FIRST AMERICAN INVESTMENT FUNDS, INC.
STATEMENT OF ADDITIONAL INFORMATION
DATED OCTOBER 28, 2008
TAX FREE FUNDS
ARIZONA TAX FREE FUND
CALIFORNIA INTERMEDIATE TAX FREE FUND
CALIFORNIA TAX FREE FUND
COLORADO INTERMEDIATE TAX FREE FUND
COLORADO TAX FREE FUND
INTERMEDIATE TAX FREE FUND
MINNESOTA INTERMEDIATE TAX FREE FUND
MINNESOTA TAX FREE FUND
MISSOURI TAX FREE FUND
NEBRASKA TAX FREE FUND
OHIO TAX FREE FUND
OREGON INTERMEDIATE TAX FREE FUND
SHORT TAX FREE FUND
TAX FREE FUND
BOND FUNDS
CORE BOND FUND
HIGH INCOME BOND FUND
INFLATION PROTECTED SECURITIES FUND
INTERMEDIATE GOVERNMENT BOND FUND
INTERMEDIATE TERM BOND FUND
SHORT TERM BOND FUND
TOTAL RETURN BOND FUND
U.S. GOVERNMENT MORTGAGE FUND
This Statement of Additional Information relates to the Class A, Class
B, Class C, Class R and Class Y Shares of the funds named above (the "Funds"),
each of which is a series of First American Investment Funds, Inc. ("FAIF").
This Statement of Additional Information is not a prospectus, but should be read
in conjunction with the current Prospectuses dated October 28, 2008. The
financial statements included as part of the Funds' Annual Reports to
shareholders for the fiscal period ended June 30, 2008 for all funds are
incorporated by reference into this Statement of Additional Information. This
Statement of Additional Information is incorporated into the Funds' Prospectuses
by reference. To obtain copies of Prospectuses or the Funds' Annual Report(s) at
no charge, write the Funds' distributor, Quasar Distributors, LLC, 615 East
Michigan Street, Milwaukee, WI 53202, or call Investor Services at 800 677-FUND.
Please retain this Statement of Additional Information for future reference.
NOTE REGARDING PROPOSED FUND MERGERS
The Board of Directors of FAIF has approved the merger of California
Intermediate Tax Free Fund into California Tax Free Fund and the merger of
Colorado Intermediate Tax Free Fund into Colorado Tax Free Fund. The mergers
must be approved by the shareholders of California Intermediate Tax Free Fund
and Colorado Intermediate Tax Free Fund, respectively. It is currently
anticipated that proxy materials regarding the mergers will be distributed to
shareholders sometime during the fourth quarter of 2008. Until the mergers are
completed, California Intermediate Tax Free Fund and Colorado Intermediate Tax
Free Fund will remain open for investment by both current and new shareholders.
TABLE OF CONTENTS
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GENERAL INFORMATION ................................................ 1
ADDITIONAL INFORMATION CONCERNING FUND INVESTMENTS ................. 1
Asset-Backed Securities ......................................... 2
Brady Bonds ..................................................... 2
Collateralized Debt Obligations ................................. 3
Corporate Debt Securities ....................................... 3
Closed-End Investment Companies ................................. 3
Debt Obligations Rated Less Than Investment Grade ............... 3
Dollar Rolls .................................................... 4
Equity and Convertible Securities ............................... 4
Exchange Traded Funds ........................................... 5
Fixed and Floating Rate Debt Obligations ........................ 5
Foreign Currency Transactions ................................... 5
Foreign Securities .............................................. 6
Futures and Options on Futures .................................. 8
Guaranteed Investment Contracts ................................. 11
Inflation Protected Securities .................................. 11
Interest Rate Caps and Floors ................................... 12
Inverse Floating Rate Municipal Obligations ..................... 12
Lending of Portfolio Securities ................................. 12
Mortgage-Backed Securities ...................................... 13
Municipal Bonds and Other Municipal Obligations ................. 15
Options Transactions ............................................ 17
Participation Interests ......................................... 19
Payment-In-Kind Debentures and Delayed Interest Securities ...... 19
Real Estate Investment Trust ("REIT") Securities ................ 19
Repurchase Agreements ........................................... 20
Royalty Trusts .................................................. 20
Short-Term Temporary Investments ................................ 21
Swap Agreements ................................................. 22
Temporary Taxable Investments ................................... 23
Trust Preferred Securities ...................................... 23
U.S. Government Securities ...................................... 24
When-Issued and Delayed Delivery Transactions ................... 24
Zero Coupon Securities .......................................... 25
Special Factors Affecting Single State Tax Free Funds ........... 25
INVESTMENT RESTRICTIONS ............................................ 41
FUND NAMES ......................................................... 43
DISCLOSURE OF PORTFOLIO HOLDINGS ................................... 44
Public Disclosure ............................................... 44
Nonpublic Disclosure ............................................ 44
DIRECTORS AND EXECUTIVE OFFICERS ................................... 46
Independent Directors ........................................... 46
Executive Officers .............................................. 47
Standing Committees of the Board of Directors ................... 49
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Fund Shares Owned by the Directors .............................. 51
Compensation .................................................... 51
Sales Loads ..................................................... 52
CODE OF ETHICS ..................................................... 52
PROXY VOTING POLICIES .............................................. 52
INVESTMENT ADVISORY AND OTHER SERVICES FOR THE FUNDS ............... 53
Investment Advisor .............................................. 53
Additional Payments to Financial Intermediaries ................. 54
Administrator ................................................... 58
Transfer Agent .................................................. 59
Distributor ..................................................... 60
Custodian and Independent Registered Public Accounting Firm ..... 64
PORTFOLIO MANAGERS ................................................. 64
Other Accounts Managed .......................................... 64
Compensation .................................................... 65
Ownership of Fund Shares ........................................ 66
PORTFOLIO TRANSACTIONS AND ALLOCATION OF BROKERAGE ................. 67
CAPITAL STOCK ...................................................... 69
NET ASSET VALUE AND PUBLIC OFFERING PRICE .......................... 82
TAXATION ........................................................... 85
ADDITIONAL INFORMATION ABOUT CERTAIN SHAREHOLDER SERVICES .......... 87
Reducing Class A Sales Charges .................................. 87
Sales of Class A Shares at Net Asset Value ...................... 87
Class A Shares Reinvestment Right ............................... 88
Redeeming Shares by Telephone ................................... 88
Redeeming Shares by Mail ........................................ 89
Receipt of Orders by Financial Intermediaries ................... 89
Redemptions Before Purchase Instruments Clear ................... 89
Research Requests ............................................... 89
FINANCIAL STATEMENTS ............................................... 89
RATINGS ............................................................ Appendix A
PROXY VOTING POLICIES AND PROCEDURES ............................... Appendix B
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GENERAL INFORMATION
First American Investment Funds, Inc. ("FAIF") was incorporated in the
State of Maryland on August 20, 1987 under the name "SECURAL Mutual Funds, Inc."
The Board of Directors and shareholders, at meetings held January 10, 1991, and
April 2, 1991, respectively, approved amendments to the Articles of
Incorporation providing that the name "SECURAL Mutual Funds, Inc." be changed to
"First American Investment Funds, Inc."
FAIF is organized as a series fund and currently issues its shares in
43 series. Each series of shares represents a separate investment portfolio with
its own investment objective and policies (in essence, a separate mutual fund).
The series of FAIF to which this Statement of Additional Information relates are
named on the cover. These series are referred to in this Statement of Additional
Information as the "Funds."
For purposes of this Statement of Additional Information, "Bond
Funds," and "Tax Free Funds" shall consist of the Funds identified as such on
the cover of this Statement of Additional Information. The Funds are open-end
management investment companies and, except for the Tax Free Funds (other than
Intermediate Tax Free Fund, Short Tax Free Fund, and Tax Free Fund), are
diversified investment companies. The Tax Free Funds (other than Intermediate
Tax Free Fund, Short Tax Free Fund, and Tax Free Fund) are non-diversified
investment companies.
Shareholders may purchase shares of each Fund through five separate
classes, Class A, Class B (except for certain Bond Funds and the Tax Free
Funds), Class C (except certain Bond Funds and certain Tax Free Funds), Class R
(except for certain Bond Funds and the Tax Free Funds) and Class Y, which
provide for variations in distribution costs, shareholder servicing fees, voting
rights and dividends. To the extent permitted by the Investment Company Act of
1940, as amended ("1940 Act"), the Funds may also provide for variations in
other costs among the classes. In addition, a sales load is imposed on the sale
of Class A, Class B and Class C Shares of the Funds. Except for the foregoing
differences among the classes pertaining to costs and fees, each share of each
Fund represents an equal proportionate interest in that Fund.
The Articles of Incorporation and Bylaws of FAIF provide that meetings
of shareholders be held as determined by the Board of Directors and as required
by the 1940 Act. Maryland corporation law requires a meeting of shareholders to
be held upon the written request of shareholders holding 10% or more of the
voting shares of FAIF, with the cost of preparing and mailing the notice of such
meeting payable by the requesting shareholders. The 1940 Act requires a
shareholder vote for, among other things, all amendments to fundamental
investment policies and restrictions, for approval of investment advisory
contracts and amendments thereto, and for amendments to Rule 12b-1 distribution
plans.
This Statement of Additional Information may also refer to affiliated
investment companies, including: First American Funds, Inc. ("FAF"); First
American Strategy Funds, Inc. ("FASF"); Mount Vernon Securities Lending Trust
(the "Mount Vernon Trust"); and eight separate closed-end funds (American
Strategic Income Portfolio Inc., American Strategic Income Portfolio Inc.--II,
American Strategic Income Portfolio Inc.--III, American Municipal Income
Portfolio Inc., Minnesota Municipal Income Portfolio Inc., First American
Minnesota Municipal Income Fund II, Inc., American Select Portfolio Inc., and
American Income Fund, Inc.), collectively referred to as the First American
Closed-End Funds ("FACEF").
ADDITIONAL INFORMATION CONCERNING FUND INVESTMENTS
The principal investment strategies of each Fund are set forth in that
Fund's Prospectuses. Additional information concerning principal investment
strategies of the Funds, and other investment strategies that may be used by the
Funds, is set forth below. The Funds have attempted to identify investment
strategies that will be employed in pursuing each Fund's investment objective.
Additional information concerning the Funds' investment restrictions is set
forth below under "Investment Restrictions."
If a percentage limitation on investments by a Fund stated in this SAI
or the Prospectuses is adhered to at the time of an investment, a later increase
or decrease in percentage resulting from changes in asset value will not be
deemed to violate the limitation except in the case of the limitations on
borrowing. A Fund which is limited to investing in securities with specified
ratings or of a certain credit quality is not required to sell a security if its
rating is reduced or its credit quality declines after purchase, but the Fund
may consider doing so. Descriptions of the rating categories of
1
Standard & Poor's Ratings Services, a division of The McGraw-Hill Companies,
Inc. ("Standard & Poor's"), Fitch, Inc. ("Fitch") and Moody's Investors Service,
Inc. ("Moody's) are contained in Appendix A.
ASSET-BACKED SECURITIES
Core Bond Fund, Inflation Protected Securities Fund, Intermediate Term
Bond Fund, Short Term Bond Fund, and Total Return Bond Fund may invest in
asset-backed securities as a principal investment strategy. High Income Bond
Fund and U.S. Government Mortgage Fund may invest in such securities as a
non-principal investment strategy. Asset-backed securities generally constitute
interests in, or obligations secured by, a pool of receivables other than
mortgage loans, such as automobile loans and leases, credit card receivables,
home equity loans and trade receivables. Asset-backed securities generally are
issued by a private special-purpose entity. Their ratings and creditworthiness
typically depend on the legal insulation of the issuer and transaction from the
consequences of a sponsoring entity's bankruptcy, as well as on the credit
quality of the underlying receivables and the amount and credit quality of any
third-party credit enhancement supporting the underlying receivables or the
asset-backed securities. Asset-backed securities and their underlying
receivables generally are not issued or guaranteed by any governmental entity.
BRADY BONDS
High Income Bond Fund and Total Return Bond Fund may invest in U.S.
dollar-denominated "Brady Bonds" as a non-principal investment strategy. These
foreign debt obligations, which may be fixed rate par bonds or floating rate
discount bonds, are generally collateralized in full as to repayment of
principal at maturity by U.S. Treasury zero-coupon obligations that have the
same maturity as the Brady Bonds. Interest payments on these Brady Bonds
generally are collateralized on a one-year or longer rolling-forward basis by
cash or securities in an amount that, in the case of fixed rate bonds, is equal
to at least one year of interest payments or, in the case of floating rate
bonds, initially is equal to at least one year's interest payments based on the
applicable interest rate at that time and is adjusted at regular intervals
thereafter. Brady Bonds can be viewed as having three or four valuation
components: (i) the collateralized repayment of principal at final maturity;
(ii) the collateralized interest payments; (iii) the uncollateralized interest
payments; and (iv) any uncollateralized repayment of principal at maturity.
Those uncollateralized amounts constitute what is called the "residual risk."
If there is a default on collateralized Brady Bonds resulting in
acceleration of the payment obligations of the issuer, the zero-coupon U.S.
Treasury securities held as collateral for the payment of principal will not be
distributed to investors, nor will those obligations be sold to distribute the
proceeds. The collateral will be held by the collateral agent to the scheduled
maturity of the defaulted Brady Bonds. The defaulted bonds will continue to
remain outstanding, and the face amount of the collateral will equal the
principal payments which would have then been due on the Brady Bonds in the
normal course. Because of the residual risk of Brady Bonds and the history of
defaults with respect to commercial bank loans by public and private entities of
countries issuing Brady Bonds, Brady Bonds are considered speculative
investments.
COLLATERALIZED DEBT OBLIGATIONS
The Bond Funds, other than Intermediate Government Bond Fund and U.S.
Government Mortgage Securities Fund, may invest in Collateralized Debt
Obligations ("CDOs") as a non-principal investment strategy. Similar to CMOs
described below under "--Mortgage-Backed Securities," CDOs are debt obligations
typically issued by a private special-purpose entity and collateralized
principally by debt securities (including, for example, high-yield, high-risk
bonds, structured finance securities including asset-backed securities, CDOs,
mortgage-backed securities and REITs) or corporate loans. The special purpose
entity typically issues one or more classes (sometimes referred to as
"tranches") of rated debt securities, one or more unrated classes of debt
securities that are generally treated as equity interests, and a residual equity
interest. The tranches of CDOs typically have different interest rates,
projected weighted average lives and ratings, with the higher rated tranches
paying lower interest rates. One or more forms of credit enhancement are almost
always necessary in a CDO structure to obtain the desired credit ratings for the
most highly rated debt securities issued by the CDO. The types of credit
enhancement used include "internal" credit enhancement provided by the
underlying assets themselves, such as subordination, excess spread and cash
collateral accounts, hedges provided by interest rate swaps, and "external"
credit enhancement provided by third parties, principally financial guaranty
insurance issued by monoline insurers. Despite this credit enhancement, CDO
tranches can experience substantial losses due to actual defaults, increased
sensitivity to defaults due to collateral default and the disappearance of lower
rated protecting tranches, market anticipation of defaults, as well as aversion
to CDO securities as a class. CDOs can be less liquid than other publicly held
debt issues, and require additional structural analysis.
2
CORPORATE DEBT SECURITIES
The Bond Funds, other than Intermediate Government Bond Fund and U.S.
Government Mortgage Fund, may invest in corporate debt securities as a principal
investment strategy. U.S. Government Mortgage Fund may invest in such securities
as a non-principal investment strategy. Corporate debt securities are fully
taxable debt obligations issued by corporations. These securities fund capital
improvements, expansions, debt refinancing or acquisitions that require more
capital than would ordinarily be available from a single lender. Investors in
corporate debt securities lend money to the issuing corporation in exchange for
interest payments and repayment of the principal at a set maturity date. Rates
on corporate debt securities are set according to prevailing interest rates at
the time of the issue, the credit rating of the issuer, the length of the
maturity and other terms of the security, such as a call feature. Corporate debt
securities are subject to the risk of an issuer's inability to meet principal
and interest payments on the obligations and may also be subject to price
volatility due to such factors as market interest rates, market perception of
the creditworthiness of the issuer and general market liquidity. In addition,
corporate restructurings, such as mergers, leveraged buyouts, takeovers or
similar corporate transactions are often financed by an increase in a corporate
issuer's debt securities. As a result of the added debt burden, the credit
quality and market value of an issuer's existing debt securities may decline
significantly.
CLOSED-END INVESTMENT COMPANIES
The Bond Funds may invest up to 10% of their total assets in common or
preferred shares of closed-end investment companies that invest in Fund-eligible
investments, to the extent permitted under the 1940 Act. Shares of certain
closed-end investment companies may at times be acquired only at market prices
representing premiums to their net asset values. Shares acquired at a premium to
their net asset value may be more likely to subsequently decline in price,
resulting in a loss to the Fund and its shareholders. If a Fund acquires shares
of closed-end investment companies, Fund shareholders would bear both their
proportionate share of the expenses of the Fund (including management and
advisory fees) and, indirectly, the expenses of such closed-end investment
companies.
DEBT OBLIGATIONS RATED LESS THAN INVESTMENT GRADE
Core Bond Fund, Inflation Protected Securities Fund, Short Term Bond
Fund, Total Return Bond Fund, and the Tax Free Funds may invest in both
investment grade and non-investment grade debt obligations. High Income Bond
Fund invests primarily in non-investment grade debt obligations. Debt
obligations rated less than "investment grade" are sometimes referred to as
"high yield securities" or "junk bonds." To be consistent with the ratings
methodology used by Lehman Brothers, the provider of the benchmarks of the Bond
Funds, a debt obligation is considered to be rated "investment grade" if two of
Moody's, Standard & Poor's and Fitch rate the security investment-grade (i.e. at
least Baa, BBB and BBB, respectively). If ratings are provided by only two of
those rating agencies, the more conservative rating is used to determine whether
the security is investment-grade. If only one of those rating agencies provides
a rating, that rating is used. Inflation Protected Securities Fund and the Tax
Free Funds may invest in non-investment grade debt obligations rated at least B
by two of Standard & Poor's, Moody's and Fitch, unless only one of those rating
agencies rates the security, in which case that rating must be at least B, or in
unrated securities determined to be of comparable quality by FAF Advisors, Inc.,
the Funds' investment advisor ("FAF Advisors" or the "Advisor"). Core Bond Fund,
Short Term Bond Fund, and Total Return Bond Fund may not invest in
non-investment grade debt obligations rated by two of Standard & Poor's, Fitch
and Moody's lower than CCC, CCC or Caa, respectively, unless only one of those
rating agencies rates the security, in which case that rating must be at least
CCC or Caa, or in unrated securities determined to be of comparable quality by
the Advisor. There are no minimum rating requirements for High Income Bond Fund
(which means that the Fund may invest in bonds in default).
The "equity securities" in which certain Funds may invest include
corporate debt obligations which are convertible into common stock. These
convertible debt obligations may include non-investment grade obligations.
Yields on non-investment grade debt obligations will fluctuate over
time. The prices of such obligations have been found to be less sensitive to
interest rate changes than higher rated obligations, but more sensitive to
adverse economic changes or individual corporate developments. Also, during an
economic downturn or period of rising interest rates, highly leveraged issuers
may experience financial stress which could adversely affect their ability to
service principal and interest payment obligations, to meet projected business
goals, and to obtain additional financing. In addition, periods of economic
uncertainty and changes can be expected to result in increased volatility of
market prices of non-investment grade debt obligations. If the issuer of a
security held by a Fund defaulted, the Fund might incur additional expenses to
seek recovery.
3
In addition, the secondary trading market for non-investment grade
debt obligations may be less developed than the market for investment grade
obligations. This may make it more difficult for a Fund to value and dispose of
such obligations. Adverse publicity and investor perceptions, whether or not
based on fundamental analysis, may decrease the values and liquidity of
non-investment grade obligations, especially in a thin secondary trading market.
Certain risks also are associated with the use of credit ratings as a
method for evaluating non-investment grade debt obligations. For example, credit
ratings evaluate the safety of principal and interest payments, not the market
value risk of such obligations. In addition, credit rating agencies may not
timely change credit ratings to reflect current events. Thus, the success of a
Fund's use of non-investment grade debt obligations may be more dependent on the
Advisor's own credit analysis than is the case with investment grade
obligations.
DOLLAR ROLLS
The Bond Funds other than Intermediate Government Bond Fund may enter
into mortgage "dollar rolls" in which a Fund sells securities and simultaneously
contracts with the same counterparty to repurchase similar (same type, coupon
and maturity) but not identical securities on a specified future date. Core Bond
Fund, Intermediate Term Bond Fund, and Total Return Bond Fund do so as a
principal investment strategy. In a mortgage dollar roll, a Fund gives up the
right to receive principal and interest paid on the securities sold. However,
the Fund would benefit to the extent of any difference between the price
received for the securities sold and the lower forward price for the future
purchase plus any fee income received. Unless such benefits exceed the income,
capital appreciation and gain or loss due to mortgage prepayments that would
have been realized on the securities sold as part of the mortgage dollar roll,
the use of this technique will diminish the investment performance of the Fund
compared with what such performance would have been without the use of mortgage
dollar rolls. The Fund will segregate until the settlement date cash or liquid
securities in an amount equal to the forward purchase price.
EQUITY AND CONVERTIBLE SECURITIES
As a non-principal investment strategy, High Income Bond Fund and
Total Return Bond Fund may invest in equity securities, including common stock,
master limited partnership (MLP) and other partnership units. The advisor
anticipates that such investments will consist predominantly of income-oriented
equity securities or partnership units. Common stock represents units of
ownership in a corporation. Owners typically are entitled to vote on the
selection of directors and other important matters as well as to receive
dividends on their holdings. In the event that a corporation is liquidated, the
claims of secured and unsecured creditors and owners of bonds and preferred
stock take precedence over the claims of those who own common stock. The price
of common stock is generally determined by corporate earnings, type of products
or services offered, projected growth rates, experience of management,
liquidity, and general market conditions for the markets on which the stock
trades. Stocks may decline significantly in price over short or extended periods
of time. Price changes may occur in the market as a whole, or they may occur in
only a particular country, company, industry, or sector of the market. In
addition, the types of stocks in which a particular fund invests may
underperform the market or may not pay dividends as anticipated.
MLPs are limited partnerships in which the ownership units (i.e.,
limited partnership interests) are publicly traded. MLP units are registered
with the SEC and are freely traded on a securities exchange or in the
over-the-counter market. Many MLPs operate in the oil and gas related
businesses, including energy processing and distribution. Many MLPs are
pass-through entities that generally are taxed at the unit holder level and are
not subject to federal or state income tax at the partnership level. Annual
income, gains, losses, deductions and credits of an MLP pass through directly to
its unitholders. Distributions from an MLP may consist in part of a return of
capital. Generally, an MLP is operated under the supervision of one or more
general partners. Limited partners are not involved in the day-to-day management
of the partnership. The risks of investing in an MLP are generally those
involved in investing in a partnership as opposed to a corporation. For example,
state law governing partnerships is often less restrictive than state law
governing corporations. Accordingly, there may be fewer protections afforded
investors in an MLP than investors in a corporation. Investments held by MLPs
may be relatively illiquid, limiting the MLPs' ability to vary their portfolios
promptly in response to changes in economic or other conditions. MLPs may have
limited financial resources, their securities may trade infrequently and in
limited volume, and they may be subject to more abrupt or erratic price
movements than securities of larger or more broadly-based companies. Investment
in MLPs by High Income Bond Fund and Total Return Bond Fund also subject these
Funds to the risks associated with the specific industry or industries in which
the MLPs invest. Additionally, since MLPs generally conduct business in multiple
states, the Funds may be subject to income or franchise tax in each of the
states in which the partnership does business. The additional cost of
4
preparing and filing the tax returns and paying the related taxes may adversely
impact the Funds' return on their investment in MLPs.
The Bond Funds other than Intermediate Government Bond Fund, U.S.
Government Mortgage Fund, and Short Term Bond Fund, may invest in preferred
stock as a non-principal investment strategy. Preferred stock, unlike common
stock, offers a stated dividend rate payable from the issuer's earnings.
Preferred stock dividends may be cumulative or non-cumulative, participating, or
auction rate. If interest rates rise, the fixed dividend on preferred stocks may
be less attractive, causing the price of preferred stocks to decline. Preferred
stock may have mandatory sinking fund provisions, as well as call/redemption
provisions prior to maturity, a negative feature when interest rates decline.
All of the Bond Funds other than Intermediate Government Bond Fund, as
a non-principal investment strategy, may invest in debt securities which are
convertible into or exchangeable for, or which carry warrants or other rights to
acquire, common or preferred stocks. Equity interests acquired through
conversion, exchange or exercise of rights to acquire stock will be disposed of
by each of the Bond Funds as soon as practicable in an orderly manner (except
that the Bond Funds that may invest in common stocks and/or preferred stocks
directly are not required to dispose of any stock so acquired).
EXCHANGE TRADED FUNDS
The Funds other than Intermediate Government Bond Fund may invest in
exchange traded funds ("ETFs") as a non-principal investment strategy. These are
a type of index fund bought and sold on a securities exchange. An ETF trades
like common stock and represents a fixed portfolio of securities designed to
track a particular market index. Each Fund could purchase an ETF to temporarily
gain exposure to a portion of the U.S. or a foreign market while awaiting
purchase of underlying securities. The risks of owning an ETF generally reflect
the risks of owning the underlying securities they are designed to track,
although lack of liquidity in an ETF could result in it being more volatile and
ETFs have management fees that increase their costs.
FIXED AND FLOATING RATE DEBT OBLIGATIONS
The debt obligations in which the Bond Funds invest as either a
principal or non-principal investment strategy may have either fixed or floating
rates. Floating rate securities are generally offered at an initial interest
rate which is at or above prevailing market rates. The interest rate paid on
these securities is then reset periodically (commonly every 90 days) to an
increment over some predetermined interest rate index. Commonly utilized indices
include the three-month Treasury bill rate, the 180-day Treasury bill rate, the
one-month or three-month London Interbank Offered Rate (LIBOR), the prime rate
of a bank, the commercial paper rates, or the longer-term rates on U.S. Treasury
securities. Fixed rate securities tend to exhibit more price volatility during
times of rising or falling interest rates than securities with floating rates of
interest. This is because floating rate securities behave like short-term
instruments in that the rate of interest they pay is subject to periodic
adjustments based on a designated interest rate index. Fixed rate securities pay
a fixed rate of interest and are more sensitive to fluctuating interest rates.
In periods of rising interest rates the value of a fixed rate security is likely
to fall. Fixed rate securities with short-term characteristics are not subject
to the same price volatility as fixed rate securities without such
characteristics. Therefore, they behave more like floating rate securities with
respect to price volatility.
FOREIGN CURRENCY TRANSACTIONS
Core Bond Fund, Inflation Protected Securities Fund, Short Term Bond
Fund and Total Return Bond Fund may invest in securities which are purchased and
sold in foreign currencies. The value of the Funds' assets as measured in U.S.
dollars therefore may be affected favorably or unfavorably by changes in foreign
currency exchange rates and exchange control regulations. The Funds also will
incur costs in converting U.S. dollars to local currencies, and vice versa. The
Funds therefore may enter into foreign currency transactions as a principal
investment strategy.
The Funds will conduct their foreign currency transactions either on a
spot (i.e., cash) basis at the spot rate prevailing in the foreign currency
exchange market, or through forward foreign currency exchange contracts
("forward currency contracts") to purchase or sell foreign currencies at a
future date.
The Funds may enter into forward currency contracts in order to hedge
against adverse movements in exchange rates between currencies. The Funds may
engage in "transaction hedging" to protect against a change in the foreign
currency exchange rate between the date a Fund contracts to purchase or sell a
security and the settlement date,
5
or to "lock in" the U.S. dollar equivalent of a dividend or interest
payment made in a foreign currency. They also may engage in "portfolio hedging"
to protect against a decline in the value of their portfolio securities as
measured in U.S. dollars which could result from changes in exchange rates
between the U.S. dollar and the foreign currencies in which the
portfolio securities are purchased and sold. The Funds also may hedge foreign
currency exchange rate risk by engaging in foreign currency futures and options
transactions.
Although a foreign currency hedge may be effective in protecting a
Fund from losses resulting from unfavorable changes in exchanges rates between
the U.S. dollar and foreign currencies, it also would limit the gains
which might be realized by the Fund from favorable changes in exchange rates.
The Advisor's decision whether to enter into currency hedging transactions will
depend in part on its view regarding the direction and amount in which exchange
rates are likely to move. The forecasting of movements in exchange rates is
extremely difficult, so that it is highly uncertain whether a hedging strategy,
if undertaken, would be successful. To the extent that the advisor's view
regarding future exchange rates proves to have been incorrect, a Fund may
realize losses on its foreign currency transactions.
Forward Currency Contracts. A forward currency contract involves an
obligation to purchase or sell a specific currency at a future date, which may
be any fixed number of days from the date of the contract agreed upon by the
parties, at a price set at the time of the contract. These contracts are traded
directly between currency traders (usually large commercial banks) and their
customers. A Fund will not enter into such forward contracts or maintain a net
exposure in such contracts where it would be obligated to deliver an amount of
foreign currency in excess of the value of its securities or other assets
denominated in that currency. Each Fund will comply with applicable Securities
and Exchange Commission ("SEC") positions requiring it to segregate assets to
cover its commitments with respect to such contracts. The Funds generally will
not enter into a forward currency contract with a term longer than one year.
Foreign Currency Futures Transactions. Unlike forward foreign currency
exchange contracts, foreign currency futures contracts and options on foreign
currency futures contracts are standardized as to amount and delivery period and
may be traded on boards of trade and commodities exchanges or directly with a
dealer which makes a market in such contracts and options. It is anticipated
that such contracts may provide greater liquidity and lower cost than forward
foreign currency exchange contracts. As part of their financial futures
transactions, the Funds may use foreign currency futures contracts and options
on such futures contracts. Through the purchase or sale of such contracts, the
Funds may be able to achieve many of the same objectives as through investing in
forward foreign currency exchange contracts.
Foreign Currency Options. A foreign currency option provides the
option buyer with the right to buy or sell a stated amount of foreign currency
at the exercise price at a specified date or during the option period. A call
option gives its owner the right, but not the obligation, to buy the currency,
while a put option gives its owner the right, but not the obligation, to sell
the currency. The option seller (writer) is obligated to fulfill the terms of
the option sold if it is exercised. However, either seller or buyer may close
its position during the option period in the secondary market for such options
at any time prior to expiration.
A foreign currency call option rises in value if the underlying
currency appreciates. Conversely, a foreign currency put option rises in value
if the underlying currency depreciates. While purchasing a foreign currency
option may protect a Fund against an adverse movement in the value of a foreign
currency, it would limit the gain which might result from a favorable movement
in the value of the currency. For example, if the Fund were holding securities
denominated in an appreciating foreign currency and had purchased a foreign
currency put to hedge against a decline in the value of the currency, it would
not have to exercise its put. In such an event, however, the amount of the
Fund's gain would be offset in part by the premium paid for the option.
Similarly, if the Fund entered into a contract to purchase a security
denominated in a foreign currency and purchased a foreign currency call to hedge
against a rise in the value of the currency between the date of purchase and the
settlement date, the Fund would not need to exercise its call if the currency
instead depreciated in value. In such a case, the Fund could acquire the amount
of foreign currency needed for settlement in the spot market at a lower price
than the exercise price of the option.
FOREIGN SECURITIES
General. Core Bond Fund, High Income Bond Fund, Inflation Protected
Securities Fund, Intermediate Term Bond Fund, Short Term Bond Fund, and Total
Return Bond Fund may invest in foreign securities as a principal investment
strategy.
6
Core Bond Fund, High Income Bond Fund, Intermediate Term Bond Fund,
and Short Term Bond Fund may invest up to 25% of total assets, and Inflation
Protected Securities Fund and Total Return Bond Fund each may invest without
limitation, in foreign securities payable in U.S. dollars. These securities may
include securities issued or guaranteed by (i) the Government of Canada, any
Canadian Province or any instrumentality and political subdivision thereof; (ii)
any other foreign government agency or instrumentality; (iii) foreign
subsidiaries of U.S. corporations and (iv) foreign issuers having total capital
and surplus at the time of investment of at least $1 billion. In addition, up to
20% of the net assets of Inflation Protected Securities Fund, 20% of the total
assets of Total Return Bond Fund, and 10% of the total assets of Core Bond Fund
and Short Term Bond Fund may be invested in non-dollar denominated foreign
securities.
Investment in foreign securities is subject to special investment
risks that differ in some respects from those related to investments in
securities of U.S. domestic issuers. These risks include political, social or
economic instability in the country of the issuer, the difficulty of predicting
international trade patterns, the possibility of the imposition of exchange
controls, expropriation, limits on removal of currency or other assets,
nationalization of assets, foreign withholding and income taxation, and foreign
trading practices (including higher trading commissions, custodial charges and
delayed settlements). Foreign securities also may be subject to greater
fluctuations in price than securities issued by U.S. corporations. The principal
markets on which these securities trade may have less volume and liquidity, and
may be more volatile, than securities markets in the United States.
In addition, there may be less publicly available information about a
foreign company than about a U.S. domiciled company. Foreign companies generally
are not subject to uniform accounting, auditing and financial reporting
standards comparable to those applicable to U.S. domestic companies. There is
also generally less government regulation of securities exchanges, brokers and
listed companies abroad than in the United States. Confiscatory taxation or
diplomatic developments could also affect investment in those countries. In
addition, foreign branches of United States banks, foreign banks and foreign
issuers may be subject to less stringent reserve requirements and to different
accounting, auditing, reporting, and record keeping standards than those
applicable to domestic branches of United States banks and U.S. domestic
issuers.
Emerging Markets. Core Bond Fund, High Income Bond Fund, Short Term
Bond Fund, and Total Return Bond Fund may invest in securities issued by the
governmental and corporate issuers that are located in emerging market countries
as a principal investment strategy. Inflation Protected Securities Fund and
Intermediate Term Bond Fund may invest in such securities as a non-principal
investment strategy. Investments in securities of issuers in emerging market
countries may be subject to potentially higher risks than investments in
developed countries. These risks include (i) less social, political and economic
stability; (ii) the small current size of the markets for such securities and
the currently low or nonexistent volume of trading, which may result in a lack
of liquidity and in greater price volatility; (iii) certain national policies
which may restrict the Fund's investment opportunities, including restrictions
on investment in issuers or industries deemed sensitive to national interests;
(iv) foreign taxation; (v) the absence of developed structures governing private
or foreign investment or allowing for judicial redress for injury to private
property; (vi) the limited development and recent emergence, in certain
countries, of a capital market structure or market-oriented economy; and (vii)
the possibility that recent favorable economic developments in certain countries
may be slowed or reversed by unanticipated political or social events in such
countries.
Despite the dissolution of the Soviet Union, the Communist Party may
continue to exercise a significant role in certain (particularly Eastern
European) countries. To the extent of the Communist Party's influence,
investments in such countries will involve risks of nationalization,
expropriation and confiscatory taxation. The communist governments of a number
of such countries expropriated large amounts of private property in the past, in
many cases without adequate compensation, and there can be no assurance that
such expropriation will not occur in the future. In the event of such
expropriation, the Fund could lose a substantial portion of any investments it
has made in the affected countries. Further, no accounting standards exist in
many developing countries. Finally, even though certain currencies may be
convertible into U.S. dollars, the conversion rates may be artificial to the
actual market values and may be adverse to Fund shareholders.
Certain countries, which do not have market economies, are
characterized by an absence of developed legal structures governing private and
foreign investments and private property. Certain countries require governmental
approval prior to investments by foreign persons, or limit the amount of
investment by foreign persons in a particular company, or limit the investment
of foreign persons to only a specific class of securities of a company that may
have less advantageous terms than securities of the company available for
purchase by nationals.
7
Authoritarian governments in certain countries may require that a
governmental or quasi-governmental authority act as custodian of the Fund's
assets invested in such country. To the extent such governmental or
quasi-governmental authorities do not satisfy the requirements of the 1940 Act
to act as foreign custodians of the Fund's cash and securities, the Fund's
investment in such countries may be limited or may be required to be effected
through intermediaries. The risk of loss through governmental confiscation may
be increased in such countries.
Depositary Receipts. The Funds' investments in foreign securities may
include investment in depositary receipts, including American Depositary
Receipts (ADRs) and European Depositary Receipts (EDRs). U.S. dollar-denominated
ADRs, which are traded in the United States on exchanges or over-the-counter,
are issued by domestic banks. ADRs represent the right to receive securities of
foreign issuers deposited in a domestic bank or a correspondent bank. ADRs do
not eliminate all the risk inherent in investing in the securities of foreign
issuers. However, by investing in ADRs rather than directly in foreign issuers'
stock, a Fund can avoid currency risks during the settlement period for either
purchases or sales. In general, there is a large, liquid market in the United
States for many ADRs. The information available for ADRs is subject to the
accounting, auditing and financial reporting standards of the domestic market or
exchange on which they are traded, which standards are more uniform and more
exacting than those to which many foreign issuers may be subject. The Funds may
also invest in EDRs and in other similar instruments representing securities of
foreign companies. EDRs are securities that are typically issued by foreign
banks or foreign trust companies, although U.S. banks or U.S. trust companies
may issue them. EDRs are structured similarly to the arrangements of ADRs. EDRs,
in bearer form, are designed for use in European securities markets and are not
necessarily denominated in the currency of the underlying security.
Certain depositary receipts, typically those denominated as
unsponsored, require the holders thereof to bear most of the costs of the
facilities while issuers of sponsored facilities normally pay more of the costs
thereof. The depository of an unsponsored facility frequently is under no
obligation to distribute shareholder communications received from the issuer of
the deposited securities or to pass through the voting rights to facility
holders in respect to the deposited securities, whereas the depository of a
sponsored facility typically distributes shareholder communications and passes
through voting rights.
FUTURES AND OPTIONS ON FUTURES
The Funds other than Intermediate Government Bond Fund may engage in
futures transactions and options on futures as a principal investment strategy,
including stock and interest rate index futures contracts and options thereon
and, with respect to Inflation Protected Securities Fund only, commodity and
commodity index futures contracts and options thereon. Certain Funds may also
enter into foreign currency futures transactions, which are discussed in more
detail above under "--Foreign Currency Transactions."
A futures contract is an agreement between two parties to buy and sell
a security or commodity for a set price on a future date. These contracts are
traded on exchanges, so that, in most cases, either party can close out its
position on the exchange for cash, without delivering the security or commodity.
An option on a futures contract gives the holder of the option the right to buy
or sell a position in a futures contract to the writer of the option, at a
specified price and on or before a specified expiration date.
An interest rate, commodity, foreign currency or index futures
contract provides for the future sale by one party and purchase by another party
of a specified quantity of a financial instrument, commodity, foreign currency
or the cash value of an index at a specified price and time. A futures contract
on an index is an agreement pursuant to which two parties agree to take or make
delivery of an amount of cash equal to the difference between the value of the
index at the close of the last trading day of the contract and the price at
which the index contract was originally written. Although the value of an index
might be a function of the value of certain specified securities, no physical
delivery of these securities is made. Inflation Protected Securities Fund may
also invest in commodity futures contracts and options thereon. A commodity
futures contract is an agreement between two parties, in which one party agrees
to buy a commodity, such as an energy, agricultural or metal commodity from the
other party at a later date at a price and quantity agreed upon when the
contract is made.
Futures options possess many of the same characteristics as options on
securities, currencies and indexes (discussed below under "--Options
Transactions"). A futures option gives the holder the right, in return for the
premium paid, to assume a long position (call) or short position (put) in a
futures contract at a specified exercise price at any time during the period of
the option. Upon exercise of a call option, the holder acquires a long position
in the futures contract and the writer is assigned the opposite short position.
In the case of a put option, the opposite is true.
The Funds intend generally to use futures contracts and futures
options to hedge against market risk. For example, a Bond Fund might use futures
contracts to hedge against anticipated changes in interest rates that might
8
adversely affect either the value of the Fund's securities or the price of the
securities that the Fund intends to purchase. The Fund's hedging activities may
include sales of futures contracts as an offset against the effect of expected
increases in interest rates, and purchases of futures contracts as an offset
against the effect of expected declines in interest rates. Although other
techniques could be used to reduce a Fund's exposure to interest rate
fluctuations, the Fund may be able to hedge its exposure more effectively and
perhaps at a lower cost by using futures contracts and futures options.
The Funds may enter into futures contracts and futures options which
are standardized and traded on a U.S. or foreign exchange, board of trade or
similar entity, or quoted on an automated quotation system. The Funds may also
enter into over-the-counter (OTC) transactions in such instruments. Transactions
in the OTC markets generally are conducted on a principal-to-principal basis.
The terms and conditions of these instruments generally are not standardized and
tend to be more specialized or complex, and the instruments may be harder to
value. In addition, there may not be a liquid market for OTC derivatives. As a
result, it may not be possible to initiate a transaction or liquidate a position
at an advantageous time or price.
When a purchase or sale of a futures contract is made by a Fund, the
Fund is required to deposit with its custodian (or broker, if legally permitted)
a specified amount of liquid assets ("initial margin"). The margin required for
a futures contract is set by the exchange on which the contract is traded and
may be modified during the term of the contract. Margin requirement on foreign
exchanges may be modified during the term of the contract. Margin requirements
on foreign exchanges may be different than U.S. exchanges. The initial margin is
in the nature of a performance bond or good faith deposit on the futures
contract which is returned to the Fund upon termination of the contract,
assuming all contractual obligations have been satisfied. The Fund expects to
earn interest income on its initial margin deposits. A futures contract held by
the Fund is valued daily at the official settlement price of the exchange on
which it is traded. Each day the Fund pays or receives cash, called "variation
margin," equal to the daily change in value of the futures contract. This
process is known as "marking to market." Variation margin does not represent a
borrowing or loan by the Fund but is instead a settlement between the Fund and
the broker of the amount one would owe the other if the futures contract
expired. In computing daily net asset value, the Fund will mark to market its
open futures positions.
The Fund is also required to deposit and maintain margin with respect
to put and call options on futures contracts written by it. Such margin deposits
will vary depending on the nature of the underlying futures contract (and the
related initial margin requirements), the current market value of the option,
and other futures positions held by the Fund.
Futures transactions also involve brokerage costs and the Fund may
have to segregate additional liquid assets in accordance with applicable SEC
requirements.
Although some futures contracts call for making or taking delivery of
the underlying currency, securities or commodities, generally these obligations
are closed out prior to delivery by offsetting purchases or sales of matching
futures contracts (same exchange, underlying currency, security or commodity,
and delivery month). Closing out a futures contract sale is effected by
purchasing a futures contract for the same aggregate amount of the specific type
of financial instrument or commodity with the same delivery date. If an
offsetting purchase price is less than the original sale price, the Fund
realizes a capital gain, or if it is more, the Fund realizes a capital loss.
Conversely, if an offsetting sale price is more than the original purchase
price, the Fund realizes a capital loss. The transaction costs must also be
included in these calculations.
The Funds may write covered straddles consisting of a call and a put
written on the same underlying futures contract. A straddle will be covered when
sufficient assets are deposited to meet the Fund's immediate obligations.
Limitations on Use of Futures and Futures Options. Aggregate initial
margin deposits for futures contracts, and premiums paid for related options,
may not exceed 5% of a Fund's total assets. Futures transactions will be limited
to the extent necessary to maintain a Fund's qualification as a regulated
investment company under the Internal Revenue Code of 1986, as amended (the
"Code").
Risks Associated with Futures and Futures Options. There are several
risks associated with the use of futures contracts and futures options as
hedging techniques. A purchase or sale of a futures contract may result in
losses in excess of the amount invested in the futures contract. There can be no
guarantee that there will be a correlation between price movements in the
hedging vehicle and in the Fund securities being hedged. In addition, there are
significant differences between the securities and futures markets that could
result in an imperfect correlation between the markets, causing a given hedge
not to achieve its objectives. The degree of imperfection of correlation depends
on circumstances
9
such as variations in speculative market demand for futures and futures options,
including technical influences in futures trading and futures options, and
differences between the financial instruments being hedged and the instruments
underlying the standard contracts available for trading in such respects as
interest rate levels, maturities, and creditworthiness of issuers. A decision as
to whether, when and how to hedge involves the exercise of skill and judgment,
and even a well-conceived hedge may be unsuccessful to some degree because of
market behavior or unexpected interest rate trends.
Futures exchanges may limit the amount of fluctuation permitted in
certain futures contract prices during a single trading day. The daily limit
establishes the maximum amount that the price of a futures contract may vary
either up or down from the previous day's settlement price at the end of the
current trading session. Once the daily limit has been reached in a futures
contract subject to the limit, no more trades may be made on that day at a price
beyond that limit. The daily limit governs only price movements during a
particular trading day and therefore does not limit potential losses because the
limit may work to prevent the liquidation of unfavorable positions. For example,
futures prices have occasionally moved to the daily limit for several
consecutive trading days with little or no trading, thereby preventing prompt
liquidation of positions and subjecting some holders of futures contracts to
substantial losses
There can be no assurance that a liquid market will exist at a time
when a Fund seeks to close out a futures or a futures option position, and the
Fund would remain obligated to meet margin requirements until the position is
closed. In addition, many of the contracts discussed above are relatively new
instruments without a significant trading history. As a result, there can be no
assurance that an active secondary market will develop or continue to exist.
Risks Associated with Commodity Futures Contracts. There are several
additional risks associated with transactions in commodity futures contracts.
Storage. Unlike the financial futures markets, in the commodity
futures markets there are costs of physical storage associated with purchasing
the underlying commodity. The price of the commodity futures contract will
reflect the storage costs of purchasing the physical commodity, including the
time value of money invested in the physical commodity. To the extent that the
storage costs for an underlying commodity change while the Fund is invested in
futures contracts on that commodity, the value of the futures contract may
change proportionately.
Reinvestment. In the commodity futures markets, producers of the
underlying commodity may decide to hedge the price risk of selling the commodity
by selling futures contracts today to lock in the price of the commodity at
delivery tomorrow. In order to induce speculators to purchase the other side of
the same futures contract, the commodity producer generally must sell the
futures contract at a lower price than the expected future spot price.
Conversely, if most hedgers in the futures market are purchasing futures
contracts to hedge against a rise in prices, then speculators will only sell the
other side of the futures contract at a higher futures price than the expected
future spot price of the commodity. The changing nature of the hedgers and
speculators in the commodity markets will influence whether futures prices are
above or below the expected future spot price, which can have significant
implications for Inflation Protected Securities Fund. If the nature of hedgers
and speculators in futures markets has shifted when it is time for the Fund to
reinvest the proceeds of a maturing contract in a new futures contract, the Fund
might reinvest at higher or lower futures prices, or choose to pursue other
investments.
Other Economic Factors. The commodities which underlie commodity
futures contracts may be subject to additional economic and non-economic
variables, such as drought, floods, weather, livestock disease, embargoes,
tariffs, and international economic, political and regulatory developments.
These factors may have a larger impact on commodity prices and commodity-linked
instruments, including futures contracts, than on traditional securities.
Certain commodities are also subject to limited pricing flexibility because of
supply and demand factors. Others are subject to broad price fluctuations as a
result of the volatility of the prices for certain raw materials and the
instability of supplies of other materials. These additional variables may
create additional investment risks which subject Inflation Protected Securities
Fund's investments to greater volatility than investments in traditional
securities.
CFTC Information. The Commodity Futures Trading Commission (the
"CFTC"), a federal agency, regulates trading activity pursuant to the Commodity
Exchange Act, as amended (the "CEA"). The CFTC requires the registration of a
Commodity Pool Operator (a "CPO"), which is defined as any person engaged in a
business which is of the nature of an investment trust, syndicate or a similar
form of enterprise, and who, in connection therewith, solicits, accepts or
receives from others funds, securities or property for the purpose of trading in
a commodity for future delivery on or subject to the rules of any contract
market. The CFTC has adopted Rule 4.5, which provides an exclusion from the
definition of commodity pool operator for any registered investment company
which files a notice of eligibility. The
10
Funds have filed a notice of eligibility claiming exclusion from the status of
CPO and, therefore, are not subject to registration or regulation as a CPO under
the CEA.
GUARANTEED INVESTMENT CONTRACTS
Short Term Bond Fund may purchase investment-type insurance products
such as Guaranteed Investment Contracts ("GICs") as a non-principal investment
strategy. A GIC is a deferred annuity under which the purchaser agrees to pay
money to an insurer (either in a lump sum or in installments) and the insurer
promises to pay interest at a guaranteed rate for the life of the contract. GICs
may have fixed or variable interest rates. A GIC is a general obligation of the
issuing insurance company. The purchase price paid for a GIC becomes part of the
general assets of the insurer, and the contract is paid at maturity from the
general assets of the insurer. In general, GICs are not assignable or
transferable without the permission of the issuing insurance companies and can
be redeemed before maturity only at a substantial discount or penalty. GICs,
therefore, are usually considered to be illiquid investments. Short Term Bond
Fund will purchase only GICs which are obligations of insurance companies with a
policyholder's rating of A or better by A.M. Best Company.
INFLATION PROTECTED SECURITIES
Inflation Protected Securities Fund invests in inflation protected
securities as a principal investment strategy. The other Funds may invest in
such securities as a non-principal investment strategy. Inflation protected
securities are fixed income securities designed to provide protection against
the negative effects of inflation. Two structures are common. The U.S. Treasury
and some other issuers use a structure that accrues inflation into the principal
value of the bond. Most other issuers pay out the inflation accruals as part of
a semiannual coupon.
Inflation protected securities issued by the U.S. Treasury have
maturities of five, ten, twenty or thirty years, although it is possible that
securities with other maturities will be issued in the future. The U.S. Treasury
securities pay interest on a semi-annual basis, equal to a fixed percentage of
the inflation-adjusted principal amount. For example, if the Fund purchased an
inflation protected bond with a par value of $1,000 and a 3% real rate of return
coupon (payable 1.5% semi-annually), and inflation over the first six months
were 1%, the mid-year par value of the bond would be $1,010 and the first
semi-annual interest payment would be $15.15 ($1,010 times 1.5%). If inflation
during the second half of the year resulted in the whole years' inflation
equaling 3%, the end-of-year par value of the bond would be $1,030 and the
second semi-annual interest payment would be $15.45 ($1,030 times 1.5%).
If the periodic adjustment rate measuring inflation falls, the
principal value of U.S. Treasury inflation protected securities will be adjusted
downward, and consequently the interest payable on these securities (calculated
with respect to a smaller principal amount) will be reduced. Repayment of the
original bond principal upon maturity (as adjusted for inflation) is guaranteed
in the case of U.S. Treasury inflation protected bonds, even during a period of
deflation. However, the current market value of the bonds is not guaranteed, and
will fluctuate. Other inflation-protected securities that accrue inflation into
their principal value may or may not provide a similar guarantee. If a guarantee
of principal is not provided, the adjusted principal value of the bond repaid at
maturity may be less than the original principal.
The value of inflation-protected securities is expected to change in
response to changes in real interest rates. Real interest rates in turn are tied
to the relationship between nominal interest rates and the rate of inflation.
Therefore, if inflation were to rise at a faster rate than nominal interest
rates, real interest rates might decline, leading to an increase in value of
inflation protected securities. In contrast, if nominal interest rates increased
at a faster rate than inflation, real interest rates might rise, leading to a
decrease in value of inflation-protected securities.
The periodic adjustment of U.S. inflation protected bonds is tied to
the Consumer Price Index for Urban Consumers ("CPI-U"), which is calculated
monthly by the U.S. Bureau of Labor Statistics. The CPI-U is a measurement of
changes in the cost of living, made up of components such as housing, food,
transportation and energy. Inflation protected securities issued by a foreign
government are generally adjusted to reflect a comparable inflation index,
calculated by that government. There can be no assurance that the CPI-U or any
foreign inflation index will accurately measure the real rate of inflation in
the prices of goods and services. Moreover, there can be no assurance that the
rate of inflation in a foreign country will be correlated to the rate of
inflation in the United States. If the market perceives that the adjustment
mechanism of an inflation-protected security does not accurately adjust for
inflation, the value of the security could be adversely affected.
11
While inflation protected securities are expected to be protected from
long-term inflationary trends, short-term increases in inflation may lead to a
decline in value. The calculation of the inflation index ratio for inflation
protected securities issued by the U.S. Treasury incorporates an approximate
three-month lag, which may have an effect on the trading price of the
securities, particularly during periods of significant, rapid changes in the
inflation index. To the extent that inflation has increased during the three
months prior to an interest payment, that interest payment will not be protected
from the inflation increase. Further, to the extent that inflation has increased
during the final three months of a security's maturity, the final value of the
security will not be protected against that increase, which will negatively
impact the value of the security. If interest rates rise due to reasons other
than inflation (for example, due to changes in currency exchange rates),
investors in inflation-protected securities may not be protected to the extent
that the increase is not reflected in the bond's inflation measure.
Any increase in the principal amount of an inflation-protected
security will be considered taxable income to the Fund, even though the Fund
does not receive its principal until maturity.
INTEREST RATE CAPS AND FLOORS
As a principal investment strategy, the Bond Funds other than
Intermediate Government Bond Fund may purchase or sell interest rate caps and
floors to preserve a return or a spread on a particular investment or portion of
its portfolio or for other non-speculative purposes. The Tax Free Funds may do
so as a non-principal investment strategy. The purchase of an interest rate cap
entitles the purchaser, to the extent a specified index exceeds a predetermined
interest rate, to receive payments of interest on a contractually based
principal amount from the party selling such interest rate cap. The purchase of
an interest rate floor entitles the purchaser, to the extent a specified index
falls below a predetermined interest rate, to receive payments of interest on a
contractually based principal amount from the party selling such interest rate
floor.
INVERSE FLOATING RATE MUNICIPAL OBLIGATIONS
Each of the Tax Free Funds, as a principal investment strategy, may
invest up to 10% of its total assets in inverse floating rate municipal
obligations. An inverse floating rate obligation entitles the holder to receive
interest at a rate which changes in the opposite direction from, and in the same
magnitude as or in a multiple of, changes in a specified index rate. Although an
inverse floating rate municipal obligation would tend to increase portfolio
income during a period of generally decreasing market interest rates, its value
would tend to decline during a period of generally increasing market interest
rates. In addition, its decline in value may be greater than for a fixed-rate
municipal obligation, particularly if the interest rate borne by the floating
rate municipal obligation is adjusted by a multiple of changes in the specified
index rate. For these reasons, inverse floating rate municipal obligations have
more risk than more conventional fixed-rate and floating rate municipal
obligations.
LENDING OF PORTFOLIO SECURITIES
In order to generate additional income, as a principal investment
strategy, each of the Bond Funds other than Intermediate Government Bond Fund
may lend portfolio securities representing up to one-third of the value of its
total assets to broker-dealers, banks or other institutional borrowers of
securities. As with other extensions of credit, there may be risks of delay in
recovery of the securities or even loss of rights in the collateral should the
borrower of the securities fail financially. However, the Funds will only enter
into domestic loan arrangements with broker-dealers, banks, or other
institutions which the Advisor has determined are creditworthy under guidelines
established by the Board of Directors. The Funds will pay a portion of the
income earned on the lending transaction to the placing broker and may pay
administrative and custodial fees in connection with these loans.
In these loan arrangements, the Funds will receive collateral in the
form of cash, United States government securities or other high-grade debt
obligations equal to at least 100% of the value of the securities loaned. This
collateral must be valued daily by the Advisor or the applicable Fund's lending
agent and, if the market value of the loaned securities increases, the borrower
must furnish additional collateral to the lending Fund. During the time
portfolio securities are on loan, the borrower pays the lending Fund any
dividends or interest paid on the securities. Loans are subject to termination
at any time by the lending Fund or the borrower. While a Fund does not have the
right to vote securities on loan, it would terminate the loan and regain the
right to vote if that were considered important with respect to the investment.
12
When a Fund lends portfolio securities to a borrower, payments in lieu
of dividends made by the borrower to the Fund will not constitute "qualified
dividends" taxable at the same rate as long-term capital gains, even if the
actual dividends would have constituted qualified dividends had the Fund held
the securities. See "Taxation."
U.S. Bank, N.A. acts as securities lending agent for the Funds and
receives separate compensation for such services, subject to compliance with
conditions contained in an SEC exemptive order permitting U.S. Bank to provide
such services and receive such compensation. U.S. Bank receives fees up to 25%
of each fund's net income from securities lending transactions. For each Fund,
collateral for securities on loan will be invested in a money market fund
administered by FAF Advisors and FAF Advisors will receive an administration fee
equal to 0.02% of such fund's average daily net assets.
MORTGAGE-BACKED SECURITIES
The Bond Funds other than High Income Bond Fund and Intermediate
Government Bond Fund may invest in mortgage-backed securities as a principal
investment strategy. High Income Bond Fund may invest in such securities as a
non-principal investment strategy. These investments include Agency Pass-Through
Certificates, private mortgage pass-through securities, collateralized mortgage
obligations, and commercial mortgage-backed securities, as defined and described
below.
Agency Pass-Through Certificates. Agency Pass-Through Certificates are
mortgage pass-through certificates representing undivided interests in pools of
residential mortgage loans. Distribution of principal and interest on the
mortgage loans underlying an Agency Pass-Through Certificate is an obligation of
or guaranteed by the Government National Mortgage Association (GNMA, or Ginnie
Mae), the Federal National Mortgage Association (FNMA, or Fannie Mae) or the
Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac). GNMA is a wholly
owned corporate instrumentality of the United States within the Department of
Housing and Urban Development. The guarantee of GNMA with respect to GNMA
certificates is backed by the full faith and credit of the United States, and
GNMA is authorized to borrow from the United States Treasury in an amount which
is at any time sufficient to enable GNMA, with no limitation as to amount, to
perform its guarantee.
FNMA is a federally chartered and privately owned corporation
organized and existing under federal law. Although the Secretary of the Treasury
of the United States has discretionary authority to lend funds to FNMA, neither
the United States nor any agency thereof is obligated to finance FNMA's
operations or to assist FNMA in any other manner.
FHLMC is a federally chartered corporation organized and existing
under federal law, the common stock of which is owned by the Federal Home Loan
Banks. Neither the United States nor any agency thereof is obligated to finance
FHLMC's operations or to assist FHLMC in any other manner.
The mortgage loans underlying GNMA certificates are partially or fully
guaranteed by the Federal Housing Administration or the Veterans Administration,
while the mortgage loans underlying FNMA certificates and FHLMC certificates are
conventional mortgage loans which are, in some cases, insured by private
mortgage insurance companies. Agency Pass-Through Certificates may be issued in
a single class with respect to a given pool of mortgage loans or in multiple
classes.
The residential mortgage loans evidenced by Agency Pass-Through
Certificates and upon which CMOs (as described further below) are based
generally are secured by first mortgages on one- to four-family residential
dwellings. Such mortgage loans generally have final maturities ranging from 15
to 40 years and generally provide for monthly payments in amounts sufficient to
amortize their original principal amounts by the maturity dates. Each monthly
payment on such mortgage loans generally includes both an interest component and
a principal component, so that the holder of the mortgage loans receives both
interest and a partial return of principal in each monthly payment. In general,
such mortgage loans can be prepaid by the borrowers at any time without any
prepayment penalty. In addition, many such mortgage loans contain a
"due-on-sale" clause requiring the loans to be repaid in full upon the sale of
the property securing the loans. Because residential mortgage loans generally
provide for monthly amortization and may be prepaid in full at any time, the
weighted average maturity of a pool of residential mortgage loans is likely to
be substantially shorter than its stated final maturity date. The rate at which
a pool of residential mortgage loans is prepaid may be influenced by many
factors and is not predictable with precision.
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Private mortgage pass-through securities ("Private Pass-Throughs").
Private Pass-Throughs are structured similarly to GNMA, FNMA and FHLMC mortgage
pass-through securities and are issued by originators of and investors in
mortgage loans, including savings and loan associations, mortgage bankers,
commercial banks, investment banks and special purpose subsidiaries of the
foregoing. These securities usually are backed by a pool of fixed or adjustable
rate loans. Since Private Pass-Throughs typically are not guaranteed by an
entity having the credit status of GNMA, FNMA or FHLMC, such securities
generally are structured with one or more types of credit enhancement. Such
credit support falls into two categories: (i) liquidity protection and (ii)
protection against losses resulting from ultimate default by an obligor on the
underlying assets. Liquidity protection refers to the provisions of advances,
generally by the entity administering the pool of assets, to ensure that the
pass-through of payments due on the underlying pool occurs in a timely fashion.
Protection against losses resulting from ultimate default enhances the
likelihood of ultimate payment of the obligations on at least a portion of the
assets in the pool. Such protection may be provided through guarantees,
insurance policies or letters of credit obtained by the issuer or sponsor from
third parties, through various means of structuring the transaction or through a
combination of such approaches. The Funds will not pay any additional fees for
such credit support, although the existence of credit support may increase the
price of a security.
The ratings of securities for which third-party credit enhancement
provides liquidity protection or protection against losses from default are
generally dependent upon the continued creditworthiness of the enhancement
provider. The ratings of such securities could be subject to reduction in the
event of deterioration in the creditworthiness of the credit enhancement
provider even in cases where the delinquency and loss experience on the
underlying pool of assets is better than expected.
Collateralized Mortgage Obligations ("CMOs"). CMOs are debt
obligations typically issued by a private special-purpose entity and
collateralized by residential or commercial mortgage loans or Agency
Pass-Through Certificates. A Fund will invest only in CMOs that are rated within
the rating categories in which the Fund is otherwise allowed to invest or which
are of comparable quality in the judgment of the Advisor. Because CMOs are debt
obligations of private entities, payments on CMOs generally are not obligations
of or guaranteed by any governmental entity, and their ratings and
creditworthiness typically depend, among other factors, on the legal insulation
of the issuer and transaction from the consequences of a sponsoring entity's
bankruptcy.
CMOs generally are issued in multiple classes, with holders of each
class entitled to receive specified portions of the principal payments and
prepayments and/or of the interest payments on the underlying mortgage loans.
These entitlements can be specified in a wide variety of ways, so that the
payment characteristics of various classes may differ greatly from one another.
For instance, holders may hold interests in CMO tranches called Z-tranches which
defer interest and principal payments until one or other classes of the CMO have
been paid in full. In addition, for example:
- In a sequential-pay CMO structure, one class is entitled to
receive all principal payments and prepayments on the underlying
mortgage loans (and interest on unpaid principal) until the
principal of the class is repaid in full, while the remaining
classes receive only interest; when the first class is repaid in
full, a second class becomes entitled to receive all principal
payments and prepayments on the underlying mortgage loans until
the class is repaid in full, and so forth.
- A planned amortization class ("PAC") of CMOs is entitled to
receive principal on a stated schedule to the extent that it is
available from the underlying mortgage loans, thus providing a
greater (but not absolute) degree of certainty as to the schedule
upon which principal will be repaid.
- An accrual class of CMOs provides for interest to accrue and be
added to principal (but not be paid currently) until specified
payments have been made on prior classes, at which time the
principal of the accrual class (including the accrued interest
which was added to principal) and interest thereon begins to be
paid from payments on the underlying mortgage loans.
- An interest-only class of CMOs entitles the holder to receive all
of the interest and none of the principal on the underlying
mortgage loans, while a principal-only class of CMOs entitles the
holder to receive all of the principal payments and prepayments
and none of the interest on the underlying mortgage loans.
- A floating rate class of CMOs entitles the holder to receive
interest at a rate which changes in the same direction and
magnitude as changes in a specified index rate. An inverse
floating rate class of CMOs entitles the holder to receive
interest at a rate which changes in the opposite direction from,
and in the
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same magnitude as or in a multiple of, changes in a specified
index rate. Floating rate and inverse floating rate classes also
may be subject to "caps" and "floors" on adjustments to the
interest rates which they bear.
- A subordinated class of CMOs is subordinated in right of payment
to one or more other classes. Such a subordinated class provides
some or all of the credit support for the classes that are senior
to it by absorbing losses on the underlying mortgage loans before
the senior classes absorb any losses. A subordinated class which
is subordinated to one or more classes but senior to one or more
other classes is sometimes referred to as a "mezzanine" class. A
subordinated class generally carries a lower rating than the
classes that are senior to it, but may still carry an investment
grade rating.
It generally is more difficult to predict the effect of changes in
market interest rates on the return on mortgage-backed securities than to
predict the effect of such changes on the return of a conventional fixed-rate
debt instrument, and the magnitude of such effects may be greater in some cases.
The return on interest-only and principal-only mortgage-backed securities is
particularly sensitive to changes in interest rates and prepayment speeds. When
interest rates decline and prepayment speeds increase, the holder of an
interest-only mortgage-backed security may not even recover its initial
investment. Similarly, the return on an inverse floating rate CMO is likely to
decline more sharply in periods of increasing interest rates than that of a
fixed-rate security. For these reasons, interest-only, principal-only and
inverse floating rate mortgage-backed securities generally have greater risk
than more conventional classes of mortgage-backed securities. None of the Bond
Funds will invest more than 10% of its total assets in interest-only,
principal-only, inverse interest only or inverse floating rate mortgage-backed
securities.
Commercial Mortgage-Backed Securities. Commercial mortgage-backed
securities include securities that reflect an interest in, and are secured by,
mortgage loans on commercial property, such as hotels, office buildings, retail
stores, hospitals, and other commercial buildings. These securities may have a
lower prepayment uncertainty than other mortgage-backed securities because
commercial mortgage loans generally prohibit or impose penalties on prepayments
of principal. In addition, commercial mortgage-backed securities often are
structured with some form of credit enhancement to protect against potential
losses on the underlying mortgage loans. Many of the risks of investing in
commercial mortgage-backed securities reflect the risks of investing in the real
estate securing the underlying mortgage loans. These risks reflect the effects
of local and other economic conditions on real estate markets, the ability of
tenants to make loan payments, and the ability of a property to attract and
retain tenants. Commercial mortgage-backed securities may be less liquid and may
exhibit greater price volatility than other types of mortgage-backed securities.
Adjustable Rate Mortgage Securities ("ARMS"). The Bond Funds, other
than Intermediate Government Bond Fund, may invest in ARMS as a non-principal
investment strategy. ARMS are pass-through mortgage securities collateralized by
mortgages with interest rates that are adjusted from time to time. ARMS also
include adjustable rate tranches of CMOs. The adjustments usually are determined
in accordance with a predetermined interest rate index and may be subject to
certain limits. While the values of ARMS, like other debt securities, generally
vary inversely with changes in market interest rates (increasing in value during
periods of declining interest rates and decreasing in value during periods of
increasing interest rates), the values of ARMS should generally be more
resistant to price swings than other debt securities because the interest rates
of ARMS move with market interest rates. The adjustable rate feature of ARMS
will not, however, eliminate fluctuations in the prices of ARMS, particularly
during periods of extreme fluctuations in interest rates.
ARMS typically have caps which limit the maximum amount by which the
interest rate may be increased or decreased at periodic intervals or over the
life of the loan. To the extent interest rates increase in excess of the caps,
ARMS can be expected to behave more like traditional debt securities and to
decline in value to a greater extent than would be the case in the absence of
such caps. Also, since many adjustable rate mortgages only reset on an annual
basis, it can be expected that the prices of ARMS will fluctuate to the extent
changes in prevailing interest rates are not immediately reflected in the
interest rates payable on the underlying adjustable rate mortgages. The extent
to which the prices of ARMS fluctuate with changes in interest rates will also
be affected by the indices underlying the ARMS.
MUNICIPAL BONDS AND OTHER MUNICIPAL OBLIGATIONS
The Tax Free Funds invest principally in municipal bonds and other
municipal obligations. These bonds and other obligations are issued by the
states and by their local and special-purpose political subdivisions. The term
"municipal bond" includes short-term municipal notes issued by the states and
their political subdivisions.
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Municipal Bonds. The two general classifications of municipal bonds
are "general obligation" bonds and "revenue" bonds. General obligation bonds are
secured by the governmental issuer's pledge of its faith, credit and taxing
power for the payment of principal and interest upon a default by the issuer of
its principal and interest payment obligations. They are usually paid from
general revenues of the issuing governmental entity. Revenue bonds, on the other
hand, are usually payable only out of a specific revenue source rather than from
general revenues. Revenue bonds ordinarily are not backed by the faith, credit
or general taxing power of the issuing governmental entity. The principal and
interest on revenue bonds for private facilities are typically paid out of rents
or other specified payments made to the issuing governmental entity by a private
company which uses or operates the facilities. Examples of these types of
obligations are industrial revenue bond and pollution control revenue bonds.
Industrial revenue bonds are issued by governmental entities to provide
financing aid to community facilities such as hospitals, hotels, business or
residential complexes, convention halls and sport complexes. Pollution control
revenue bonds are issued to finance air, water and solids pollution control
systems for privately operated industrial or commercial facilities.
Revenue bonds for private facilities usually do not represent a pledge
of the credit, general revenues or taxing powers of issuing governmental entity.
Instead, the private company operating the facility is the sole source of
payment of the obligation. Sometimes, the funds for payment of revenue bonds
come solely from revenue generated by operation of the facility. Revenue bonds
which are not backed by the credit of the issuing governmental entity frequently
provide a higher rate of return than other municipal obligations, but they
entail greater risk than obligations which are guaranteed by a governmental unit
with taxing power. Federal income tax laws place substantial limitations on
industrial revenue bonds, and particularly certain specified private activity
bonds issued after August 7, 1986. In the future, legislation could be
introduced in Congress which could further restrict or eliminate the income tax
exemption for interest on debt obligations in which the Funds may invest.
Refunded Bonds. The Tax Free Funds may invest in refunded bonds.
Refunded bonds may have originally been issued as general obligation or revenue
bonds, but become refunded when they are secured by an escrow fund, usually
consisting entirely of direct U.S. government obligations and/or U.S. government
agency obligations sufficient for paying the bondholders. There are two types of
refunded bonds: pre-refunded bonds and escrowed-to-maturity ("ETM") bonds. The
escrow fund for a pre-refunded municipal bond may be structured so that the
refunded bonds are to be called at the first possible date or a subsequent call
date established in the original bond debenture. The call price usually includes
a premium from 1% to 3% above par. This type of structure usually is used for
those refundings that either reduce the issuer's interest payment expenses or
change the debt maturity schedule. In escrow funds for ETM refunded municipal
bonds, the maturity schedules of the securities in the escrow funds match the
regular debt-service requirements on the bonds as originally stated in the bond
indentures.
Derivative Municipal Securities. The Tax Free Funds may also acquire
derivative municipal securities, which are custodial receipts of certificates
underwritten by securities dealers or banks that evidence ownership of future
interest payments, principal payments or both on certain municipal securities.
The underwriter of these certificates or receipts typically purchases municipal
securities and deposits them in an irrevocable trust or custodial account with a
custodian bank, which then issues receipts or certificates that evidence
ownership of the periodic unmatured coupon payments and the final principal
payment on the obligation.
The principal and interest payments on the municipal securities
underlying custodial receipts may be allocated in a number of ways. For example,
payments may be allocated such that certain custodial receipts may have variable
or floating interest rates and others may be stripped securities which pay only
the principal or interest due on the underlying municipal securities. The Tax
Free Funds may each invest up to 10% of their total assets in custodial receipts
which have inverse floating interest rates and other inverse floating rate
municipal obligations.
Municipal Leases and Certificates of Participation. The Tax Free Funds
also may purchase municipal lease obligations, primarily through certificates of
participation (or "participation interests"). Participation interests in
municipal leases are undivided interests in a lease, installment purchase
contract or conditional sale contract entered into by a state or local
governmental unit to acquire equipment or facilities. Municipal leases
frequently have special risks which generally are not associated with general
obligation bonds or revenue bonds.
Municipal leases and installment purchase or conditional sales
contracts (which usually provide for title to the leased asset to pass to the
governmental issuer upon payment of all amounts due under the contract) have
evolved as a means for governmental issuers to acquire property and equipment
without meeting the constitutional and statutory requirements for the issuance
of municipal debt. The debt issuance limitations are deemed to be inapplicable
because of the inclusion in many leases and contracts of "non-appropriation"
clauses that provide that the governmental issuer has no obligation to make
future payments under the lease or contract unless money is appropriated for
this purpose by the
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appropriate legislative body on a yearly or other periodic basis. Although these
kinds of obligations are secured by the leased equipment or facilities, the
disposition of the pledged property in the event of non-appropriation or
foreclosure might, in some cases, prove difficult and time-consuming. In
addition, disposition upon non-appropriation or foreclosure might not result in
recovery by a Fund of the full principal amount represented by an obligation.
In light of these concerns, the Tax Free Funds have adopted and follow
procedures for determining whether municipal lease obligations purchased by the
Funds are liquid and for monitoring the liquidity of municipal lease securities
held in each Fund's portfolio. These procedures require that a number of factors
be used in evaluating the liquidity of a municipal lease security, including the
frequency of trades and quotes for the security, the number of dealers willing
to purchase or sell the security and the number of other potential purchasers,
the willingness of dealers to undertake to make a market in security, the nature
of the marketplace in which the security trades, and other factors which the
Advisor may deem relevant. As set forth in "Investment Restrictions" below, each
such Fund is subject to limitations on the percentage of illiquid securities it
can hold.
OPTIONS TRANSACTIONS
To the extent set forth below, the Funds may purchase put and call
options on securities, stock indices, interest rate indices, commodity indices,
and/or foreign currencies. These transactions will be undertaken for the purpose
of reducing risk to the Funds; that is, for "hedging" purposes, or, in the case
of options written by a Fund, to produce additional income. Options on futures
contracts are discussed above under "-- Futures and Options on Futures."
Options on Securities. As a principal investment strategy, the Bond
Funds (other than Intermediate Government Bond Fund) may purchase put and call
options on securities they own or have the right to acquire. A put option on a
security gives the purchaser of the option the right (but not the obligation) to
sell, and the writer of the option the obligation to buy, the underlying
security at a stated price (the "exercise price") at any time before the option
expires. A call option on a security gives the purchaser the right (but not the
obligation) to buy, and the writer the obligation to sell, the underlying
security at the exercise price at any time before the option expires. The
purchase price for a put or call option is the "premium" paid by the purchaser
for the right to sell or buy.
A Fund may purchase put options to hedge against a decline in the
value of its portfolio. By using put options in this way, a Fund would reduce
any profit it might otherwise have realized in the underlying security by the
amount of the premium paid for the put option and by transaction costs. In
similar fashion, a Fund may purchase call options to hedge against an increase
in the price of securities that the Fund anticipates purchasing in the future.
The premium paid for the call option plus any transaction costs will reduce the
benefit, if any, realized by the Fund upon exercise of the option, and, unless
the price of the underlying security rises sufficiently, the option may expire
unexercised.
Options on Interest Rate and Commodity Indices. As principal
investment strategies, the Bond Funds (other than Intermediate Government Bond
Fund) and the Tax Free Funds may purchase put and call options on interest rate
indices and Inflation Protected Securities Fund may purchase put and call
options on commodity indices. An option on an index gives the holder the right
to receive, upon exercise of the option, an amount of cash if the closing value
of the index upon which the option is based is greater than, in the case of a
call, or less than, in the case of a put, the exercise price of the option. This
amount of cash is equal to the difference between the closing price of the index
and the exercise price of the option expressed in dollars times a specified
multiple (the "multiplier"). The writer of the option is obligated, for the
premium received, to make delivery of this amount. Settlements for index options
are always in cash. Gain or loss depends on market movements with respect to
specific financial instruments or commodities. The multiplier for index options
determines the total dollar value per contract of each point in the difference
between the exercise price of an option and the current value of the underlying
index. Options on different indices may have different multipliers.
Options on Currencies. Foreign currency options are discussed in
detail above under "--Foreign Currency Transactions - Foreign Currency Options."
Writing Options--Inflation Protected Securities Fund. Inflation
Protected Securities Fund may write (sell) covered put and call options as a
principal investment strategy. These transactions would be undertaken
principally to produce additional income. The Fund may write covered straddles
consisting of a combination of a call and a put written on the same underlying
instrument.
17
Covered Options. The Funds will write options only if they are
"covered." In the case of a call option on a security, the option is "covered"
if the Fund owns the security underlying the call or has an absolute and
immediate right to acquire that security without additional cash consideration
(or, if additional cash consideration is required, cash or other liquid assets
in such amount are segregated) upon conversion or exchange of the securities
held by the Fund. For a call option on an index or currency, the option is
covered if the Fund segregates liquid assets in an amount equal to the contract
value of the index or currency. A call option is also covered if the Fund holds
a call on the same security, index or currency as the call written where the
exercise price of the call held is (i) equal to or less than the exercise price
of the call written, or (ii) greater than the exercise price of the call
written, provided the difference is maintained by the Fund in segregated liquid
assets. A put option on a security, currency or index is "covered" if the Fund
segregates liquid assets equal to the exercise price. A put option is also
covered if the Fund holds a put on the same security, currency or index as the
put written where the exercise price of the put held is (i) equal to or greater
than the exercise price of the put written, or (ii) less than the exercise price
of the put written, provided the difference is maintained by the Fund in
segregated liquid assets. A straddle will be covered when sufficient assets are
deposited to meet the Fund's immediate obligations. The Fund may use the same
liquid assets to cover both the call and put options where the exercise price of
the call and put are the same, or the exercise price of the call is higher than
that of the put. In such cases, the Fund will also segregate liquid assets
equivalent to the amount, if any, by which the put is "in the money."
Expiration or Exercise of Options. If an option written by a Fund
expires unexercised, the Fund realizes a capital gain equal to the premium
received at the time the option was written. If an option purchased by a Fund
expires unexercised, the Fund realizes a capital loss equal to the premium paid.
Prior to the earlier of exercise or expiration, an exchange traded option may be
closed out by an offsetting purchase or sale of an option of the same series
(type, exchange, underlying security, currency or index, exercise price, and
expiration). There can be no assurance, however, that a closing purchase or sale
transaction can be effected when the Fund desires.
A Fund may sell put or call options it has previously purchased, which
could result in a net gain or loss depending on whether the amount realized on
the sale is more or less than the premium and other transaction costs paid on
the put or call option which is sold. Prior to exercise or expiration, an option
may be closed out by an offsetting purchase or sale of an option of the same
series. A Fund will realize a capital gain from a closing purchase transaction
if the cost of the closing option is less than the premium received from writing
the option, or, if it is more, the Fund will realize a capital loss. If the
premium received from a closing sale transaction is more than the premium paid
to purchase the option, the Fund will realize a capital gain or, if it is less,
the Fund will realize a capital loss. The principal factors affecting the market
value of a put or a call option include supply and demand, interest rates, the
current market price of the underlying security, currency or index in relation
to the exercise price of the option, the volatility of the underlying security,
currency or index, and the time remaining until the expiration date.
The premium paid for a put or call option purchased by a Fund is an
asset of the Fund. The premium received for an option written by a Fund is
recorded as a deferred credit. The value of an option purchased or written is
marked to market daily and is valued at the closing price on the exchange on
which it is traded or, if not traded on an exchange or no closing price is
available, at the mean between the last bid and asked price.
Risks Associated with Options Transactions. There are several risks
associated with options transactions. For example, there are significant
differences between the securities and options markets that could result in an
imperfect correlation between these markets, causing a given transaction not to
achieve its objectives. A decision as to whether, when and how to use options
involves the exercise of skill and judgment, and even a well-conceived
transaction may be unsuccessful to some degree because of market behavior or
unexpected events.
During the option period, the covered call writer has, in return for
the premium on the option, given up the opportunity to profit from a price
increase in the underlying security above the exercise price, but, as long as
its obligation as a writer continues, has retained the risk of loss should the
price of the underlying security decline. The writer of an option has no control
over the time when it may be required to fulfill it obligations as a writer of
the option. Once an option writer has received an exercise notice, it cannot
effect a closing purchase transaction in order to terminate its obligation under
the option and must deliver the underlying security at the exercise price. If a
put or call option purchased by a Fund is not sold when it has remaining value,
and if the market price of the underlying security remains equal to or greater
than the exercise price (in the case of a put) or remains less than or equal to
the exercise price (in the case of a call), the Fund will lose its entire
investment in the option. Also, where a put or call option on a particular
security is purchased to hedge against price movements in a related security,
the price of the put or call option may move more or less than the price of the
related security.
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There can be no assurance that a liquid market will exist when a Fund
seeks to close out an option position. If a Fund were unable to close out an
option that it had purchased on a security, it would have to exercise the option
in order to realize any profit or the option may expire worthless. If a Fund
were unable to close out a covered call option that it had written on a
security, it would not be able to sell the underlying security unless the option
expired without exercise.
If trading were suspended in an option purchased by a Fund, the Fund
would not be able to close out the option. If restrictions on exercise were
imposed, a Fund might be unable to exercise an option it had purchased. Except
to the extent that a call option on an index written by a Fund is covered by an
option on the same index purchased by the Fund, movements in the index may
result in a loss to the Fund; however, such losses may be mitigated by changes
in the value of the Fund's securities during the period the option was
outstanding.
Limitations. None of the Funds will invest more than 5% of the value
of its total assets in purchased options, provided that options which are "in
the money" at the time of purchase may be excluded from this 5% limitation. A
call option is "in the money" if the exercise price is lower than the current
market price of the underlying security or index, and a put option is "in the
money" if the exercise price is higher than the current market price. A Fund's
loss exposure in purchasing an option is limited to the sum of the premium paid
and the commission or other transaction expenses associated with acquiring the
option.
PARTICIPATION INTERESTS
High Income Bond Fund and Total Return Bond Fund, as a non-principal
investment strategy, may acquire participation interests in senior, fully
secured floating rate loans that are made primarily to U.S. companies. Each
Fund's investments in participation interests are subject to its limitation on
investments in illiquid securities. The Funds may purchase only those
participation interests that mature in one year or less, or, if maturing in more
than one year, have a floating rate that is automatically adjusted at least once
each year according to a specified rate for such investments, such as a
published interest rate or interest rate index. Participation interests are
primarily dependent upon the creditworthiness of the borrower for payment of
interest and principal. Such borrowers may have difficulty making payments and
may have senior securities rated as low as C by Moody's or Fitch or D by
Standard & Poor's.
PAYMENT-IN-KIND DEBENTURES AND DELAYED INTEREST SECURITIES
High Income Bond Fund and Total Return Bond Fund, as a non-principal
investment strategy, may invest in debentures the interest on which may be paid
in other securities rather than cash ("PIKs"). Typically, during a specified
term prior to the debenture's maturity, the issuer of a PIK may provide for the
option or the obligation to make interest payments in debentures, common stock
or other instruments (i.e., "in kind" rather than in cash). The type of
instrument in which interest may or will be paid would be known by the Fund at
the time of investment. While PIKs generate income for purposes of generally
accepted accounting standards, they do not generate cash flow and thus could
cause the Fund to be forced to liquidate securities at an inopportune time in
order to distribute cash, as required by the Code.
Unlike PIKs, delayed interest securities do not pay interest for a
specified period. Because values of securities of this type are subject to
greater fluctuations than are the values of securities that distribute income
regularly, they may be more speculative than such securities.
REAL ESTATE INVESTMENT TRUST ("REIT") SECURITIES
High Income Bond Fund may invest in securities of real estate
investment trusts as a non-principal investment strategy. REITs are publicly
traded corporations or trusts that specialize in acquiring, holding, and
managing residential, commercial or industrial real estate. A REIT is not taxed
at the entity level on income distributed to its shareholders or unitholders if
it distributes to shareholders or unitholders at least 90% of its taxable income
for each taxable year and complies with regulatory requirements relating to its
organization, ownership, assets and income.
REITs generally can be classified as Equity REITs, Mortgage REITs and
Hybrid REITs. An Equity REIT invests the majority of its assets directly in real
property and derives its income primarily from rents and from capital gains on
real estate appreciation which are realized through property sales. A Mortgage
REIT invests the majority of its assets in real estate mortgage loans and
services its income primarily from interest payments. A Hybrid REIT combines the
characteristics of an Equity REIT and a Mortgage REIT.
19
The Fund's investment in the real estate industry subjects the Fund to
risks associated with that industry. The real estate industry has been subject
to substantial fluctuations and declines on a local, regional and national basis
in the past and may continue to be in the future. Real property values and
income from real property may decline due to general and local economic
conditions, overbuilding and increased competition, increases in property taxes
and operating expenses, changes in zoning laws, casualty or condemnation losses,
regulatory limitations on rents, changes in neighborhoods and in demographics,
increases in market interest rates, or other factors. Factors such as these may
adversely affect companies which own and operate real estate directly, companies
which lend to such companies, and companies which service the real estate
industry.
The Fund is also subject to risks associated with direct investments
in REITs. Equity REITs will be affected by changes in the values of and income
from the properties they own, while Mortgage REITs may be affected by the credit
quality of the mortgage loans they hold. In addition, REITs are dependent on
specialized management skills and on their ability to generate cash flow for
operating purposes and to make distributions to shareholders or unitholders.
REITs may have limited diversification and are subject to risks associated with
obtaining financing for real property, as well as to the risk of
self-liquidation. REITs also can be adversely affected by their failure to
qualify for tax-free pass-through treatment of their income under the Code or
their failure to maintain an exemption from registration under the 1940 Act. By
investing in REITs indirectly through the Fund, a shareholder bears not only a
proportionate share of the expenses of the Fund, but also may indirectly bear
similar expenses of some of the REITs in which it invests.
REPURCHASE AGREEMENTS
Each Fund may invest in repurchase agreements as a non-principal
investment strategy. Ordinarily, a Fund does not expect its investment in
repurchase agreements to exceed 10% of its total assets. However, because each
Fund may invest without limit in cash and short-term securities for temporary
defensive purposes, there is no limit on each Fund's ability to invest in
repurchase agreements. A repurchase agreement involves the purchase by a Fund of
securities with the agreement that after a stated period of time, the original
seller will buy back the same securities ("collateral") at a predetermined price
or yield. Repurchase agreements involve certain risks not associated with direct
investments in securities. If the original seller defaults on its obligation to
repurchase as a result of its bankruptcy or otherwise, the purchasing Fund will
seek to sell the collateral, which could involve costs or delays. Although
collateral (which may consist of any fixed income security which is an eligible
investment for the Fund entering into the repurchase agreement) will at all
times be maintained in an amount equal to the repurchase price under the
agreement (including accrued interest), a Fund would suffer a loss if the
proceeds from the sale of the collateral were less than the agreed-upon
repurchase price. The Advisor will monitor the creditworthiness of the firms
with which the Funds enter into repurchase agreements.
The Funds' custodian will hold the securities underlying any
repurchase agreement, or the securities will be part of the Federal
Reserve/Treasury Book Entry System. The market value of the collateral
underlying the repurchase agreement will be determined on each business day. If
at any time the market value of the collateral falls below the repurchase price
under the repurchase agreement (including any accrued interest), the appropriate
Fund will promptly receive additional collateral (so the total collateral is an
amount at least equal to the repurchase price plus accrued interest).
ROYALTY TRUSTS
Each of the Bond Funds may invest in publicly-traded royalty trusts as
a non-principal investment strategy. Royalty trusts are income-oriented equity
investments that indirectly, through the ownership of trust units, provide
investors (called "unit holders") with exposure to energy sector assets such as
coal, oil and natural gas. A royalty trust receives royalty income from the
production of a natural resource and then distributes this income to unit
holders less deductions for management fees and capital expenses. The trusts
have no physical operations of their own and have no management or employees;
rather, they are merely financing vehicles. Other companies mine the resources
and pay royalties on those resources to the trust.
The level of royalty income the trust receives is subject to swings in
commodity prices and production levels, which can cause distributions of royalty
income to be very inconsistent. Commodity prices can fluctuate widely on a
month-to-month basis in response to a variety of factors that are beyond the
control of the trust, including political conditions in a major commodity
producing region, especially the Middle East in the case of crude oil, worldwide
economic conditions, weather conditions, the supply and price of domestic and
foreign energy resources, the level of consumer demand, the price and
availability of alternative energy resources, the proximity to, and capacity of,
20
transportation facilities, the effect of worldwide energy conservation measures,
and the nature and extent of governmental regulation and taxation. When prices
decline, the trust is affected in two ways. First, net royalties are reduced.
Second, exploration and development activity on the underlying properties may
decline as some projects may become uneconomic and are either delayed or
eliminated. It is impossible to predict future crude oil and natural gas price
movements, and this reduces the predictability of future cash distributions to
unit holders.
The assets of the trust are depleting assets and, if the operators
developing the underlying properties do not perform additional development
projects, the assets may deplete faster than expected. In some cases, operators
may sacrifice opportunities to reinvest in the business in order to maintain or
increase the level of royalty income passed onto the trust. Eventually, the
assets of the trust will cease to produce in commercial quantities and the trust
will cease to receive royalties. There is no guarantee that distributions made
to a unit holder over the life of these depleting assets will equal or exceed
the purchase price paid by the unit holder. If the business starts to lose
money, the trust can reduce or even eliminate distributions.
Trust unit holders generally have limited or no voting rights and
limited ability to enforce the trust's rights against the current or future
operators developing the underlying properties. For example, there is no
requirement for annual meetings of trust unit holders or for an annual election
of the trustee(s). In some cases, the limited liability of unit holders is also
uncertain. The unit holders are not protected from the liabilities of the trust
to the same extent that a shareholder would be protected from a corporation's
liabilities, and could theoretically have unlimited liability for the actions of
the trust.
Royalty trusts are structured to avoid taxes at the entity level. In a
traditional corporate tax structure, net income is taxed at the corporate level
and again as dividends in the hands of the unit holder. An income trust, if
properly structured, should not be subject to U.S Federal income tax. This
flow-through structure means that the distributions to unit holders are
generally higher than dividends from an equivalent corporate entity. Each unit
holder is taxable on this pro rata share of the trust's net income.
Distributions from U.S. royalty trusts are considered ordinary income to the
holder and are taxed accordingly. Due to the depleting nature of oil and gas
assets, a depletion deduction is available to unit holders to defer taxes on
royalty income, enhancing the taxable equivalent yield. The flow-through tax
structure of royalty trusts could be challenged under existing laws, or the tax
laws could change.
SHORT-TERM TEMPORARY INVESTMENTS
In an attempt to respond to adverse market, economic, political or
other conditions, each of the Funds may temporarily invest without limit in a
variety of short-term instruments such as commercial paper and variable amount
master demand notes; U.S. dollar-denominated time and savings deposits
(including certificates of deposit); bankers' acceptances; obligations of the
U.S. government or its agencies or instrumentalities; repurchase agreements
collateralized by eligible investments of a Fund; securities of other mutual
funds that invest primarily in debt obligations with remaining maturities of 13
months or less (which investments also are subject to an advisory fee); and
other similar high-quality short-term U.S. dollar-denominated obligations. The
other mutual funds in which the Funds may so invest include money market funds
advised by the Advisor.
Each of the Funds may also invest in Eurodollar certificates of
deposit issued by foreign branches of U.S. or foreign banks; Eurodollar time
deposits, which are U.S. dollar-denominated deposits in foreign branches of U.S.
or foreign banks; and Yankee certificates of deposit, which are U.S.
dollar-denominated certificates of deposit issued by U.S. branches of foreign
banks and held in the United States. In each instance, these Funds may only
invest in bank instruments issued by an institution which has capital, surplus
and undivided profits of more than $100 million or the deposits of which are
insured by the Bank Insurance Fund or the Savings Association Insurance Fund.
Short-term investments and repurchase agreements may be entered into
on a joint basis by the Funds and other funds advised by the Advisor to the
extent permitted by an exemptive order issued by the SEC with respect to the
Funds. A brief description of certain kinds of short-term instruments follows:
Commercial Paper. Commercial paper consists of unsecured promissory
notes issued by corporations. Issues of commercial paper normally have
maturities of less than nine months and fixed rates of return. Subject to the
limitations described in the Prospectuses, the Funds may purchase commercial
paper consisting of issues rated at the time of purchase within the two highest
rating categories by Standard & Poor's, Fitch or Moody's, or which have been
assigned an equivalent rating by another nationally recognized statistical
rating organization. The Funds also may invest
21
in commercial paper that is not rated but that is determined by the Advisor to
be of comparable quality to instruments that are so rated. For a description of
the rating categories of Standard & Poor's, Fitch and Moody's, see Appendix A.
Bankers' Acceptances. Bankers' acceptances are credit instruments
evidencing the obligation of a bank to pay a draft drawn on it by a customer.
These instruments reflect the obligation both of the bank and of the drawer to
pay the full amount of the instrument upon maturity.
Variable Amount Master Demand Notes. Variable amount master demand
notes are unsecured demand notes that permit the indebtedness thereunder to vary
and provide for periodic adjustments in the interest rate according to the terms
of the instrument. Because master demand notes are direct lending arrangements
between a Fund and the issuer, they are not normally traded. Although there is
no secondary market in the notes, a Fund may demand payment of principal and
accrued interest at any time. While the notes are not typically rated by credit
rating agencies, issuers of variable amount master demand notes (which are
normally manufacturing, retail, financial, and other business concerns) must
satisfy the same criteria as set forth above for commercial paper. The Advisor
will consider the earning power, cash flow and other liquidity ratios of the
issuers of such notes and will continuously monitor their financial status and
ability to meet payment on demand.
Variable Rate Demand Obligations. Variable rate demand obligations
("VRDO") are securities in which the interest rate is adjusted at pre-designated
periodic intervals. VRDOs may include a demand feature which is a put that
entitles the holder to receive the principal amount of the underlying security
or securities and which may be exercised either at any time on no more than 30
days' notice or at specified intervals not exceeding 397 calendar days on no
more than 30 days' notice.
SWAP AGREEMENTS
The Bond Funds other than Intermediate Government Bond Fund may enter
into interest rate, total return and credit default swap agreements as a
principal investment strategy. These Funds may also enter into options on the
foregoing types of swap agreements ("swap options") and in bonds issued by
special purpose entities that are backed by a pool of swaps.
Swap agreements are two party contracts entered into primarily by
institutional investors for a specified period of time. In a standard swap
transaction, two parties agree to exchange the returns (or differentials in
rates of return) earned or realized on a particular predetermined investment or
index. The gross returns to be exchanged or swapped between the parties are
generally calculated with respect to a notional amount, i.e., the return on or
increase in value of a particular dollar amount invested at a particular
interest rate or in a basket of securities representing a particular index. A
swap option is a contract that gives a counterparty the right (but not the
obligation) to enter into a new swap agreement or to shorten, extend, cancel, or
otherwise modify an existing swap agreement at some designated future time on
specified terms. The Funds may write (sell) and purchase put and call swap
options.
Interest rate swaps involve the exchange of a fixed rate of interest
for a floating rate of interest, usually over a one- to ten-year term. In a
total return swap, one party agrees to pay the other the "total return" of a
defined underlying asset, usually in return for a specified fixed or floating
cash flow unrelated to the credit worthiness of the underlying asset. A total
return swap may be applied to any underlying asset but is most commonly used
with equity indices, single stocks, bonds and defined portfolios of loans and
mortgages. Credit default swaps involve the exchange of a monthly interest rate
spread over a period of time for the risk of default by an individual corporate
borrower or with respect to a basket of securities.
One example of the use of swaps within a Fund may be to manage the
interest rate sensitivity of the Fund. The Fund might receive or pay a fixed
interest rate of a particular maturity and pay or receive a floating rate in
order to increase or decrease the duration of the Fund. Or, the Fund may buy or
sell swap options to effect the same result. The Fund may also replicate a
security by selling it, placing the proceeds in cash deposits, and receiving a
fixed rate in the swap market.
Another example of the use of swaps within a Fund is the use of credit
default swaps to buy or sell credit protection. A credit default swap is a
bilateral contract that enables an investor to buy or sell protection against a
defined-issuer credit event. The seller of credit protection against a security
or basket of securities receives an upfront or periodic payment to compensate
against potential default events. The Fund may enhance income by selling
protection or protect credit risk by buying protection. Market supply and demand
factors may cause distortions between the cash
22
securities market and the credit default swap market. The credit protection
market is still relatively new and should be considered illiquid.
A Fund might enter into a total return swap involving an underlying
index or basket of securities to create exposure to a potentially
widely-diversified range of securities in a single trade. An index total return
swap can be used by a portfolio manager to assume risk, without the
complications of buying the component securities from what may not always be the
most liquid of markets.
Most swap agreements entered into by a Fund would calculate the
obligations of the parties to the agreement on a "net basis." Consequently, a
Fund's current obligations (or rights) under a swap agreement will generally be
equal only to the net amount to be paid or received under the agreement based on
the relative values of the positions held by each party to the agreement (the
"net amount"). A Fund's current obligations under a net swap agreement will be
accrued daily (offset against any amounts owed to the Fund) and any accrued but
unpaid net amounts owed to a swap counterparty will be covered by assets
determined to be liquid by the Advisor.
The use of swap agreements by a Fund entails certain risks. Interest
rate swaps could result in losses if interest rate changes are not correctly
anticipated by the Fund. Total return swaps could result in losses if the
underlying asset does not perform as anticipated by the fund. Credit default
swaps could result in losses if the Fund does not correctly evaluate the
creditworthiness of the company or companies on which the credit default swap is
based.
A Fund will generally incur a greater degree of risk when it writes a
swap option than when it purchases a swap option. When a Fund purchases a swap
option it risks losing only the amount of the premium it has paid should it
decide to let the option expire unexercised. However, when a Fund writes a swap
option it will be obligated, upon exercise of the option, according to the terms
of the underlying agreement.
Because swaps are two party contracts and because they may have terms
of greater than seven days, swap agreements may be considered to be illiquid.
Moreover, a Fund bears the risk of loss of the amount expected to be received
under a swap agreement in the event of the default or bankruptcy of a swap
agreement counterparty. The swaps market is a relatively new market and is
largely unregulated. It is possible that developments in the swaps market,
including potential government regulation, could adversely affect a Fund's
ability to terminate existing swap agreements or to realize amounts to be
received under such agreements.
TEMPORARY TAXABLE INVESTMENTS
The Tax Free Funds may make temporary taxable investments. Temporary
taxable investments will include only the following types of obligations
maturing within 13 months from the date of purchase: (i) obligations of the U.S.
government, its agencies and instrumentalities (including zero coupon
securities); (ii) commercial paper rated not less than A-1 by Standard & Poor's,
F1 by Fitch or P-1 by Moody's or which has been assigned an equivalent rating by
another nationally recognized statistical rating organization; (iii) other
short-term debt securities issued or guaranteed by corporations having
outstanding debt rated not less than BBB- by Standard & Poor's or Fitch or Baa3
by Moody's or which have been assigned an equivalent rating by another
nationally recognized statistical rating organization; (iv) certificates of
deposit of domestic commercial banks subject to regulation by the U.S.
government or any of its agencies or instrumentalities, with assets of $500
million or more based on the most recent published reports; and (v) repurchase
agreements with domestic banks or securities dealers involving any of the
securities which the Fund is permitted to hold.
TRUST PREFERRED SECURITIES
The Bond Funds other than Intermediate Government Bond Fund may invest
in trust preferred securities as a non-principal investment strategy. Trust
preferred securities are preferred securities typically issued by a special
purpose trust subsidiary and backed by subordinated debt of that subsidiary's
parent corporation. Trust preferred securities may have varying maturity dates,
at times in excess of 30 years, or may have no specified maturity date with an
onerous interest rate adjustment if not called on the first call date. Dividend
payments of the trust preferred securities generally coincide with interest
payments on the underlying subordinated debt. Trust preferred securities
generally have a yield advantage over traditional preferred stocks, but unlike
preferred stocks, distributions are treated as interest rather than dividends
for federal income tax purposes and therefore, are not eligible for the
dividends-received deduction. See "Taxation." Trust preferred securities are
subject to unique risks, which include the fact that dividend payments will only
be paid if interest payments on the underlying obligations are made, which
interest payments are dependent on the
23
financial condition of the parent corporation and may be deferred for up to 20
consecutive quarters. There is also the risk that the underlying obligations,
and thus the trust preferred securities, may be prepaid after a stated call date
or as a result of certain tax or regulatory events, resulting in a lower yield
to maturity.
U.S. GOVERNMENT SECURITIES
The Bond Funds, other than High Income Bond Fund, invest in U.S.
government securities as a principal investment strategy. High Income Bond Fund
and the Tax Free Funds may invest in such securities as a non-principal
investment strategy. The U.S. government securities in which the Funds may
invest are either issued or guaranteed by the U.S. government, its agencies or
instrumentalities. The U.S. government securities in which the Funds invest
principally are:
- direct obligations of the U.S. Treasury, such as U.S. Treasury
bills, notes, and bonds;
- notes, bonds, and discount notes issued and guaranteed by U.S.
government agencies and instrumentalities supported by the full
faith and credit of the United States;
- notes, bonds, and discount notes of U.S. government agencies or
instrumentalities which receive or have access to federal
funding; and
- notes, bonds, and discount notes of other U.S. government
instrumentalities supported only by the credit of the
instrumentalities.
The government securities in which the Funds may invest are backed in
a variety of ways by the U.S. government or its agencies or instrumentalities.
Some of these securities, such as Government National Mortgage Association
("GNMA") mortgage-backed securities, are backed by the full faith and credit of
the U.S. government. Other securities, such as obligations of the Federal
National Mortgage Association ("FNMA") or the Federal Home Loan Mortgage
Corporation ("FHLMC") are backed by the credit of the agency or instrumentality
issuing the obligations but not the full faith and credit of the U.S.
government. No assurances can be given that the U.S. government will provide
financial support to these other agencies or instrumentalities because it is not
obligated to do so. See "-- Mortgage-Backed Securities" above for a description
of these securities and the Funds that may invest in them.
WHEN-ISSUED AND DELAYED DELIVERY TRANSACTIONS
Each of the Funds may purchase securities on a when-issued or delayed
delivery basis as a non-principal investment strategy. When such a transaction
is negotiated, the purchase price is fixed at the time the purchase commitment
is entered, but delivery of and payment for the securities take place at a later
date. A Fund will not accrue income with respect to securities purchased on a
when-issued or delayed delivery basis prior to their stated delivery date.
Pending delivery of the securities, each Fund will segregate cash or liquid
securities in an amount sufficient to meet its purchase commitments.
The purchase of securities on a when-issued or delayed delivery basis
exposes a Fund to risk because the securities may decrease in value prior to
delivery. In addition, a Fund's purchase of securities on a when-issued or
delayed delivery basis while remaining substantially fully invested could
increase the amount of the Fund's total assets that are subject to market risk,
resulting in increased sensitivity of net asset value to changes in market
prices. A seller's failure to deliver securities to a Fund could prevent the
Fund from realizing a price or yield considered to be advantageous.
When a Fund agrees to purchase securities on a when-issued or delayed
delivery basis, the Fund will segregate cash or liquid securities in an amount
sufficient to meet the Fund's purchase commitments. It may be expected that a
Fund's net assets will fluctuate to a greater degree when it sets aside
securities to cover such purchase commitments than when it sets aside cash. In
addition, because a Fund will set aside cash or liquid securities to satisfy its
purchase commitments, its liquidity and the ability of the Advisor to manage it
might be affected in the event its commitments to purchase when-issued or
delayed delivery securities ever became significant. Under normal market
conditions, however, a Fund's commitments to purchase when-issued or delayed
delivery securities will not exceed 25% of the value of its total assets.
24
ZERO COUPON SECURITIES
The Bond Funds and the Tax Free Funds may invest in zero coupon, fixed
income securities. The Tax Free Funds do so as a principal investment strategy.
The Bond Funds do so as a non-principal investment strategy. Zero coupon
securities pay no cash income to their holders until they mature and are issued
at substantial discounts from their value at maturity. When held to maturity,
their entire return comes from the difference between their purchase price and
their maturity value. Because interest on zero coupon securities is not paid on
a current basis, the values of securities of this type are subject to greater
fluctuations than are the value of securities that distribute income regularly
and may be more speculative than such securities. Accordingly, the values of
these securities may be highly volatile as interest rates rise or fall. In
addition, while zero coupon securities generate income for purposes of generally
accepted accounting standards, they do not generate cash flow and thus could
cause a Fund to be forced to liquidate securities at an inopportune time in
order to distribute cash, as required by the Internal Revenue Code of 1986, as
amended (the "Code").
SPECIAL FACTORS AFFECTING SINGLE STATE TAX FREE FUNDS
As described in their Prospectuses, except during temporary defensive
periods, each of Arizona Tax Free Fund, California Intermediate Tax Free Fund,
California Tax Free Fund, Colorado Intermediate Tax Free Fund, Colorado Tax Free
Fund, Minnesota Intermediate Tax Free Fund, Minnesota Tax Free Fund, Missouri
Tax Free Fund, Nebraska Tax Free Fund, Ohio Tax Free Fund and Oregon
Intermediate Tax Free Fund will invest primarily in municipal obligations issued
by the state indicated by the particular Fund's name, and by the local and
special-purpose political subdivisions of that state. Each such Fund, therefore,
is susceptible to the political, economic and regulatory factors affecting
issuers of the applicable state's municipal obligations. The following
highlights only some of the more significant financial trends for each such
state, and is based on information drawn from reports prepared by state budget
officials, official statements and prospectuses relating to securities offerings
of or on behalf of the respective state, its agencies, instrumentalities and
political subdivisions, and other publicly available documents, as available on
the date of this Statement of Additional Information. For each state,
obligations of the local governments may be affected by budgetary pressures
affecting the state and economic conditions in the state. The Funds have not
independently verified any of the information contained in such official
statements and other publicly available documents, but are not aware of any
facts which would render such information inaccurate.
The economy and financial operations of each state are exposed to the
risk of cyclical national recessions. In a recession, credit quality can drop if
debt issuers do not maintain a balance between revenues and expenditures. The
economy of any state is inextricably linked to the health of the U.S. national
economy. The current global credit crisis, difficulties in the real estate
market and signs of global recession have eroded confidence on Wall Street and
among consumers. Considerable risks remain for the national economy, including
the threat of further U.S. involvement in wars abroad and additional threats of
terrorism in the U.S. These, and other national threats, may directly or
indirectly influence the obligations of each state's local governments.
ARIZONA. Located in the country's Sunbelt, the State of Arizona has
been, and is projected to continue to be, one of the fastest growing areas in
the United States. The population of Arizona in 2007 was approximately 6.3
million, ranking 16th in the nation. The State is divided into 15 counties. Two
of these counties, Maricopa County (including Phoenix) and Pima County
(including Tucson), are more urban in nature and account for approximately 75%
of total population and 80% of total wage and salary employment in Arizona,
based on 2000 estimates. Also, the statewide population tends to fluctuate
seasonally. The State has a significant winter tourist and part-time resident
population. These demographic factors affect the amounts of revenue generated to
pay for Arizona bonds. It also limits the diversity of these bonds.
Arizona's gross domestic product ("GDP") was $247 billion in 2007,
making Arizona the 17th largest state economy. Arizona's average annual growth
rate ranked 10th in the U.S. for the period from 2000 through 2006. As growth in
the mining and agricultural sectors has diminished over the last 25 years,
significant job growth has occurred in the areas of aerospace and high
technology, construction, finance, insurance, and real estate. In 2007, the
fastest growing industry in Arizona was natural resources and mining, while
there was a decline within the construction industry after several years of
growth. Many of the State's export industries -- those that bring money into the
region from outside --are tied to business spending. Arizona's strong reliance
on the electronics manufacturing industry exposes it to dependence on the pace
of business investment in information technology products and services.
High-tech industries include electronics, instruments, aircraft, space vehicles
and communications. Tourism, particularly in the urban areas, is heavily skewed
to business travel. Manufacturing, which is heavily high tech, is also tied to
business spending as a result of the massive levels of investment by firms in
productivity tools. In addition, the State's dependence on the hospitality and
construction industries exposes its economy to shocks in consumer confidence.
25
Arizona's seasonally adjusted unemployment rate was 5.9% in September
2008, up 55% from the historical low of 3.8% in September 2007. The U.S.
seasonally adjusted unemployment rate for September 2008 was 6.1%, up 30% from
the rate of 4.7% in September 2008. In its October 2008 report, the Arizona
Department of Commerce Research Administration's (ADCRA's) updated forecast
projects a continued loss of nonfarm jobs for the 2008-2009 forecast period with
a decrease of more than 47,000 jobs (or 1.8%). ADCRA projects that the Arizona
recovery will be delayed until late 2009 and early 2010 because of higher
commodity prices, especially for food and energy, stagnant incomes and the
effects of the crisis in finance and housing. Stagnant incomes and rising prices
have reduced the real spending power of the consumer and damaged the industries
dependent on consumer spending such as trade, transportation, leisure and
hospitality. Indicators of the continued downturn in the housing market include
rising rates of mortgage foreclosures, declining sales of new and existing
homes, higher inventories of unsold houses, falling housing starts and a
continued decline in home prices. The reduction of credit availability as a
result of widening financial market instability has served to compound the
downturn in housing by increasing the difficulty in securing home loans for many
buyers. As a result of tighter credit, less money is available to make loans not
only for houses, but also other consumer and business purchases. Because of this
reduced spending, firms are expected to decrease output and employment.
Unfortunately, the current financial crisis has spread to other parts of the
world and is contributing to the slowdown in global economic growth. Besides
financial turbulence, higher commodity prices (especially for food and energy)
have also contributed to a global economic slowdown. ADCRA's updated forecast
projects a greater loss of nonfarm employment (-47,000 jobs or -1.8%) in
2008-2009 compared to its previous forecast released in May 2008 (-9,200 jobs,
or -0.3%) because of a loss in business and consumer confidence. Higher food and
energy prices, falling home values, stagnant incomes and contracting credit have
all combined to erode business and consumer confidence.
The General Fund budget for the State for each fiscal year ("FY") is
required by law to be balanced, with planned expenditures being no higher than
anticipated revenues and other available funds. In Arizona, on average, around
88% of General Fund revenue flow is made up of individual income tax and sales
tax collections, with corporate income taxes accounting for less than 10% even
in robust years. Since most of the State's tax revenues come from volatile
sources - sales and individual income taxes - the result is often fiscal stress
during times of recession. Revenue collections have shown weakness during FY
2008, as employment deteriorates and consumers continue to hold back, evidenced
by July-August 2008 collections falling more than $100 million below the enacted
forecast. In October 2008, at Governor Janet Napolitano's direction, the
Governor's Office of Strategic Planning and Budgeting ("OSPB") prepared three
Budget Management Plan scenarios, covering a range of FY 2009 revenues. These
plans have been developed to ensure the FY 2009 budget remains in balance. The
policies used to achieve this plan state that the integral functions of State
government must not be compromised; recommended spending reductions will be on
an agency-by-agency and program-by-program basis, not across-the-board; all
voter-protected and constitutionally created programs will be exempt from
spending reductions; and appropriate application of previously used and accepted
budgetary practices will be employed. The Budget Management Plan consists of
four elements: a State agency budget savings strategy, which will reduce State
General Fund expenditures by $75 million to $250 million in FY 2009; use of the
Budget Stabilization Fund ("Rainy Day Fund"), with approximately $120 million
available in FY 2009; fund transfers of approximately $50 million from balances
of other funds to the General Fund; and additional FY 2009 Budget Management
Options, which are expected to generate between $75 million and $380 million
toward balancing the General Fund.
In 1990 the State legislature enacted the formula-based Rainy Day Fund
into which deposits are required to be made during years of "above-trend"
economic growth, for use in "below-trend" periods. It is, in essence, the
state's savings account. In prior years, the Rainy Day Fund has been tapped for
uses not originally intended by the statute. For example, funds from the Rainy
Day Fund were used to pay for the Arizona State Hospital in FY 2000-FY 2003. In
FY 2001-FY 2007, Rainy Day funds were transferred for payments on the
Alternative Fuels Tax Credit. After these outlays, the Rainy Day Fund was
entirely replenished by FY 2008. Funds from the Rainy Day Fund were used to help
with the FY 2008 budget shortfall when the economy started turning down. The
cash balance in the Rainy Day Fund as of August 30, 2008 was $201 million, and
approximately $80 million is estimated to be used to balance the FY 2008
26
budget. The Governor's proposal is to transfer $120 million to the General Fund
to help balance the FY 2009 budget, utilizing the Rainy Day Fund for its
intended purpose.
The State of Arizona does not issue general obligation bonds. As a
result, Arizona municipal bonds are issued by local jurisdictions (cities,
school districts) or are tied to specific municipal projects. This also means
that bonds are not always backed by statewide revenues. The State enters into
certain lease transactions that are subject to annual renewal at its option.
Local governmental units in the State are also authorized to incur indebtedness.
The major source of financing for such local government indebtedness is an ad
valorem property tax. In addition to financing public projects, local
governments may also issue revenue bonds to be paid from the revenues of an
enterprise or the proceeds of an excise tax, or from assessment bonds payable
from special assessments. Arizona local governments have also financed public
projects through leases that are subject to annual appropriation at the option
of the local government.
Local governments face additional risks and constraints that may limit
their ability to raise money. Certain obligations held by the Arizona Tax Free
Fund may be obligations of issuers that rely in whole or in part, directly or
indirectly, on ad valorem property taxes as a source of revenue. Arizona law
limits the taxing powers of Arizona local governments and districts. There are
two separate tax systems: a Primary system for taxes levied to pay current
operation and maintenance expenses; and a Secondary system for taxes levied to
pay principal and interest on bonded indebtedness, special district assessments
and tax overrides. There are specific provisions under each system governing
property value, the basis of assessment and maximum annual tax levies.
Under the Primary system, property value is the basis for determining
primary property taxes of locally assessed real property and may increase by
more than 10% per year only under certain circumstances. Under the Secondary
system, there is no limitation on annual increases in full cash value of any
property. Under the Primary system, annual tax levies are limited based on the
nature of the property being taxed, and the nature of the taxing authority.
Taxes levied for Primary purposes on residential property only are limited to 1%
of the full cash value of such property. In addition, taxes levied for Primary
purposes on all types of property by counties, cities, towns and community
college districts are limited to a maximum increase of 2% over the prior year's
levy, plus any amount directly attributable to new construction and annexation
and involuntary tort judgments. The 2% limitation does not apply to taxes levied
for Primary purposes on behalf of local school districts. Annual tax levies for
bonded indebtedness and special district assessments are unlimited under the
Secondary system.
There are periodic attempts in the form of voter initiatives and
legislative proposals to further limit the amount of annual increases in taxes
that can be levied by the various taxing jurisdictions without voter approval.
In June 2006, Governor Napolitano signed State legislation to freeze local
property tax assessments at the 2005 level, with annual increases limited to 2%
plus the value of new construction. It is possible that if other such proposals
were enacted, there would be an adverse impact on State or local government
financing. It is not possible to predict whether any such proposals will be
enacted in the future or what would be their possible impact on State or local
government financing.
Provisions of the Arizona Constitution and State legislation limit
increases in annual expenditures by counties, cities and towns and community
college districts and school districts to an amount determined by the Arizona
Economic Estimates Commission. This limitation is based on the entity's actual
expenditures for FY 1979-80, with this base adjusted annually to reflect changes
in population, cost of living, and boundaries.
Budgetary pressures affecting the State and the ability of the State
to raise revenue may affect obligations of the State or local governments. A
1992 amendment to the Constitution of Arizona states that any legislation that
provides for a net increase in State revenues will be effective only on the
affirmative vote of two-thirds of the members of each house of the State
Legislature, and Gubernatorial approval. If the Governor vetoes the measure,
then the legislation may not become effective unless the legislation is approved
by an affirmative vote of three-fourths of the members of each house. The
constitutional amendment does not apply to the effects of inflation, increasing
assessed valuation or any other similar effect that increases State revenue but
which is not caused by an affirmative act of the Legislature. The
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budgets enacted since FY 1993-94 have not provided for any increases in State
revenues that required an approval from two-thirds of the State Legislature.
As of July 2008, Arizona was assigned an issuer credit rating of "AA"
by Standard & Poor's and "Aa3" by Moody's. Any explanation concerning the
significance of such ratings must be obtained from the rating agencies. There
can be no assurance that such ratings will be maintained in the future. It
should be noted that the creditworthiness of obligations issued by local Arizona
issuers may be unrelated to the creditworthiness of obligations issued by the
State of Arizona, and that there is no obligation on the part of the State to
make payment on such local obligations in the event of default.
The foregoing information constitutes only a brief summary of some of
the general factors that may impact certain issuers of Arizona municipal
obligations and does not purport to be a complete or exhaustive description of
all adverse conditions to which the issuers of such obligations held by the
Arizona Tax Free Fund are subject. This information has not been independently
verified. Additionally, many factors, including national economic, social and
environmental policies and conditions, which are not within the control of the
issuers of Arizona municipal bonds, could affect or could have an adverse impact
on the financial condition of the issuers. The Fund is unable to predict whether
or to what extent such factors or other factors may affect the issuers of
Arizona municipal obligations, the market value or marketability of such
obligations or the ability of the respective issuers of the obligations acquired
by the Fund to pay interest on or principal of such obligations.
CALIFORNIA. The economy of the State of California is the largest in
the U.S. and one of the largest in the world, having a gross domestic product
("GDP") of over $1.8 trillion in 2007. California accounts for slightly over 13%
of the nation's output. The nation's next largest state economy--Texas--is about
62% the size of California's economy. The State's population of over 36.5
million has more than doubled since 1960 and now constitutes about 12% of the
U.S. total.
In its October 2008 Finance Bulletin, the State of California Finance
Department reported that the ongoing housing and financial crises continued to
roil the California economy through August 2008. The state lost payroll jobs for
the sixth consecutive month in August, and the unemployment rate rose again.
Home building slowed, but home sales had stabilized. The State lost jobs in
seven out of the first eight months of 2008. Since nonfarm employment peaked in
July 2007, the state has lost 83,700 jobs, or 6,440 per month on average.
California's unemployment rate rose to 7.7% in August, up from a revised 7.4% in
July, and up from 5.5% a year earlier. The 2.2% increase from August 2007 to
August 2008 was the largest year-over-year increase since July 1991. However, as
much as a third of that jump may have been due to the U.S. Bureau of Labor
Statistics' practice--adopted in January 2005--of adjusting state unemployment
estimates so that they add up to the national estimate. This "benchmarking" of
states' unemployment estimates has resulted in a huge increase in the
variability of California's unemployment statistics. Home building slowed
considerably in August, with slowdowns in both single and multi-family home
building. Residential permits were issued at a seasonally adjusted annual rate
of 55,645 units, down over 56.2% from a year earlier. Single-family permits were
down 55.0%, while multi-family permitting was down 57.4%. New home permitting
during the first eight months of 2008 was down 43.8% from the same months of
2007 and down 60% from the same period of 2006. Nonresidential construction also
slowed in August. Nonresidential construction permitting was down 21.9% in
August from a year earlier. For the first eight months of 2008 as a whole,
nonresidential permitting was down 5.5% from the same months of 2007. In August,
California real estate markets basically moved sideways. Existing home sales and
home prices were essentially unchanged from July. Sales of existing
single-family detached homes totaled 490,850 units at a seasonally adjusted
annualized rate, according to the California Association of Realtors.
Inventories remained elevated--although much better than at the beginning of the
year. The Association's unsold inventory index stood at 6.7 months in August for
the second consecutive month. The median price of existing, single-family homes
sold in August was $350,140, essentially unchanged from July, but down 40.5%
from August 2007.
The State's principal sources of General Fund revenues are the
California personal income tax, sales tax, and bank and corporate taxes. The
weakening State economy in 2007 and 2008, which is projected to continue in
2009, has resulted in significant reductions in State tax revenues below earlier
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projections, creating an estimated budget gap of $15 billion that will need to
be addressed in FY 2008-09. To balance the budget, Governor Schwarzenegger has
proposed significant expenditure cuts in State programs and other one-time
actions. The most significant of these actions is a proposal to securitize
future receipts from the State Lottery, which, combined with a new budget
stabilization procedure described below, would add $5.1 billion to FY 2008-09
revenues. Both of these actions will require voter approval at the November 2008
election. In addition, the State faces pressure on its cash management program
and expects to have to access external markets for cash management borrowings
commencing in the first quarter of FY 2008-09.
The FY 2008-09 Budget Act (the "2008 Budget Act") was adopted by the
Legislature on September 18, 2008, along with a number of implementing measures,
and signed by the Governor on September 23, 2008. In approving the 2008 Budget
Act the Governor vetoed $850 million in General Fund appropriations). General
Fund revenues and transfers for FY 2008-09 are projected at $103.0 billion, an
increase of $1.8 billion or 1.8% compared with revised estimates for FY 2007-08.
General Fund expenditures for FY 2008-09 are projected at $103.4 billion, a
decrease of $0.1 billion from the $103.3 billion for 2007-08. The 2008 Budget
Act projects to end FY 2008-09 with a $1.7 billion total reserve. As part of the
2008 Budget Act, the Legislature approved a constitutional amendment to be
placed on the next statewide ballot after November 2008 that would mandate at
least 3% to 12.5% of General Fund revenues each year to be sequestered into the
Budget Stabilization Account ("BSA"), unless the BSA is full or moneys are being
accessed in a deficit year. In addition to the annual transfer, in years that
revenues are above 5% of the amounts included in the budget act for that fiscal
year would be required to be transferred. Under normal circumstances, the State
would set aside $1.509 billion for FY 2008-09 in the BSA for rainy day purposes.
On May 28, 2008, the Governor issued an Executive Order which officially
suspends the BSA transfer for FY 2008-09. The 2008 Budget Act reflects the
suspension of this transfer to the BSA for FY 2008-09. The 2008 Budget Act also
includes legislation that, if approved by the voters of the State, authorizes
the California State Lottery to adopt changes to improve its financial
performance. The 2008 Budget Act is proposing to securitize future lottery
revenues to fund a newly created Debt Retirement Fund, with the first $5.0
billion in securitization revenues to be available in FY 2009-10. The 2008
Budget Act has several other major General Fund components, including tax law
changes, and additional funding for K-12 education, higher education, health and
human services, and transportation.
As of July 2008, California maintained an issuer credit rating of "A+"
by both Standard & Poor's and Fitch, and "A1" by Moody's. There can be no
assurance that such ratings will be maintained in the future. It should be noted
that the creditworthiness of obligations issued by local California issuers may
be unrelated to the creditworthiness of obligations issued by the State of
California, and that there is no obligation on the part of the State to make
payment on such local obligations in the event of default.
In addition to California's credit quality, there are a number of
additional risks to investing in California municipal securities. Certain
municipal securities may be obligations of issuers that rely in whole or in part
on State revenues for payment of such obligations. Such revenues may be affected
by limitations imposed on new taxes or tax increases. In 1978, State voters
approved an amendment to the State Constitution known as Proposition 13. The
amendment limits ad valorem (according to value) taxes on real property and
restricts the ability of taxing entities to increase real property taxes and
assessments, and limits the ability of local governments to raise other taxes.
State legislation was adopted that provided for the reallocation of property
taxes and other revenues to local public agencies, increased State aid to such
agencies, and provided for the assumption by the State of certain obligations
previously paid out of local funds. More recent legislation has reduced State
assistance payments to local governments. There can be no assurance that any
particular level of State aid to local governments will be maintained in future
years. For example, when vehicle license fees, which go to local governments,
were recently lowered, the State contributed the amount of money lost so local
governments would not lose needed income. The Governor's May 2005 revised
budget, by way of example, included pay-back of 50% of the Vehicle License Fee
Gap due to local governments. Local governments could suffer financially if the
State government were to halt such payments. In addition, local governments may
face other reductions in State fiscal aid for various programs.
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Some local governments in California have experienced notable
financial difficulties, and there is no assurance that any California issuer
will make full or timely payments of principal or interest or remain solvent.
For example, in December 1994, Orange County, California, together with its
pooled investment funds, which included investment funds from other governments,
filed for bankruptcy. Orange County has since emerged from bankruptcy. Los
Angeles County, the nation's largest county, in the recent past has also
experienced financial difficulty and its financial condition will continue to be
affected by the large number of county residents who are dependent on government
services and a structural deficit in its health department.
To close certain loopholes in previously passed Propositions,
California voters approved Proposition 218 in November 1996. It requires that
all taxes for general purposes obtain a simple majority popular vote and that
taxes for special purposes obtain a two-thirds majority vote. Proposition 218
limits the authority of local governments to impose property-related
assessments, fees and charges, requiring that such assessments be limited to the
special benefit conferred and prohibiting their use for general governmental
services. Proposition 218 also allows voters to use their initiative power to
reduce or repeal previously authorized taxes, assessments, fees and charges. It
is unclear how this right of local initiative may be used in cases where taxes
or charges have been or will be specifically pledged to secure debt issues. The
interpretation and application of Proposition 218 will ultimately be determined
by the courts with respect to a number of matters, and it is not possible at
this time to predict with certainty the outcome of such cases. Due to
limitations like Propositions 13 and 218, obligations of the State or local
governments may be affected by the ability of the State to raise revenue.
Article XIII B of the California Constitution (the "Appropriation
Limit") imposes a limit on annual appropriations from tax proceeds. Originally
adopted in 1979, Article XIII B was modified by Proposition 98 in 1988 and
Proposition 111 in 1990. Excluded from the Appropriation Limits are prior (pre
1979) debt service and subsequent debt incurred as the result of voter
authorizations, court mandates, qualified capital outlay projects and certain
increases in gasoline taxes and motor vehicle weight fees. Certain civil
disturbance emergencies declared by the Governor and appropriations approved by
a two-thirds vote of the legislature are excluded from the determination of
excess appropriations, and the appropriations limit may be overridden by local
voter approval for up to a four-year period. On November 8, 1988, California
voters approved Proposition 98, a combined initiative constitutional amendment
and statute called "the Classroom Instruction Improvement and Accountability
Act." This amendment changed school funding below the University level by
guaranteeing K-14 schools a minimum share of General Fund Revenues. Suspension
of the Proposition 98 funding formula requires a two-thirds vote of Legislature
and the Governor's concurrence. Proposition 98 also contains provisions
transferring certain funds in excess of the Article XIII B limit to K-14
schools. As amended by Proposition 111, the Appropriation Limit recalculated
annually by taking the actual FY1986-1987 limit and applying the Proposition 111
cost of living and population adjustments as if that limit had been in effect.
The Appropriations Limit is tested over consecutive two-year periods under this
amendment. Any excess "proceeds of taxes" received over such two-year period
above the Appropriation Limits for the two-year period is divided equally
between transfers to K-14 and taxpayers.
In March 2004, California voters approved two measures designed to
address the cumulative budget deficit and to implement structural reform. Under
the California Economic Recovery Bond Act (Proposition 57), the State is
authorized to issue up to $15 billion of economic recovery bonds (of which $10.9
billion have been issued as of October 2006 to finance the negative General Fund
reserve as of June 30, 2004, and other General Fund obligations undertaken prior
to June 30, 2004. The Balanced Budget Amendment (Proposition 58), discussed
above, restricts future long-term deficit financing and requires the State to
adopt and maintain a balanced budget and to establish a reserve fund.
In November 2006, voters approved Proposition 1A, which had been
placed on the ballot by the Legislature as Senate Constitutional Amendment No.
7, to protect Proposition 42 transportation funds from any further suspensions.
Current provisions of the State Constitution enacted as Proposition 42 in 2002,
permit the suspension of the annual transfer of motor vehicle fuel sales tax
revenues from the General Fund to the Transportation Investment Fund if the
Governor declares that the transfer will result in a "significant negative
fiscal impact" on the General Fund and the Legislature agrees with a two-thirds
vote of each
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house. The new measure modifies the constitutional provisions of Proposition 42
in a manner similar to Proposition 1A of 2004, so that if such a suspension
occurs, the amount owed by the General Fund must be repaid to the Transportation
Investment Fund within three years, and only two such suspensions can be made
within any ten-year period. In FY 2003-04, the scheduled Proposition 42 transfer
of $868 million was suspended, and in FY 2004-05 the full transfer of $1.258
billion was suspended. The Proposition 42 transfer was fully funded in FY
2005-06 at $1.359 billion. The 2006 Budget Act fully funded the Proposition 42
transfer at $1.415 billion for FY 2006-07, and also included $1.415 ($1.215
billion from the General Fund) for advance repayment of a portion of the FY
2003-04 and FY 2004-05 suspensions. The 2007 Budget Act fully funded the
Proposition 42 transfer at $1.439 billion and the required repayment for
remaining Proposition 42 debts at $83 million for FY 2007-08. The 2008 Budget
Act fully funds the Proposition 42 transfer for FY 2008-09 at $1.432 billion
with another $83 million to repay a portion of past suspensions.
California has been burdened with unexpected repercussions from
electricity market deregulation and adverse developments in the electric
utilities industry. These include imbalances between supply and demand,
unexpectedly high and volatile generating costs, decreased system reliability,
increased competitive pressures, deterioration in the financial condition and
credit quality of electric utilities, and the effects of changing environmental,
safety, licensing and other requirements. Widely publicized difficulties in
California's energy supplies had been seen in early 2001 to pose some risks to
the economy, but during the summers of 2001 and 2002 there were no electricity
blackouts or shortages of natural gas. Energy difficulties are mitigated by the
fact that California's economy is very energy-efficient. U.S. Department of
Energy statistics for 1999 revealed that California ranked 50th of the 50 states
in energy expenditures as a percentage of State domestic product. Additional
risks exist and others may develop in the future. The timing and success of any
market, regulatory, legislative, or other solution to these problems is
uncertain.
There are numerous civil actions pending against the State, which
could, if decided against the State, require the State to make significant
future expenditures and may substantially impair revenues and cash flow. It is
not possible to predict what impact, if any, such proceedings may have on the
California Tax Free Fund and California Intermediate Tax Free Fund.
Finally, California is subject to unique natural hazard risks.
Earthquakes can cause localized economic harm that could limit the ability of
governments to repay debt. Cycles of drought and flooding are also concerns
insofar as they affect agricultural production, power generation, and the supply
of drinking water. One of the State's most acute problems is its need for water.
Wells and underground aquifers are drying up in San Diego County and Southern
California because of several years of drought, an occurrence that has had
little effect upon current water supplies, but which could eventually put added
strain on the region's scarcest, shrinking, resource. Cutbacks in federally
funded water projects in the 1970s and 80s led many California cities to begin
buying water from areas with a surplus, but political problems associated with
water sharing continue.
The foregoing information constitutes only a brief summary of some of
the general factors that may impact certain issuers of California municipal
obligations and does not purport to be a complete or exhaustive description of
all adverse conditions to which the issuers of such obligations held by the
California Intermediate Tax Free Fund and California Tax Free Fund are subject.
This information has not been independently verified. Additionally, many
factors, including national economic, social and environmental policies and
conditions, which are not within the control of the issuers of California
municipal bonds, could affect or could have an adverse impact on the financial
condition of the issuers. The Funds are unable to predict whether or to what
extent such factors or other factors may affect the issuers of California
municipal obligations, the market value or marketability of such obligations or
the ability of the respective issuers of the obligations acquired by the Funds
to pay interest on or principal of such obligations.
COLORADO. The State of Colorado is the most populous state in the
Rocky Mountain region. The State has two distinctive geographic and economic
areas. The eastern half of the State consists of the eastern plains, which are
flat, open and largely devoted to farming, and the Front Range, which contains
the major metropolises. The State's population and wealth are concentrated in
the Front Range, principally in
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four major metropolitan areas: Denver/Boulder, Colorado Springs, Fort
Collins/Greeley and Pueblo. The population of Colorado in 2007 was 4.8 million,
ranking 22nd in the nation. These demographic factors affect the amounts of
revenue generated to pay for Colorado bonds. They may also limit the diversity
of these bonds.
Denver, the State capital and the largest city in Colorado, is the
major economic center in the State and the Rocky Mountain region, having
developed as a regional center for transportation, communication, finance and
banking. More recently, the Front Range has attracted advanced-technology
industries. Colorado's gross domestic product ("GDP") was $236 billion in 2007,
making Colorado the 20th largest state economy. The State's economy is sensitive
to the national economy, leading to economic performance that depends a great
deal on economic performance at the national level. The State economy and State
financial operations are exposed to the risk of cyclical national recessions. In
a recession, credit quality can drop if debt issuers do not maintain a balance
between revenues and expenditures.
Colorado's economy continues to show that it is more resilient and
perhaps better poised to rebound from the current national financial turmoil
than the national economy. By comparison, Colorado is experiencing lower
unemployment, greater job growth, and lower inflation than the nation overall,
and is supportive of Colorado's focus on booming industries like renewable and
non-renewable energy, biosciences, and technology. While there is still a
significant amount of uncertainty surrounding the recent problems in the
financial industry, and the federal bailout of governmental sponsored
enterprises Freddie Mac and Fannie Mae, the current circumstances appear to have
affected Colorado far less than other states, for several reasons. First, in
general, wholesale and retail energy prices have been on the decline since early
July. Second, crude oil prices have made renewable energy producers more
economically competitive. The cluster of major research universities and federal
laboratories in the State along with the State's efforts to attract the
renewable energy industry to Colorado have resulted in the State becoming a
magnet for private-sector ventures in renewable energy. It appears this sector
will lead the way for economic growth in Colorado for the foreseeable future.
Third, although certain parts of the State remain distressed by foreclosures,
the current state of the residential real estate market is substantially
stronger in Colorado than the rest of the country. According to the Standard &
Poor's / Case-Shiller index, Denver's real estate market is one of the strongest
of any major metropolitan area of the country. In the most recent data
available, the price index for Denver posted a one-month increase of 1.5% in
June. Compared to June 2007, home prices in Denver are down 5%. However, this is
the mildest decrease of any large metropolitan area except Dallas, Texas. Real
estate also continues to be strong on the Western Slope, in response to the
continuing influx of oil and gas workers.
The September 2008 Revenue Forecast of the Colorado Office of State
Planning and Budgeting ("OSPB") projects that personal income will grow 5.2% in
2008 and 4.4% in 2009. These estimates reflect 0.9% and 1.8% reductions from the
June 2008 forecast and are due primarily to lower wage and salary growth as well
as an unemployment rate that is significantly higher than previously expected.
The Colorado unemployment rate dropped to 3.8% in 2007, its lowest reading since
2000. The general economic slowdown has pulled unemployment rates closer to
historical average rates between 5% and 6%. Due to slowing growth in sectors
that typically hire young persons and seasonal help, the Colorado unemployment
rate is projected to reach an average of 4.9% for calendar 2008, where it is
anticipated to remain through 2009, before starting a slow decline. Colorado's
economy cannot be totally insulated from broader economic issues. With the
recent events in the credit markets, there is concern that regardless of
Colorado's focus on immerging industries, there will not be enough access to
capital for these businesses to exceed. It is too early to tell whether the
federal government's capital infusions will be sufficient to stabilize markets
and stimulate the financial system.
Because of limitations in the State Constitution, the State of
Colorado issues no general obligation bonds. Although Colorado has no
outstanding general obligation debt, as of July 2007, Standard & Poor's rates
Colorado lease obligations "AA-" and Moody's rates these obligations "Aaa."
Fitch has no ratings for Colorado obligations. These ratings reflect the State's
credit quality only and do not indicate the creditworthiness of other tax-exempt
securities in which the Funds may invest.
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The State's budget process begins in June of each year when State
departments prepare both operating and capital budgets for the fiscal year
beginning 13 months later. In August, these budgets are submitted to the OSPB
for review and analysis. The OSPB advises the governor on departmental budget
requests and overall budgetary status. Budget decisions are made by the governor
following consultation with affected departments and the OSPB. The State
Constitution requires that expenditures for any fiscal year not exceed revenues
for such fiscal year.
Certain municipal securities may be obligations of issuers that rely
in whole or in part on State revenues for payment of such obligations. The
largest source of the State's General Fund revenues is receipts generated by the
individual income tax. Since most of Colorado's tax revenues come from volatile
sources - sales and personal income taxes - the result is often fiscal stress
during times of recession.
Like many states, the State of Colorado faced budgetary constraints as
a result of the recession that started in spring 2001 and the events of
September 11, 2001. Over the last few years, however, the State's financial
situation has improved. Colorado managed to close an $809 million gap in 2003
with spending reductions and revenue enhancement measures. The State's General
Fund ended FY 2002-03 with a $224.9 million reserve and FY 2003-04 with a $346.9
million reserve. In FY 2004-05, the State's General Fund ended the year with a
$331.4 million reserve. This reserve exceeded the statutory 4% reserve,
described below, by $94 million. The FY 2005-06 General Fund ended the year with
a $688.5 million reserve, exceeding the statutory 4% reserve by $436.8 million.
The FY 2006-07 General Fund ended the year with a $536.7 million reserve,
exceeding the statutory 4% reserve by $269.7 million. The FY 2007-08 General
Fund ended the year with a $325.4 million reserve, exceeding the statutory 4%
reserve by $41.9 million. According to the OSPB's September 2008 forecast, after
increasing 2.7% in FY 2007-08, gross General Fund revenues are expected to
increase 4.3% in FY 2008-09 and 5.0% in FY 2009-10. Through FY 2008-09, the
State is projected to have enough General Fund revenue to maintain
appropriations growth of 6%. The State is not projected to have excess General
Fund reserves after FY 2007-08.
The adoption by voters of revenue and expenditure limitations poses
additional risks in Colorado. In Colorado, unlike many states, only voters can
approve tax increases, making it harder to increase State and local revenues.
The Taxpayers Bill of Rights ("TABOR") is one limitation, which applies to all
levels of State and local government. TABOR limits increases in State revenue
collections from one year to the next to the rate of inflation rate plus the
percentage of population growth and requires voter approval of tax increases.
Voter approval is also required for any new taxes or to increase current taxes.
Any surpluses the State collects must be returned to taxpayers. There is no
provision in TABOR to account for cyclical revenue swings. After logging TABOR
revenue surpluses for five years, the TABOR surplus disappeared in FY 2001-02
and remained absent through FY 2003-04. In FY 2004-05, the TABOR surplus
reappeared after a four-year absence, totaling $44.7 million. Colorado voters in
November 2005 passed Referendum C, which (i) allows the State to keep and spend
revenues above normal TABOR limits for five years and (ii) beginning in 2011,
creates a new State spending cap equal to the greatest amount of money collected
in any fiscal year between 2006 and 2010, adjusted for inflation and population
growth in 2011 and subsequent years. The constitutional spending limit will be
reinstated in 2010, at which point Colorado could begin to see budgetary issues
once again.
The State has accumulated very limited emergency reserve funds and it
does not currently have a device in place, such as a "Rainy Day" fund, to smooth
government revenues and expenditures over the business cycle. Colorado operates
under two separate reserve requirements that obligate the State to set aside
moneys. First, the statutory reserve requires that 4% of General Fund
appropriations be set aside for revenue shortfalls. If at any time during the
year revenue projections indicate that there would not be sufficient General
Fund revenues to maintain at least half of the required 4% (i.e., 2%), the
Governor must take steps to reduce or restrict spending. Secondly, Article XX of
the Colorado Constitution, enacted by popular vote in response to the 1992 TABOR
initiative, includes a requirement for an "emergency reserve fund" of 3% of the
annual budget. This emergency reserve fund is specifically forbidden for use in
economic emergencies. It can only be used in the case of a natural disaster like
a flood or tornado, and all dollars used must be repaid by the close of the
fiscal year.
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Issuers of municipal securities that rely on revenue sources, such as
property taxes, may encounter financial constraints that impact the obligations
of these issuers. Recently, many of the State's resort-related commercial real
estate has converted to residential property in the form of timeshares. Under
the State constitution, commercial properties are taxed at a higher rate than
are residential parcels. As more commercial real estate converts into
residential real estate, there may be less tax income from property tax to fund
local governments. Under the Gallagher Amendment to the Colorado Constitution
enacted in 1982 the State's total residential assessed value cannot make up more
than 45% of the overall assessed value of property in the State. That means as
home values rise, or new homes are constructed, the 45% cap forces residential
real estate to be assessed at an ever-decreasing rate.
The State's tourism industry is a major component of Colorado's
economic base. It encompasses a cross section of economic sectors, though not
reported as a separate economic sector. Accommodations & food services, along
with recreation services, provide a reasonable indication of tourism activity.
According to a June 2008 report by the Colorado Tourism Office, the number of
visitors to Colorado in 2007 surpassed a 1992 record set shortly before state
funding for advertising was slashed. Though tourism funding was restarted in
2000, it had taken the state nearly eight years to regain the market share that
was lost. The 2007 data shows tourism was up 4% and tourism spending was up 10%
to $9.8 billion from 2006. This marked the fourth consecutive year tourism had
grown in the state. Colorado was 17th in overall market share and first in share
of overnight ski trips in 2007. The state had dropped to 23rd in overall ranking
in 2004.
Finally, Colorado is subject to unpredictable weather. If there is
good snow for the upcoming ski season the profits of ski resorts and the tourism
industry as a whole could likely benefit. Ample snow would also likely mean
fuller reservoirs and could potentially reduce the chance of severe droughts.
Cycles of drought and flooding are concerns insofar as they affect agricultural
production, power generation, and the supply of drinking water.
The foregoing information constitutes only a brief summary of some of
the general factors that may impact certain issuers of Colorado municipal
obligations and does not purport to be a complete or exhaustive description of
all adverse conditions to which the issuers of such obligations held by the
Colorado Intermediate Tax Free Fund and Colorado Tax Free Fund are subject. This
information has not been independently verified. Additionally, many factors,
including national economic, social and environmental policies and conditions,
which are not within the control of the issuers of Colorado municipal bonds,
could affect or could have an adverse impact on the financial condition of the
issuers. The Funds are unable to predict whether or to what extent such factors
or other factors may affect the issuers of Colorado municipal obligations, the
market value or marketability of such obligations or the ability of the
respective issuers of the obligations acquired by the Funds to pay interest on
or principal of such obligations.
MINNESOTA. Minnesota's constitutionally prescribed fiscal period is a
biennium, and Minnesota operates on a biennial budget basis. Legislative
appropriations for each biennium are prepared and adopted during the final
legislative session of the immediately preceding biennium. Prior to each fiscal
year of a biennium, Minnesota's Department of Finance allots a portion of the
applicable biennial appropriation to each agency or other entity for which an
appropriation has been made. An agency or other entity may not expend moneys in
excess of its allotment. If revenues are insufficient to balance total available
resources and expenditures, Minnesota's commissioner of finance, with the
approval of the governor, is required to reduce allotments to the extent
necessary to balance expenditures and forecasted available resources for the
then current biennium. The governor may prefer legislative action when a large
reduction in expenditures appears necessary, and if Minnesota's legislature is
not in session the governor is empowered to convene a special session.
Diversity and a significant natural resource base are two important
characteristics of the Minnesota economy. Generally, the structure of the
State's economy parallels the structure of the United States economy as a whole.
There are, however, employment concentrations in the manufacturing categories of
fabricated metals, machinery, computers and electronics, and food. Historically,
the State's
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unemployment rate had consistently been less than the national unemployment
rate, but in 2007 Minnesota's unemployment rate for the year was equal to the
U.S. average, and in the first eight months of 2008 Minnesota's unemployment
rate was greater than or equal to the U.S. average in three (February through
April). Since 1980, Minnesota per capita income generally has remained above the
national average. In 2007, Minnesota per capita personal income was 106.3% of
its U.S. counterpart.
The State relies heavily on a progressive individual income tax and a
retail sales tax for revenue, which results in a fiscal system that is sensitive
to economic conditions. During the first half of 2003, the State addressed
substantial projected budget deficits by substantially reducing projected
spending, including aid to local government and higher education, transferring
funds from other accounts, deferring certain expenditures and transfers, in some
cases by borrowing funds, deferring certain sales tax refunds, and raising fees.
On February 27, 2004, the Minnesota Department of Finance released an Economic
Forecast projecting, under then current laws, a general fund deficit of $160
million for the biennium ending June 30, 2005. A forecasted deficit is not
automatically reduced by the budget reserve, because gubernatorial or
legislative action is required to access the reserve. Minnesota's Constitution
prohibits borrowing for operating purposes beyond the end of a biennium, but the
commissioner of finance, with the approval of the governor, has statutory
authority in the event of a projected deficit to release reserve funds and
reduce unexpended allotments of prior transfers and appropriations. The State
legislature adjourned its 2004 regular session without substantially reducing
the projected deficit, but the governor exercised his statutory powers to
eliminate the projected deficit, primarily through reductions in spending. On
February 28, 2005, the Department of Finance released an updated Economic
Forecast projecting, under then current laws, a general fund balance of $175
million for the biennium ending June 30, 2005, but, after reflecting
legislatively mandated allocations of this surplus to restoring the State's
budget reserve to $653 million and reversing some shifts in the timing of school
aid payments, the projected balance was reduced to zero. The Department also
forecast a $466 million General Fund shortfall for the biennium ending June 30,
2007, after allowing for a $350 million cash flow account and a $653 million
budget reserve, based on projected expenditures of $30.2 billion. The State
enacted legislation to eliminate the shortfall, largely relying on a new
cigarette fee and a variety of tax increases.
The General Fund had a substantial unrestricted surplus of $1.1
billion at the end of the last biennium, June 30, 2007. The Department of
Finance February 2008 Forecast, however, projected a $935 million (2.7%) General
Fund deficit for June 30, 2009, after reducing the projected $68 million
unreserved balance by the statutorily mandated $653 million budget reserve and
$350 million cash flow account. Legislation was enacted to increase revenues by
$206 million, reduce overall spending by $125 million, transfer $110 million of
funds from certain non-general funds, and reduce the budget reserve by $500
million to $153 million. As a result, end of session estimates projected a $6
million unrestricted General Fund balance for June 30, 2009, based on
expenditures of $34.593 billion, after reducing the projected $509 unreserved
balance by the $153 million budget reserve and the $350 million cash flow
account. The Minnesota Council of Economic Advisors has, for some time, urged
the State to increase its budget reserve substantially to 5% of biennial
spending. Planning estimates for the next biennium ending June 30, 2011,
reflecting the legislation, indicated that projected revenues would fall short
of projected expenditures by $946 million, not taking into account any balances
carried forward from the current biennium. While wage and price inflation is
included in revenue planning estimates, State law prohibits using a general
inflation adjustment to project expenditures. A general inflation adjustment of
1.9% each fiscal year would add $1.041 billion to expenditures for the next
biennium. The Department's next official Forecast will not be released until
November, so the information provided above does not reflect the nation's recent
economic difficulties. In its October 2008 Economic Update, the Department of
Finance reported that revenues for the fiscal year ending June 30, 2008 were
substantially greater than previously forecast, and that revenues during the
quarter ending September 30, 2008 also were more than estimated, despite very
weak sales tax collections. But the Update also warned that the State's national
economic consultant has forecast a much weaker economy for the remainder of 2008
and all of 2009 than was reflected in the budget projections discussed above.
Furthermore, the banking, securities and investment, and insurance sectors are
important contributors to the State's economy, reflecting approximately 5.9% of
total employment and an even larger share of wages and salaries.
35
The State is a party to a variety of civil actions that could
adversely and materially affect the State's General Fund. In addition,
substantial portions of State and local revenues are derived from federal
expenditures, and reductions in federal aid to the State and its political
subdivisions and other federal spending cuts may have substantial adverse
effects on the economic and fiscal condition of the State and its local
governmental units. Risks are inherent in making revenue and expenditure
forecasts. Economic or fiscal conditions less favorable than those reflected in
State budget forecasts may create additional budgetary pressures.
State grants and aids represent a large percentage of the total
revenues of cities, towns, counties and school districts in Minnesota, so State
budgetary difficulties may have substantial adverse effects on such local
government units. Generally, the State has no obligation to make payments on
local obligations in the event of a default. Accordingly, factors in addition to
the State's financial and economic condition will affect the creditworthiness of
Minnesota tax-exempt obligations that are not backed by the full faith and
credit of the State. Even with respect to revenue obligations, no assurance can
be given that economic or other fiscal difficulties and the resultant impact on
State and local government finances will not adversely affect the ability of the
respective obligors to make timely payment of the principal of and interest on
Minnesota tax-exempt obligations that are held by the Funds or the value or
marketability of such obligations.
Certain Minnesota tax legislation could adversely affect the
tax-exemption, value and marketability of Minnesota municipal bonds held by the
Funds. (Please see the final two paragraphs in "Taxation".) Possible future
changes in federal and State income tax laws, including rate reductions, also
could adversely affect the value and marketability of such bonds.
The foregoing information constitutes only a brief summary of some of
the general factors that may impact certain issuers of Minnesota municipal
obligations and does not purport to be a complete or exhaustive description of
all adverse conditions to which the issuers of such obligations held by the
Funds are subject. This information has not been independently verified.
Additionally, many factors, including national economic, social and
environmental policies and conditions, that are not within the control of the
issuers of Minnesota municipal bonds, could affect or could have an adverse
impact on the financial condition of the issuers. The Funds are unable to
predict whether or to what extent such factors or other factors may affect the
issuers of Minnesota municipal obligations, the market value or marketability of
such obligations or the ability of the respective issuers of the obligations
acquired by the Funds to pay interest on or principal of such obligations.
MISSOURI. Missouri's gross domestic product ("GDP") was over $229
billion in 2007, making Missouri the 22nd largest state economy. Missouri's
economy rests chiefly on industry, with aerospace and transportation equipment
as the main industries. Food products, chemicals, printing and publishing,
machinery, fabricated metals, and electrical equipment are also important. The
development of resorts in the Ozarks, including Branson and several lakes, has
boosted tourism income. St. Louis is an important center for the manufacture of
metals and chemicals. In Kansas City, long a leading market for livestock and
wheat, the manufacture of vending machines and of cars and trucks are leading
industries. Because Missouri and certain municipalities have large exposure to
manufacturing, trends in these industries, over the long term, may impact the
demographic and financial position of Missouri and its municipalities. Missouri
remains important agriculturally. With over 100,000 farms, the State ranks
second only to Texas. The most valuable farm products are soybeans, corn,
cattle, hogs, wheat, and dairy items. The State consistently ranks high in the
amount of cash it receives from farm crops, livestock and products. Because of
this, Missouri is subject to unique natural hazard risks. Cycles of drought and
flooding are concerns insofar as they affect agricultural production, in
addition to affecting drinking water and power supplies. Defense-related
businesses play an important role in Missouri's economy. In addition to the
large number of civilians employed at the various military installations and
training bases in the State, aircraft production and defense-related businesses
receive sizable annual defense contract awards, and thus Missouri is vulnerable
to possible cutbacks in defense spending. Over the past two decades, Missouri
has consistently ranked among the top eight states in total military contract
awards.
36
The June 2008 economic report from the Missouri Economic Research and
Information Center ("MERIC") shows that the end of 2007 and first half of 2008
have been a difficult time for both the U.S. and Missouri economies. The housing
market has not yet stabilized, creating problems across a wide array of
industries. A number of the State's large employers are in the auto industry
(Daimler Chrysler and Ford are the 17th and 19th largest employers,
respectively), which continues to struggle. The Kansas City Ford plant produces
the Ford F150 pickup truck and Chrysler's St. Louis plant produces minivans and
pickup trucks. These operations may face cut backs in production and employment.
In addition, the State has a heavy weighting of jobs in the defense industry,
which could weaken should military spending decline. Rising energy prices are
weighing on consumers and businesses alike. Consumer budgets are feeling the
additional strain of rising food prices. Labor markets are weak, with employment
decreasing in the majority of industries and unemployment rising. According to
U.S. Bureau of Labor Statistics' data, through November 2007, the State gained
12,000 jobs over the previous twelve months, growth of 0.4%, and 87,900 jobs
since January 2005. Between November 2006 and November 2007, 6,200 jobs were
lost in motor vehicle and transportation equipment manufacturing, a reduction of
9.5%. Conversely, the State gained 18,900 private service-producing jobs over
the same period, an increase of 1.0%. Despite this churning in the job market,
on a year-over-year basis, personal income growth during calendar year 2007 is
projected to be 5.4%, which is above average. Missouri's economic outlook over
the next two years is similar to that of the nation, weighed down by the general
outlook in the housing and automotive industries. However, Missouri's exporters
are benefiting from the weak dollar, and continue setting new records for total
exports. Growth will continue in the service sectors. Below average employment
growth of 0.4 to 0.6% is expected annually. Personal income growth will slow to
4.0% in 2008, increasing to 4.3% in 2009. Risks to this outlook include slower
consumer spending as a result of sharply reduced residential investment activity
and higher energy prices, and further slowdowns in vehicle manufacturing.
The State faces significant challenges related to the expenditure
demands of Medicaid, elementary and secondary education, higher education, and
correctional institutions. From a financial standpoint, Missouri continues to
proactively address its budget concerns and maintains a conservative financial
management policy. The Missouri Constitution limits the amount of taxes that can
be imposed in addition to giving the governor line-item veto power and the
authority to withhold allotments of appropriated funds in the course of a fiscal
year whenever actual revenues are below projections. A constitutional amendment
also requires a reserve fund be maintained at 7.5% of the previous year's net
general revenue collections. It remains fully funded.
General revenue growth below long-term averages is expected in FY
2009. The revised FY 2008 and initial FY 2009 revenue estimates project net
growth of 3.1% and 3.4%, respectively. The revenue base has held up well through
the first half of 2008. Growth in individual income tax receipts is expected to
remain strong. However, consumer spending on taxable items is being dragged down
as consumers consider reducing debt loads and dealing with high energy prices.
Tax changes in the form of income tax relief for seniors and sales tax relief
for manufacturers will slow revenue growth. Another year of substantial tax
credit growth will reduce receipts. General revenues in FY 2009 will be affected
by the slowing in the overall economy. Finally, the continued implementation of
the 2004 transportation ballot initiative, Constitutional Amendment No. 3, will
impact FY 2008 and FY 2009. This will lower general revenue collections by an
estimated $30 million annually.
Fixing any potential State revenue shortfalls may be complicated by
the fact that the State Constitution prohibits raising taxes beyond a certain
point without voter approval. The adoption by voters of revenue and expenditure
limitations, like Missouri's Hancock Amendment, a measure that limits the growth
of State-government income, has placed many local governments under a degree of
fiscal stress. The amendment, which was approved by voters in 1980, generally
restricts the growth of State income to the rate of growth of personal income in
Missouri. It also requires that voters must approve most government tax or fee
increases.
In November 2000, the voters of Missouri approved the creation of a
Budget Reserve Fund (commonly called the "Rainy Day" fund) by combining the
State's Cash Operating Reserve Fund and the Budget Stabilization Fund. The fund
is required to have 7.5% of the previous year's net general revenue
37
collections. Reductions in the Rainy Day fund may adversely affect future State
budgets if such funds are needed to cover additional revenue shortfalls.
Local governments face additional constraints that may limit their
ability to raise money. These constraints may impact the municipal obligations
of these issuers. In Missouri, the property tax has traditionally been the
largest source of revenue for local governments in general. Property taxes are
taxes on the value of real property (such as land and buildings) owned by a
resident or business in the community and are paid on an annual basis. For
counties, property tax revenues are 40% of total revenues, and for
municipalities, 17%. In Missouri, tax levies were reduced following reassessment
pursuant to Article X Section 22 of the Constitution of Missouri adopted by the
voters in 1980 to ensure that taxing jurisdictions would not reap windfalls as a
result of biennial reassessments. Thus, revenues generated after implementation
of reassessment did not increase appreciably from revenues received prior to the
statewide reassessment program.
Missouri's general obligation debt carries ratings of "Aaa" by Moody's
and "AAA" by Standard & Poor's and Fitch. Missouri is one of only seven states
that has received this rating from all three rating organizations. General
obligation bonds can only be issued through voter-approved amendments to the
State's Constitution.
There are also limitations on State and local debt issuance that may
affect the ability to generate revenue on a State and local level. Limitations
on the State debt and bond issues are contained in Article III, Section 37 of
the Constitution of Missouri. The General Assembly, or the people by initiative,
may submit the proposition to incur indebtedness to voters of the State, and the
bonds may be issued if approved by a majority of those voting. Locally, under
Article V of the Missouri Constitution, no county, city, incorporated town or
village, school district or other political corporation or subdivision of the
State is allowed to incur debt beyond the income and revenue provided for such
year plus any unencumbered balances from previous years.
Missouri has a Constitutional Amendment, Article X, approved by voters
in November 1980, that limits revenue to the ratio of FY 1980-81 State revenue
to calendar year 1979 State personal income (about 5.6%) multiplied by the
greater of State personal income in the previous calendar year or the average
State personal income over the previous three calendar years. No assurances can
be given that the amount of revenue derived from taxes will remain at its
current level or that the amount of State grants to local governments will
continue. Future spending cuts and budgetary constraints may adversely affect
local government by placing shifting additional monetary and administrative
burdens onto local governments.
The foregoing information constitutes only a brief summary of some of
the general factors that may impact certain issuers of Missouri municipal
obligations and does not purport to be a complete or exhaustive description of
all adverse conditions to which the issuers of such obligations held by the
Missouri Tax Free Fund are subject. This information has not been independently
verified. Additionally, many factors, including national economic, social and
environmental policies and conditions, which are not within the control of the
issuers of Missouri municipal bonds, could affect or could have an adverse
impact on the financial condition of the issuers. The Fund is unable to predict
whether or to what extent such factors or other factors may affect the issuers
of Missouri municipal obligations, the market value or marketability of such
obligations or the ability of the respective issuers of the obligations acquired
by the Fund to pay interest on or principal of such obligations.
NEBRASKA. Agriculture is Nebraska's dominant occupational pursuit. The
State's chief agricultural products are cattle, corn, hogs, soybeans, and wheat.
As the dollar depreciates against other foreign currencies, U.S. exports are
promoted. Nebraska's agriculture sector has a large dependency on international
markets. If the U.S. dollar falls too quickly, this could harm Nebraska's
trading partners, weakening their economies and lowering their demand for
Nebraska products. A controlled lowering of the U.S. dollar is most beneficial
to the Nebraska economy. Because of the importance of agriculture, Nebraska is
also subject to unique natural hazard risks. Cycles of drought and flooding are
concerns insofar as they affect agricultural production, power generation, and
the supply of drinking water. Droughts also lead to
38
less sales tax revenue, less income tax, fewer sales at retailers in rural
Nebraska and other potential negative effects on local municipal government.
Nebraska's gross domestic product ("GDP") was $80 billion in 2007,
making Nebraska the 36th largest state economy. Nebraska's largest industry is
food processing, which derives much of its raw materials from local farms. The
State has diversified its industries since World War II, and the manufacture of
electrical machinery, primary metals, and transportation equipment, is also
important. Mineral deposits of oil (discovered in Cheyenne County in 1949-50),
sand and gravel, and stone contribute to the State's economy. Data from the
State Department of Labor show Nebraska's total nonfarm employment (not
seasonally adjusted) at 974,336, which is 1.1% more than August 2007. Nebraska's
annual average unemployment rate has been among the lowest in the nation for the
last decade. In August 2008, State labor data showed Nebraska's unemployment
rate (not seasonally adjusted) at 3.2%, compared to 6.1% nationally. The Bureau
of Business Research of the University of Nebraska-Lincoln and the Nebraska
Business Forecast Council remain optimistic on Nebraska's economic future and
have published the following comments about its economy. Aggregate farm income
is expected to grow rapidly in the next two years. Solid broad-based employment
growth, rising proprietor incomes, and strong growth in dividend and interest
incomes will lead to strong overall growth in non-farm personal income. While
housing construction will not fully recover until 2008 or 2009, other components
of the construction industry, such as hospital, health care, hotel and
restaurant construction activity should grow steadily. Nebraska should also
continue to benefit from further decentralization of manufacturing activity away
from the industrial Midwest to areas in Nebraska. Opportunities continue to
improve in the food processing sector and the transportation and warehousing
industries are expected to continue to expand rapidly. Finally, strong growth is
expected in services employment, in areas such as health care and social
assistance.
The General Fund is the chief operating fund of the State. The major
General Fund liability is the estimated tax refunds payable of $291 million.
Such refunds payable are $11 million less than the expected taxes owed the
State. Other assets of the General Fund available to pay non tax-refund
liabilities exceed such liabilities by $961 million. On June 30, 2006, the
General Fund had a positive fund balance of $692 million. While both revenues
and expenditures increased in 2007, revenues again exceeded expenditures which
increased the fund balance $285 million in 2007, which was about equal to the
$289 million increase that occurred in 2006. This operating increase in 2007,
when coupled with the $6 million of net transfers out, caused the General Fund
balance to increase by $279 million, ending with a fund balance of $972 million.
Revenues in 2007 were more than anticipated and were up $131 million over 2006
chiefly due to (1) an increase in income tax revenue of $58 million (a 3%
increase) over 2006 and (2) increased investment income of $57 million due to
more funds being invested at higher interest rates. Sales taxes from increased
retail sales were up 1.5% over last year. Expenditures were less than budgeted
due to continued efforts by agency heads to be conservative in spending.
To compensate for any downturns in revenues, the State has maintained
a budgetary basis Cash Reserve Fund. While this Cash Reserve Fund is commingled
with General Fund cash in the General Fund financial statements, it is separate
and distinct in that, by State statute, it can only be used (1) when the cash
balance of the General Fund is insufficient to meet General Fund current
obligations and (2) for legislatively mandated transfers to other funds. Any
money transferred in accordance with item one above must be repaid as soon as
there is sufficient cash in the General Fund cash account to do so. No such need
existed in 2007. The Cash Reserve Fund was at $177 million at the beginning of
2006. Due to the fact that 2005 revenues exceeded the forecast, a statutory
requirement caused a $262 million transfer from the General Fund cash account to
the Cash Reserve Fund in fiscal year 2006 in July 2005. Offsetting this large
transfer was a $146 million payment made on August 1, 2005 from the Cash Reserve
Fund to settle a lawsuit against the State related to a low-level radioactive
waste site. There were also other transfers out of the Fund of $19 million,
leaving a Cash Reserve Fund balance at June 30, 2006 of $274 million. The
statutory transfer for excess receipts for FY 2006 of $260 million was made in
July, 2006. There were transfers out of the reserve of $18 million, leaving a
balance of $516 million at June 30, 2007.
Certain municipal securities may be obligations of issuers that rely
in whole or in part on State revenues for payment of such obligations. A decline
in State revenues may adversely affect the obligations of these municipal
security issuers.
39
General obligation bonds of the State maintain an "AA+" rating from
Standard and Poor's, as of July 2008. There can be no assurance that such
ratings will be maintained in the future. It should be noted that the
creditworthiness of obligations issued by local Nebraska issuers may be
unrelated to the creditworthiness of obligations issued by the State of
Nebraska, and that there is no obligation on the part of the State to make
payment on such local obligations in the event of default.
The foregoing information constitutes only a brief summary of some of
the general factors which may impact certain issuers of Nebraska municipal
obligations and does not purport to be a complete or exhaustive description of
all adverse conditions to which the issuers of such obligations held by the
Nebraska Tax Free Fund are subject. This information has not been independently
verified. Additionally, many factors, including national economic, social and
environmental policies and conditions, which are not within the control of the
issuers of Nebraska municipal bonds, could affect or could have an adverse
impact on the financial condition of the issuers. The Fund is unable to predict
whether or to what extent such factors or other factors may affect the issuers
of Nebraska municipal obligations, the market value or marketability of such
obligations or the ability of the respective issuers of the obligations acquired
by the Fund to pay interest on or principal of such obligations.
OHIO. Ohio's gross domestic product ("GDP") was $466 billion in 2007,
making Ohio the 7th largest state economy. Ohio ranks third in the nation in
manufacturing, with a concentration of both durable and non-durable goods
production, especially transportation equipment (mostly cars, trucks and their
parts), primary metals (principally iron and steel), fabricated metal products,
non-metallic mineral products, electrical equipment and appliances, machinery,
and plastic and rubber products. As a result of Ohio's reliance on
manufacturing, the State's general economic activity, as in many other
industrially developed states, tends to be more cyclical than in some other
states and in the nation as a whole. Economic activity in and around Ohio has
been sluggish. Ohio's seasonally adjusted unemployment rate was 7.2% in
September 2008, up from 5.9% in September 2007. The U.S. seasonally adjusted
unemployment rate for September 2008 was 6.1%. Total employment in Ohio is
expected to increase 7.3% over the 10-year period from 2004-2014. Personal
income in Ohio grew at 4.7% in 2007. The State is projecting slow growth through
2008 with a 1.9% increase in personal income. Industrial and construction
activity deteriorated in Ohio and across the country over the course of the
summer in 2008. Real consumer income and spending probably declined during the
third quarter of 2008 and is expected to decline further during the fourth
quarter.
Although manufacturing remains the largest single major sector in
Ohio, the service-producing sectors now produce a combined 76% of the State's
GDP and are expected to account for virtually all job growth over the 2004-2014
period. Service sectors concentrated in Ohio include the management of companies
and enterprises and, to a lesser extent, the provision of health care and social
assistance.
The State operates on the basis of a fiscal biennium for its
appropriations and expenditures. Under current law that biennium for operating
purposes runs from July 1 in an odd-numbered year to June 30 in the next
odd-numbered year. The current fiscal biennium began July 1, 2007 and will end
June 30, 2009. Most State operations are financed through the general revenue
fund ("GRF"). Personal income and sales use taxes are the major GRF sources.
Growth and depletion of GRF ending fund balances show a consistent pattern
related to national economic conditions, with the ending fiscal year balance
reduced during less favorable and increased during more favorable economic
periods. The Ohio constitution prohibits the State from borrowing money to fund
operating expenditures in the GRF. Therefore, by law, the GRF's budget must be
balanced so that appropriations do not exceed available cash receipts and cash
balances for the current fiscal year. The State also maintains a "rainy day"
fund, the Budget Stabilization Fund ("BSF"), generally funded by designation
from the fiscal year GRF surplus, if any, and which under current law and until
used is intended to carry a balance of up to 5% of the GRF revenue for the
preceding fiscal year.
Fiscal Year ("FY") 2008 GRF tax revenues were $31.8 million below
original estimates. Total expenditures in FY 2008 totaled $26.4 billion, which
was 1.9% above FY 2007 levels, but 2.4% below original forecast. As of the end
of FY 2008 (June 30, 2008), the State had a GRF budgetary fund balance of $807.5
million, up from the $215.5 million fund balance at the end of FY 2007. With the
State's economy expected to be negatively affected by the national economic
downturn, the Ohio Office of Budget and
40
Management ("OBM") has been closely monitoring the State's major revenue sources
(especially the sales, personal and corporate income taxes) and in January 2008
reduced its original GRF revenue projections by $172.6 million for FY 2008 and
$385.1 for FY 2009. Based on those lower GRF revenue estimates and increased
costs associated with rising Medicaid caseloads, OBM projected a budgetary
shortfall for the current biennium (June 30, 2009) of $733 million. In response,
on January 31, 2008, Governor Ted Strickland issued an executive order directing
expenditure reductions and spending controls totaling approximately $509.1
million for the biennium as well as limitations on major purchases, hiring and
travel. An employee reduction plan was also announced aimed at reducing the
State's workforce by up to 2,700 through attrition, unfilled vacancies and an
early retirement incentive program. Expressly excluded from the cutbacks are
appropriations for or relating to debt service on State obligations, State
higher education instructional support, foundation formula support for primary
and secondary education, Medicaid entitlement programs, and ad valorem property
tax relief payments. The General Assembly has also identified the following
measures including (i) various transfers totaling $183 million, including
unspent agency appropriations; (ii) cancelling cost of living adjustments for
certain exempt State employees; and (iii) authorizing expansion of the State-run
lottery system to include "keno" games. Based on the expenditure reductions,
spending controls and other measures identified above, OBM is currently
projecting a positive GRF fund balance at the end of the current biennium. The
State's Constitution precludes the State from ending a fiscal year or biennium
in a "deficit" position. The Governor and OBM will continue to closely monitor
revenues and expenditures and work with the General Assembly to ensure these
positive GRF ending fund balances.
Most capital improvements in Ohio are funded through the issuance of
debt. The incurrence or assumption of debt by the State without a popular vote
is, with limited exceptions, prohibited by the State Constitution. Currently,
tax supported general obligation debt of the State is authorized to be incurred
for the following purposes: highways, local infrastructure, coal development,
natural resources, higher education, common schools, conservation, research and
development, and site development. State special obligation debt is authorized
by the State Constitution for certain specified purposes. This debt is not
supported by excises or taxes levied by the General Assembly. Rather, debt
service payments are subject to biennial appropriations (from the GRF, with
certain exceptions) by the General Assembly pursuant to leases or agreements
entered into by the State. A 1999 constitutional amendment provides an annual
debt service "cap" applicable to future issuances of State general obligations
and other State direct obligations payable from the GRF or net State lottery
proceeds. Generally, and except for the additional $650,000,000 of general
obligation debt approved by voters at the November 8, 2005 election for research
and development and the development of sites and facilities, new bonds may not
be issued if future fiscal year debt service on those new and the then
outstanding bonds of those categories would exceed 5% of the total estimated GRF
revenues plus net State lottery proceeds during the fiscal year of issuance.
Direct obligations of the State subject to the debt service cap include general
obligation and special obligation bonds that are paid from the State's GRF, but
exclude general obligation bonds payable from non-GRF funds (such as highway
bonds that are paid from highway user receipts). Application of the 5% cap may
be waived in a particular instance by a three-fifths vote of each house of the
Ohio General Assembly.
State and local agencies issue obligations that are payable from
revenues from or relating to certain facilities (but not from taxes). By
judicial interpretation, these obligations are not "debt" within constitutional
provisions described above. Ohio's general obligation debt is rated "Aa1" by
Moody's and "AA+" by Fitch. There can be no assurance that such ratings will be
maintained in the future. It should be noted that the creditworthiness of
obligations issued by local Ohio issuers may be unrelated to the
creditworthiness of obligations issued by the State of Ohio, and that there is
no obligation on the part of the State to make payment on such local obligations
in the event of default.
The foregoing information constitutes only a brief summary of some of
the general factors that may impact certain issuers of Ohio municipal
obligations and does not purport to be a complete or exhaustive description of
all adverse conditions to which the issuers of such obligations held by the Ohio
Tax Free Fund are subject. This information has not been independently verified.
Additionally, many factors, including national economic, social and
environmental policies and conditions, which are not within the control of the
issuers of Ohio municipal bonds, could affect or could have an adverse impact on
the financial condition of the issuers. The Fund is unable to predict whether or
to what extent such factors
41
or other factors may affect the issuers of Ohio municipal obligations, the
market value or marketability of such obligations or the ability of the
respective issuers of the obligations acquired by the Fund to pay interest on or
principal of such obligations.
OREGON. Oregon has a diverse economic base with significant components
in timber and other natural resources, construction, high technology,
manufacturing, trade and tourism. Oregon's gross domestic product ("GDP") was
$158 billion in 2007, making Oregon the 26th largest state economy. According to
the September 2008 data from the Oregon Office of Economic Analysis ("OEA"), the
second quarter of 2008 would have been the 20th consecutive quarter of rising
employment in the State. This five-year pace was cut short one quarter with a
seasonally adjusted job decline of 1.7%. Except for the 1.6% job growth in the
first quarter of 2008, the quarterly job gains have been below 1.0% since the
second quarter of 2007. On a year-over-year basis, jobs increased in the second
quarter by 0.4%. The same areas which have been pressuring the U.S. economy over
the past year are also taking their toll on the Oregon economy. The combined
softening impacts of housing, financial, and energy markets are causing
widespread slowing in job markets. Employment sectors that lost jobs in the
second quarter include construction, manufacturing, retail trade, information,
financial activities, and leisure and hospitality. Although the job losses are
spread across many sectors, private education and health services had strong job
gains. OEA forecasts a decline of 0.7% in total employment in third quarter 2008
and further declines of 0.9% in the fourth quarter of 2008. The first quarter of
2009 will still be anemic with growth of 0.4%. The Oregon economy is not
forecasted to recover until the latter part of 2009.
The OEA's September 2008 forecast for General Fund revenues for the
2007-09 biennium is $12.9 billion, a decrease of $119.2 million from the June
2008 forecast. The relatively small decrease (approximately 1%) is the result of
the expectation of the current economic slowdown extending well into 2009,
rather than turning around earlier in the year. The projected ending balance for
2007-09 equals $23.8 million, $119.2 million below the June 2008 forecast. Total
General Fund revenues are forecasted to increase 19.9% to $15.5 billion in the
2009-11.
Like other segments of Oregon's economy, geography and natural
resources have played a role in the development of the State's international
activities. The majority of the State's international trade occurs through the
Port of Portland, where an efficient system for dealing with a large number of
vessels has been developed, including modern grain elevators, cranes, break-bulk
and containerized cargo facilities, and ship repair and dry-dock facilities.
Other important ports are located at the coastal cities of Astoria, Newport and
Coos Bay. The State has a total of 23 port districts, all of which are located
on navigable waterways.
Oregon natural resources attract millions of visitors each year.
Nearly four hundred miles of the Oregon Coast define its western border, where
all the beaches are public by statute. With nine climate regions, Oregon offers
a variety of environments from rain forest to high desert, and plateau to
dormant volcanic ranges topped with glacier-covered peaks. As Oregon's economy
continues to diversify, tourism plays a vital role in creating new job
opportunities and strengthening local and regional revenues. In 2007, an
estimated $8.3 billion was generated in Oregon by travel spending, a 5.2%
increase over 2005 spending.
The Oregon budget is approved on a biennial basis by separate
appropriation measures. Although the governor recommends a budget, no omnibus
budget measure is approved. A biennium begins July 1 and ends June 30 of
odd-numbered years. Measures are passed for the approaching biennium during each
regular legislative session, held beginning in January of odd-numbered years.
The most significant feature of the budgeting process in Oregon is the
constitutional requirement that the budget be in balance at the end of each
biennium. Because of this provision, Oregon may not budget a deficit and is
required to alleviate any revenue shortfalls within each biennium.
The 1979 Legislative Assembly approved a statutory mechanism under
which taxpayers could receive a tax refund if certain conditions occurred after
the close of the legislative session. This statutory process was made a
constitutional requirement by voters at the November 2000 General Election. If
the estimated revenues from either of two General Fund revenue categories of
corporate tax or all other revenues (which includes the personal income tax) is
exceeded by more than 2%, a tax credit for corporations or a tax refund for
individuals is extended to all taxpayers in that category (also known as the
42
"2% kicker"). For corporations, the credit is based on the tax liability for the
calendar year containing the end of the biennium (for example, 1999 liability
for the 1997-99 kicker). For individuals, the refund is based on the previous
calendar year's tax liability (for example, the 1998 liability for the 1997-99
kicker). The personal tax refund has been triggered eight times since 1981 and
was last triggered for during the 2005-2007 biennium. The corporate tax credit
was last triggered in 2003-05, the sixth time that it has occurred. Under the
constitutional amendment adopted in November 2000, the State may retain the
kicker moneys only if two-thirds of each house of the Legislative Assembly votes
to keep the kicker.
Oregon does not have a sales tax. As a result, State tax revenues are
particularly sensitive to economic recessions. The principal source of State tax
revenues are personal income and corporate income taxes. The State derives a
substantial majority of its general fund revenues from its personal income tax
and is, therefore, particularly susceptible to economic changes that affect
personal income levels. Among the risks facing the Oregon economy are:
geopolitical events and domestic economic factors (such as inflation, increased
interest rates or stock market corrections) that could depress business activity
or consumer behavior; changes in the value of the U.S. dollar against foreign
currencies that could lower demand for Oregon products; a possible collapse of
the housing market; rising regional energy prices slower than anticipated
recovery or outsourcing of manufacturing; and possible reforms to the State's
public employees retirement system, possible State and local government budget
shortfalls and other potential initiatives and reforms that could result in
increased taxes, reduced services and increased debt to address unfunded
liabilities.
The Oregon State Constitution reserves to the people the initiative
power to amend the constitution and State statutes by placing measures on the
general election ballot. In the November 2004 general election, Oregon voters
approved Measure 37, which entitles certain landowners to compensation for the
decline in market value of their property as a result of certain land use
regulations, or alternatively, to have land use regulations waived as to their
use of their property. Measure 37 primarily affects the State, counties and
certain other units of local government that make and enforce Oregon's land use
laws. According to a report of the Institute of Portland Metropolitan Studies at
Portland State University, at the end of October 2006, approximately 3,500
Measure 37 claims had been filed, requesting a total of more than $6 billion in
compensation. The vast majority of Measure 37 claims submitted have resulted in
a waiver of land use regulations. There can be no assurance that most Measure 37
claims will continue to be waived in the future, or that litigation will not
require the payment of some claims. A lawsuit was filed challenging the
constitutionality of Measure 37, and in February 2006, the Oregon Supreme Court
held that the measure does not violate the Oregon or U.S. Constitution.
Additional lawsuits have been filed, and remain pending, challenging denials of
claims and waivers.
The 2003 State Legislative Assembly enacted certain changes to the
Oregon Public Employees Retirement System (PERS). These changes were challenged
in several lawsuits in State and federal courts. The Oregon State Supreme Court
ruled on several of the cases in March 2005, upholding some changes and
rejecting others. Other cases remain pending in State and federal courts.
Depending on the outcome of these cases, State and local governments may need to
increase taxes, reduce other expenditures or increase bonded indebtedness to
cover unfunded liabilities to PERS.
As of July 2008, all outstanding general obligation bonds of the State
of Oregon are rated "AA" by S&P and "Aa2" by Moody's. Each such rating reflects
only the views of the respective rating agency, and an explanation of the
significance of such rating may be obtained from such rating agency. There is no
assurance that such ratings will continue for any given period of time or that
they will not be revised downward or withdrawn entirely by such rating agency
if, in the judgment of such rating agency, circumstances so warrant. Any such
downward revisions or withdrawals of ratings could have adverse effects on the
market price of the State's municipal obligations.
The foregoing information constitutes only a brief summary of some of
the general factors that may impact certain issuers of Oregon municipal
obligations and does not purport to be a complete or exhaustive description of
all adverse conditions to which the issuers of such obligations held by the
Oregon Intermediate Tax Free Fund are subject. This information has not been
independently verified.
43
Additionally, many factors, including national economic, social and
environmental policies and conditions, which are not within the control of the
issuers of Oregon municipal bonds, could affect or could have an adverse impact
on the financial condition of the issuers. The Fund is unable to predict whether
or to what extent such factors or other factors may affect the issuers of Oregon
municipal obligations, the market value or marketability of such obligations or
the ability of the respective issuers of the obligations acquired by the Fund to
pay interest on or principal of such obligations.
INVESTMENT RESTRICTIONS
In addition to the investment objectives and policies set forth in the
Prospectus and under the caption "Additional Information Concerning Fund
Investments" above, each of the Funds is subject to the investment restrictions
set forth below. The investment restrictions set forth in paragraphs 1 through 8
below are fundamental and cannot be changed with respect to a Fund without
approval by the holders of a majority of the outstanding shares of that Fund as
defined in the 1940 Act, i.e., by the lesser of the vote of (a) 67% of the
shares of the Fund present at a meeting where more than 50% of the outstanding
shares are present in person or by proxy, or (b) more than 50% of the
outstanding shares of the Fund.
None of the Funds will:
1. Concentrate its investments in a particular industry, except that
any Fund with one or more industry concentrations implied by its
name shall, in normal market conditions, concentrate in
securities of issues within that industry or industries. For
purposes of this limitation, the U.S. Government, and state or
municipal governments and their political subdivisions are not
considered members of any industry.
44
Whether a Fund is concentrating in an industry shall be
determined in accordance with the 1940 Act, as interpreted or
modified from time to time by any regulatory authority having
jurisdiction.
2. Borrow money or issue senior securities, except as permitted
under the 1940 Act, as interpreted or modified from time to time
by any regulatory authority having jurisdiction.
3. With respect to 75% of its total assets, purchase securities of
an issuer (other than (i) securities issued by other investment
companies, (ii) securities issued by the U.S. Government, its
agencies, instrumentalities or authorities, or (iii) repurchase
agreements fully collateralized by U.S. Government securities) if
(a) such purchase would, at the time, cause more than 5% of the
Fund's total assets taken at market value to be invested in the
securities of such issuer; or (b) such purchase would, at the
time, result in more than 10% of the outstanding voting
securities of such issuer being held by the Fund. This investment
restriction does not apply to the Tax Free Funds (other than Tax
Free Fund, Short Tax Free Fund and Intermediate Tax Free Fund).
4. Invest in companies for the primary purpose of control or
management.
5. Purchase physical commodities or contracts relating to physical
commodities. With respect to Inflation Protected Securities Fund,
this restriction shall not prohibit the Fund from investing in
options on commodity indices, commodity futures contracts and
options thereon, commodity-related swap agreements, and other
commodity-related derivative instruments.
6. Purchase or sell real estate unless as a result of ownership of
securities or other instruments, but this shall not prevent the
Funds from investing in securities or other instruments backed by
real estate or interests therein or in securities of companies
that deal in real estate or mortgages.
7. Act as an underwriter of securities of other issuers, except to
the extent that, in connection with the disposition of portfolio
securities, it may be deemed an underwriter under applicable
laws.
8. Make loans except as permitted under the 1940 Act, as interpreted
or modified from time to time by any regulatory authority having
jurisdiction.
For purposes of applying the limitation set forth in number 1 above,
according to the current interpretation by the SEC, a Fund would be concentrated
in an industry if 25% or more of its total assets, based on current market value
at the time of purchase, were invested in that industry. The Funds will use
industry classifications provided by Bloomberg, Lehman Brothers, or other
similar sources to determine its compliance with this limitation.
For purposes of applying the limitation set forth in number 2 above,
under the 1940 Act as currently in effect, the Fund is not permitted to issue
senior securities, except that the Fund may borrow from any bank if immediately
after such borrowing the value of the Fund's total assets is at least 300% of
the principal amount of all of the Fund's borrowings (i.e., the principal amount
of the borrowings may not exceed 33 1/3% of the Fund's total assets). In the
event that such asset coverage shall at any time fall below 300% the Fund shall,
within three days thereafter (not including Sundays and holidays) reduce the
amount of its borrowings to an extent that the asset coverage of such borrowing
shall be at least 300%.
For purposes of applying the limitation set forth in number 8 above,
there are no limitations with respect to unsecured loans made by the Fund to an
unaffiliated party. However, when the Fund loans its portfolio securities, the
obligation on the part of the Fund to return collateral upon termination of the
loan could be deemed to involve the issuance of a senior security within the
meaning of Section 18(f) of the 1940 Act. In order to avoid violation of Section
18(f), the Fund may not make a loan of portfolio securities if, as a result,
more than one-third of its total asset value (at market value computed at the
time of making a loan) would be on loan.
Because each of the Tax Free Funds refers to tax-free investments in
its name, each has a fundamental investment policy that it will normally invest
at least 80% of its assets in investments that pay interest exempt from federal
and, for state-specific funds, applicable state income tax, including the
federal alternative minimum tax and, for the state-specific funds (except for
Arizona Tax Free Fund, Missouri Tax Free Fund, Nebraska Tax Free Fund, Ohio Tax
Free Fund, and Oregon Intermediate Tax Free Fund), the applicable state
alternative minimum tax.
The following restrictions are non-fundamental and may be changed by
FAIF's Board of Directors without a shareholder vote:
None of the Funds will:
1. Invest more than 15% of its net assets in all forms of illiquid
investments.
45
2. Borrow money in an amount exceeding 10% of the borrowing Fund's
total assets except that High Income Bond Fund may borrow up to
one-third of its total assets and pledge up to 15% of its total
assets to secure such borrowings. None of the Funds will borrow
money for leverage purposes. For the purpose of this investment
restriction, the use of options and futures transactions and the
purchase of securities on a when-issued or delayed delivery basis
shall not be deemed the borrowing of money. No Fund will make
additional investments while its borrowings exceed 5% of total
assets.
3. Make short sales of securities.
4. Lend portfolio securities representing in excess of one-third of
the value of its total assets.
5. Pledge any assets, except in connection with any permitted
borrowing and then in amounts not in excess of one-third of the
Fund's total assets, provided that for the purposes of this
restriction, margin deposits, security interests, liens and
collateral arrangements with respect to options, futures
contracts, options on futures contracts, and other permitted
investments and techniques are not deemed to be a pledge of
assets for purposes of this limitation.
6. Acquire any securities of registered open-end investment
companies or registered unit investment trusts in reliance on
subparagraph (F) or subparagraph (G) of Section 12(d)(1) of the
1940 Act.
With respect to the non-fundamental restriction set forth in number 1
above, the Fund will monitor portfolio liquidity on an ongoing basis and, in the
event more than 15% of the Fund's net assets are invested in illiquid
investments, the Fund will reduce its holdings of illiquid securities in an
orderly fashion in order to maintain adequate liquidity.
The Board of Directors has adopted guidelines and procedures under
which the Funds' investment advisor is to determine whether the following types
of securities which may be held by certain Funds are "liquid" and to report to
the Board concerning its determinations: (i) securities eligible for resale
pursuant to Rule 144A under the Securities Act of 1933; (ii) commercial paper
issued in reliance on the "private placement" exemption from registration under
Section 4(2) of the Securities Act of 1933, whether or not it is eligible for
resale pursuant to Rule 144A; (iii) interest-only and principal-only, inverse
floating and inverse interest-only securities issued or guaranteed by the U.S.
Government or its agencies or instrumentalities; and (iv) municipal leases and
securities that represent interests in municipal leases.
For determining compliance with its investment restriction relating to
industry concentration, each Fund classifies asset-backed securities in its
portfolio in separate industries based upon a combination of the industry of the
issuer or sponsor and the type of collateral. The industry of the issuer or
sponsor and the type of collateral will be determined by the Advisor. For
example, an asset-backed security known as "Money Store 94-D A2" would be
classified as follows: the issuer or sponsor of the security is The Money Store,
a personal finance company, and the collateral underlying the security is
automobile receivables. Therefore, the industry classification would be Personal
Finance Companies -- Automobile. Similarly, an asset-backed security known as
"Midlantic Automobile Grantor Trust 1992-1 B" would be classified as follows:
the issuer or sponsor of the security is Midlantic National Bank, a banking
organization, and the collateral underlying the security is automobile
receivables. Therefore, the industry classification would be Banks --
Automobile. Thus, an issuer or sponsor may be included in more than one
"industry" classification, as may a particular type of collateral.
46
FUND NAMES
With respect to any Fund, with the exception of any Tax Free Fund,
that has adopted an investment strategy pursuant to Rule 35d-1 of the 1940 Act,
whereby at least 80% of the Fund's net assets (plus the amount of any borrowings
for investment purposes) must be invested in a strategy suggested by the Fund's
name, a policy has been adopted by the Funds to provide shareholders with at
least 60 days notice in the event of a planned change to the investment
strategy. Such notice to shareholders will meet the requirements of Rule
35d-1(c).
DISCLOSURE OF PORTFOLIO HOLDINGS
PUBLIC DISCLOSURE
Each Fund is required by the SEC to file its portfolio holdings
schedule with the SEC on a quarterly basis. This schedule is filed with each
fund's annual and semi-annual reports on form N-CSR for the second and fourth
fiscal quarters and on Form N-Q for the first and third fiscal quarters. These
filings are generally available within sixty days of the end of the relevant
Fund's fiscal quarter. In addition, the First American Fund Family makes
portfolio holdings information publicly available for all First American Funds
other than Equity Index Fund, Mid Cap Index Fund and Small Cap Index Fund (the
"Index Funds," series of FAIF), the series of FAF (the "Money Market Funds"),
which are money market funds, and the series of the Mount Vernon Trust by
posting the information on the First American Funds website on a quarterly
basis. The Funds will attempt to post such information within ten business days
of the quarter end. Until such time as it is posted, it will be Undisclosed
Holdings Information, as defined below, and subject to the Funds' procedures
regarding the disclosure of Undisclosed Holdings Information.
NONPUBLIC DISCLOSURE
The Funds' board of directors has adopted policies and procedures (the
"Disclosure Policies"), which prohibit the release of information concerning
portfolio holdings, or information derived therefrom ("Undisclosed Holdings
Information"), that has not been made public through SEC filings or the website.
Different exceptions to this prohibition are made depending on the type of third
party that receives the Undisclosed Holdings Information. The Disclosure
Policies are designed to prevent the use of portfolio holdings information to
trade against the Funds, or otherwise use the information in a way that would
harm the Funds, and to prevent selected investors from having nonpublic
information that will allow them to make advantageous decisions with respect to
purchasing and selling Fund shares.
Because the portfolios of the Index Funds generally mirror the
composition of published indices, the Index Funds are not subject to the
Disclosure Policies. In addition, the Money Market Funds are not subject to the
Disclosure Policies because these Funds hold only short-term money market
securities that generally do not vary significantly in value over short periods
of time. The Mount Vernon Trust is not subject to the Disclosure Policies
because the series of the trust are not available to the general public, but are
only offered in connection with the investment of collateral received in
connection with securities lending. Because of the types of securities held by,
or the limited purpose of, the foregoing Funds, such Funds' portfolio holdings
information would not be subject to the types of misuses that the Disclosure
Policies are designed to prevent.
Disclosure within FAF Advisors and Its Affiliates and to Fund
Directors. Undisclosed Holdings Information and information derived therefrom is
provided, or otherwise made available, on a daily basis (a) without prior
approval, to individuals who are employed by FAF Advisors and who have a need to
know the information, such as investment, compliance and treasury personnel, and
(b) to individuals employed by affiliates of FAF Advisors who are not otherwise
entitled to receive such information under "Disclosure to Fund Service Providers
and Prospective Service Providers," below, if (1) such individuals are subject
to FAF Advisors Code of Ethics, or that of an affiliate, which imposes a duty
not to trade on such information; (2) the fund to which such information relates
is subject to FAF Advisors' market timing review; and (3) FAF Advisors' Internal
Compliance Controls Committee has determined that improper use of such
information by such individuals is not likely to affect the funds in any
material respect based on factors such as the types of funds to which the
Undisclosed Holdings Information relate, the flows of investment into such
funds, and reports of portfolio managers regarding the stability of assets in
such funds.
Undisclosed Holdings Information and information derived therefrom
also may be provided to directors of the First American Funds and their service
providers, such as counsel, as part of the materials for regular or special
board of directors meetings without prior approval.
47
Disclosure to Fund Service Providers and Prospective Service
Providers. Undisclosed Holdings Information and information derived therefrom is
provided, or otherwise made available, on a daily basis to the Advisor (as
described above), sub-advisors, custodians, administrators, transfer agents,
securities lending agents, and outside accountants. Undisclosed Holdings
Information may also be provided to outside counsel, entities that provide Class
B share financing, proxy voting organizations, financial printers, pricing
services and other organizations that provide or propose to provide services to
the First American Funds. Prior to receiving Undisclosed Holdings Information, a
service provider or prospective service provider must enter into a written
agreement with the Funds to maintain the information in confidence, to use the
information only for the purpose for which it is provided, and not to trade on
the basis of any such information that is material nonpublic information.
Notwithstanding the foregoing, any sub-advisor to a First American Fund may
disclose Undisclosed Holdings Information and information derived therefrom to
any third party which it employs to perform accounting, administrative,
reporting or ancillary services required to enable such sub-advisor to perform
its functions under its sub-advisory agreement relating to such First American
Fund, provided that (a) the third party is subject to a confidentiality
agreement that specifically prevents the misuse of such information, and (b) the
sub-advisor agrees in substance (i) to act in good faith and with due diligence
in the selection, use and monitoring of such third parties, and (ii) to be
solely responsible for any loss caused by, or mistake, gross negligence or
misconduct of, such third party.
Disclosure to Fund Ranking and Ratings Organizations. Undisclosed
Holdings Information and information derived therefrom may be provided to
organizations that provide mutual fund rankings and ratings, such as
Morningstar, Lipper, Moody's, and Standard & Poor's, and to entities that
provide investment coverage and/or analytical information regarding a Fund's
portfolio, provided that the recipient has entered into a written agreement with
the Fund to maintain the information in confidence, to use the information only
for the purpose for which it is provided, and not to trade on the basis of any
such information that is material nonpublic information.
Disclosure to Investors, Prospective Investors, and Investor
Consultants. The Disclosure Policies provide that Undisclosed Holdings
Information and information derived therefrom may be provided to investors,
prospective investors, or investor consultants with the prior approval of the
Funds' Chief Compliance Officer in the specific instance. The Chief Compliance
Officer will only approve such disclosure after concluding that it is in the
best interests of the Fund in question and its shareholders and if the recipient
has agreed in writing to maintain the information in confidence and not to trade
on the basis of any such information that is material nonpublic information. In
considering a request for such approval, the Chief Compliance Officer also shall
identify and consider any conflict of interest between the Fund and its
shareholders, on the one hand, and the Advisor and its affiliates, on the other,
which is presented by the request. If the Chief Compliance Officer determines
that there is a conflict of interest between the Fund and its shareholders on
the one hand and the Advisor and its affiliates, on the other, he or she will
approve such disclosure only if he or she determines that such conflict is
materially mitigated by the execution of a confidentiality agreement and that,
despite such conflict of interest, disclosure is in the best interests of the
relevant Fund and its shareholders. The Funds' Chief Compliance Officer is
responsible for the creation of a written record that states the basis for the
conclusion that the disclosure is in the best interests of the relevant Fund and
its shareholders.
Disclosure as Required by Applicable Law. Undisclosed Holdings
Information and information derived therefrom may be disclosed to any person as
required by applicable laws, rules and regulations. For example, such
information may be disclosed in response to regulatory requests for information
or in response to legal process in litigation matters.
Disclosure of Limited Holdings. Portfolio managers, analysts and other
personnel of the Advisor and any sub-advisor may discuss portfolio information
in interviews with members of the media, or in due diligence or similar meetings
with clients or prospective purchasers of Fund shares or their representatives.
In no case will a material number of portfolio holdings be provided that have
not yet been posted on the First American Funds website or filed with the SEC
unless the recipient has entered into a written agreement with the Funds to
maintain the confidentiality of such information and not to trade on the basis
of any such information that is material nonpublic information. In addition,
brokers and dealers may be provided with individual portfolio holdings in order
to obtain bids or bid and asked prices (if securities held by a Fund are not
priced by the Fund's regular pricing services) or in connection with portfolio
transactions.
No Compensation or Consideration. Neither the Funds, nor the Advisor
or any sub-advisor or any affiliate of either, including the Chief Compliance
Officer or his or her designee, will solicit or accept any compensation or other
consideration in connection with the disclosure of Undisclosed Holdings
Information or information derived therefrom.
Chief Compliance Officer Reports to Fund Board. The Funds' Chief
Compliance Officer must provide a quarterly report to the Funds' board of
directors addressing exceptions to these policies and procedures during the
preceding quarter, if any.
Detective and Corrective Action. Any unauthorized release of
Undisclosed Holdings Information which comes to the attention of an employee of
the Advisor shall be reported to the Chief Compliance Officer. The Chief
Compliance Officer shall recommend an appropriate sanction to be imposed by the
individual's supervisor if the individual releasing such information is an
employee of the Advisor or other appropriate action if the individual is not an
employee of the Advisor.
48
Designee of Chief Compliance Officer. In the event of the absence or
unavailability of the Chief Compliance Officer, all of the obligations of the
Chief Compliance Officer may be performed by his or her designee.
DIRECTORS AND EXECUTIVE OFFICERS
The directors and executive officers of FAIF are listed below,
together with their business addresses and their principal occupations during
the past five years. The Board of Directors is generally responsible for the
overall operation and management of FAIF. The Board of Directors consists
entirely of directors who are not "interested persons" of FAIF, as that term is
defined in the 1940 Act ("Independent Directors").
INDEPENDENT DIRECTORS
NUMBER OF OTHER
POSITION(S) TERM OF OFFICE PORTFOLIOS IN FUND DIRECTORSHIPS
NAME, ADDRESS, AND HELD AND LENGTH OF PRINCIPAL OCCUPATION(S) COMPLEX OVERSEEN HELD BY
YEAR OF BIRTH WITH FUND TIME SERVED DURING PAST 5 YEARS BY DIRECTOR DIRECTOR*
- ---------------------- ----------- -------------------------- ------------------------- --------------------- ---------------
Benjamin R. Field III, Director Term expiring earlier of Retired; Senior Financial First American Funds None
P.O. Box 1329, death, resignation, Advisor, Bemis Company, Complex: twelve
Minneapolis, MN removal, disqualification, Inc. from May 2002 registered investment
55440-1329 (1938) or successor duly elected through February 2004. companies, including
and qualified. Director of 62 portfolios
FAIF since September 2003.
Roger A. Gibson, Director Term expiring earlier of Director, Charterhouse First American Funds None
P.O. Box 1329, death, resignation, Group, Inc., a private Complex: twelve
Minneapolis, MN removal, disqualification, equity firm, since registered investment
55440-1329 (1946) or successor duly elected October 2005; Vice companies, including
and qualified. Director of President and Chief 62 portfolios
FAIF since October 1997. Operating Officer, Cargo
- United Airlines, from
July 2001 through
retirement in June 2004.
Victoria J. Herget, Director Term expiring earlier of Investment consultant and First American Funds None
P.O. Box 1329, death, resignation, non-profit board member. Complex: twelve
Minneapolis, MN removal, disqualification, registered investment
55440-1329 (1951) or successor duly elected companies, including
and qualified. Director of 62 portfolios
FAIF since September 2003.
John P. Kayser Director Term expiring earlier of Retired; Principal from First American Funds None
P.O. Box 1329, death, resignation, 1983 to 2004, William Complex: twelve
Minneapolis, MN removal, disqualification, Blair & Company, LLC, a registered investment
55440-1329 (1949) or successor duly elected Chicago-based investment companies, including
and qualified. Director of firm. 62 portfolios
FAIF since October 2006.
Leonard W. Kedrowski, Director Term expiring earlier of Owner and President, First American Funds None
P.O. Box 1329, death, resignation, Executive and Management Complex: twelve
Minneapolis, MN removal, disqualification, Consulting, Inc., a registered investment
55440-1329 (1941) or successor duly elected management consulting companies, including
and qualified. Director of firm; Board member, GC 62 portfolios
FAIF since November 1993. McGuiggan Corporation
(dba Smyth Companies), a
label printer; former
Chief Executive Officer,
Creative Promotions
International, LLC, a
promotional award
programs and products
company, through October
2003.
Richard K. Riederer, Director Term expiring earlier of Owner and CEO, RKR First American Funds Cleveland-
P.O. Box 1329, death, resignation, Consultants, Inc., a Complex: twelve Cliffs Inc. (a
Minneapolis, MN removal, disqualification, consulting company registered investment producer of
or successor duly elected providing advice on companies, including iron ore
and qualified. Director of business strategy, 62 portfolios pellets)
FAIF mergers and acquisitions,
and non-profit board
49
NUMBER OF OTHER
POSITION(S) TERM OF OFFICE PORTFOLIOS IN FUND DIRECTORSHIPS
NAME, ADDRESS, AND HELD AND LENGTH OF PRINCIPAL OCCUPATION(S) COMPLEX OVERSEEN HELD BY
YEAR OF BIRTH WITH FUND TIME SERVED DURING PAST 5 YEARS BY DIRECTOR DIRECTOR*
- ---------------------- ----------- -------------------------- ------------------------- --------------------- ---------------
55440-1329 (1944) since August 2001. member since 2005.
Joseph D. Strauss, Director Term expiring earlier of Attorney At Law, Owner First American Funds None
P.O. Box 1329, death, resignation, and President, Strauss Complex: twelve
Minneapolis, MN removal, disqualification, Management Company, a registered investment
55440-1329 (1940) or successor duly elected Minnesota holding company companies, including
and qualified. Director of for various 62 portfolios
FAIF since April 1991. organizational management
business ventures; Owner,
Chairman and Chief
Executive Officer,
Community Resource
Partnerships, Inc., a
strategic planning,
operations management,
government relations,
transportation planning
and public relations
organization; Owner,
Chairman and Chief
Executive Officer,
Excensus(TM) LLC, a
strategic demographic
planning and application
development firm.
Virginia L. Stringer, Chair; Chair term three years. Governance consultant and First American Funds None
P.O. Box 1329, Director Director term expiring non-profit board member; Complex: twelve
Minneapolis, MN earlier of death, former Owner and registered investment
55440-1329 (1944) resignation, removal, President, Strategic companies, including
disqualification, or Management Resources, 62 portfolios
successor duly elected and Inc., a management
qualified. Chair of FAIF's consulting firm;
Board since September Executive Consultant for
1997; Director of FAIF State Farm Insurance
since September 1987. Company through 2003.
James M. Wade, Director Term expiring earlier of Owner and President, Jim First American Funds None
P.O. Box 1329, death, resignation, Wade Homes, a Complex: twelve
Minneapolis, MN removal, disqualification, homebuilding company. registered investment
55440-1329 (1943) or successor duly elected companies, including
and qualified. Director of 62 portfolios
FAIF since August 2001.
- ----------
* Includes only directorships in a company with a class of securities
registered pursuant to Section 12 of the Securities Exchange Act or subject
to the requirements of Section 15(d) of the Securities Exchange Act, or any
company registered as an investment company under the Investment Company
Act.
EXECUTIVE OFFICERS
TERM OF OFFICE
NAME, ADDRESS, AND POSITION(S) HELD AND LENGTH OF
YEAR OF BIRTH WITH FUND TIME SERVED PRINCIPAL OCCUPATION(S) DURING PAST 5 YEARS
- ------------------------- ---------------- --------------------- --------------------------------------------------------------
Thomas S. Schreier, Jr., President & Re-elected by the Chief Executive Officer of FAF Advisors, Inc.; Chief
FAF Advisors, Inc., Vice President Board annually; Investment Officer of FAF Advisors, Inc. since September 2007.
800 Nicollet Mall, - Investments President of FAIF
Minneapolis, MN 55402 since February 2001
(1962) *
50
TERM OF OFFICE
NAME, ADDRESS, AND POSITION(S) HELD AND LENGTH OF
YEAR OF BIRTH WITH FUND TIME SERVED PRINCIPAL OCCUPATION(S) DURING PAST 5 YEARS
- ------------------------- ---------------- --------------------- --------------------------------------------------------------
Jeffery M. Wilson, Vice President - Re-elected by the Senior Vice President of FAF Advisors, Inc.
FAF Advisors, Inc. Administration Board annually; Vice
800 Nicollet Mall, President -
Minneapolis, MN 55402 Administration of
(1956) * FAIF since March 2000
Charles D. Gariboldi, Jr. Treasurer Re-elected by the Mutual Funds Treasurer, FAF Advisors, Inc., since October
FAF Advisors, Inc. Board annually; 2004; prior thereto, Vice President - Investment Accounting
800 Nicollet Mall, Treasurer of FAIF and Fund Treasurer, Thrivent Financial for Lutherans.
Minneapolis, MN 55402 Since December 2004
(1959) *
Jill M. Stevenson, Assistant Re-elected by the Assistant Mutual Funds Treasurer, FAF Advisors, Inc. since
FAF Advisors, Inc. Treasurer Board annually; September 2005; prior thereto, Director and Senior Project
800 Nicollet Mall, Assistant Treasurer Manager, FAF Advisors, Inc.
Minneapolis, MN 55402 of FAIF since
(1965) * September 2005
David H. Lui, Chief Compliance Re-elected by the Chief Compliance Officer, FAF Advisors, Inc. since February
FAF Advisors, Inc. Officer Board annually; Chief 2005; Chief Compliance Officer, Franklin Advisors, Inc. and
800 Nicollet Mall, Compliance Officer of Chief Compliance Counsel, Franklin Templeton Investments from
Minneapolis, MN 55402 FAIF since February March 2004 to February 2005; prior thereto, Vice President,
(1960) * 2005 Charles Schwab & Co., Inc.
Mark D. Corns Anti-Money Re-elected by the Director of Compliance, FAF Advisors, Inc. since June 2006;
FAF Advisors, Inc. Laundering Board annually; Compliance Manager, FAF Advisors, Inc. from January 2005 to
800 Nicollet Mall, Officer Anti-Money Laundering June 2006; prior thereto, Compliance Manager,
Minneapolis, MN 55402 Officer of FAIF since OppenheimerFunds, Inc.
(1963) * September 2008
Kathleen L. Prudhomme, Secretary Re-elected by the Deputy General Counsel, FAF Advisors, Inc., since November
FAF Advisors, Inc. Board annually; 2004; prior thereto, Partner, Dorsey & Whitney LLP, a
800 Nicollet Mall, Secretary of FAIF Minneapolis-based law firm.
Minneapolis, MN 55402 since December 2004;
(1953) * Assistant Secretary
of FAIF from
September 1998
through December 2004
Richard J. Ertel, Assistant Re-elected by the Counsel, FAF Advisors, Inc., since May 2006; prior thereto,
FAF Advisors, Inc., Secretary Board annually; Counsel, Ameriprise Financial Services, Inc. from September
800 Nicollet Mall, Assistant Secretary 2004 to May 2006; prior thereto, Counsel, FAF Advisors, Inc.
Minneapolis, MN 55402 of FAIF since June
(1967) * 2006 and from June
2003 through August
2004
James D. Alt, Assistant Re-elected by the Partner, Dorsey & Whitney LLP, a Minneapolis-based law firm.
Dorsey & Whitney LLP Secretary Board annually;
50 South Sixth Street, Assistant Secretary
Suite 1500, Minneapolis, of FAIF since
MN 55402 (1951) December 2004;
Secretary of FAIF
from June 2002
through December
2004; Assistant
Secretary of FAIF
from September 1998
through June 2002
James R. Arnold, Assistant Re-elected by the Senior Vice President, U.S. Bancorp Fund Services, LLC
U.S. Bancorp Fund Secretary Board annually;
Services, LLC, Assistant Secretary
615 E. Michigan Street, of FAIF since June
Milwaukee, WI 53202 2003
(1957)*
- ----------
* Messrs. Schreier, Wilson, Gariboldi, Lui, Corns, and Ertel, Ms. Stevenson
and Ms. Prudhomme are each officers and/or employees of FAF Advisors, Inc.,
which serves as investment advisor and administrator for FAIF. Mr. Arnold
is an officer of U.S. Bancorp Fund Services, LLC, which is a subsidiary of
U.S. Bancorp and which serves as transfer agent for FAIF.
51
STANDING COMMITTEES OF THE BOARD OF DIRECTORS
There are currently three standing committees of the FAIF Board of
Directors: Audit Committee, Pricing Committee and Governance Committee.
NUMBER OF FUND
COMPLEX
COMMITTEE
MEETINGS HELD
DURING FAIF'S
FISCAL PERIOD
COMMITTEE FUNCTION COMMITTEE MEMBERS ENDED 6/30/08
---------------------------------------------------- --------------------------------- --------------
Audit The purposes of the Committee are (1) to oversee the Leonard W. Kedrowski (Chair) 8
Committee Funds' accounting and financial reporting policies Benjamin R. Field III
and practices, their internal controls and, as John P. Kayser
appropriate, the internal controls of certain Richard K. Riederer
service providers; (2) to oversee the quality of the Virginia L. Stringer (ex-officio)
Funds' financial statements and the independent
audit thereof; (3) to assist Board oversight of the
Funds' compliance with legal and regulatory
requirements; and (4) to act as a liaison between
the Funds' independent auditors and the full Board
of Directors. The Audit Committee, together with the
Board of Directors, has the ultimate authority and
responsibility to select, evaluate and, where
appropriate, replace the outside auditor (or to
nominate the outside auditor to be proposed for
shareholder approval in any proxy statement).
Pricing The Committee is responsible for valuing portfolio Roger A. Gibson (Chair) 5
Committee securities for which market quotations are not Benjamin R. Field III
readily available, pursuant to procedures James M. Wade
established by the Board of Directors. Virginia L. Stringer (ex-officio)
Governance The Committee has responsibilities relating to (1) Joseph D. Strauss (Chair) 5
Committee Board and Committee composition (including, James M. Wade
interviewing and recommending to the Board nominees Victoria J. Herget
for election as directors; reviewing the Virginia L. Stringer (ex-officio)
independence of all independent directors; reviewing
Board composition to determine the appropriateness
of adding individuals with different backgrounds or
skills; reporting to the Board on which current and
potential members of the Audit Committee qualify as
Audit Committee Financial Experts; recommending a
successor to the Board Chair when a vacancy occurs;
consulting with the Board Chair on Committee
assignments; and in anticipation of the Board's
request for shareholder approval of a slate of
directors, recommending to the Board the slate of
directors to be presented for Board and shareholder
approval); (2) Committee structure (including, at
least annually, reviewing each Committee's structure
and membership and reviewing each Committee's
charter and suggesting changes thereto); (3)
director education (including developing an annual
education calendar; monitoring independent director
attendance at educational seminars and conferences;
developing and conducting orientation sessions for
new independent directors; and managing the Board's
education program in a cost-effective manner); and
(4) governance practices (including reviewing and
making recommendations regarding director
compensation and director expenses; monitoring
director investments in the Funds; monitoring
compliance with director retirement policies;
reviewing compliance with the prohibition from
serving on the board of directors of mutual funds
that are not part of the First American Fund
Complex; if requested, assisting the Board Chair in
overseeing self-evaluation process; in collaboration
with outside counsel, developing policies and
procedures addressing matters which should
52
NUMBER OF FUND
COMPLEX
COMMITTEE
MEETINGS HELD
DURING FAIF'S
FISCAL PERIOD
COMMITTEE FUNCTION COMMITTEE MEMBERS ENDED 6/30/08
---------------------------------------------------- --------------------------------- --------------
come before the Committee in the proper exercise of
its duties; reviewing the Board's adherence to
industry "best practices;" reviewing and
recommending changes in Board governance policies,
procedures and practices; reporting the Committee's
activities to the Board and making such
recommendations; reviewing and, as appropriate;
recommending that the Board make changes to the
Committee's charter).
In addition to the above committees, the Board of Directors also
appoints a Fund Review Liaison. The responsibility of the Fund Review Liaison is
to lead the Board of Directors, together with the Board Chair, in evaluating
Fund performance, Fund service provider contracts and arrangements for execution
of Fund trades. Ms. Herget is the current Fund Review Liaison.
The Governance Committee will consider shareholder recommendations for
director nominees in the event there is a vacancy on the Board of Directors or
in connection with any special shareholders meeting which is called for the
purpose of electing directors. FAIF does not hold regularly scheduled annual
shareholders meetings. There are no differences in the manner in which the
Governance Committee evaluates nominees for director based on whether the
nominee is recommended by a shareholder.
A shareholder who wishes to recommend a director nominee should submit
his or her recommendation in writing to the Chair of the Board (Ms. Stringer) or
the Chair of the Governance Committee (Mr. Strauss), in either case at First
American Funds, P.O. Box 1329, Minneapolis, Minnesota 55440-1329. At a minimum,
the recommendation should include:
- the name, address, and business, educational, and/or other
pertinent background of the person being recommended;
- a statement concerning whether the person is "independent" within
the meaning of New York Stock Exchange and American Stock
Exchange listing standards and is not an "interested person" as
defined in the Investment Company Act of 1940;
- any other information that the Funds would be required to include
in a proxy statement concerning the person if he or she was
nominated; and
- the name and address of the person submitting the recommendation,
together with the number of Fund shares held by such person and
the period for which the shares have been held.
The recommendation also can include any additional information which
the person submitting it believes would assist the Governance Committee in
evaluating the recommendation. Shareholder recommendations for nominations to
the Board will be accepted on an ongoing basis and will be kept on file for
consideration when there is a vacancy on the Board or prior to a shareholders
meeting called for the purpose of electing directors.
FUND SHARES OWNED BY THE DIRECTORS
The information in the table below discloses the dollar ranges of (i)
each Director's beneficial ownership in FAIF, and (ii) each Director's aggregate
beneficial ownership in all funds within the First American Funds complex,
including in each case the value of fund shares elected by Directors in the
directors' deferred compensation plan.
AGGREGATE DOLLAR RANGE OF EQUITY SECURITIES
NAME OF DIRECTOR DOLLAR RANGE OF EQUITY SECURITIES IN FAIF IN THE FIRST AMERICAN FUNDS COMPLEX*
- --------------------- ----------------------------------------- -------------------------------------------
Benjamin R. Field III $10,001-$50,000 Over $100,000
Roger A. Gibson Over $100,000 Over $100,000
Victoria J. Herget Over $100,000 Over $100,000
53
AGGREGATE DOLLAR RANGE OF EQUITY SECURITIES
NAME OF DIRECTOR DOLLAR RANGE OF EQUITY SECURITIES IN FAIF IN THE FIRST AMERICAN FUNDS COMPLEX*
- --------------------- ----------------------------------------- -------------------------------------------
John P. Kayser Over $100,000 Over $100,000
Leonard W. Kedrowski $50,001-$100,000 Over $100,000
Richard K. Riederer Over $100,000 Over $100,000
Joseph D. Strauss Over $100,000 Over $100,000
Virginia L. Stringer Over $100,000 Over $100,000
James M. Wade Over $100,000 Over $100,000
- ----------
* The dollar range disclosed is based on the value of the securities as of
June 30, 2008.
As of October 15, 2008, none of the Independent Directors or their
immediate family members owned, beneficially, or of record, any securities in
(i) an investment advisor or principal underwriter of the Funds or (ii) a person
(other than a registered investment company) directly or indirectly controlling,
controlled by, or under common control with an investment advisor or principal
underwriter of the Funds.
COMPENSATION
The First American Family of Funds, which includes FAIF, FAF, FASF,
and FACEF, currently pays directors who are not paid employees or affiliates of
the Funds an annual retainer of $135,000 ($245,000 in the case of the Chair).
The Fund Review Liaison and the Audit Committee Chair each receive an additional
annual retainer of $20,000. The other standing Committee Chairs receive an
additional annual retainer of $15,000. In addition, directors are paid the
following fees for attending Board and committee meetings:
- $1,000 for attending the first day of an in-person Board of
Directors meeting ($1,500 in the case of the Chair);
- $2,000 for attending the second day of an in-person Board of
Directors meeting ($3,000 in the case of the Chair);
- $1,000 for attending the third day of an in-person Board of
Directors meeting ($1,500 in the case of the Chair), assuming the
third day ends no later than early afternoon;
- $500 for in-person attendance at any committee meeting ($750 in
the case of the Chair of each committee);
A Director who participates telephonically in any in-person Board or
Committee meeting receives half of the fee that Director would have received for
attending, in-person, the Board or Committee meeting. For telephonic Board and
Committee meetings, the Chair and each Director and Committee Chair, as
applicable, receive a fee equal to half the fee he or she would have received
for attending an in-person meeting.
Directors also receive $3,500 per day when traveling, on behalf of a
Fund, out of town on Fund business which does not involve a Board or committee
meeting. In addition, directors are reimbursed for their out-of-pocket expenses
in traveling from their primary or secondary residence to Board and committee
meetings, on Fund business and to attend mutual fund industry conferences or
seminars. The amounts specified above are allocated evenly among the funds in
the First American Family of Funds.
The directors may elect to defer payment of up to 100% of the fees
they receive in accordance with a Deferred Compensation Plan (the "Plan"). Under
the Plan, a director may elect to have his or her deferred fees treated as if
they had been invested in shares of one or more funds and the amount paid to the
director under the Plan will be determined based on the performance of such
investments. Distributions may be taken in a lump sum or over a period of years.
The Plan will remain unfunded for federal income tax purposes under the Internal
Revenue Code of 1986, as amended. Deferral of director fees in accordance with
the Plan will have a negligible impact on Fund assets and liabilities and will
not obligate the Funds to retain any director or pay any particular level of
compensation. The Funds do not provide any other pension or retirement benefits
to directors.
Legal fees and expenses are also paid to Dorsey & Whitney LLP, the law
firm of which James D. Alt, Assistant Secretary of FAIF, FAF, FASF, and FACEF,
is a partner.
54
The following table sets forth information concerning aggregate
compensation paid to each director of FAIF (i) by FAIF (column 2), and (ii) by
FAIF, FAF, FASF, Mount Vernon Trust, and FACEF collectively (column 5) during
the fiscal year ended June 30, 2008. No executive officer or affiliated person
of FAIF received any compensation from FAIF in excess of $60,000 during such
fiscal year or fiscal period.
Compensation during Fiscal Year Ended June 30, 2008
AGGREGATE PENSION OR ESTIMATED TOTAL COMPENSATION
COMPENSATION RETIREMENT BENEFITS ANNUAL BENEFITS FROM REGISTRANT AND
FROM ACCRUED AS PART OF UPON FUND COMPLEX PAID
NAME OF PERSON, POSITION REGISTRANT (1) FUND EXPENSES RETIREMENT TO DIRECTORS (2)
- ------------------------ -------------- ------------------- --------------- -------------------
Benjamin R. Field III, Director $101,379 -0- -0- $155,500
Roger A. Gibson, Director 109,206 -0- -0- 168,000
Victoria J. Herget, Director 111,803 -0- -0- 172,250
John P. Kayser, Director 100,401 -0- -0- 154,000
Leonard W. Kedrowski, Director 114,130 -0- -0- 176,250
Richard K. Riederer, Director 100,075 -0- -0- 153,500
Joseph D. Strauss, Director 109,823 -0- -0- 168,625
Virginia L. Stringer, Director & Chair 182,059 -0- -0- 279,250
James M. Wade, Director 100,890 -0- -0- 154,750
- ----------
(1) Included in the Aggregate Compensation from Registrant are amounts deferred
by Directors pursuant to the Deferred Compensation Plan discussed below.
Pursuant to this Plan, compensation was deferred for the following
directors: Roger A. Gibson, $21,583; Victoria J. Herget, $33,194; Leonard
W. Kedrowski, $52,031; and Joseph D. Strauss, $7,564.
(2) Included in the Total Compensation are amounts deferred for the following
directors pursuant to the Deferred Compensation Plan: Roger A. Gibson,
$33,600; Victoria J. Herget, $51,675; Leonard W. Kedrowski, $81,000; and
Joseph D. Strauss, $11,775.
SALES LOADS
Directors of the Funds and certain other Fund affiliates may purchase
the Funds' Class A shares at net asset value without a sales charge. See the
Class A share prospectuses for details.
CODE OF ETHICS
First American Investment Funds, Inc., FAF Advisors, Inc., and Quasar
Distributors, LLC have each adopted a Code of Ethics pursuant to Rule 17j-1 of
the 1940 Act. Each of these Codes of Ethics permits personnel to invest in
securities for their own accounts, including securities that may be purchased or
held by the Funds. These Codes of Ethics are on public file with, and are
available from, the SEC.
PROXY VOTING POLICIES
The policies and procedures that the Funds use to determine how to
vote proxies relating to their portfolio securities are set forth in Appendix B.
INVESTMENT ADVISORY AND OTHER SERVICES FOR THE FUNDS
INVESTMENT ADVISOR
FAF Advisors, Inc. (the "Advisor"), 800 Nicollet Mall, Minneapolis,
Minnesota 55402, serves as the investment advisor and manager of the Funds. The
Advisor is a wholly owned subsidiary of U.S. Bank National Association ("U.S.
Bank"), 800 Nicollet Mall, Minneapolis, Minnesota 55402, a national banking
association that has professionally managed accounts for individuals, insurance
companies, foundations, commingled accounts, trust funds, and others for over 75
years. U.S. Bank is, in turn, a subsidiary of U.S. Bancorp, 800 Nicollet Mall,
Minneapolis, Minnesota 55402, which is a regional multi-state bank holding
company headquartered in Minneapolis, Minnesota that primarily serves the
Midwestern, Rocky Mountain and Northwestern states. U.S. Bancorp operates four
banks and eleven trust companies with banking offices in twenty-four contiguous
states. U.S. Bancorp also has various other subsidiaries engaged in financial
services. At September 30, 2008, U.S. Bancorp and its consolidated subsidiaries
had consolidated assets of more than $247 billion, consolidated deposits of more
than $139 billion and shareholders' equity of $21.7 billion.
55
Pursuant to an Investment Advisory Agreement dated April 2, 1991 (the
"Advisory Agreement"), as amended, the Funds engaged U.S. Bank, through its
First American Asset Management division ("FAAM"), to act as investment Advisor
for, and to manage the investment of, the series of FAIF then in existence. The
Advisory Agreement was assigned to the Advisor on May 2, 2001. The monthly fees
paid to the Advisor are calculated on an annual basis based on each Fund's
average daily net assets (before any waivers), as set forth in the table below:
GROSS ADVISORY
FUND FEE %
- ---- --------------
Core Bond Fund 0.50
High Income Bond Fund 0.70
Inflation Protected Securities Fund 0.50
Intermediate Government Bond Fund 0.50
Intermediate Term Bond Fund 0.50
Short Term Bond Fund 0.50
Total Return Bond Fund 0.60
U.S. Government Mortgage Fund 0.50
Arizona Tax Free Fund 0.50
California Intermediate Tax Free Fund 0.50
California Tax Free Fund 0.50
Colorado Intermediate Tax Free Fund 0.50
Colorado Tax Free Fund 0.50
Intermediate Tax Free Fund 0.50
Minnesota Intermediate Tax Free Fund 0.50
Minnesota Tax Free Fund 0.50
Missouri Tax Free Fund 0.50
Nebraska Tax Free Fund 0.50
Ohio Tax Free Fund 0.50
Oregon Intermediate Tax Free Fund 0.50
Short Tax Free Fund 0.50
Tax Free Fund 0.50
The Advisory Agreement requires the Advisor to arrange, if requested
by FAIF, for officers or employees of the Advisor to serve without compensation
from the Funds as directors, officers, or employees of FAIF if duly elected to
such positions by the shareholders or directors of FAIF. The Advisor has the
authority and responsibility to make and execute investment decisions for the
Funds within the framework of the Funds' investment policies, subject to review
by the Board of Directors of FAIF. The Advisor is also responsible for
monitoring the performance of the various organizations providing services to
the Funds, including the Funds' distributor, shareholder services agent,
custodian, and accounting agent, and for periodically reporting to FAIF's Board
of Directors on the performance of such organizations. The Advisor will, at its
own expense, furnish the Funds with the necessary personnel, office facilities,
and equipment to service the Funds' investments and to discharge its duties as
investment advisor of the Funds.
In addition to the investment advisory fee, each Fund pays all of its
expenses that are not expressly assumed by the Advisor or any other organization
with which the Fund may enter into an agreement for the performance of services.
Each Fund is liable for such nonrecurring expenses as may arise, including
litigation to which the Fund may be a party. FAIF may have an obligation to
indemnify its directors and officers with respect to such litigation. The
Advisor will be liable to the Funds under the Advisory Agreement for any
negligence or willful misconduct by the Advisor other than liability for
investments made by the Advisor in accordance with the explicit direction of the
Board of Directors or the investment objectives and policies of the Funds. The
Advisor has agreed to indemnify the Funds with respect to any loss, liability,
judgment, cost or penalty that a Fund may suffer due to a breach of the Advisory
Agreement by the Advisor.
The Advisor may agree to a voluntary fee waiver for each of the Funds,
which will be set forth in the Funds' Prospectuses. Any such fee waiver (or
reimbursement) may be discontinued at any time. The Advisor also may absorb or
reimburse expenses of the Funds from time to time, in its discretion, while
retaining the ability to be reimbursed by the Funds for such amounts prior to
the end of the fiscal year. This practice would have the effect of lowering a
Fund's overall expense ratio and of increasing yield to investors, or the
converse, at the time such amounts are absorbed or reimbursed, as the case may
be.
The following table sets forth total advisory fees before waivers and
after waivers for each of the Funds for the fiscal period ended June 30, 2006,
and the fiscal years ended June 30, 2007 and June 30, 2008:
56
FISCAL PERIOD ENDED FISCAL YEAR ENDED FISCAL YEAR ENDED
JUNE 30, 2006 JUNE 30, 2007 JUNE 30, 2008
----------------------------- ----------------------------- -----------------------------
ADVISORY FEE ADVISORY FEE ADVISORY FEE ADVISORY FEE ADVISORY FEE ADVISORY FEE
FUND BEFORE WAIVERS AFTER WAIVERS BEFORE WAIVERS AFTER WAIVERS BEFORE WAIVERS AFTER WAIVERS
- ---- -------------- ------------- -------------- ------------- -------------- -------------
Core Bond Fund $7,017,650 $5,935,542 $8,798,340 $7,780,479 $8,264,262 $7,301,988
High Income Bond Fund 1,357,103 989,397 1,881,003 1,352,241 1,772,113 1,252,833
Inflation Protected Securities Fund 1,131,338 622,109 1,647,597 957,956 1,307,444 711,566
Intermediate Government Bond Fund 213,042 40,252 198,072 --(1) 286,383 15,863
Intermediate Term Bond Fund 3,821,013 2,458,961 4,288,699 3,805,205 3,959,470 3,517,146
Short Term Bond Fund 2,360,705 1,466,158 2,314,192 1,439,839 1,727,361 1,004,154
Total Return Bond Fund 1,615,159 1,144,295 3,596,965 2,836,969 6,050,535 4,855,983
U.S. Government Mortgage Fund 683,727 460,952 816,259 476,605 742,878 396,168
Arizona Tax Free Fund 98,606 --(1) 138,213 --(1) 144,351 --(1)
California Intermediate Tax Free Fund 209,430 96,198 296,787 116,028 285,693 104,990
California Tax Free Fund 131,244 --(1) 188,316 --(1) 199,996 --(1)
Colorado Intermediate Tax Free Fund 170,566 62,672 211,050 37,206 233,616 57,455
Colorado Tax Free Fund 81,346 --(1) 117,350 --(1) 114,795 --(1)
Intermediate Tax Free Fund 2,462,096 1,953,362 3,128,701 2,674,306 3,089,673 2,674,331
Minnesota Intermediate Tax Free Fund 809,293 593,589 992,725 752,160 957,861 729,409
Minnesota Tax Free Fund 609,547 422,113 852,931 599,164 866,712 609,708
Missouri Tax Free Fund 656,211 467,075 799,608 555,043 797,616 552,095
Nebraska Tax Free Fund 152,530 --(1) 200,007 --(1) 192,020 --(1)
Ohio Tax Free Fund 155,376 --(1) 211,667 --(1) 227,153 --(1)
Oregon Intermediate Tax Free Fund 494,201 332,012 609,795 402,080 609,599 404,259
Short Tax Free Fund 1,072,516 586,855 1,013,458 545,583 761,835 370,044
Tax Free Fund 1,838,505 1,428,776 2,687,624 2,264,314 2,682,998 2,264,794
(1) Advisory and certain other fees for the period were waived by the Advisor
to comply with total operating expense limitations that were agreed upon by
the funds and the Advisor.
ADDITIONAL PAYMENTS TO FINANCIAL INTERMEDIARIES
In addition to the sales charge payments and the distribution, service
and transfer agency fees described in the prospectus and elsewhere in this
Statement of Additional Information, the Advisor and/or the Distributor may make
additional payments out of its own assets to selected intermediaries that sell
shares of First American Funds (such as brokers, dealers, banks, registered
investment advisors, retirement plan administrators and other intermediaries;
hereinafter, individually, "Intermediary," and collectively, "Intermediaries")
under the categories described below for the purposes of promoting the sale of
Fund shares, maintaining share balances and/or for sub-accounting,
administrative or shareholder processing services.
The amounts of these payments could be significant and may create an
incentive for an Intermediary or its representatives to recommend or offer
shares of the Funds or other First American Funds to its customers. The
Intermediary may elevate the prominence or profile of the Funds within the
Intermediary's organization by, for example, placement on a list of preferred or
recommended funds, and/or granting the Advisor and/or the Distributor
preferential or enhanced opportunities to promote the Funds in various ways
within the Intermediary's organization.
These payments are made pursuant to negotiated agreements with
Intermediaries. The payments do not change the price paid by investors for the
purchase of a share or the amount a Fund will receive as proceeds from such
sales. Furthermore, these payments are not reflected in the fees and expenses
listed in the fee table section of the Funds' prospectuses and described above
because they are not paid by the Funds.
The categories of payments described below are not mutually exclusive,
and a single Intermediary may receive payments under all categories.
Marketing Support Payments and Program Servicing Payments
The Advisor and/or the Distributor may make payments for marketing
support and/or program servicing to selected Intermediaries that are registered
as holders or dealers of record for accounts invested in one or more of the
First American Funds or that make First American Fund shares available through
employee benefit plans or fee-based advisory programs to compensate them for the
variety of services they provide.
57
Marketing Support Payments. Services for which an Intermediary
receives marketing support payments may include business planning assistance,
advertising, educating the Intermediary's personnel about the First American
Funds and shareholder financial planning needs, placement on the Intermediary's
preferred or recommended fund company list, and access to sales meetings, sales
representatives and management representatives of the Intermediary. In addition,
Intermediaries may be compensated for enabling Fund representatives to
participate in and/or present at conferences or seminars, sales or training
programs for invited registered representatives and other employees, client and
investor events and other events sponsored by the Intermediary.
The Advisor and/or the Distributor compensates Intermediaries
differently depending upon, among other factors, the number or value of Fund
shares that the Intermediary sells or may sell, the value of the assets invested
in the Funds by the Intermediary's customers, redemption rates, ability to
attract and retain assets, reputation in the industry and the level and/or type
of marketing assistance and educational activities provided by the Intermediary.
Such payments are generally asset based but also may include the payment of a
lump sum.
Program Servicing Payments. Services for which an Intermediary
receives program servicing payments typically include recordkeeping, reporting,
or transaction processing, but may also include services rendered in connection
with Fund/investment selection and monitoring, employee enrollment and
education, plan balance rollover or separation, or other similar services. An
Intermediary may perform program services itself or may arrange with a third
party to perform program services.
Program servicing payments typically apply to employee benefit plans,
such as retirement plans, or fee-based advisory programs but may apply to retail
sales and assets in certain situations. The payments are based on such factors
as the type and nature of services or support furnished by the Intermediary and
are generally asset based.
Marketing Support and Program Servicing Payment Guidelines. In the
case of any one Intermediary, marketing support and program servicing payments
are not expected, with certain limited exceptions, to exceed, in the aggregate,
0.35% of the average net assets of Fund shares attributable to that Intermediary
on an annual basis. Such exceptions include instances in which an Intermediary
does not receive distribution fees with respect to a Fund share class which
provides a distribution fee, in which case such Intermediary may receive up to
0.50% of the average net assets of that Fund share class attributable to that
Intermediary on an annual basis. U.S. Bank, N.A. and its affiliates may be
eligible to receive payments that exceed 0.35% of the average net assets of Fund
shares attributable to U.S. Bank, N.A. or its affiliates on an annual basis. In
addition, in connection with the sale of a business by the Advisor's parent
company, U.S. Bank, N.A., to Great-West Life & Annuity Insurance Company
("Great-West"), the Advisor has entered into a services agreement with GWFS
Equities, Inc., an affiliate of Great-West, which provides for payments of up to
0.60% of the average net assets of Fund shares attributable to GWFS Equities,
Inc. on an annual basis.
Other Payments
From time to time, the Advisor and/or the Distributor, at its expense,
may provide other compensation to Intermediaries that sell or arrange for the
sale of shares of the Fund(s), which may be in addition to marketing support and
program servicing payments described above. For example, the Advisor and/or the
Distributor may: (i) compensate Intermediaries for National Securities Clearing
Corporation networking system services (e.g., shareholder communication, account
statements, trade confirmations, and tax reporting) on an asset based or per
account basis; (ii) compensate Intermediaries for providing Fund shareholder
trading information; (iii) make one-time or periodic payments to reimburse
selected Intermediaries for items such as ticket charges (i.e., fees that an
Intermediary charges its representatives for effecting transactions in Fund
shares) of up to $25 per purchase or exchange order, operational charges (e.g.,
fees that an Intermediary charges for establishing a Fund on its trading
system), and literature printing and/or distribution costs; and (iv) at the
direction of a retirement plan's sponsor, reimburse or pay direct expenses of an
employee benefit plan that would otherwise be payable by the plan.
When not provided for in a marketing support or program servicing
agreement, the Advisor and/or the Distributor may pay Intermediaries for
enabling the Advisor and/or the Distributor to participate in and/or present at
conferences or seminars, sales or training programs for invited registered
representatives and other Intermediary employees, client and investor events and
other Intermediary -sponsored events, and for travel expenses, including lodging
incurred by registered representatives and other employees in connection with
prospecting, asset retention and due diligence trips. These payments may vary
depending upon the nature of the event. The Advisor and/or the
58
Distributor makes payments for such events as it deems appropriate, subject to
its internal guidelines and applicable law.
The Advisor and/or the Distributor occasionally sponsors due diligence
meetings for registered representatives during which they receive updates on
various First American Funds and are afforded the opportunity to speak with
portfolio managers. Invitations to these meetings are not conditioned on selling
a specific number of shares. Those who have shown an interest in First American
Funds, however, are more likely to be considered. To the extent permitted by
their firm's policies and procedures, all or a portion of registered
representatives' expenses in attending these meetings may be covered by the
Advisor and/or the Distributor.
Certain employees of the Advisor and its affiliates may receive cash
compensation from the Advisor and/or the Distributor in connection with
establishing new client relationships with the First American Funds. Total
compensation of employees of the Advisor and/or the Distributor with marketing
and/or sales responsibilities is based in part on their generation of new client
relationships, including new client relationships with the First American Funds.
Other compensation may be offered to the extent not prohibited by
state laws or any self-regulatory agency, such as FINRA. Investors can ask their
Intermediary for information about any payments it receives from the Advisor
and/or the Distributor and the services it provides for those payments.
Investors may wish to take Intermediary payment arrangements into
account when considering and evaluating any recommendations relating to Fund
shares.
Intermediaries Receiving Additional Payments
The following is a list of Intermediaries receiving one or more of the
types of payments discussed above as of September 30, 2008:
401(k) Company, Inc. (The)
Acclaim Benefits, Inc.
ADP Broker-Dealer, Inc.
A.G. Edwards & Sons, Inc.
AIG Retirement Company
American United Life Insurance Company
Ameriprise Financial Services, Inc.
Benefit Plan Administrative Services, Inc.
Bisys Retirement Services, Inc.
Charles Schwab & Co., Inc.
Citigroup Global Markets Inc.
CitiStreet Advisors LLC / CitiStreet LLC
Commonwealth Equity Services, LLP, DBA Commonwealth Financial Network
Country Trust Bank
CPI Qualified Plan Consultants, Inc.
D.A. Davidson & Co.
Digital Retirement Solutions, Inc.
Dyatech, LLC
ExpertPlan, Inc.
Fidelity Brokerage Services LLC / National Financial Services LLC / Fidelity
Investments Institutional Operations Company, Inc.
Fidelity Investments Institutional Operations Company, Inc.
Fintegra, LLC
Fiserv Trust Company
Genesis Employee Benefits, Inc. DBA America's VEBA Solution
GWFS Equities, Inc.
Hewitt Associates LLC
ICMA Retirement Corporation
International Clearing Trust Company
Janney Montgomery Scott LLC
J.P. Morgan Retirement Plan Services, LLC
59
Leggette Actuaries, Inc.
Lincoln Retirement Services Company LLC / AMG Service Corp.
Linsco/Private Ledger Corp.
Marshall & Ilsley Trust Company, N.A.
Massachusetts Mutual Life Insurance Company
Mercer HR Outsourcing LLC
Merrill Lynch, Pierce, Fenner & Smith Inc.
MetLife Securities, Inc.
Mid Atlantic Capital Corporation
Morgan Stanley & Co., Incorporated
MSCS Financial Services, LLC
Newport Retirement Services, Inc.
NYLife Distributors LLC
Pershing LLC
Planners Network, Inc.
Principal Life Insurance Company
Prudential Insurance Company of America (The)
Prudential Investment Management Services, LLC / Prudential Investments LLC
Raymond James & Associates / Raymond James Financial Services, Inc.
RBC Dain Rauscher, Inc.
Reliance Trust Company
Retirement Plan Company, LLC (The)
Robert W. Baird & Co., Inc.
Stifel, Nicolaus & Co., Inc.
SunGard Institutional Brokerage Inc.
Symetra Life Insurance Company
T. Rowe Price Investment Services, Inc. / T. Rowe Price Retirement Plan
Services, Inc.
TD Ameritrade, Inc.
UBS Financial Services, Inc.
Unified Trust Company, N.A.
U.S. Bancorp Investments, Inc.
U.S. Bank, N.A.
Vanguard Group, Inc.
Wachovia Bank, N.A.
Wachovia Securities, LLC
Wells Fargo Bank, N.A.
Wilmington Trust Company
Wilmington Trust Retirement and Institutional Services Company (formerly AST
Capital Trust Company)
Woodbury Financial Services, Inc.
Any additions, modification or deletions to the list of Intermediaries
identified above that have occurred since September 30, 2008 are not reflected.
ADMINISTRATOR
FAF Advisors, Inc. (the "Administrator") serves as Administrator
pursuant to an Administration Agreement between the Administrator and the Funds,
dated July 1, 2006. U.S. Bancorp Fund Services, LLC ("USBFS"), 615 East Michigan
Street, Milwaukee, WI 53202, serves as sub-administrator pursuant to a
Sub-Administration Agreement between the Administrator and USBFS dated July 1,
2005. USBFS is a subsidiary of U.S. Bancorp. Under the Administration Agreement,
the Administrator provides, or compensates others to provide, services to the
Funds. These services include various legal, oversight, administrative, and
accounting services. The Funds pay the Administrator fees which are calculated
daily and paid monthly. Prior to July 1, 2006, such fees were equal to each
Fund's pro rata share of an amount equal, on an annual basis, to 0.15% of the
aggregate average daily net assets of all open-end mutual funds in the First
American Family of Funds up to $8 billion, 0.135% on the next $17 billion of
aggregate average daily net assets, 0.12% on the next $25 billion of aggregate
average daily net assets, and 0.10% of the aggregate average daily net assets in
excess of $50 billion. All fees paid to USBFS, as sub-administrator, are paid
from the administration fee.
60
Prior to July 1, 2006, as part of the transfer agent fee, the Funds
paid USBFS a fee equal, on an annual basis, to 0.10% of each fund's average
daily net assets, to compensate USBFS for providing certain shareholder services
and reimbursed USBFS for its payments to financial intermediaries that establish
and maintain omnibus accounts and provide customary services for such accounts.
Effective July 1, 2006, this fee was incorporated into the administration fee
which, as a result, on an annual basis, is 0.25% of the aggregate average daily
net assets of all open-end mutual funds in the First American Family of Funds up
to $8 billion, 0.235% on the next $17 billion of the aggregate average daily net
assets, 0.22% on the next $25 billion of the aggregate average daily net assets,
and 0.20% of the aggregate average daily net assets in excess of $50 billion. In
addition to these fees, the Funds may reimburse the Administrator for any
out-of-pocket expenses incurred in providing administration services.
The following table sets forth total administrative fees, after
waivers, paid by each of the Funds listed below to the Administrator and USBFS
for the fiscal period ended June 30, 2006, and the fiscal years ended June 30,
2007 and June 30, 2008:
FISCAL PERIOD FISCAL YEAR FISCAL YEAR
ENDED ENDED ENDED
FUND JUNE 30, 2006 JUNE 30, 2007 JUNE 30, 2008
- ---- ------------- ------------- -------------
Core Bond Fund $1,773,007 $3,890,198 $3,643,554
High Income Bond Fund 244,896 595,479 556,303
Inflation Protected Securities Fund 285,778 733,425 577,013
Intermediate Government Bond Fund 53,857 88,392 125,072
Intermediate Term Bond Fund 965,643 1,908,661 1,745,816
Short Term Bond Fund 596,629 1,026,892 764,278
Total Return Bond Fund 339,926 1,293,655 2,255,056
U.S. Government Mortgage Fund 172,779 362,655 323,012
Arizona Tax Free Fund 24,907 61,522 62,842
California Intermediate Tax Free Fund 52,906 132,163 125,467
California Tax Free Fund 33,157 83,980 87,446
Colorado Intermediate Tax Free Fund 43,100 93,948 101,874
Colorado Tax Free Fund 20,550 52,117 49,768
Intermediate Tax Free Fund 622,068 1,392,829 1,364,196
Minnesota Intermediate Tax Free Fund 204,496 442,655 422,395
Minnesota Tax Free Fund 153,985 379,744 381,768
Missouri Tax Free Fund 165,804 356,037 351,363
Nebraska Tax Free Fund 38,535 88,906 83,714
Ohio Tax Free Fund 39,253 94,319 99,562
Oregon Intermediate Tax Free Fund 124,892 271,584 268,069
Short Tax Free Fund 271,073 451,236 336,382
Tax Free Fund 464,449 1,193,928 1,181,356
TRANSFER AGENT
USBFS serves as the Funds' transfer agent pursuant to a Transfer
Agency and Shareholder Servicing Agreement (the "Transfer Agent Agreement")
between USBFS and the Funds dated July 1, 2006. For the period July 1, 2005 to
July 1, 2006, the Funds paid $18,500 per share class and additional per account
fees for transfer agent services. These fees were allocated to each Fund based
upon the fund's pro rata share of the aggregate average daily net assets of the
funds that comprise FAIF. Under the Transfer Agent Agreement, the Funds also
paid USBFS a fee equal, on an annual basis, to 0.10% of each Fund's average
daily net assets as compensation for providing certain shareholder services and
to reimburse USBFS for its payments to intermediaries with whom it has
contracted to establish and service omnibus accounts. In addition, USBFS was
reimbursed for its out-of-pocket expenses incurred while providing its services
to the Funds.
Effective July 1, 2006, the Funds are charged transfer agent fees on a
per shareholder account basis, subject to a minimum fee per share class. These
fees will be charged to each fund based on the number of accounts within that
fund. The 0.10% fee for shareholder services and payments to financial
intermediaries has been incorporated into the administration fee. The $18,500
per share class fee that was charged in addition to per account fees has been
eliminated. The Funds will continue to reimburse USBFS for out-of-pocket
expenses incurred in providing transfer agent services.
The following table sets forth transfer agent fees paid by the Funds
to USBFS for the fiscal period ended June 30, 2006, and the fiscal years ended
June 30, 2007 and June 30, 2008:
61
FISCAL PERIOD FISCAL YEAR FISCAL YEAR
ENDED ENDED ENDED
FUND JUNE 30, 2006 JUNE 30, 2007 JUNE 30, 2008
- ---- ------------- ------------- -------------
Core Bond Fund $1,904,710 $249,886 $219,760
High Income Bond Fund 263,075 118,170 109,184
Inflation Protected Securities Fund 306,877 91,151 90,007
Intermediate Government Bond Fund 57,906 53,824 54,000
Intermediate Term Bond Fund 1,037,728 57,013 54,000
Short Term Bond Fund 641,285 117,083 102,261
Total Return Bond Fund 364,892 110,026 107,999
U.S. Government Mortgage Fund 185,655 110,169 107,999
Arizona Tax Free Fund 26,753 72,573 72,000
California Intermediate Tax Free Fund 56,822 54,104 54,000
California Tax Free Fund 35,614 72,307 72,000
Colorado Intermediate Tax Free Fund 46,307 54,075 54,000
Colorado Tax Free Fund 22,069 72,576 72,000
Intermediate Tax Free Fund 668,293 54,665 54,000
Minnesota Intermediate Tax Free Fund 219,726 54,682 54,000
Minnesota Tax Free Fund 165,412 77,570 72,000
Missouri Tax Free Fund 178,136 72,125 72,000
Nebraska Tax Free Fund 41,396 72,390 72,000
Ohio Tax Free Fund 42,167 72,097 72,000
Oregon Intermediate Tax Free Fund 134,205 53,961 54,000
Short Tax Free Fund 291,362 53,227 54,000
Tax Free Fund 498,840 75,047 72,000
DISTRIBUTOR
Quasar Distributors, LLC ("Quasar" or the "Distributor") serves as the
distributor for the Funds' shares pursuant to a Distribution Agreement dated
July 1, 2005 (the "Distribution Agreement"). The Distributor is a wholly owned
subsidiary of U.S. Bancorp.
Fund shares and other securities distributed by the Distributor are
not deposits or obligations of, or endorsed or guaranteed by, U.S. Bank or its
affiliates, and are not insured by the Bank Insurance Fund, which is
administered by the Federal Deposit Insurance Corporation.
Under the Distribution Agreement, the Funds have granted to the
Distributor the exclusive right to sell shares of the Funds as agent and on
behalf of the Funds. The Distributor pays compensation pursuant to the
Distribution Agreement to securities firms, financial institutions (including,
without limitation, banks) and other industry professionals (the "Participating
Intermediaries") which enter into sales agreements with the Distributor. U.S.
Bancorp Investment Services, Inc. ("USBI"), a broker-dealer affiliated with the
Advisor, and U.S. Bank, are Participating Intermediaries.
The Class A Shares pay to the Distributor a shareholder servicing fee
at an annual rate of 0.25% of the average daily net assets of the Class A
Shares. The fee may be used by the Distributor to provide compensation for
shareholder servicing activities with respect to the Class A Shares. The
shareholder servicing fee is intended to compensate the Distributor for ongoing
servicing and/or maintenance of shareholder accounts and may be used by the
Distributor to provide compensation to intermediaries through whom shareholders
hold their shares for ongoing servicing and/or maintenance of shareholder
accounts. This fee is calculated and paid each month based on average daily net
assets of Class A Shares each Fund for that month.
The Class B Shares pay to the Distributor a shareholder servicing fee
at the annual rate of 0.25% of the average daily net assets of the Class B
Shares. The fee may be used by the Distributor to provide compensation for
shareholder servicing activities with respect to the Class B Shares beginning
one year after purchase. The Class B Shares also pay to the Distributor a
distribution fee at the annual rate of 0.75% of the average daily net assets of
the Class B Shares. The distribution fee is intended to compensate the
distributor for advancing a commission to intermediaries purchasing Class B
Shares.
The Class C Shares pay to the Distributor a shareholder servicing fee
at the annual rate of 0.25% of the average daily net assets of the Class C
Shares. The fee may be used by the Distributor to provide compensation for
shareholder servicing activities with respect to the Class C Shares. This fee is
calculated and paid each month based on average daily net assets of the Class C
Shares. The Class C Shares also pay to the Distributor a distribution fee at the
annual rate
62
of 0.75% of the average daily net assets of the Class C Shares. The Distributor
may use the distribution fee to provide compensation to intermediaries through
which shareholders hold their shares beginning one year after purchase.
The Class R Shares pay to the Distributor a distribution fee at the
annual rate of 0.50% of the average daily net assets of Class R Shares. The fee
may be used by the Distributor to provide initial and ongoing sales compensation
to its investment executives and to Participating Intermediaries in connection
with sales of Class R Shares and to pay for advertising and other promotional
expenses in connection with the distribution of Class R shares. This fee is
calculated and paid each month based on average daily net assets of the Class R
Shares.
The Distributor receives no compensation for distribution of the Class
Y Shares.
The Distribution Agreement provides that it will continue in effect
for a period of more than one year from the date of its execution only so long
as such continuance is specifically approved at least annually by the vote of a
majority of the Board members of FAIF and by the vote of the majority of those
Board members of FAIF who are not interested persons of FAIF and who have no
direct or indirect financial interest in the operation of FAIF's Rule 12b-1
Distribution and Service Plan or in any agreement related to such plan.
The following tables set forth the amount of underwriting commissions
paid by certain Funds and the amount of such commissions retained by Quasar,
during the fiscal period ended June 30, 2006, and the fiscal years ended June
30, 2007 and June 30, 2008:
TOTAL UNDERWRITING COMMISSIONS
FISCAL PERIOD FISCAL YEAR FISCAL YEAR
ENDED ENDED ENDED
FUND JUNE 30, 2006 JUNE 30, 2007 JUNE 30, 2008
- ---- ------------- ------------- -------------
Core Bond Fund $ 34,389 $ 41,491 $ 46,620
High Income Bond Fund 38,640 35,818 22,250
Inflation Protected Securities Fund 9,051 5,810 4,596
Intermediate Government Bond Fund 1,430 671 17,068
Intermediate Term Bond Fund 11,326 7,064 4,605
Short Term Bond Fund 10,466 5,976 5,947
Total Return Bond Fund 23,549 8,437 39,564
U.S. Government Mortgage Fund 8,924 20,319 3,858
Arizona Tax Free Fund 16,857 15,362 12,335
California Intermediate Tax Free Fund 4,603 14,190 3,074
California Tax Free Fund 48,900 48,994 64,530
Colorado Intermediate Tax Free Fund 665 5,022 9,758
Colorado Tax Free Fund 3,223 6,000 6,916
Intermediate Tax Free Fund 4,619 914 5,437
Minnesota Intermediate Tax Free Fund 25,247 6,123 27,853
Minnesota Tax Free Fund 189,617 330,339 357,965
Missouri Tax Free Fund 22,031 59,848 18,993
Nebraska Tax Free Fund 7,335 7,782 15,672
Ohio Tax Free Fund 4,958 1,275 3,508
Oregon Intermediate Tax Free Fund 15,532 1,439 6,097
Short Tax Free Fund 30 2,243 39
Tax Free Fund 29,586 48,169 55,389
UNDERWRITING COMMISSIONS RETAINED BY QUASAR
FISCAL PERIOD FISCAL YEAR FISCAL YEAR
ENDED ENDED ENDED
FUND JUNE 30, 2006 JUNE 30, 2007 JUNE 30, 2008
- ---- ------------- ------------- -------------
Core Bond Fund $ 2,924 $ 3,895 $ 4,547
High Income Bond Fund 5,630 4,993 1,584
Inflation Protected Securities Fund 1,380 344 335
Intermediate Government Bond Fund 292 186 4,313
Intermediate Term Bond Fund 1,671 1,098 918
Short Term Bond Fund 2,741 887 917
Total Return Bond Fund 2,053 969 3,384
U.S. Government Mortgage Fund 689 1,935 424
Arizona Tax Free Fund 1,131 998 898
California Intermediate Tax Free Fund 572 2,001 392
California Tax Free Fund 3,890 4,588 5,050
Colorado Intermediate Tax Free Fund 91 708 1,274
63
FISCAL PERIOD FISCAL YEAR FISCAL YEAR
ENDED ENDED ENDED
FUND JUNE 30, 2006 JUNE 30, 2007 JUNE 30, 2008
- ---- ------------- ------------- -------------
Colorado Tax Free Fund 539 451 501
Intermediate Tax Free Fund 781 107 1,049
Minnesota Intermediate Tax Free Fund 3,866 777 4,946
Minnesota Tax Free Fund 15,207 25,975 40,301
Missouri Tax Free Fund 1,825 5,594 1,401
Nebraska Tax Free Fund 490 663 1,042
Ohio Tax Free Fund 408 71 254
Oregon Intermediate Tax Free Fund 2,634 205 777
Short Tax Free Fund 3 582 6
Tax Free Fund 2,323 4,229 4,262
The Distributor received the following compensation from the Funds
during the Funds' most recent fiscal year ended June 30, 2008:
NET UNDERWRITING COMPENSATION ON
DISCOUNTS AND REDEMPTIONS AND BROKERAGE OTHER
COMMISSIONS REPURCHASES COMMISSIONS COMPENSATION*
---------------- --------------- ----------- -------------
Core Bond Fund $ 4,547 $17,423 -- --
High Income Bond Fund 1,584 11,009 -- --
Inflation Protected Securities Fund 335 38 -- --
Intermediate Government Bond Fund 4,313 -- -- --
Intermediate Term Bond Fund 918 -- -- --
Short Term Bond Fund 917 -- -- --
Total Return Bond Fund 3,384 1,707 -- --
U.S. Government Mortgage Fund 424 13,554 -- --
Arizona Tax Free Fund 898 55 -- --
California Intermediate Tax Free Fund 392 -- -- --
California Tax Free Fund 5,050 681 -- --
Colorado Intermediate Tax Free Fund 1,274 -- -- --
Colorado Tax Free Fund 501 1,056 -- --
Intermediate Tax Free Fund 1,049 -- -- --
Minnesota Intermediate Tax Free Fund 4,946 -- -- --
Minnesota Tax Free Fund 40,301 17,831 -- --
Missouri Tax Free Fund 1,401 -- -- --
Nebraska Tax Free Fund 1,042 -- -- --
Ohio Tax Free Fund 254 -- -- --
Oregon Intermediate Tax Free Fund 777 -- -- --
Short Tax Free Fund 6 -- -- --
Tax Free Fund 4,262 79 -- --
* As disclosed below, the Funds also paid fees to the Distributor under
FAIF's Rule 12b-1 Distribution and Service Plan. None of those fees were
retained by the Distributor. The Distributor is compensated from fees
earned by U.S. Bancorp Fund Services, LLC, under a separate arrangement as
part of the Sub-Administration Agreement between FAF Advisors and U.S.
Bancorp Fund Services, LLC.
FAIF has also adopted a Distribution and Service Plan with respect to
the Class A, Class B, Class C and Class R Shares of the Funds pursuant to Rule
12b-1 under the 1940 Act (the "Plan"). Rule 12b-1 provides in substance that a
mutual fund may not engage directly or indirectly in financing any activity
which is primarily intended to result in the sale of shares, except pursuant to
a plan adopted under the Rule. The Plan authorizes the Distributor to retain the
sales charges paid upon purchase of Class A, Class B and Class C Shares and
authorize the Funds to pay the Distributor distribution and/or shareholder
servicing fees. The Plan is a "compensation-type" plan under which the
Distributor is entitled to receive the distribution and shareholder servicing
fees regardless of whether its actual distribution and shareholder servicing
expenses are more or less than the amount of the fees. The distribution fees
under the Plan are used for primary purpose of compensating broker-dealers for
their sales of the Funds. The shareholder servicing fees are used primarily for
the purpose of providing compensation for the ongoing servicing and/or
maintenance of shareholder accounts. The Plan authorizes the Distributor to
retain the contingent deferred sales charge applied on redemptions of Class B
and C Shares, except that portion which is reallowed to Participating
Intermediaries. The Plan recognizes that the Distributor and the Advisor, in
their discretion, may from time to time use their own assets to pay for certain
additional costs of distributing Class A, Class B, Class C and Class R Shares.
Any such arrangements to pay such additional costs may be commenced or
discontinued by the Distributor or the Advisor at any time.
64
The following table sets forth the total Rule 12b-1 fees, after
waivers, paid by certain of the Funds for the fiscal year ended June 30, 2008
with respect to the Class A shares, Class B shares, Class C shares and Class R
shares of the Funds. As noted above, no distribution fees are paid with respect
to Class Y shares.
FISCAL YEAR ENDED JUNE 30, 2008
RULE 12B-1 FEES
----------------------------------------
CLASS A CLASS B CLASS C CLASS R
FUND SHARES SHARES SHARES SHARES
- ---- -------- ------- -------- --------
Core Bond Fund $252,258 $84,960 $ 45,193 $1,136
High Income Bond Fund 70,673 40,004 70,845 946
Inflation Protected Securities Fund 7,604 * 3,439 5,122
Intermediate Government Bond Fund 6,381 * * *
Intermediate Term Bond Fund 43,960 * * *
Short Term Bond Fund 96,088 * * *
Total Return Bond Fund 37,684 22,445 28,816 1,202
U.S. Government Mortgage Fund 31,046 43,125 26,187 4,056
Arizona Tax Free Fund 18,317 * 8,703 *
California Intermediate Tax Free Fund 1,567 * * *
California Tax Free Fund 18,522 * 9,853 *
Colorado Intermediate Tax Free Fund 9,140 * * *
Colorado Tax Free Fund 16,584 * 17,884 *
Intermediate Tax Free Fund 41,979 * * *
Minnesota Intermediate Tax Free Fund 13,922 * * *
Minnesota Tax Free Fund 260,325 * 110,184 *
Missouri Tax Free Fund 60,444 * 3,283 *
Nebraska Tax Free Fund 15,929 * 11,548 *
Ohio Tax Free Fund 1,670 * 1,276 *
Oregon Intermediate Tax Free Fund 10,433 * * *
Short Tax Free Fund 3,570 * * *
Tax Free Fund 89,731 * 18,572 *
- ----------
* Fund or class was not in operation during this fiscal period.
The following table sets forth the Rule 12b-1 fees the Distributor
paid to Participating Intermediaries for the fiscal year ended June 30, 2008
with respect to the Class A shares, Class B shares, Class C shares and Class R
shares of the Funds.
FISCAL YEAR ENDED JUNE 30, 2008
--------------------------------------
CLASS A CLASS B CLASS C CLASS R
SHARES SHARES SHARES SHARES
-------- ------- ------- -------
Core Bond Fund $131,262 $18,929 $14,237 $370
High Income Bond Fund 16,389 6,836 15,984 644
Inflation Protected Securities Fund 5,040 * 1,723 --
Intermediate Government Bond Fund 1,949 * * *
Intermediate Term Bond Fund 24,014 * * *
Short Term Bond Fund 48,260 * * *
Total Return Bond Fund 26,540 4,489 16,463 249
U.S. Government Mortgage Fund 24,294 9,967 5,711 --
Arizona Tax Free Fund 364 * 2,067 *
California Intermediate Tax Free Fund 4,590 * * *
California Tax Free Fund 22,704 * 7,766 *
Colorado Intermediate Tax Free Fund 4,975 * * *
Colorado Tax Free Fund 4,718 * 2,356 *
Intermediate Tax Free Fund 22,934 * * *
Minnesota Intermediate Tax Free Fund 15,067 * * *
Minnesota Tax Free Fund 36,640 * 64,808 *
Missouri Tax Free Fund 50,217 * 2,482 *
Nebraska Tax Free Fund 3,217 * 4,848 *
Ohio Tax Free Fund 1,249 * 945 *
Oregon Intermediate Tax Free Fund 6,959 * * *
Short Tax Free Fund 3,074 * * *
Tax Free Fund 28,911 * 5,109 *
- ----------
* Fund or class was not in operation during this fiscal period.
65
CUSTODIAN AND INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Custodian. U.S. Bank, 60 Livingston Avenue, St. Paul, MN 55101, acts
as the custodian for each Fund (the "Custodian"). U.S. Bank is a subsidiary of
U.S. Bancorp. The Custodian takes no part in determining the investment policies
of the Funds or in deciding which securities are purchased or sold by the Funds.
All of the instruments representing the investments of the Funds and all cash
are held by the Custodian. The Custodian delivers securities against payment
upon sale and pays for securities against delivery upon purchase. The Custodian
also remits Fund assets in payment of Fund expenses, pursuant to instructions of
FAIF's officers or resolutions of the Board of Directors.
As compensation for its services as custodian to the Funds, the
Custodian is paid a monthly fee calculated on an annual basis equal to 0.005% of
each such Fund's average daily net assets. In addition, the Custodian is
reimbursed for its out-of-pocket expenses incurred while providing services to
the Funds. The Custodian continues to serve so long as its appointment is
approved at least annually by the Board of Directors including a majority of the
directors who are not interested persons (as defined under the 1940 Act) of
FAIF.
Independent Registered Public Accounting Firm. Ernst & Young LLP, 220
South Sixth Street, Suite 1400, Minneapolis, Minnesota 55402, serves as the
Funds' independent registered public accounting firm, providing audit services,
including audits of the annual financial statements.
PORTFOLIO MANAGERS
OTHER ACCOUNTS MANAGED
The following table sets forth the number and total assets of the
mutual funds and accounts managed by the Funds' portfolio managers as of June
30, 2008.
NUMBER OF AMOUNT SUBJECT TO
PORTFOLIO MANAGER TYPE OF ACCOUNT MANAGED ACCOUNTS ASSETS PERFORMANCE-BASED FEE
- ----------------- -------------------------------- --------- -------------- --------------------------
Christopher L. Drahn Registered Investment Company 3 $243.1 million 0
Other Pooled Investment Vehicles 0 0 0
Other Accounts 5 $209.3 million 0
Jeffrey J. Ebert Registered Investment Company 0 0 0
Other Pooled Investment Vehicles 0 0 0
Other Accounts 14 $736.7 million 1 account - $137.5 million
John T. Fruit Registered Investment Company 1 $ 74.8 million 0
Other Pooled Investment Vehicles 0 0 0
Other Accounts 0 0 0
Michael S. Hamilton Registered Investment Company 1 $412.0 million 0
Other Pooled Investment Vehicles 0 0 0
Other Accounts 2 $175.0 million 0
Gregory A. Hanson Registered Investment Company 0 0 0
Other Pooled Investment Vehicles 0 0 0
Other Accounts 13 $ 1.2 billion 0
Wan-Chong Kung Registered Investment Company 0 0 0
Other Pooled Investment Vehicles 0 0 0
Other Accounts 12 $423.0 million 0
Chris J. Neuharth Registered Investment Company 5 $696.4 million 0
Other Pooled Investment Vehicles 1 $984.0 million 0
Other Accounts 12 $ 1.3 billion 1 account - $137.5 million
66
NUMBER OF AMOUNT SUBJECT TO
PORTFOLIO MANAGER TYPE OF ACCOUNT MANAGED ACCOUNTS ASSETS PERFORMANCE-BASED FEE
- ----------------- -------------------------------- --------- -------------- --------------------------
Marie A. Newcome Registered Investment Company 0 0 0
Other Pooled Investment Vehicles 1 $984.0 million 0
Other Accounts 32 $415.0 million 0
Jason J. O'Brien Registered Investment Company 0 0 0
Other Pooled Investment Vehicles 0 0 0
Other Accounts 0 0 0
Timothy A. Palmer Registered Investment Company 0 0 0
Other Pooled Investment Vehicles 1 $108.7 million 0
Other Accounts 13 $576.0 million 0
Linda M. Sauber Registered Investment Company 0 0 0
Other Pooled Investment Vehicles 0 0 0
Other Accounts 0 0 0
Jeffrey T. Schmitz Registered Investment Company 0 0 0
Other Pooled Investment Vehicles 0 0 0
Other Accounts 0 0 0
Michael L. Welle Registered Investment Company 0 0 0
Other Pooled Investment Vehicles 0 0 0
Other Accounts 1 $ 2.0 million 0
Douglas J. White Registered Investment Company 4 $655.1 million 0
Other Pooled Investment Vehicles 0 0 0
Other Accounts 6 $121.8 million 0
SIMILAR ACCOUNTS. The Funds' portfolio managers often manage multiple
accounts. The Advisor has adopted policies and procedures regarding brokerage
and trade allocation and allocation of investment opportunities that it believes
are reasonably designed to address potential conflicts of interest associated
with managing multiple accounts for multiple clients.
COMPENSATION
Portfolio manager compensation consists primarily of base pay, an
annual cash incentive and long term incentive payments.
Base pay is determined based upon an analysis of the portfolio
manager's general performance, experience, and market levels of base pay for
such position.
Portfolio managers are paid an annual incentive based upon investment
performance, generally over the past one- and three-year periods unless the
portfolio manager's tenure is shorter. The maximum potential annual cash
incentive is equal to a multiple of base pay, determined based upon the
particular portfolio manager's performance and experience, and market levels of
base pay for such position.
For managers of the Bond Funds, the portion of the maximum potential
annual cash incentive that is paid out is based upon performance relative to the
portfolio's benchmark and performance relative to an appropriate Lipper industry
peer group. Generally, the threshold for payment of an annual cash incentive is
(i) benchmark performance and (ii) median performance versus the peer group, and
the maximum annual cash incentive is attained at (i) a spread over the benchmark
which the Advisor believes will, over time, deliver top quartile performance and
(ii) top quartile performance versus the Lipper industry peer group.
For managers of the Tax Free Funds, the portion of the maximum
potential annual cash incentive that is paid out is based upon performance
relative to an appropriate Lipper industry peer group, and for certain portfolio
managers
67
is also based on a subjective component. Generally, the threshold for payment of
an annual cash incentive is median performance versus the peer group, and the
maximum annual cash incentive is attained at top quartile performance versus the
Lipper industry peer group.
Investment performance is measured on a pre-tax basis, gross of fees
for Fund results and for the Lipper industry peer group.
Long term incentive payments are paid to portfolio managers on an
annual basis based upon general performance and expected contributions to the
success of the Advisor. Long-term incentive payments are comprised of two
components: (i) performance equity units of the Advisor and (ii) U.S. Bancorp
options and restricted stock.
There are generally no differences between the methods used to
determine compensation with respect to the Funds and the Other Accounts shown in
the table below.
OWNERSHIP OF FUND SHARES
The following table indicates as of June 30, 2008 the value, within
the indicated range, of shares beneficially owned by the portfolio managers in
each Fund they manage. For purposes of this table, the following letters
indicate the range listed next to each letter:
A - $0
B - $1 - $10,000
C - $10,001 - $50,000
D - $50,001 - $100,000
E - $100,001 - $500,000
F - $500,001 - $1,000,000
G - More than $1 million
OWNERSHIP IN FUND
PORTFOLIO MANAGER FUND OWNERSHIP IN FUND COMPLEX
- ----------------- ------------------------------------- ----------------- -----------------
Christopher L. Drahn California Intermediate Tax Free Fund A F
California Tax Free Fund A
Colorado Intermediate Tax Free Fund A
Colorado Tax Free Fund A
Intermediate Tax Free Fund A
Minnesota Intermediate Tax Free Fund A
Minnesota Tax Free Fund A
Missouri Tax Free Fund A
Nebraska Tax Free Fund A
Ohio Tax Free Fund A
Oregon Intermediate Tax Free Fund A
Short Tax Free Fund A
Tax Free Fund A
Jeffrey J. Ebert Core Bond Fund C D
Intermediate Term Bond Fund A
Total Return Bond Fund A
John T. Fruit High Income Bond Fund D E
Michael S. Hamilton Arizona Tax Free Fund A D
California Intermediate Tax Free Fund A
California Tax Free Fund A
Ohio Tax Free Fund A
Oregon Intermediate Tax Free Fund A
Gregory A. Hanson High Income Bond Fund A E
Wan-Chong Kung Core Bond Fund D E
Inflation Protected Securities Fund A
Intermediate Government Bond Fund A
Intermediate Term Bond Fund A
Total Return Bond Fund A
Chris J. Neuharth Core Bond Fund D E
Short Term Bond Fund A
68
OWNERSHIP IN FUND
PORTFOLIO MANAGER FUND OWNERSHIP IN FUND COMPLEX
- ----------------- ------------------------------------- ----------------- -----------------
Total Return Bond Fund A
U.S. Government Mortgage Fund A
Marie A. Newcome Short Term Bond Fund A C
Jason J. O'Brien U.S. Government Mortgage Fund A D
Timothy A. Palmer Core Bond Fund A B
Total Return Bond Fund A
Linda M. Sauber Inflation Protected Securities Fund A D
Intermediate Government Bond Fund A
Jeffrey T. Schmitz High Income Bond Fund A C
Michael L. Welle Colorado Intermediate Tax Free Fund A B
Colorado Tax Free Fund A
Nebraska Tax Free Fund A
Short Tax Free Fund A
Douglas J. White Arizona Tax Free Fund A E
Intermediate Tax Free Fund A
Minnesota Intermediate Tax Free Fund A
Minnesota Tax Free Fund A
Missouri Tax Free Fund A
Tax Free Fund A
PORTFOLIO TRANSACTIONS AND ALLOCATION OF BROKERAGE
Decisions with respect to which securities are to be bought or sold,
the total amount of securities to be bought or sold, the broker-dealer with or
through which the securities transactions are to be effected and the commission
rates applicable to the trades are made by the Advisor.
In selecting a broker-dealer to execute securities transactions, the
Advisor considers a variety of factors, including the execution capability,
financial responsibility and responsiveness of the broker-dealer in seeking best
price and execution. Subject to the satisfaction of its obligation to seek best
execution, other factors the Advisor may consider include a broker-dealer's
access to initial public offerings and the nature and quality of any brokerage
and research products and services the broker-dealer provides. However, the
Advisor may cause the Funds to pay a broker-dealer a commission in excess of
that which another broker-dealer might have charged for effecting the same
transaction (a practice commonly referred to as "paying up"). However, the
Advisor may cause the Funds to pay up in recognition of the value of brokerage
and research products and services provided to the Advisor by the broker-dealer.
The broker-dealer may directly provide such products or services to the Advisor
or purchase them form a third party and provide them to the Advisor. In such
cases, the Funds are in effect paying for the brokerage and research products
and services in so-called "soft-dollars". However, the Advisor will authorize
the Funds to pay an amount of commission for effecting a securities transaction
in excess of the amount of commission another broker or dealer would have
charged only if the Advisor determined in good faith that the amount of such
commission was reasonable in relation to the value of the brokerage and research
products and services provided by such broker or dealer, viewed in terms of
either that particular transaction or the overall responsibilities of the
Advisor with respect to the managing its accounts.
The types of research products and services the Advisor receives
include economic analysis and forecasts, financial market analysis and
forecasts, industry and company specific analysis, interest rate forecasts, and
other services that assist in the investment decision making process. Research
products and services are received primarily in the form of written reports,
computer-generated services, telephone contacts and personal meetings with
security analysts. Research services may also be provided in the form of
meetings arranged with corporate and industry spokespersons or may be generated
by third parties but are provided to the Advisor by, or through, broker-dealers.
The research products and services the Advisor receives from
broker-dealers are supplemental to, and do not necessarily reduce, the Advisor's
own normal research activities. As a practical matter, however, it would be
impossible for the Advisor to generate all of the information presently provided
by broker-dealers. The expenses of the Advisor would be materially increased if
they attempted to generate such additional information through their own staffs.
To the extent that the Advisor could use cash to purchase many of the brokerage
and research products and services received
69
for allocating securities transactions to broker-dealers, the Advisor are
relieved of expenses that they might otherwise bear when such services are
provided by broker-dealers.
As a general matter, the brokerage and research products and services
the Advisor receive from broker-dealers are used to service all of their
respective accounts. However, any particular brokerage and research product or
service may not be used to service each and every client account, and may not
benefit the particular accounts that generated the brokerage commissions. For
example, equity commissions may pay for brokerage and research products and
services utilized in managing fixed income accounts.
In some cases, the Advisor may receive brokerage or research products
or services that are used for both brokerage or research purposes and other
purposes, such as accounting, record keeping, administration or marketing. In
such cases, the Advisor will make a good faith effort to decide the relative
proportion of the cost of such products or services used for non-brokerage or
research purposes and will pay for such portion from its own funds. In such
circumstance, the Advisor has a conflict of interest in making such decisions.
Many of the Funds' portfolio transactions involve payment of a
brokerage commission by the appropriate Fund. In some cases, transactions are
with dealers or issuers who act as principal for their own accounts and not as
brokers. Transactions effected on a principal basis, other than certain
transactions effected on a so-called riskless principal basis, are made without
the payment of brokerage commissions but at net prices which usually include a
spread or markup. In effecting transactions in over-the-counter securities, the
Funds typically deal with market makers unless it appears that better price and
execution are available elsewhere.
Foreign equity securities may be held in the form of American
Depositary Receipts, or ADRs, European Depositary Receipts, or EDRs, or
securities convertible into foreign equity securities. ADRs and EDRs may be
listed on stock exchanges or traded in the over-the-counter markets in the
United States or overseas. The foreign and domestic debt securities and money
market instruments in which the Funds may invest are generally traded in the
over-the-counter markets.
The Funds do not effect any brokerage transactions in their portfolio
securities with any broker or dealer affiliated directly or indirectly with the
Advisor or Distributor unless such transactions, including the frequency
thereof, the receipt of commission payable in connection therewith, and the
selection of the affiliated broker or dealer effecting such transactions are not
unfair or unreasonable to the shareholders of the Funds, as determined by the
Board of Directors. Any transactions with an affiliated broker or dealer must be
on terms that are both at least as favorable to the Funds as the Funds can
obtain elsewhere and at least as favorable as such affiliated broker or dealer
normally gives to others.
When two or more clients of the Advisor are simultaneously engaged in
the purchase or sale of the same security, the prices and amounts are allocated
in a manner considered by the Advisor to be equitable to each client. In some
cases, this system could have a detrimental effect on the price or volume of the
security as far as each client is concerned. In other cases, however, the
ability of the clients to participate in volume transactions may produce better
executions for each client.
The following table sets forth the aggregate brokerage commissions
paid by certain of the Funds during the fiscal period ended June 30, 2006, and
the fiscal years ended June 30, 2007 and June 30, 2008:
FISCAL PERIOD FISCAL YEAR FISCAL YEAR
ENDED ENDED ENDED
JUNE 30, 2006 JUNE 30, 2007 JUNE 30, 2008
------------- ------------- -------------
Core Bond Fund $ 3,545 $ 1,352 $ --
High Income Bond Fund 15,449 36,147 38,569
Inflation Protected Securities Fund 331 8,805 2,888
Intermediate Government Bond Fund -- -- --
70
Intermediate Term Bond Fund 2,029 1,775 --
Short Term Bond Fund -- 1,131 --
Total Return Bond Fund 6,363 37,148 26,392
U.S. Government Mortgage Fund -- 342 --
Arizona Tax Free Fund -- -- --
California Intermediate Tax Free Fund -- -- --
California Tax Free Fund -- -- --
Colorado Intermediate Tax Free Fund -- -- --
Colorado Tax Free Fund -- -- --
Intermediate Tax Free Fund -- -- --
Minnesota Intermediate Tax Free Fund -- -- --
Minnesota Tax Free Fund -- -- --
Missouri Tax Free Fund -- -- --
Nebraska Tax Free Fund -- -- --
Ohio Tax Free Fund -- -- --
Oregon Intermediate Tax Free Fund -- -- --
Short Tax Free Fund -- -- --
Tax Free Fund -- -- --
- ----------
- -- No commissions paid.
At June 30, 2008, certain Funds held the securities of their "regular
brokers or dealers" as follows:
REGULAR BROKER OR AMOUNT OF
DEALER ISSUING SECURITIES HELD
FUND SECURITIES BY FUND (000) TYPE OF SECURITIES
- ---- ----------------- --------------- ---------------------
Core Bond Merrill Lynch $ 9,491 Corporate Obligations
Morgan Stanley 15,119 Corporate Obligations
Inflation Protected Securities Merrill Lynch $ 1,477 Corporate Obligations
Intermediate Term Bond CS First Boston $ 6,112 Corporate Obligations
Merrill Lynch 4,859 Corporate Obligations
Morgan Stanley 6,491 Corporate Obligations
Short Term Bond Goldman Sachs $ 2,637 Corporate Obligations
Morgan Stanley 3,871 Corporate Obligations
Total Return Bond Merrill Lynch $ 2,448 Corporate Obligations
Morgan Stanley 5,330 Corporate Obligations
CAPITAL STOCK
Each share of each Fund's $.01 par value common stock is fully paid,
nonassessable, and transferable. Shares may be issued as either full or
fractional shares. Fractional shares have pro rata the same rights and
privileges as full shares. Shares of the Funds have no preemptive or conversion
rights.
Each share of a Fund has one vote. On some issues, such as the
election of directors, all shares of all FAIF Funds vote together as one series.
The shares do not have cumulative voting rights. On issues affecting only a
particular Fund, the shares of that Fund will vote as a separate series.
Examples of such issues would be proposals to alter a fundamental investment
restriction pertaining to a Fund or to approve, disapprove or alter a
distribution plan.
The Bylaws of FAIF provide that annual shareholders meetings are not
required and that meetings of shareholders need only be held with such frequency
as required under Minnesota law and the 1940 Act.
As of October 6, 2008, the directors and officers of FAIF as a group
owned less than 1% of each Fund's outstanding shares and the Funds were aware
that the following persons owned of record 5% or more of the outstanding shares
of each class of stock of the Funds:
71
PERCENTAGE OF OUTSTANDING SHARES
-----------------------------------------------
CLASS A CLASS B CLASS C CLASS Y CLASS R
------- ------- ------- ------- -------
ARIZONA TAX FREE
MS&CO FBO 14.00%
TAYLOR TRUST FARMS LLC A
PARTNERSHIP
ROBERT W MOORE MGR
PO BOX 128
WADDELL AZ 85355-0128
RAMESH C PATRI 5.70%
4733 E QUARTZ MOUNTAIN RD
PARADISE VLY AZ 85253-3202
SCOTT TRUST 5.20%
MARIAN G SCOTT TR
U/A 04/17/2000
4507 191ST PL NE
SAMMAMISH WA 98074-4633
UBS FINANCIAL SERVICES INC. FBO 5.07%
MARIAN HATFIELD TTEE
JMA SUBTRUST
U/A DTD 06/30/99
9411 W KERRY LN
PEORIA AZ 85382-3691
WILLIAM BLAIR & CO. L.L.C. 15.29%
MARTHA ELFRIEDE BROWN
222 W ADAMS STREET
CHICAGO IL 60606-5312
MS&CO FBO 13.21%
THOMAS A STEELE TTEE
SARABELLE STEELE REV
LIV TR U/A DTD 4/24/2001
17 HARBORVIEW DR
RYE NH 03870-6119
MS&CO FBO 9.30%
LOIS A DOYLE TTEE
LOIS ANNE DOYLE TR U/A
DTD 07/21/1994
9608 W PINERIDGE DR
SUN CITY AZ 85351-2443
FIRST CLEARING, LLC 8.53%
DONALD L FLAMM REV TRUST TRUST
DONALD L FLAMM TTEE
6115 LINCOLN DR APT 355
EDINA MN 55436-1630
WELLS FARGO INVESTMENTS LLC 7.49%
625 MARQUETTE AVE S 13TH FLOOR
MINNEAPOLIS MN 55402-2323
NFS LLC FEBO 6.76%
HARRIET B MARTIN REVOCABLE LIVIN
HARRIET MARTIN
U/A 10/22/07
5401 W DAILEY ST APT 3111
GLENDALE AZ 85306-4773
FIRST CLEARING, LLC 6.66%
THE ROBERT P COURSEY TRUST
7231 E BROADWAY RD APT 121
MESA AZ 85208-9218
72
PERCENTAGE OF OUTSTANDING SHARES
-----------------------------------------------
CLASS A CLASS B CLASS C CLASS Y CLASS R
------- ------- ------- ------- -------
BAND & CO 69.44%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
CAPINCO 18.67%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 11.89%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
CALIFORNIA INTERMEDIATE TAX FREE
LPL FINANCIAL 7.87%
9785 TOWNE CENTRE DR
SAN DIEGO CA 92121-1968
UBS FINANCIAL SERVICES INC. FBO 7.70%
LINBROOK TILE, INC.
1656 S STATE COLLEGE BLVD
ANAHEIM CA 92806-6021
U.S. BANCORP INVESTMENTS INC. 7.20%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
U.S. BANCORP INVESTMENTS INC. 5.92%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
BAND & CO 79.72%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 16.74%
PO BOX 1787
MILWAUKEE WI 53201-1787
CALIFORNIA TAX FREE
U.S. BANCORP INVESTMENTS INC 12.41%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
US BANCORP INVESTMENTS INC. 7.03%
60 LIVINGSTON AVE
ST PAUL MN 55107-2292
U.S. BANCORP INVESTMENTS INC. 11.48%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
U.S. BANCORP INVESTMENTS INC. 11.29%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
U.S. BANCORP INVESTMENTS INC. 10.59%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
73
PERCENTAGE OF OUTSTANDING SHARES
-----------------------------------------------
CLASS A CLASS B CLASS C CLASS Y CLASS R
------- ------- ------- ------- -------
MERRILL LYNCH PIERCE FENNER & SMITH 5.50%
ATTN PHYSICAL TEAM
4800 DEER LAKE DR E
JACKSONVILLE FL 32246-6484
MSANDCO FBO 5.30%
C R BROWN & J BROWN TTEE
BROWN FAMILY TRUST U/A
DTD 09/13/1995
79765 LIGA
LAQUINTA CA 92253-4578
BAND & CO 85.14%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 11.17%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
COLORADO INTERMEDIATE TAX FREE
MERRILL LYNCH PIERCE FENNER & SMITH 11.15%
ATTN PHYSICAL TEAM
4800 DEER LAKE DR E
JACKSONVILLE FL 32246-6484
BAND & CO 81.42%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 13.34%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
COLORADO TAX FREE
UBS FINANCIAL SERVICES INC. FBO 8.06%
M B E LIMITED PARTNERSHIP
C/O DON DITMARS
A PARTNERSHIP
PO BOX 126
CASTLE ROCK CO 80104-0126
BAND & CO 64.43%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
NFS LLC FEBO 19.58%
ALLIANCE BANK NA
ALLIANCE BANK TRUST DEPARTMENT
160 MAIN ST
ONEIDA NY 13421-1629
WASHINGTON & CO 12.45%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
CORE BOND
74
PERCENTAGE OF OUTSTANDING SHARES
-----------------------------------------------
CLASS A CLASS B CLASS C CLASS Y CLASS R
------- ------- ------- ------- -------
ORCHARD TRUST CO LLC TRUSTEE/C 7.03%
FBO RETIREMENT PLANS
8515 E ORCHARD RD 2T2
GREENWOOD VLG CO 80111-5002
ORCHARD TRUST CO LLC TRUSTEE/C 13.51%
FBO RETIREMENT PLANS
8515 E ORCHARD RD 2T2
GREENWOOD VLG CO 80111-5002
BAND & CO 59.24%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
CAPINCO 12.71%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 12.20%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
ORCHARD TRUST CO LLC TRUSTEE/C 7.68%
FBO RETIREMENT PLANS
8515 E ORCHARD RD 2T2
GREENWOOD VLG CO 80111-5002
US BANK CUST 6.74%
US BANCORP CAP
U/A 01-01-1984
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2575
MG TRUST COMPANY TRUSTEE 39.77%
MICHIGAN EDUCATIONAL PERSONNEL
SERV
700 17TH STREET
SUITE 300
DENVER CO 80202-3531
MG TRUST 20.91%
SHUMATE TRI-CITY LLC 401K
700 17TH ST STE 300
DENVER CO 80202-3531
INTERNATIONAL CLEARING TRUST CO 10.36%
TR AMERICAN MEDICAL
IDENTIFICATIONS
LTD LLP PSP
6940 COLUMBIA GATEWAY DR STE 200
COLUMBIA MD 21046-2876
MG TRUST CO CUST FBO 9.38%
IVERSEN & BIONDO ASSOCIATES INC
401K
700 17TH ST STE 300
DENVER CO 80202-3531
75
PERCENTAGE OF OUTSTANDING SHARES
-----------------------------------------------
CLASS A CLASS B CLASS C CLASS Y CLASS R
------- ------- ------- ------- -------
MG TRUST COMPANY CUST. FBO 5.58%
M. LONDON, INC. 401K
401K
700 17TH ST STE 300
DENVER CO 80202-3531
HIGH INCOME BOND
BAND & CO 75.81%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 12.75%
PO BOX 1787
MILWAUKEE WI 53201-1787
CAPINCO 9.93%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
U S BANCORP INVESTMENTS INC 73.71%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
MG TRUST COMPANY CUST. FBO 15.59%
JOHNSON-QUAID VENTURES, LLC
700 17TH ST STE 300
DENVER CO 80202-3531
INFLATION PROTECTED SECURITIES
NFS LLC FEBO 11.62%
ALEXANDER PRIMAK JEWELRY INC
2 W 47TH ST
NEW YORK NY 10036-3319
U.S. BANCORP INVESTMENTS INC. 7.48%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
MERRILL LYNCH PIERCE FENNER & SMITH 23.53%
ATTN PHYSICAL TEAM
4800 DEER LAKE DR E
JACKSONVILLE FL 32246-6484
FIRST CLEARING LLC 10.16%
MICHELLE J PERRY
85 FULTON ST
WEEHAWKEN NJ 07086-7060
U S BANCORP INVESTMENTS INC 9.41%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
PERSHING LLC 9.40%
PO BOX 2052
JERSEY CITY NJ 07303-2052
U S BANCORP INVESTMENTS INC 8.68%
60 LIVINGSTON AVE
ST PAUL MN 55107-2292
76
PERCENTAGE OF OUTSTANDING SHARES
-----------------------------------------------
CLASS A CLASS B CLASS C CLASS Y CLASS R
------- ------- ------- ------- -------
U S BANCORP INVESTMENTS INC 6.33%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
BAND & CO 65.13%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
CAPINCO 16.16%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 13.43%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
PIMS/PRUDENTIAL RETIREMENT 99.90%
AS NOMINEE FOR THE TTEE/CUST PL 007
PBC MANAGEMENT, INC.
1148 BROADWAY
3RD FLOOR MAIN OFFICE
COLUMBUS GA 31901
INTERMEDIATE GOVERNMENT BOND
AMERITRADE INC 23.10%
PO BOX 2226
OMAHA NE 68103-2226
MERRILL LYNCH PIERCE FENNER & SMITH 10.23%
ATTN PHYSICAL TEAM
4800 DEER LAKE DR E
JACKSONVILLE FL 32246-6484
TRUSTLYNX & CO 7.49%
TRUSTLYNX
PO BOX 173736
DENVER CO 80217-3736
US BANK CUST 50.38%
US BANCORP CAP
U/A 01-01-1984
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2575
BAND & CO 20.19%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 14.58%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
CAPINCO 13.59%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
INTERMEDIATE TAX FREE
77
PERCENTAGE OF OUTSTANDING SHARES
-----------------------------------------------
CLASS A CLASS B CLASS C CLASS Y CLASS R
------- ------- ------- ------- -------
UNIFIED TRUST COMPANY NA 7.02%
OMNIBUS TRUST
2353 ALEXANDRIA DR STE 100
LEXINGTON KY 40504-3208
ROBERT W BAIRD & CO. INC. 6.06%
777 EAST WISCONSIN AVENUE
MILWAUKEE WI 53202-5300
BAND & CO 63.19%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 27.54%
PO BOX 1787
MILWAUKEE WI 53201-1787
CAPINCO 8.77%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
INTERMEDIATE TERM BOND
ORCHARD TRUST CO LLC TRUSTEE/C 12.72%
FBO RETIREMENT PLANS
8515 E ORCHARD RD 2T2
GREENWOOD VLG CO 80111-5002
BAND & CO 55.25%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
CAPINCO 22.13%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 15.21%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
MINNESOTA INTERMEDIATE TAX FREE
PERSHING LLC 8.72%
PO BOX 2052
JERSEY CITY NJ 07303-2052
US BANCORP INVESTMENTS INC 7.93%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
PERSHING LLC 5.55%
PO BOX 2052
JERSEY CITY NJ 07303-2052
78
PERCENTAGE OF OUTSTANDING SHARES
-----------------------------------------------
CLASS A CLASS B CLASS C CLASS Y CLASS R
------- ------- ------- ------- -------
ALFRED P GALE 5.48%
2350 HIGHLAND RD
MAPLE PLAIN MN 55359-9570
BAND & CO 92.40%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
MINNESOTA TAX FREE
MERRILL LYNCH PIERCE FENNER & SMITH 9.64%
ATTN PHYSICAL TEAM
4800 DEER LAKE DR E
JACKSONVILLE FL 32246-6484
BAND & CO 92.39%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
MISSOURI TAX FREE
PERSHING LLC 41.32%
PO BOX 2052
JERSEY CITY NJ 07303-2052
U S BANCORP INVESTMENTS INC 33.13%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
CO FBO 8.03%
MILDRED W ROBERTS
512 E 109TH TER
KANSAS CITY MO 64131-4003
U.S. BANCORP INVESTMENTS INC. 5.84%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
UBS FINANCIAL SERVICES INC. FBO 5.25%
JOSEPH M MALTERS
KATHRYN KIRK-MALTERS TRUST
10685 LARSON LN
ROLLA MO 65401-8108
BAND & CO 88.89%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 8.56%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
NEBRASKA TAX FREE
RICHARD H WARMAN 18.96%
TOD
4641 N 56TH ST
LINCOLN NE 68504-1716
79
PERCENTAGE OF OUTSTANDING SHARES
-----------------------------------------------
CLASS A CLASS B CLASS C CLASS Y CLASS R
------- ------- ------- ------- -------
RBC CAPITAL MARKETS CORP FBO 16.50%
J JOHN GRAINGER
2929 VAN DORN ST
LINCOLN NE 68502-4261
A G EDWARDS & SONS INC 14.83%
W J & S A MOHANNA TTEES
W J M TR UAD 5/23/05
1 N JEFFERSON AVE
SAINT LOUIS MO 63103-2287
US BANCORP INVESTMENTS INC 11.83%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
MERRILL LYNCH PIERCE FENNER & SMITH 9.69%
ATTN PHYSICAL TEAM
4800 DEER LAKE DR E
JACKSONVILLE FL 32246-6484
WELLS FARGO INVESTMENTS LLC 6.38%
625 MARQUETTE AVE S 13TH FLOOR
MINNEAPOLIS MN 55402-2323
BAND & CO 77.02%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 14.19%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
CAPINCO 6.11%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
OHIO TAX FREE
U.S. BANCORP INVESTMENTS INC. 32.32%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
U.S. BANCORP INVESTMENTS INC. 14.70%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
MERRILL LYNCH PIERCE FENNER & SMITH 10.36%
ATTN PHYSICAL TEAM
4800 DEER LAKE DR E
JACKSONVILLE FL 32246-6484
U S BANCORP INVESTMENTS INC 9.69%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
U.S. BANCORP INVESTMENTS INC. 8.36%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
U.S. BANCORP INVESTMENTS INC. 37.29%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
80
PERCENTAGE OF OUTSTANDING SHARES
-----------------------------------------------
CLASS A CLASS B CLASS C CLASS Y CLASS R
------- ------- ------- ------- -------
ROBERT W BAIRD & CO INC 22.90%
777 EAST WISCONSIN AVENUE
MILWAUKEE WI 53202-5300
RAYMOND JAMES & ASSOC INC 17.94%
FBO EDWIN H TASSET &
MARILYN J TASSET TTEE
TASSET & MARILYN J TASSET TRUST
5970 WILMER RD
CINCINNATI OH 45247-5930
PERSHING LLC 16.10%
PO BOX 2052
JERSEY CITY NJ 07303-2052
BAND & CO 83.08%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
CAPINCO 14.20%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
OREGON INTERMEDIATE TAX FREE
PIPER JAFFRAY 10.92%
800 NICOLLET MALL 8TH STREET
MINNEAPOLIS MN 55402
U.S. BANCORP INVESTMENTS INC. 7.13%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
BAND & CO 51.06%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 47.23%
PO BOX 1787
MILWAUKEE WI 53201-1787
SHORT TAX FREE
U.S. BANCORP INVESTMENTS INC. 24.68%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
U.S. BANCORP INVESTMENTS INC. 14.99%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
MERRILL LYNCH PIERCE FENNER & SMITH 11.34%
ATTN PHYSICAL TEAM
4800 DEER LAKE DR E
JACKSONVILLE FL 32246-6484
U S BANCORP INVESTMENTS INC 5.90%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
U.S. BANCORP INVESTMENTS INC. 5.20%
60 LIVINGSTON AVE
SAINT PAUL MN 55107-2292
81
PERCENTAGE OF OUTSTANDING SHARES
-----------------------------------------------
CLASS A CLASS B CLASS C CLASS Y CLASS R
------- ------- ------- ------- -------
BAND & CO 61.63%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 32.90%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
SHORT TERM BOND
BAND & CO 48.89%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
CAPINCO 23.67%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 19.31%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
TAX FREE
A G EDWARDS & SONS INC 5.15%
ROBIN MELVA ANDERSON
1 N JEFFERSON AVE
SAINT LOUIS MO 63103-2287
MERRILL LYNCH PIERCE FENNER & SMITH 28.20%
ATTN PHYSICAL TEAM
4800 DEER LAKE DR E
JACKSONVILLE FL 32246-6484
NFS LLC FEBO 6.40%
IONE R DILLEY TTEE
KENNETH P DILLEY REVOC TRUST
U/A 4/8/97
2092 NW 134TH ST
CLIVE IA 50325-7507
RAYMOND JAMES & ASSOC INC 5.21%
FBO MARY S WHALEY
POLLY P CARTER &
WILLIAM H STEVENS JR TTEE
1730 SAINT JAMES CIR
THE VILLAGES FL 32162-7651
FIRST CLEARING, LLC 5.08%
ETHEL PEDERSON TRUST
ETHEL PEDERSON TTEE
1632 168TH PL NE
BELLEVUE WA 98008-2910
BAND & CO 83.68%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 12.01%
PO BOX 1787
MILWAUKEE WI 53201-1787
82
PERCENTAGE OF OUTSTANDING SHARES
-----------------------------------------------
CLASS A CLASS B CLASS C CLASS Y CLASS R
------- ------- ------- ------- -------
TOTAL RETURN BOND
MERRILL LYNCH PIERCE FENNER & SMITH 14.09%
ATTN PHYSICAL TEAM
4800 DEER LAKE DR E
JACKSONVILLE FL 32246-6484
CHARLES SCHWAB & CO INC 5.36%
SPECIAL CUSTODY ACCT FBO
CUSTOMERS
ATTN MUTUAL FUNDS
101 MONTGOMERY ST
SAN FRANCISCO CA 94104-4151
BAND & CO 62.86%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
CAPINCO 27.31%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 8.73%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
MG TRUST CO CUST FBO 57.46%
OMAHA NEON SIGN INC
700 17TH ST STE 300
DENVER CO 80202-3531
MG TRUST CO CUST FBO 12.16%
WATERMAN EXECUTIVE SEARCH 401K
700 17TH ST STE 300
DENVER CO 80202-3531
MG TRUST 7.81%
MARACOM CORP 401K
700 17TH ST STE 300
DENVER CO 80202-3531
U.S. GOVERNMENT MORTGAGE
ORCHARD TRUST CO LLC TRUSTEE/C 5.53%
FBO RETIREMENT PLANS
8515 E ORCHARD RD 2T2
GREENWOOD VLG CO 80111-5002
BAND & CO 66.65%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
CAPINCO 16.19%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
WASHINGTON & CO 12.65%
C/O US BANK
PO BOX 1787
MILWAUKEE WI 53201-1787
83
PERCENTAGE OF OUTSTANDING SHARES
-----------------------------------------------
CLASS A CLASS B CLASS C CLASS Y CLASS R
------- ------- ------- ------- -------
COUNSEL TRUST DBA MATC FBO 8.26%
OMNI METAL FINISHING INC 401K PSP & TRUST
1251 WATERFRONT PL STE 525
PITTSBURGH PA 15222-4228
MG TRUST CO CUST FBO 7.82%
LEBLANC & ASSOCIATES 401K RETIRE
700 17TH ST STE 300
DENVER CO 80202-3531
ROBERT K LUCAS FBO 7.55%
LUCAS GENERAL CONTRACTING CORP
401 K PROFIT SHARING PLAN & TRUST
1111 QUAIL ST
NEWPORT BEACH CA 92660-2705
COUNSEL TRUST DBA MATC FBO 7.19%
GENEA ENERGY PARTNERS INC 401K PSP & TRUST
1251 WATERFRONT PL STE 525
PITTSBURGH PA 15222-4228
STEVE BARNES FBO 6.03%
BARNES FIRM 401K PSP & TRUST
17 COURT STREET SUITE 700
BUFFALO NY 14202-3204
COUNSEL TRUST DBA MATC FBO 5.77%
CHILD CARE CONNECTION INC 401K PSP & TRUST
1251 WATERFRONT PL STE 525
PITTSBURGH PA 15222-4228
JOSEPH ZENGER FBO 5.48%
ZENGER GROUP INC 401K PSP & TRUST
525 HERTEL AVE
BUFFALO NY 14207-2305
COUNSEL TRUST DBA MATC FBO 5.43%
PRINCIPAL TECHNICAL SERVICES I
401 K PROFIT SHARING PLAN & TRUST
1251 WATERFRONT PL STE 525
PITTSBURGH PA 15222-4228
NET ASSET VALUE AND PUBLIC OFFERING PRICE
The public offering price of the shares of a Fund generally equals the
Fund's net asset value plus any applicable sales charge. A summary of any
applicable sales charge assessed on Fund share purchases is set forth in the
Funds' Prospectuses. The public offering price of the Class A Shares of the Bond
Funds and Tax Free Funds as of June 30, 2008 was as set forth below. Please note
that the public offering prices of Class B, Class C, Class R and Class Y Shares
are the same as net asset value since no sales charges are imposed on the
purchase of such shares.
84
PUBLIC OFFERING PRICE
FUND CLASS A
- ---- ---------------------
Core Bond Fund $11.34
High Income Bond Fund 9.03
Inflation Protected Securities Fund 10.65
Intermediate Government Bond Fund 8.61
Intermediate Term Bond Fund 10.13
Short Term Bond Fund 10.12
Total Return Bond Fund 10.34
U.S. Government Mortgage Fund 10.59
Arizona Tax Free Fund 10.89
California Intermediate Tax Free Fund 10.22
California Tax Free Fund 11.19
Colorado Intermediate Tax Free Fund 10.42
Colorado Tax Free Fund 10.74
Intermediate Tax Free Fund 10.75
Minnesota Intermediate Tax Free Fund 9.97
Minnesota Tax Free Fund 10.95
Missouri Tax Free Fund 11.91
Nebraska Tax Free Fund 10.51
Ohio Tax Free Fund 10.46
Oregon Intermediate Tax Free Fund 9.90
Short Tax Free Fund 10.02
Tax Free Fund 10.72
The net asset value of each Fund's shares is determined on each day
during which the New York Stock Exchange (the "NYSE") is open for business. The
NYSE is not open for business on the following holidays (or on the nearest
Monday or Friday if the holiday falls on a weekend): New Year's Day, Martin
Luther King, Jr. Day, Washington's Birthday (observed), Good Friday, Memorial
Day (observed), Independence Day, Labor Day, Thanksgiving Day and Christmas Day.
Each year the NYSE may designate different dates for the observance of these
holidays as well as designate other holidays for closing in the future. To the
extent that the securities held by a Fund are traded on days that the Fund is
not open for business, such Fund's net asset value per share may be affected on
days when investors may not purchase or redeem shares. This may occur, for
example, where a Fund holds securities which are traded in foreign markets.
On June 30, 2008, the net asset values per share for each class of
shares of the Bond Funds and the Tax Free Funds were calculated as follows.
SHARES NET ASSET
NET ASSETS OUTSTANDING VALUE PER SHARE
-------------- ----------- ---------------
CORE BOND FUND
Class A $ 94,571,118 8,707,147 $10.86
Class B 7,732,967 717,798 10.77
Class C 4,383,158 404,833 10.83
Class R 288,530 26,505 10.89
Class Y 1,468,598,935 135,256,706 10.86
HIGH INCOME BOND FUND
Class A 24,419,926 2,823,009 8.65
Class B 3,496,024 406,147 8.61
Class C 6,490,049 753,295 8.62
Class R 184,267 20,974 8.79
Class Y 204,163,961 23,588,159 8.66
INFLATION PROTECTED SECURITIES FUND
Class A 3,293,871 322,773 10.20
Class C 365,159 35,866 10.18
Class R 1,175,028 115,157 10.20
Class Y 278,748,935 27,318,001 10.20
INTERMEDIATE GOVERNMENT BOND FUND
Class A 6,504,487 772,767 8.42
Class Y 63,783,675 7,578,802 8.42
INTERMEDIATE TERM BOND FUND
Class A 28,363,640 2,864,006 9.90
Class Y 766,932,470 77,718,878 9.87
85
SHARES NET ASSET
NET ASSETS OUTSTANDING VALUE PER SHARE
-------------- ----------- ---------------
SHORT TERM BOND FUND
Class A 59,932,784 6,060,579 9.89
Class Y 257,403,037 26,018,027 9.89
TOTAL RETURN BOND FUND
Class A 15,566,745 1,572,666 9.90
Class B 2,383,872 241,746 9.86
Class C 3,672,999 373,234 9.84
Class R 293,544 29,503 9.95
Class Y 1,069,211,317 108,060,194 9.89
U.S. GOVERNMENT MORTGAGE FUND
Class A 11,295,032 1,114,187 10.14
Class B 3,736,521 367,916 10.16
Class C 2,258,500 223,700 10.10
Class R 1,585,280 156,626 10.12
Class Y 123,436,338 12,174,419 10.14
ARIZONA TAX FREE FUND
Class A 6,704,362 642,881 10.43
Class C 1,376,101 132,127 10.41
Class Y 17,522,323 1,679,268 10.43
CALIFORNIA INTERMEDIATE TAX FREE FUND
Class A 4,462,902 446,537 9.99
Class Y 52,924,481 5,284,041 10.02
CALIFORNIA TAX FREE FUND
Class A 12,076,031 1,127,884 10.71
Class C 2,479,775 231,330 10.72
Class Y 30,484,856 2,846,466 10.71
COLORADO INTERMEDIATE TAX FREE FUND
Class A 6,199,206 608,610 10.19
Class Y 43,932,874 4,324,553 10.16
COLORADO TAX FREE FUND
Class A 5,815,248 565,878 10.28
Class C 2,858,935 278,780 10.26
Class Y 15,888,597 1,543,355 10.29
INTERMEDIATE TAX FREE FUND
Class A 27,553,614 2,622,261 10.51
Class Y 630,820,068 60,157,623 10.49
MINNESOTA INTERMEDIATE TAX FREE FUND
Class A 22,058,693 2,263,171 9.75
Class Y 175,681,170 18,124,448 9.69
MINNESOTA TAX FREE FUND
Class A 102,089,002 9,740,731 10.48
Class C 20,061,472 1,922,273 10.44
Class Y 44,992,808 4,298,531 10.47
MISSOURI TAX FREE FUND
Class A 23,135,281 2,029,897 11.40
Class C 406,210 35,743 11.36
Class Y 137,745,894 12,080,177 11.40
NEBRASKA TAX FREE FUND
Class A 5,688,612 565,246 10.06
Class C 1,798,440 180,034 9.99
Class Y 29,533,416 2,935,510 10.06
OHIO TAX FREE FUND
Class A 634,894 63,372 10.02
Class C 254,598 25,750 9.89
Class Y 48,510,541 4,844,686 10.01
86
SHARES NET ASSET
NET ASSETS OUTSTANDING VALUE PER SHARE
-------------- ----------- ---------------
OREGON INTERMEDIATE TAX FREE FUND
Class A 5,966,445 616,555 9.68
Class Y 120,800,315 12,477,536 9.68
SHORT TAX FREE FUND
Class A 2,308,581 235,908 9.79
Class Y 143,984,908 14,712,819 9.79
TAX FREE FUND
Class A 35,556,382 3,466,705 10.26
Class C 3,104,279 304,135 10.21
Class Y 448,774,363 43,707,538 10.27
TAXATION
Each Fund intends to fulfill the requirements of Subchapter M of the
Internal Revenue Code of 1986, as amended (the "Code"), to qualify as a
regulated investment company. If so qualified, each Fund will not be liable for
federal income taxes to the extent it distributes its taxable income to its
shareholders.
With respect to a Fund's investments in U.S. Treasury
inflation-protected securities and other inflation-protected securities that
accrue inflation into their principal value, the Fund will be required to treat
as original issue discount any increase in the principal amount of the
securities that occurs during the course of its taxable year. If the Fund
purchases such inflation-protected securities that are issued in stripped form
either as stripped bonds or coupons, it will be treated as if it had purchased a
newly issued debt instrument having original issue discount. Generally, the
original issue discount equals the difference between the "stated redemption
price at maturity" of the obligation and its "issue price" as those terms are
defined in the Code. The Fund will be required to accrue as ordinary income a
portion of such original issue discount even though it receives no cash
currently as interest payment corresponding to the amount of the original issue
discount. Because the Fund is required to distribute substantially all of its
net investment income (including accrued original issue discount) in order to be
taxed as a regulated investment company, it may be required to distribute an
amount greater than the total cash income it actually receives. Accordingly, in
order to make the required distributions, the Fund may be required to borrow or
liquidate securities.
If one of the Tax Free Funds disposes of a municipal obligation that
it acquired after April 30, 1993 at a market discount, it must recognize any
gain it realizes on the disposition as ordinary income (and not as capital gain)
to the extent of the accrued market discount.
Some of the investment practices that may be employed by the Funds
will be subject to special provisions that, among other things, may defer the
use of certain losses of such Funds, affect the holding period of the securities
held by the Funds and, particularly in the case of transactions in or with
respect to foreign currencies, affect the character of the gains or losses
realized. These provisions may also require the Funds to mark-to-market some of
the positions in their respective portfolios (i.e., treat them as closed out) or
to accrue original discount, both of which may cause such Funds to recognize
income without receiving cash with which to make distributions in amounts
necessary to satisfy the distribution requirements for qualification as a
regulated investment company and for avoiding income and excise taxes.
Accordingly, in order to make the required distributions, a Fund may be required
to borrow or liquidate securities. Each Fund will monitor its transactions and
may make certain elections in order to mitigate the effect of these rules and
prevent disqualification of the Funds as regulated investment companies.
When a Fund lends portfolio securities to a borrower as described
above in "Lending of Portfolio Securities," payments in lieu of dividends made
by the borrower to the Fund will not constitute "qualified dividends" taxable at
the same rate as long-term capital gains, even if the actual dividends would
have constituted qualified dividends had the Fund held the securities. Such
payments in lieu of dividends are taxable as ordinary income.
It is expected that any net gain realized from the closing out of
futures contracts, options, or forward currency contracts will be considered
gain from the sale of securities or currencies and therefore qualifying income
for purposes of the requirement that a regulated investment company derive at
least 90% of gross income from investment securities.
87
Any loss on the sale or exchange of shares of a Fund generally will be
disallowed to the extent that a shareholder acquires or contracts to acquire
shares of the same Fund within 30 days before or after such sale or exchange.
Furthermore, if Fund shares with respect to which a long-term capital gain
distribution has been made are held for less than six months, any loss on the
sale of exchange of such shares will be treated as a long-term capital loss to
the extent of such long-term capital gain distribution. Furthermore, if a
shareholder of any of the Tax Free Funds receives an exempt-interest dividend
from such fund and then disposes of his or her shares in such fund within six
months after acquiring them, any loss on the sale or exchange of such shares
will be disallowed to the extent of the exempt-interest dividend.
For federal tax purposes, if a shareholder exchanges shares of a Fund
for shares of any other FAIF Fund pursuant to the exchange privilege (see
"Purchasing, Redeeming, and Exchanging Shares" in the Prospectuses), such
exchange will be considered a taxable sale of the shares being exchanged.
Furthermore, if a shareholder of Class A, Class B or Class C Shares carries out
the exchange within 90 days of purchasing shares in a fund on which he or she
has incurred a sales charge, the sales charge cannot be taken into account in
determining the shareholder's gain or loss on the sale of those shares to the
extent that the sales charge that would have been applicable to the purchase of
the later-acquired shares in the other Fund is reduced because of the exchange
privilege. However, the amount of any sales charge that may not be taken into
account in determining the shareholder's gain or loss on the sale of the
first-acquired shares may be taken into account in determining gain or loss on
the eventual sale or exchange of the later-acquired shares.
Pursuant to the Code, distributions of net investment income by a Fund
to a shareholder who is a foreign shareholder (as defined below) will be subject
to U.S. withholding tax (at a rate of 30% or lower treaty rate). Withholding
will not apply if a dividend paid by a Fund to a foreign shareholder is
"effectively connected" with a U.S. trade or business of such shareholder, in
which case the reporting and withholding requirements applicable to U.S.
citizens or domestic corporations will apply. Distributions of net long-term
capital gains are not subject to tax withholding but, in the case of a foreign
shareholder who is a nonresident alien individual, such distributions ordinarily
will be subject to U.S. income tax at a rate of 30% if the individual is
physically present in the U.S. for more than 182 days during the taxable year.
Each Fund will report annually to its shareholders the amount of any
withholding.
A foreign shareholder is any person who is not (i) a citizen or
resident of the United States, (ii) a corporation, partnership or other entity
organized in the United States or under the laws of the Untied States or a
political subdivision thereof, (iii) an estate whose income is includible in
gross income for U.S. federal income tax purposes or (iv) a trust whose
administration is subject to the primary supervision of the U.S. court and which
has one or more U.S. fiduciaries who have authority to control all substantial
decisions of the trust.
The foregoing relates only to federal income taxation and is a general
summary of the federal tax law in effect as of the date of this Statement of
Additional Information.
With respect to the Minnesota Intermediate Tax Free Fund and the
Minnesota Tax Free Fund, the 1995 Minnesota Legislature enacted a statement of
intent (codified at Minn. Stat. Section 289A.50, subdivision 10) that interest
on obligations of Minnesota governmental units and Indian tribes be included in
the net income of individuals, estates and trusts for Minnesota income tax
purposes if a court determines that Minnesota's exemption of such interest
unlawfully discriminates against interstate commerce because interest on
obligations of governmental issuers located in other states is so included. This
provision applies to taxable years that begin during or after the calendar year
in which any such court decision becomes final, irrespective of the date on
which the obligations were issued.
On May 19, 2008, the U.S. Supreme Court decided the case of Department
of Revenue of Kentucky v. Davis, in which a taxpayer had challenged Kentucky's
scheme of taxation under which it exempted from taxation interest on the bonds
of the Commonwealth of Kentucky and its political subdivisions while subjecting
to tax interest on bonds of other states and their political subdivisions. The
Supreme Court held that Kentucky's taxing scheme did not violate the Commerce
Clause. The Court, however, dealt with bonds of the state and its political
subdivisions that financed governmental projects, and noted that the case did
not present the question of the treatment of private activity bonds that are
used to finance projects for private entities. (The Court's opinion also did not
address the issue of discriminatory treatment of Indian tribal bonds.) The
Court's opinion left open the possibility that another party could challenge a
state's discriminatory treatment of the interest on private activity bonds on
the ground that it violates the Commerce Clause. The management of the Funds is
not aware that any such case has been brought. Nevertheless, a court in the
future could hold that a state's discriminatory treatment of private activity
bonds of issuers located within or outside the state violates the Commerce
Clause, and in that case the 1995 Minnesota legislative provision could take
effect and
88
interest on certain Minnesota obligations held by the Minnesota Intermediate Tax
Free Fund and Minnesota Tax Free Fund would become taxable in Minnesota.
ADDITIONAL INFORMATION ABOUT CERTAIN SHAREHOLDER SERVICES
REDUCING CLASS A SALES CHARGES
Sales charges on the purchase of Class A shares can be reduced through
(i) quantity discounts and accumulated purchases, or (ii) signing a 13-month
letter of intent.
QUANTITY DISCOUNTS AND ACCUMULATED PURCHASES: Each Fund will combine
purchases made by an investor, the investor's spouse or domestic partner, and
the investor's dependent children when it calculates the sales charge.
For each Fund, the sales charge discount will be determined by adding
(i) the purchase price (including sales charge) of the Fund shares that are
being purchased, plus (ii) the purchase price of the Class A, Class B and Class
C shares of any other First American fund (other than a money market fund) that
you are concurrently purchasing, plus (iii) the current net asset value of Class
A, Class B and Class C shares of the Fund or any other First American fund
(other than a money market fund) that you already own. In order for an investor
to receive the sales charge reduction on Class A Shares, the Fund must be
notified by the investor in writing or by his or her financial intermediary at
the time the purchase is made that Fund shares are already owned or that
purchases are being combined. If the purchase price of shares that the investor
owns is higher than their current net asset value, the investor may receive
credit for this higher purchase price instead, but only if the investor notifies
the Fund of this request in advance in writing and provides written records of
the original purchase price.
LETTER OF INTENT: If an investor intends to purchase, in the
aggregate, at least $50,000 of Class A or Class C shares in the Funds or other
First American funds (other than money market funds) over the next 13 months,
the sales charge may be reduced by signing a letter of intent to that effect.
This letter of intent includes a provision for a sales charge adjustment
depending on the amount actually purchased within the 13-month period and a
provision for the Funds' custodian to hold a percentage equal to the maximum
sales charge rate of the total amount intended to be purchased in escrow (in
shares) until the purchase is completed.
The amount held in escrow will be applied to the investor's account at
the end of the 13-month period after deduction of the sales load applicable to
the dollar value of shares actually purchased. In this event, an appropriate
number of escrowed shares may be redeemed in order to realize the difference in
the sales charge.
A letter of intent will not obligate the investor to purchase shares,
but if he or she does, each purchase during the period will be at the sales
charge applicable to the total amount intended to be purchased. Absent complete
and current notification from the investor or from his or financial intermediary
to the Fund, the investor may not realize the benefit of a reduced sales charge.
SALES OF CLASS A SHARES AT NET ASSET VALUE
General. The Class A, B and C share prospectuses for the Funds set
forth the categories of investors eligible to purchase Class A shares without a
sales charge.
Purchases of $1 Million or More. Class A shares may be purchased
without a sales charge by non-retirement accounts if the purchase, when
aggregated with certain Class A, B and C share purchases as described in the
Funds' Class A, B and C share prospectuses, totals $1 million or more. Your
investment professional or financial intermediary may receive a commission equal
to 1.00% on purchases of $1 million to $3 million, 0.50% on purchases in excess
of $3 million up to $10 million, and 0.25% on purchases in excess of $10
million. Note that your investment professional or financial intermediary will
only receive a commission equal to the rate required by the actual investment
(without taking into account aggregation). For example, if your aggregated
investments, including your current investment, total $6 million, but your
current investment equals $2 million, your investment professional or financial
intermediary may receive a commission equal to 1.00% of $2 million. If such a
commission is paid, you will be assessed a contingent deferred sales charge
(CDSC) of 1% if you sell your shares within 18 months.
Class A Shares may also be purchased without a sales charge by 401(k),
403(b) and 457 plans, and profit sharing and pension plans, which invest $1
million or more. Your representative must notify the Fund if your
89
retirement/deferred compensation plan is eligible for the sales load waiver.
Securities firms, financial institutions and other industry professionals that
enter into sales agreements with the Funds' distributor to perform share
distribution services may receive a commission on such sales of the Funds equal
to 0.25% on purchases in excess of $10 million. If such a commission is paid,
the plan will be assessed a contingent deferred sales charge (CDSC) of 0.25% if
it sells the shares within 18 months. A commission is paid only on Class A
shares of First American Funds.
CLASS A SHARES REINVESTMENT RIGHT
If Class A Shares of a Fund have been redeemed, the shareholder has a
one-time right, within 180 days, to reinvest the redemption proceeds in Class A
Shares of any First American fund at the next-determined net asset value without
any sales charge. The Fund must be notified by the shareholder in writing or by
his or her financial intermediary of the reinvestment in order to eliminate a
sales charge. If the shareholder redeems his or her shares of a Fund, there may
be tax consequences.
REDEEMING SHARES BY TELEPHONE
A shareholder may redeem shares of a Fund, if he or she elects the
privilege on the initial shareholder application, by calling his or her
financial intermediary to request the redemption. Shares will be redeemed at the
net asset value next determined after the Fund receives the redemption request
from the financial intermediary (less the amount of any applicable contingent
deferred sales charge). Redemption requests must be received by the financial
intermediary by the time specified by the intermediary in order for shares to be
redeemed at that day's net asset value, and redemption requests must be
transmitted to and received by the Funds as of the close of regular trading on
the New York Stock Exchange (usually by 3:00 p.m. Central time) in order for
shares to be redeemed at that day's net asset value unless the financial
intermediary has been authorized to accept redemption requests on behalf of the
Funds. Pursuant to instructions received from the financial institution,
redemptions will be made by check or by wire transfer. It is the financial
institution's responsibility to transmit redemption requests promptly. Certain
financial intermediaries are authorized to act as the Funds' agent for the
purpose of accepting redemption requests, and the Funds will be deemed to have
received a redemption request upon receipt of the request by the financial
intermediary.
Shareholders who did not purchase their shares of a Fund through a
financial intermediary may redeem their shares by telephoning Investor Services
at 800 677-FUND. At the shareholder's request, redemption proceeds will be paid
by check mailed to the shareholder's address of record or wire transferred to
the shareholder's account at a domestic commercial bank that is a member of the
Federal Reserve System, normally within one business day, but in no event more
than seven days after the request. Wire instructions must be previously
established on the account or provided in writing. The minimum amount for a wire
transfer is $1,000. If at any time the Funds determine it necessary to terminate
or modify this method of redemption, shareholders will be promptly notified. The
Funds may limit telephone redemption requests to an aggregate of $50,000 per day
across the First American Fund family.
In the event of drastic economic or market changes, a shareholder may
experience difficulty in redeeming shares by telephone. If this should occur,
another method of redemption should be considered. Neither the Administrator nor
any Fund will be responsible for any loss, liability, cost or expense for acting
upon wire transfer instructions or telephone instructions that they reasonably
believe to be genuine. The Administrator and the Funds will each employ
reasonable procedures to confirm that instructions communicated are genuine.
These procedures may include taping of telephone conversations. To ensure
authenticity of redemption or exchange instructions received by telephone, the
Administrator examines each shareholder request by verifying the account number
and/or tax identification number at the time such request is made. The
Administrator subsequently sends confirmation of both exchange sales and
exchange purchases to the shareholder for verification. If reasonable procedures
are not employed, the Administrator and the Funds may be liable for any losses
due to unauthorized or fraudulent telephone transactions.
REDEEMING SHARES BY MAIL
Any shareholder may redeem Fund shares by sending a written request to
the Administrator, shareholder servicing agent, financial intermediary or USBFS.
The written request should include the shareholder's name, the Fund name, the
account number, and the share or dollar amount requested to be redeemed, and
should be signed exactly as the shares are registered. Shareholders should call
the Fund, shareholder servicing agent or financial intermediary for assistance
in redeeming by mail. Unless another form of payment is requested, a check for
redemption proceeds normally is mailed within three days, but in no event more
than seven days, after receipt of a proper written redemption request.
90
Shareholders requesting a redemption of $50,000 or more, a redemption
of any amount to be sent to an address other than that on record with the Fund,
or a redemption payable other than to the shareholder of record, must have
signatures on written redemption requests guaranteed by:
- a trust company or commercial bank the deposits of which are
insured by the Bank Insurance Fund, which is administered by the
Federal Deposit Insurance Corporation ("FDIC");
- a member firm of the New York, American, Boston, Midwest, or
Pacific Stock Exchanges or of the National Association of
Securities Dealers;
- a savings bank or savings and loan association the deposits of
which are insured by the Savings Association;
- any other "eligible guarantor institution," as defined in the
Securities Exchange Act of 1934.
The Funds do not accept signatures guaranteed by a notary public.
The Funds, the Administrator and USBFS have adopted standards for
accepting signature from the above institutions. The Funds may elect in the
future to limit eligible signature guarantees to institutions that are members
of a signature guarantee program. The Funds, the Administrator and USBFS reserve
the right to amend these standards at any time without notice.
RECEIPT OF ORDERS BY FINANCIAL INTERMEDIARIES
The Funds have authorized one or more Intermediaries to receive
purchase and redemption orders on the Funds' behalf. Intermediaries are
authorized to designate other intermediaries to receive purchase and redemption
orders on the Funds' behalf. A Fund will be deemed to have received a purchase
or redemption order when an authorized Intermediary or, if applicable, an
Intermediary's authorized designee, receives the order. An order will be priced
at the applicable Fund's net asset value next computed after the order is
received by an authorized Intermediary or the Intermediary's authorized designee
and accepted by the Fund.
REDEMPTIONS BEFORE PURCHASE INSTRUMENTS CLEAR
When shares are purchased by check or with funds transmitted through
the Automated Clearing House, the proceeds of redemptions of those shares are
not available until the Administrator or USBFS is reasonably certain that the
purchase payment has cleared, which could take up to fifteen calendar days from
the purchase date.
RESEARCH REQUESTS
The Funds reserve the right, upon notice, to charge you a fee to cover
the costs of special requests for information that require extensive research or
employee resources. Such requests could include a request for historical account
transcripts or the retrieval of a significant number of documents.
FINANCIAL STATEMENTS
The financial statements of FAIF included in its Annual Report to
shareholders for the fiscal year ended June 30, 2008 are incorporated herein by
reference.
91
APPENDIX A
RATINGS
A rating of a rating service represents that service's opinion as to
the credit quality of the rated security. However, such ratings are general and
cannot be considered absolute standards of quality or guarantees as to the
creditworthiness of an issuer. A rating is not a recommendation to purchase,
sell or hold a security, because it does not take into account market value or
suitability for a particular investor. Market values of debt securities may
change as a result of a variety of factors unrelated to credit quality,
including changes in market interest rates.
When a security has been rated by more than one service, the ratings
may not coincide, and each rating should be evaluated independently. Ratings are
based on current information furnished by the issuer or obtained by the rating
services from other sources which they consider reliable. Ratings may be
changed, suspended or withdrawn as a result of changes in or unavailability of
such information, or for other reasons. In general, the Funds are not required
to dispose of a security if its rating declines after it is purchased, although
they may consider doing so.
RATINGS OF LONG-TERM CORPORATE DEBT OBLIGATIONS AND MUNICIPAL BONDS
STANDARD & POOR'S
AAA: An obligation rated AAA has the highest rating assigned by
Standard & Poor's. The obligor's capacity to meet its financial
commitment on the obligation is extremely strong.
AA: An obligation rated AA differs from the highest rated obligations
only in small degree. The obligor's capacity to meet its financial
commitment on the obligation is very strong.
A: An obligation rated A is somewhat more susceptible to the adverse
effects of changes in circumstances and economic conditions than bonds
in higher rated categories. However, the obligor's capacity to meet
its financial commitment on the obligation is still strong.
BBB: An obligation rated BBB exhibits adequate protection parameters.
However, adverse economic conditions or changing circumstances are
more likely to lead to a weakened capacity of the obligor to meet its
financial commitment on the obligation.
Obligations rated BB, B, CCC, CC, and C are regarded as having
significant speculative characteristics. BB indicates the least degree of
speculation and C the highest. While such obligations will likely have some
quality and protective characteristics, these may be outweighed by large
uncertainties or major exposures to adverse conditions.
BB: An obligation rated BB is less vulnerable to nonpayment than other
speculative issues. However, it faces major ongoing uncertainties or
exposure to adverse business, financial or economic conditions which
could lead to the obligor's inadequate capacity to meet its financial
commitment on the obligation.
B: An obligation rated B is more vulnerable to nonpayment than
obligations rated BB, but the obligor currently has the capacity to
meet its financial commitment on the obligation. Adverse business,
financial, or economic conditions will likely impair the obligor's
capacity or willingness to meet its financial commitment on the
obligation.
CCC: An obligation rated CCC is currently vulnerable to nonpayment,
and is dependent upon favorable business, financial, and economic
conditions for the obligor to meet its financial commitment on the
obligation. In the event of adverse business, financial, or economic
conditions, the obligor is not likely to have the capacity to meet its
financial commitment on the obligation.
CC: An obligation rated CC is currently highly vulnerable to
nonpayment.
1
C: A subordinated debt or preferred stock obligation rated C is
currently highly vulnerable to nonpayment. The C rating may be used to
cover a situation where a bankruptcy petition has been filed or
similar action taken, but payments on this obligation are being
continued. A C also will be assigned to a preferred stock issue in
arrears on dividends or sinking fund payments, but that is currently
paying.
D: An obligation rated D is in payment default. The D rating category
is used when payments on an obligation are not made on the date due
even if the applicable grace period has not expired, unless Standard &
Poor's believes that such payments will be made during such grace
period. The D rating also will be used upon the filing of a bankruptcy
petition or the taking of a similar action if payments on an
obligation are jeopardized.
The ratings from AA to CCC may be modified by the addition of a plus
(+) or minus (-) sign to show relative standing within the major rating
categories.
MOODY'S
AAA: Bonds and preferred stock that are rated Aaa are judged to be of
the best quality. They carry the smallest degree of investment risk
and are generally referred to as "gilt edge." Interest payments are
protected by a large or exceptionally stable margin and principal is
secure. While the various protective elements are likely to change,
such changes as can be visualized are most unlikely to impair the
fundamentally strong position of such issues.
AA: Bonds and preferred stock that are rated Aa are judged to be of
high quality by all standards. Together with the Aaa group, they
comprise what are generally known as high-grade bonds. They are rated
lower than the best bonds because margins of protection may not be as
large as in Aaa securities, or fluctuation of protective elements may
be of greater amplitude, or there may be other elements present which
make the long-term risks appear somewhat greater than in Aaa
securities.
A: Bonds and preferred stock that are rated A possess many favorable
investment attributes and are to be considered as upper-medium-grade
obligations. Factors giving security to principal and interest are
considered adequate, but elements may be present which suggest a
susceptibility to impairment some time in the future.
BAA: Bonds and preferred stock that are rated Baa are considered as
medium-grade obligations (i.e., they are neither highly protected nor
poorly secured). Interest payments and principal security appear
adequate for the present, but certain protective elements may be
lacking or may be characteristically unreliable over any great length
of time. Such securities lack outstanding investment characteristics,
and in fact have speculative characteristics as well.
BA: Bonds and preferred stock that are rated Ba are judged to have
speculative elements; their future cannot be considered as well
assured. Often the protection of interest and principal payments may
be very moderate, and thereby not well safeguarded during both good
and bad times over the future. Uncertainty of position characterizes
issues in this class.
B: Bonds and preferred stock that are rated B generally lack
characteristics of the desirable investment. Assurance of interest and
principal payments or of maintenance of other terms of the contract
over any long period of time may be small.
CAA: Bonds and preferred stock that are rated Caa are of poor
standing. Such issues may be in default or there may be present
elements of danger with respect to principal or interest.
CA: Bonds and preferred stock that are rated Ca represent obligations
that are speculative in a high degree. Such issues are often in
default or have other marked shortcomings.
C: Bonds and preferred stock that are rated C are the lowest rated
class of bonds, and issues so rated can be regarded as having
extremely poor prospects of ever attaining any real investment
standing.
2
Moody's applies numerical modifiers 1, 2, and 3 in each generic rating
classification from Aa through Caa. The modifier 1 indicates that the obligation
ranks in the higher end of its generic rating category; the modifier 2 indicates
a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of
that generic rating category.
FITCH
AAA: Securities considered to be investment grade and of the highest
credit quality. These ratings denote the lowest expectation of credit
risk and are assigned only in case of exceptionally strong capacity
for timely payment of financial commitments. This capacity is highly
unlikely to be adversely affected by foreseeable events.
AA: Securities considered to be investment grade and of very high
credit quality. These ratings denote a very low expectation of credit
risk and indicate very strong capacity for timely payment of financial
commitments. This capacity is not significantly vulnerable to
foreseeable events.
A: Securities considered to be investment grade and of high credit
quality. These ratings denote a low expectation of credit risk and
indicate strong capacity for timely payment of financial commitments.
This capacity may, nevertheless, be more vulnerable to changes in
circumstances or in economic conditions than is the case for higher
ratings.
BBB: Securities considered to be investment grade and of good credit
quality. These ratings denote that there is currently a low
expectation of credit risk. The capacity for timely payment of
financial commitments is considered adequate, but adverse changes in
circumstances and in economic conditions are more likely to impair
this capacity. This is the lowest investments grade category.
BB: Securities considered to be speculative. These ratings indicate
that there is a possibility of credit risk developing, particularly as
the result of adverse economic change over time; however, business or
financial alternatives may be available to allow financial commitments
to be met. Securities rated in this category are not investment grade.
B: Securities are considered highly speculative. These ratings
indicate that significant credit risk is present, but a limited margin
of safety remains. Financial commitments are currently being met;
however, capacity for continued payment is contingent upon a
sustained, favorable business and economic environment.
CCC, CC AND C: Securities have high default risk. Default is a real
possibility, and capacity for meeting financial commitments is solely
reliant upon sustained, favorable business or economic developments.
CC ratings indicate that default of some kind appears probable, and C
ratings signal imminent default.
DDD, DD AND D: Securities are in default. The ratings of obligations
in this category are based on their prospects for achieving partial or
full recovery in a reorganization or liquidation of the obligor. While
expected recovery values are highly speculative and cannot be
estimated with any precision, the following serve as general
guidelines. DDD obligations have the highest potential for recovery,
around 90%-100% of outstanding amounts and accrued interest. DD
indicates potential recoveries in the range of 50%-90%, and D the
lowest recovery potential, i.e., below 50%.
Entities rated in this category have defaulted on some or all of their
obligations. Entities rated DDD have the highest prospect for resumption of
performance or continued operation with or without a formal reorganization
process. Entities rated DD and D are generally undergoing a formal
reorganization or liquidation process; those rated DD are likely to satisfy a
higher portion of their outstanding obligations, while entities rated D have a
poor prospect for repaying all obligations.
The ratings from AA to CCC may be modified by the addition of a plus
(+) or minus (-) sign to show the relative standing within the major rating
categories.
3
RATINGS OF MUNICIPAL NOTES
STANDARD & POOR'S
SP-1: Strong capacity to pay principal and interest. An issue
determined to possess a very strong capacity to pay debt service is
given a plus (+) designation.
SP-2: Satisfactory capacity to pay principal and interest, with some
vulnerability to adverse financial and economic changes over the term
of the notes.
SP-3: Speculative capacity to pay principal and interest.
None of the Funds will purchase SP-3 municipal notes.
MOODY'S. Generally, Moody's ratings for state and municipal short-term
obligations are designated Moody's Investment Grade ("MIG"); however, where an
issue has a demand feature which makes the issue a variable rate demand
obligation, the applicable Moody's rating is "VMIG."
MIG 1/VMIG 1: This designation denotes the superior credit quality.
Excellent protection is afforded by established cash flows, highly
reliable liquidity support, or demonstrated broad-based access to the
market for refinancing.
MIG 2/VMIG 2: This designation denotes strong credit quality. Margins
of protection are ample although not as large as in the preceding
group.
MIG 3/VMIG 3: This designation denotes acceptable credit quality.
Liquidity and cash flow protection may be narrow and market access for
refinancing is likely to be less well established.
None of the Funds will purchase MIG 2/VMIG 3 municipal notes.
RATINGS OF COMMERCIAL PAPER
STANDARD & POOR'S
Commercial paper ratings are graded into four categories, ranging from
A for the highest quality obligations to D for the lowest. None of the Funds
will purchase commercial paper rated A-3 or lower.
A-1: A short-term obligation rated A-1 is rated in the highest
category by Standard & Poor's. The obligor's capacity to meet its financial
commitment on the obligation is strong. Within this category, certain
obligations are designated with a plus sign (+). This indicates that the
obligor's capacity to meet its financial commitment on these obligations is
extremely strong.
A-2: A short-term obligation rated A-2 is somewhat more susceptible to
the adverse effects of changes in circumstances and economic conditions than
obligations in higher rating categories. However, the obligor's capacity to meet
its financial commitment on the obligation is satisfactory.
A-3: A short-term obligation rated A-3 exhibits adequate protection
parameters. However, adverse economic conditions or changing circumstances are
more likely to lead to a weakened capacity of the obligor to meet its financial
commitment on the obligation.
MOODY'S
Moody's employs the following three designations, all judged to be
investment grade, to indicate the relative repayment capacity of rated issuers.
None of the Funds will purchase Prime-3 commercial paper.
4
PRIME-1: Issuers rated Prime-1 (or supporting institutions) have a
superior ability for repayment of senior short-term debt obligations. Prime-1
repayment ability will often be evidenced by many of the following
characteristics: o Leading market positions in well-established industries.
- High rates of return on funds employed.
- Conservative capitalization structure with moderate reliance on
debt and ample asset protection.
- Broad margins in earnings coverage of fixed financial charges and
high internal cash generation.
- Well-established access to a range of financial markets and
assured sources of alternate liquidity.
PRIME-2: Issuers rated Prime-2 (or supporting institutions) have a
strong ability for repayment of senior short-term debt obligations. This will
normally be evidenced by many of the characteristics cited above but to a lesser
degree. Earnings trends and coverage ratios, while sound, may be more subject to
variation. Capitalization characteristics, while still appropriate, may be more
affected by external conditions. Ample alternate liquidity is maintained.
PRIME-3: Issuers (or supporting institutions) rated Prime-3 have an
acceptable ability for repayment of senior short-term obligations. The effect of
industry characteristics and market compositions may be more pronounced.
Variability in earnings and profitability may result in changes in the level of
debt-protection measurements and may require relatively high financial leverage.
Adequate alternate liquidity is maintained.
FITCH
Fitch employs the following three designations, all judged to be
investment grade, to indicate the relative repayment capacity of rated issuers.
None of the Funds will purchase F3 commercial paper.
F1: Securities possess the highest credit quality. This designation
indicates the strongest capacity for timely payment of financial commitments and
may have an added "+" to denote any exceptionally strong credit feature.
F2: Securities possess good credit quality. This designation indicates
a satisfactory capacity for timely payment of financial commitments, but the
margin of safety is not as great as in the case of the higher ratings.
F3: Securities possess fair credit quality. This designation indicates
that the capacity for timely payments of financial commitments is adequate;
however, near-term adverse changes could result in a reduction to non-investment
grade.
5
APPENDIX B
FAF ADVISORS, INC.
PROXY VOTING POLICIES AND PROCEDURES
GENERAL PRINCIPLES
FAF Advisors, Inc. ("FAF Advisors") is the investment adviser for the First
American family of mutual funds (the "Funds") and for institutional and other
separately managed accounts (collectively, with the Funds, "Client Accounts").
As such, Client Accounts may confer upon FAF Advisors complete discretion to
vote proxies. It is FAF Advisors' duty to vote proxies in the best interests of
its clients. In voting proxies, FAF Advisors also seeks to maximize total
investment return for its clients.
In the event that FAF Advisors contracts with another investment adviser to act
as a sub-adviser for a Client Account, FAF Advisors may delegate proxy voting
responsibility to the sub-adviser. Where FAF has delegated proxy voting
responsibility, the sub-adviser will be responsible for developing and adhering
to its own proxy voting policies. FAF Advisors will approve a sub-adviser's
proxy voting policies, and will review these policies at least annually.
FAF Advisors' Investment Policy Committee ("IPC"), comprised of the firm's most
senior investment professionals, is charged with oversight of the proxy voting
policies and procedures. The IPC is responsible for (1) approving the proxy
voting policies and procedures, and (2) oversight of the activities of FAF
Advisors' Proxy Voting Administration Committee ("PVAC"). The PVAC is
responsible for providing an administrative framework to facilitate and monitor
FAF Advisors' exercise of its fiduciary duty to vote client proxies and fulfill
the obligations of reporting and recordkeeping under the federal securities
laws.
POLICIES
The IPC, after reviewing and concluding that such policies are reasonably
designed to vote proxies in the best interests of clients, has approved and
adopted the proxy voting policies of Institutional Shareholder Services, Inc.
("ISS"), a leading national provider of proxy voting administrative and research
services. As a result, such policies set forth FAF Advisors' positions on
recurring proxy issues and criteria for addressing non-recurring issues. These
policies are reviewed periodically by ISS, and therefore are subject to change.
Even though it has adopted ISS' policies, FAF Advisors maintains the fiduciary
responsibility for all proxy voting decisions.
PROCEDURES
A. Supervision of Proxy Voting Service
The PVAC shall supervise the relationship with FAF Advisors' proxy voting
service, ISS. ISS apprises FAF Advisors of shareholder meeting dates, provides
research on proxy proposals and voting recommendations, and casts the actual
proxy votes. ISS also serves as FAF Advisors' proxy voting record keeper and
generates reports on how proxies were voted.
B. Conflicts of Interest
As an affiliate of U.S. Bancorp, a large multi-service financial institution,
FAF Advisors recognizes that there are circumstances wherein it may have a
perceived or real conflict of interest in voting the proxies of issuers or proxy
proponents (e.g., a special interest group) who are clients or potential clients
of some part of the U.S. Bancorp enterprise. Directors and officers of such
companies may have personal or familial relationships with the U.S. Bancorp
enterprise and/or its employees that could give rise to potential conflicts of
interest.
FAF Advisors will vote proxies in the best interest of its clients regardless of
such real or perceived conflicts of interest. By adopting ISS' policies, FAF
Advisors believes the risk related to conflicts will be minimized.
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To further minimize this risk, the IPC will review ISS' conflict avoidance
policy at least annually to ensure that it adequately addresses both the actual
and perceived conflicts of interest the proxy voting service may face.
In the event that ISS faces a material conflict of interest with respect to a
specific vote, the PVAC shall direct ISS how to vote. The PVAC shall receive
voting direction from the Head of Equity Research, who will seek voting
direction from appropriate investment personnel. Before doing so, however, the
PVAC will confirm that FAF Advisors faces no material conflicts of its own with
respect to the specific proxy vote.
If the PVAC concludes that a material conflict does exist, it will recommend to
the IPC a course of action designed to address the conflict. Such actions could
include, but are not limited to:
1. Obtaining instructions from the affected client(s) on how to vote
the proxy;
2. Disclosing the conflict to the affected client(s) and seeking
their consent to permit FAF Advisors to vote the proxy;
3. Voting in proportion to the other shareholders;
4. Recusing an IPC member from all discussion or consideration of
the matter, if the material conflict is due to such person's
actual or potential conflict of interest; or
5. Following the recommendation of a different independent third
party.
In addition to all of the above, members of the IPC and the PVAC must notify FAF
Advisors' Chief Compliance Officer of any direct, indirect or perceived improper
influence exerted by any employee, officer or director within the U.S. Bancorp
enterprise or First American Fund complex with regard to how FAF Advisors should
vote proxies. The Chief Compliance Officer will investigate the allegations and
will report the findings to FAF Advisors' Chief Executive Officer and the
General Counsel. If it is determined that improper influence was attempted,
appropriate action shall be taken. Such appropriate action may include
disciplinary action, notification of the appropriate senior managers within the
U.S. Bancorp enterprise, or notification of the appropriate regulatory
authorities. In all cases, the IPC shall not consider any improper influence in
determining how to vote proxies, and will vote in the best interests of clients.
C. Proxy Vote Override
From time to time, a Portfolio Manager may initiate action to override the ISS
recommendation for a particular vote. Any such override shall be reviewed by FAF
Advisors' Legal Department for material conflicts. If the Legal Department
determines that no material conflicts exist, the approval of one investment
professional on the IPC or the Head of Equity Research shall authorize the
override. If a material conflict exists then the override will not be
effectuated.
D. Securities Lending
In order to generate incremental revenue, some clients may participate in U.S.
Bank's securities lending program. If a client has elected to participate in the
lending program then it will not have the right to vote the proxies of any
securities that are on loan as of the shareholder meeting record date. A client,
or a Portfolio Manager, may place restrictions on loaning securities and/or
recall a security on loan at any time. Such actions must be affected prior to
the record date for a meeting if the purpose for the restriction or recall is to
secure the vote.
Portfolio Managers and/or Analysts who become aware of upcoming proxy issues
relating to any securities in portfolios they manage, or issuers they follow,
will consider the desirability of recalling the affected securities that are on
loan or restricting the affected securities prior to the record date for the
matter. If the proxy issue is determined to be material, and the determination
is made prior to the shareholder meeting record date the Portfolio Manager(s)
will contact the Securities Lending Department to recall securities on loan or
restrict the loaning of any security held in any portfolio they manage, if they
determine that it is in the best interest of shareholders to do so. Training
regarding the process to recall securities on loan or restrict the loaning of
securities is given to all Portfolio Managers and Analysts.
E. Proxy Voting for ERISA Clients
In the event that a proxy voting issue arises for an ERISA client, FAF Advisors
is prohibited from voting shares with respect to any issue advanced by a party
in interest, such as U.S. Bancorp or any of the First American Funds.
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F. Proxy Voting Records
As required by Rule 204-2 of the Investment Company Act of 1940, FAF Advisors
shall make and retain five types of records relating to proxy voting; (1) proxy
voting policies and procedures; (2) proxy statements received for client and
fund securities; (3) records of votes cast on behalf of clients and funds; (4)
records of written requests for proxy voting information and written responses
from the advisor to either a written or oral request; and (5) any documents
prepared by the advisor that were material to making a proxy voting decision or
that memorialized the basis for the decision. FAF Advisors may rely on ISS to
make and retain on our behalf records pertaining to the rule.
Each sub-advisor shall be responsible for making and retaining all proxy voting
records required by the rule and shall provide them to FAF Advisors upon
request.
G. Fund of Funds Provision
In instances where FAF Advisors provides investment advice to a fund of funds
that acquires shares of affiliated funds or three percent or more of the
outstanding voting securities of an unaffiliated fund, the acquiring fund shall
seek instructions from its shareholders as to how to vote shares of those
acquired funds, or to vote the shares in the same proportion as the vote of all
other shareholders of the acquired fund. If compliance with this policy results
in a vote of any shares in a manner different than the ISS recommendation, such
vote will not require compliance with the Proxy Vote Override procedures set
forth above.
H. Review and Reports
The PVAC shall maintain a review schedule. The schedule shall include reviews
for the proxy voting policy, the proxy voting record, account maintenance, and
other reviews as deemed appropriate by the PVAC. The PVAC shall review the
schedule at least annually.
The PVAC will report to the IPC with respect to all identified conflicts and how
they were addressed. These reports will include all Client Accounts, including
those that are sub-advised. With respect to the review of votes cast on behalf
of investments by the Funds, such review will also be reported to the Board of
Directors of the Funds at each of their regularly scheduled meetings.
I. Vote Disclosure to Shareholders
FAF Advisors shall disclose its proxy voting record on the Funds' website at
www.firstamericanfunds.com and/or on the SEC's website at www.sec.gov.
Additionally, shareholders can receive, on request, the voting records for the
Funds by calling a toll free number (1-800-677-3863).
FAF Advisors' institutional and separately managed account clients can contact
their relationship manager for more information on FAF Advisors' policies and
the proxy voting record for their account. The information available includes
name of issuer, ticker/CUSIP, shareholder meeting date, description of item and
FAF Advisors' vote.
J. Form N-PX
FAF Advisors will cause Form N-PX to be filed with the Securities and Exchange
Commission, and ensure that any other proxy vote related filings as required by
regulation or contract are timely made.
ISS PROXY VOTING GUIDELINES SUMMARY
The following is a concise summary of ISS's proxy voting policy guidelines.
1. Auditors
AUDITOR RATIFICATION
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Vote FOR proposals to ratify auditors, unless any of the following apply:
- An auditor has a financial interest in or association with the
company, and is therefore not independent;
- There is reason to believe that the independent auditor has rendered
an opinion which is neither accurate nor indicative of the company's
financial position;
- Poor accounting practices are identified that rise to a serious level
of concern, such as: fraud; misapplication of GAAP; and material
weaknesses identified in Section 404 disclosures; or
- Fees for non-audit services ("other" fees) are excessive.
Vote CASE-BY-CASE on shareholder proposals asking for audit firm rotation,
taking into account:
- The tenure of the audit firm;
- The length of rotation specified in the proposal;
- Any significant audit-related issues at the company;
- The number of audit committee meetings held each year;
- The number of financial experts serving on the committee; and
- Whether the company has a periodic renewal process where the auditor
is evaluated for both audit quality and competitive price.
2. Board of Directors
VOTING ON DIRECTOR NOMINEES IN UNCONTESTED ELECTIONS
Vote AGAINST or WITHHOLD from individual directors who:
- Attend less than 75 percent of the board and committee meetings
without a valid excuse;
- Sit on more than six public company boards;
- Are CEOs of public companies who sit on the boards of more than two
public companies besides their own--withhold only at their outside
boards.
Vote AGAINST or WITHHOLD from all nominees of the board of directors, (except
from new nominees, who should be considered on a CASE-BY-CASE basis) if:
- The company's proxy indicates that not all directors attended 75
percent of the aggregate of their board and committee meetings, but
fails to provide the required disclosure of the names of the directors
involved. If this information cannot be obtained, vote
against/withhold from all incumbent directors;
- The company's poison pill has a dead-hand or modified dead-hand
feature. Vote against/withhold every year until this feature is
removed;
- The board adopts or renews a poison pill without shareholder approval,
does not commit to putting it to shareholder vote within 12 months of
adoption (or in the case of an newly public company, does not commit
to put the pill to a shareholder vote within 12 months following the
IPO), or reneges on a commitment to put the pill to a vote, and has
not yet received a withhold/against recommendation for this issue;
- The board failed to act on a shareholder proposal that received
approval by a majority of the shares outstanding the previous year (a
management proposal with other than a FOR recommendation by management
will not be considered as sufficient action taken);
- The board failed to act on a shareholder proposal that received
approval of the majority of shares cast for the previous two
consecutive years (a management proposal with other than a FOR
recommendation by management will not be considered as sufficient
action taken);
- The board failed to act on takeover offers where the majority of the
shareholders tendered their shares;
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- At the previous board election, any director received more than 50
percent withhold/against votes of the shares cast and the company has
failed to address the underlying issue(s) that caused the high
withhold/against vote;
- The company is a Russell 3000 company that underperformed its industry
group (GICS group) under ISS' "Performance Test for Directors" policy;
- The board is classified, and a continuing director responsible for a
problematic governance issue at the board/committee level that would
warrant a withhold/against vote recommendation is not up for
election--any or all appropriate nominees (except new) may be held
accountable.
Vote AGAINST or WITHHOLD from inside directors and affiliated outside directors
when:
- The inside or affiliated outside director serves on any of the three
key committees: audit, compensation, or nominating;
- The company lacks an audit, compensation, or nominating committee so
that the full board functions as that committee;
- The company lacks a formal nominating committee, even if board attests
that the independent directors fulfill the functions of such a
committee;
- The full board is less than majority independent.
Vote AGAINST or WITHHOLD from the members of the audit committee if:
- The non-audit fees paid to the auditor are excessive (see discussion
under "Auditor Ratification");
- Poor accounting practices are identified which rise to a level of
serious concern, such as: fraud; misapplication of GAAP; and material
weaknesses identified in Section 404 disclosures; or
- There is persuasive evidence that the audit committee entered into an
inappropriate indemnification agreement with its auditor that limits
the ability of the company, or its shareholders, to pursue legitimate
legal recourse against the audit firm.
Vote AGAINST or WITHHOLD from the members of the compensation committee if:
- There is a negative correlation between the chief executive's pay and
company performance;
- The company reprices underwater options for stock, cash or other
consideration without prior shareholder approval, even if allowed in
their equity plan;
- The company fails to submit one-time transfers of stock options to a
shareholder vote;
- The company fails to fulfill the terms of a burn-rate commitment made
to shareholders;
- The company has backdated options (see "Options Backdating" policy);
- The company has poor compensation practices (see "Poor Pay Practices"
policy). Poor pay practices may warrant withholding votes from the CEO
and potentially the entire board as well.
Vote AGAINST or WITHHOLD from directors, individually or the entire board, for
egregious actions or failure to replace management as appropriate.
CLASSIFICATION/DECLASSIFICATION OF THE BOARD
Vote AGAINST proposals to classify the board. Vote FOR proposals to repeal
classified boards and to elect all directors annually.
CUMULATIVE VOTING
Generally vote AGAINST proposals to eliminate cumulative voting. Generally vote
FOR proposals to restore or provide for cumulative voting unless:
- The company has proxy access or a similar structure to allow
shareholders to nominate directors to the company's ballot; and
- The company has adopted a majority vote standard, with a carve-out for
plurality voting in situations where there are more nominees than
seats, and a director resignation policy to address failed elections.
Vote FOR proposals for cumulative voting at controlled companies (insider voting
power > 50 percent).
INDEPENDENT CHAIR (SEPARATE CHAIR/CEO)
Generally vote FOR shareholder proposals requiring that the chairman's position
be filled by an independent director, unless there are compelling reasons to
recommend against the proposal, such as a counterbalancing governance structure.
This should include all the following:
- Designated lead director, elected by and from the independent board
members with clearly delineated and comprehensive duties. (The role
may alternatively reside with a presiding director,
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vice chairman, or rotating lead director; however the director must
serve a minimum of one year in order to qualify as a lead director.)
The duties should include, but are not limited to, the following:
- presides at all meetings of the board at which the chairman is
not present, including executive sessions of the independent
directors;
- serves as liaison between the chairman and the independent
directors;
- approves information sent to the board;
- approves meeting agendas for the board;
- approves meeting schedules to assure that there is sufficient
time for discussion of all agenda items;
- has the authority to call meetings of the independent directors;
- if requested by major shareholders, ensures that he is available
for consultation and direct communication;
- The company publicly discloses a comparison of the duties of its
independent lead director and its chairman;
- The company publicly discloses a sufficient explanation of why it
chooses not to give the position of chairman to the independent lead
director, and instead combine the chairman and CEO positions;
- Two-thirds independent board;
- All independent key committees;
- Established governance guidelines;
- The company should not have underperformed both its peers and index on
the basis of both one-year and three-year total shareholder returns*,
unless there has been a change in the chairman/CEO position within
that time; and
- The company does not have any problematic governance issues.
Vote FOR the proposal if the company does not provide disclosure with respect to
any or all of the bullet points above. If disclosure is provided, evaluate on a
CASE-BY-CASE basis.
* The industry peer group used for this evaluation is the average of the 12
companies in the same six-digit GICS group that are closest in revenue to
the company. To fail, the company must underperform its index and industry
group on all four measures (one- and three-year on industry peers and
index).
MAJORITY VOTE SHAREHOLDER PROPOSALS
Generally vote FOR precatory and binding resolutions requesting that the board
change the company's bylaws to stipulate that directors need to be elected with
an affirmative majority of votes cast, provided it does not conflict with the
state law where the company is incorporated. Binding resolutions need to allow
for a carve-out for a plurality vote standard when there are more nominees than
board seats. Companies are strongly encouraged to also adopt a post-election
policy (also known as a director resignation policy) that will provide
guidelines so that the company will promptly address the situation of a holdover
director.
OPEN ACCESS
Vote shareholder proposals asking for open or proxy access on a CASE-BY-CASE
basis, taking into account:
- The ownership threshold proposed in the resolution;
- The proponent's rationale for the proposal at the targeted company in
terms of board and director conduct.
3. Proxy Contests
VOTING FOR DIRECTOR NOMINEES IN CONTESTED ELECTIONS
Vote CASE-BY-CASE on the election of directors in contested elections,
considering the following factors:
- Long-term financial performance of the target company relative to its
industry;
- Management's track record;
- Background to the proxy contest;
- Qualifications of director nominees (both slates);
- Strategic plan of dissident slate and quality of critique against
management;
- Likelihood that the proposed goals and objectives can be achieved
(both slates);
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- Stock ownership positions.
REIMBURSING PROXY SOLICITATION EXPENSES
Vote CASE-BY-CASE on proposals to reimburse proxy solicitation expenses. When
voting in conjunction with support of a dissident slate, vote FOR the
reimbursement of all appropriate proxy solicitation expenses associated with the
election.
Generally vote FOR shareholder proposals calling for the reimbursement of
reasonable costs incurred in connection with nominating one or more candidates
in a contested election where the following apply:
- The election of fewer than 50 percent of the directors to be elected
is contested in the election;
- One or more of the dissident's candidates is elected;
- Shareholders are not permitted to cumulate their votes for directors;
and
- The election occurred, and the expenses were incurred, after the
adoption of this bylaw.
4. Takeover Defenses
POISON PILLS
Vote FOR shareholder proposals requesting that the company submit its poison
pill to a shareholder vote or redeem it UNLESS the company has: (1) A
shareholder approved poison pill in place; or (2) The company has adopted a
policy concerning the adoption of a pill in the future specifying that the board
will only adopt a shareholder rights plan if either:
- Shareholders have approved the adoption of the plan; or
- The board, in its exercise of its fiduciary responsibilities,
determines that it is in the best interest of shareholders under the
circumstances to adopt a pill without the delay that would result from
seeking stockholder approval (i.e., the "fiduciary out" provision). A
poison pill adopted under this fiduciary out will be put to a
shareholder ratification vote within 12 months of adoption or expire.
If the pill is not approved by a majority of the votes cast on this
issue, the plan will immediately terminate.
Vote FOR shareholder proposals calling for poison pills to be put to a vote
within a year after adoption. If the company has no non-shareholder approved
poison pill in place and has adopted a policy with the provisions outlined
above, vote AGAINST the proposal. If these conditions are not met, vote FOR the
proposal, but with the caveat that a vote within 12 months would be considered
sufficient.
Vote CASE-by-CASE on management proposals on poison pill ratification, focusing
on the features of the shareholder rights plan. Rights plans should contain the
following attributes:
- No lower than a 20 percent trigger, flip-in or flip-over;
- A term of no more than three years;
- No dead-hand, slow-hand, no-hand, or similar feature that limits the
ability of a future board to redeem the pill;
- Shareholder redemption feature (qualifying offer clause); if the board
refuses to redeem the pill 90 days after a qualifying offer is
announced, 10 percent of the shares may call a special meeting, or
seek a written consent to vote on rescinding the pill.
SHAREHOLDER ABILITY TO CALL SPECIAL MEETINGS
Vote AGAINST proposals to restrict or prohibit shareholder ability to call
special meetings. Vote FOR proposals that remove restrictions on the right of
shareholders to act independently of management.
SUPERMAJORITY VOTE REQUIREMENTS
Vote AGAINST proposals to require a supermajority shareholder vote. Vote FOR
proposals to lower supermajority vote requirements.
5. Mergers and Corporate Restructurings
For mergers and acquisitions, review and evaluate the merits and drawbacks of
the proposed transaction, balancing various and sometimes countervailing factors
including:
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- Valuation - Is the value to be received by the target shareholders (or
paid by the acquirer) reasonable? While the fairness opinion may
provide an initial starting point for assessing valuation
reasonableness, emphasis is placed on the offer premium, market
reaction and strategic rationale.
- Market reaction - How has the market responded to the proposed deal? A
negative market reaction should cause closer scrutiny of a deal.
- Strategic rationale - Does the deal make sense strategically? From
where is the value derived? Cost and revenue synergies should not be
overly aggressive or optimistic, but reasonably achievable. Management
should also have a favorable track record of successful integration of
historical acquisitions.
- Negotiations and process - Were the terms of the transaction
negotiated at arm's-length? Was the process fair and equitable? A fair
process helps to ensure the best price for shareholders. Significant
negotiation "wins" can also signify the deal makers' competency. The
comprehensiveness of the sales process (e.g., full auction, partial
auction, no auction) can also affect shareholder value.
- Conflicts of interest - Are insiders benefiting from the transaction
disproportionately and inappropriately as compared to non-insider
shareholders? As the result of potential conflicts, the directors and
officers of the company may be more likely to vote to approve a merger
than if they did not hold these interests. Consider whether these
interests may have influenced these directors and officers to support
or recommend the merger. The aggregate CIC figure may be a misleading
indicator of the true value transfer from shareholders to insiders.
Where such figure appears to be excessive, analyze the underlying
assumptions to determine whether a potential conflict exists.
- Governance - Will the combined company have a better or worse
governance profile than the current governance profiles of the
respective parties to the transaction? If the governance profile is to
change for the worse, the burden is on the company to prove that other
issues (such as valuation) outweigh any deterioration in governance.
6. State of Incorporation
REINCORPORATION PROPOSALS
Vote CASE-BY-CASE on proposals to change a company's state of incorporation,
taking into consideration both financial and corporate governance concerns,
including:
- The reasons for reincorporating;
- A comparison of the governance provisions;
- Comparative economic benefits; and
- A comparison of the jurisdictional laws.
7. Capital Structure
COMMON STOCK AUTHORIZATION
Vote CASE-BY-CASE on proposals to increase the number of shares of common stock
authorized for issuance using a model developed by ISS. Vote FOR proposals to
approve increases beyond the allowable increase when a company's shares are in
danger of being delisted or if a company's ability to continue to operate as a
going concern is uncertain.
In addition, for capital requests less than or equal to 300 percent of the
current authorized shares that marginally fail the calculated allowable cap
(i.e., exceed the allowable cap by no more than 5 percent), on a CASE-BY-CASE
basis, vote FOR the increase based on the company's performance and whether the
company's ongoing use of shares has shown prudence. Factors should include, at a
minimum, the following:
- Rationale;
- Good performance with respect to peers and index on a five-year total
shareholder return basis; Absence of non-shareholder approved poison
pill;
- Reasonable equity compensation burn rate;
- No non-shareholder approved pay plans; and
- Absence of egregious equity compensation practices.
DUAL-CLASS STOCK
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Vote AGAINST proposals to create a new class of common stock with superior
voting rights. Vote AGAINST proposals at companies with dual-class capital
structures to increase the number of authorized shares of the class of stock
that has superior voting rights. Vote FOR proposals to create a new class of
nonvoting or sub-voting common stock if:
- It is intended for financing purposes with minimal or no dilution to
current shareholders;
- It is not designed to preserve the voting power of an insider or
significant shareholder.
ISSUE STOCK FOR USE WITH RIGHTS PLAN
Vote AGAINST proposals that increase authorized common stock for the explicit
purpose of implementing a non-shareholder approved shareholder rights plan
(poison pill).
PREFERRED STOCK
Vote AGAINST proposals authorizing the creation of new classes of preferred
stock with unspecified voting, conversion, dividend distribution, and other
rights ("blank check" preferred stock), and AGAINST proposals to increase the
number of blank check preferred stock authorized for issuance when no shares
have been issued or reserved for a specific purpose. Vote FOR proposals to
create "declawed" blank check preferred stock (stock that cannot be used as a
takeover defense), and FOR proposals to authorize preferred stock in cases where
the company specifies the voting, dividend, conversion, and other rights of such
stock and the terms of the preferred stock appear reasonable. Vote CASE-BY-CASE
on proposals to increase the number of blank check preferred shares after
analyzing the number of preferred shares available for issue given a company's
industry and performance in terms of shareholder returns.
8. Executive and Director Compensation
EQUITY COMPENSATION PLANS
Vote CASE-BY-CASE on equity-based compensation plans. Vote AGAINST the equity
plan if any of the following factors apply:
- The total cost of the company's equity plans is unreasonable;
- The plan expressly permits the repricing of stock options without
prior shareholder approval;
- There is a disconnect between CEO pay and the company's performance;
- The company's three year burn rate exceeds the greater of 2% and the
mean plus one standard deviation of its industry group; or
- The plan is a vehicle for poor pay practices.
POOR PAY PRACTICES
Vote AGAINST or WITHHOLD from compensation committee members, the CEO, and
potentially the entire board, if the company has poor compensation practices.
Vote AGAINST equity plans if the plan is a vehicle for poor compensation
practices.
The following practices, while not exhaustive, are examples of poor compensation
practices:
- Egregious employment contracts (e.g., multi-year guarantees for salary
increases, bonuses, and equity compensation);
- Excessive perks (overly generous cost and/or reimbursement of taxes
for personal use of corporate aircraft, personal security systems
maintenance and/or installation, car allowances, and/or other
excessive arrangements relative to base salary);
- Abnormally large bonus payouts without justifiable performance linkage
or proper disclosure (e.g., performance metrics that are changed,
canceled, or replaced during the performance period without adequate
explanation of the action and the link to performance);
- Egregious pension/SERP (supplemental executive retirement plan)
payouts (inclusion of additional years of service not worked that
result in significant payouts, or inclusion of performance-based
equity awards in the pension calculation;
- New CEO with overly generous new hire package (e.g., excessive "make
whole" provisions);
- Excessive severance and/or change-in-control provisions: Inclusion of
excessive change-in-control or severance payments, especially those
with a multiple in excess of 3X cash pay;
- Severance paid for a "performance termination," (i.e., due to the
executive's failure to perform job functions at the appropriate
level);
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- Change-in-control payouts without loss of job or substantial
diminution of job duties (single-triggered);
- Perquisites for former executives such as car allowances,
personal use of corporate aircraft, or other inappropriate
arrangements;
- Poor disclosure practices, (unclear explanation of how the CEO is
involved in the pay setting process, retrospective performance targets
and methodology not discussed, or methodology for benchmarking
practices and/or peer group not disclosed and explained);
- Internal pay disparity (e.g., excessive differential between CEO total
pay and that of next highest-paid named executive officer);
- Other excessive compensation payouts or poor pay practices at the
company.
DIRECTOR COMPENSATION
Vote CASE-BY-CASE on compensation plans for non-employee directors, based on the
cost of the plans against the company's allowable cap.
On occasion, director stock plans that set aside a relatively small number of
shares when combined with employee or executive stock compensation plans will
exceed the allowable cap. Vote for the plan if ALL of the following qualitative
factors in the board's compensation are met and disclosed in the proxy
statement:
- Director stock ownership guidelines with a minimum of three times the
annual cash retainer.
- Vesting schedule or mandatory holding/deferral period:
- A minimum vesting of three years for stock options or restricted
stock; or
- Deferred stock payable at the end of a three-year deferral
period.
- Mix between cash and equity:
- A balanced mix of cash and equity, for example 40 percent cash/60
percent equity or 50 percent cash/50 percent equity; or
- If the mix is heavier on the equity component, the vesting
schedule or deferral period should be more stringent, with the
lesser of five years or the term of directorship.
- No retirement/benefits and perquisites provided to non-employee
directors; and
- Detailed disclosure provided on cash and equity compensation delivered
to each non-employee director for the most recent fiscal year in a
table. The column headers for the table may include the following:
name of each non-employee director, annual retainer, board meeting
fees, committee retainer, committee-meeting fees, and equity grants.
EMPLOYEE STOCK PURCHASE PLANS--QUALIFIED PLANS
Vote CASE-BY-CASE on qualified employee stock purchase plans. Vote FOR employee
stock purchase plans where all of the following apply:
- Purchase price is at least 85 percent of fair market value;
- Offering period is 27 months or less; and
- The number of shares allocated to the plan is 10 percent or less of
the outstanding shares.
Vote AGAINST qualified employee stock purchase plans where any of the following
apply:
- Purchase price is less than 85 percent of fair market value; or
- Offering period is greater than 27 months; or
- The number of shares allocated to the plan is more than 10 percent of
the outstanding shares.
EMPLOYEE STOCK PURCHASE PLANS--NON-QUALIFIED PLANS
Vote CASE-by-CASE on nonqualified employee stock purchase plans. Vote FOR
nonqualified employee stock purchase plans with all the following features:
- Broad-based participation (i.e., all employees of the company with the
exclusion of individuals with 5 percent or more of beneficial
ownership of the company);
- Limits on employee contribution, which may be a fixed dollar amount or
expressed as a percent of base salary;
- Company matching contribution up to 25 percent of employee's
contribution, which is effectively a discount of 20 percent from
market value;
- No discount on the stock price on the date of purchase since there is
a company matching contribution.
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Vote AGAINST nonqualified employee stock purchase plans when any of the plan
features do not meet the above criteria. If the company matching contribution
exceeds 25 percent of employee's contribution, evaluate the cost of the plan
against its allowable cap.
OPTIONS BACKDATING
In cases where a company has practiced options backdating, vote AGAINST or
WITHHOLD on a CASE-BY-CASE basis from the members of the compensation committee,
depending on the severity of the practices and the subsequent corrective actions
on the part of the board. Vote AGAINST or WITHHOLD from the compensation
committee members who oversaw the questionable options practices or from current
compensation committee members who fail to respond to the issue proactively,
depending on several factors, including, but not limited to:
- Reason and motive for the options backdating issue (inadvertent vs.
deliberate grant date changes);
- Length of time of options backdating;
- Size of restatement due to options backdating;
- Corrective actions taken by the board or compensation committee, such
as canceling or repricing backdated options, or recoupment of option
gains on backdated grants;
- Adoption of a grant policy that prohibits backdating, and creation of
a fixed grant schedule or window period for equity grants going
forward.
OPTION EXCHANGE PROGRAMS/REPRICING OPTIONS
Vote CASE-by-CASE on management proposals seeking approval to exchange/reprice
options, considering:
- Historic trading patterns--the stock price should not be so volatile
that the options are likely to be back "in-the-money" over the near
term;
- Rationale for the re-pricing--was the stock price decline beyond
management's control?
- Is this a value-for-value exchange?
- Are surrendered stock options added back to the plan reserve?
- Option vesting--does the new option vest immediately or is there a
black-out period?
- Term of the option--the term should remain the same as that of the
replaced option;
- Exercise price--should be set at fair market or a premium to market;
- Participants--executive officers and directors should be excluded.
If the surrendered options are added back to the equity plans for re-issuance,
then also take into consideration the company's three-year average burn rate. In
addition to the above considerations, evaluate the intent, rationale, and timing
of the repricing proposal. The proposal should clearly articulate why the board
is choosing to conduct an exchange program at this point in time. Repricing
underwater options after a recent precipitous drop in the company's stock price
demonstrates poor timing. Repricing after a recent decline in stock price
triggers additional scrutiny and a potential AGAINST vote on the proposal. At a
minimum, the decline should not have happened within the past year. Also,
consider the terms of the surrendered options, such as the grant date, exercise
price and vesting schedule. Grant dates of surrendered options should be far
enough back (two to three years) so as not to suggest that repricings are being
done to take advantage of short-term downward price movements. Similarly, the
exercise price of surrendered options should be above the 52-week high for the
stock price.
Vote FOR shareholder proposals to put option repricings to a shareholder vote.
STOCK PLANS IN LIEU OF CASH
Vote CASE-by-CASE on plans that provide participants with the option of taking
all or a portion of their cash compensation in the form of stock, and on plans
that do not provide a dollar-for-dollar cash for stock exchange. In cases where
the exchange is not dollar-for-dollar, the request for new or additional shares
for such equity program will be considered using the binomial option pricing
model. In an effort to capture the total cost of total compensation, ISS will
not make any adjustments to carve out the in-lieu-of cash compensation. Vote FOR
non-employee director-only equity plans that provide a dollar-for-dollar
cash-for-stock exchange.
TRANSFER PROGRAMS OF STOCK OPTIONS
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Vote AGAINST or WITHHOLD from compensation committee members if they fail to
submit one-time transfers to shareholders for approval.
Vote CASE-BY-CASE on one-time transfers. Vote FOR if:
- Executive officers and non-employee directors are excluded from
participating;
- Stock options are purchased by third-party financial institutions at a
discount to their fair value using option pricing models such as
Black-Scholes or a Binomial Option Valuation or other appropriate
financial models;
- There is a two-year minimum holding period for sale proceeds (cash or
stock) for all participants.
Additionally, management should provide a clear explanation of why options are
being transferred and whether the events leading up to the decline in stock
price were beyond management's control. A review of the company's historic stock
price volatility should indicate if the options are likely to be back
"in-the-money" over the near term.
Vote AGAINST equity plan proposals if the details of ongoing Transfer of Stock
Options programs are not provided to shareholders. Since TSOs will be one of the
award types under a stock plan, the ongoing TSO program, structure and mechanics
must be disclosed to shareholders. The specific criteria to be considered in
evaluating these proposals include, but not limited, to the following:
- Eligibility;
- Vesting;
- Bid-price;
- Term of options;
- Transfer value to third-party financial institution, employees and the
company.
Amendments to existing plans that allow for introduction of transferability of
stock options should make clear that only options granted post-amendment shall
be transferable.
SHAREHOLDER PROPOSALS ON COMPENSATION
ADVISORY VOTE ON EXECUTIVE COMPENSATION (SAY-ON-PAY)
Generally, vote FOR shareholder proposals that call for non-binding shareholder
ratification of the compensation of the named executive officers and the
accompanying narrative disclosure of material factors provided to understand the
Summary Compensation Table.
COMPENSATION CONSULTANTS--DISCLOSURE OF BOARD OR COMPANY'S UTILIZATION
Generally vote FOR shareholder proposals seeking disclosure regarding the
company, board, or compensation committee's use of compensation consultants,
such as company name, business relationship(s) and fees paid.
DISCLOSURE/SETTING LEVELS OR TYPES OF COMPENSATION FOR EXECUTIVES AND DIRECTORS
Generally, vote FOR shareholder proposals seeking additional disclosure of
executive and director pay information, provided the information requested is
relevant to shareholders' needs, would not put the company at a competitive
disadvantage relative to its industry, and is not unduly burdensome to the
company. Vote AGAINST shareholder proposals seeking to set absolute levels on
compensation or otherwise dictate the amount or form of compensation. Vote
AGAINST shareholder proposals requiring director fees be paid in stock only.
Vote CASE-BY-CASE on all other shareholder proposals regarding executive and
director pay, taking into account company performance, pay level versus peers,
pay level versus industry, and long-term corporate outlook.
PAY FOR SUPERIOR PERFORMANCE
Generally vote FOR shareholder proposals based on a case-by-case analysis that
requests the board establish a pay-for-superior performance standard in the
company's compensation plan for senior executives. The proposal should have the
following principles:
- Sets compensation targets for the plan's annual and long-term
incentive pay components at or below the peer group median;
- Delivers a majority of the plan's target long-term compensation
through performance-vested, not simply time-vested, equity awards;
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- Provides the strategic rationale and relative weightings of the
financial and non-financial performance metrics or criteria used in
the annual and performance-vested long-term incentive components of
the plan;
- Establishes performance targets for each plan financial metric
relative to the performance of the company's peer companies;
- Limits payment under the annual and performance-vested long-term
incentive components of the plan to when the company's performance on
its selected financial performance metrics exceeds peer group median
performance.
Consider the following factors in evaluating this proposal:
- What aspects of the company's annual and long-term equity incentive
programs are performance-driven?
- If the annual and long-term equity incentive programs are performance
driven, are the performance criteria and hurdle rates disclosed to
shareholders or are they benchmarked against a disclosed peer group?
- Can shareholders assess the correlation between pay and performance
based on the current disclosure?
- What type of industry and stage of business cycle does the company
belong to?
PERFORMANCE-BASED AWARDS
Vote CASE-BY-CASE on shareholder proposal requesting that a significant amount
of future long-term incentive compensation awarded to senior executives shall be
performance-based and requesting that the board adopt and disclose challenging
performance metrics to shareholders, based on the following analytical steps:
- First, vote FOR shareholder proposals advocating the use of
performance-based equity awards, such as performance contingent
options or restricted stock, indexed options or premium-priced
options, unless the proposal is overly restrictive or if the company
has demonstrated that it is using a "substantial" portion of
performance-based awards for its top executives. Standard stock
options and performance-accelerated awards do not meet the criteria to
be considered as performance-based awards. Further, premium-priced
options should have a premium of at least 25 percent and higher to be
considered performance-based awards.
- Second, assess the rigor of the company's performance-based equity
program. If the bar set for the performance-based program is too low
based on the company's historical or peer group comparison, generally
vote FOR the proposal. Furthermore, if target performance results in
an above target payout, vote FOR the shareholder proposal due to
program's poor design. If the company does not disclose the
performance metric of the performance-based equity program, vote FOR
the shareholder proposal regardless of the outcome of the first step
to the test.
In general, vote FOR the shareholder proposal if the company does not meet both
of these two requirements.
PRE-ARRANGED TRADING PLANS (10B5-1 PLANS)
Generally vote FOR shareholder proposals calling for certain principles
regarding the use of prearranged trading plans (10b5-1 plans) for executives.
These principles include:
- Adoption, amendment, or termination of a 10b5-1 plan must be disclosed
within two business days in a Form 8-K;
- Amendment or early termination of a 10b5-1 plan is allowed only under
extraordinary circumstances, as determined by the board;
- Ninety days must elapse between adoption or amendment of a 10b5-1 plan
and initial trading under the plan;
- Reports on Form 4 must identify transactions made pursuant to a 10b5-1
plan;
- An executive may not trade in company stock outside the 10b5-1 Plan.
- Trades under a 10b5-1 plan must be handled by a broker who does not
handle other securities transactions for the executive.
RECOUP BONUSES
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Vote on a CASE-BY-CASE on proposals to recoup unearned incentive bonuses or
other incentive payments made to senior executives if it is later determined
that fraud, misconduct, or negligence significantly contributed to a restatement
of financial results that led to the awarding of unearned incentive
compensation, taking into consideration:
- If the company has adopted a formal recoupment bonus policy; or
- If the company has chronic restatement history or material financial
problems.
SEVERANCE AGREEMENTS FOR EXECUTIVES/GOLDEN PARACHUTES
Vote FOR shareholder proposals requiring that golden parachutes or executive
severance agreements be submitted for shareholder ratification, unless the
proposal requires shareholder approval prior to entering into employment
contracts. Vote on a CASE-BY-CASE basis on proposals to ratify or cancel golden
parachutes. An acceptable parachute should include, but is not limited to, the
following:
- The triggering mechanism should be beyond the control of management;
- The amount should not exceed three times base amount (defined as the
average annual taxable W-2 compensation during the five years prior to
the change of control);
- Change-in-control payments should be double-triggered, i.e., (1) after
a change in control has taken place, and (2) termination of the
executive as a result of the change in control. Change in control is
defined as a change in the company ownership structure.
SUPPLEMENTAL EXECUTIVE RETIREMENT PLANS (SERPS)
Generally vote FOR shareholder proposals requesting to put extraordinary
benefits contained in SERP agreements to a shareholder vote unless the company's
executive pension plans do not contain excessive benefits beyond what is offered
under employee-wide plans. Generally vote FOR shareholder proposals requesting
to limit the executive benefits provided under the company's supplemental
executive retirement plan (SERP) by limiting covered compensation to a senior
executive's annual salary and excluding of all incentive or bonus pay from the
plan's definition of covered compensation used to establish such benefits.
9. Corporate Social Responsibility (CSR) Issues
CONSUMER LENDING
Vote CASE-BY CASE on requests for reports on the company's lending guidelines
and procedures, including the establishment of a board committee for oversight,
taking into account:
- Whether the company has adequately disclosed mechanisms to prevent
abusive lending practices;
- Whether the company has adequately disclosed the financial risks of
the lending products in question;
- Whether the company has been subject to violations of lending laws or
serious lending controversies;
- Peer companies' policies to prevent abusive lending practices.
PHARMACEUTICAL PRICING
Generally vote AGAINST proposals requesting that companies implement specific
price restraints on pharmaceutical products unless the company fails to adhere
to legislative guidelines or industry norms in its product pricing.
Vote CASE-BY-CASE on proposals requesting that the company evaluate their
product pricing considering:
- The existing level of disclosure on pricing policies;
- Deviation from established industry pricing norms;
- The company's existing initiatives to provide its products to needy
consumers;
- Whether the proposal focuses on specific products or geographic
regions.
PRODUCT SAFETY AND TOXIC MATERIALS
Generally vote FOR proposals requesting the company to report on its policies,
initiatives/procedures, and oversight mechanisms related to toxic materials
and/or product safety in its supply chain, unless:
- The company already discloses similar information through existing
reports or policies such as a supplier code of conduct and/or a
sustainability report;
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- The company has formally committed to the implementation of a toxic
materials and/or product safety and supply chain reporting and
monitoring program based on industry norms or similar standards within
a specified time frame; and
- The company has not been recently involved in relevant significant
controversies or violations.
Vote CASE-BY-CASE on resolutions requesting that companies develop a feasibility
assessment to phase-out of certain toxic chemicals and/or evaluate and disclose
the financial and legal risks associated with utilizing certain chemicals,
considering:
- Current regulations in the markets in which the company operates;
- Recent significant controversy, litigation, or fines stemming from
toxic chemicals or ingredients at the company; and
- The current level of disclosure on this topic.
CLIMATE CHANGE
In general, vote FOR resolutions requesting that a company disclose information
on the impact of climate change on the company's operations unless:
- The company already provides current, publicly available information
on the perceived impact that climate change may have on the company as
well as associated policies and procedures to address such risks
and/or opportunities;
- The company's level of disclosure is comparable to or better than
information provided by industry peers; and
- There are no significant fines, penalties, or litigation associated
with the company's environmental performance.
GREENHOUSE GAS EMISSIONS
Generally vote FOR proposals requesting a report on greenhouse gas emissions
from company operations and/or products unless this information is already
publicly disclosed or such factors are not integral to the company's line of
business. Generally vote AGAINST proposals that call for reduction in greenhouse
gas emissions by specified amounts or within a restrictive time frame unless the
company lags industry standards and has been the subject of recent, significant
fines, or litigation resulting from greenhouse gas emissions.
POLITICAL CONTRIBUTIONS AND TRADE ASSOCIATIONS SPENDING
Generally vote AGAINST proposals asking the company to affirm political
nonpartisanship in the workplace so long as:
- The company is in compliance with laws governing corporate political
activities; and
- The company has procedures in place to ensure that employee
contributions to company-sponsored political action committees (PACs)
are strictly voluntary and not coercive.
Vote AGAINST proposals to publish in newspapers and public media the company's
political contributions as such publications could present significant cost to
the company without providing commensurate value to shareholders. Vote
CASE-BY-CASE on proposals to improve the disclosure of a company's political
contributions and trade association spending, considering:
- Recent significant controversy or litigation related to the company's
political contributions or governmental affairs; and
- The public availability of a company policy on political contributions
and trade association spending including information on the types of
organizations supported, the business rationale for supporting these
organizations, and the oversight and compliance procedures related to
such expenditures.
Vote AGAINST proposals barring the company from making political contributions.
Businesses are affected by legislation at the federal, state, and local level
and barring contributions can put the company at a competitive disadvantage.
Vote AGAINST proposals asking for a list of company executives, directors,
consultants, legal counsels, lobbyists, or investment bankers that have prior
government service and whether such service had a bearing on the business of the
company. Such a list would be burdensome to prepare without providing any
meaningful information to shareholders.
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SUSTAINABILITY REPORTING
Generally vote FOR proposals requesting the company to report on policies and
initiatives related to social, economic, and environmental sustainability,
unless:
- The company already discloses similar information through existing
reports or policies such as an environment, health, and safety (EHS)
report; a comprehensive code of corporate conduct; and/or a diversity
report; or
- The company has formally committed to the implementation of a
reporting program based on Global Reporting Initiative (GRI)
guidelines or a similar standard within a specified time frame.
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