets | 78 | ||||||||||
Decrease in payable upon receipt of securities on loan | (5,624) | ||||||||||
Decrease in payables to related parties | (16) | ||||||||||
Decrease in accrued expenses and other liabilities | (2,296) | ||||||||||
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Net cash flow provided by operating activities | 19,877 | ||||||||||
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Cash Flows Provided by Financing Activities | |||||||||||
Proceeds from shares sold | 1,831,274 | ||||||||||
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Net cash flow provided by financing activities | 1,831,274 | ||||||||||
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Net increase in cash | 1,851,151 | ||||||||||
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Cash | |||||||||||
Beginning of the period | 101,763 | ||||||||||
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End of the period | 1,952,914 | ||||||||||
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8 See accompanying Notes to Financial Statements.
Table of Contents
Highland Special Situations Fund |
Selected data for a share outstanding throughout each period is as follows:
Common Shares Per Share Operating Performance:
For the Six Months Ended June 30, 2014 | ||||||||||||||||||||||||
For the Years Ended December 31, | ||||||||||||||||||||||||
2013 | 2012 | 2011 | 2010 | 2009 | ||||||||||||||||||||
Net Asset Value, Beginning of Period | $ | 6.04 | $ | 4.49 | $ | 3.36 | $ | 3.60 | $ | 6.98 | $ | 4.94 | ||||||||||||
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Income from Investment Operations: | ||||||||||||||||||||||||
Net investment income/(loss) | (0.05) | 0.05 | (0.04) | (a) | (0.01) | 0.06 | (a) | 0.51 | ||||||||||||||||
Net realized and unrealized gain/(loss) | 0.22 | 1.50 | 1.17 | (0.23) | 0.46 | 2.19 | ||||||||||||||||||
Distributions from net investment income to preferred shareholders, including declared distributions | — | — | — | — | (0.03) | (0.01) | ||||||||||||||||||
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Total from investment operations, applicable to common shareholders | 0.17 | 1.55 | 1.13 | (0.24) | 0.49 | 2.69 | ||||||||||||||||||
Less Distributions Declared to Common Shareholders: | ||||||||||||||||||||||||
From net investment income | — | — | — | — | (0.05) | (0.65) | ||||||||||||||||||
From return of capital | — | — | — | — | (3.82) | — | ||||||||||||||||||
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Total distributions declared to common shareholders | — | — | — | — | (3.87) | (0.65) | ||||||||||||||||||
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Net Asset Value, End of Period | $ | 6.21 | $ | 6.04 | $ | 4.49 | $ | 3.36 | $ | 3.60 | $ | 6.98 | ||||||||||||
Total Return(b) | 2.81 | %(c) | 34.52 | % | 33.23 | % | (6.39) | % | 12.88 | % | 54.56 | % | ||||||||||||
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Common Share Information at End of Period: | ||||||||||||||||||||||||
Ratios based on average net assets of common shares: | ||||||||||||||||||||||||
Ratios and Supplemental Data: | ||||||||||||||||||||||||
Net assets, end of period (in 000’s) | $ | 2,721 | $ | 816 | $ | 605 | $ | 2,757 | $ | 2,951 | $ | 42,293 | ||||||||||||
Gross expenses | 4.23 | %(e) | 8.52 | % | 6.86 | % | 5.77 | % | 3.94 | % | 2.52 | % | ||||||||||||
Net expenses(d) | 2.00 | %(e) | 2.00 | % | 5.95 | % | 5.77 | % | 3.94 | % | 2.52 | % | ||||||||||||
Net investment income/(loss) | (1.53) | %(e) | 0.93 | % | (1.55) | % | (0.27) | % | 1.46 | %(f) | 7.21 | %(f) | ||||||||||||
Common and Preferred Share Information at End of Period: | ||||||||||||||||||||||||
Ratios based on net assets of common and preferred shares: | ||||||||||||||||||||||||
Gross expenses | 4.23 | %(e) | 8.52 | % | 6.86 | % | 5.77 | % | 3.88 | % | 2.50 | % | ||||||||||||
Net expenses(d) | 2.00 | %(e) | 2.00 | % | 5.95 | % | 5.77 | % | 3.88 | % | 2.50 | % | ||||||||||||
Net investment income/(loss) | (1.53) | %(e) | 0.93 | % | (1.55) | % | (0.27) | % | 1.33 | % | 7.06 | % | ||||||||||||
Portfolio turnover rate | — | % | — | % | — | % | 8 | % | 3 | %(g) | 87 | % | ||||||||||||
Preferred Share Information at End of Period | ||||||||||||||||||||||||
Aggregate amount outstanding, end of period (000’s) | $ | — | $ | — | $ | — | $ | — | $ | — | $ | 411 | ||||||||||||
Asset coverage per share(h) | $ | — | $ | — | $ | — | $ | — | $ | — | $ | 103,902 |
(a) | Per share net investment income has been calculated using the average share method. |
(b) | Total return at net asset value assuming all distributions reinvested. |
(c) | Not annualized |
(d) | Net expense ratio has been calculated after applying any waiver/reimbursement, if applicable. |
(e) | Annualized |
(f) | Net investment income ratio does not reflect payment to preferred shareholders. The ratio reflecting such payment was 1.34% and 7.13% for the years ended December 31, 2010 and December 31, 2009, respectively. |
(g) | Portfolio turnover rate excludes securities delivered from processing the redemption-in-kind. |
(h) | Asset coverage per share equals net assets of common shares plus the redemption value of the preferred shares divided by the total number of preferred shares outstanding at the end of the period. During the year ended December 31, 2010 all the preferred shares were redeemed. |
9 See accompanying Notes to Financial Statements.
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June 30, 2014 | Highland Special Situations Fund |
Note 1. Organization
Highland Special Situations Fund (the “Fund”) is a Delaware statutory trust and is registered with the Securities and Exchange Commission (the “SEC”) under the Investment Company Act of 1940, as amended (the “1940 Act”), as a nondiversified, closed-end management investment company. The Fund commenced operations on May 18, 2005.
Common Shares
The Fund may issue an unlimited number of common shares, par value $0.001 per share (the “Common Shares”). The Fund will offer Common Shares, only to investors that are both accredited investors and qualified clients on a private placement basis, and only with the approval of a majority of the Fund’s outstanding Shares.
Preferred Shares
The Fund is authorized to issue up to 500 shares of Series P Preferred Shares (“Series P Shares”). Series P Shares pay cumulative preferential dividends of approximately 8% per year and are preferred as to liquidation value over the Common Shares. The purchase price for each Series P Shares is $1,000. The Series P Shares have a liquidation preference equal to $1,000 (the “Liquidation Preference”) plus any accumulated but unpaid dividends and will be redeemable at the option of the Fund in whole or part at any time in an amount equal to the Liquidation Preference plus accumulated and unpaid dividends thereon calculated as of the date of redemption. On or after the fifth anniversary of the commencement of the Fund’s operations, holders of Series P Shares have the right, with no less than 90 days prior written notice to the Fund, to sell such Series P Shares to the Fund at an amount equal to the Liquidation Preference plus accumulated and unpaid dividends. The right of the holders of Series P Shares to sell their shares to the Fund requires Series P Shares to be presented as a liability for financial reporting purposes. The Fund will not issue Series P Shares unless immediately thereafter the Series P Shares have asset coverage of at least 200%. As of June 30, 2014, there are no Series P Shares issued and outstanding.
The Fund is also authorized to issue one share of Series S Preferred Shares (the “Special Share”). The Special Share will have a liquidation preference equal to $1,000 plus any accumulated and unpaid dividend. The Special Share will be redeemable at the option of the Fund in whole or part at any time after the termination for any or no reason of the investment management agreement in accordance with the provisions thereof in an amount equal to the Liquidation Preference plus accumulated and unpaid dividends thereon calculated as of the date of redemption. The Fund will not issue Series P Shares or a Special Share (together, the “Preferred Shares”) unless immediately thereafter the Preferred Shares have an asset coverage of at least 200%. As of June 30, 2014, the Special Share had not been issued.
The Preferred Shares are senior to and have certain class-specific preferences over the Common Shares. Under the 1940 Act, the Preferred Shares must have the right to elect at least two Trustees at all times and a majority of the Trustees in the event of serious dividend arrearages. Preferred Shares also have certain class voting rights under the1940 Act.
Note 2. Significant Accounting Policies
The following summarizes the significant accounting policies consistently followed by the Fund in the preparation of its financial statements.
Use of Estimates
The Fund’s financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which require management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Changes in the economic environment, financial markets and any other parameters used in determining these estimates could cause actual results to differ materially.
Fund Valuation
The net asset value (“NAV”) of the Fund’s common shares is calculated as of the last business day of each month, in connection with each issuance of common shares by the Fund, as of each distribution date (after giving effect to the relevant declaration) and on such other dates as determined by the Fund’s Board of Trustees (the “Board” or “Trustees”),
10 Annual Report
Table of Contents
NOTES TO FINANCIAL STATEMENTS (continued)
June 30, 2014 | Highland Special Situations Fund |
or its designee, in accordance with procedures approved by the Board. The NAV is calculated by dividing the value of the Fund’s net assets attributable to common shares by the numbers of common shares outstanding.
Valuation of Investments
In computing the Fund’s net assets attributable to common shares, securities with readily available market quotations on the New York Stock Exchange, NASDAQ or other nationally recognized exchange, use the closing quotations on the respective exchange for valuation of those securities. Securities for which there are no readily available market quotations will be valued at the mean between the most recently quoted bid and ask prices provided by the principal market makers. If there is more than one such principal market maker, the value shall be the average of such means. Securities without a sale price or quotations from principal market makers on the valuation day may be priced by an independent pricing service. Generally, the Fund’s loan and bond positions are not traded on exchanges and consequently are valued based on a mean of the bid and ask price from the third-party pricing services or broker-dealer sources that Highland Capital Management Fund Advisors, L.P. (the “Investment Adviser”) has determined to generally have the capability to provide appropriate pricing services and have been approved by the Trustees.
Securities for which market quotations are not readily available, for which the Fund has determined the price received from a pricing service or broker-dealer is “stale” or otherwise does not represent fair value (such as when events materially affecting the value of securities occur between the time when market price is determined and calculation of the Fund’s NAV, will be valued by the Fund at fair value, as determined by the Board or its designee in good faith in accordance with procedures approved by the Board, taking into account factors reasonably determined to be relevant, including: (i) the fundamental analytical data relating to the investment; (ii) the nature and duration of restrictions on disposition of the securities; and (iii) an evaluation of the forces that influence the market in which these securities are purchased and sold. In these cases, the Fund’s NAV will reflect the affected portfolio securities’ fair value as determined in the judgment of the Board or its designee instead of being determined by the market. Using a fair value pricing methodology to value securities may result in a value that is different from a security’s most recent sale price and from the prices used by other investment companies to calculate their NAV. Determination of fair value is uncertain because it involves subjective judgments and estimates.
There can be no assurance that the Fund’s valuation of a security will not differ from the amount that it realizes upon the sale of such security. Those differences could have a material impact to the Fund.
Fair Value Measurements
The Fund has performed an analysis of all existing investments and derivative instruments to determine the significance and character of all inputs to their fair value determination. The levels of fair value inputs used to measure the Fund’s investments are characterized into a fair value hierarchy. Where inputs for an asset or liability fall into more than one level in the fair value hierarchy, the investment is classified in its entirety based on the lowest level input that is significant to that investment’s valuation. The three levels of the fair value hierarchy are described below:
Level 1 — Quoted unadjusted prices for identical instruments in active markets to which the Fund has access at the date of measurement;
Level 2 — Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active, but are valued based on executed trades; broker quotations that constitute an executable price; and alternative pricing sources supported by observable inputs are classified within Level 2. Level 2 inputs are either directly or indirectly observable for the asset in connection with market data at the measurement date; and
Level 3 — Model derived valuations in which one or more significant inputs or significant value drivers are unobservable. In certain cases, investments classified within Level 3 may include securities for which the Fund has obtained indicative quotes from broker-dealers that do not necessarily represent prices the broker may be willing to trade on, as such quotes can be subject to material management judgment. Unobservable inputs are those inputs that reflect the Fund’s own assumptions that market participants would use to price the asset or liability based on the best available information.
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NOTES TO FINANCIAL STATEMENTS (continued)
June 30, 2014 | Highland Special Situations Fund |
The Investment Adviser has established policies and procedures, as described above and approved by the Board, to ensure that valuation methodologies for investments and financial instruments that are categorized within all levels of the fair value hierarchy are fair and consistent. A Pricing Committee has been established to provide oversight of the valuation policies, processes and procedures, and is comprised of personnel from the Investment Adviser. The Pricing Committee meets monthly to review the proposed valuations for investments and financial instruments and is responsible for evaluating the overall fairness and consistent application of those policies.
As of June 30, 2014, the Fund’s investments consisted of senior loans, corporate bonds and notes and common stocks. The fair value of the Fund’s loans and bonds are generally based on quotes received from brokers or independent pricing services. Loans and bonds with quotes that are based on actual trades with a sufficient level of activity on or near the measurement date are classified as Level 2 assets. Loans and bonds that are priced using quotes derived from implied values, indicative bids, or a limited number of actual trades are classified as Level 3 assets because the inputs used by the brokers and pricing services to derive the values are not readily observable.
The fair value of the Fund’s common stocks that are not actively traded on national exchanges are generally priced using quotes derived from implied values, indicative bids, or a limited amount of actual trades and are classified as Level 3 assets because the inputs used by the brokers and pricing services to derive the values are not readily observable.
At the end of each calendar quarter, management evaluates the Level 2 and 3 assets and liabilities for changes in liquidity, including but not limited to: whether a broker is willing to execute at the quoted price, the depth and consistency of prices from third party services, and the existence of contemporaneous, observable trades in the market. Additionally, management evaluates the Level 1 and 2 assets and liabilities on a quarterly basis for changes in listings or delistings on national exchanges.
Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value of the Fund’s investments may fluctuate from period to period. Additionally, the fair value of investments may differ significantly from the values that would have been used had a ready market existed for such investments and may differ materially from the values the Fund may ultimately realize. Further, such investments may be subject to legal and other restrictions on resale or otherwise less liquid than publicly traded securities.
The inputs or methodology used for valuing securities are not necessarily an indication of the risk associated with investing in those securities. Transfers in and out of the levels are recognized at the value at the end of the period. A summary of the inputs used to value the Fund’s assets as of June 30, 2014 is as follows:
Total value at June 30, 2014 | Level 1 Quoted Price | Level 2 Significant | Level 3 Significant Inputs | |||||||||||||
Special Situations Fund | ||||||||||||||||
Assets | ||||||||||||||||
U.S. Senior Loans(1) | $ | 156,212 | $ | — | $ | 156,212 | $ | |||||||||
Corporate Bonds & Notes(1) | 2,201 | — | — | 2,201 | ||||||||||||
Common Stocks | ||||||||||||||||
Commercial & Professional Services | 43,804 | 43,804 | — | |||||||||||||
Healthcare Equipment & Services | 46,206 | — | — | 46,206 | ||||||||||||
Media | 499,228 | — | 499,228 | |||||||||||||
Investment Companies | 43,556 | 43,556 | — | |||||||||||||
Total | $ | 791,207 | $ | 87,360 | $ | 655,440 | $ | 48,407 |
(1) See Investment Portfolio detail for industry breakout.
The Fund did not have any liabilities that were measured at fair value on a recurring basis at June 30, 2014.
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NOTES TO FINANCIAL STATEMENTS (continued)
June 30, 2014 | Highland Special Situations Fund |
The table below sets forth a summary of changes in the Fund’s Level 3 assets (assets measured at fair value using significant unobservable inputs) for the period ended June 30, 2014.
Highland Special Situations Fund | Balance as of | Transfers 3 | Transfers Out of Level 3 | Net Amortization (Accretion) of Premium/ (Discount) | Net Realized Gains/ (Losses) | Net Unrealized Gains/ (Losses) | Net Purchases(1) | Net (Sales)(1) | Balance as of June 30, 2014 | Change in Unrealized Gain/(Loss) on Level 3 securities still held at period end | ||||||||||||||||||||||||||||||
Corporate Bonds & | $ | 8,077 | $ | — | $ | — | $ | — | $ | — | $ | (5,876 | ) | $ | — | $ | — | $ | 2,201 | $ | (5,876 | ) | ||||||||||||||||||
Common Stocks |
| |||||||||||||||||||||||||||||||||||||||
Healthcare Equipment & Services | 82,203 | — | — | — | 47,956 | (35,997 | ) | — | (47,956 | ) | 46,206 | (35,997 | ) | |||||||||||||||||||||||||||
Total | $ | 90,280 | $ | — | $ | — | $ | — | $ | 47,956 | $ | (41,873 | ) | $ | — | $ | (47,956 | ) | $ | 48,407 | $ | (41,873 | ) |
(1) | Includes any applicable borrowings and/or paydowns made on revolving credit facilities held in the Fund’s Investment Portfolio. |
Investments designated as Level 3 may include assets valued using quotes or indications furnished by brokers which are based on models or estimates and may not be executable prices. In light of the developing market conditions, the Investment Adviser continues to search for observable data points and evaluate broker quotes and indications received for portfolio investments. Determination of fair values is uncertain because it involves subjective judgments and estimates that are unobservable.
For the period ended June 30, 2014, there were no transfers between Levels 1, 2 or 3.
The following table summarizes the valuation techniques used and unobservable inputs developed to determine the fair value of material Level 3 investments:
Highland Special Situations Fund | Ending Balance at 06/30/14 | Valuation Technique | Unobservable Inputs | Input Value(s) | ||||||||||
Debt | $ | 2,201 | Broker - Quoted | N/A | N/A | |||||||||
Common Stocks | 46,206 | | Fair Valuation - Multiple Scenarios | | Discount Rate Scenario Probabilities |
| 21% Various |
| ||||||
Total | $ | 48,407 |
The significant unobservable inputs used in the fair value measurement of the Fund’s debt investments are discount rates and scenario probabilities. Significant increases or decreases in either of those inputs in isolation would result in a significantly lower or higher fair value measurement.
Security Transactions
Security transactions are accounted for on the trade date. Realized gains/(losses) on investments sold are recorded on the basis of specific identification method for both financial statement and U.S. federal income tax purposes
Income Recognition
Corporate actions (including cash dividends) are recorded on the ex-dividend date, net of applicable withholding taxes, except for certain foreign corporate actions, which are recorded as soon after ex-dividend date as such information becomes available. Interest income is recorded on the accrual basis.
Accretion of discount and amortization of premium on taxable bonds and loans are computed to the call or maturity date, whichever is shorter, using the effective yield method. Withholding taxes on foreign dividends have been provided for in accordance with the Fund’s understanding of the applicable country’s tax rules and rates.
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NOTES TO FINANCIAL STATEMENTS (continued)
June 30, 2014 | Highland Special Situations Fund |
U.S. Federal Income Tax Status
The Fund is treated as a separate taxpayer for U.S. federal income tax purposes. The fund intends to qualify each year as a “regulated investment company” under Subchapter M of the Internal Revenue Code of 1986, as amended, and will distribute substantially all of its taxable income and gains, if any, for the tax year, and as such will not be subject to U.S. federal income taxes. In addition, the Fund intends to distribute, in each calendar year, all of its net investment income, capital gains and certain other amounts, if any, such that the Fund should not be subject to U.S. federal excise tax. Therefore, no U.S. federal income or excise tax provisions are recorded.
Management has analyzed the Fund’s tax positions taken on U.S. federal income tax returns for all open tax years (current and prior three tax years), and has concluded that no provision for U.S. federal income tax is required in the Fund’s financial statements. The Fund’s U.S. federal and state income and U.S. federal excise tax returns for tax years for which the applicable statutes of limitations have not expired are subject to examination by the Internal Revenue Service and state departments of revenue. Furthermore, management of the Fund is also not aware of any tax positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly change in the next 12 months.
Distributions to Shareholders
Dividends and distributions from net investment income are distributed each year based on the criteria set forth below. Holders of Series P Shares are entitled to receive cumulative dividends in the amount of 8% per year of $1,000 for each Series P Share owned. Distributions to holders of Common Shares will consist of all net investment income remaining after the payment of dividends on the Series P Shares. Capital gain distributions, deemed capital gain distributions and ordinary income dividends will be allocated between the holders of Common Shares and Series P Shares in proportion to the total distributions paid during the taxable year. The Fund will not declare or pay any distribution with respect to Common Shares unless the Preferred Shares have asset coverage of at least 200% after deducting the amount of the dividend. During the period ended June 30, 2014, the Fund made no distributions.
Statement of Cash Flows
Information on financial transactions which have been settled through the receipt or disbursement of cash is presented in the Statement of Cash Flows. The cash amount shown in the Statement of Cash Flows is the amount included within the Fund’s Statement of Assets and Liabilities and includes cash on hand at its custodian bank, if any.
Cash & Cash Equivalents
The Fund considers liquid assets deposited with a bank and certain short term debt instruments with original maturities of 3 months or less to be cash equivalents. These investments represent amounts held with financial institutions that are readily accessible to pay Fund expenses or purchase investments. Cash and cash equivalents are valued at cost plus accrued interest, which approximates market value. The value of cash equivalents denominated in foreign currencies is determined by converting to U.S. dollars on the date of the Statement of Assets and Liabilities.
Foreign Currency
Accounting records of the Fund are maintained in U.S. dollars. Foreign currencies, investments and other assets and liabilities denominated in foreign currencies are translated into U.S. dollars at the exchange rates using the current 4:00 PM London Time Spot Rate. Fluctuations in the value of the foreign currencies and other assets and liabilities resulting from changes in exchange rates, between trade and settlement dates on securities transactions and between the accrual and payment dates on dividends, interest income and foreign withholding taxes, are recorded as unrealized foreign currency gains/(losses). Realized gains/(losses) and unrealized appreciation/(depreciation) on investment securities and income and expenses are translated on the respective dates of such transactions. The effects of changes in foreign currency exchange rates on investments in securities are not segregated in the Statement of Operations from the effects of changes in market prices of those securities, but are included with the net realized and unrealized gain or loss on investment securities. As of June 30, 2014, the Fund did not hold foreign currency.
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NOTES TO FINANCIAL STATEMENTS (continued)
June 30, 2014 | Highland Special Situations Fund |
Note 3. Securities Lending
The Fund may make secured loans of its portfolio securities amounting to not more than one-third of the value of its total assets, thereby realizing additional income. The risks in lending portfolio securities, as with other extensions of credit, consist of possible delays in recovery of the securities or possible loss of rights in the collateral should the borrower fail financially and possible investment losses in the investment of collateral. Pursuant to the Fund’s securities lending policy, securities loans are made to unaffiliated broker dealers pursuant to agreements requiring that loans be continuously secured by collateral in cash or short-term debt obligations at least equal at all times to the prior day value of the securities subject to the loan. The borrower pays to the Fund an amount equal to any interest or dividends received on securities subject to the loan. The Fund retains all or a portion of the interest received on investment of the cash collateral and receives a fee from the borrower.
Securities lending transactions are entered into Securities Lending Authorization Agreements (“SLAA”), which provides the right, in the event of default (including bankruptcy or insolvency) for the non-defaulting party to liquidate the collateral and calculate a net exposure to the defaulting party or request additional collateral. In the event that a borrower defaults, the Fund, as lender, would offset the market value of the collateral received against the market value of the securities loaned. The value of the collateral is typically greater than that of the market value of the securities loaned, leaving the lender with a net amount payable to the defaulting party. However, bankruptcy or insolvency laws of a particular jurisdiction may impose restrictions on or prohibitions against such a right of offset in the event of a SLAA counterparty’s bankruptcy or insolvency. Under the SLAA, the Fund can reinvest cash collateral, or, upon an event of default, resell or repledge the collateral, and the borrower can resell or repledge the loaned securities. The risks of securities lending also include the risk that the borrower may not provide additional collateral when required or may not return the securities when due. To mitigate this risk, the Fund benefits from a borrower default indemnity provided by State Street Bank and Trust Company (“State Street”). State Street’s indemnity allows for full replacement of securities lent.
The following table presents financial instruments that are subject to enforceable netting arrangements as of June 30, 2014:
Gross Amounts Not Offset in the Statement of Assets and Liabilities
| ||||||
Gross Amounts of Assets Presented in Statement of Assets & Liabilities | Financial Instrument | Collateral Received | Net Amount (not less than 0) | |||
$43,556(1) | $43,804(2)(3) | $- | $- |
(1) | In some instances, the actual collateral received and/or pledged may be more than the amount shown here due to overcollateralization |
(2) | Represents market value of securities on loan at year end. |
(3) | For the period ended June 30, 2014, the market value of securities loaned by the Fund was $43,804. The loaned securities were secured with cash collateral of $43,556, which was invested in the State Street Navigator Prime Securities Lending Portfolio. |
Note 4. U.S. Federal Income Tax Information
The character of income and gains to be distributed is determined in accordance with income tax regulations which may differ from U.S. GAAP. These differences include (but are not limited to) investments organized as partnerships for tax purposes, foreign taxes, investments in futures, losses deferred to off-setting positions, tax treatment of organizational start-up costs, losses deferred due to wash sale transactions, tax treatment of net investment loss and distributions in excess of net investment income, dividends deemed paid upon shareholder redemption of fund shares and tax attributes from fund reorganizations. Reclassifications are made to the Fund’s capital accounts to reflect income and gains available for distribution (or available capital loss carryovers) under income tax regulations. These reclassifications have no impact on net investment income, realized gains or losses, or net asset value of the Fund. The calculation of net investment income per share in the Financial Highlights table excludes these adjustments. Management intends to change the Fund’s tax year-end from December 31 to June 30.
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NOTES TO FINANCIAL STATEMENTS (continued)
June 30, 2014 | Highland Special Situations Fund |
For the period ended June 30, 2014, permanent differences chiefly resulting from the tax treatment of net operating losses and other adjustments were identified and reclassified among the components of the Fund’s net assets are as follows:
Accumulated Net Investment Income | Accumulated Net Realized Loss | Paid-In Capital | ||||
$(4,604) | $4,604 | $- |
For the period ended June 30, 2014, the Fund’s tax year end, components of distributable earnings on a tax basis are as follows:
Undistributed Ordinary Income | Undistributed Capital Gains | Long-Term | Undistributed Tax-Exempt | Other Temporary Difference(2) | Accumulated Capital and Other Losses | Net Tax Appreciation/ (Depreciation)(1) | ||||||||||||||
$6,646 | $- | $- | $(1,566) | $(8,966,293) | $100,422 |
(1) | Any differences between book-basis and tax-basis net unrealized appreciation/(depreciation) are primarily due to default loan market discounts and partnership adjustments. |
(2) | The other temporary difference consists of outstanding organizational expenses, partnership adjustments and default loan market discounts. |
For the period ended June 30, 2014, the Fund had capital loss carryovers as indicated below. The capital loss carryovers are available to offset future realized capital gains to the extent provided in the Code and regulations promulgated thereunder. To the extent that these carryover losses are used to offset future capital gains, it is probable that the gains so offset will not be distributed to shareholders because they would be taxable as ordinary income.
06/30/2017 | 06/30/2018 | No Expiration Long- Term(1) | Total | |||||||||
$3,212,361(2) | $3,076,455 | (2) | $2,659,072 | $8,947,888 |
(1) | On December 22, 2010, the Regulated Investment Company Modernization Act of 2010 (the “Modernization Act”) was signed into law. The Modernization Act modifies several of the Federal income and excise tax provisions related to RICs. Under the Modernization Act, new capital losses may now be carried forward indefinitely, and retain the character of the original loss as compared with pre-enactment law where capital losses could be carried forward for eight years, and carried forward as short-term capital losses, irrespective of the character of the original loss. |
(2) | The Fund’s ability to utilize the capital loss carryforward may be limited. |
The tax character of distributions paid during the period ended June 30, 2014 and the year ended December 31, 2013 (unless otherwise indicated) were as follows:
Distributions Paid From: | 06/30/2014 | 12/31/2013 | ||||
Ordinary Income(1) | $- | $- |
(1) | For tax purposes, short-term capital gains distributions, if any, are considered ordinary income distributions. |
Unrealized appreciation and depreciation at June 30, 2014, based on cost of investments for U.S. federal income tax purposes was:
Gross Appreciation | Gross Depreciation | Net Appreciation/ (Depreciation)(1) | Cost | |||||
$327,631 | $227,209 | $100,422 | $690,785 |
(1) | Any differences between book-basis and tax-basis net unrealized appreciation/ (depreciation) are primarily due to default loan market discounts and partnership adjustments. |
Qualified Late Year Ordinary and Post October Losses
Under current laws, certain capital losses realized after October 31 may be deferred and treated as occurring on the first day of the following fiscal year. For the period ended June 30, 2014, the Fund elected to defer $18,406 in late year ordinary losses incurred from November 1, 2013 through June 30, 2014.
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NOTES TO FINANCIAL STATEMENTS (continued)
June 30, 2014 | Highland Special Situations Fund |
Note 5. Transactions with Affiliates & Expenses Incurred by the Fund Investment Management, Carried Interest, Trustee and Other Fees
Expense Limitations
Highland has contractually agreed to “limit the total annual operating expenses (exclusive of fees paid by the Fund pursuant to its distribution plan under Rule 12b-1 under the Investment Company Act of 1940, as amended, taxes, brokerage commissions and other transaction costs, acquired fund fees and expenses and extraordinary expenses) of the Fund to 2.00% of average daily net assets attributable to any class of the Fund” through at least December 31, 2014. To the extent Highland waives its fee or reimburses expenses to satisfy the contractual limitation set forth above (the “cap”), it may seek repayment of a portion or all of such amounts at any time within thirty-six months after the date the Fund accrues the liability, subject to the cap. There can be no assurance that this fee reduction will be sufficient to avoid any loss. For the six month period ended June 30, 2014, the Investment Adviser reimbursed $5,486. At June 30, 2014, $40,893 remained eligible for recoupment.
Management Fee
The Investment Adviser receives an investment management fee (the “Management Fee”) of 1.50% per year, calculated monthly and paid quarterly, of the aggregate NAV of the Fund. NAV for purposes of calculating management fee, shall mean the market value of all liquid securities at the time of valuation and the cost of any illiquid assets at the time of valuation. Assets are considered “illiquid” if the Investment Adviser reasonably determines, in accordance with procedures adopted by the Board, that (i) reliable market quotations are not readily available for such security, or (ii) although reliable quotations are readily available, the majority of such securities held by accounts managed by the Investment Adviser could not be sold or disposed of in the ordinary course of business (without taking into account any illiquidity or similar discounts) within fourteen trading days at approximately the price at which the security is valued by the Fund without significantly depressing the level of such market quotations. The limitation in (ii) above is not applicable if the inability to dispose of a majority of such securities within such period is due to the fact that the Investment Adviser is an affiliate of the issuer or possesses inside information regarding such issuer. The Investment Adviser voluntarily has agreed to waive all of its advisory fee beginning on May 1, 2012. For the six month period ended June 30, 2014, the Investment Adviser waived $21,010. The voluntary waiver can be terminated at any time.
Carried Interest Fee
The carried interest will be paid as a fee pursuant to the investment management agreement between the Fund and the Investment Adviser. The carried interest is an amount (payable annually) such that after receipt thereof the Investment Adviser will have received from the Fund 20% of the realized and unrealized cumulative total return of the Fund on its assets attributable to the Common Shares and the Special Share. The carried interest shall be payable as of December 31 of each year and shall be paid not later than completion of the audit of the Fund for such year. If there is positive return through any interim month in excess of the high watermark described below, the Fund will accrue an appropriate amount in respect of the earned carried interest potentially payable at the end of the year. If there is negative return in any calendar year, no carried interest will be paid until the negative return (as a percentage of average net assets attributable to the Common Shares and the Special Share, or, if less, as a percentage of such net assets at the time such negative return is experienced) has been recovered in full (“High Watermark Provision”). For the avoidance of doubt, all total return (positive or negative) will be determined in dollars (the percentage figure in connection with recoupment of negative return being utilized solely to calculate the dollar amount of negative return required to be recouped). For purposes of all carried interest calculations, illiquid assets (as defined for purposes of the Management Fee) will be valued at the lesser of cost or fair market value (as determined by the Investment Adviser in good faith). As of June 30, 2014, the Fund did not have any carried interest.
Fees Paid to Officers and Trustees
Each Trustee who is not an “interested person” of the Fund as defined in the 1940 Act (the “Independent Trustees”) receives an annual retainer of $150,000 payable in quarterly installments and allocated among each portfolio in the Highland Fund Complex based on relative net assets. The “Highland Fund Complex” consists of all of the registered investment companies advised by the Investment Adviser and any affiliates as of the period covered by this annual report.
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NOTES TO FINANCIAL STATEMENTS (continued)
June 30, 2014 | Highland Special Situations Fund |
The Fund pays no compensation to its one interested Trustee or any of its officers, all of whom are employees of the Investment Adviser.
Note 6. Disclosure of Significant Risks and Contingencies
The primary risks of investing in the Funds are described below in alphabetical order:
Carried Interest Risk
The carried interest may create an incentive for the Investment Adviser to make investments that are risky or more speculative than would otherwise be the case. The way in which the amount of the carried interest is determined may encourage the Investment Adviser to use leverage to increase the return on the Fund’s investments. If the Investment Adviser acquires poorly performing assets with such leverage, the loss to the Fund could be substantial. Finally, because a portion of the carried interest is likely to reflect interest and dividend income and is calculated on an accrual basis regardless of whether the Fund has received a cash payment, the Investment Adviser might have an incentive to invest in zero coupon or deferred interest securities in circumstances where it would not have done so but for the opportunity to continue to earn carried interest even when the issuer would not be able to make cash payments on such securities. The foregoing risks could be increased because the Investment Adviser is not obligated to reimburse the Fund for any carried interest received even if the Fund subsequently incurs losses or never receives in cash income that was previously accrued.
Concentration Risk
The Fund may focus its investments in instruments of only a few companies. The concentration of the Fund’s portfolio in any one obligor would subject the Fund to a greater degree of risk with respect to defaults by such obligor, and the concentration of the portfolio in any one industry would subject the Fund to a greater degree of risk with respect to economic downturns relating to such industry.
Credit Risk
Investments rated below investment grade are commonly referred to as high-yield, high risk or “junk debt.” They are regarded as predominantly speculative with respect to the issuing company’s continuing ability to meet principal and/ or interest payments. Investments in high yield debt and high yield Senior Loans may result in greater net asset value fluctuation than if the Fund did not make such investments.
Corporate debt obligations, including Senior Loans, are subject to the risk of non-payment of scheduled interest and/or principal. Non-payment would result in a reduction of income to the Fund, a reduction in the value of the corporate debt obligation experiencing non-payment and a potential decrease in the NAV of the Fund.
Illiquid Securities Risk
The investments made by the Fund may be illiquid, and consequently the Fund may not be able to sell such investments at prices that reflect the Investment Adviser’s assessment of their value or the amount originally paid for such investments by the Fund. Illiquidity may result from the absence of an established market for the investments as well as legal, contractual or other restrictions on their resale and other factors. Furthermore, the nature of the Fund’s investments, especially those in financially distressed companies, may require a long holding period prior to profitability.
Indemnification Risk
The Fund has a variety of indemnification obligations under contracts with its service providers. The Fund’s maximum exposure under these arrangements is unknown. The Board has approved the advancement of certain expenses to a service provider in connection with pending litigation subject to appropriate documentation and safeguards.
Leverage Risk
The Fund may use leverage in their investment program, including the use of borrowed funds and investments in certain types of options, such as puts, calls and warrants, which may be purchased for a fraction of the price of the underlying securities. While such strategies and techniques increase the opportunity to achieve higher returns on the amounts invested, they also increase the risk of loss. To the extent the Fund purchases securities with borrowed funds, its net
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NOTES TO FINANCIAL STATEMENTS (continued)
June 30, 2014 | Highland Special Situations Fund |
assets will tend to increase or decrease at a greater rate than if borrowed funds are not used. If the interest expense on borrowings were to exceed the net return on the portfolio securities purchased with borrowed funds, the Fund’s use of leverage would result in a lower rate of return than if the Fund were not leveraged.
Note 7. Investment Transactions
Purchases & Sales of Securities
For the period ended June 30, 2014, the Fund did not have any purchases or sales of securities.
Note 8. Significant Shareholders
At June 30, 2014, one affiliated shareholder (“Significant Shareholder”) owned 100% of the net assets applicable to Common Shares. The investment activity of this shareholder could have a material impact on the Fund. The Fund will not accept any other subscription for Common Shares without the consent of the Trustees and the written consent of the Significant Shareholder.
Note 9. Subsequent Events
Management has evaluated the impact of all subsequent events on the Fund through the date the financial statements were issued, and has determined that there were the following subsequent events:
Effective July 1, 2014, the Fund changed its fiscal year end from December 31 to June 30. Also, effective July 1, 2014, the Fund was reorganized into the Highland Opportunistic Credit Fund (the “Acquiring Fund”) by transferring all of the assets and obligations in the Fund in exchange for shares of the Acquiring Fund. The Board approved the reorganization on June 6, 2014.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of Highland Special Situations Fund: |
In our opinion, the accompanying statement of assets and liabilities, including the investment portfolio, and the related statements of operations, of changes in net assets, and of cash flows and the financial highlights present fairly, in all material respects, the financial position of Highland Special Situations Fund (the “Fund”) at June 30, 2014, the results of its operations and its cash flows for the six months ended June 30, 2014, the changes in its net assets for the six months ended June 30, 2014 and the year ended June 30, 2014 and the financial highlights for each of the periods indicated, in conformity with accounting principles generally accepted in the United States of America. These financial statements and financial highlights (hereafter referred to as “financial statements”) are the responsibility of the Fund’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our procedures included confirmation of investments at June 30, 2014 by correspondence with the custodian, brokers, and banks with whom the Fund owns assignments in loans, and where replies were not received, we performed other auditing procedures. We believe that our audit provides a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
Dallas, Texas
August 29, 2014
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ADDITIONAL PORTFOLIO INFORMATION (unaudited)
Highland Special Situations Fund |
Additional Portfolio Information
The Investment Adviser and its affiliates manage other accounts, including registered and private funds and individual accounts. Although investment decisions for the Fund are made independently from those of such other accounts, the Investment Adviser may, consistent with applicable law, make investment recommendations to other clients or accounts that may be the same or different from those made to the Fund, including investments in different levels of the capital structure of a company, such as equity versus senior loans, or that take contrary provisions in multiple levels of the capital structure. 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, this may create situations where a client could be disadvantaged because of the investment activities conducted by the Investment Adviser for other client accounts. When the Fund and one or more of such other accounts is prepared to invest in, or desires to dispose of, the same security, available investments or opportunities for each will be allocated in a manner believed by the Investment Adviser to be equitable to the Fund and such other accounts. The Investment Adviser also may aggregate orders to purchase and sell securities for the Fund and such other accounts. Although the Investment Adviser believes that, over time, the potential benefits of participating in volume transactions and negotiating lower transaction costs should benefit all accounts including the Fund, in some cases these activities may adversely affect the price paid or received by the Fund or the size of the position obtained or disposed of by the Fund.
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ADDITIONAL INFORMATION (unaudited)
June 30, 2014 | Highland Special Situations Fund |
Trustees and Officers
The Board of Trustees (the “Board”) provides broad oversight of the operations and affairs of the Funds and protects the interests of shareholders. The Board has overall responsibility to manage and control the business affairs of the Funds, including the complete and exclusive authority to establish policies regarding the management, conduct and operation of the Funds’ business. The names and birthdates of the Trustees and officers of the Funds, 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 for each Trustee and officer of the Funds is c/o Highland Capital Management Fund Advisors, L.P., 200 Crescent Court, Suite 700, Dallas, Texas 75201.
Name and Date of Birth
| Position(s) with the Funds
| Term of Office and Length of Time Served(1)
| Principal Occupation(s) During Past Five Years
| Number of Portfolios in Highland Fund Complex Overseen by Trustee (2)
| Other Directorships/ Held During Past Five
| |||||
Independent Trustees
| ||||||||||
Timothy K. Hui
(6/13/1948) | Trustee | Indefinite Term;
Trustee since inception in 2006 | Dean of Educational Resources since July 2012 and from July 2006 to January 2008, Vice President from February 2008 to June 2012, and Assistant Provost for Graduate Education from July 2004 to June 2006 at Cairn University. | 14 | None | |||||
Bryan A. Ward
(2/4/1955) | Trustee | Indefinite Term; Trustee since inception in 2006 | Senior Manager, Accenture, LLP (a consulting firm) since January 2002. | 14 | None | |||||
Terrence O. Jones
(7/3/1963) | Trustee | Indefinite Term; Trustee since December 2013 | Chief Investment Officer, Banco Santander/Optimal Investments from November 2008 to April 2009; Founder and President, Battersby Capital Management LLC from January 2006 to November 2008; and Managing Director, Goldman Sachs Hedge Fund Strategies from December 2001 to December 2005. | 14 | Genworth Life Insurance Company of New York; Father Judge High School |
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ADDITIONAL INFORMATION (unaudited) (continued)
June 30, 2014 | Highland Special Situations Fund |
Name and Date of Birth
| Position(s) with the Funds
| Term of Office and Length of Time Served(1)
| Principal Occupation(s) During Past Five Years
| Number of Portfolios in Highland Fund Complex Overseen by Trustee (2)
| Other Directorships/ Held During Past Five
| |||||
Dr. Bob Froehlich Trustee
(4/28/1953) | Indefinite Term; Trustee since December 2013 | Executive Vice President and Chief Investment Strategist, The Hartford Mutual Funds from 2009 until retirement in 2012; Vice Chairman of Deutsche Asset Management from 2002 to 2009. | 14 | Director of American Realty Capital Finance Trust, Inc.; Director of KC Concession, Inc.; Trustee of American AR Capital Real Estate Fund; Director of American Realty Capital Healthcare Trust II; Director, American Realty Capital Daily Net Asset Value Trust, Inc.; Director of American Sports Enterprise, Inc.; Director of Davidson Investment Advisors | ||||||
Interested Trustees | ||||||||||
John Honis3
(6/16/1958) | Trustee | Indefinite Term; Trustee since July 2013. | President of Rand Advisors, LLC since August 2013: Partner of Highland Capital Management, L.P. (“HCM”). | 14 | None | |||||
Ethan Powell3
(6/20/1975) | Trustee; Chairman of the Board; Executive Vice President and Secretary (Principal Executive Officer) | Indefinite Term; Trustee since December 2013; Chairman of the Board since December 2013;
Executive Vice President since June 2012; Secretary since November 2010 | Trustee of NexPoint Credit Strategies Fund (“NHF”), Highland Funds II, Highland Funds I and Highland Special Situations Fund (“HSSF”) from June 2012 until July 2013; Chief Product Strategist of NexPoint Advisors, L.P. and HCMFA since 2012; Senior Retail Fund Analyst of HCM since 2007 and of HCMFA since its inception and Secretary of the funds in the Highland Fund Complex since November 2010. | 14 | None |
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ADDITIONAL INFORMATION (unaudited) (continued)
June 30, 2014 | Highland Special Situations Fund |
Name and Date of Birth
| Position(s) with the Funds
| Term of Office and Length of Time Served
| Principal Occupation(s) During Past Five Years
| |||
Officers | ||||||
Brian Mitts
(8/26/1970) | Treasurer (Principal Accounting Officer and Principal Financial Officer) | Indefinite Term; Treasurer since November 2010 | Chief Financial Officer and Financial and Operations Principal of Highland Capital Funds Distributor, Inc. since November 2013; Chief Operations Officer of HCMFA since 2012; Senior Retail Fund Analyst of HCM since 2007 and HCMFA since its inception; Principal Accounting Officer and Treasurer of the funds in the Highland Fund Complex since November 2010; Manager of Financial Reporting at HBK Investments (a hedge fund) from 2005 to 2007. | |||
Ethan Powell
(6/20/1975) | Trustee; Chairman of the Board; Executive Vice President and Secretary (Principal Executive Officer) | Indefinite Term; Trustee since December 2013; Chairman of the Board since December 2013; Executive Vice President since June 2012; Secretary since November 2010 | Chief Product Strategist of HCMFA since 2012; Senior Retail Fund Analyst of HCM since 2007 and HCMFA since its inception; and Secretary of the funds in the Highland Fund Complex since November 2010; Manager in the Merger and Acquisitions Division at Ernst & Young from 1999 to 2007. | |||
Alan Head
(8/5/1973)
| Chief Compliance Officer | Indefinite Term; Chief Compliance Officer since January 2012 | Chief Compliance Officer of Highland Capital Funds Distributor, Inc. since November 2013; Compliance Director at HCM and Chief Compliance Officer of NexBank Securities, Inc. (an affiliated broker-dealer) since November 2010; President of NexBank Securities, Inc. from November 2011 to March 2014;Vice President, Manager of Reporting and Research from May 2008 to September 2010 and Compliance; Manager from August 2005 to May 2008 at Capital Institutional Services. | |||
Dustin NorrisAssistant Treasurer
(1/6/1984) | Indefinite Term; Assistant Treasurer since November 2012 | Director of Product Strategy at HCMFA since May 2014; Assistant Treasurer of the funds in the Highland Fund Complex since November 2012; Senior Accounting Manager at HCMFA from August 2012 to May 2014; Fund Accountant at HCM from June 2010 to August 2012; Auditor at Deloitte & Touche LLP from 2009 to June 2010. |
1 | On an annual basis, as a matter of Board policy, the Governance Committee reviews each Trustee’s performance and determines whether to extend each such Trustee’s service for another year. Effective June 2013, the Board adopted a retirement policy wherein the Governance Committee shall not recommend the continued service as a Trustee of a Board member who is older than 80 years of age at the time the Governance Committee reports its findings to the Board. |
2 | The “Highland Fund Complex” consists of all of the registered investment companies overseen by the Board and advised by the Adviser or an affiliated person of the Adviser. |
3 | Mr. Powell is deemed to be an “interested person” of the Funds under the 1940 Act because of his position with HCMFA. Mr. Honis is deemed to be an “interested person” of the Fund under the 1940 Act because of his position with HCM, an affiliate of HCMFA. |
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IMPORTANT INFORMATION ABOUT THIS REPORT
Investment Adviser
Highland Capital Management Fund Advisors, L.P.
200 Crescent Court, Suite 700
Dallas, TX 75201
Transfer Agent
Boston Financial Data Services, Inc.
2000 Crown Colony Drive
Quincy, MA 02169-0953
Custodian
State Street Bank and Trust Company
One Lincoln Street
Boston, Massachusetts 02111
Independent Registered Public Accounting Firm
PricewaterhouseCoopers LLP
2001 Ross Avenue, Suite 1800
Dallas, TX 75201
Fund Counsel
Ropes & Gray LLP
Prudential Tower
800 Boylston Street
Boston, MA 02199
This report has been prepared for shareholders of Highland Special Situations Fund (the “Fund”). The Fund mails one shareholder report to each shareholder address. If you would like more than one report, please call shareholder services at 1-877-665-1287 to request that additional reports be sent to you.
A description of the policies and procedures that the Fund uses to determine how to vote proxies relating to its portfolio securities, and the Fund’s proxy voting records for the most recent 12-month period ended December 31, are available (i) without charge, upon request, by calling 1-877-665-1287 and (ii) on the Securities and Exchange Commission’s website at http://www.sec.gov.
The Fund files its complete schedule of portfolio holdings with the Securities and Exchange Commission for the first and third quarters of each fiscal year on Form N-Q. The Fund’s Forms N-Q are available on the Commission’s website at http://www.sec.gov and also may be reviewed and copied at the Commission’s Public Reference Room in Washington, DC. Information on the Public Reference Room may be obtained by calling 1-800-SEC-0330. Shareholders may also obtain the Form N-Q by visiting the Fund’s website at www.highlandfunds.com.
The Statements of Additional Information include additional information about the Fund’s Trustees and are available upon request without charge by calling 1-877- 665-1287.
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Item 2. Code of Ethics.
(a) | The registrant, as of the end of the period covered by this report, has adopted a code of ethics that applies to the registrant’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, regardless of whether these individuals are employed by the registrant or a third party. |
(b) | Not applicable. |
(c) | There have been no amendments, during the period covered by this report, to a provision of the code of ethics that applies to the registrant’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, regardless of whether these individuals are employed by the registrant or a third party, and that relates to any element of the code of ethics description. |
(d) | The registrant has not granted any waivers, including an implicit waiver, from a provision of the code of ethics that applies to the registrant’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, regardless of whether these individuals are employed by the registrant or a third party, that relates to one or more of the items set forth in paragraph (b) of this item’s instructions. |
(e) | Not applicable. |
(f) | The registrant’s code of ethics is attached. |
Item 3. Audit Committee Financial Expert.
As of the end of the period covered by the report, the registrant’s board of trustees has determined that Bryan Ward is qualified to serve as an audit committee financial expert serving on its audit committee and that he is “independent,” as defined by Item 3 of Form N-CSR.
Item 4. Principal Accountant Fees and Services.
Highland Special Situations Fund changed its fiscal year from December 31 to June 30.
Audit Fees
(a) | The aggregate fees billed for professional services rendered by the principal accountant for the audit of the registrant’s annual financial statements or services that are normally provided by the accountant in connection with statutory and regulatory filings or engagements are $21,000 for the fiscal year ending December 31, 2012, $16,500 for the fiscal year ending December 31, 2013 and $33,000 for the fiscal year ending June 30, 2014. |
Audit-Related Fees
(b) | The aggregate fees billed for assurance and related services by the principal accountant that are reasonably related to the performance of the audit of the registrant’s financial statements and are not reported under paragraph (a) of this Item are $8,500 for the fiscal year ending December 31, 2012, $8,500 for the fiscal year ending December 31, 2013 and $0 for the fiscal year ending June 30, 2014. The nature of the services related to agreed-upon procedures, performed on the Fund’s semi-annual financial statements. |
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Tax Fees
(c) | The aggregate fees billed for professional services rendered by the principal accountant for tax compliance, tax advice, and tax planning are $9,000 for the fiscal year ending December 31, 2012, $9,833 for the fiscal year ending December 31, 2013 and $9,833 for the fiscal year ending June 30, 2014. The nature of the services related to assistance on the Fund’s tax returns and excise tax calculations. |
All Other Fees
(d) | The aggregate fees billed in each of the last two fiscal years for products and services provided by the principal accountant, other than the services reported in paragraphs (a) through (c) of this Item are $0 for the fiscal year ending December 31, 2012, $0 for the fiscal year ending December 31, 2013 and $0 for the fiscal year ending June 30, 2014. |
(e)(1) | Disclose the audit committee’s pre-approval policies and procedures described in paragraph (c)(7) of Rule 2-01 of Regulation S-X: |
The Audit Committee shall:
(a) have direct responsibility for the appointment, compensation, retention and oversight of the Fund’s independent auditors and, in connection therewith, to review and evaluate matters potentially affecting the independence and capabilities of the auditors; and
(b) review and pre-approve (including associated fees) all audit and other services to be provided by the independent auditors to the Fund and all non-audit services to be provided by the independent auditors to the Fund’s investment adviser or any entity controlling, controlled by or under common control with the investment adviser (an “Adviser Affiliate”) that provides ongoing services to the Fund, if the engagement relates directly to the operations and financial reporting of the Fund; and
(c) establish, to the extent permitted by law and deemed appropriate by the Audit Committee, detailed pre-approval policies and procedures for such services; and
(d) consider whether the independent auditors’ provision of any non-audit services to the Fund, the Fund’s investment adviser or an Adviser Affiliate not pre-approved by the Audit Committee are compatible with maintaining the independence of the independent auditors.
(e)(2) | The percentage of services described in each of paragraphs (b) through (d) of this Item that were approved by the audit committee pursuant to paragraph (c)(7)(i)(C) of Rule 2-01 of Regulation S-X are as follows: |
(b) 100%
(c) 100%
(d) N/A
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(f) | The percentage of hours expended on the principal accountant’s engagement to audit the registrant’s financial statements for the most recent fiscal year that were attributed to work performed by persons other than the principal accountant’s full-time, permanent employees was less than fifty percent. |
(g) | The aggregate non-audit fees billed by the registrant’s accountant for services rendered to the registrant, and rendered to the registrant’s investment adviser (not including any sub-adviser whose role is primarily portfolio management and is subcontracted with or overseen by another investment adviser), and any entity controlling, controlled by, or under common control with the adviser that provides ongoing services to the registrant were $475,000 for the fiscal year ending December 31, 2012, $475,000 for the fiscal year ending December 31, 2013 and $455,500 for the fiscal year ending June 30, 2014. |
(h) | The registrant’s audit committee of the board of directors has considered whether the provision of non-audit services that were rendered to the registrant’s investment adviser (not including any sub-adviser whose role is primarily portfolio management and is subcontracted with or overseen by another investment adviser), and any entity controlling, controlled by, or under common control with the investment adviser that provides ongoing services to the registrant that were not pre-approved pursuant to paragraph (c)(7)(ii) of Rule 2-01 of Regulation S-X is compatible with maintaining the principal accountant’s independence. |
Item 5. Audit Committee of Listed Registrants.
Not applicable.
Item 6. Investments.
(a) | Schedule of Investments in securities of unaffiliated issuers as of the close of the reporting period is included as part of the report to shareholders filed under Item 1 of this form. |
(b) | Not applicable. |
Item 7. Disclosure of Proxy Voting Policies and Procedures for Closed-End Management Investment Companies.
Highland Capital Management, L.P.
Proxy Voting Policy
General Principals
This Policy applies to securities held in Client accounts (including registered investment companies and other pooled investment vehicles) as to which the Company has voting authority, directly or indirectly. Indirect voting authority exists where the Company’s voting authority is implied by a general delegation of investment authority without reservation of proxy voting authority.
The Company shall vote proxies in respect of securities owned by or on behalf of a Client in the Client’s best economic interests and without regard to the interests of the Company or any other Client of the Company.
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Voting Procedures
Monitoring
A member of the settlement group (the “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. The Portfolio Manager(s) may consult a member of the settlement group as necessary.
Voting
Upon receipt of notice from the settlement designee, the Portfolio Manager(s) of the fund(s) in which 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 accordance with the Guidelines set forth below.
Guidelines
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. This Policy is designed to be implemented in a manner reasonably expected to ensure that voting rights are exercised in the best interests of the Company’s clients. Each proxy is voted on a case-by-case basis taking into consideration any relevant contractual obligations as well as other relevant facts and circumstances. In general, the Company reviews and considers corporate governance issues related to proxy matters and generally supports proposals that foster good corporate governance practices. Portfolio manager(s) may vote proxies as recommended by the security issuers management on routine matters related to the operation of the issuer and on matters not expected to have a significant impact on the issuer and/or its shareholders, because the Company believes that recommendations by the issuer are generally in shareholders’ best interests, and therefore in the best economic interest of the Company’s clients.
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 Company’s compliance department prior to causing the proxy to be voted.
For a security held by a an investment company, the Company shall disclose the conflict and its reasoning for voting as it did to the Retail Fund’s Board of Trustees at the next regularly scheduled quarterly meeting. In voting proxies for securities held by an investment company, the Company may consider only the interests of the Fund. It is the responsibility of the compliance department to document the basis for the decision and furnish the documentation to the Board of Trustees. The Company may resolve the conflict of interest by following the proxy voting recommendation of a disinterested third party (such as ISS, Glass Lewis, or another institutional proxy research firm).
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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 Client’s 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 matters being voted upon are not material events affecting the securities and 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.
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 the Recordkeeping section of this Policy.
Material Conflicts of Interest
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:
(i) | The issuer is a Client of the Company, or of an affiliate, accounting for more than 5% of the Company’s or affiliate’s annual revenues. |
(ii) | The issuer is an entity that reasonably could be expected to pay the Company or its affiliates more than $1 million through the end of the Company’s next two full fiscal years. |
(iii) | The issuer is an entity in which a “Covered Person” (as defined in the Company’s 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 (the “Code of Ethics”)) has a beneficial interest contrary to the position held by the Company on behalf of Clients. |
(iv) | The issuer is an entity in which an officer or partner of the Company or a relative 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 Company’s 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. |
(v) | The matter under consideration could reasonably be expected to result in a material financial benefit to the Company or its affiliates through the end of the Company’s next two full fiscal years (for example, a vote to increase an investment advisory fee for a Fund advised by the Company or an affiliate). |
(vi) | Another Client or prospective Client of the Company, directly or indirectly, conditions future engagement of the Company on voting proxies in respect of any Client’s securities on a particular matter in a particular way. |
(vii) | The Company holds various classes and types of equity and debt securities of the same issuer contemporaneously in different Client portfolios. |
(viii) | Any other circumstance where the Company’s duty to serve its Clients’ interests, typically referred to as its “duty of loyalty,” could be compromised. |
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:
(i) | The securities in respect of which the Company has the power to vote account for less than 1% of the issuer’s outstanding voting securities, but only if: (i) such securities do not represent one of the 10 largest holdings of such issuer’s outstanding voting securities and (ii) such securities do not represent more than 2% of the Client’s holdings with the Company. |
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(ii) | 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. |
Recordkeeping
The Company shall retain records relating to the voting of proxies, including:
(i) | Copies of this Policy and any amendments thereto; |
(ii) | A copy of each proxy statement that the Company receives regarding Client securities. |
(iii) | Records of each vote cast by the Company on behalf of Clients. |
(iv) | 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. |
(v) | 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. |
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 Company’s fiscal year during which the last entry was made in the records, the first two years in an appropriate office of the Company.
The Company may rely on proxy statements filed on the SEC’s 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).
Records relating to the voting of proxies for securities held by investment company clients will be reported periodically, as requested, to the investment company’s Board of Trustees and, to the SEC on an annual basis pursuant to Form N-PX.
Item 8. Portfolio Managers of Closed-End Management Investment Companies.
(a)(1) | Identification of Portfolio Manager(s) or Management Team Members and Description of Role of Portfolio Manager(s) or Management Team Members |
The Fund’s portfolio manager, who is primarily responsible for the day-to-day management of the Fund’s portfolio, is Jim Dondero.
Jim Dondero– Mr. Dondero has over 25 years of experience in the credit markets. In addition to his role at NexPoint Advisors, L.P., Mr. Dondero is the President of Highland Capital Management, L.P. (“HCM”), which he co-founded in 1993. Prior to founding HCM, Mr. Dondero served as Chief Investment Officer of Protective Life’s 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, high-yield bonds, emerging market debt, derivatives, and equity securities. He received a BS in Commerce (Accounting and Finance) from the University of Virginia. Mr. Dondero is a Certified Public Accountant, a Certified Management Accountant, and a Chartered Financial Analyst.
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(a)(2) | Other Accounts Managed by Portfolio Manager(s) or Management Team Member and Potential Conflicts of Interest |
Other Accounts Managed by Portfolio Manager(s) or Management Team Member
The following table provides information about funds and accounts, other than the Fund, for which the Fund’s portfolio manager is primarily responsible for the day-to-day portfolio management as of June 30, 2014.
Jim Dondero
Type of Accounts | Total # of Accounts Managed | Total Assets (millions) | # of Accounts Managed with Performance-Based Advisory Fee | Total Assets with Performance-Based Advisory Fee (millions) | ||||
Registered Investment Companies: | 2 | $1,150.5 | 0 | $ 0 | ||||
Other Pooled Investment Vehicles: | 2 | $186.2 | 0 | $ 0 | ||||
Other Accounts: | 0 | $ 0 | 0 | $ 0 |
Potential Conflicts of Interests
Highland Capital Management Fund Advisors, L.P. (“Highland” or the “Adviser”) and/or its general partner, limited partners, officers, affiliates and employees provide investment advice to other parties and manage other accounts and private investment vehicles similar to the Fund. In connection with such other investment management activities, the Adviser and/or its general partner, limited partners, officers, affiliates and employees may decide to invest the funds of one or more other accounts or recommend the investment of funds by other parties, rather than the Fund’s monies, in a particular security or strategy. In addition, the Adviser and such other persons will determine the allocation of funds from the Fund and such other accounts to investment strategies and techniques on whatever basis they consider appropriate or desirable in their sole and absolute discretion.
The 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 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 Adviser furnishes advisory services to numerous clients in addition to the Fund, and the Adviser may, consistent with applicable law, make investment recommendations to other clients or accounts (including accounts that are hedge funds or have performance or higher fees paid to the Adviser or in which portfolio managers have a personal interest in the receipt of such fees) that may be the same as or different from those made to the Fund. In addition, the Adviser, its affiliates and any of their partners, directors, officers, stockholders or employees may or may not have an interest in the securities whose purchase and sale the Adviser recommends to the Fund. Actions with respect to securities of the same kind may be the same as or different from the action that the Adviser, or any of its affiliates, or any of their partners, directors, officers, stockholders or employees or any member of their families may take with respect to the same securities. Moreover, the Adviser may refrain from rendering any advice or services concerning securities of companies of which any of the Adviser’s (or its affiliates’) partners, directors, officers or employees are directors or officers, or companies as to which the Adviser or any of its affiliates or partners, directors, officers 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 Adviser includes disclosure regarding these matters to its clients in both its Form ADV and investment advisory agreements.
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The Adviser, its affiliates or their partners, directors, officers and employees similarly serve or may serve other entities that operate in the same or related lines of business. 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 Fund. As a result, the Adviser will face conflicts in the allocation of investment opportunities to the Fund 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 Adviser will endeavor to allocate investment opportunities in a fair and equitable manner which may, subject to applicable regulatory constraints, involve pro rata co-investment by the Fund and such other clients or may involve a rotation of opportunities among the Fund and such other clients.
While the Adviser does not believe there will be frequent conflicts of interest, if any, the Adviser and its affiliates have both subjective and objective procedures and policies in place designed to manage the potential conflicts of interest between the Adviser’s fiduciary obligations to the Fund and their similar fiduciary obligations to other clients so that, for example, investment opportunities are allocated in a fair and equitable manner among the Fund and such other clients. An investment opportunity that is suitable for multiple clients of the 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 1940 Act. There can be no assurance that the Adviser’s 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 Fund. Not all conflicts of interest can be expected to be resolved in favor of the Fund.
(a)(3) | Compensation Structure of Portfolio Manager(s) or Management Team Members |
Highland’s 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 pre-tax relative performance of a portfolio manager’s underlying account, the pre-tax combined performance of the portfolio managers’ underlying accounts, and the pre-tax 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 Highland, such as its “Short-Term Incentive Plan” and its “Long-Term Incentive Plan,” described below.
Base compensation. Generally, portfolio managers receive base compensation based on their seniority and/or their position with Highland, which may include the amount of assets supervised and other management roles within Highland. Base compensation is determined by taking into account current industry norms and market data to ensure that Highland pays a competitive base compensation.
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 paid to recognize specific business contributions and to ensure that the total level of compensation is competitive with the market, as well as participation in incentive plans, including one or more of the following:
Short-Term Incentive 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 Capital in order to promote the success of 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.
Because each person’s compensation is based on his or her individual performance, Highland Capital does not have a typical percentage split among base salary, bonus and other compensation. 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 Highland Capital.
(a)(4) | Disclosure of Securities Ownership |
The following table sets forth the dollar range of equity securities beneficially owned by the portfolio manager in the Fund as of June 30, 2014.
Name of Portfolio Manager | Dollar Ranges of Equity Securities Beneficially Owned by Portfolio Manager | |
Jim Dondero | $500,001 - $1,000,000 |
(b) | Not applicable. |
Item 9. Purchases of Equity Securities by Closed-End Management Investment Company and Affiliated Purchasers.
Not applicable.
Item 10. Submission of Matters to a Vote of Security Holders.
There have been no material changes to the procedures by which the shareholders may recommend nominees to the registrant’s board of directors.
Item 11. Controls and Procedures.
(a) | The registrant’s principal executive and principal financial officers, or persons performing similar functions, have concluded that the registrant’s disclosure controls and procedures (as defined in Rule 30a-3(c) under the Investment Company Act of 1940, as amended (the “1940 Act”) (17 CFR 270.30a-3 (c)) are effective, as of a date within 90 days of the filing date of the report that includes the disclosure required by this paragraph, based on their evaluation of these controls and procedures required by Rule 30a-3(b) under the 1940 Act (17 CFR 270.30a-3(b)) and Rules 13a-15(b) or 15d-15(b) under the Securities Exchange Act of 1934, as amended (17 CFR 240.13a-15(b) or 240.15d-15(b)). |
(b) | There were no changes in the registrant’s internal control over financial reporting (as defined in Rule 30a-3(d) under the 1940 Act (17 CFR 270.30a-3(d)) that occurred during the registrant’s second fiscal quarter of the period covered by this report that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting. |
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Item 12. Exhibits.
(a)(1) | Code of ethics, or any amendment thereto, that is the subject of disclosure required by Item 2 is attached hereto. |
(a)(2) | Certifications pursuant to Rule 30a-2(a) under the 1940 Act and Section 302 of the Sarbanes-Oxley Act of 2002 are attached hereto. |
(a)(3) | Not applicable. |
(b) | Certifications pursuant to Rule 30a-2(b) under the 1940 Act and Section 906 of the Sarbanes-Oxley Act of 2002 are attached hereto. |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934 and the Investment Company Act of 1940, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
HIGHLAND SPECIAL SITUATIONS FUND
By (Signature and Title): | /s/ Ethan Powell | |
Ethan Powell | ||
Executive Vice President and Principal Executive Officer | ||
(Principal Executive Officer) |
Date: September 8, 2014
Pursuant to the requirements of the Securities Exchange Act of 1934 and the Investment Company Act of 1940, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
By (Signature and Title): | /s/ Ethan Powell | |
Ethan Powell | ||
Executive Vice President and Principal Executive Officer | ||
(Principal Executive Officer) |
Date: September 8, 2014
By (Signature and Title): | /s/ Brian Mitts | |
Brian Mitts | ||
Chief Financial Officer and Treasurer | ||
(Principal Financial Officer) |
Date: September 8, 2014