This filing relates solely to Class III shares of GMO Short-Duration Collateral Fund. No information contained herein is intended to amend or supersede any
prior filing relating to any other series of the Registrant.
At present, GMO Short-Duration Collateral Fund (SDCF) is not pursuing an active investment program and is gradually liquidating its portfolio.
Grantham, Mayo, Van Otterloo & Co. LLC (GMO), the investment manager to SDCF, recommended to the Board, and the Board agreed, that effective on or about February 12, 2014 (the Implementation Date), SDCF will
begin to pursue a more active investment program. Whereas SDCF does not currently pay any management fee under its existing management contract with GMO, in anticipation of this change, the Board and a majority of SDCFs outstanding shares
approved the implementation of a 0.25% annual management fee pursuant to an amended and restated management contract (the New Management Contract) between the Trust, on behalf of SDCF, and GMO, to become effective on the Implementation
Date.
In connection with SDCFs new investment program and the New Management Contract, the Board also approved other changes to SDCFs class
and fee structure and changes to SDCFs investment objective, principal investment strategies and name. With respect to the new class structure, the Board approved (i) the reclassification and redesignation of outstanding shares of SDCF as
Class VI shares of SDCF effective on or about the Implementation Date, and (ii) the establishment of Class III shares of SDCF. With respect to the new fee structure, effective on or about the Implementation Date, SDCF will (i) implement a
new shareholder servicing fee arrangement pursuant to which Class III and Class VI shares of SDCF will pay GMO annual shareholder service fees of 0.15% and 0.055%, respectively, of each classs average daily net assets, and (ii) charge a
purchase premium of 0.40% of the amount invested and a redemption fee of 0.40% of the amount redeemed, subject to the waivers and reductions described elsewhere in the Prospectus. Also effective on or about the Implementation Date, GMO will begin
pursuing an active investment program for SDCF that is substantially the same as that being pursued for GMO Debt Opportunities Fund (DOF), a series of the Trust described in a separate private placement memorandum, and SDCF will change
its investment objective and principal investment strategies to match those of DOF.
In addition, the Board has approved the merger of DOF into SDCF,
which is also expected to occur on or about the Implementation Date (the DOF/SDCF Merger). Pursuant to the DOF/SDCF Merger, DOF will exchange its portfolio assets for shares of SDCF and will then distribute those shares to its
shareholders and liquidate. The DOF/SDCF Merger, which does not require shareholder approval, is expected to constitute a tax-free reorganization for U.S. federal income tax purposes.
Following the completion of the DOF/SDCF Merger, SDCF will change its name to GMO Debt Opportunities Fund and will adopt the following name
policy to comply with the requirements of Rule 35d-1 under the 1940 Act: Under normal circumstances, the Fund invests directly and indirectly (e.g., through other GMO Funds or derivatives) at least 80% of its assets in debt
investments. It is anticipated that, while SDCF will be the surviving entity of the DOF/SDCF Merger for corporate and U.S. federal income tax purposes, DOF will be the surviving entity for accounting purposes, meaning that the combined entity
will adopt the financial reporting and performance history of DOF upon completion of the DOF/SDCF Merger.
In connection with these changes, effective as of the Implementation Date, the sections captioned
Investment objective, Fees and expenses, Example, Portfolio turnover, Principal investment strategies, and Principal risks of investing in the Fund on pages 101-102 of the
Prospectus will be amended and restated substantially as follows:
The table
below describes the fees and expenses that you may pay if you buy and hold shares of the Fund.
(expenses that you pay each year as a percentage of the value of your investment)
This example is intended to help you compare the cost of investing in the Fund with the cost of investing in other mutual funds. The example
assumes that you invest $10,000 in the Fund for the time periods indicated. The example also assumes that your investment has a 5% return each year and that the Funds operating expenses remain the same as those shown in the table. Although
your actual costs may be higher or lower, based on these assumptions your costs would be:
The Fund pays
transaction costs, such as commissions, when it buys and sells securities. A higher portfolio turnover rate may result in higher transaction costs and, when Fund shares are held in a taxable account, higher taxes. These costs, which are not
reflected in Annual Fund operating expenses or in the Example, affect the
Funds performance. During its fiscal year ended February 28, 2013, the Funds portfolio turnover rate (excluding short-term investments) was 0% of the average value of its
portfolio.
The Fund invests primarily in debt investments and is not restricted in its exposure to any type of debt investment, without regard to credit
rating. The Fund may invest in debt investments issued by a wide range of private issuers and by federal, state, local, and non-U.S. governments (whether or not guaranteed or insured by those governments). The Fund may invest in asset-backed
securities, including, but not limited to, securities backed by pools of residential and commercial mortgages, credit-card receivables, home equity loans, automobile loans, educational loans, corporate and sovereign bonds, and bank loans made to
corporations. In addition, the Fund may invest in corporate debt securities, money market instruments, and commercial paper, and enter into credit default swaps, reverse repurchase agreements, and repurchase agreements. The Fund also may use other
exchange-traded and over-the-counter (OTC) derivatives. The Fund is not limited in its use of derivatives or in the absolute face value of its derivative positions. As a result of its derivative positions, the Fund may have gross investment
exposures in excess of its net assets (i.e., the Fund may be leveraged) and therefore is subject to heightened risk of loss. The Funds performance can depend substantially, if not primarily, on the performance of assets or indices underlying
its derivatives even though it does not own those assets or indices.
The Funds debt investments may include all types of interest
rate, payment, and reset terms, including fixed rate, adjustable rate, zero coupon, contingent, deferred, payment-in-kind, and auction rate features. The Fund may invest in securities of any credit quality and has no limit on how much it may invest
in below investment grade securities (commonly referred to as junk bonds).
As of the date of this Prospectus, the Fund has
invested substantially all of its assets in asset-backed securities, a substantial portion of which are below investment grade.
The Fund
also may invest in U.S. Treasury Fund and unaffiliated money market funds.
In selecting debt investments for the Funds portfolio,
the Manager emphasizes issue selection in its investment process, which involves examination of various sectors of structured product. The Manager uses analytical techniques to seek to find relative value among sectors and individual securities. The
factors considered and investment methods used by the Manager can change over time.
The Fund does not maintain a specified interest rate
duration for its portfolio.
Under normal circumstances, the Fund invests directly and indirectly (e.g., through other GMO Funds or
derivatives) at least 80% of its assets in debt investments (see Name Policies).
The value of the Funds shares changes with the value of the Funds investments. Many factors can affect this value, and you may lose
money by investing in the Fund. The Fund is a
non-diversified investment company
under the Investment Company Act of 1940, as amended, and therefore a decline in the market price of a particular security held by the Fund may affect the
Funds performance more than if the Fund were a diversified investment company. The principal risks of investing in the Fund are summarized below. For a more complete discussion of these risks, see Description of Principal Risks.
The
Securities and Exchange Commission has not approved or disapproved these securities or passed upon the adequacy of this prospectus. Any representation to the contrary is a criminal offense.
Total return
comparable to that of its benchmark, the J.P. Morgan U.S. 3 Month Cash Index.
The table below describes the fees and expenses that you may pay if you buy and hold shares of the Fund.
(expenses that you pay
each year as a percentage of the value of your investment)
This
example is intended to help you compare the cost of investing in the Fund with the cost of investing in other mutual funds. The example assumes that you invest $10,000 in the Fund for the time periods indicated, regardless of whether or not you
redeem your shares at the end of such periods. The example also assumes that your investment has a 5% return each year and that the Funds operating expenses remain the same as those shown in the table. Although your actual costs may be higher
or lower, based on these assumptions your costs would be:
The Fund pays transaction costs, such as commissions, when it buys and sells securities. A higher portfolio turnover rate may result in higher
transaction costs and, when Fund shares are held in a taxable account, higher taxes. These costs, which are not reflected in Annual Fund operating expenses or in the Example, affect the Funds performance. During its fiscal year ended
February 28, 2013, the Funds portfolio turnover rate (excluding short-term investments) was 0% of the average value of its portfolio.
The Fund
is not pursuing an active investment program and is gradually liquidating its portfolio.
The Fund primarily holds asset-backed
securities, including, but not limited to, securities backed by pools of residential and commercial mortgages, credit-card receivables, home equity loans, automobile loans, educational loans, corporate and sovereign bonds and bank loans made to
corporations. In addition, the Fund holds government securities, corporate debt securities and money market instruments. The Fund also may invest in unaffiliated money market funds.
Because of the deterioration in credit markets that became acute in 2008, the Fund currently has and is expected to continue to have material
exposure to below investment grade securities.
The Manager does not seek to maintain a specified interest rate duration for the Fund.
Since October 2008, the Fund has declared and paid distributions when it has acquired a meaningful cash position rather than reinvesting
that cash in portfolio securities. The Fund currently intends to continue this practice. A substantial portion of any such distributions could constitute a return of capital to shareholders for tax purposes. See Distributions and Taxes
below for more information on the tax implications of such distributions.
The value of the Funds shares changes with the value of the Funds investments. Many factors can affect this value, and you may lose
money by investing in the Fund. The Fund is a
non-diversified investment company
under the Investment Company Act of 1940, as amended, and therefore a decline in the market price of a particular security held by the Fund may affect the
Funds performance more than if the Fund were a diversified investment company. The principal risks of investing in the Fund are summarized below. For a more complete discussion of these risks, see Description of Principal Risks.
DESCRIPTION OF PRINCIPAL RISKS
Investing in mutual funds involves many risks. Factors that may affect the Funds portfolio as a whole, called principal
risks, are discussed briefly in the Funds summary and in additional detail in this section. The risks of investing in the Fund depend on the types of investments in its portfolio and the investment strategies the Manager employs on its
behalf. This section describes the principal risks and some related risks but does not describe every potential risk of investing in the Fund. The Fund could be subject to additional risks because of the types of investments it makes and market
conditions, which may change over time. The SAI includes more information about the Fund and its investments.
To the extent the Fund
invests in other GMO Funds and other investment companies (as further described in Additional Information About the Funds Investment Strategies, Risks, and Expenses), the Fund is exposed to the risks to which the underlying funds
in which it invests are exposed. Therefore, unless otherwise noted, the principal risks summarized below include both direct and indirect risks, and, as indicated in the Additional Information About the Funds Investment Strategies,
Risks, and Expenses section of this Prospectus, references in this section to investments made by the Fund include those made both directly by the Fund and indirectly by the Fund through other GMO Funds and other investment companies.
An investment in the Fund, by itself, generally does not provide a complete investment program but rather is intended to serve as part of an
investors overall portfolio of investments. An investment in the Fund is not a bank deposit and, therefore, is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.
CREDIT RISK.
This is the risk that the issuer or guarantor of a fixed income investment or the obligor of an obligation
underlying an asset-backed security will be unable or unwilling to satisfy its obligation to pay principal and interest or otherwise to honor its obligations in a timely manner. The market price of a fixed income investment will normally decline as
a result of the issuers, guarantors, or obligors failure to meet its payment obligations or the downgrading of its credit rating. This risk is particularly acute in environments (like those of 2008) in which financial services
firms are exposed to systemic risks of the type evidenced by the insolvency of Lehman Brothers and subsequent market disruptions.
All
fixed income securities are subject to credit risk. Financial strength and solvency of an issuer are the primary factors influencing credit risk. The risk varies depending upon whether the issuer is a corporation or U.S. or non-U.S. government (or
sub-division or instrumentality) and whether the particular security has a priority over other obligations of the issuer in payment of principal and interest and whether it has any collateral backing or credit enhancement. Credit risk may change
over the life of a fixed income security. U.S. government securities are subject to varying degrees of credit risk depending upon whether the securities are supported by the full faith and credit of the United States, supported by the ability to
borrow from the U.S. Treasury, supported only by the credit of the issuing U.S. government agency, instrumentality, or corporation, or otherwise supported by the United States. For example, issuers of many types of U.S. government securities (e.g.,
the Federal Home Loan Mortgage Corporation (Freddie Mac), Federal National Mortgage Association (Fannie Mae), and Federal Home Loan Banks), although chartered or sponsored by Congress, are not funded by Congressional
appropriations and their fixed income securities, including mortgage-backed and other asset-backed securities, are neither guaranteed nor insured by the U.S. government. These securities are subject to more credit risk than U.S. government
securities that are supported by the full faith and credit of the United States (e.g., U.S. Treasury bonds). Investments in sovereign debt involve the risk that the governmental entities responsible for repayment may be unable or unwilling to pay
interest and repay principal when due. A governmental entitys willingness or ability to pay interest and repay principal in a timely manner may be affected by a variety of factors, including its cash flow, the size of its reserves, its access
to foreign exchange, the relative size of its debt service burden to its economy as a whole, and political constraints. In addition, payment of principal of fixed income securities guaranteed by the U.S. government can be delayed because the
guarantee generally only requires payment upon maturity of the securities. Investments in quasi-sovereign issuers are subject to the additional risk that the issuer may default independently of its sovereign. Sovereign debt risk is greater for fixed
income securities issued or guaranteed by emerging countries.
In some cases, the credit risk of a fixed income security is reflected in
its credit ratings, and to the extent the Fund holds such a security the Fund is subject to the risk that its rating will be downgraded.
Securities issued by the U.S. Treasury historically have presented minimal credit risk. However, recent events have led to a downgrade in the
long-term U.S. credit rating by at least one major rating agency and have introduced greater uncertainty about the ability of the U.S. to repay its obligations. A further credit rating downgrade or a U.S. credit default could decrease the value and
increase the volatility of the Funds investments.
As described under Market Risk Asset-Backed Securities below,
asset-backed securities may be backed by many types of assets and their payment of interest and repayment of principal largely depend on the cash flows generated by the assets backing them. The credit risk of a particular asset-backed security
depends on many factors, as described in Market Risk Asset Backed Securities below.
7
The obligations of issuers also are subject to bankruptcy, insolvency and other laws affecting
the rights and remedies of creditors. The Fund also is exposed to credit risk on a reference security to the extent it writes protection under credit default swaps. See Derivatives Risk below for more information regarding risks
associated with the use of credit default swaps.
The extent to which the market price of a fixed income security changes in response to a
credit event depends on a number of factors and can be difficult to predict. For example, floating rate securities may have final maturities of ten or more years, but their effective durations will tend to be very short. If the issuer of floating
rate securities experiences an adverse credit event, or a change occurs in its perceived creditworthiness, the market price of its securities could decline much more than would be predicted by a change in their yield relative to their effective
duration.
Credit risk is particularly pronounced for below investment grade securities (commonly referred to as junk bonds),
which are defined in this Prospectus under Additional Information About the Funds Investment Strategies, Risks, and Expenses. The sovereign debt of many non-U.S. governments, including their sub-divisions and instrumentalities, is
below investment grade. Many asset-backed securities also are below investment grade. Below investment grade securities have speculative characteristics, often are less liquid than higher quality securities, present a greater risk of default and are
more susceptible to real or perceived adverse industry conditions. In the event of default of sovereign debt, the Fund may be unable to pursue legal action against the sovereign issuer.
MARKET RISK.
The Fund is subject to market risk, which is the risk that the market value of its holdings will decline.
Market risks include:
Fixed Income Investments.
The Fund invests in fixed income securities (including bonds, notes, bills,
synthetic debt instruments, and asset-backed securities) and is subject to various market risks. The market price of a fixed income investment can decline due to a number of market-related factors, including rising interest rates and widening credit
spreads, or decreased liquidity stemming from the markets uncertainty about the value of a fixed income investment (or class of fixed income investments). In addition, the market price of fixed income investments with complex structures, such
as asset-backed securities and sovereign and quasi-sovereign debt instruments, can decline due to market uncertainty about their credit quality and the reliability of their payment streams. Some fixed income securities also are subject to
unscheduled prepayment, and the Fund may be unable to invest prepayments at as high a yield as was provided by the fixed income security. When interest rates rise, these securities also may be repaid more slowly than anticipated, which could cause
the market price of the Funds investment to decrease. During periods of economic uncertainty and change, the market price of the Funds investments in below investment grade securities (commonly referred to as junk bonds) may
be particularly volatile. Often junk bonds are subject to greater sensitivity to interest rate and economic changes than higher rated bonds and can be more difficult to value (see Determination of Net Asset Value) exposing the Fund to
the risk that the price at which it sells them will be less than the value placed on them when they were held by the Fund. See Credit Risk and Liquidity Risk below for more information about these risks.
A principal risk of the Fund is that an increase in prevailing interest rates will cause the market price of the Funds investments in
fixed income securities to decline. The risk associated with increases in interest rates (also called interest rate risk) is generally greater to the extent the Fund invests in fixed income securities with longer durations and in some
cases duration can increase.
The extent to which a fixed income securitys price changes with changes in interest rates is referred
to as interest rate duration, which can be measured mathematically or empirically. A longer-maturity investment generally has longer interest rate duration because the investments fixed rate is locked in for a longer period of time.
Floating-rate or adjustable-rate securities, however, generally have shorter interest rate durations because their interest rates are not fixed but rather float up and down as interest rates change. Conversely, inverse floating-rate securities have
durations that move in the opposite direction from short-term interest rates and thus tend to underperform fixed rate securities when interest rates rise but outperform them when interest rates decline. Fixed income securities paying no interest,
such as zero coupon and principal-only securities, create additional interest rate risk.
The market price of inflation indexed bonds
(including Inflation-Protected Securities issued by the U.S. Treasury (TIPS)) normally changes when real interest rates change. Their value typically will decline during periods of rising real interest rates (i.e., nominal interest rate
minus inflation) and increase during periods of declining real interest rates. Real interest rates may not fluctuate in the same manner as nominal interest rates. In some interest rate environments, such as when real interest rates are rising faster
than nominal interest rates, the market price of inflation indexed bonds may decline more than the price of non-inflation indexed (or nominal) fixed income bonds with similar maturities. The market price of the Funds inflation indexed bonds,
however, will not necessarily change in the same proportion as changes in nominal interest rates, and short term increases in inflation may lead to a decline in their price. Moreover, if the index measuring inflation falls, the principal value of
inflation indexed bond investments will be adjusted downward, and, consequently, the interest they pay (calculated with respect to a smaller principal amount) will be reduced. In the case of TIPS, the U.S. government guarantees the repayment of the
original bond principal upon maturity (as adjusted for inflation).
Generally, when interest rates on short term U.S. Treasury obligations
equal or approach zero, to the extent the Fund invests a substantial portion of its assets in U.S. Treasury obligations, it will have a negative return unless the Manager waives or reduces its management fees.
8
Asset-Backed Securities.
Investments in asset-backed securities not only are
subject to all of the market risks described above for fixed income securities but to other market risks as well.
Because the Fund
invests in asset-backed securities, it is exposed to the risk that these securities experience severe credit downgrades, illiquidity, defaults, and declines in market value. These risks are particularly acute during periods of adverse market
conditions, such as those that occurred in 2008. Asset-backed securities may be backed by many types of assets, including pools of residential and commercial mortgages, automobile loans, educational loans, home equity loans, and credit-card
receivables. They also may be backed by pools of corporate or sovereign bonds, bank loans made to corporations, or a combination of these bonds and loans (commonly referred to as collateralized debt obligations or collateralized
loan obligations) and by the fees earned by service providers.
As described under Market Risk Fixed Income
Investments above, the market price of fixed income investments with complex structures, such as asset-backed securities, can decline due to a number of factors, including market uncertainty about their credit quality and the reliability of
their payment streams. Payment of interest on asset-backed securities and repayment of principal largely depend on the cash flow generated by the assets backing the securities, as well as the deal structure (e.g., determination as to the amount of
underlying assets or other support needed to produce the cash flows necessary to service interest and make principal payments), the quality of the underlying assets, the level of credit support and the credit quality of the credit-support provider,
if any, and the reliability of various other service providers with access to the payment stream. A problem in any one of these areas can lead to a reduction in the payment stream the Manager expected the Fund to receive at the time the Fund
purchased the asset-backed security. Asset-backed securities involve risk of loss of principal if obligors of the underlying obligations default and the value of the defaulted obligations exceeds whatever credit support the securities may have.
Asset-backed securities backed by sub-prime mortgage loans, in particular, may cause the Fund to suffer significantly greater declines in value due to defaults, as sub-prime mortgage loans are typically made to less creditworthy borrowers and thus
have a higher risk of default than conventional mortgage loans. The obligations of issuers (and obligors of asset-backed securities) also are subject to bankruptcy, insolvency and other laws affecting the rights and remedies of creditors. As of the
date of this Prospectus, many asset-backed securities owned by the Fund that were once rated investment grade are now rated below investment grade. See Credit Risk above for more information about credit risk.
With the deterioration of worldwide economic and liquidity conditions that occurred and became acute in 2008, the markets for asset-backed
securities became fractured, and uncertainty about the creditworthiness of those securities (and underlying assets) caused credit spreads (the difference between yields on asset-backed securities and U.S. government securities) to widen
dramatically. Concurrently, systemic risks of the type evidenced by the insolvency of Lehman Brothers and subsequent market disruptions reduced the ability of financial institutions to make markets in many fixed income securities. These events
reduced liquidity and contributed to substantial declines in the market prices of asset-backed and other fixed income securities. These conditions may occur again. Also, government actions and proposals affecting the terms of underlying home and
consumer loans, changes in demand for products (e.g., automobiles) financed by those loans, and the inability of borrowers to refinance existing loans (e.g., sub-prime mortgages) have had, and may continue to have, adverse valuation and liquidity
effects on asset-backed securities.
The market price of an asset-backed security may depend on the servicing of its underlying assets and
is, therefore, subject to risks associated with the negligence or defalcation of its servicer. In some circumstances, the mishandling of related documentation also may affect the rights of security holders in and to the underlying assets. The
insolvency of an entity that generated the assets underlying an asset-backed security is likely to result in a decline in the market price of that security, as well as costs and delays. The obligations underlying asset-backed securities, in
particular securities backed by pools of residential and commercial mortgages, also are subject to unscheduled prepayment, and the Fund may be unable to invest prepayments at as high a yield as was provided by the asset-backed security. When
interest rates rise, these obligations also may be repaid more slowly than anticipated, which could cause the market price of the Funds investment to decrease.
The risk of investing in asset-backed securities has increased since the deterioration in worldwide economic and liquidity conditions referred
to above because performance of the various sectors in which the assets underlying asset-backed securities are concentrated (e.g., auto loans, student loans, sub-prime mortgages, and credit card receivables) has become more highly correlated. See
Focused Investment Risk below for more information about risks of investing in correlated sectors. A single financial institution may serve as a trustee for many asset-backed securities. As a result, a disruption in that
institutions business may have a material impact on many investments. The risks associated with asset-backed securities are particularly pronounced for the Fund because it primarily holds asset-backed securities.
LIQUIDITY RISK.
Liquidity risk is the risk that low trading volume, lack of a market maker, large position size, or legal
restrictions (including daily price fluctuation limits or circuit breakers) limits or prevents the Fund from selling particular securities or unwinding derivative positions at desirable prices. In addition to these risks, the Fund is
exposed to liquidity risk when it has an obligation to purchase particular securities (e.g., as a result of entering into reverse repurchase agreements, writing a put, or closing a short position). The Fund is exposed to greater liquidity risk than
other GMO Funds because it has principal investment strategies that involve investment in asset-backed securities. These types of investments can be difficult to value (see Determination of Net Asset Value), exposing the Fund to the risk
that the price at which it sells them will be less than the value placed on them when they were held by the Fund. In addition, TIPS have exhibited periods of greatly reduced liquidity when disruptions in fixed income markets have
9
occurred, such as the events surrounding the bankruptcy of Lehman Brothers in 2008. Less liquid securities are more susceptible than other securities to price declines when market prices decline
generally.
The Fund may buy securities that are less liquid than those in its benchmark.
FOCUSED INVESTMENT RISK.
To the extent that the Funds investments are focused in particular countries, regions,
sectors, companies, or industries with high positive correlations to one another (e.g., different industries within broad sectors, such as technology or financial services), or in securities from issuers with high positive correlations to one
another, it is subject to greater overall risk than a fund whose investments are more diversified. To the extent the Fund invests in the securities of a limited number of issuers, it is particularly exposed to adverse developments affecting those
issuers, and a decline in the market price of a particular security held by the Fund is likely to affect the Funds performance more than if the Fund invested in the securities of a larger number of issuers.
To the extent the Fund focuses its investments in a particular type of security or sector, or in securities of companies in a particular
industry, it is vulnerable to events affecting those securities, sectors, or companies. Securities, sectors, or companies that share common characteristics are often subject to similar business risks and regulatory burdens, and often react similarly
to specific economic, market, political or other developments.
Similarly, to the extent the Fund has a significant portion of its assets
in investments tied economically to (or related to) a particular geographic region, non-U.S. country or particular market (e.g., emerging markets), it has more exposure to regional and country economic risks than funds making non-U.S. investments
throughout the world. The political and economic prospects of one country or group of countries within the same geographic region may affect other countries in that region, and a recession, debt crisis or decline in currency valuation in one country
can spread to other countries. Furthermore, companies in a particular geographic region or country are vulnerable to events affecting other companies in that region or country because they often share common characteristics, are exposed to similar
business risks and regulatory burdens, and react similarly to specific economic, market, political or other developments. See also Non-U.S. Investment Risk below.
MANAGEMENT AND OPERATIONAL RISK.
The Fund is subject to management risk because it relies on the Managers ability
to achieve its investment objective. The Fund runs the risk that the Managers investment techniques will fail to produce desired results and cause the Fund to incur significant losses. The Manager also may fail to use derivatives effectively,
choosing to hedge or not to hedge positions at disadvantageous times.
The Fund runs the risk that GMOs assessment of an investment
may be wrong. There can be no assurance that key personnel of the Manager will continue to be employed by the Manager. The loss of their services could have an adverse impact on the Managers ability to achieve the Funds investment
objective.
The Fund also is subject to the risk of loss as a result of other services provided by the Manager and other service
providers, including pricing, administrative, accounting, tax, legal, custody, transfer agency, and other services. Operational risk includes the possibility of loss caused by inadequate procedures and controls, human error, and system failures by a
service provider. For example, trading delays or errors (both human and systematic) could prevent the Fund from benefiting from potential investment gains or avoiding losses on the security. The Manager is not contractually liable to the Fund for
losses associated with operational risk absent the Managers willful misfeasance, bad faith, gross negligence, or reckless disregard of its contractual obligations to provide services to the Fund. Other Fund service providers also have
limitations on their liability to the Fund for losses resulting from their errors.
DERIVATIVES RISK.
The Fund may
invest in derivatives, which are financial contracts whose value depends on, or is derived from, the value of underlying assets, reference rates, or indices. Derivatives involve the risk that changes in their value may not move as expected relative
to the value of the assets, rates, or indices they are designed to track. Derivatives include futures, non-U.S. currency contracts, swap contracts, reverse repurchase agreements, and other over-the-counter (OTC) contracts. Derivatives
may relate to securities, interest rates, currencies or currency exchange rates, inflation rates, commodities, and indices. The SAI contains a description of the various types and uses of derivatives in the Funds investment strategies.
The use of derivatives involves risks that are in addition to, and potentially greater than, the risks of investing directly in securities and
other more traditional assets. In particular, the Funds use of OTC derivatives exposes it to the risk that the counterparties will be unable or unwilling to make timely settlement payments or otherwise honor their obligations. An OTC
derivatives contract typically can be closed only with the consent of the other party to the contract. If the counterparty defaults, the Fund will have contractual remedies but may not be able to enforce them. Because the contract for each OTC
derivative is individually negotiated, the counterparty may interpret contractual terms (e.g., the definition of default) differently than the Fund, and if it does, the Fund may decide not to pursue its claims against the counterparty to avoid
incurring the cost and unpredictability of legal proceedings. The Fund, therefore, may be unable to obtain payments the Manager believes are owed to it under OTC derivatives contracts, or those payments may be delayed or made only after the Fund has
incurred the costs of litigation.
The Fund may invest in derivatives that (i) do not require the counterparty to post collateral
(e.g., non-U.S. currency forwards), (ii) require collateral but that do not provide for the Funds security interest in it to be perfected, (iii) require a significant upfront
10
deposit by the Fund unrelated to the derivatives intrinsic value, or (iv) do not require that collateral be regularly marked-to-market. When a counterpartys obligations are not
fully secured by collateral, the Fund runs the risk of having limited recourse if the counterparty defaults. Even when obligations are required by contract to be collateralized, the Fund often will not receive the collateral the day the collateral
is called for.
The Fund may invest in derivatives with a limited number of counterparties, and events affecting the creditworthiness of
any of those counterparties may have a pronounced effect on the Fund. Derivatives risk is particularly acute in environments (like those of 2008) in which financial services firms are exposed to systemic risks of the type evidenced by the insolvency
of Lehman Brothers and subsequent market disruptions. In addition, during those periods, the Fund may have a greater need for cash to provide collateral for large swings in its mark-to-market obligations under the derivatives in which it has
invested.
Derivatives also present other risks described in this section, including market risk, liquidity risk, credit risk, and
counterparty risk. Many derivatives, in particular OTC derivatives, are complex and their valuation often requires modeling and judgment, which increases the risk of mispricing or improper valuation. The pricing models used may not produce
valuations that are consistent with the values the Fund realizes when it closes or sells an OTC derivative. Valuation risk is more pronounced when the Fund enters into OTC derivatives with specialized terms because the value of those derivatives in
some cases is determined only by reference to similar derivatives with more standardized terms. As a result, incorrect valuations may result in increased cash payments to counterparties, undercollateralization and/or errors in the calculation of the
Funds net asset value.
The Funds use of derivatives may not be effective or have the desired results. Moreover, suitable
derivatives will not be available in all circumstances. For example, the economic costs of taking some derivative positions may be prohibitive, and if a counterparty or its affiliate is deemed to be an affiliate of the Fund, the Fund will not be
permitted to trade with that counterparty. In addition, the Manager may decide not to use derivatives to hedge or otherwise reduce the Funds risk exposures, potentially resulting in losses for the Fund.
Swap contracts and other OTC derivatives are highly susceptible to liquidity risk (see Liquidity Risk above) and counterparty risk
(see Counterparty Risk below), and are subject to documentation risks. Because many derivatives have a leverage component (i.e., a notional value in excess of the assets needed to establish and/or maintain the derivative position),
adverse changes in the value or level of the underlying asset, rate or index may result in a loss substantially greater than the amount invested in the derivative itself.
The Funds use of derivatives may be subject to special tax rules and could generate additional taxable income for shareholders. See
Distributions and Taxes below.
The U.S. government recently enacted legislation that provides for new regulation of the
derivatives market, including clearing, margin, reporting, and registration requirements. Because the legislation leaves much to rule making (and many of the rules are not yet final), its ultimate impact remains unclear.
Under recently adopted rules and regulations, transactions in some types of swaps (including interest rate swaps and credit default swaps on
North American and European indices) are required to be centrally cleared. In a transaction involving those swaps (cleared derivatives), the Funds counterparty is a clearing house, rather than a bank or broker. Since the Fund is
not a member of any clearing houses and only members of a clearing house (clearing members) can participate directly in the clearing house, the Fund will hold cleared derivatives through accounts at clearing members. In cleared
derivatives transactions, the Fund will make payments (including margin payments) to and receive payments from a clearing house through its accounts at clearing members. Clearing members guarantee performance of their clients obligations to
the clearing house.
In many ways, cleared derivative arrangements are less favorable to mutual funds than bilateral arrangements. For
example, the Fund may be required to provide more margin for cleared derivatives transactions than for bilateral derivatives transactions. Also, in contrast to a bilateral derivatives transaction, following a period of notice to the Fund, a clearing
member generally can require termination of an existing cleared derivatives transaction at any time or an increase in margin requirements above the margin that the clearing member required at the beginning of a transaction. Clearing houses also have
broad rights to increase margin requirements for existing transactions or to terminate those transactions at any time. Any increase in margin requirements or termination of existing cleared derivatives transactions by the clearing member or the
clearing house could interfere with the ability of the Fund to pursue its investment strategy. Further, any increase in margin requirements by a clearing member could expose the Fund to greater credit risk to its clearing member, because (as
described under Counterparty Risk below) margin for cleared derivatives transactions in excess of a clearing houses margin requirements typically is held by the clearing member. Also, the Fund is subject to risk if it enters into a
derivatives transaction that is required to be cleared (or that the Manager expects to be cleared), and no clearing member is willing or able to clear the transaction on the Funds behalf. While the documentation in place between the Fund and
its clearing members generally provides that the clearing members will accept for clearing all cleared derivatives transactions that are within credit limits (specified in advance) for the Fund, the Fund is still subject to the risk that no clearing
member will be willing or able to clear a transaction. In those cases, the transaction might have to be terminated, and the Fund could lose some or all of the benefit of the transaction, including loss of an increase in the value of the transaction
and/or loss of hedging protection. In addition, the documentation governing the relationship between the Fund and clearing members is drafted by the clearing members and generally is less favorable to the Fund than typical bilateral derivatives
documentation. For example, documentation relating to cleared derivatives
11
generally includes a one-way indemnity by the Fund in favor of the clearing member for losses the clearing member incurs as the Funds clearing member and typically does not provide the Fund
any remedies if the clearing member defaults or becomes insolvent.
These and other new rules and regulations could, among other things,
further restrict the Funds ability to engage in, or increase the cost to the Fund of, derivatives transactions, for example, by making some types of derivatives no longer available to the Fund, increasing margin or capital requirements, or
otherwise limiting liquidity or increasing transaction costs. These regulations are new and evolving, so their potential impact on the Fund and the financial system are not yet known. While the new regulations and central clearing of some
derivatives transactions are designed to reduce systemic risk (i.e., the risk that the interdependence of large derivatives dealers could cause them to suffer liquidity, solvency or other challenges simultaneously), there is no assurance that the
new clearing mechanisms will achieve that result, and in the meantime, as noted above, central clearing exposes the Fund to new kinds of risks and costs.
COUNTERPARTY RISK.
To the extent the Fund enters into contracts with counterparties, such as repurchase or reverse
repurchase agreements or OTC derivatives contracts, or lends its securities, it runs the risk that the counterparty will be unable or unwilling to make timely settlement payments or otherwise honor its obligations. If a counterparty fails to meet
its contractual obligations, goes bankrupt, or otherwise experiences a business interruption, the Fund could miss investment opportunities or otherwise hold investments it would prefer to sell, resulting in losses for the Fund. The Fund is not
subject to any limits on its exposure to any one counterparty nor to a requirement that counterparties maintain a specific rating by a nationally recognized rating organization to be considered for potential transactions. To the extent that
GMOs view with respect to a particular counterparty changes (whether due to external events or otherwise), existing transactions are not required to be terminated or modified. Additionally, new transactions may be entered into with a
counterparty that is no longer considered eligible if the transaction is primarily designed to reduce the overall risk of potential exposure to that counterparty (for example, re-establishing the transaction with a lesser notional amount).
Counterparty risk is pronounced during unusually adverse market conditions and is particularly acute in environments (like those of 2008) in which financial services firms are exposed to systemic risks of the type evidenced by the insolvency of
Lehman Brothers and subsequent market disruptions.
Participants in OTC derivatives markets typically are not subject to the same level of
credit evaluation and regulatory oversight as are members of exchange-based markets, and, therefore, OTC derivatives generally expose the Fund to greater counterparty risk than exchange-traded derivatives. The Fund is subject to the risk that a
counterparty will not settle a derivative in accordance with its terms because of a dispute over the terms of the contract (whether or not bona fide) or because of a credit or liquidity problem. If a counterpartys obligation to the Fund is not
collateralized, then the Fund is essentially an unsecured creditor of the counterparty. If a counterparty defaults, the Fund will have contractual remedies, but the Fund may be unable to enforce them, thus causing the Fund to suffer a loss.
Counterparty risk is greater for derivatives with longer maturities because of the longer time that events may occur that prevent settlement. Counterparty risk also is greater when the Fund has concentrated its derivatives with a single or small
group of counterparties as it sometimes does as a result of its use of swaps and other OTC derivatives. Significant exposure to a single counterparty increases the Funds counterparty risk. To the extent the Fund uses swap contracts, it is
subject, in particular, to the creditworthiness of the counterparties because some types of swap contracts have durations longer than six months (and, in some cases, decades). The creditworthiness of a counterparty may be adversely affected by
greater than average volatility in the markets, even if the counterpartys net market exposure is small relative to its capital. Counterparty risk still exists even if a counterpartys obligations are secured by collateral because the
Funds interest in the collateral may not be perfected or additional collateral may not be promptly posted as required.
The Fund
also is subject to counterparty risk because it executes its securities transactions through brokers and dealers. If a broker or dealer fails to meet its contractual obligations, goes bankrupt, or otherwise experiences a business interruption, the
Fund could miss investment opportunities or be unable to dispose of investments it would prefer to sell, resulting in losses for the Fund.
Counterparty risk with respect to derivatives will be affected by new rules and regulations affecting the derivatives market. As described
under Derivatives Risk above, some derivatives transactions are required to be centrally cleared, and a party to a cleared derivatives transaction is subject to the credit risk of the clearing house and the clearing member through which
it holds its cleared position, rather than the credit risk of its original counterparty to the derivatives transaction. Credit risk of market participants with respect to derivatives that are centrally cleared is concentrated in a few clearing
houses, and it is not clear how an insolvency proceeding of a clearing house would be conducted and what impact an insolvency of a clearing house would have on the financial system. A clearing member is obligated by contract and by applicable
regulation to segregate all funds received from customers with respect to cleared derivatives transactions from the clearing members proprietary assets. However, all funds and other property received by a clearing member from its customers
with respect to cleared derivatives are generally held by the clearing member on a commingled basis in an omnibus account, and the clearing member may invest those funds in certain instruments permitted under the applicable regulations. Therefore,
the Fund might not be fully protected in the event of the bankruptcy of the Funds clearing member because the Fund would be limited to recovering only a pro rata share of all available funds segregated on behalf of the clearing members
customers for a relevant account class. Also, the clearing member is required to transfer to the clearing house the amount of margin required by the clearing house for cleared derivatives, which amounts are generally held in an omnibus account at
the clearing house for all customers of the clearing member. Regulations promulgated by the Commodities Futures Trading Commission require that the clearing member notify the clearing house of the initial margin provided by the clearing member to
the clearing house that is
12
attributable to each customer. However, if the clearing member does not accurately report the Funds initial margin, the Fund is subject to the risk that a clearing house will use the
Funds assets held in an omnibus account at the clearing house to satisfy payment obligations of a defaulting customer of the clearing member to the clearing house. In addition, clearing members generally provide the clearing house the net
amount of variation margin required for cleared swaps for all of its customers in the aggregate, rather than individually for each customer. The Fund is therefore subject to the risk that a clearing house will not make variation margin payments owed
to the Fund if another customer of the clearing member has suffered a loss and is in default, and the risk that the Fund will be required to provide additional variation margin to the clearing house before the clearing house will move the
Funds cleared derivatives transactions to another clearing member. In addition, if a clearing member does not comply with the applicable regulations or its agreement with the Fund, or in the event of fraud or misappropriation of customer
assets by a clearing member, the Fund could have only an unsecured creditor claim in an insolvency of the clearing member with respect to the margin held by the clearing member.
NON-U.S. INVESTMENT RISK.
To the extent the Fund invests in non-U.S. securities, it is subject to additional and more
varied risks than if its investments were limited to U.S. securities. The securities markets of many non-U.S. countries include securities of only a limited number of companies in a limited number of industries. As a result, the market prices of
many of those securities fluctuate more than those of U.S. securities. In addition, issuers of non-U.S. securities often are not subject to the same degree of regulation as U.S. issuers. Reporting, accounting, custody, and auditing standards of
non-U.S. countries differ, in some cases significantly, from U.S. standards. Non-U.S. portfolio transactions generally involve higher commission rates, transfer taxes, and custodial costs. In addition, some jurisdictions may limit the Funds
ability to profit from short-term trading (as defined in the relevant jurisdiction).
The Fund may be subject to non-U.S. taxation,
including potentially on a retroactive basis, on (i) capital gains it realizes or dividends or interest it receives on non-U.S. investments, (ii) transactions in those investments, and (iii) the repatriation of proceeds generated from
the sale of those investments. The Fund may seek to collect a refund in respect of taxes paid to a non-U.S. country. In those cases, all or a portion of those taxes could ultimately be recovered by the Fund. However, the recovery process could take
several years and the Fund will incur expenses in its efforts to collect the refund, which will reduce the benefit of any recovery. The Funds efforts to collect a refund may not be successful, in which case the Fund will have incurred
additional expenses for no economic benefit. The Funds decision to pursue a refund is in its sole discretion, and it may decide not to pursue a refund, even if eligible.
Also, investing in non-U.S. securities exposes the Fund to the risk of nationalization, expropriation, or confiscatory taxation of assets of
their issuers, adverse changes in investment regulations, capital requirements or exchange controls (which may include suspension of the ability to transfer currency from a country), and adverse political and diplomatic developments.
In some non-U.S. markets, custody arrangements for securities provide significantly less protection than custody arrangements in U.S. markets,
and prevailing custody and trade settlement practices (e.g., the requirement to pay for securities prior to receipt) expose the Fund to credit and other risks it does not have in the U.S. with respect to participating brokers, custodians, clearing
banks or other clearing agents, escrow agents, and issuers. Fluctuations in non-U.S. currency exchange rates also will affect the market value of the Funds non-U.S. investments.
U.S. investors are required to maintain a license to invest directly in many non-U.S. markets. These licenses are often subject to
limitations, including maximum investment amounts. Once a license is obtained, the Funds ability to continue to invest directly is subject to the risk that the license will be terminated or suspended. If a license is terminated or suspended,
to obtain exposure to the market the Fund will be required to purchase American Depositary Receipts, Global Depositary Receipts, shares of other funds that are licensed to invest directly, or derivative instruments. The receipt of a non-U.S. license
by one of the Managers clients may preclude other clients, including the Fund, from obtaining a similar license, and this could limit the Funds investment opportunities. In addition, the activities of another of the Managers
clients could cause the suspension or revocation of a license and thereby limit the Funds investment opportunities.
To the extent
that the Fund invests a significant portion of its assets in securities of issuers tied economically to emerging countries (or investments related to emerging markets) , it is subject to greater non-U.S. investment risk than if it invested primarily
in more developed non-U.S. countries (or markets). The risks of investing in those securities include: greater fluctuations in currency exchange rates; increased risk of default (by both government and private issuers); greater social, economic, and
political uncertainty and instability (including the risk of war or natural disaster); increased risk of nationalization, expropriation, or other confiscation of assets of issuers of securities in the Funds portfolio; greater governmental
involvement in the economy; less governmental supervision and regulation of the securities markets and participants in those markets; controls on non-U.S. investment, capital controls and limitations on repatriation of invested capital, dividends,
interest and other income and on the Funds ability to exchange local currencies for U.S. dollars; inability to purchase and sell investments or otherwise settle security or derivative transactions (i.e., a market freeze); unavailability of
currency hedging techniques; differences in, or lack of, auditing and financial reporting standards and resulting unavailability of material information about issuers; slower clearance and settlement; difficulties in obtaining and/or enforcing legal
judgments; and significantly smaller market capitalizations of issuers.
13
MARKET DISRUPTION AND GEOPOLITICAL RISK.
The Fund is subject to the risk
that geopolitical and other events will disrupt securities markets, adversely affect global economies and markets and thereby decrease the value of the Funds investments. The wars in Iraq and Afghanistan have had a substantial effect on the
economies and securities markets of the U.S. and other countries. Terrorism in the U.S. and around the world has had a similar global impact and has increased geopolitical risk. The terrorist attacks on September 11, 2001 resulted in the
closure of some U.S. securities markets for four days, and similar attacks are possible in the future. Securities markets may be susceptible to market manipulation (e.g., the potential manipulation of the London Interbank Offered Rate (LIBOR)) or
other fraudulent trade practices, which could disrupt the orderly functioning of these markets or adversely affect the value of investments traded in these markets, including investments of the Fund. While the U.S. government has honored its credit
obligations continuously for the last 200 years, it remains possible that the U.S. could default on its obligations. While it is impossible to predict the consequences of such an unprecedented event, it is likely that a default by the U.S. would be
highly disruptive to the U.S. and global securities markets and could significantly impair the value of the Funds investments. Similarly, political events within the U.S. at times have resulted, and may in the future result, in a shutdown of
government services, which could negatively affect the U.S. economy, decrease the value of many Fund investments, and increase uncertainty in or impair the operation of the U.S. or other securities markets. The uncertainty surrounding the sovereign
debt of a significant number of European Union countries, as well as the continued existence of the European Union itself, have disrupted and may continue to disrupt markets in the U.S. and around the world. If one or more countries leave the
European Union or the European Union dissolves, the worlds securities markets likely will be significantly disrupted. Substantial government interventions (e.g., currency controls) also could negatively impact the Fund. War, terrorism,
economic uncertainty, and related geopolitical events have led, and in the future may lead, to increased short-term market volatility and may have adverse long-term effects on U.S. and world economies and markets generally. Likewise, natural and
environmental disasters, such as the earthquake and tsunami in Japan in early 2011, and systemic market dislocations of the kind surrounding the insolvency of Lehman Brothers in 2008, if repeated, would be highly disruptive to economies and markets,
adversely affecting individual companies and industries, securities markets, interest rates, credit ratings, inflation, investor sentiment, and other factors affecting the value of the Funds investments. During such market disruptions, the
Funds exposure to the risks described elsewhere in this Description of Principal Risks section will likely increase. Market disruptions, including sudden government interventions, can also prevent the Fund from implementing its
investment program for a period of time and achieving its investment objective. For example, a market disruption may adversely affect the orderly functioning of the securities markets and may cause the Funds derivatives counterparties to
discontinue offering derivatives on some underlying commodities, securities, reference rates, or indices, or to offer them on a more limited basis.
LARGE SHAREHOLDER RISK.
To the extent that a large number of shares of the Fund is held by a single shareholder (e.g., an
institutional investor or another GMO Fund) or a group of shareholders with a common investment strategy (e.g., GMO asset allocation accounts), the Fund is subject to the risk that a redemption by those shareholders of all or a large portion of
their Fund shares will adversely affect the Funds performance if it is forced to sell portfolio securities to raise the cash needed to satisfy the redemption request. In addition, GMO Funds and other accounts over which GMO has investment
discretion that invest in the Fund are not subject to restrictions on the frequency of trading of Fund shares. Other GMO Funds and separate accounts managed by the Manager for its clients may hold substantial percentages of the shares of the Fund,
and asset allocation decisions by the Manager may result in substantial redemptions from (or investments in) the Fund. These transactions may adversely affect the Funds performance to the extent that the Fund is required to sell investments
(or invest cash) at times when it would not otherwise do so. Redemptions of a large number of shares also may increase transaction costs or, by necessitating a sale of portfolio securities, accelerate the realization of taxable income and/or gains
to shareholders. They also potentially limit the use of any capital loss carryforwards and certain other losses to offset future realized capital gains (if any). In addition, to the extent the Fund invests in other GMO Funds subject to large
shareholder risk, it is indirectly subject to this risk.
NON-DIVERSIFIED FUND.
The Fund is not a
diversified investment company within the meaning of the Investment Company Act of 1940, as amended. This means it is allowed to invest in the securities of a relatively small number of issuers and/or non-U.S. currencies. As a result,
the Fund may be subject to greater credit, market and other risks, and poor performance by a single issuer may have a greater impact on its performance, than if it were diversified.
14
FUND BENCHMARK
The following section provides additional information about the Funds benchmark listed under Investment objective and the
Average Annual Total Returns table in the Fund summary:
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Benchmark
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Description
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J.P. Morgan U.S. 3 Month Cash Index
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The J.P. Morgan U.S. 3 Month Cash Index is an independently maintained and widely published index comprised of three month U.S. dollar Euro-deposits.
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STATEMENT OF ADDITIONAL INFORMATION
February 9, 2014
GMO
Short-Duration Collateral Fund
Class III:
This Statement of Additional Information (SAI) is not a prospectus. It relates to the Prospectus for Class III shares of GMO Short-Duration
Collateral Fund (the Fund) dated February 9, 2014, as amended and revised from time to time thereafter (the Prospectus), and should be read in conjunction therewith. Information from the Prospectus and the annual and
semi-annual reports to shareholders of the Fund is (or, in the case of information relating to Class III shares, will be, when available) incorporated by reference into this SAI. The Prospectus and the annual and semi-annual reports to shareholders
of the Fund may be obtained (in the case of Class III shares, when available) free of charge from GMO Trust (the Trust), 40 Rowes Wharf, Boston, Massachusetts 02110, or by calling the Trust collect at 1-617-346-7646.
Table of Contents
-i-
INVESTMENT OBJECTIVES AND POLICIES
The investment objective and principal strategies of, and risks of investing in, the Fund are described in the Prospectus. Unless otherwise indicated in the
Prospectus or this Statement of Additional Information (SAI), the investment objective and policies of the Fund may be changed without shareholder approval.
FUND INVESTMENTS
The following list indicates the types of investments that the Fund is generally permitted (but not required) to make. The Fund may, however, make other types
of investments, provided the investments are consistent with the Funds investment objective and policies and the Funds investment restrictions do not expressly prohibit it from so doing.
Investors should note that, when used in this SAI, the term invest includes both direct investing and indirect investing and the term
investments includes both direct investments and indirect investments. For instance, the Fund may invest indirectly or make indirect investments by investing in another investment company or in derivatives and synthetic instruments with
economic characteristics similar to the underlying asset. Accordingly, the following charts indicate the types of investments that the Fund is directly or indirectly permitted to make.
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U.S. Equity Securities
1
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Foreign Investments Foreign Issuers
2
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Foreign Investments Foreign Issuers (Traded on U.S. Exchanges)
2
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Foreign Investments Emerging Countries
2
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Swap Contracts and Other Two-Party Contracts
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Foreign Currency Transactions
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Debt and Other Fixed Income Securities
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1
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Debt and Other Fixed Income Securities Long and Medium Term Corporate & Government Bonds
3
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Debt and Other Fixed Income Securities Short-Term Corporate & Government Bonds
3
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Cash and Other High Quality Investments
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U.S. Government Securities and Foreign Government Securities
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Auction Rate Securities
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Asset-Backed and Related Securities
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Adjustable Rate Securities
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Below Investment Grade Securities
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Distressed or Defaulted Instruments
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Firm Commitments and When-Issued Securities
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Reverse Repurchase Agreements and Dollar Roll Agreements
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Illiquid Securities, Private Placements, Restricted Securities, and IPOs and Other Limited Opportunities
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Investments in Other Investment Companies or Other Pooled Investments
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Footnotes to Fund Investments List
1
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For more information, see, among other sections, Description of Principal Risks Market Risk Equities in the Prospectus.
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2
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For more information, see, among other sections, Description of Principal Risks Non-U.S. Investment Risk in the Prospectus and Descriptions
and Risks of Fund Investments Risks of Non-U.S. Investments herein.
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3
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For more information, see, among other sections, Descriptions and Risks of Fund Investments U.S. Government Securities and Foreign Government
Securities herein.
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(
Note
: Some of the footnotes to the above list refer investors to various risks described in the
Description of Principal Risks section of the Prospectus for more information relating to a particular type of investment included in the list. The presence of such a risk cross reference for a particular Fund investment is not intended
to indicate that such risk is a principal risk of the
2
Fund, and instead is intended to provide more information regarding the risks associated with the particular investment. Please refer to the Fund Summary and Description of
Principal Risks sections of the Prospectus for a description of the Funds principal risks.)
DESCRIPTIONS AND RISKS OF FUND INVESTMENTS
The following is a description of investment practices in which the Fund may engage and the risks associated with their use. To the extent the Fund invests in
other series of the Trust (each series of the Trust, including the Fund, a GMO Fund, and collectively, the GMO Funds) or other investment companies (collectively with any GMO Funds in which the Fund invests, the
underlying Funds), as noted in the Prospectus or in Fund Investments in this SAI, it is indirectly exposed to the investment practices of the underlying Funds in which it invests, and is therefore subject to all risks
associated with the practices of the underlying Funds.
UNLESS OTHERWISE NOTED HEREIN, THE INVESTMENT PRACTICES AND ASSOCIATED RISKS DETAILED BELOW ALSO INCLUDE THOSE TO WHICH THE FUND INDIRECTLY MAY BE EXPOSED THROUGH ITS INVESTMENT IN THE
UNDERLYING FUNDS. ANY REFERENCES TO INVESTMENTS MADE BY
THE
FUND INCLUDE THOSE THAT MAY BE MADE BOTH DIRECTLY BY THE FUND AND INDIRECTLY BY THE FUND (E.G., THROUGH ITS INVESTMENTS IN THE UNDERLYING FUNDS OR THROUGH ITS INVESTMENTS IN
DERIVATIVES OR SYNTHETIC INSTRUMENTS).
Portfolio Turnover
Based on Grantham, Mayo, Van Otterloo & Co. LLCs (GMO or the Manager) assessment of market conditions, the Manager may
trade the Funds investments more frequently at some times than at others, resulting in a higher portfolio turnover rate. Increased portfolio turnover involves correspondingly greater brokerage commissions and other transaction costs, which
will be borne directly by the Fund, and which may adversely affect the Funds performance. It also may give rise to additional taxable income for its shareholders, including through the realization of capital gains or other types of income that
are taxable to Fund shareholders when distributed by the Fund to them, unless those shareholders are themselves exempt from taxation or otherwise investing in the Fund through a tax-advantaged account. If portfolio turnover results in the
recognition of short-term capital gains, those gains, when distributed to shareholders, typically are taxed to shareholders at ordinary income tax rates. The after-tax impact of portfolio turnover is not considered when making investment decisions
for the Fund. See Distribution and Taxes in the Prospectus and Distributions and Taxes in this SAI for more information.
The historical portfolio turnover rate for the Fund is shown under the heading Financial Highlights in the Prospectus.
Diversified and Non-Diversified Portfolios
As stated in
the Prospectus, the Fund is non-diversified under the Investment Company Act of 1940, as amended (the 1940 Act) and is not required to satisfy the requirements for diversified funds. A non-diversified fund is permitted (but
is not required) to invest a higher percentage of its assets in the securities of fewer issuers. That concentration could increase the risk of loss to the Fund resulting from a decline in the market value of particular portfolio securities.
3
Investment in a non-diversified fund may entail greater risks than investment in a diversified fund.
Notwithstanding that the Fund is non-diversified, the Fund must meet diversification standards to qualify as a regulated investment
company under the Internal Revenue Code of 1986, as amended (the Code). See Taxes below for a description of these diversification standards.
Accelerated Transactions
For the Fund to take advantage
of certain available investment opportunities, the Manager may need to make investment decisions on an expedited basis. In such cases, the information available to the Manager at the time of an investment decision may be limited. The Manager may
not, therefore, have access to the detailed information necessary for a full analysis and evaluation of the investment opportunity.
Risks of Non-U.S.
Investments
General
.
Investment in non-U.S. issuers or securities principally traded outside the United States may involve
special risks due to foreign economic, political, and legal developments, including favorable or unfavorable changes in currency exchange rates, exchange control regulations (including currency blockage), expropriation, nationalization or
confiscatory taxation of assets, and possible difficulty in obtaining and enforcing judgments against foreign entities. The Fund may be subject to foreign taxes on (i) capital gains it realizes or dividends or interest it receives on non-U.S.
securities, (ii) transactions in those securities, or (iii) the repatriation of proceeds generated from the sale of those securities. Any taxes or other charges paid or incurred by the Fund in respect of its foreign securities will reduce
its yield. The Fund may seek to collect a refund in respect of taxes paid to a non-U.S. country. In those cases, all or a portion of those taxes could ultimately be recovered by the Fund. However, the recovery process could take several years and
the Fund will incur expenses in its efforts to collect the refund, which will reduce the benefit of any recovery. The Funds efforts to collect a refund may not be successful, in which case the Fund will have incurred additional expenses for no
economic benefit. The Funds decision to pursue a refund is in its sole discretion, and it may decide not to pursue a refund, even if eligible. See Taxes below for more information about other special tax considerations applicable
to non-U.S. investments.
In addition, the tax laws of some foreign jurisdictions in which the Fund may invest are unclear and interpretations of such
laws can change over time, including on a retroactive basis in which case the Fund and/or its shareholders, as applicable, could potentially incur foreign taxes on a retroactive basis. Moreover, in order to comply with guidance related to the
accounting and disclosure of uncertain tax positions under U.S. generally accepted accounting principles (GAAP), the Fund may be required to accrue for book purposes certain foreign taxes in respect of its foreign securities or other
foreign investments that it may or may not ultimately pay. Such tax accruals will reduce the Funds net asset value at the time accrued, even though, in some cases, the Fund ultimately will not pay the related tax liabilities. Conversely, the
Funds net asset value will be increased by any tax accruals that are ultimately reversed.
4
Issuers of foreign securities are subject to different, often less comprehensive, accounting, custody, reporting,
and disclosure requirements than U.S. issuers. The securities of some foreign governments, companies, and securities markets are less liquid, and at times more volatile, than comparable U.S. securities and securities markets. Foreign brokerage
commissions and related fees also are generally higher than in the United States. The Fund also may be affected by different custody and/or settlement practices or delayed settlements in some foreign markets. The laws of some foreign countries may
limit the Funds ability to invest in securities of certain issuers located in those countries. Foreign countries may have reporting requirements with respect to the ownership of securities, and those reporting requirements may be subject to
interpretation or change without prior notice to investors. While the Fund makes reasonable efforts to stay informed of foreign reporting requirements relating to the Funds foreign portfolio securities (e.g., through the Funds brokerage
contacts, publications of the Investment Company Institute, which is the national association of U.S. investment companies, the Funds custodial network, and, to the extent deemed appropriate by the Fund under the circumstances, local counsel
in the relevant foreign country), no assurance can be given that the Fund will satisfy applicable foreign reporting requirements at all times.
Emerging Countries.
The risks described above apply to an even greater extent to investments in emerging countries. The securities markets of
emerging countries are generally smaller, less developed, less liquid, and more volatile than the securities markets of the United States and developed foreign countries, and disclosure and regulatory standards in many respects are less stringent.
In addition, the securities markets of emerging countries are typically subject to a lower level of monitoring and regulation. Government enforcement of existing securities regulations is limited, and any such enforcement may be arbitrary and the
results may be difficult to predict. In addition, reporting requirements of emerging countries with respect to the ownership of securities are more likely to be subject to interpretation or changes without prior notice to investors than more
developed countries.
Many emerging countries have experienced substantial, and in some periods extremely high, rates of inflation for many years.
Inflation and rapid fluctuations in inflation rates have had and may continue to have negative effects on such countries economies and securities markets.
Economies of emerging countries generally are heavily dependent on international trade and, accordingly, have been and may continue to be affected adversely
by trade barriers, exchange controls, managed adjustments in relative currency values, and other protectionist measures imposed or negotiated by the countries with which they trade. Economies of emerging countries also have been and may continue to
be adversely affected by economic conditions in the countries with which they trade. The economies of emerging countries may be predominantly based on only a few industries or dependent on revenues from particular commodities. In many cases,
governments of emerging countries continue to exercise significant control over their economies, and government actions relative to the economy, as well as economic developments generally, may affect the capacity of creditors in those countries to
make payments on their debt obligations, regardless of their financial condition.
5
Custodial services are often more expensive and other investment-related costs higher in emerging countries than
in developed countries, which could reduce the Funds income from investments in securities or debt instruments of emerging country issuers.
Emerging countries are more likely than developed countries to experience political uncertainty and instability, including the risk of war, terrorism,
nationalization, limitations on the removal of funds or other assets, or diplomatic developments that affect U.S. investments in these countries. No assurance can be given that adverse political changes will not cause the Fund to suffer a loss of
any or all of its investments (or, in the case of fixed-income securities, interest) in emerging countries.
Special Risks of Investing in Asian
Securities.
In addition to the risks of foreign investments and emerging countries investments described above, investments in Asia are subject to other risks. The economies of Asian countries are at varying levels of development. Markets of
countries whose economies are in the early stages of development typically exhibit a high concentration of market capitalization and have less trading volume, lower liquidity, and more volatility than more developed markets. Some Asian countries
depend heavily on foreign trade. The economies of some Asian countries are not diversified and are based on only a few commodities or industries.
Investments in Asia also are susceptible to social, political, legal, and operational risks. Some countries have authoritarian or relatively unstable
governments. Some governments in the region provide less supervision and regulation of their financial markets and in some countries less financial information is available than is typical of more developed markets. Some Asian countries restrict
direct foreign investment in securities markets, and investments in securities traded on those markets may be made, if at all, only indirectly (e.g., through depositary receipts, derivatives, etc.).
Asian countries periodically experience increases in market volatility and declines in foreign currency exchange rates. Currency fluctuations affect the value
of securities because the prices of these securities are generally denominated or quoted in currencies other than the U.S. dollar. Fluctuations in currency exchange rates can also affect a countrys or companys ability to service its
debt.
Investment in particular Asian countries is subject to unique risks, yet the political and economic prospects of one country or group of countries
can affect other countries in the region. For example, the economies of some Asian countries are directly affected by Japanese capital investment in the region and by Japanese consumer demands. In addition, a recession, a debt crisis, or a decline
in currency valuation in one Asian country may spread to other Asian countries.
Special Risks of Investing in Russian Securities.
The Fund
may invest directly in the securities of Russian issuers or may have indirect exposure to Russian securities through its investment in one or more of the GMO Funds with direct investments in Russia. Investment in those securities presents many of
the same risks as investing in the securities of emerging country issuers, as described in the preceding sections. The social, political, legal, and operational risks of investing
6
in Russian issuers, and of having assets held in custody within Russia, however, may be particularly pronounced relative to investments in more developed countries. Russias system of share
registration and custody creates certain risks of loss (including the risk of total loss) that are not normally associated with investments in other securities markets.
A risk of particular note with respect to direct investment in Russian securities results from the way in which ownership of shares of companies is normally
recorded. Ownership of shares (except where shares are held through depositories that meet the requirements of the 1940 Act) is defined according to entries in the companys share register and normally evidenced by share extracts
from the register or, in certain circumstances, by formal share certificates. However, there is no central registration system for shareholders and these services are carried out by the companies themselves or by registrars located throughout
Russia. The share registrars are controlled by the issuer of the security, and investors are provided with few legal rights against such registrars. These registrars are not necessarily subject to effective state supervision, nor are they licensed
with any governmental entity. It is possible for the Fund to lose its registration through fraud, negligence, or even mere oversight. The Fund will endeavor to ensure that its interest is appropriately recorded, which may involve a custodian or
other agent inspecting the share register and obtaining extracts of share registers through regular confirmations. However, these extracts have no legal enforceability and it is possible that a subsequent illegal amendment or other fraudulent act
may deprive the Fund of its ownership rights or improperly dilute its interests. In addition, while applicable Russian regulations impose liability on registrars for losses resulting from their errors, it may be difficult for the Fund to enforce any
rights it may have against the registrar or issuer of the securities in the event of a loss of share registration. Further, significant delays or problems may occur in registering the transfer of securities, which could cause the Fund to incur
losses due to a counterpartys failure to pay for securities the Fund has delivered or the Funds inability to complete its contractual obligations because of theft or other reasons.
Also, although a Russian public enterprise having a certain minimum number of shareholders is required by law to contract out the maintenance of its
shareholder register to an independent entity that meets certain criteria, this regulation has not always been strictly enforced in practice. Because of this lack of independence, management of a company may be able to exert considerable influence
over who can purchase and sell the companys shares by illegally instructing the registrar to refuse to record transactions in the share register.
Securities Lending
The Fund may make secured loans of
its portfolio securities amounting to not more than one-third of its total assets. For these purposes, total assets include the proceeds of such loans. The risks in lending portfolio securities, as with other extensions of credit, consist of
possible delay in recovery of the securities or possible loss of rights in the collateral should the borrower fail financially, including possible impairment of the Funds ability to vote the securities. However, securities loans will be made
to broker-dealers that the Manager believes to be of relatively high credit standing pursuant to agreements requiring that the loans be collateralized by cash, liquid securities, or shares of other investment companies with a value at least equal to
the market value of the loaned securities (marked to market daily). If a loan is collateralized by U.S. government or other securities, the Fund receives a fee from the borrower. If a loan is collateralized by cash,
7
the Fund typically invests the cash collateral for its own account in one or more money market funds (in which case the Fund will bear its pro rata share of such money market funds fees and
expenses), or directly in interest-bearing, short-term securities, and typically pays a fee to the borrower that normally represents a portion of the Funds earnings on the collateral. As with other extensions of credit, the Fund bears the risk
of delay in the recovery of loaned securities and of loss of rights in the collateral should the borrower fail financially. The Fund also bears the risk that the value of investments made with collateral may decline. The Fund bears the risk of total
loss with respect to the investment of collateral.
Voting rights or rights to consent with respect to the loaned securities pass to the borrower. The
Fund has the right to call loans at any time on reasonable notice and will do so if both (i) the Manager receives adequate notice of a proposal upon which shareholders are being asked to vote, and (ii) the Manager believes that the
benefits to the Fund of voting on such proposal outweigh the benefits to the Fund of having the security remain out on loan. However, the Fund bears the risk of delay in the return of the security, impairing the Funds ability to vote on such
matters. The Manager has retained lending agents on behalf of the Fund that are compensated based on a percentage of the Funds return on its securities lending. The Fund also may pay various fees in connection with securities loans, including
shipping fees and custodian fees.
Convertible Securities
A convertible security is a security (a bond or preferred stock) that may be converted at a stated price within a specified period into a specified number of
shares of common stock of the same or a different issuer. Convertible securities are senior to common stock in a corporations capital structure, but are usually subordinated to senior debt obligations of the issuer. Convertible securities
provide holders, through their conversion feature, an opportunity to participate in increases in the market price of their underlying securities. The price of a convertible security is influenced by the market price of the underlying security, and
tends to increase as the market price rises and decrease as the market price declines. The Manager regards convertible securities as a form of equity security.
The value of a convertible security is a function of its investment value (determined by its yield in comparison with the yields of other
securities of comparable maturity and quality that do not have a conversion privilege) and its conversion value (the securitys worth, at market value, if converted into the underlying common stock). The investment value of a
convertible security is influenced by changes in interest rates, with investment value declining as interest rates increase and increasing as interest rates decline. The credit standing of the issuer and other factors also may have an effect on the
convertible securitys investment value. The conversion value of a convertible security is determined by the market price of the underlying common stock. If the conversion value is low relative to the investment value, as in the case of
broken or busted convertibles, the price of the convertible security is governed principally by its investment value. To the extent the market price of the underlying common stock approaches or exceeds the conversion price,
the price of the convertible security will be increasingly influenced by its conversion value. A convertible security generally will sell at a premium over its conversion value by the extent to which investors place value on the right to acquire the
underlying common stock while holding a fixed income security. Generally, the amount of the premium decreases as the convertible security approaches maturity.
8
A convertible security may be subject to redemption at the option of the issuer at a price established in the
convertible securitys governing instrument. If a convertible security held by the Fund is called for redemption, the Fund will be required to permit the issuer to redeem the security, convert it into the underlying common stock, or sell it to
a third party.
Warrants and Rights
Warrants and
rights generally give the holder the right to receive, upon exercise, a security of the issuer at a stated price. The Fund typically uses warrants and rights in a manner similar to its use of options on securities, as described in Options and
Futures below. Risks associated with the use of warrants and rights are generally similar to risks associated with the use of options. Unlike most options, however, warrants and rights are issued in specific amounts, and warrants generally
have longer terms than options. Warrants and rights are not likely to be as liquid as exchange-traded options backed by a recognized clearing agency. In addition, the terms of warrants or rights may limit the Funds ability to exercise the
warrants or rights at such time, or in such quantities, as the Fund would otherwise wish.
Options and Futures
The Fund may use options and futures for various purposes, including for investment purposes and as a means to hedge other investments. See Uses of
Derivatives below for more information regarding the various derivatives strategies the Fund may employ using options and futures. The use of options contracts, futures contracts, and options on futures contracts involves risk. Thus, while the
Fund may benefit from the use of options, futures, and options on futures, unanticipated changes in interest rates, securities prices, currency exchange rates, or other underlying assets or reference rates may adversely affect the Funds
performance.
Options on Securities and Indices.
The Fund may purchase and sell put and call options on equity, fixed income, or other
securities or indices in standardized exchange-traded contracts. An option on a security or index is a contract that gives the holder of the option, in return for a premium, the right (but not the obligation) to buy from (in the case of a call) or
sell to (in the case of a put) the writer of the option the security underlying the option (or the cash value of the index underlying the option) at a specified price. Upon exercise, the writer of an option on a security has the obligation to
deliver the underlying security upon payment of the exercise price or to pay the exercise price upon delivery of the underlying security. Upon exercise, the writer of an option on an index is required to pay the difference between the cash value of
the index and the exercise price multiplied by the specified multiplier for the index option.
Purchasing Options on Securities and Indices.
Among
other reasons, the Fund may purchase a put option to hedge against a decline in the value of a portfolio security. If such a decline occurs, the put option will permit the Fund to sell the security at the higher exercise price or to close out the
option at a profit. By using put options in this manner, the Fund will 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 its transaction costs. In order for a
put option purchased by the Fund to be
9
profitable, the market price of the underlying security must decline sufficiently below the exercise price to
cover the premium paid by the Fund and transaction costs.
Among other reasons, the Fund may purchase call options to hedge against an increase in the
price of securities the Fund anticipates purchasing in the future. If such a price increase occurs, a call option will permit the Fund to purchase the securities at the exercise price or to close out the option at a profit. The premium paid for the
call option, plus any transaction costs, will reduce the benefit, if any, that the Fund realizes upon exercise of the option and, unless the price of the underlying security rises sufficiently, the option may expire worthless to the Fund. Thus, for
a call option purchased by the Fund to be profitable, the market price of the underlying security must rise sufficiently above the exercise price to cover the premium paid by the Fund to the writer and transaction costs.
In the case of both call and put options, the purchaser of an option risks losing the premium paid for the option plus related transaction costs if the option
expires worthless.
Writing Options on Securities and Indices.
Because the Fund receives a premium for writing a put or call option, the Fund may
seek to increase its return by writing call or put options on securities or indices. The premium the Fund receives for writing an option will increase the Funds return in the event the option expires unexercised or is closed out at a profit.
The size of the premium the Fund receives reflects, among other things, the relationship of the market price and volatility of the underlying security or index to the exercise price of the option, the remaining term of the option, supply and demand,
and interest rates.
The Fund may write a call option on a security or other instrument held by the Fund (commonly known as writing a covered call
option). In such case, the Fund limits its opportunity to profit from an increase in the market price of the underlying security above the exercise price of the option. Alternatively, the Fund may write a call option on securities in which it
may invest but that are not currently held by the Fund (commonly known as writing a naked call option). During periods of declining securities prices or when prices are stable, writing these types of call options can be a profitable
strategy to increase the Funds income with minimal capital risk. However, when securities prices increase, the Fund is exposed to an increased risk of loss, because if the price of the underlying security or instrument exceeds the
options exercise price, the Fund will suffer a loss equal to the amount by which the market price exceeds the exercise price at the time the call option is exercised, minus the premium received. Calls written on securities that the Fund does
not own are riskier than calls written on securities owned by the Fund because there is no underlying security held by the Fund that can act as a partial hedge. When such a call is exercised, the Fund must purchase the underlying security to meet
its call obligation or make a payment equal to the value of its obligation in order to close out the option. Calls written on securities that the Fund does not own have speculative characteristics and the potential for loss is unlimited. There is
also a risk, especially with less liquid preferred and debt securities, that the securities may not be available for purchase.
The Fund also may write a
put option on a security. In so doing, the Fund assumes the risk that it may be required to purchase the underlying security for an exercise price higher than its then-
10
current market price, resulting in a loss on exercise equal to the amount by which the market price of the
security is below the exercise price minus the premium received.
OTC Options
.
The Fund also may invest in OTC options.
OTC options differ from exchange-traded options in that they are two-party contracts, with price and other terms negotiated between the buyer and seller, and generally do not have as much market liquidity as exchange-traded options.
Closing Options Transactions
.
The holder of an option may terminate its position in a put or call option it has purchased by allowing it
to expire or by exercising the option. If an option is American-style, it may be exercised on any day up to its expiration date. In contrast, a European-style option may be exercised only on its expiration date.
In addition, a holder of an option may terminate its obligation prior to the options expiration by effecting an offsetting closing transaction. In the
case of exchange-traded options, the Fund, as a holder of an option, may effect an offsetting closing sale transaction by selling an option of the same series as the option previously purchased. The Fund realizes a loss from a closing sale
transaction if the premium received from the sale of the option is less than the premium paid to purchase the option (plus transaction costs). Similarly, the Fund that has written an option may effect an offsetting closing purchase transaction by
buying an option of the same series as the option previously written. The Fund realizes a loss from a closing purchase transaction if the cost of the closing purchase transaction (option premium plus transaction costs) is greater than the premium
received from writing the option. If the Fund desires to sell a security on which it has written a call option, it will effect a closing purchase prior to or concurrently with the sale of the security. There can be no assurance, however, that a
closing purchase or sale can be effected when the Fund desires to do so.
Risk Factors in Options Transactions.
The market price of options
written by the Fund will be affected by many factors, including changes in the market price or dividend rates of underlying securities (or in the case of indices, the securities comprising such indices); changes in interest rates or exchange rates;
changes in the actual or perceived volatility of the relevant stock market and underlying securities; and the time remaining before an options expiration. The market price of an option also may be adversely affected if the market for the
option becomes less liquid. In addition, since an American-style option allows the holder to exercise its rights any time prior to the options expiration, the writer of an American-style option has no control over when it may be required to
fulfill its obligations as a writer of the option. (This risk is not present when writing a European-style option since the holder may only exercise the option on its expiration date.)
The Funds ability to use options as part of their investment programs depends on the liquidity of those instruments. In addition, a liquid market may
not exist when the Fund seeks to close out an option position. If the 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. As the writer of a call option on a portfolio security, during the options life, the Fund foregoes the opportunity to profit from increases in the market value of the security underlying the call option above the sum of the premium
and the strike price of the call, but
11
retains the risk of loss (net of premiums received) should the price of the underlying security decline. Similarly, as the writer of a call option on a securities index, the Fund foregoes the
opportunity to profit from increases in the index over the strike price of the option, though it retains the risk of loss (net of premiums received) should the price of the Funds portfolio securities decline. If the Fund writes a call option
and does not hold the underlying security or instrument, the amount of the Funds potential loss is theoretically unlimited.
An exchange-traded
option may be closed out by means of an offsetting transaction only on a national securities exchange (Exchange), which provides a secondary market for an option of the same series. If a liquid secondary market for an exchange-traded
option does not exist, the Fund might not be able to effect an offsetting closing transaction for a particular option. Reasons for the absence of a liquid secondary market on an Exchange include the following: (i) insufficient trading interest
in some options; (ii) restrictions by an Exchange on opening or closing transactions, or both; (iii) trading halts, suspensions, or other restrictions on particular classes or series of options or underlying securities; (iv) unusual
or unforeseen interruptions in normal operations on an Exchange; (v) inability to handle current trading volume; or (vi) discontinuance of options trading (or trading in a particular class or series of options) (although outstanding
options on an Exchange that were issued by the Options Clearing Corporation should continue to be exercisable in accordance with their terms). In addition, the hours of trading for options on an Exchange may not conform to the hours during which the
securities held by the Fund are traded. To the extent that the options markets close before the markets for the underlying securities, significant price and rate movements can take place in the markets for underlying securities that are not
immediately reflected in the options markets.
The Exchanges generally have established limits on the maximum number of options an investor or group of
investors acting in concert may write. The Fund, the Manager, and other funds advised by the Manager may constitute such a group. These limits could restrict the Funds ability to purchase or write options on a particular security.
An OTC option may be closed only with the counterparty, although either party may engage in an offsetting transaction that puts that party in the same
economic position as if it had closed out the option with the counterparty; however, the exposure to counterparty risk may differ. No guarantee exists that the Fund will be able to effect a closing purchase or a closing sale with respect to a
specific option at any particular time. See Swap Contracts and Other Two-Party Contracts Risk Factors in Swap Contracts, OTC Options, and Other Two-Party Contracts below for a discussion of counterparty risk and other risks
associated with investing in OTC options.
Currency Options.
The Fund may purchase and sell options on currencies. Options on currencies
possess many of the same characteristics as options on securities and generally operate in a similar manner. The Fund may purchase or sell options on currencies. See Foreign Currency Transactions below for more information on the
Funds use of currency options.
Futures.
To the extent consistent with applicable law and its investment restrictions, the Fund is
permitted to invest in futures contracts may invest in futures contracts on, among other things, financial instruments (such as a U.S. government security or other fixed income security),
12
individual equity securities (single stock futures), securities indices, interest rates, currencies, inflation indices, and (to the extent the Fund is permitted to invest in
commodities and commodity-related derivatives) commodities or commodities indices. Futures contracts on securities indices are referred to herein as Index Futures. The purchase of futures contracts can serve as a long hedge, and the sale
of futures contracts can serve as a limited short hedge. The purchase and sale of futures contracts also may be used for speculative purposes.
Certain
futures contracts are physically settled (i.e., involve the making and taking of delivery of a specified amount of an underlying security or other asset). For instance, the sale of futures contracts on foreign currencies or financial instruments
creates an obligation of the seller to deliver a specified quantity of an underlying foreign currency or financial instrument called for in the contract for a stated price at a specified time. Conversely, the purchase of such futures contracts
creates an obligation of the purchaser to pay for and take delivery of the underlying foreign currency or financial instrument called for in the contract for a stated price at a specified time. In some cases, the specific instruments delivered or
taken, respectively, on the settlement date are not determined until on or near that date. That determination is made in accordance with the rules of the exchange on which the sale or purchase was made. Some futures contracts are cash settled
(rather than physically settled), which means that the purchase price is subtracted from the current market value of the instrument and the net amount, if positive, is paid to the purchaser by the seller of the futures contract and, if negative, is
paid by the purchaser to the seller of the futures contract. In particular, Index Futures are agreements pursuant to which two parties agree to take or make delivery of an amount of cash equal to the difference between the value of a securities
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 a securities index might be a function of the value of certain specified securities, no physical
delivery of these securities is made.
The purchase or sale of a futures contract differs from the purchase or sale of a security or option in that no
price or premium is paid or received. Instead, an amount of cash, U.S. government securities, or other liquid assets equal in value to a percentage of the face amount of the futures contract must be deposited with the broker. This amount is known as
initial margin. The amount of the initial margin is generally set by the market on which the contract is traded (margin requirements on foreign exchanges may be different than those on U.S. exchanges). Subsequent payments to and from the broker,
known as variation margin, are made on a daily basis as the price of the underlying futures contract fluctuates, making the long and short positions in the futures contract more or less valuable, a process known as marking to the market.
Prior to the settlement date of the futures contract, the position may be closed by taking an opposite position. A final determination of variation margin is then made, additional cash is required to be paid to or released by the broker, and the
purchaser realizes a loss or gain. In addition, a commission is paid to the broker on each completed purchase and sale.
Although some futures contracts
call for making or taking delivery of the underlying securities, currencies, commodities, or other underlying instrument, in most cases futures contracts are closed before the settlement date without the making or taking of delivery by offsetting
purchases or sales of matching futures contracts (i.e., with the same exchange, underlying financial instrument, currency, commodity, or index, and delivery month). If the price of the
13
initial sale exceeds the price of the offsetting purchase, the seller is paid the difference and realizes a gain. Conversely, if the price of the offsetting purchase exceeds the price of the
initial sale, the seller realizes a loss. Similarly, a purchase of a futures contract is closed out by selling a corresponding futures contract. If the offsetting sale price exceeds the original purchase price, the purchaser realizes a gain, and, if
the original purchase price exceeds the offsetting sale price, the purchaser realizes a loss. Any transaction costs must also be included in these calculations.
In the United States, futures contracts are traded only on commodity exchanges or boards of trade known as contract markets approved
by the Commodity Futures Trading Commission (CFTC), and must be executed through a futures commission merchant or brokerage firm that is a member of the relevant market. The Fund also may purchase futures contracts on foreign exchanges
or similar entities, which are not regulated by the CFTC and may not be subject to the same degree of regulation as the U.S. contract markets. See Additional Risks of Options on Securities, Futures Contracts, and Options on Futures Contracts
Traded on Foreign Exchanges below.
Index Futures.
To the extent consistent with applicable law and investment restrictions, the Fund
may purchase or sell Index Futures. The Fund may close open positions on a contract market on which Index Futures are traded at any time up to and including the expiration day. In general, all positions that remain open at the close of business on
that day must be settled on the next business day (based on the value of the relevant index on the expiration day). Additional or different margin requirements as well as settlement procedures may apply to foreign stock Index Futures.
Interest Rate Futures.
The Fund may engage in transactions involving the use of futures on interest rates. These transactions may be in
connection with investments in U.S. government securities and other fixed income securities.
Inflation Linked Futures.
The
Fund may engage in transactions involving inflation linked futures, including Consumer Price Index (CPI) futures, which are exchange-traded futures contracts that represent the inflation on a notional value of $1,000,000 for a period of
three months, as implied by the CPI. Inflation linked futures may be used by the Fund to hedge the inflation risk in nominal bonds (i.e., non-inflation indexed bonds) thereby creating synthetic inflation indexed bonds. The Fund also may
combine inflation linked futures with U.S. Treasury futures contracts to create synthetic inflation indexed bonds issued by the U.S. Treasury. See Indexed Investments Inflation Indexed Bonds below for a discussion of
inflation indexed bonds.
Currency Futures.
The Fund may buy and sell futures contracts on currencies. See Foreign Currency
Transactions below for a description of the Funds use of currency futures.
Options on Futures Contracts.
Options on futures
contracts give the purchaser the right in return for the premium paid to assume a long position (in the case of a call option) or a short position (in the case of a put option) in a futures contract at the option exercise price at any time during
the period of the option (in the case of an American-style option) or on the expiration date (in the case of European-style option). Upon exercise of a call option, the holder acquires a long
14
position in the futures contract and the writer is assigned the opposite short position. In the case of a put option, the holder acquires a short position and the writer is assigned the opposite
long position in the futures contract. Accordingly, in the event that an option is exercised, the parties will be subject to all the risks associated with the trading of futures contracts, such as payment of initial and variation margin deposits.
The Fund may use options on futures contracts in lieu of writing or buying options directly on the underlying securities or purchasing and selling the
underlying futures contracts. For example, to hedge against a possible decrease in the value of its portfolio securities, the Fund may purchase put options or write call options on futures contracts rather than selling futures contracts. Similarly,
the Fund may hedge against a possible increase in the price of securities the Fund expects to purchase by purchasing call options or writing put options on futures contracts rather than purchasing futures contracts. In addition, the Fund may
purchase and sell interest rate options on U.S. Treasury or Eurodollar futures to take a long or short position on interest rate fluctuations. Options on futures contracts generally operate in the same manner as options purchased or written directly
on the underlying investments. See Foreign Currency Transactions below for a description of the Funds use of options on currency futures.
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 may
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.
A position in an option on a futures contract may be terminated by the purchaser or seller prior to expiration by effecting a closing purchase or sale
transaction, subject to the availability of a liquid secondary market, which is the purchase or sale of an option of the same type (i.e., the same exercise price and expiration date) as the option previously purchased or sold. The difference between
the premiums paid and received represents the Funds profit or loss on the transaction.
Risk Factors in Futures and Futures Options
Transactions
.
Investment in futures contracts involves risk. A purchase or sale of futures contracts may result in losses in excess of the amount invested in the futures contract. If a futures contract is used for hedging, an
imperfect correlation between movements in the price of the futures contract and the price of the security, currency, or other investment being hedged creates risk. Correlation is higher when the investment being hedged underlies the futures
contract. Correlation is lower when the investment being hedged is different than the security, currency, or other investment underlying the futures contract, such as when a futures contract on an index of securities or commodities is used to hedge
a single security or commodity, a futures contract on one security (e.g., U.S. Treasury bonds) or commodity (e.g., gold) is used to hedge a different security (e.g., a mortgage-backed security) or commodity (e.g., copper), or when a futures contract
in one currency is used to hedge a security denominated in another currency. In the case of Index Futures and futures on commodity indices, changes in the price of those futures contracts may not correlate perfectly with price movements in the
relevant index due to market distortions. In the event of an imperfect correlation between a futures position and the portfolio position (or anticipated position) intended to be hedged, the Fund may realize a loss on the futures contract at the same
15
time the Fund is realizing a loss on the portfolio position intended to be hedged. To compensate for imperfect correlations, the Fund may purchase or sell futures contracts in a greater amount
than the hedged investments if the volatility of the price of the hedged investments is historically greater than the volatility of the futures contracts. Conversely, the Fund may purchase or sell fewer futures contracts if the volatility of the
price of the hedged investments is historically less than that of the futures contract. The successful use of transactions in futures and related options for hedging also depends on the direction and extent of exchange rate, interest rate, and asset
price movements within a given time frame. For example, to the extent equity prices remain stable during the period in which a futures contract or option is held by the Fund investing in equity securities (or such prices move in a direction opposite
to that anticipated), the Fund may realize a loss on the futures transaction, which is not fully or partially offset by an increase in the value of its portfolio securities. As a result, the Funds total return for such period may be less than
if it had not engaged in the hedging transaction.
All participants in the futures market are subject to margin deposit and maintenance requirements.
Instead of meeting margin calls, investors may close futures contracts through offsetting transactions, which could distort normal correlations. The margin deposit requirements in the futures market are less onerous than margin requirements in the
securities market, allowing for more speculators who may cause temporary price distortions. Trading hours for foreign stock Index Futures may not correspond perfectly to the trading hours of the foreign exchange to which a particular foreign stock
Index Future relates. As a result, the lack of continuous arbitrage may cause a disparity between the price of foreign stock Index Futures and the value of the relevant index.
The Fund may purchase futures contracts (or options on them) as an anticipatory hedge against a possible increase in the price of a currency in which
securities the Fund anticipates purchasing is denominated. In such instances, the currency may instead decline. If the Fund does not then invest in those securities, the Fund may realize a loss on the futures contract that is not offset by a
reduction in the price of the securities purchased.
The Funds ability to engage in the futures and options on futures strategies described above
depends on the liquidity of those instruments. Trading interest in various types of futures and options on futures cannot be predicted. Therefore, no assurance can be given that the Fund will be able to utilize these instruments at all or that their
use will be effective. In addition, a liquid market may not exist at a time when the Fund seeks to close out a futures or option on a futures contract position, and the Fund would remain obligated to meet margin requirements until the position is
closed. The liquidity of a secondary market in a futures contract may be adversely affected by daily price fluctuation limits established by commodity exchanges to limit the amount of fluctuation in a futures contract price during a
single trading day. Once the daily limit has been reached, no trades of the contract may be entered at a price beyond the limit, thus preventing the liquidation of open futures positions. In the past, prices have exceeded the daily limit on several
consecutive trading days. Short (and long) positions in Index Futures or futures on commodities indices may be closed only by purchasing (or selling) a futures contract on the exchange on which the Index Futures or commodity futures, as applicable,
are traded.
16
As discussed above, if the Fund purchases or sells a futures contract, it is only required to deposit initial and
variation margin as required by relevant CFTC regulations and the rules of the contract market. The Funds net asset value will generally fluctuate with the value of the security or other instrument underlying a futures contract as if it were
already in the Funds portfolio. Futures transactions can have the effect of investment leverage. Furthermore, if the Fund combines short and long positions, in addition to possible declines in the values of its investment securities, the Fund
will incur losses if the index underlying the long futures position underperforms the index underlying the short futures position.
In addition, if the
Funds futures brokers become bankrupt or insolvent, or otherwise default on their obligations to the Fund, the Fund may not receive all amounts owing to it in respect of its trading, despite the futures clearinghouse fully discharging all of
its obligations. Furthermore, in the event of the bankruptcy of a futures broker, the Fund could be limited to recovering only a pro rata share of all available funds segregated on behalf of the futures brokers combined customer accounts, even
though certain property specifically traceable to the Fund was held by the futures broker.
Additional Risks of Options on Securities,
Futures Contracts, and Options on Futures Contracts Traded on Foreign Exchanges.
Options on securities, futures contracts, options on futures contracts, and options on currencies may be traded on foreign exchanges. Such transactions
may not be regulated as effectively as similar transactions in the United States (which are regulated by the CFTC) and may be subject to greater risks than trading on domestic exchanges. For example, some foreign exchanges may be principal markets
so that no common clearing facility exists and a trader may look only to the broker for performance of the contract. The lack of a common clearing facility creates counterparty risk. If a counterparty defaults, the Fund normally will have
contractual remedies against that counterparty, but may be unsuccessful in enforcing those remedies. When seeking to enforce a contractual remedy, the Fund also is subject to the risk that the parties may interpret contractual terms (e.g., the
definition of default) differently. Counterparty risk is greater for derivatives with longer maturities where events may intervene to prevent settlement. Counterparty risk is also greater when the Fund has concentrated its derivatives with a single
or small group of counterparties as it sometimes does as a result of its use of swaps and other OTC derivatives. To the extent the Fund has significant exposure to a single counterparty, this risk will be particularly pronounced for the Fund. If a
dispute occurs, the cost and unpredictability of the legal proceedings required for the Fund to enforce its contractual rights may lead the Fund to decide not to pursue its claims against the counterparty. The Fund thus assumes the risk that it may
be unable to obtain payments owed under foreign futures contracts or that those payments may be delayed or made only after the Fund has incurred the costs of litigation. In addition, unless the Fund hedges against fluctuations in the exchange rate
between the currencies in which trading is done on foreign exchanges and other currencies, any profits that the Fund might realize in trading could be offset (or worse) by adverse changes in the exchange rate. The value of foreign options and
futures also may be adversely affected by other factors unique to foreign investing (see Risks of Non-U.S. Investments above).
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Swap Contracts and Other Two-Party Contracts
The Fund may use swap contracts (or swaps) and other two-party contracts for the same or similar purposes as options and futures. See Uses of
Derivatives below for more information regarding the various derivatives strategies the Fund may employ using swap contracts and other two-party contracts.
Swap Contracts.
The Fund may directly or indirectly use various different types of swaps, such as swaps on securities and securities indices,
total return swaps, interest rate swaps, currency swaps, credit default swaps, variance swaps, commodity swaps, inflation swaps, and other types of available swap agreements. Swap contracts are two-party contracts entered into primarily by
institutional investors for periods ranging from a few weeks to a number of years. Under a typical swap, one party may agree to pay a fixed rate or a floating rate determined by reference to a specified instrument, rate, or index, multiplied in each
case by a specified amount (notional amount), while the other party agrees to pay an amount equal to a different floating rate multiplied by the same notional amount. On each payment date, the parties obligations are netted, with
only the net amount paid by one party to the other.
Swap contracts are typically individually negotiated and structured to provide exposure to a variety
of different types of investments or market factors. Swap contracts may be entered into for hedging or non-hedging purposes and therefore may increase or decrease the Funds exposure to the underlying instrument, rate, asset or index. Swaps can
take many different forms and are known by a variety of names. The Fund is not limited to any particular form or variety of swap agreement if the Manager determines it is consistent with the Funds investment objective and policies.
The Fund may enter into swaps on securities, baskets of securities or securities indices. For example, the parties to a swap contract may agree to exchange
returns calculated on a notional amount of a security, basket of securities, or securities index (e.g., S&P 500 Index). Additionally, the Fund may use total return swaps, which typically involve commitments to pay amounts computed in the same
manner as interest in exchange for a market-linked return, both based on notional amounts. The Fund may use such swaps to gain investment exposure to the underlying security or securities where direct ownership is either not legally possible or is
economically unattractive. To the extent the total return of the security, basket of securities, or index underlying the transaction exceeds or falls short of the offsetting interest rate obligation, the Fund will receive a payment from or make a
payment to the counterparty, respectively.
In addition, the Fund may enter into an interest rate swap in order to protect against declines in the value
of fixed income securities held by the Fund. In such an instance, the Fund may agree with a counterparty to pay a fixed rate (multiplied by a notional amount) and the counterparty pay a floating rate multiplied by the same notional amount. If
interest rates rise, resulting in a diminution in the value of the Funds portfolio, the Fund would receive payments under the swap that would offset, in whole or in part, such diminution in value. The Fund also may enter into swaps to modify
its exposure to particular currencies using currency swaps. For instance, the Fund may enter into a currency swap between the U.S. dollar and the Japanese Yen in order to increase or decrease its exposure to each such currency.
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The Fund may use inflation swaps (including inflation swaps tied to the CPI), which involve commitments to pay a
regular stream of inflation indexed cash payments in exchange for receiving a stream of nominal interest payments (or vice versa), where both payment streams are based on a notional amount. The nominal interest payments may be based on either a
fixed interest rate or variable interest rate, such as LIBOR. Inflation swaps may be used to hedge the inflation risk in nominal bonds (i.e., non-inflation indexed bonds), thereby creating synthetic inflation indexed bonds, or combined with U.S.
Treasury futures contracts to create synthetic inflation indexed bonds issued by the U.S. Treasury. See Indexed Investments Inflation Indexed Bonds below.
In addition, the Fund may directly or indirectly use credit default swaps to take an active long or short position with respect to the likelihood of default
by a corporate or sovereign issuer of fixed income securities (including asset-backed securities). In a credit default swap, one party pays, in effect, an insurance premium through a stream of payments to another party in exchange for the right to
receive a specified return in the event of default (or similar events) by one or more third parties on their obligations. For example, in purchasing a credit default swap, the Fund may pay a premium in return for the right to put specified bonds or
loans to the counterparty, such as a U.S. or foreign issuer or basket of such issuers, upon issuer default (or similar events) at their par (or other agreed-upon) value. The Fund, as the purchaser in a credit default swap, bears the risk that the
investment might expire worthless. It also would be subject to counterparty risk the risk that the counterparty may fail to satisfy its payment obligations to the Fund in the event of a default (or similar event) (see Risk Factors in
Swap Contracts, OTC Options, and Other Two-Party Contracts below). In addition, as a purchaser in a credit default swap, the Funds investment would only generate income in the event of an actual default (or similar event) by the issuer
of the underlying obligation. The Fund also may invest in credit default indices, which are indices that reflect the performance of a basket of credit default swaps.
The Fund also may use credit default swaps for investment purposes by selling a credit default swap, in which case the Fund will receive a premium from its
counterparty in return for the Funds taking on the obligation to pay the par (or other agreed-upon) value to the counterparty upon issuer default (or similar events). As the seller in a credit default swap, the Fund effectively adds economic
leverage to its portfolio because, in addition to its total net assets, the Fund is subject to investment exposure on the notional amount of the swap. If no event of default (or similar event) occurs, the Fund would keep the premium received from
the counterparty and generally would have no payment obligations, with the exception of an initial payment made on the credit default swap or any margin requirements with the credit default swap counterparty. For credit default swap agreements,
trigger events for payment under the agreement vary by the type of underlying investment (e.g., corporate and sovereign debt, asset-backed securities, and credit default swap indices) and by jurisdiction (e.g., United States, Europe and Asia). The
Fund may use volatility swaps. Volatility swaps involve the exchange of forward contracts on the future realized volatility of a given underlying asset, and allow the Fund to take positions on the volatility of that underlying asset. The Fund also
may use a particular type of volatility swap, known as a variance swap agreement, which involves an agreement by two parties to exchange cash flows based on the measured variance (volatility squared) of a specified underlying asset. One party agrees
to exchange a fixed rate or strike price payment for the floating rate or realized price variance on the underlying asset with respect to the
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notional amount. At inception, the strike price chosen is generally fixed at a level such that the fair value of the swap is zero. As a result, no money changes hands at the initiation of the
contract. At the expiration date, the amount paid by one party to the other is the difference between the realized price variance of the underlying asset and the strike price multiplied by the notional amount. A receiver of the realized price
variance would receive a payment when the realized price variance of the underlying asset is greater than the strike price and would make a payment when that variance is less than the strike price. A payer of the realized price variance would make a
payment when the realized price variance of the underlying asset is greater than the strike price and would receive a payment when that variance is less than the strike price. This type of agreement is essentially a forward contract on the future
realized price variance of the underlying asset.
Contracts for Differences.
Contracts for differences are swap arrangements in which the
parties agree that their return (or loss) will be based on the relative performance of two different groups or baskets of securities. Often, one or both baskets will be an established securities index. The Funds return will be based on changes
in value of theoretical long futures positions in the securities comprising one basket (with an aggregate face value equal to the notional amount of the contract for differences) and theoretical short futures positions in the securities comprising
the other basket. The Fund also may use actual long and short futures positions and achieve similar market exposure by netting the payment obligations of the two contracts. The Fund will only enter into contracts for differences (and analogous
futures positions) when the Manager believes that the basket of securities constituting the long position will outperform the basket constituting the short position. If the short basket outperforms the long basket, the Fund will realize a loss
even in circumstances when the securities in both the long and short baskets appreciate in value.
Interest Rate Caps, Floors, and
Collars.
The Fund may use interest rate caps, floors, and collars for the same or similar purposes as it uses interest rate futures contracts and related options and, as a result, will be subject to similar risks. See Options and
Futures Risk Factors in Options Transactions and Risk Factors in Futures and Futures Options Transactions above. Like interest rate swap contracts, interest rate caps, floors, and collars are two-party agreements in
which the parties agree to pay or receive interest on a notional principal amount and are generally individually negotiated with a specific counterparty. The purchaser of an interest rate cap receives interest payments from the seller to the extent
that the return on a specified index exceeds a specified interest rate. The purchaser of an interest rate floor receives interest payments from the seller to the extent that the return on a specified index falls below a specified interest rate. The
purchaser of an interest rate collar receives interest payments from the seller to the extent that the return on a specified index falls outside the range of two specified interest rates.
Swaptions
.
An option on a swap agreement, also called a swaption, is an OTC option that gives the buyer the right, but not the
obligation, to enter into a swap on a specified future date in exchange for paying a market-based premium. A receiver swaption gives the owner the right to receive the total return of a specified asset, reference rate, or index (such as a call
option on a bond). A payer swaption gives the owner the right to pay the total return of a specified asset,
20
reference rate, or index (such as a put option on a bond). Swaptions also include options that allow one of the
counterparties to terminate or extend an existing swap.
Risk Factors in Swap Contracts, OTC Options, and Other Two-Party Contracts.
The
Fund may only close out a swap, contract for differences, cap, floor, collar, or OTC option (including swaption) with its particular counterparty, and may only transfer a position with the consent of that counterparty. If a counterparty fails to
meet its contractual obligations, goes bankrupt, or otherwise experiences a business interruption, the Fund could miss investment opportunities or otherwise hold investments it would prefer to sell, resulting in losses for the Fund. If the
counterparty defaults, the Fund will have contractual remedies, but there can be no assurance that the counterparty will be able to meet its contractual obligations or that the Fund will be able to enforce its rights. For example, because the
contract for each OTC derivatives transaction is individually negotiated with a specific counterparty, the Fund is subject to the risk that a counterparty may interpret contractual terms (e.g., the definition of default) differently than the Fund.
The cost and unpredictability of the legal proceedings required for the Fund to enforce its contractual rights may lead it to decide not to pursue its claims against the counterparty. Counterparty risk is greater for derivatives with longer
maturities where events may intervene to prevent settlement. Counterparty risk is also greater when the Fund has concentrated its derivatives with a single or small group of counterparties as it sometimes does as a result of its use of swaps and
other OTC derivatives. To the extent the Fund has significant exposure to a single counterparty, this risk will be particularly pronounced for the Fund. The Fund, therefore, assumes the risk that it may be unable to obtain payments the Manager
believes are owed under an OTC derivatives contract or that those payments may be delayed or made only after the Fund has incurred the costs of litigation. In addition, counterparty risk is pronounced during unusually adverse market conditions and
is particularly acute in environments (like those of 2008) in which financial services firms are exposed to systemic risks of the type evidenced by the insolvency of Lehman Brothers and subsequent market disruptions.
The credit rating of a counterparty may be adversely affected by greater-than-average volatility in the markets, even if the counterpartys net market
exposure is small relative to its capital.
Counterparty risk with respect to derivatives will be affected by new rules and regulations affecting the
derivatives market. Some derivatives transactions are required to be centrally cleared, and a party to a cleared derivatives transaction is subject to the credit risk of the clearing house and the clearing member through which it holds its
cleared position, rather than the credit risk of its original counterparty to the derivatives transaction. Credit risk of market participants with respect to derivatives that are centrally cleared is concentrated in a few clearing houses, and
it is not clear how an insolvency proceeding of a clearing house would be conducted and what impact an insolvency of a clearing house would have on the financial system. A clearing member is obligated by contract and by applicable regulation to
segregate all funds received from customers with respect to cleared derivatives positions from the clearing members proprietary assets. However, all funds and other property received by a clearing member from its customers with respect to
cleared derivatives are generally held by the clearing member on a commingled basis in an omnibus account, and the clearing member may invest those funds in instruments permitted under the applicable regulations. Therefore, the Fund might not be
fully protected in the event of the bankruptcy of the Funds clearing member because the Fund would be limited to
21
recovering only a pro rata share of the funds held in the omnibus account for the relevant account class. Also, the clearing member is required to transfer to the clearing house the amount of
margin required by the clearing house for cleared derivatives, which amounts are generally held in an omnibus account at the clearing house for all customers of the clearing member. Regulations promulgated by the CFTC require that the clearing
member notify the clearing house of the initial margin provided by the clearing member to the clearing house that is attributable to each customer. However, if the clearing member does not accurately report the Funds initial margin, the Fund
is subject to the risk that a clearing house will use the Funds assets held in an omnibus account at the clearing house to satisfy payment obligations of a defaulting customer of the clearing member to the clearing house. In addition, clearing
members generally provide the clearing house the net amount of variation margin required for cleared swaps for all of its customers in the aggregate, rather than individually for each customer. The Fund is therefore subject to the risk that a
clearing house will not make variation margin payments owed to the Fund if another customer of the clearing member has suffered a loss and is in default, and the risk that the Fund will be required to provide additional variation margin to the
clearing house before the clearing house will move the Funds cleared derivatives transactions to another clearing member. In addition, if a clearing member does not comply with the applicable regulations or its agreement with the Fund, or in
the event of fraud or misappropriation of customer assets by a clearing member, the Fund could have only an unsecured creditor claim in an insolvency of the clearing member with respect to the margin held by the clearing member.
Additional Risk Factors in OTC Derivatives Transactions.
Participants in OTC derivatives markets typically are not subject to the same level of
credit evaluation and regulatory oversight as are members of exchange-based markets and, therefore, OTC derivatives generally expose the Fund to greater counterparty risk than exchange-traded derivatives.
Among other trading agreements, the Fund is party to International Swaps and Derivatives Association, Inc. Master Agreements (ISDA Agreements) or
other similar types of agreements with select counterparties that generally govern over-the-counter derivative transactions entered into by the Fund. The ISDA Agreements typically include representations and warranties as well as contractual terms
related to collateral, events of default, termination events, and other provisions. Termination events may include the decline in the net assets of the Fund below a certain level over a specified period of time and entitle a counterparty to elect to
terminate early with respect to some or all the transactions under the ISDA Agreement with that counterparty. Such an election by one or more of the counterparties could have a material adverse impact on the Funds operations. Due to declines
in the net assets of the Fund, one or more counterparties are entitled to terminate early but none has taken such action.
Additional Risk Factors
in Cleared Derivatives Transactions.
Under recently adopted rules and regulations, transactions in some types of swaps (including interest rate swaps and credit default swaps on North American and European indices) are required to be
centrally cleared. In a transaction involving those swaps (cleared derivatives), the Funds counterparty is a clearing house, rather than a bank or broker. Since the Fund is not a member of a clearing house and only members of a
clearing house (clearing members) can participate directly in the clearing house, the Fund will hold cleared derivatives through accounts at clearing members. In cleared derivatives positions, the Fund will make payments (including
margin payments) to and receive
22
payments from a clearing house through its accounts at clearing members. Clearing members guarantee performance of their clients obligations to the clearing house.
In many ways, cleared derivative arrangements are less favorable to mutual funds than bilateral arrangements. For example, the Fund may be required to provide
more margin for cleared derivatives positions than for bilateral derivatives positions. Also, in contrast to a bilateral derivatives position, following a period of notice to the Fund, a clearing member generally can require termination of an
existing cleared derivatives position at any time or an increase in margin requirements above the margin that the clearing member required at the beginning of a transaction. Clearing houses also have broad rights to increase margin requirements for
existing positions or to terminate those positions at any time. Any increase in margin requirements or termination of existing cleared derivatives positions by the clearing member or the clearing house could interfere with the ability of the Fund to
pursue its investment strategy. Further, any increase in margin requirements by a clearing member could expose the Fund to greater credit risk to its clearing member because margin for cleared derivatives positions in excess of a clearing
houses margin requirements typically is held by the clearing member. Also, the Fund is subject to risk if it enters into a derivatives transaction that is required to be cleared (or that the Manager expects to be cleared), and no clearing
member is willing or able to clear the transaction on the Funds behalf. While the documentation in place between the Fund and its clearing members generally provides that the clearing members will accept for clearing all cleared derivatives
transactions that are within credit limits (specified in advance) for the Fund, the Fund is still subject to the risk that no clearing member will be willing or able to clear a transaction. In those cases, the position might have to be terminated,
and the Fund could lose some or all of the benefit of the position, including loss of an increase in the value of the position and/or loss of hedging protection. In addition, the documentation governing the relationship between the Fund and clearing
members is drafted by the clearing members and generally is less favorable to the Fund than typical bilateral derivatives documentation. For example, documentation relating to cleared derivatives generally includes a one-way indemnity by the Fund in
favor of the clearing member for losses the clearing member incurs as the Funds clearing member and typically does not provide the Fund any remedies if the clearing member defaults or becomes insolvent. While futures contracts entail similar
risks, the risks likely are more pronounced for cleared swaps due to their more limited liquidity and market history.
These and other new rules and
regulations could, among other things, further restrict the Funds ability to engage in, or increase the cost to the Fund of, derivatives transactions, for example, by making some types of derivatives no longer available to the Fund, increasing
margin or capital requirements, or otherwise limiting liquidity or increasing transaction costs. These regulations are new and evolving, so their potential impact on the Fund and the financial system are not yet known. While the new regulations and
central clearing of some derivatives transactions are designed to reduce systemic risk (i.e., the risk that the interdependence of large derivatives dealers could cause them to suffer liquidity, solvency or other challenges simultaneously), there is
no assurance that the new clearing mechanisms will achieve that result, and in the meantime, as noted above, central clearing exposes the Fund to new kinds of risks and costs.
Use of Futures and Related Options, Interest Rate Floors, Caps and Collars, Certain Types of Swap Contracts and Related Instruments
Commodity Pool Operator Status.
The Fund has claimed an exclusion from the definition of commodity pool operator under the Commodity
23
Exchange Act (CEA) pursuant to Rule 4.5 under the CEA (the exclusion) promulgated by the CFTC. Accordingly, neither the Fund nor GMO (with respect to the Fund) is subject
to registration or regulation as a commodity pool operator under the CEA. To remain eligible for the exclusion, the Fund will be limited in its ability to use certain financial instruments regulated under the CEA (commodity
interests), including futures and options on futures and certain swaps transactions. In the event that the Funds investments in commodity interests are not within the thresholds set forth in the exclusion, GMO may be required to register
as a commodity pool operator with the CFTC with respect to the Fund. GMOs eligibility to claim the exclusion with respect to the Fund will be based upon, among other things, the level and scope of the Funds investment in
commodity interests, the purposes of such investments, and the manner in which the Fund holds out its use of commodity interests. The Funds ability to invest in commodity interests (including, but not limited to, futures and swaps on
broad-based securities indexes and interest rates) is limited by GMOs intention to operate the Fund in a manner that would permit GMO to continue to claim the exclusion under Rule 4.5, which may adversely affect the Funds total return.
In the event GMO becomes unable to rely on the exclusion in Rule 4.5 and is required to register with the CFTC as a commodity pool operator with respect to the Fund, the Funds expenses may increase, adversely affecting the Funds total
return.
Foreign Currency Transactions
Currency
exchange rates may fluctuate significantly over short periods of time. They generally are determined by the forces of supply and demand in the currency exchange markets, trade balances, the relative merits of investments in different countries,
actual or perceived changes in interest rates, differences in relative values of similar assets in different currencies, long-term opportunities for investment and capital appreciation, and other complex factors. Currency exchange rates also can be
affected unpredictably as a result of intervention (or the failure to intervene) by the U.S. or foreign governments, central banks, or supranational agencies such as the International Monetary Fund, or by currency or exchange controls or political
and economic developments in the U.S. or abroad. Currencies in which the Funds assets are denominated, or in which the Fund has taken a long position, may be devalued against other currencies, resulting in a loss to the Fund. Similarly,
currencies in which the Fund has taken a short position may increase in value relative to other currencies, resulting in a loss to the Fund.
In addition,
some currencies are illiquid (e.g., emerging country currencies), and the Fund may not be able to convert these currencies into U.S. dollars, in which case the Manager may decide to purchase U.S. dollars in a parallel market where the exchange rate
is materially and adversely different. Exchange rates for many currencies (e.g., emerging country currencies) are particularly affected by exchange control regulations.
The Fund may buy or sell foreign currencies or deal in forward foreign currency contracts, currency futures contracts and related options, and options on
currencies. The Fund may use such currency instruments for hedging, investment, and/or currency risk management. Currency risk management may include taking overweighted or underweighted currency positions relative to both the securities portfolio
of the Fund and the Funds performance benchmark or index. The Fund also may purchase forward foreign exchange contracts in conjunction with U.S. dollar-denominated securities in order to create a synthetic foreign currency-denominated security
that
24
approximates desired risk and return characteristics when the non-synthetic securities either are not available in foreign markets or possess undesirable characteristics.
Forward foreign currency contracts are contracts between two parties to purchase and sell a specified quantity of a particular currency at a specified price,
with delivery and settlement to take place on a specified future date. A forward foreign currency contract can reduce the Funds exposure to changes in the value of the currency it will deliver and can increase its exposure to changes in the
value of the currency it will receive for the duration of the contract. The effect on the value of the Fund is similar to the effect of selling securities denominated in one currency and purchasing securities denominated in another currency.
Contracts to sell a particular foreign currency would limit any potential gain that might be realized by the Fund if the value of the hedged currency increases. In addition, it is not always possible to hedge fully or perfectly against currency
fluctuations affecting the value of the securities denominated in foreign currencies because the value of such securities also is likely to fluctuate because of independent factors not related to currency fluctuations. If a forward foreign currency
contract is used for hedging, an imperfect correlation between movements in the price of the forward foreign currency contract and the price of the currency or other investment being hedged creates risk.
Forward foreign currency contracts involve a number of the same characteristics and risks as currency futures contracts (discussed below) but there also are
several differences. Forward foreign currency contracts settle only at the pre-determined settlement date. This can result in deviations between forward foreign currency prices and currency futures prices, especially in circumstances where interest
rates and currency futures prices are positively correlated. Second, in the absence of exchange trading and involvement of clearing houses, there are no standardized terms for forward currency contracts. Accordingly, the parties are free to
establish such settlement times and underlying amounts of a currency as desirable, which may vary from the standardized provisions available through any currency futures contract.
The Fund also may purchase or sell currency futures contracts and related options. Currency futures contracts are contracts to buy or sell a standard quantity
of a particular currency at a specified future date and price. However, currency futures can be and often are closed out prior to delivery and settlement. In addition, the Fund may use options on currency futures contracts, which give their holders
the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) a specified currency futures contract at a fixed price during a specified period. See Options and Futures Futures above
for more information on futures contracts and options on futures contracts.
The Fund also may purchase or sell options on currencies. These give their
holders the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) a specified quantity of a particular currency at a fixed price during a specified period. Options on currencies possess many of
the same characteristics as options on securities and generally operate in a similar manner. They may be traded on an exchange or in the OTC markets. Options on currencies traded on U.S. or other exchanges may be subject to position limits, which
may limit the ability of the Fund to reduce foreign currency risk using options. See Options and Futures Currency Options above for more information on currency options.
25
Repurchase Agreements
The Fund may enter into repurchase agreements with banks and broker-dealers. A repurchase agreement is a contract under which the Fund acquires a security
(usually an obligation of the government in the jurisdiction where the transaction is initiated or in whose currency the agreement is denominated) for a relatively short period (usually less than a week) for cash and subject to the commitment of the
seller to repurchase the security for an agreed-upon price on a specified date. The repurchase price exceeds the acquisition price and reflects an agreed-upon market rate unrelated to the coupon rate on the purchased security. Repurchase agreements
afford the Fund the opportunity to earn a return on temporarily available cash without market risk, although the Fund bears the risk of a sellers failure to meet its obligation to pay the repurchase price when it is required to do so. Such a
default may subject the Fund to expenses, delays, and risks of loss including: (i) possible declines in the value of the underlying security while the Fund seeks to enforce its rights thereto, (ii) possible reduced levels of income and
lack of access to income during this period, and (iii) the inability to enforce its rights and the expenses involved in attempted enforcement. Entering into repurchase agreements entails certain risks, which include the risk that the
counterparty to the repurchase agreement may not be able to fulfill its obligations, as discussed above, that the parties may disagree as to the meaning or application of contractual terms, or that the instrument may not perform as expected. See
Description of Principal Risks Counterparty Risk in the Prospectus.
Debt and Other Fixed Income Securities Generally
Debt and other fixed income securities include fixed and floating rate securities of any maturity. Fixed rate securities pay a specified rate of interest or
dividends. Floating rate securities pay a rate that is adjusted periodically by reference to a specified index or market rate. Fixed and floating rate securities include securities issued by federal, state, local, and foreign governments and related
agencies, and by a wide range of private issuers, and generally are referred to in this SAI as fixed income securities. Indexed bonds are a type of fixed income security whose principal value and/or interest rate is adjusted periodically
according to a specified instrument, index, or other statistic (e.g., another security, inflation index, currency, or commodity). See Adjustable Rate Securities and Indexed Investments below. In addition, the Fund may create
synthetic bonds which approximate desired risk and return profiles. This may be done where a non-synthetic security having the desired risk/return profile either is unavailable (e.g., short-term securities of certain foreign
governments) or possesses undesirable characteristics (e.g., interest payments on the security would be subject to foreign withholding taxes). See, for example, Options and Futures Inflation-Linked Futures above.
Holders of fixed income securities are exposed to both market and credit risk. Market risk (or interest rate risk) relates to changes in a
securitys value as a result of changes in interest rates. In general, the values of fixed income securities increase when interest rates fall and decrease when interest rates rise. Credit risk relates to the ability of an issuer to make
payments of principal and interest. Obligations of issuers are subject to bankruptcy, insolvency and other laws that affect the rights and remedies of creditors. Fixed income securities denominated in foreign currencies also are subject to the risk
of a decline in the value of the denominating currency.
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Because interest rates vary, the future income of the Fund that invests in floating rate fixed income securities
cannot be predicted with certainty. To the extent the Fund invests in indexed securities, the future income of the Fund also will be affected by changes in those securities indices over time (e.g., changes in inflation rates, currency rates,
or commodity prices).
The Fund may invest in a wide range of debt and fixed income instruments, including, but not limited to, Asset-Backed and
Mortgage-Backed Securities, U.S. Government and Foreign Government Securities and Zero Coupon Securities, described below.
Cash and Other High Quality
Investments
The Fund may temporarily invest a portion of its assets in cash or cash items pending other investments or to maintain liquid assets
required in connection with some of the Funds investments. These cash items and other high quality debt securities may include money market instruments, such as securities issued by the United States Government and its agencies, bankers
acceptances, commercial paper, and bank certificates of deposit. If a custodian holds cash on behalf of the Fund, the Fund may be an unsecured creditor in the event of the insolvency of the custodian. In addition, the Fund will be subject to credit
risk with respect to such a custodian, which may be heightened to the extent the Fund takes a temporary defensive position.
U.S. Government Securities
and Foreign Government Securities
U.S. government securities include securities issued or guaranteed by the U.S. government or its authorities,
agencies, or instrumentalities. Foreign government securities include securities issued or guaranteed by foreign governments (including political subdivisions) or their authorities, agencies, or instrumentalities or by supra-national agencies.
Different kinds of U.S. government securities and foreign government securities have different kinds of government support. For example, some U.S. government securities (e.g., U.S. Treasury bonds) are supported by the full faith and credit of the
United States. Other U.S. government securities are issued or guaranteed by federal agencies or government-chartered or -sponsored enterprises but are neither guaranteed nor insured by the U.S. government (e.g., debt securities issued by the Federal
Home Loan Mortgage Corporation (Freddie Mac), Federal National Mortgage Association (Fannie Mae), and Federal Home Loan Banks (FHLBs)). Similarly, some foreign government securities are supported by the full faith
and credit of a foreign national government or political subdivision and some are not. Foreign government securities of some countries may involve varying degrees of credit risk as a result of financial or political instability in those countries or
the possible inability of the Fund to enforce its rights against the foreign government. As with issuers of other fixed income securities, sovereign issuers may be unable or unwilling to satisfy their obligations to pay principal or interest
payments.
Supra-national agencies are agencies whose member nations make capital contributions to support the agencies activities. Examples include
the International Bank for Reconstruction and Development (the World Bank), the Asian Development Bank, and the Inter-American Development Bank.
As with
other fixed income securities, U.S. government securities and foreign government securities expose their holders to market risk because their values typically change as interest
27
rates fluctuate. For example, the value of U.S. government securities or foreign government securities may fall during times of rising interest rates. Yields on U.S. government securities and
foreign government securities tend to be lower than those of corporate securities of comparable maturities. Generally, when interest rates on short term U.S. Treasury obligations equal or approach zero, if the Fund invests a substantial portion of
its assets in U.S. Treasury obligations, it will have a negative return unless the Manager waives or reduces its management fees.
In addition to
investing directly in U.S. government securities and foreign government securities, the Fund may purchase certificates of accrual or similar instruments evidencing undivided ownership interests in interest payments and/or principal payments of U.S.
government securities and foreign government securities. The Fund also may invest in Separately Traded Registered Interest and Principal Securities (STRIPS), which are interests in separately traded interest and principal component parts
of U.S. Treasury obligations that represent future interest payments, principal payments, or both, are direct obligations of the U.S. government, and are transferable through the federal reserve book-entry system. Certificates of accrual and similar
instruments may be more volatile than other government securities.
Auction Rate Securities
Auction rate securities consist of auction rate municipal securities and auction rate preferred securities sold through an auction process issued by closed-end
investment companies, municipalities and governmental agencies. Provided that the auction mechanism is successful, auction rate securities usually permit the holder to sell the securities in an auction at par value at specified intervals. The
dividend is reset by Dutch auction in which bids are made by broker-dealers and other institutions for a certain amount of securities at a specified minimum yield. The dividend rate set by the auction is the lowest interest or dividend
rate that covers all securities offered for sale. While this process is designed to permit auction rate securities to be traded at par value, there is the risk that an auction will fail due to insufficient demand for the securities.
Asset-Backed and Related Securities
An asset-backed
security is a fixed income security that predominantly derives its creditworthiness from cash flows relating to a pool of assets. There are a number of different types of asset-backed and related securities, including mortgage-backed securities,
securities backed by other pools of collateral (such as automobile loans, student loans, sub-prime mortgages, and credit- card receivables), collateralized mortgage obligations, and collateralized debt obligations, each of which is described in more
detail below. Investments in asset-backed securities are subject to all of the market risks for fixed-income securities described in the Prospectus under Description of Principal Risks Market Risk Fixed Income Investments
and elsewhere in this SAI.
Mortgage-Backed Securities.
Mortgage-backed securities are asset-backed securities backed by pools of
residential and commercial mortgages, which may include sub-prime mortgages. Mortgage-backed securities may be issued by agencies or instrumentalities of the U.S. government (including those whose securities are neither guaranteed nor insured by the
U.S. government, such as Freddie Mac, Fannie Mae, and FHLBs), foreign governments (or their agencies or instrumentalities), or non-governmental issuers. Interest and principal payments
28
(including prepayments) on the mortgage loans underlying mortgage-backed securities pass through to the holders of the mortgage-backed securities. Prepayments occur when the mortgagor on an
individual mortgage loan prepays the remaining principal before the loans scheduled maturity date. Unscheduled prepayments of the underlying mortgage loans may result in early payment of the applicable mortgage-backed securities held by the
Fund. The Fund may be unable to invest prepayments in an investment that provides as high a yield as the mortgage-backed securities. Consequently, early payment associated with mortgage-backed securities may cause these securities to experience
significantly greater price and yield volatility than traditional fixed income securities. Many factors affect the rate of mortgage loan prepayments, including changes in interest rates, general economic conditions, further deterioration of
worldwide economic and liquidity conditions, the location of the property underlying the mortgage, the age of the mortgage loan, governmental action, including legal impairment of underlying home loans, changes in demand for products financed by
those loans, the inability of borrowers to refinance existing loans (e.g., sub-prime mortgages), and social and demographic conditions. During periods of falling interest rates, the rate of mortgage loan prepayments usually increases, which tends to
decrease the life of mortgage-backed securities. During periods of rising interest rates, the rate of mortgage loan prepayments usually decreases, which tends to increase the life of mortgage-backed securities.
Mortgage-backed securities are subject to varying degrees of credit risk, depending on whether they are issued by agencies or instrumentalities of the U.S.
government (including those whose securities are neither guaranteed nor insured by the U.S. government) or by non-governmental issuers. Securities issued by private organizations may not be readily marketable, and since the deterioration of
worldwide economic and liquidity conditions that became acute in 2008, mortgage-backed securities have been subject to greater liquidity risk. These conditions may occur again. Also, government actions and proposals affecting the terms of underlying
home loans, changes in demand for products (e.g., automobiles) financed by those loans, and the inability of borrowers to refinance existing loans (e.g., sub-prime mortgages), have had, and may continue to have, adverse valuation and liquidity
effects on mortgage-backed securities. Although liquidity of mortgage-backed securities has improved recently, there can be no assurance that in the future the market for mortgage-backed securities will continue to improve and become more liquid. In
addition, mortgage-backed securities are subject to the risk of loss of principal if the obligors of the underlying obligations default in their payment obligations, and to certain other risks described in Other Asset-Backed Securities
below. The risk of defaults associated with mortgage-backed securities is generally higher in the case of mortgage-backed investments that include sub-prime mortgages. See Description of Principal Risks Market Risk Asset-Backed
Securities and Credit Risk in the Prospectus for more information regarding credit and other risks associated with investments in asset-backed securities.
Mortgage-backed securities may include Adjustable Rate Securities as such term is defined in Adjustable Rate Securities below.
Other Asset-Backed Securities.
Similar to mortgage-backed securities, other types of asset-backed securities may be issued by agencies or
instrumentalities of the U.S. government (including those whose securities are neither guaranteed nor insured by the U.S. government), foreign governments (or their agencies or instrumentalities), or non-governmental issuers. These
29
securities include securities backed by pools of automobile loans, educational loans, home equity loans, and credit-card receivables. The underlying pools of assets are securitized through the
use of trusts and special purpose entities. These securities may be subject to risks associated with changes in interest rates and prepayment of underlying obligations similar to the risks of investment in mortgage-backed securities described
immediately above. Additionally, since the deterioration of worldwide economic and liquidity conditions that became acute in 2008, asset-backed securities have been subject to greater liquidity risk. These conditions may occur again. Also,
government actions and proposals affecting the terms of underlying home and consumer loans, changes in demand for products (e.g., automobiles) financed by those loans, and the inability of borrowers to refinance existing loans (e.g., sub-prime
mortgages), have had, and may continue to have, adverse valuation and liquidity effects on asset-backed securities. Although liquidity of asset-backed securities has improved recently, there can be no assurance that in the future the market for
asset-backed securities will continue to improve and become more liquid. The risk of investing in asset-backed securities has increased because performance of the various sectors in which the assets underlying asset-backed securities are
concentrated (e.g., auto loans, student loans, sub-prime mortgages, and credit card receivables) has become more highly correlated since the deterioration in worldwide economic and liquidity conditions referred to above.
Payment of interest on asset-backed securities and repayment of principal largely depends on the cash flows generated by the underlying assets backing the
securities and, in certain cases, may be supported by letters of credit, surety bonds, or other credit enhancements. The amount of market risk associated with asset-backed securities depends on many factors, including the deal structure (i.e.,
determination as to the amount of underlying assets or other support needed to produce the cash flows necessary to service interest and make principal payments), the quality of the underlying assets, the level of credit support, if any, provided for
the securities, and the credit quality of the credit-support provider, if any. Asset-backed securities involve risk of loss of principal if obligors of the underlying obligations default in payment of the obligations and the defaulted obligations
exceed the securities credit support. The obligations of issuers (and obligors of underlying assets) also are subject to bankruptcy, insolvency and other laws affecting the rights and remedies of creditors. In addition, the existence of
insurance on an asset-backed security does not guarantee that principal and/or interest will be paid because the insurer could default on its obligations. In recent years, a significant number of asset-backed security insurers have defaulted on
their obligations.
The market value of an asset-backed security may be affected by the factors described above and other factors, such as the
availability of information concerning the pool and its structure, the creditworthiness of the servicing agent for the pool, the originator of the underlying assets, or the entities providing the credit enhancement. The market value of asset-backed
securities also can depend on the ability of their servicers to service the underlying collateral and is, therefore, subject to risks associated with servicers performance. In some circumstances, a servicers or originators
mishandling of documentation related to the underlying collateral (e.g., failure to properly document a security interest in the underlying collateral) may affect the rights of the security holders in and to the underlying collateral. In addition,
the insolvency of an entity that generated the assets underlying an asset-backed security is likely to result in a decline in the market price of that security as well as costs and delays.
30
Certain types of asset-backed securities present additional risks that are not presented by mortgage-backed
securities. In particular, certain types of asset-backed securities may not have the benefit of a security interest in the related assets. For example, many securities backed by credit-card receivables are unsecured. In addition, the Fund may invest
in securities backed by pools of corporate or sovereign bonds, bank loans made to corporations, or a combination of these bonds and loans, many of which may be unsecured (commonly referred to as collateralized debt obligations or
collateralized loan obligations ) (see Collateralized Debt Obligations (CDOs) below). Even when security interests are present, the ability of an issuer of certain types of asset-backed securities to enforce those
interests may be more limited than that of an issuer of mortgage-backed securities. For instance, automobile receivables generally are secured, but by automobiles rather than by real property. Most issuers of automobile receivables permit loan
servicers to retain possession of the underlying assets. In addition, because of the large number of underlying vehicles involved in a typical issue of asset-backed securities and technical requirements under state law, the trustee for the holders
of the automobile receivables may not have a proper security interest in all of the automobiles. Therefore, recoveries on repossessed automobiles may not be available to support payments on these securities.
In addition, certain types of asset-backed securities may experience losses on the underlying assets as a result of certain rights provided to consumer
debtors under federal and state law. In the case of certain consumer debt, such as credit-card debt, debtors are entitled to the protection of a number of state and federal consumer credit laws, many of which give such debtors the right to set off
certain amounts owed on their credit-cards (or other debt), thereby reducing their balances due. For instance, a debtor may be able to offset certain damages for which a court has determined that the creditor is liable to the debtor against amounts
owed to the creditor by the debtor on his or her credit-card.
Collateralized Mortgage Obligations (CMOs); Strips and Residuals.
A CMO is a debt obligation backed by a portfolio of mortgages or mortgage-backed securities held under an indenture. The issuer of a CMO generally pays interest and prepaid principal on a monthly basis. These payments are secured by the
underlying portfolio, which typically includes mortgage pass-through securities guaranteed by Freddie Mac, Fannie Mae, or the Government National Mortgage Association (Ginnie Mae) and their income streams, and which also may include
whole mortgage loans and private mortgage bonds.
CMOs are issued in multiple classes, often referred to as tranches. Each class has a
different maturity and is entitled to a different schedule for payments of principal and interest, including pre-payments.
In a typical CMO transaction,
the issuer of the CMO bonds uses proceeds from the CMO offering to buy mortgages or mortgage pass-through certificates (the Collateral). The issuer then pledges the Collateral to a third party trustee as security for the CMOs. The issuer
uses principal and interest payments from the Collateral to pay principal on the CMOs, paying the tranche with the earliest maturity first. Thus, the issuer pays no principal on a tranche until all other tranches with earlier maturities are paid in
full. The early retirement of a particular class or
31
series has the same effect as the prepayment of mortgage loans underlying a mortgage-backed pass-through security.
CMOs may be less liquid and may exhibit greater price volatility than other types of mortgage- or other asset-backed securities.
The Fund also may invest in CMO residuals, which are issued by agencies or instrumentalities of the U.S. government or by private lenders of, or investors in,
mortgage loans, including savings and loan associations, homebuilders, mortgage banks, commercial banks, and investment banks. A CMO residual represents excess cash flow generated by the Collateral after the issuer of the CMO makes all required
principal and interest payments and after the issuers management fees and administrative expenses have been paid. Thus, CMO residuals have value only to the extent income from the Collateral exceeds the amount necessary to satisfy the
issuers debt obligations on all other outstanding CMOs. The amount of residual cash flow resulting from a CMO will depend on, among other things, the characterization of the mortgage assets, the coupon rate of each class of CMO, prevailing
interest rates, the amount of administrative expenses, and the pre-payment experience on the mortgage assets.
CMOs also include certificates representing
undivided interests in payments of interest-only or principal-only (IO/PO Strips) on the underlying mortgages.
IO/PO Strips and CMO residuals
tend to be more volatile than other types of securities. If the underlying securities are prepaid, holders of IO/PO Strips and CMO residuals may lose a substantial portion or the entire value of their investment. In addition, if a CMO pays interest
at an adjustable rate, the cash flows on the related CMO residual will be extremely sensitive to rate adjustments.
Collateralized Debt Obligations
(CDOs).
The Fund may invest in CDOs, which include collateralized bond obligations (CBOs), collateralized loan obligations (CLOs), and other similarly structured securities. CBOs and CLOs are asset-backed
securities. A CBO is an obligation of a trust or other special purpose vehicle backed by a pool of fixed income securities. A CLO is an obligation of a trust or other special purpose vehicle typically collateralized by a pool of loans, which may
include domestic and foreign senior secured and unsecured loans, and subordinate corporate loans, including loans that may be rated below investment-grade, or equivalent unrated loans.
For both CBOs and CLOs, the cash flows from the trust are split into two or more portions, called tranches, which vary in risk and yield. The riskier portions
are the residual, equity, and subordinate tranches, which bear some or all of the risk of default by the bonds or loans in the trust, and therefore protect the other, more senior tranches from default in all but the most severe circumstances. Since
it is partially protected from defaults, a senior tranche from a CBO trust or CLO trust typically has higher ratings and lower yields than its underlying securities, and can be rated investment grade. Despite the protection from the riskier
tranches, senior CBO or CLO tranches can experience substantial losses due to actual defaults (including collateral default), the total loss of the riskier tranches due to losses in the collateral, market anticipation of defaults, fraud by the
trust, and the illiquidity of CBO or CLO securities.
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The risks of an investment in a CDO largely depend on the type of underlying collateral securities and the
tranche in which the Fund invests. The Fund may invest in any tranche of a CBO or CLO. Typically, CBOs, CLOs and other CDOs are privately offered and sold, and thus, are not registered under the securities laws. As a result, the Fund may
characterize its investments in CDOs as illiquid, unless an active dealer market for a particular CDO allows the CDO to be purchased and sold in Rule 144A transactions. CDOs are subject to the typical risks associated with debt instruments discussed
elsewhere in this SAI and the Prospectus, including interest rate risk (which may be exacerbated if the interest rate payable on a structured financing changes based on multiples of changes in interest rates or inversely to changes in interest
rates), default risk, prepayment risk, credit risk, liquidity risk, market risk, structural risk, and legal risk Additional risks of CDOs include: (i) the possibility that distributions from collateral securities will be insufficient to make
interest or other payments; (ii) the possibility that the quality of the collateral may decline in value or default, due to factors such as the availability of any credit enhancement, the level and timing of payments and recoveries on and the
characteristics of the underlying receivables, loans, or other assets that are being securitized, remoteness of those assets from the originator or transferor, the adequacy of and ability to realize upon any related collateral, and the capability of
the servicer of the securitized assets; (iii) market and liquidity risks affecting the price of a structured finance investment, if required to be sold, at the time of sale; and (iv) if the particular structured product is invested in a
security in which the Fund is also invested, this would tend to increase the Funds overall exposure to the credit of the issuer of such securities, at least on an absolute, if not on a relative basis. In addition, due to the complex nature of
a CDO, an investment in a CDO may not perform as expected. An investment in a CDO also is subject to the risk that the issuer and the investors may interpret the terms of the instrument differently, giving rise to disputes.
The Fund may invest in covered bonds, which are debt securities issued by banks or other credit institutions that are backed by both the issuing institution
and underlying pool of assets that compose the bond (a cover pool). The cover pool for a covered bond is typically composed of residential or commercial mortgage loans or loans to public sector institutions. A covered bond may lose value
if the credit rating of the issuing bank or credit institution is downgraded or the quality of the assets in the cover pool deteriorates.
Adjustable
Rate Securities
Adjustable rate securities are securities that have interest rates that reset at periodic intervals, usually by reference to an
interest rate index or market interest rate. Adjustable rate securities include U.S. government securities and securities of other issuers. Some adjustable rate securities are backed by pools of mortgage loans. Although the rate adjustment feature
may act as a buffer to reduce sharp changes in the value of adjustable rate securities, changes in market interest rates or changes in the issuers creditworthiness may still affect their value. Because the interest rate is reset only
periodically, changes in the interest rates on adjustable rate securities may lag changes in prevailing market interest rates. Also, some adjustable rate securities (or, in the case of securities backed by mortgage loans, the underlying mortgages)
are subject to caps or floors that limit the maximum change in interest rate during a specified period or over the life of the security. Because of the rate adjustments, adjustable rate securities are less likely than
non-
33
adjustable rate securities of comparable quality and maturity to increase significantly in value when market interest rates fall.
Below Investment Grade Securities
The Fund may invest
some or all of its assets in securities or instruments rated below investment grade (that is, rated below Baa3/P-2 by Moodys Investors Service, Inc. (Moodys) or below BBB-/A-2 by Standard & Poors
(S&P) for a particular security/commercial paper, or securities unrated by Moodys or S&P that are determined by the Manager to be of comparable quality to securities so rated) at the time of purchase, including securities
in the lowest rating categories and comparable unrated securities (Below Investment Grade Securities) (commonly referred to as junk bonds). In addition, the Fund may hold securities that are downgraded to
below-investment-grade status after the time of purchase by the Fund. Many issuers of high yield debt are highly leveraged, and their relatively high debt-to-equity ratios create increased risks that their operations might not generate sufficient
cash flow to service their debt obligations. In addition, many issuers of high yield debt may be (i) in poor financial condition, (ii) experiencing poor operating results, (iii) having substantial capital needs or negative net worth,
or (iv) facing special competitive or product obsolescence problems, and may include companies involved in bankruptcy or other reorganizations or liquidation proceedings. Compared to higher quality fixed income securities, Below Investment
Grade Securities offer the potential for higher investment returns but subject holders to greater credit and market risk. The ability of an issuer of Below Investment Grade Securities to meet principal and interest payments is considered
speculative. The Funds investments in Below Investment Grade Securities are more dependent on the Managers own credit analysis than its investments in higher quality bonds. Certain of these securities may not be publicly traded, and
therefore it may be difficult to obtain information as to the true condition of the issuers. The market for Below Investment Grade Securities may be more severely affected than other financial markets by economic recession or substantial interest
rate increases, changing public perceptions, or legislation that limits the ability of certain categories of financial institutions to invest in Below Investment Grade Securities. In addition, the market may be less liquid for Below Investment Grade
Securities than for other types of securities. Reduced liquidity can affect the values of Below Investment Grade Securities, make their valuation and sale more difficult, and result in greater volatility. Because Below Investment Grade Securities
are difficult to value and are more likely to be fair valued (see Determination of Net Asset Value in the Prospectus and herein), particularly during erratic markets, the values realized on their sale may differ from the values at which
they are carried on the books of the Fund. Some Below Investment Grade Securities in which the Fund invests may be in poor standing or in default.
Securities in the lowest investment-grade category (BBB or Baa) also have some speculative characteristics. See Appendix A Commercial Paper and
Corporate Debt Ratings for more information concerning commercial paper and corporate debt ratings.
Distressed or Defaulted Instruments
The Fund may invest in securities, claims, and obligations of U.S. and non-U.S. issuers which are experiencing significant financial or business difficulties
(including companies involved in bankruptcy or other reorganization and liquidation proceedings). The Fund may purchase
34
distressed securities and instruments of all kinds, including equity and debt instruments and, in particular, loans, loan participations, claims held by trade or other creditors, bonds, notes,
non-performing and sub-performing mortgage loans, beneficial interests in liquidating trusts or other similar types of trusts, fee interests and financial interests in real estate, partnership interests and similar financial instruments, executory
contracts and participations therein, many of which are not publicly traded and which may involve a substantial degree of risk.
Investments in distressed
or defaulted instruments generally are considered speculative and may involve substantial risks not normally associated with investments in healthier companies, including adverse business, financial or economic conditions that can lead to defaulted
payments and insolvency proceedings.
In particular, defaulted obligations might be repaid, if at all, only after lengthy workout or bankruptcy
proceedings, during which the issuer might not make any interest or other payments. The amount of any recovery may be adversely affected by the relative priority of the Funds investment in the issuers capital structure. The ability to
enforce obligations may be adversely affected by actions or omissions of predecessors in interest that give rise to counterclaims or defenses, including causes of action for equitable subordination or debt recharacterization. In addition, such
investments, collateral securing such investments, and payments made in respect of such investments may be challenged as fraudulent conveyances or to be subject to avoidance as preferences under certain circumstances.
Investments in distressed securities inherently have more credit risk than do investments in similar securities and instruments of non-distressed companies,
and the degree of risk associated with any particular distressed securities may be difficult or impossible for the Manager to determine within reasonable standards of predictability. The level of analytical sophistication, both financial and legal,
necessary for successful investment in distressed securities is unusually high.
If the Managers evaluation of the eventual recovery value of a
defaulted instrument should prove incorrect, the Fund may lose a substantial portion or all of its investment or it may be required to accept cash or instruments with a value less than the Funds original investment.
Investments in financially distressed companies domiciled outside the United States involve additional risks. Bankruptcy law and creditor reorganization
processes may differ substantially from those in the United States, resulting in greater uncertainty as to the rights of creditors, the enforceability of such rights, reorganization timing and the classification, seniority and treatment of claims.
In certain developing countries, although bankruptcy laws have been enacted, the process for reorganization remains highly uncertain.
In addition,
investments in distressed or defaulted instruments can present special tax issues for the Fund. See Taxes below for more information.
Zero
Coupon Securities
To the extent the Fund invests in zero coupon fixed income securities, it accrues interest income at a fixed rate based
on initial purchase price and length to maturity, but the securities do
35
not pay interest in cash on a current basis. The Fund is required to distribute the accrued income to its shareholders, even though the Fund is not receiving the income in cash on a current
basis. Thus, the Fund may have to sell other investments to obtain cash to make income distributions (including at a time when it may not be advantageous to do so). See Taxes below. The market value of zero coupon securities is often
more volatile than that of non-zero coupon fixed income securities of comparable quality and maturity. Zero coupon securities include IO/PO Strips and STRIPS.
Indexed Investments
The Fund may invest in various
transactions and instruments that are designed to track the performance of an index (including, but not limited to, securities indices and credit default indices). Indexed securities are securities the redemption values and/or coupons of which are
indexed to a specific instrument, group of instruments, index, or other statistic. Indexed securities typically, but not always, are debt securities or deposits whose value at maturity or coupon rate is determined by reference to other securities,
securities or inflation indices, currencies, precious metals or other commodities, or other financial indicators. For example, the maturity value of gold-indexed securities depends on the price of gold and, therefore, their price tends to rise and
fall with gold prices.
While investments that track the performance of an index may increase the number, and thus the diversity, of the underlying assets
to which the Fund is exposed, such investments are subject to many of the same risks of investing in the underlying assets that comprise the index discussed elsewhere in this section, as well as certain additional risks that are not typically
associated with investments in such underlying assets. An investment that is designed to track the performance of an index may not replicate and maintain exactly the same composition and relative weightings of the assets in the index. Additionally,
the liquidity of the market for such investments may be subject to the same conditions affecting liquidity in the underlying assets and markets and could be relatively less liquid in certain circumstances. The performance of indexed securities
depends on the performance of the security, security index, inflation index, currency, or other instrument to which they are indexed. Interest rate changes in the U.S. and abroad also may influence performance. Indexed securities also are subject to
the credit risks of the issuer, and their values are adversely affected by declines in the issuers creditworthiness.
The Funds investments in
certain indexed securities, including inflation indexed bonds, may generate taxable income in excess of the interest they pay to the Fund, which may cause the Fund to sell investments to obtain cash to make income distributions to shareholders
(including at a time when it may not be advantageous to do so). See Taxes below.
Currency-Indexed Securities.
Currency-indexed
securities have maturity values or interest rates determined by reference to the values of one or more foreign currencies. Currency-indexed securities also may have maturity values or interest rates that depend on the values of a number of different
foreign currencies relative to each other.
Inverse Floating Obligations.
Indexed securities in which the Fund may invest include so-called
inverse floating obligations or residual interest bonds on which the interest rates typically decline as the index or reference rates, typically short-term interest rates, increase and
36
increase as index or reference rates decline. An inverse floating obligation may have the effect of investment leverage to the extent that its interest rate varies by a magnitude that exceeds the
magnitude of the change in the index or reference rate of interest. Generally, leverage will result in greater price volatility.
Inflation Indexed
Bonds.
The Fund may invest in inflation indexed bonds and in futures contracts on inflation indexed bonds. See Options and Futures Inflation Linked Futures above for a discussion of inflation linked futures. Inflation
indexed bonds are fixed income securities whose principal value is adjusted periodically according to the rate 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 CPI accruals as part of a semiannual coupon.
Inflation indexed securities issued by the U.S.
Treasury (or TIPS) have maturities of approximately three, five, ten, or thirty years, although it is possible that securities that have other maturities will be issued in the future. 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 indexed bond with a par value of $1,000 and a 3% real rate of return coupon (payable 1.5% semi-annually), and
the rate of inflation over the first six months was 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 inflation indexed bonds will be adjusted downward and, consequently, the
interest they pay (calculated with respect to a smaller principal amount) will be reduced. The U.S. government guarantees the repayment of the original bond principal upon maturity (as adjusted for inflation) in the case of a TIPS, even during a
period of deflation, although the inflation-adjusted principal received could be less than the inflation-adjusted principal that had accrued to the bond at the time of purchase. However, the current market value of the bonds is not guaranteed and
will fluctuate. The Fund also may invest in other inflation-related bonds which 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 indexed bonds normally changes when real interest rates change. Real interest rates, in turn, are tied to the
relationship between nominal interest rates (i.e., stated interest rates) and the rate of inflation. Therefore, if the rate of inflation rises at a faster rate than nominal interest rates, real interest rates (i.e., nominal interest rate minus
inflation) might decline, leading to an increase in value of inflation indexed bonds. In contrast, if nominal interest rates increase at a faster rate than inflation, real interest rates might rise, leading to a decrease in value of inflation
indexed bonds. There can be no assurance, however, that the value of inflation indexed bonds will change in the same proportion as changes in nominal interest rates, and short term increases in inflation may lead to a decline in their value.
37
Although inflation indexed bonds protect their holders from long-term inflationary trends, short-term increases
in inflation may result in a decline in value. In addition, inflation indexed bonds do not protect holders from increases in interest rates due to reasons other than inflation (such as changes in currency exchange rates).
The periodic adjustment of U.S. inflation indexed 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 indexed bonds issued by a foreign government are
generally adjusted to reflect changes in a comparable inflation index calculated by the foreign government. No assurance can be given that the CPI-U or any foreign inflation index will accurately measure the real rate of inflation in the prices of
goods and services. In addition, no assurance can be given that the rate of inflation in a foreign country will correlate to the rate of inflation in the United States.
Coupon payments received by the Fund from inflation indexed bonds are included in the Funds gross income for the period in which they accrue. In
addition, any increase in the principal amount of an inflation indexed bond constitutes taxable ordinary income to investors in the Fund, even though principal is not paid until maturity.
Structured Notes
Similar to indexed securities,
structured notes are derivative debt securities, the interest rate or principal of which is determined by reference to changes in the value of a specific asset, reference rate, or index (the reference) or the relative change in two or
more references. The interest rate or the principal amount payable upon maturity or redemption may increase or decrease, depending upon changes in the reference. The terms of a structured note may provide that, in certain circumstances, no principal
is due at maturity and, therefore, may result in a loss of invested capital. Structured notes may be indexed positively or negatively, so that appreciation of the reference may produce an increase or decrease in the interest rate or value of the
principal at maturity. In addition, changes in the interest rate or the value of the principal at maturity may be fixed at a specified multiple of the change in the value of the reference, making the value of the note particularly volatile.
Structured notes may entail a greater degree of market risk than other types of debt securities because the investor bears the risk of the reference.
Structured notes also may be more volatile, less liquid, and more difficult to price accurately than less complex securities or more traditional debt securities.
Firm Commitments and When-Issued Securities
The Fund may
enter into firm commitments and similar agreements with banks or broker-dealers for the purchase or sale of securities at an agreed-upon price on a specified future date. For example, if the Fund invests in fixed-income securities, it may enter into
a firm commitment agreement if the Manager anticipates a decline in interest rates and believes it is able to obtain a more advantageous future yield by committing currently to purchase securities to be issued later. The Fund generally does not earn
income on the securities it has committed to purchase until
38
after delivery. The Fund may take delivery of the securities or, if deemed advisable as a matter of investment strategy, may sell the securities before the settlement date. When payment is due on
when-issued or delayed-delivery securities, the Fund makes payment from then-available cash flow or the sale of securities, or from the sale of the when-issued or delayed-delivery securities themselves (which may have a value greater or less than
what the Fund paid for them).
Reverse Repurchase Agreements and Dollar Roll Agreements
The Fund may enter into reverse repurchase agreements and dollar roll agreements with banks and brokers to enhance return. Reverse repurchase agreements
involve sales by the Fund of portfolio securities concurrently with an agreement by the Fund to repurchase the same securities at a later date at a fixed price. During the reverse repurchase agreement period, the Fund continues to receive principal
and interest payments on the securities and also has the opportunity to earn a return on the collateral furnished by the counterparty to secure its obligation to redeliver the securities.
Dollar rolls are transactions in which the Fund sells securities for delivery in the current month and simultaneously contracts to repurchase substantially
similar (same type and coupon) securities on a specified future date. During the roll period, the Fund foregoes principal and interest paid on the securities. The Fund is compensated by the difference between the current sales price and the forward
price for the future purchase (often referred to as the drop) as well as by the interest earned on the cash proceeds of the initial sale.
If
the buyer in a reverse repurchase agreement or dollar roll agreement files for bankruptcy or becomes insolvent, the Funds use of proceeds from the sale of its securities may be restricted while the other party or its trustee or receiver
determines whether to honor the Funds right to repurchase the securities. Furthermore, in that situation the Fund may be unable to recover the securities it sold in connection with a reverse repurchase agreement and as a result would realize a
loss equal to the difference between the value of the securities and the payment it received for them. This loss would be greater to the extent the buyer paid less than the value of the securities the Fund sold to it (e.g., a buyer may only be
willing to pay $95 for a bond with a market value of $100). The Funds use of reverse repurchase agreements also subjects the Fund to interest costs based on the difference between the sale and repurchase price of a security involved in such a
transaction. Additionally, reverse repurchase agreements entail the same risks as over-the-counter derivatives. These include the risk that the counterparty to the reverse repurchase agreement may not be able to fulfill its obligations, as discussed
above, that the parties may disagree as to the meaning or application of contractual terms, or that the instrument may not perform as expected. See Description of Principal Risks Derivatives Risk and Counterparty
Risk in the Prospectus and Uses of Derivatives below. Reverse repurchase agreements and dollar rolls are not considered borrowings by the Fund for purposes of the Funds fundamental investment restriction on borrowings.
39
Illiquid Securities, Private Placements, Restricted Securities, and IPOs and Other Limited Opportunities
At the time of purchase, the Fund may invest up to 15% of its net assets in illiquid securities. For this purpose, illiquid securities are
securities that the Fund may not sell or dispose of within seven days in the ordinary course of business at approximately the amount at which the Fund has valued the securities.
A repurchase agreement maturing in more than seven days is considered illiquid, unless it can be terminated after a notice period of seven days or less.
Private Placements and Restricted Investments.
Illiquid securities include securities of private issuers, securities traded in unregulated or
shallow markets, securities issued by entities deemed to be affiliates of the Fund, and securities that are purchased in private placements and are subject to legal or contractual restrictions on resale. Because relatively few purchasers of these
securities may exist, especially in the event of adverse economic and liquidity conditions or adverse changes in the issuers financial condition, the Fund may not be able to initiate a transaction or liquidate a position in such investments at
a desirable price. Disposing of illiquid securities may involve time-consuming negotiation and legal expenses, and selling them promptly at an acceptable price may be difficult or impossible.
While private placements may offer attractive opportunities not otherwise available in the open market, the securities purchased are usually restricted
securities or are not readily marketable. Restricted securities cannot be sold without being registered under the Securities Act of 1933, as amended (the 1933 Act), unless they are sold pursuant to an exemption from
registration (such as Rules 144 or 144A). Securities that are not readily marketable are subject to other legal or contractual restrictions on resale. The Fund may have to bear the expense of registering restricted securities for resale and the risk
of substantial delay in effecting registration. The Fund selling its securities in a registered offering may be deemed to be an underwriter for purposes of Section 11 of the 1933 Act. In such event, the Fund may be liable to
purchasers of the securities under Section 11 if the registration statement prepared by the issuer, or the prospectus forming a part of it, is materially inaccurate or misleading, although the Fund may have a due diligence defense.
At times, the inability to sell illiquid securities can make it more difficult to determine their fair value for purposes of computing the Funds net
asset value. The judgment of the Manager normally plays a greater role in valuing these securities than in valuing publicly traded securities.
IPOs
and Other Limited Opportunities
.
The Fund may purchase securities of companies that are offered pursuant to an initial public offering (IPO) or other similar limited opportunities. Although companies can be any age or size
at the time of their IPO, they are often smaller and have a limited operating history, which involves a greater potential for the value of their securities to be impaired following the IPO. The price of a companys securities may be highly
unstable at the time of its IPO and for a period thereafter due to factors such as market psychology prevailing at the time of the IPO, the absence of a prior public market, the small number of shares available, and limited availability of investor
information. Securities purchased in IPOs have a tendency to fluctuate in value significantly shortly after the IPO
40
relative to the price at which they were purchased. These fluctuations could impact the net asset value and return earned on the Funds shares. Investors in IPOs can be adversely affected by
substantial dilution in the value of their shares, by sales of additional shares, and by concentration of control in existing management and principal shareholders. In addition, all of the factors that affect the performance of an economy or equity
markets may have a greater impact on the shares of IPO companies. IPO securities tend to involve greater risk due, in part, to public perception and the lack of publicly available information and trading history.
Investments in Other Investment Companies or Other Pooled Investments
Subject to applicable regulatory requirements, the Fund may invest in shares of both open- and closed-end investment companies (including other GMO Funds,
money market funds, and exchange-traded funds (ETFs)). Investing in another investment company exposes the Fund to all the risks of that investment company and, in general, subjects it to a pro rata portion of the other investment
companys fees and expenses. The Fund also may invest in private investment funds, vehicles, or structures.
ETFs are hybrid investment companies
that are registered as open-end investment companies or unit investment trusts (UITs) but possess some of the characteristics of closed-end funds. ETFs in which the Fund may invest typically hold a portfolio of common stocks that is
intended to track the price and dividend performance of a particular index. The Fund also may invest in actively-managed ETFs. Common examples of ETFs include S&P Depositary Receipts (SPDRs), Vanguard ETFs, and iShares, which may be
purchased from the UIT or investment company issuing the securities or in the secondary market (SPDRs, Vanguard ETFs, and iShares are predominantly listed on the NYSE Arca). The market price for ETF shares may be higher or lower than the ETFs
net asset value. The sale and redemption prices of ETF shares purchased from the issuer are based on the issuers net asset value.
Because ETFs are
investment companies, investments in ETFs would, absent exemptive relief, be limited under applicable statutory limitations. Those limitations restrict the Funds investment in the shares of an ETF or other investment company to up to 5% of the
Funds assets (which may represent no more than 3% of the securities of such ETF or other investment company) and limit aggregate investments in all ETFs and other investment companies to 10% of the Funds assets.
Legal and Regulatory Risk
Legal, tax, and regulatory
changes could occur during the term of the Fund that may adversely affect the Fund. New (or revised) laws or regulations or interpretations of existing law may be issued by the IRS or Treasury Department, the CFTC, the SEC, the U.S. Federal Reserve
or other banking regulators, or other governmental regulatory authorities, or self-regulatory organizations that supervise the financial markets that could adversely affect the Fund. In particular, these agencies are empowered to promulgate a
variety of new rules pursuant to recently enacted financial reform legislation in the United States. The Fund also may be adversely affected by changes in the enforcement or interpretation of existing statutes and rules by these governmental
regulatory authorities or self-regulatory organizations. In addition, the securities and futures markets are subject to comprehensive statutes, regulations, and margin
41
requirements. The CFTC, the SEC, the Federal Deposit Insurance Corporation, other regulators, and self-regulatory organizations and exchanges are authorized to take extraordinary actions in the
event of market emergencies. The regulation of derivatives transactions and funds that engage in such transactions is an evolving area of law and is subject to modification by government and judicial action.
The U.S. government recently enacted legislation that provides for new regulation of the derivatives market, including clearing, margin, reporting, and
registration requirements. The CFTC, SEC and other federal regulators have been tasked with developing the rules and regulations enacting the provisions of the Dodd-Frank Act. While certain of the rules are not effective, other rules are not yet
final, so its ultimate impact remains unclear. New regulations could, among other things, restrict the Funds ability to engage in derivatives transactions (for example, by making certain types of derivatives transactions no longer available to
the Fund) and/or increase the costs of such derivatives transactions (for example, by increasing margin or capital requirements), and the Fund may be unable to execute its investment strategy as a result.
The CFTC and certain futures exchanges have established limits, referred to as position limits, on the maximum net long or net short positions
which any person may hold or control in particular options and futures contracts (and certain related swaps positions). All positions owned or controlled by the same person or entity, even if in different accounts, may be aggregated for purposes of
determining whether the applicable position limits have been exceeded. Thus, even if the Fund does not intend to exceed applicable position limits, it is possible that different clients managed by the Manager and its affiliates may be aggregated for
this purpose. Although it is possible that the trading decisions of the Manager may have to be modified and that positions held by the Fund may have to be liquidated in order to avoid exceeding such limits, the Manager believes that this is
unlikely. The modification of investment decisions or the elimination of open positions, if it occurs, may adversely affect the profitability of the Fund.
The SEC has in the past adopted interim rules requiring reporting of all short positions above a certain de minimis threshold and may adopt rules requiring
monthly public disclosure in the future. In addition, other non-U.S. jurisdictions where the Fund may trade have adopted reporting requirements. If the Funds short positions or its strategy become generally known, it could have a significant
effect on the Managers ability to implement its investment strategy. In particular, it would make it more likely that other investors could cause a short squeeze in the securities held short by the Fund forcing the Fund to cover
its positions at a loss. Such reporting requirements also may limit the Managers ability to access management and other personnel at certain companies where the Manager seeks to take a short position. In addition, if other investors engage in
copycat behavior by taking positions in the same issuers as the Fund, the cost of borrowing securities to sell short could increase drastically and the availability of such securities to the Fund could decrease drastically. Such events could make
the Fund unable to execute its investment strategy. Short sales are also subject to certain SEC regulations. If the SEC were to adopt additional restrictions regarding short sales, they could restrict the Funds ability to engage in short sales
in certain circumstances, and the Fund may be unable to execute its investment strategy as a result.
42
The SEC and regulatory authorities in other jurisdictions may adopt (and in certain cases, have adopted) bans on
short sales of certain securities in response to market events. Bans on short selling may make it impossible for the Fund to execute certain investment strategies and may have a material adverse effect on the Funds ability to generate returns.
Pending regulations would require any creditor that makes a loan and any securitizer of a loan to retain at least 5% of the credit risk on any loan that
is transferred, sold or conveyed by such creditor or securitizer. It is currently unclear how these requirements would apply to loan participations, syndicated loans, and loan assignments. If the Fund invests in loans, it could be adversely affected
by the regulation. The effect of any future regulatory change on the Fund could be substantial and adverse.
ADDITIONAL INVESTMENT STRATEGIES
Short Sales
The Fund may seek to hedge investments or
realize additional gains through short sales. The Fund may make short sales against the box, meaning the Fund may make short sales where the Fund owns, or has the right to acquire at no added cost, securities or currencies identical to
those sold short. If the Fund makes a short sale against the box, the Fund will not immediately deliver the securities or currencies sold and will not immediately receive the proceeds from the sale. However, with respect to securities, the Fund is
required to hold securities equivalent in kind and amount to the securities sold short (or securities convertible or exchangeable into such securities) while the short sale is outstanding. Once the Fund closes out its short position by delivering
the securities or currencies sold short, it will receive the proceeds of the sale. The Fund will incur transaction costs, including interest, in connection with opening, maintaining, and closing short sales against the box.
The Fund will incur a loss as a result of a short sale if the price of the security or index or currency increases between the date of the short sale and the
date on which the Fund replaces the borrowed security or currency. The Fund will realize a gain if the price of the security or currency declines between those dates. The amount of any gain will be decreased, and the amount of any loss increased, by
the amount of the premium, dividends or interest the Fund may be required to pay in connection with a short sale. Short sales that are not against the box involve a form of investment leverage, and the amount of the Funds loss on such a short
sale is theoretically unlimited. Under adverse market conditions, the Fund may have difficulty purchasing securities or currencies to meet its short sale delivery obligations, and may have to sell portfolio securities or currencies to raise the
capital necessary to meet its short sale obligations at a time when it would be unfavorable to do so. If a request for return of borrowed securities and/or currencies occurs at a time when other short sellers of the securities and/or currencies are
receiving similar requests, a short squeeze can occur, and the Fund may be compelled to replace borrowed securities and/or currencies previously sold short with purchases on the open market at the most disadvantageous time, possibly at
prices significantly in excess of the proceeds received in originally selling the securities and/or currencies short. In addition, the Fund may have difficulty purchasing securities and/or currencies to meet its delivery obligations in the case of
less liquid securities and/or currencies sold short by the Fund such as certain
43
emerging market country securities or securities of companies with smaller market capitalizations. The Fund also may take short positions in securities through various derivative products. These
derivative products will typically expose the Fund to economic risks similar to those associated with shorting securities directly.
There can be no
assurance that the short positions that the Fund holds will act as an effective hedge against its long positions. Any decrease in negative correlation or increase in positive correlation between the positions the Manager anticipated would be
offsetting (such as short and long positions in securities or currencies held by the Fund) could result in significant losses for the Fund.
To the extent
the Manager employs a hedging strategy for the Fund, the success of any such hedging strategy will depend, in part, upon the Managers ability to correctly assess the degree of correlation between the performance of the instruments used in the
hedging strategy and the performance of the investments being hedged.
USES OF DERIVATIVES
Introduction and Overview
Derivatives
are financial contracts whose value depends on, or is derived from, the value of underlying assets, reference rates, or indices, to increase, decrease, or adjust elements of the investment exposures of the Funds portfolio. Derivatives may
relate to securities, interest rates, currencies, currency exchange rates, inflation rates, commodities, and indices, and include foreign currency contracts, swap contracts, reverse repurchase agreements, and other exchange-traded and OTC contracts.
This overview outlines various ways in which the Fund may use different types of exchange-traded and OTC derivatives in implementing its investment
program. It is intended to supplement the information included in the Prospectus, including the risks associated with derivatives described under Description of Principal Risks in the Prospectus, and the information provided in the
Fund Investments and Descriptions and Risks of Fund Investments sections of this SAI. This overview, however, is not intended to be exhaustive and the Fund may use types of derivatives and/or employ derivatives strategies not
otherwise described in this SAI or the Prospectus.
In addition, the Fund may decide not to employ any of the strategies described below, and no assurance
can be given that any strategy used will succeed. Also, suitable derivatives transactions may not be available in all circumstances and there can be no assurance that the Fund will be able to identify or employ a desirable derivatives transaction at
any time or from time to time, or that any such transactions will be successful.
The Fund may take advantage of instruments and any security or synthetic
or derivative instruments which are not presently contemplated for use by the Fund or which are not currently available, but which may be developed, to the extent such opportunities are both consistent with the Funds investment objective and
legally permissible for the Fund. The Fund may become a
44
party to various other customized derivative instruments entitling the counterparty to certain payments on the gain or loss on the value of an underlying or referenced instrument.
Note
: Unless otherwise noted below in this section, the uses of derivatives discussed herein with respect to the Fund only refer to the Funds
direct use of such derivatives. As indicated in the Prospectus and in the Fund Investments section of this SAI, the Fund may invest in other Funds of the Trust, which, in turn, may use types of derivatives and/or employ derivatives
strategies that differ from those described in this SAI or the Prospectus.
Function of Derivatives in the Fund.
The types of derivatives
used and derivatives strategies employed by the Fund and the extent the Fund uses derivatives may vary depending on the Funds specific investment objective and strategies. The Fund may use exchange-traded and OTC financial derivatives as an
integral part of its investment program. In addition, specific market conditions may influence the Managers choice of derivatives and derivatives strategies for the Fund, in some cases to a significant extent.
Legal and Regulatory Risk Relating to Derivatives.
As described above under Descriptions and Risks of Fund Investments
Legal and Regulatory Risk, the U.S. government recently enacted legislation which includes provisions for new regulation of the derivatives market, including clearing, margin, reporting, and registration requirements. Because the
legislation leaves much to rule making (and many of the rules are not yet final), its ultimate impact remains unclear. The regulatory changes could, among other things, restrict the Funds ability to engage in derivatives transactions
(including because certain types of derivatives transactions may no longer be available to the Fund) and/or increase the costs of such derivatives transactions (including through increased margin or capital requirements), and the Fund may be unable
to execute its investment strategy as a result.
Use of Derivatives by the Fund
The Fund may use derivatives as a substitute for direct investment in securities or other assets. In particular, the Fund may use swaps or other derivatives
on an index, a single security, or a basket of securities to gain investment exposures (e.g., by selling protection under a credit default swap). The Fund also may use currency derivatives (including forward currency contracts, futures contracts,
swap contracts, and options) to gain exposure to a given currency.
The Fund may use derivatives in an attempt to reduce their investment exposures (which
may result in a reduction below zero). For example, the Fund may use credit default swaps to take a short position with respect to the likelihood of default by an issuer. The Fund also may use currency derivatives in an attempt to reduce (which may
result in a reduction below zero) some aspect of the currency exposure in its portfolio. For these purposes, the Fund may use an instrument denominated in a different currency that the Manager believes is highly correlated with the relevant
currency.
The Fund may use derivatives in an attempt to adjust elements of their investment exposures to various securities, sectors, markets, indices,
and currencies without actually having to sell existing investments or make new direct investments. For instance, the Manager may alter the interest rate exposure of debt instruments by employing interest rate swaps. Such a strategy is
45
designed to maintain the Funds exposure to the credit of an issuer through the debt instrument but adjust the Funds interest rate exposure through the swap. With these swaps, the Fund
and its counterparties exchange interest rate exposure, such as fixed versus variable rates and shorter duration versus longer duration exposure. In adjusting their investment exposures, the Fund also may use currency derivatives in an attempt to
adjust its currency exposure, seeking currency exposure that is different (in some cases, significantly different) from the currency exposure represented by its portfolio investments.
The Fund is not limited in its use of derivatives or in the absolute face value of its derivative positions. As a result of its derivative positions, the Fund
may have gross investment exposures in excess of its net assets (i.e., the Fund may be leveraged) and therefore is subject to heightened risk of loss.
INVESTMENT RESTRICTIONS
Fundamental Restrictions:
The following are Fundamental
Investment Restrictions of the Fund, which may
not
be changed without shareholder approval:
(1) The Fund may not borrow money except under the
following circumstances: (i) The Fund may borrow money from banks so long as after such a transaction, the total assets (including the amount borrowed) less liabilities other than debt obligations, represent at least 300% of outstanding debt
obligations; (ii) The Fund may also borrow amounts equal to an additional 5% of its total assets without regard to the foregoing limitation for temporary purposes, such as for the clearance and settlement of portfolio transactions and to meet
shareholder redemption requests; and (iii) The Fund may enter into transactions that are technically borrowings under the 1940 Act because they involve the sale of a security coupled with an agreement to repurchase that security (e.g
.
,
reverse repurchase agreements, dollar rolls, and other similar investment techniques) without regard to the asset coverage restriction described in (i) above, so long as and to the extent that the Funds custodian earmarks and maintains
cash and/or high-grade debt securities equal in value to its obligations in respect of these transactions.
Under current pronouncements of the SEC staff,
the above types of transactions are not treated as involving senior securities so long as and to the extent that the Fund maintains liquid assets equal in value to its obligations in respect of these transactions.
(2) The Fund may not purchase securities on margin, except such short-term credits as may be necessary for the clearance of purchases and sales of securities.
(For this purpose, the deposit or payment of initial or variation margin in connection with futures contracts or related options transactions is not considered the purchase of a security on margin.)
(3) The Fund may not make short sales of securities or maintain a short position for the Funds account unless at all times when a short position is open
the Fund owns an equal amount of such securities or owns securities which, without payment of any further consideration, are
46
convertible into or exchangeable for securities of the same issue as, and equal in amount to, the securities sold short.
This restriction does not prohibit the payment of an amount to exercise the right to acquire the identical securities, provided that the Fund maintains
segregated liquid assets in an amount sufficient to exercise such right.
(4) The Fund may not underwrite securities issued by other persons except to the
extent that, in connection with the disposition of its portfolio investments, it may be deemed to be an underwriter under federal securities laws.
(5)
The Fund may not purchase or sell real estate, although it may purchase securities of issuers which deal in real estate, including securities of real estate investment trusts, and may purchase securities which are secured by interests in real
estate.
(6) The Fund may not make loans, except by purchase of debt obligations or by entering into repurchase agreements or through the lending of the
Funds portfolio securities. Loans of portfolio securities may be made with respect to 100% of the Funds total assets.
(7) The Fund may not
concentrate more than 25% of the value of its total assets in any one industry.
For purposes of this Fundamental Restriction (7), the U.S. government and
its agencies and instrumentalities are not considered to be an industry.
(8) The Fund may not purchase or sell commodities or commodity contracts, except
that the Fund may purchase and sell financial futures contracts and options thereon.
For purposes of this Fundamental Restriction (8), at the time of
the establishment of the restriction, swap contracts on financial instruments or rates were not within the understanding of the term commodities or commodity contracts, and notwithstanding any federal legislation or
regulatory action by the CFTC that subject such swaps to regulation by the CFTC, the Fund will not consider such instruments to be commodities or commodity contracts for purposes of this restriction.
(9) The Fund may not issue senior securities, as defined in the 1940 Act and as amplified by rules, regulations and pronouncements of the SEC.
The SEC has concluded that even though reverse repurchase agreements, firm commitment agreements, and standby commitment agreements fall within the functional
meaning of the term evidence of indebtedness, the issue of compliance with Section 18 of the 1940 Act will not be raised with the SEC by the Division of Investment Management if the Fund covers such obligations or maintains liquid
assets equal in value to its obligations with respect to these transactions. Similarly, so long as such assets are maintained, the issue of compliance with Section 18 will not be raised with respect to any of the following: any swap contract or
contract
47
for differences; any pledge or encumbrance of assets permitted by Non-Fundamental Restriction (4) below; any borrowing permitted by Fundamental Restriction (1) above; any collateral
arrangements with respect to initial and variation margin permitted by Non-Fundamental Restriction (4) below; and the purchase or sale of options, forward contracts, futures contracts or options on futures contracts.
Non-Fundamental Restrictions:
The following are
Non-Fundamental Investment Restrictions of the Fund, which may be changed by the Trustees without shareholder approval:
(1) The Fund may not buy or sell
oil, gas, or other mineral leases, rights or royalty contracts, although it may purchase securities of issuers that deal in oil, gas, or other mineral leases, rights or royalty contracts, including securities of royalty trusts, and may purchase
securities which are secured by, or otherwise hold or represent interests in, oil, gas, or other mineral leases, rights or royalty contracts.
(2) The
Fund may not make investments for the purpose of gaining control of a companys management.
(3) The Fund may not invest more than 15% of its net
assets in illiquid securities.
(4) The Fund may not pledge, hypothecate, mortgage, or otherwise encumber its assets in excess of 33 1/3% of the
Funds total assets (taken at cost). (For the purposes of this restriction, collateral arrangements with respect to swap agreements, the writing of options, stock index, interest rate, currency or other futures, options on futures contracts and
collateral arrangements with respect to initial and variation margin are not deemed to be a pledge or other encumbrance of assets. The deposit of securities or cash or cash equivalents in escrow in connection with the writing of covered call or put
options, respectively, is not deemed to be a pledge or encumbrance.)
Except as indicated above in Fundamental Restriction (1), all percentage limitations
on investments set forth herein and in the Prospectus will apply at the time of the making of an investment and shall not be considered violated unless an excess or deficiency occurs or exists immediately after and as a result of such investment.
The phrase shareholder approval, as used in the Prospectus and in this SAI, and the phrases vote of a majority of the outstanding
voting securities and the approval of shareholders, as used herein with respect to the Fund, mean the affirmative vote of the lesser of (1) more than 50% of the outstanding shares of the Fund, or (2) 67% or more of the
shares of the Fund present at a meeting if more than 50% of the outstanding shares are represented at the meeting in person or by proxy. Except for policies and restrictions that are explicitly described as fundamental in the Prospectus or this SAI,
the investment policies and restrictions of the Fund may be changed by the Trusts Trustees without the approval of shareholders of the Fund. Policies and restrictions of the Fund that are explicitly described as fundamental in the Prospectus
or this SAI cannot be changed without the approval of shareholders of the Fund.
48
DETERMINATION OF NET ASSET VALUE
The net asset value (or NAV) of each class of shares of the Fund, as applicable, is determined as of the close of regular trading on the New York
Stock Exchange (NYSE), generally at 4:00 p.m. Boston time. Current net asset value per share for the Fund is available at http://www.gmo.com.
The NAV per share of a class of shares of the Fund is determined by dividing the total value of the Funds portfolio investments and other assets, less
any liabilities, allocated to that share class by the total number of outstanding shares of that class. NAV is not determined on any days when the NYSE is closed for business. In addition, NAV is not determined (and accordingly transactions in
shares of the Fund are not processed) on days when the U.S. bond markets are closed. For these purposes, the U.S. bond markets are deemed to be closed on the dates that the Securities Industry and Financial Markets Association recommends a full
close for the trading of U.S. dollar-denominated fixed income securities in the United States.
The Fund also may elect not to determine NAV on days
during which no share is tendered for redemption and no order to purchase or sell a share is received by the Fund. Please refer to Determination of Net Asset Value in the Prospectus for additional information. In addition, to the extent
the Fund holds portfolio securities listed on non-U.S. exchanges that trade on days on which the NYSE or the U.S. bond markets are closed, the net asset value of the Funds shares may change significantly on days when shares cannot be redeemed.
Although the Manager normally does not evaluate pricing sources on a day-to-day basis, it does evaluate pricing sources on an ongoing basis and may
change a pricing source at any time. The Manager monitors erratic or unusual movements (including unusual inactivity) in the prices supplied for a security and has discretion to override a price supplied by a source (e.g., by taking a price supplied
by another) when it believes that the price supplied is not reliable. Although alternative pricing sources may be available for securities held by the Fund, those alternative sources are not typically part of the valuation process and do not
necessarily provide greater certainty about the prices used by the Fund.
DISTRIBUTIONS
The Prospectus describes the distribution policies of the Fund under the heading Distribution and Taxes. The Fund generally maintains a policy to
pay its shareholders, as dividends, substantially all net investment income, if any, and all net realized capital gains, if any, after offsetting any available capital loss carryforwards. The Fund generally maintains a policy to make distributions
at least annually, sufficient to avoid the imposition of a nondeductible 4% excise tax on certain undistributed amounts of ordinary income and net realized capital gain. The Fund, from time to time and at the Funds discretion, also may make
unscheduled distributions of net investment income, short-term capital gains, and/or long-term capital gains prior to large redemptions by shareholders from the Fund or as otherwise deemed appropriate by the Fund. From time to time or as otherwise
provided in the Prospectus, distributions by the
49
Fund could constitute, for U.S. federal income tax purposes, a return of capital to shareholders (see discussion in Taxes below).
TAXES
Tax
Status and Taxation of the Fund
The Fund is treated as a separate taxable entity for U.S. federal income tax purposes. The Fund intends to qualify
each year as a regulated investment company (RIC) under Subchapter M of the Internal Revenue Code of 1986, as amended (previously defined above as the Code). In order to qualify for the special tax treatment accorded RICs and
their shareholders, the Fund must, among other things:
(a)
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derive at least 90% of its gross income for each taxable year from (i) dividends, interest, payments with respect to certain securities loans, and gains from the sale or other disposition of stock, securities, or
foreign currencies, or other income (including but not limited to gains from options, futures, or forward contracts) derived with respect to its business of investing in such stock, securities, or currencies and (ii) net income derived from
interests in qualified publicly traded partnerships (as defined below);
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(b)
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diversify its holdings so that, at the end of each quarter of the Funds taxable year, (i) at least 50% of the market value of the Funds total assets consists of cash and cash items, U.S. government
securities, securities of other RICs, and other securities limited in respect of any one issuer to a value not greater than 5% of the value of the Funds total assets and not more than 10% of the outstanding voting securities of such issuer,
and (ii) not more than 25% of the value of the Funds total assets is invested in the securities (other than those of the U.S. government or RICs) of any one issuer or of two or more issuers which the Fund controls and which are engaged in
the same, similar, or related trades or businesses, or in the securities of one or more qualified publicly traded partnerships (as defined below); and
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(c)
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distribute with respect to each taxable year at least 90% of the sum of its investment company taxable income (as that term is defined in the Code without regard to the deduction for dividends paid generally,
taxable ordinary income and the excess, if any, of net short-term capital gains over net long-term capital losses) and any net tax-exempt interest income for such year.
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In general, for purposes of the 90% gross income requirement described in paragraph (a) above, income derived from a partnership will be treated as
qualifying income only to the extent such income is attributable to items of income of the partnership which would be qualifying income if realized directly by the RIC. However, 100% of the net income derived from an interest in a qualified publicly
traded partnership (defined generally as a partnership (i) the interests in which are traded on an established securities market or are readily tradable on a secondary market or the substantial equivalent thereof, (ii) that derives at
least 90% of its income from passive income sources defined in Section 7704(d) of the Code, and (iii) that derives less than 90% of its income from the qualifying income described in paragraph (a)(i) above) will be treated as qualifying
income. In addition, although in general the passive loss rules of the Code do not
50
apply to RICs, such rules do apply to a RIC with respect to items attributable to an interest in a qualified publicly traded partnership. Further, for the purposes of the diversification test in
paragraph (b) above: (i) the term outstanding voting securities of such issuer will include the equity securities of a qualified publicly traded partnership, and (ii) identification of the issuer (or, in some cases,
issuers) of a particular Fund investment can depend on the terms and conditions of that investment. In some cases, identification of the issuer (or issuers) is uncertain under current law, and an adverse determination or future guidance by the
Internal Revenue Service (IRS) with respect to issuer identification for a particular type of investment may adversely affect the Funds ability to meet the diversification test in (b) above.
If the Fund qualifies as a RIC that is accorded special tax treatment, the Fund will not be subject to U.S. federal income tax on income distributed in a
timely manner to its shareholders in the form of dividends (including Capital Gain Dividends, as defined below).
As described above, the Fund intends
generally to distribute at least annually to its shareholders substantially all of its net investment income (including any net tax-exempt interest income), if any, and all of its net realized capital gains (including both net short-term and
long-term capital gains), if any. Any net taxable investment income or net short-term capital gains (as reduced by any net long-term capital losses) retained by the Fund will be subject to tax at the Fund level at regular corporate rates. Although
the Fund intends generally to distribute all of its net capital gain (i.e., the excess of any net long-term capital gains over net short-term capital losses) each year, the Fund reserves the right to retain for investment all or a portion of its net
capital gain. If the Fund retains any net capital gain, it will be subject to tax at the Fund level at regular corporate rates on the amount retained. In that case, the Fund is permitted to designate the retained amount as undistributed capital
gains in a timely notice to its shareholders, who would then, in turn, be (i) required to include in income for U.S. federal income tax purposes, as long-term capital gain, their shares of such undistributed amount, and (ii) entitled to
credit their proportionate shares of the tax paid by the Fund on such undistributed amount against their U.S. federal income tax liabilities, if any, and to claim refunds on a properly filed U.S. tax return to the extent the credit exceeds such
liabilities. If the Fund properly makes this designation, for U.S. federal income tax purposes, the tax basis of shares owned by a shareholder of the Fund would be increased by an amount equal under current law to the difference between the amount
of undistributed capital gains included in the shareholders gross income under clause (i) of the preceding sentence and the tax deemed paid by the shareholder under clause (ii) of the preceding sentence. The Fund is not required to,
and there can be no assurance that the Fund will, make this designation if it retains all or a portion of its net capital gain in a taxable year.
In
determining its net capital gain, including in connection with determining the amount available to support a Capital Gain Dividend (as defined below), its taxable income, and its earnings and profits, the Fund generally may elect to treat part or
all of any post-October capital loss (defined as the greatest of net capital loss, net long-term capital loss, or net short-term capital loss, in each case attributable to the portion of the taxable year after October 31) or late-year ordinary
loss (generally, (i) net ordinary loss from the sale, exchange or other taxable disposition of property, attributable to the portion of the taxable year after October 31, plus (ii) other net ordinary loss attributable to the portion
of the taxable year after December 31) as if incurred in the succeeding taxable year.
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If the Fund were to fail to distribute in a calendar year at least an amount generally equal to the sum of 98% of
its ordinary income for such calendar year and 98.2% of its capital gain net income for the one-year period ending October 31 within that year, plus any such retained amounts from the prior year, the Fund would be subject to a nondeductible 4%
excise tax on the undistributed amounts. The Fund intends generally to make distributions sufficient to avoid imposition of the 4% excise tax, although the Fund reserves the right to pay an excise tax rather than make an additional distribution when
circumstances warrant (e.g., the payment of the excise tax amount is deemed by the Fund to be de minimis).
Realized capital losses in excess of realized
capital gains (Net Capital Losses) are not permitted to be deducted against net investment income. Instead, potentially subject to the limitations described below, the Fund will carry Net Capital Losses forward from any taxable year to
subsequent taxable years to offset capital gains, if any, realized during such subsequent taxable years. Distributions from capital gains are generally made after applying any available capital loss carryforwards. Capital loss carryforwards are
reduced to the extent they offset current-year net realized capital gains, whether the Fund retains or distributes such gains.
If the Fund incurs or has
incurred Net Capital Losses in taxable years beginning after December 22, 2010 (post-2010 losses), those losses will be carried forward to one or more subsequent taxable years without expiration; any such carryforward losses will
generally retain their character as short-term or long-term. If the Fund has incurred Net Capital Losses in a taxable year beginning on or before December 22, 2010 (pre-2011 losses), the Fund is permitted to carry such losses
forward for eight taxable years; in the year to which they are carried forward, such losses are treated as short-term capital losses that first offset any short-term capital gains, and then offset any long-term capital gains. The Fund must use any
post-2010 losses, which will not expire, applying them first against gains of the same character, before it uses any pre-2011 losses. This increases the likelihood that pre-2011 losses will expire unused at the conclusion of the eight-year
carryforward period. See the Funds most recent annual shareholder report, as available, for more information concerning the Funds Net Capital Losses available to be carried forward (if any) as of the end of its most recently ended fiscal
year.
In addition, the Funds ability to use Net Capital Losses may be limited following the occurrence of certain (i) acquisitive
reorganizations and (ii) shifts in the ownership of the Fund by a shareholder owning or treated as owning 5% or more of the shares of the Fund (each, an ownership change). The Code may similarly limit the Funds ability to use
any of its other capital losses, or ordinary losses, that have accrued but have not been recognized (i.e., built-in losses) at the time of an ownership change to the extent they are realized within the five-year period following the
ownership change.
Transactions in Fund Shares
The
sale, exchange, or redemption of Fund shares may give rise to a taxable gain or loss, generally equal to the difference between the amount realized by a shareholder on the disposition of the shares (that is, gross proceeds) and the
shareholders adjusted basis in those shares. Under rules effective January 1, 2012, to the extent a shareholders account is subject to U.S. federal tax reporting (including an account for which a shareholder has informed the Fund
that it would like
52
to receive informational only U.S. federal tax reporting), the Fund generally will provide cost-basis information (on an IRS Form 1099-B) to the IRS and to the shareholder with
respect to Fund shares acquired on or after January 1, 2012 and held in such accounts (post-2011 shares), when such shares are subsequently redeemed or exchanged. Under the rules, the Fund is required to use the particular
cost-basis reporting method (e.g., average cost basis, first in-first out, specific share identification) selected by the shareholder in reporting such adjusted basis information, and if a shareholder fails to select a particular method, use the
Funds default method. This reporting is generally not required for Fund shares held in a retirement or other tax-advantaged account, unless a shareholder has opted for informational only reporting as described above. Shareholders
should contact the Fund for more information about how to select a particular cost basis accounting method in respect of any post-2011 shares, as well as for information about the Funds particular default method.
Shareholders also should consult their tax advisors concerning the application of these rules to their investment in the Fund, and for advice about selecting
a cost basis accounting method suitable for them in light of their particular circumstances. Shares of the Fund acquired prior to January 1, 2012 generally are not subject to these rules, and shareholders are responsible for keeping track of
their own basis in these shares.
If a shareholder has purchased shares of the Fund through an intermediary, in general, the intermediary and not the Fund
will be responsible for providing the cost basis and related reporting described above to the shareholder, including pursuant to the intermediarys available cost basis accounting methods. Thus, shareholders purchasing shares through an
intermediary should contact the intermediary for more information about how to select a particular cost basis accounting method in respect of any post-2011 shares, as well as for information about the intermediarys particular default method.
In general, any gain or loss realized upon a taxable disposition of shares will be treated as long-term capital gain if the shares have been held for
more than one year and as short-term capital gain if the shares have been held for not more than one year. However, in the event that the Fund were to be deemed a nonpublicly offered RIC as described under Limitation on
Deductibility of Fund Expenses below, depending on a shareholders percentage ownership in the Fund, a partial redemption of Fund shares could cause the shareholder to be treated as receiving a dividend, taxable under the rules applicable
to dividends and distributions described below, rather than capital gain income received in exchange for Fund shares. In this case, a shareholder would generally not be able to recognize any losses on the redeemed Fund shares. Shareholders should
consult their tax advisers regarding the proper tax treatment of their redemptions from the Fund.
Any loss realized upon a taxable disposition of Fund
shares held by a shareholder for six months or less generally will be treated as long-term capital loss to the extent of any Capital Gain Dividends, as defined below, received or deemed received by a shareholder with respect to those shares.
Further, all or a portion of any loss realized upon a taxable disposition of Fund shares will be disallowed under the Codes wash-sale rules if other shares of the Fund are purchased, including by means of dividend reinvestment,
within 30 days before or after the disposition. In
53
such a case, the basis of the newly purchased shares will be adjusted to reflect the disallowed loss.
Taxation of Fund Distributions
Fund distributions are
taxable to shareholders under the rules described below whether received in cash or reinvested in additional Fund shares.
Dividends and distributions on
the Funds shares are generally subject to U.S. federal income tax as described below to the extent they do not exceed the Funds realized income and gains, even though such dividends and distributions may economically represent a return
of a particular shareholders investment. Such dividends and distributions are likely to occur in respect of shares purchased at a time when the Funds net asset value reflects unrealized gains, or realized but undistributed income or
gains, that were therefore included in the price the shareholder paid for its shares. Such distributions may reduce the net asset value of the Funds shares below the shareholders cost basis in those shares. Such realized income and gains
may be required to be distributed even when the Funds net asset value also reflects unrealized losses.
For U.S. federal income tax purposes,
distributions of investment income made by the Fund are generally taxable to shareholders as ordinary income. Taxes on distributions of capital gains are determined by how long the Fund owned the investments that generated them, rather than how long
a shareholder may have owned shares in the Fund. In general, the Fund will recognize long-term capital gain or loss on investments it has owned for more than one year, and short-term capital gain or loss on investments it has owned for one year or
less. Tax rules can alter the Funds holding period in investments and thereby affect the tax treatment of gain or loss on such investments. Distributions of net capital gains (that is, the excess of net long-term capital gain over net
short-term capital loss, in each case determined with reference to loss carryforwards) that are properly reported by the Fund as capital gain dividends (Capital Gain Dividends) generally are taxable to shareholders as long-term capital
gains. Distributions attributable to net short-term capital gain (as reduced by any net long-term capital loss for the taxable year, in each case determined with reference to loss carryforwards) generally are taxable to shareholders as ordinary
income.
Distributions of investment income properly reported by the Fund as derived from qualified dividend income will be taxable to
shareholders taxed as individuals at the rates applicable to long-term capital gain, provided holding period and other requirements are met at both the shareholder and Fund levels.
In order for some portion of the dividends received by a Fund shareholder to be qualified dividend income, the Fund must meet holding period and other
requirements with respect to some portion of the dividend-paying stocks in its portfolio and the shareholder must meet holding period and other requirements with respect to the Funds shares. A dividend will not be treated as qualified dividend
income (at either the Fund or shareholder level) (i) if the dividend is received with respect to any share of stock held for fewer than 61 days during the 121-day period beginning on the date which is 60 days before the date on which such share
becomes ex-dividend with respect to such dividend (or, in the case of certain preferred stock, 91 days during the 181-day period beginning 90 days before such date), (ii) to the extent that the recipient is under an
54
obligation (whether pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property, (iii) if the recipient elects to
have the dividend income treated as investment income for purposes of the limitation on deductibility of investment interest, or (iv) if the dividend is received from a foreign corporation that is (A) not eligible for the benefits of a
comprehensive income tax treaty with the United States (with the exception of dividends paid on stock of such a foreign corporation readily tradable on an established securities market in the United States) or (B) treated as a passive
foreign investment company (as defined below).
In general, distributions of investment income reported by the Fund as derived from qualified
dividend income will be treated as qualified dividend income in the hands of a shareholder taxed as an individual, provided the shareholder meets the holding period and other requirements described above with respect to the Funds shares. If
the above-described holding period and other requirements are met at both the shareholder and Fund level, qualified dividend income will be taxed in the hands of individuals at the rates applicable to long-term capital gain. If the aggregate
qualified dividend income received by the Fund during any taxable year is 95% or more of its gross income, then 100% of the Funds dividends (other than Capital Gain Dividends) will be eligible to be treated as qualified dividend
income. For this purpose, the only gain included in the term gross income is the excess of net short-term capital gain over net long-term capital loss.
For corporate shareholders (other than S corporations), the 70% dividends-received deduction will generally apply (subject to holding period and other
requirements imposed by the Code) to the Funds dividends paid from investment income to the extent derived from dividends received from U.S. corporations for the taxable year. A dividend received by the Fund from a U.S. corporation will not be
treated as a dividend eligible for the dividends-received deduction (1) if it has been received with respect to any share of stock that the Fund has held for less than 46 days (91 days in the case of certain preferred stock) during the 91-day
period beginning on the date which is 45 days before the date on which such share becomes ex-dividend with respect to such dividend (during the 181-day period beginning 90 days before such date in the case of certain preferred stock) or (2) to
the extent that the Fund is under an obligation (pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property. Moreover, the dividends received deduction may otherwise be
disallowed or reduced (1) if the corporate shareholder fails to satisfy the foregoing requirements with respect to its shares of the Fund or (2) by application of various provisions of the Code (for instance, the dividends-received
deduction is reduced in the case of a dividend received on debt-financed portfolio stock (generally, stock acquired with borrowed funds)).
A portion of
the original issue discount (OID) accrued on certain high yield discount obligations may not be deductible to the issuer as interest and will instead be treated as a dividend for purposes of the corporate dividends-received deduction. In
such cases, if the issuer of the high yield discount obligations is a domestic corporation, dividend payments by the Fund may be eligible for the dividends-received deduction to the extent attributable to the deemed dividend portion of such OID. See
Tax Implications of Certain Investments below for more discussion of OID.
To the extent that the Fund makes a distribution of income that is
attributable to (i) income
55
received by the Fund in lieu of dividends with respect to securities on loan pursuant to a securities lending transaction or (ii) dividend income received by the Fund on securities it
temporarily purchased from a counterparty pursuant to a repurchase agreement treated for U.S. federal income tax purposes as a loan, such distribution will not constitute qualified dividend income to individual shareholders and will not be eligible
for the dividends-received deduction for corporate shareholders.
Section 1411 of the Code generally imposes a 3.8% Medicare contribution tax on
the net investment income of certain individuals whose income exceeds certain threshold amounts, and of certain trusts and estates under similar rules. For these purposes, net investment income generally includes, among other things,
(i) distributions paid by the Fund of ordinary dividends and capital gain dividends as described above, and (ii) any net gain from the sale, redemption or exchange of Fund shares. Shareholders are advised to consult their tax advisors
regarding the possible implications of this additional tax on their investment in the Fund.
The Fund may make a distribution to its shareholders in
excess of its earnings and profits in any taxable year (a Return of Capital Distribution), in which case the excess distribution will be treated as a return of capital to the extent of each shareholders tax basis in its
shares, and thereafter as capital gain. A return of capital is not taxable to the extent such an amount does not exceed a shareholders tax basis. Return of Capital Distributions reduce a shareholders tax basis in its shares, thus
reducing any loss or increasing any gain on a subsequent taxable disposition by such shareholder of the shares.
The Fund may make distributions of
capital gains in excess of its net capital gain for the taxable year (as reduced by any available capital loss carryforwards from prior taxable years). In this case, there is a possibility that the distributions will be taxable as ordinary dividend
distributions, even though the distributed excess amounts would not have been subject to tax if retained by the Fund.
The distribution paid to
shareholders by the Fund in January of a year generally is deemed to have been received by shareholders on December 31 of the preceding year, if the distribution was declared and payable to shareholders of record on a date in October, November,
or December of that preceding year.
Early each calendar year, the Trust will provide U.S. federal tax information, including information about the
character and amount of dividends and distributions paid during the preceding year, to taxable investors and others requesting such information (generally on an IRS Form 1099). In certain cases, the Fund may be required to amend tax information
reported to shareholders in respect of a particular year. In this event, shareholders may be required to file amended U.S. federal income or other tax returns in respect of such amended information and pay additional taxes (including potentially
interest and penalties), and may incur other related costs. Shareholders should consult their tax advisers in this regard.
56
Limitation on Deductibility of Fund Expenses
Very generally, pursuant to Treasury regulations, expenses of nonpublicly offered RICs, except those expenses specific to their status as a RIC or
separate entity (e.g., registration fees or transfer agency fees), are subject to special pass-through rules. A RIC is nonpublicly offered if it has fewer than 500 shareholders at all times during a taxable year, and its shares are not
continuously offered pursuant to a public offering. In the event that the Fund were deemed to be a nonpublicly offered RIC, the affected expenses (which include Management Fees) would be treated as additional dividends to certain Fund shareholders
(generally including individuals and entities that compute their taxable income in the same manner as individuals) and would be deductible by those shareholders, subject to the 2% floor on miscellaneous itemized deductions and other significant
limitations on itemized deductions set forth in the Code.
Backup Withholding
The Fund (or in the case of shares held through an intermediary, the intermediary) generally is required to withhold and remit to the U.S. Treasury a
percentage of the taxable distributions and redemption proceeds paid to any individual shareholder who fails to properly furnish the Fund (or the intermediary) with a correct taxpayer identification number, who has under-reported dividend or
interest income, or who fails to certify that he or she is not subject to such withholding. The backup withholding tax rate is 28%. Any tax withheld as a result of backup withholding does not constitute an additional tax imposed on the record owner
of the account, and may be claimed as a credit on the record owners U.S. federal income tax return, provided the appropriate information is furnished to the IRS.
Distributions to Foreign Investors
In general, absent a
specific statutory exemption, the Funds ordinary dividends are subject to a U.S. withholding tax of 30% when paid to a shareholder that is not a U.S. person within the meaning of the Code (a foreign shareholder). To the
extent withholding is made on an ordinary dividend paid to a foreign shareholder, persons who are resident in a country that has an income tax treaty with the United States may be eligible for a reduced withholding rate (upon filing of appropriate
forms), and are urged to consult their tax advisors regarding the applicability and effect of such a treaty.
The Funds Capital Gain Dividends and
Return of Capital Distributions are generally not subject to withholding when paid to a foreign shareholder, as described more fully below.
In
addition, for taxable years of the Fund beginning before January 1, 2014 (each a pre-2014 taxable year), the Fund was not required to withhold any amounts (i) with respect to distributions (other than distributions to a foreign
shareholder (A) that had not provided a satisfactory statement that the beneficial owner was not a U.S. person, (B) to the extent that the dividend was attributable to certain interest on an obligation if the foreign shareholder was the issuer or
was a 10% shareholder of the issuer, (C) that was within certain foreign countries that had inadequate information exchange with the United States, or (D) to the extent the dividend was attributable to interest paid by a person that was a related
person of the foreign shareholder and the foreign shareholder was a controlled foreign corporation) from U.S.-source interest income of types similar
57
to those not subject to U.S. federal income tax if earned directly by an individual foreign shareholder, to the extent such distributions were properly reported as such by the Fund
(interest-related dividends), and (ii) with respect to distributions (other than (A) distributions to an individual foreign shareholder who was present in the United States for a period or periods aggregating 183 days or more during the
year of the distribution and (B) distributions subject to special rules regarding the disposition of U.S. real property interests (USRPIs) as described below) of net short-term capital gains in excess of net long-term capital
losses, to the extent such distributions were properly reported as such by the Fund (short-term capital gain dividends). Short-term capital gain does not include gain from the sale of master limited partnerships to the extent such gain
is characterized as ordinary income under the Codes recapture provisions. The Fund was permitted to report such eligible parts of its dividends paid in respect of a pre-2014 taxable year as interest-related and/or short-term capital gain
dividends as were eligible, but was not required to do so.
Additionally, if the Fund invested in an underlying Fund or another investment company
registered under the 1940 Act, including an ETF, treated as a RIC for U.S. federal income tax purposes (Underlying RIC) that reported and paid such short-term capital gain or interest-related dividends to its shareholders in respect of a
taxable year of the Underlying RIC beginning before January 1, 2014, such distributions generally not subject to withholding if properly reported as such in respect of distributions paid by the Fund to its shareholders for a pre-2014 taxable year of
the Fund. Similarly, if the Fund invested in an underlying Fund that was treated as a partnership for U.S. federal income tax purposes, then to the extent that the underlying Fund allocated to the Fund income that would have given rise to
interest-related or short-term capital gain dividends if earned directly by the Fund, the Fund generally was permitted to report any dividends attributable to such income in respect of a pre-2014 taxable year as interest-related or short-term
capital gain dividends, as applicable.
The exemption from withholding for interest-related and short-term capital gain dividends has expired for
distributions with respect to taxable years of the Fund beginning on or after January 1, 2014. Therefore, as of the date of this SAI, the Fund (or intermediary, as applicable) is currently required to withhold on distributions to foreign
shareholders attributable to net interest or short-term capital gains that were formerly eligible for this withholding exemption. It is currently unclear whether Congress will extend this exemption for distributions with respect to taxable years of
the Fund beginning on or after January 1, 2014, and what the terms of such an extension would be, including whether such extension would have retroactive effect.
In the case of shares held through an intermediary, the intermediary may withhold even if the Fund properly reports the payment as an interest-related or
short-term capital gain dividend to shareholders in respect of a pre-2014 taxable year. Foreign shareholders should contact their intermediaries regarding the application of these rules to their accounts.
In certain circumstances, a foreign shareholder may be required to file appropriate U.S. federal tax forms in order to receive the benefit of these
exemptions.
Under U.S. federal tax law, a foreign shareholder is not, in general, subject to U.S. federal income tax on gains (and is not allowed a
deduction for losses) realized on the sale of shares of the Fund or on Capital Gain Dividends unless (i) such gain or Capital Gain Dividend is effectively connected with the conduct by the foreign shareholder of a trade or business within the
United States, (ii) in the case of a foreign shareholder that is an individual, the shareholder is present in the United States for a period or periods aggregating 183 days or more during the year of the sale or the receipt of the Capital Gain
Dividend and certain other conditions are met, or (iii) the special rules relating to gain attributable to the sale or exchange of USRPIs apply to the
58
foreign shareholders sale of shares of the Fund or to the Capital Gain Dividend received (as described below).
Also, foreign shareholders with respect to whom income from the Fund is effectively connected with a U.S. trade or business carried on by such
shareholder will in general be subject to U.S. federal income tax on the income derived from the Fund at the graduated rates applicable to U.S. citizens, residents, or domestic corporations, whether such income is received in cash or reinvested in
shares, and, in the case of a foreign corporation, also may be subject to a branch profits tax. If a foreign shareholder is eligible for the benefits of a tax treaty, any effectively connected income or gain will generally be subject to U.S. federal
income tax on a net basis only if it is also attributable to a permanent establishment maintained by the shareholder in the United States. Again, foreign shareholders who are residents in a country with an income tax treaty with the United States
may obtain different tax results, and are urged to consult their tax advisors.
Special withholding and other rules apply to distributions to foreign
shareholders to the extent the Fund is either a U.S. real property holding corporation (USRPHC) or would be a USRPHC but for the operation of the exceptions to the definition thereof described below. Additionally, special
withholding and other rules apply to the redemption of shares to the extent the Fund is a USRPHC or former USRPHC. Very generally, a USRPHC is a domestic corporation that holds USRPIs USRPIs are defined as any interest in U.S. real property
or any equity interest in a USRPHC or former USRPHC the fair market value of which equals or exceeds 50% of the sum of the fair market values of the corporations USRPIs, interests in real property located outside the United States, and
other assets. To the extent the Fund holds (directly or indirectly) significant interests in real estate investment trusts (as defined in Section 856 of the Code) qualifying for the special tax treatment under Subchapter M of the Code
(U.S. REITs), it may be a USRPHC. The Fund generally does not expect that it will be a USRPHC. The special rules discussed in the next paragraph also apply to distributions from the Fund to the extent it would be a USRPHC absent
exclusions from USRPI treatment for interests in domestically controlled U.S. REITs (or, prior to January 1, 2014, RICs) and not-greater-than-5% interests in publicly traded classes of stock in U.S. REITs or RICs.
To the extent the Fund is a USRPHC or would be a USRPHC but for the exceptions from the definition of USRPI (described above), under a special
look-through rule, any dividend distributions by the Fund and certain distributions made by the Fund in redemption of its shares that are attributable directly or indirectly to distributions received by the Fund from a lower-tier
REIT that the Fund is required to treat as USRPI gain in its hands will retain their character as gains realized from USRPIs in the hands of the Funds foreign shareholders. If a foreign shareholder holds (or has held in the prior year) more
than a 5% interest in any class of the Fund, such distributions generally will be treated as gains effectively connected with the conduct of a U.S. trade or business, and subject to tax at graduated rates. Moreover, such
shareholders generally will be required to file a U.S. income tax return for the year in which the gain was recognized and the Fund generally will be required to withhold 35% of the amount of such
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distribution. In the case of all other foreign shareholders (i.e., those whose interest in the Fund did not exceed 5% in any class of the Fund at any time during the prior year), the USRPI
distribution generally will be treated as ordinary income (regardless of any reporting by the Fund that such distribution is a short-term capital gain dividend or a Capital Gain Dividend), and the Fund generally must withhold 30% (or a lower
applicable treaty rate) of the amount of the distribution paid to such foreign shareholder.
Prior to January 1, 2014, the special
look-through rule discussed above for distributions by the Fund to foreign shareholders also applied to distributions attributable to (i) gains realized on the disposition of USRPIs by the Fund and (ii) distributions received by the Fund
from a lower-tier RIC that the Fund was required to treat as USRPI gain in its hands. It is currently unclear whether Congress will extend these former look-through provisions to distributions made on or after January 1, 2014, and what
the terms of any such extension would be, including whether any extension would have retroactive effect.
Foreign shareholders of the Fund also may be
subject to certain wash sale rules to prevent the avoidance of the tax filing and payment obligations discussed above through the sale and repurchase of Fund shares.
In addition, if the Fund is a USRPHC or former USRPHC, it must typically withhold 10% of the amount realized in a redemption by a greater-than-5% foreign
shareholder, and that shareholder typically must file a U.S. income tax return for the year of the disposition of Fund shares and pay any additional tax due on the sale. A similar withholding obligation may apply to Return of Capital Distributions
by the Fund if it is a USRPHC or former USRPHC to a greater-than-5% foreign shareholder, even if all or a portion of such distribution would be treated as a return of capital to the foreign shareholder. Prior to January 1, 2014, such withholding on
these redemptions and distributions generally was not required if the Fund was a domestically controlled USRPHC or, in certain limited cases, if the Fund (whether or not domestically controlled) held substantial investments in Underlying RICs that
were domestically controlled USRPHCs. These exemptions from withholding for redemptions or distributions have expired and such withholding is required, without regard to whether the Fund or any Underlying RIC in which it invests is domestically
controlled. It is currently unclear whether Congress will extend these exemptions for redemptions these exemptions for redemptions or distributions made on or after January 1, 2014, and what the terms of any such extension would be, including
whether any such extension would have retroactive effect.
Foreign shareholders should consult their tax advisors (and if holding shares through an
intermediary, their intermediary) concerning the application of these rules to their investment in the Fund.
In order to qualify for any exemptions from
withholding described above or for lower withholding tax rates under income tax treaties, or to establish an exemption from backup withholding, a foreign shareholder must comply with special certification and filing requirements relating to its
non-U.S. status (including, for example, furnishing an IRS Form W-8BEN). Foreign shareholders in the Fund should consult their tax advisors and, if holding shares through intermediaries, their intermediaries, in this regard.
Special rules (including withholding and reporting requirements) apply to foreign partnerships and those holding Fund shares through foreign partnerships.
Also, additional considerations may apply to foreign trusts and estates. Investors holding Fund shares through foreign entities should consult their tax advisors about their particular situation.
A foreign shareholder may be subject to state and local taxes and to the U.S. federal estate tax in addition to the U.S. federal income tax referred to above.
See also Other Reporting and Withholding Requirements below for information regarding the potential application of an additional withholding
regime.
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Foreign Taxes
The Funds foreign investments may be subject to foreign withholding and other taxes on dividends, interest, or capital gains, which will decrease the
Funds yield. The Fund may otherwise be subject to foreign taxation on repatriation proceeds generated from those investments or to other transaction-based foreign taxes on those investments, including potentially on a retroactive basis, which
can also decrease the Funds yield. Such foreign withholding taxes and other taxes may be reduced or eliminated under income tax treaties between the United States and certain foreign jurisdictions. In some cases, the Fund may seek to collect a
refund in respect of taxes paid to a foreign jurisdiction (see Descriptions and Risks of Fund Investments Risks of Non-U.S. Investments above for more information). The foreign withholding and other tax rates applicable to the
Funds investments in certain foreign jurisdictions may be higher, in certain circumstances, for instance, if the Fund has a significant number of foreign shareholders or if the Fund or underlying Fund invests through a subsidiary.
If, at the end of the Funds taxable year, more than 50% of the value of the total assets of the Fund is represented by direct investments in stock or
other securities of foreign corporations, the Fund may make an election that allows shareholders to claim a foreign tax credit or deduction (but not both) on their U.S. income tax return in respect of foreign taxes paid by or withheld from the Fund
on its foreign portfolio investments. Only foreign taxes that meet certain qualifications are eligible for this pass-through treatment. If the Fund is eligible for and makes such an election, its shareholders generally will include in gross income
from foreign sources their pro rata shares of such taxes paid by the Fund. A shareholders ability to claim an offsetting foreign tax credit or deduction in respect of these taxes is subject to limitations imposed by the Code, which may result
in the shareholders not receiving a full credit or deduction (if any) for the amount of such taxes. Shareholders who do not itemize deductions on their U.S. federal income tax returns may claim a credit (but not a deduction) for such foreign
taxes. However, even if the Fund is eligible to make this election, it may determine not to do so in its sole discretion, in which case any such qualified foreign taxes paid by the Fund cannot be given this special pass-through treatment
by the Fund or its shareholders. Investors should consult their tax advisors for further information relating to the foreign tax credit and deduction. Shareholders that are not subject to U.S. federal income tax, and those who invest in the Fund
through tax-advantaged accounts (including those who invest through individual retirement accounts or other tax-advantaged retirement plans), generally will receive no benefit from any tax credit or deduction passed through by the Fund.
In some cases, the Fund also may be eligible to pass through to its shareholders the foreign taxes paid by Underlying RICs in which it invests that themselves
elected to pass through such taxes to their shareholders. However, even if the Fund is eligible to make such an election for a given year, it may determine not to do so. See Special Tax Considerations Pertaining to the Funds Investment
in Underlying Funds for more information.
Withholding taxes that are accrued on dividends in respect of (i) securities on loan pursuant to a
securities lending transaction during the period that any such security was not directly held by the Fund or (ii) securities the Fund temporarily purchased from a counterparty pursuant to a repurchase agreement that is treated as a loan for
U.S. federal income tax purposes generally will
61
not qualify as a foreign tax paid by the Fund, in which case, they could not be passed through to shareholders even if the Fund meets the other requirements described above.
Shareholder Reporting Obligations With Respect to Foreign Bank and Financial Accounts
Shareholders that are U.S. persons and own, directly or indirectly, more than 50% of the Fund could be required to report annually their financial
interest in the Funds foreign financial accounts, if any, on Treasury Department Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR). Shareholders should consult their intermediaries through which Fund
investment is made (if applicable), as well as a tax advisor, regarding the applicability to them of this reporting requirement.
Other Reporting and
Withholding Requirements
The Foreign Account Tax Compliance Act (FATCA) generally requires the Fund to obtain information sufficient to
identify the status of each of its shareholders under FATCA as described more fully below. If a shareholder fails to provide this information or otherwise fails to comply with FATCA, the Fund may be required to withhold under FATCA at a rate of 30%
with respect to that shareholder, depending on the type of payment and shareholder account, beginning as early as July 1, 2014, on dividends, including Capital Gain Dividends, and the proceeds of the sale, redemption or exchange of Fund shares.
If a payment by the Fund is subject to FATCA withholding, the Fund or its agent is required to withhold even if such payment would otherwise be exempt from withholding under the rules applicable to foreign shareholders described above (e.g., Capital
Gain Dividends and short-term capital gain and interest-related dividends).
Payments to a shareholder will generally not be subject to FATCA withholding,
provided the shareholder provides the Fund with such certifications, waivers or other documentation or information as the Fund requires, including, to the extent required, with regard to such shareholders direct and indirect owners, to
establish the shareholders FATCA status and otherwise to comply with these rules. In order to avoid withholding, a shareholder that is a foreign financial institution (FFI) must either (i) become a
participating FFI by entering into a valid U.S. tax compliance agreement with the IRS, (ii) qualify for an exception from the requirement to enter into such an agreement, for example by becoming a deemed compliant FFI,
or (iii) be covered by an applicable intergovernmental agreement between the United States and a non-U.S. government to implement FATCA. In any of these cases, the investing FFI generally will be required to provide the Fund with appropriate
identifiers, certifications or documentation concerning its status.
The Fund will disclose the information that it receives from (or concerning) its
shareholders to the IRS, non-U.S. taxing authorities or other parties as necessary to comply with FATCA, related intergovernmental agreements or other applicable law or regulation.
Each prospective investor is urged to consult its tax adviser regarding the applicability of FATCA and any other reporting requirements with respect to the
prospective investors own situation, including investments through an intermediary.
The Fund and its shareholders may be subject to certain other
tax reporting requirements as a result of the investment strategies and activities of the Fund. Certain U.S. federal, state, local and foreign tax reporting requirements may require the Fund to provide certain information about its shareholders
62
to the IRS or other similar authorities responsible for tax matters in other jurisdictions (e.g., foreign countries).
Tax Implications of Certain Investments
The Funds
transactions in derivative instruments (e.g., swap agreements, options, futures or forward contracts), as well as any of its other hedging, short sales, or similar transactions, may be subject to one or more special tax rules (e.g., notional
principal contract, straddle, constructive sale, wash-sale, and short-sale rules). These rules may affect whether gains and losses recognized by the Fund are treated as ordinary or capital and/or as short-term or long-term, accelerate the
recognition of income or gains to the Fund, defer losses, and cause adjustments in the holding periods of the Funds investments. The rules could therefore affect the amount, timing, and/or character of distributions to shareholders.
The Fund may make extensive use of various types of derivative financial instruments to the extent consistent with its investment policies and restrictions.
The tax rules applicable to swaps and other derivative financial instruments are in some cases uncertain under current law, including under Subchapter M of the Code. Accordingly, while the Fund intends to account for such transactions in a manner it
deems to be appropriate, an adverse determination or future guidance by the IRS with respect to one or more of these rules (which determination or guidance could be retroactive) may adversely affect the Funds ability to meet one or more of the
relevant requirements to maintain its qualification as a RIC, as well as to avoid a fund-level tax. See Loss of RIC Status below.
Certain
investments made and investment practices engaged in by the Fund can produce a difference between its book income and its taxable income. These can include, but are not limited to, certain hedging activities, as well as investments in foreign
currencies, foreign currency-denominated debt, Section 1256 contracts (as defined below), passive foreign investment companies (as defined below), and debt obligations with discount or purchased at a premium. In addition, certain foreign
currency transactions associated with the redemption of Fund shares (in the case where the Fund permits redemptions of its shares in foreign currencies) may produce a difference between the Funds book income and its taxable income. If the
Funds book income exceeds the sum of its taxable income and net tax-exempt interest income (if any), the distribution (if any) of such excess generally will be treated as (i) a dividend to the extent of the Funds remaining earnings
and profits (including earnings and profits arising from tax-exempt interest income (if any)), (ii) thereafter, as a return of capital to the extent of the recipients basis in its shares, and (iii) thereafter, as gain from the sale
or exchange of a capital asset. If the Funds book income is less than the sum of its taxable income and net tax-exempt income (if any), the Fund could be required to make distributions exceeding book income to qualify as a RIC that is accorded
special tax treatment.
Any transactions by the Fund in foreign currencies, foreign currency-denominated debt obligations, or certain foreign currency
options, futures contracts, or forward contracts (or similar instruments) may give rise to ordinary income or loss to the extent such income or loss results from fluctuations in the value of the foreign currency concerned and, as described earlier,
can give rise to differences between the Funds book and taxable income. Such ordinary income treatment may accelerate Fund distributions to shareholders and increase the distributions taxed to shareholders as ordinary income. Any net ordinary
losses so created cannot be carried forward
63
by the Fund to offset income or gains earned in subsequent taxable years.
In general, option
premiums received by the Fund are not immediately included in the income of the Fund. Instead, the premiums generally are recognized when the option contract expires, the option is exercised by the holder, or the Fund transfers or otherwise
terminates the option (e.g., through a closing transaction). The remainder of this paragraph describes the general tax consequences to the Fund of writing a put or call option that is not subject to one or more of the special rules described in the
immediately following paragraphs. If securities or other assets are purchased by the Fund pursuant to the exercise of a put option written by it, the Fund generally will subtract the premium received from its cost basis in the securities or other
assets purchased. If a call option written by the Fund is exercised and the Fund sells or delivers the underlying securities or other assets, the Fund generally will recognize capital gain or loss equal to (i) the sum of the strike price and
the option premium received by the Fund minus (ii) the Funds basis in the underlying securities or other assets. Such gain or loss generally will be short-term or long-term depending upon the holding period of the underlying securities or
other assets. The gain or loss with respect to any termination of the Funds obligation under an option other than through the exercise of the option and related purchase, sale, or delivery of the underlying securities or other assets generally
will be short-term gain or loss depending on whether the premium income received by the Fund is greater or less than the amount paid by the Fund (if any) in terminating the transaction. Thus, for example, if an option written by the Fund expires
unexercised, the Fund generally will recognize short-term gain equal to the premium received.
Certain covered call writing activities and other option
strategies of the Fund may trigger the U.S. federal income tax straddle rules of Section 1092 of the Code, requiring the deferral of losses and the termination of holding periods on offsetting positions in options and stocks deemed to
constitute substantially similar or related property. Call options on stocks that are not deep in the money may qualify as qualified covered calls, which generally are not subject to the straddle rules; the holding period on
stock underlying qualified covered calls that are in the money although not deep in the money will be suspended during the period that such calls are outstanding. Thus, the straddle rules and the rules governing qualified
covered calls could cause gains that would otherwise constitute long-term capital gains to be treated as short-term capital gains, and distributions that would otherwise constitute qualified dividend income or qualify for the corporate
dividends-received deduction to fail to satisfy the holding period requirements and therefore to be taxed as ordinary income or to fail to qualify for the dividends-received deduction, as the case may be.
The tax treatment of certain futures contracts entered into by the Fund as well as listed non-equity options written or purchased by the Fund on certain U.S.
and non-U.S. exchanges (including options on futures contracts, equity indices, and debt securities) will be governed by Section 1256 of the Code (Section 1256 contracts). Gains or losses on Section 1256 contracts generally are
considered 60% long-term and 40% short-term capital gains or losses (60/40), although certain foreign currency gains and losses from such contracts may be treated as ordinary in character. Also, Section 1256 contracts held by the
Fund at the end of each taxable year (and, for purposes of the 4% excise tax, on certain other dates as prescribed under the Code) are marked to market, with the result that unrealized gains or losses are treated as though they were
realized and the resulting gain or loss is treated as ordinary or 60/40 gain or loss, as
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applicable.
As a result of the special tax rules described above generally applicable to the
Funds options transactions, such transactions could cause a substantial portion of the Funds income to consist of net short-term capital gains, which, when distributed, are treated as taxable to shareholders as ordinary income.
Any investment by the Fund in U.S. REIT equity securities may result in the Funds receipt of cash in excess of the U.S. REITs earnings; if the
Fund distributes these amounts, these distributions could constitute a return of capital to Fund shareholders for U.S. federal income tax purposes. Investments in U.S. REIT equity securities also may require the Fund to accrue and distribute income
not yet received. To generate sufficient cash to make the requisite distributions, the Fund may be required to sell investments (including when it is not advantageous to do so) that it otherwise would have continued to hold. Dividends received by
the Fund from a U.S. REIT will not qualify for the corporate dividends-received deduction and generally will not constitute qualified dividend income.
Under a notice issued by the IRS in October 2006 and Treasury regulations that have not yet been issued, but may apply retroactively, a portion of the
Funds income (including income allocated to the Fund from a U.S. REIT or other pass-through entity) that is attributable to a residual interest in a real estate mortgage investment conduit (REMIC) (including by investing in
residual interests in CMOs with respect to which an election to be treated as a REMIC is in effect) or an equity interest in a taxable mortgage pool (TMP) (referred to in the Code as an excess inclusion) will be subject to
U.S. federal income tax in all events. This notice also provides and the regulations are expected to provide that excess inclusion income of RICs, such as the Fund, will be allocated to shareholders of RICs in proportion to the dividends received by
such shareholders, with the same consequences as if the shareholders held the related interest directly. As a result, to the extent the Fund invests in any such interests, the Fund may not be a suitable investment for certain tax-exempt investors,
as noted below.
In general, excess inclusion income allocated to shareholders (i) cannot be offset by net operating losses (subject to a limited
exception for certain thrift institutions), (ii) will constitute unrelated business taxable income (UBTI) to entities (including a qualified pension plan, an individual retirement account, a 401(k) plan, a Keogh plan, or other
tax-exempt entity) subject to tax on UBTI, thereby potentially requiring such an entity that is allocated excess inclusion income, and otherwise might not be required to file a tax return, to file a tax return and pay tax on such income, and
(iii) in the case of a foreign shareholder, will not qualify for any reduction in U.S. federal withholding tax. A shareholder will be subject to U.S. federal income tax on such inclusions notwithstanding any exemption from such income tax
otherwise available under the Code.
Under current law, income of the Fund that would be treated as UBTI if earned directly by a tax-exempt entity
generally will not be attributed and taxed as UBTI when distributed to tax-exempt shareholders (that is, the Fund blocks this income with respect to such shareholders). Notwithstanding this blocking effect, a tax-exempt
shareholder could realize UBTI by virtue of its investment in the Fund if shares in the Fund constitute debt-financed property in the hands of the tax-exempt shareholder within the meaning of Section 514(b) of the Code. A tax-exempt
65
shareholder also may recognize UBTI if the Fund recognizes excess inclusion income derived from direct or indirect investments in residual interests in REMICs or equity interests in TMPs as
described above, if the amount of such income recognized by the Fund exceeds the Funds investment company taxable income (after taking into account deductions for dividends paid by the Fund).
In addition, special tax consequences apply to charitable remainder trusts (CRTs) that invest in RICs that invest directly or indirectly in
residual interests in REMICs or equity interests in TMPs. Under legislation enacted in December 2006, a CRT (as defined in Section 664 of the Code) that realizes any UBTI for a taxable year must pay an excise tax annually of an amount equal to
such UBTI. Under IRS guidance issued in October 2006, a CRT will not recognize UBTI as a result of investing in the Fund that recognizes excess inclusion income. Rather, if at any time during any taxable year a CRT (or one of certain other
tax-exempt shareholders, such as the United States, a state or political subdivision, or an agency or instrumentality thereof, and certain energy cooperatives) is a record holder of a share in the Fund and the Fund recognizes excess inclusion
income, then the Fund will be subject to a tax on that portion of its excess inclusion income for the taxable year that is allocable to such shareholders at the highest U.S. federal corporate income tax rate. The extent to which this IRS guidance
remains applicable in light of the December 2006 legislation is unclear. To the extent permitted under the 1940 Act, the Fund may elect to specially allocate any such tax to the applicable CRT, or other shareholder, and thus reduce such
shareholders distributions for the year by the amount of the tax that relates to such shareholders interest in the Fund. CRTs and other tax-exempt investors are urged to consult their tax advisors concerning the consequences of investing
in the Fund.
Some debt obligations with a fixed maturity date of more than one year from the date of issuance (and zero-coupon debt obligations with a
fixed maturity date of more than one year from the date of issuance) will be treated as debt obligations that are issued originally at a discount. Generally, the amount of the OID is treated as interest income and is included in the Funds
taxable income (and required to be distributed by the Fund) over the term of the debt security, even though payment of that amount is not received until a later time, usually upon partial or full repayment or disposition of the debt security. In
addition, payment-in-kind securities will give rise to income which is required to be distributed and is taxable even though the Fund holding the security receives no interest payment in cash on the security during the year.
Some debt obligations with a fixed maturity date of more than one year from the date of issuance that are acquired by the Fund in the secondary market may be
treated as having market discount. Very generally, market discount is the excess of the stated redemption price of a debt obligation (or in the case of an obligation issued with OID, its revised issue price) over the purchase price of
such obligation. Generally, any gain recognized on the disposition of, and any partial payment of principal on, a debt security having market discount is treated as ordinary income to the extent the gain, or principal payment, does not exceed the
accrued market discount on such debt security. Alternatively, the Fund may elect to accrue market discount currently, in which case the Fund will be required to include the accrued market discount in the Funds income (as ordinary
income) and thus distribute it over the term of the debt security, even though payment of that amount is not received until a later time, upon partial or full repayment or disposition of the debt security. The rate at which the market discount
accrues, and thus is included in the Funds income, will depend upon which of the permitted accrual methods the Fund elects.
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Some debt obligations with a fixed maturity date of one year or less from the date of issuance may be treated as
having OID or, in certain cases, acquisition discount (very generally, the excess of the stated redemption price over the purchase price). Generally, the Fund will be required to include the OID or acquisition discount in income (as ordinary income)
over the term of the debt security, even though payment of that amount is not received until a later time, usually when the debt security matures. The OID or acquisition discount accrues ratably in equal daily installments or, if the Fund so elects,
at a constant (compound) interest rate. If the Fund elects the constant interest rate method, the character and timing of recognition of income by the Fund will differ from what they would have been under the default pro rata method.
Increases in the principal amount of an inflation indexed bond will be treated as OID includible in income (as ordinary income) over the term of the bond,
even though payment of that amount is not received until a later time. Decreases in the principal amount of an inflation indexed bond will reduce the amount of interest from the debt instrument that would otherwise be includible in income by the
Fund. In addition, if the negative inflation adjustment exceeds the income includible by the Fund with respect to the debt instrument (including any OID) for the taxable year, such excess will be an ordinary loss to the extent the Funds total
interest inclusions on the debt instrument in prior taxable years exceed the total amount treated by the Fund as an ordinary loss on the debt instrument in prior taxable years. Any remaining excess may be carried forward to reduce taxable income
from the instrument in subsequent years.
The Fund also may purchase contingent payment debt instruments. For U.S. federal income tax purposes, holders of
contingent payment debt instruments generally have to include taxable income (as interest) on a constant yield basis without regard to whether cash is received with respect thereto. Gain on the disposition of contingent payment debt instruments
generally will be treated for U.S. federal income tax purposes as ordinary interest income rather than as capital gain.
If the Fund holds the foregoing
kinds of debt instruments, it may be required to pay out as an income distribution each year an amount which is greater than the total amount of cash interest the Fund actually received. Such distributions may be made from the cash assets of the
Fund or, if necessary, by liquidation of portfolio investments including at a time when it may not be advantageous to do so. The Fund may realize gains or losses from such liquidations. In the event the Fund realizes net long-term or short-term
capital gains from such transactions, its shareholders may receive a larger Capital Gain Dividend or ordinary dividend, respectively, than they would in the absence of such transactions.
Very generally, where the Fund purchases a bond at a price that exceeds the redemption price at maturity, that is, at a premium, the premium is amortizable
over the remaining term of the bond. In the case of a taxable bond, if the Fund makes an election applicable to all such bonds it purchases, which election is irrevocable without the consent of the IRS, the Fund reduces the current taxable income
from the bond by the amortized premium and reduces its tax basis in the bond by the amount of such offset; upon the disposition or maturity of such bonds, the Fund is generally permitted to deduct any remaining premium allocable to a prior period.
In the case of a tax-exempt bond, tax rules require the Fund to reduce its tax basis by the amount of amortized premium.
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Investments in debt obligations that are at risk of or in default present special tax issues for the Fund. Tax
rules are not entirely clear about issues such as whether and to what extent the Fund should recognize market discount on a debt obligation; when the Fund may cease to accrue interest, OID, or market discount; when and to what extent the Fund may
take deductions for bad debts or worthless investments; and how the Fund should allocate payments received on obligations in default between principal and income. These and other related issues will be addressed by the Fund when, as, and if it
invests in such investments, in order to seek to ensure that it distributes sufficient income to preserve its status as a RIC and does not become subject to U.S. federal income or excise tax.
The Funds investments in certain passive foreign investment companies (PFICs), as defined below, could subject the Fund to U.S. federal
income tax (including interest charges) on distributions received from a PFIC or on proceeds received from the disposition of shares in a PFIC, which tax cannot be eliminated by making distributions to Fund shareholders. However, the Fund may make
certain elections to avoid the imposition of that tax. For example, the Fund may elect to treat a PFIC as a qualified electing fund (QEF) (i.e., make a QEF election), in which case the Fund will be required to
include its share of the PFICs income and net capital gain annually, regardless of whether it receives any distribution from the PFIC. Alternately, the Fund may make an election to mark the gains (and to a limited extent the losses) in such
holdings to the market as though it had sold (and, solely for purposes of this mark-to-market election, repurchased) its holdings in those PFICs on the last day of the Funds taxable year. Such gains and losses are treated as
ordinary income and loss. The QEF and mark-to-market elections may have the effect of accelerating the recognition of income (without the receipt of cash) and increasing the amount required to be distributed for the Fund to avoid taxation. Making
either of these elections therefore may require the Fund to liquidate other investments (including when it is not advantageous to do so) to meet its distribution requirement, which also may accelerate the recognition of gain and affect the
Funds total return. In general, if the Fund indirectly invests in PFICs by virtue of the Funds investment in Underlying RICs or other investment companies, it may not make such elections; rather, the Underlying RICs or other investment
companies directly investing in PFICs would decide whether to make such elections.
There is a risk that the Fund may not realize that a foreign
corporation in which it invests is a PFIC for U.S. federal tax purposes and thus fail to timely make a QEF or mark-to-market election in respect of that corporation, in which event the Fund could be subject to the U.S. federal income taxes and
interest charges described above.
A PFIC is any foreign corporation in which (i) 75% or more of the gross income for the taxable year is passive
income, or (ii) the average percentage of the assets (generally by value, but by adjusted tax basis in certain cases) that produce, or are held for the production of, passive income is at least 50%. Generally, passive income for this purpose
means dividends, interest (including income equivalent to interest), royalties, rents, annuities, the excess of gains over losses from certain property transactions and commodities transactions, income from certain notional principal contracts, and
foreign currency gains. Passive income for this purpose does not include rents and royalties received by the foreign corporation from active business and certain income received from related persons.
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Dividends paid by PFICs will not be eligible to be treated as qualified dividend income or for the
dividends-received deduction.
The interest on municipal obligations is generally exempt from U.S. federal income tax. However, distributions from the
Fund derived from interest on municipal obligations are taxable to shareholders of the Fund when received. In addition, gains realized by the Fund on the sale or exchange of municipal obligations are taxable to shareholders of the Fund.
Tax Considerations Related to the Funds Investments in Other RICs.
The Funds investments in Underlying RICs can cause the Fund to be required to distribute greater amounts of net investment income and net capital gains
than the Fund would have distributed had it invested directly in the investments held by the Underlying RICs, rather than investing in shares of the Underlying RICs. Further, the amount or timing of distributions from the Fund qualifying for
treatment as a particular character (e.g., long-term capital gain, eligibility for dividends-received deduction, etc.) will not necessarily be the same as it would have been had the Fund invested directly in the investments held by the Underlying
RICs.
If the Fund receives dividends from an Underlying RIC, and the Underlying RIC reports such dividends as qualified dividend income, then the Fund is
permitted, in turn, to report a portion of
69
its distributions as qualified dividend income, provided that the Fund meets the holding period and other requirements with respect to shares of the Underlying RIC.
If the Fund receives dividends from an Underlying RIC, and the Underlying RIC reports such dividends as eligible for the dividends-received deduction, then
the Fund is permitted, in turn, to report a portion of its distributions as eligible for the dividends-received deduction, provided that the Fund meets the holding period and other requirements with respect to shares of the Underlying RIC.
Tax Considerations Related to the Funds Investments in Partnerships.
Special tax considerations apply if the Fund invests in investment companies treated as partnerships for U.S. federal income tax purposes, including certain
GMO Trust Funds offered pursuant to separate private placement memoranda. For U.S. federal income tax purposes, if the Fund invests in such a partnership, it generally will be allocated its share of the income, gains, losses, deductions, credits,
and other tax items of the partnership so as to reflect the Funds interest in the partnership. A partnership in which the Fund invests may modify its partner allocations to comply with applicable tax regulations, including, without limitation,
the income tax regulations under Sections 704, 706, 708, 734, 743, 754, and 755 of the Code. It also may make special allocations of specific tax items, including gross income, gain, deduction, or loss. These modified or special allocations could
result in the Fund, as a partner, receiving more or fewer items of income, gain, deduction, or loss (and/or income, gain, deduction, or loss of a different character) than it would in the absence of such modified or special allocations. The Fund
will be required to include in its income its share of a partnerships tax items, including gross income, gain, deduction, or loss, for any partnership taxable year ending within or with the Funds taxable year, regardless of whether or
not the partnership distributes any cash to the Fund in such year.
In general, the Fund will not recognize its share of these tax items until the close
of the partnerships taxable year. However, absent the availability of an exception, the Fund will recognize its share of these tax items as they are recognized by the partnership for purposes of determining the Funds liability for the 4%
excise tax (described above). If the Fund and a partnership have different taxable years, the Fund may be obligated to make distributions in excess of the net income and gains recognized from that partnership and yet be unable to avoid the 4% excise
tax because it is without sufficient earnings and profits at the end of its taxable year. In some cases, however, the Fund can take advantage of certain safe harbors that would allow it to include its share of a partnerships income, gain,
loss, and certain other tax items at the close of the partnerships taxable year for both excise tax purposes and general Subchapter M purposes, thus avoiding the potential complexities arising from different taxable years.
In general, cash distributions to the Fund by a partnership in which it invests (including in partial or complete redemption of its interest in the
partnership) will represent a nontaxable return of capital to the Fund up to the amount of the Funds adjusted tax basis in its interest in the partnership, with any amounts exceeding such basis treated as capital gain. Any loss may be
recognized by the Fund only if it redeems its entire interest in the partnership for money.
70
If the Fund receives allocations of income from a partnership in which it invests that are eligible for qualified
dividend treatment or the dividends-received deduction, then the Fund, in turn, may report a portion of its distributions as qualified dividend income or as eligible for the dividend-received deduction, as applicable, provided certain conditions are
met.
More generally, as a result of the foregoing and certain other special rules, the Funds investment in investment companies that are
partnerships for U.S. federal income tax purposes can cause the Funds distributions to shareholders to vary in terms of their timing, character, and/or amount from what that Funds distributions would have been had the Fund invested
directly in the investments held by those underlying partnerships.
Loss of RIC Status
If the Fund were to fail to meet the income, diversification or distribution test described in Tax Status and Taxation of the Fund above, the Fund
could in some cases cure such failure, including by paying a Fund-level tax, paying interest charges, paying penalties, making additional distributions or disposing of certain assets. If the Fund were ineligible to or otherwise did not cure such
failure for any year, or if the Fund were otherwise to not qualify for taxation as a RIC for such year, the Funds income would be taxed at the Fund level at regular corporate rates, and depending on when the Fund discovered its qualification
failure for a particular taxable year, the Fund may be subject to penalties and interest on any late payments of its Fund-level taxes for such year. In addition, in the event of any such loss of RIC status, all distributions from earnings and
profits, including distributions of net long-term capital gains and net tax-exempt income (if any), generally would be taxable to shareholders as ordinary income. Such distributions generally would be eligible (i) to be treated as qualified
dividend income in the case of shareholders taxed as individuals and (ii) for the dividends-received deduction in the case of corporate shareholders, provided, in both cases, the shareholder meets certain holding period and other requirements
in respect of the Funds shares. In addition, in order to re-qualify for taxation as a RIC that is accorded special tax treatment, the Fund may be required to recognize unrealized gains, pay substantial taxes and interest on such gains, and
make certain substantial distributions. If an Underlying RIC were to fail to qualify as a RIC in a particular taxable year, the Funds return on its investment in such Underlying RIC and, depending on the size of the Funds investment in
such Underlying RIC, the Funds ability to qualify as a RIC, could be adversely affected.
Tax Shelter Reporting Regulations
Under Treasury regulations, if a shareholder recognizes a loss on disposition of the Funds shares of $2 million or more for an individual shareholder or
$10 million or more for a corporate shareholder, the shareholder must file with the IRS a disclosure statement on Form 8886. Direct holders of portfolio securities are in many cases excepted from this reporting requirement, but under current
guidance, shareholders of a RIC are not excepted. Future guidance may extend the current exception from this reporting requirement to shareholders of most or all RICs. The fact that a loss is reportable under these regulations does not affect the
legal determination of whether the taxpayers treatment of the loss is proper. Shareholders should consult their tax advisors to determine the applicability of these regulations in light of their individual circumstances.
71
State, Local, and Other Tax Matters
The foregoing discussion relates only to the U.S. federal income tax consequences of investing in the Fund for shareholders who are U.S. citizens, residents,
or domestic corporations. The consequences under other tax laws may differ. This discussion has not addressed all aspects of taxation that may be relevant to particular shareholders in light of their own investment or tax circumstances, or to
particular types of shareholders (including insurance companies, financial institutions or broker-dealers, tax-exempt entities, foreign corporations, and persons who are not citizens or residents of the United States) subject to special treatment
under the U.S. federal income tax laws. This summary is based on the Code, the regulations thereunder, published rulings, and court decisions, all as currently in effect. These laws are subject to change, possibly on a retroactive basis.
Shareholders should consult their tax advisors about the precise tax consequences of an investment in the Fund in light of their particular tax situation, including possible foreign, state, local, or other applicable tax laws.
Special tax rules apply to investments through defined contribution plans and other tax-qualified plans. Shareholders should consult their tax advisors to
determine the suitability of shares of the Fund as an investment through such plans.
Additionally, most states permit mutual funds, such as the Fund, to
pass through to their shareholders the state tax exemption on income earned from investments in certain direct U.S. Treasury obligations, as well as some limited types of U.S. government agency securities (such as Federal Farm Credit
Bank and Federal Home Loan Bank securities), so long as the Fund meets all applicable state requirements. Therefore, shareholders in the Fund may be allowed to exclude from their state taxable income distributions made to them by the Fund to the
extent attributable to interest the Fund directly or indirectly earned on such investments. The availability of these exemptions varies by state. Investments in securities of certain U.S. government agencies, including securities issued by Ginnie
Mae, Fannie Mae, and Freddie Mac, and repurchase agreements collateralized by U.S. government securities generally do not qualify for these exemptions. Moreover, these exemptions may not be available to corporate shareholders. All shareholders
should consult their tax advisors regarding the applicability of these exemptions to their situation.
72
MANAGEMENT OF THE TRUST
The following tables present information as of as of the date of this SAI regarding each current Trustee and officer of the Trust. Each Trustees and
officers date of birth (DOB) is set forth after his or her name. Unless otherwise noted, (i) each Trustee and officer has engaged in the principal occupation(s) noted in the table for at least the most recent five years,
although not necessarily in the same capacity, and (ii) the address of each Trustee and officer is c/o GMO Trust, 40 Rowes Wharf, Boston, Massachusetts 02110. Each Trustee serves in office until the earlier of (a) the election and
qualification of a successor at the next meeting of shareholders called to elect Trustees or (b) the Trustee dies, resigns, or is removed as provided in the Trusts governing documents. Each of the Trustees of the Trust, other than
Mr. Kittredge, is not an interested person of the Trust, as such term is used in the 1940 Act (each, an Independent Trustee). Because the Fund does not hold annual meetings of shareholders, each Trustee will hold office
for an indeterminate period. Each officer serves in office until his or her successor is elected and determined to be qualified to carry out the duties and responsibilities of the office, or until the officer resigns or is removed from office.
73
|
|
|
|
|
|
|
|
|
|
|
Name and Date
of Birth
|
|
Position(s)
Held
with
the
Trust
|
|
Length of
Time Served
|
|
Principal Occupation(s)
During Past 5 Years
|
|
Number of
Portfolios in
Fund
Complex
1
Overseen
|
|
Other
Directorships
Held in
the
Past Five
Years
|
INDEPENDENT TRUSTEES
|
|
|
|
|
|
|
Donald W. Glazer, Esq.
DOB: 07/26/1944
|
|
Chairman of the Board of Trustees
|
|
Chairman of the Board of Trustees since March 2005; Lead Independent Trustee (September 2004-March 2005); Trustee since December 2000.
|
|
Consultant Law and Business
2
; Author of Legal Treatises; Director, BeiGene Ltd.
|
|
44
|
|
None.
|
|
|
|
|
|
|
Peter Tufano
DOB: 04/22/1957
|
|
Trustee
|
|
Since December 2008.
|
|
Peter Moores Dean and Professor of Finance, University of Oxford Saïd Business School (as of July 1, 2011); Sylvan C. Coleman Professor of Financial Management, Harvard Business School (1989-2011).
|
|
44
|
|
Trustee of State Street Navigator Securities Lending Trust (2 Portfolios).
|
|
|
|
|
|
|
Paul Braverman
DOB: 01/25/1949
|
|
Trustee
|
|
Since March 2010.
|
|
Director of Courier Corporation (a book publisher and manufacturer) (January 2008-present); Chief Financial Officer, Wellington Management Company, LLP (an investment adviser) (March 1986-December 2007).
|
|
44
|
|
Director of Courier Corporation (a book publisher and manufacturer).
|
|
|
|
|
|
|
INTERESTED TRUSTEE AND OFFICER
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Joseph B. Kittredge, Jr.
3
DOB: 08/22/1954
|
|
Trustee;
President and Chief Executive Officer
of the Trust
|
|
Trustee since March 2010; President and Chief Executive Officer of the Trust since March 2009.
|
|
General Counsel, Grantham, Mayo, Van Otterloo & Co. LLC (October 2005-present); Partner, Ropes & Gray LLP (1988-2005).
|
|
56
|
|
None.
|
1
|
The Fund Complex includes series of each of GMO Trust and GMO Series Trust. Mr. Kittredge also serves as a Trustee of GMO Series Trust.
|
2
|
As part of Mr. Glazers work as a consultant, he provides part-time consulting services to Goodwin Procter LLP (Goodwin). Goodwin has provided legal services to Renewable Resources, LLC, an
affiliate of GMO; GMO, in connection with its relationship with Renewable Resources; and funds managed by Renewable Resources. Mr. Glazer has represented that he has no financial interest in, and is not involved in the provision of, such legal
services. In the calendar years ended December 31, 2012 and December 31, 2013, these entities paid $71,843.01 and $0, respectively, in legal fees and disbursements to Goodwin. In correspondence with the Staff of the SEC beginning in August
2006, the Independent Trustees legal counsel provided the Staff with information regarding Mr. Glazers relationship with Goodwin and his other business activities. On September 11, 2007, based on information that had been given
to the Staff as of that date, the Staff provided oral no-action assurance consistent with the opinion of the Independent Trustees legal counsel that Mr. Glazer is not an interested person of the Trust.
|
3
|
Mr. Kittredge is an interested person of the Trust, as such term is used in the 1940 Act (an Interested Trustee), by virtue of his positions with the Trust and GMO indicated in the table
above and his interest as a member of GMO.
|
74
Information About Each Trustees Experience, Qualifications, Attributes, or Skills for Board Membership.
As described in additional detail below under Committees, the Governance Committee, which is comprised solely of Independent Trustees, has responsibility for recommending to the Board of Trustees the nomination of candidates for
election as Trustees, including identifying and evaluating the skill sets and qualifications of, potential candidates. In recommending the election of the current board members as Trustees, the Governance Committee generally considered the
educational, business, and professional experience of each Trustee in determining his or her qualifications to serve as a Trustee of the Fund and the other GMO Funds. The Governance Committee focuses on the complementary skills and experience of the
Trustees as a group, as well as on those of any particular Trustee. With respect to Messrs. Glazer, Tufano, and Braverman, the Governance Committee noted that these Trustees all had considerable experience in overseeing investment management
activities and/or related operations and in serving on the boards of other companies. In addition, the Committee also considered, among other factors, the particular attributes described below with respect to the various individual Trustees:
Donald W. Glazer Mr. Glazers experience serving as Chairman of the Board of Trustees and as a director of other companies, his professional
training and his experience as a business lawyer, including as a partner at a leading law firm, and his business experience.
Peter Tufano
Mr. Tufanos experience serving as Trustee of the Funds and as a director of other companies, and his professional training and his experience in business and finance, including as a professor of financial management at a leading business
school.
Paul Braverman Mr. Bravermans experience as a director, his professional training and his experience as a certified public
accountant and lawyer and his experience in the management of a leading investment management firm.
Joseph B. Kittredge, Jr.
Mr. Kittredges experience serving as President of the Trust and GMO Series Trust and General Counsel and a Member of GMO, his professional training and his experience as a lawyer representing mutual funds and investment management firms,
including as a partner at a leading law firm, and his perspective on Board matters as a senior executive of GMO.
Information relating to the experience,
qualifications, attributes, and skills of the Trustees is required by the registration form adopted by the SEC, does not constitute holding out the Board or any Trustee as having any special expertise or experience, and does not impose any greater
responsibility or liability on any such person or on the Board as a whole than would otherwise be the case.
75
Officers
|
|
|
|
|
|
|
Name and Date of
Birth
|
|
Position(s) Held
with the Trust
|
|
Length
of Time Served
|
|
Principal Occupation(s)
During Past 5 Years
1
|
Joseph B. Kittredge, Jr.
DOB:
08/22/1954
|
|
Trustee;
President and Chief Executive Officer
of the Trust
|
|
Trustee since March 2010; President and Chief Executive Officer of the Trust since March 2009.
|
|
General Counsel, Grantham, Mayo, Van Otterloo & Co. LLC (October 2005-present); Partner, Ropes & Gray LLP (1988-2005).
|
|
|
|
|
Sheppard N. Burnett
DOB: 10/24/1968
|
|
Treasurer and Chief Financial Officer
|
|
Chief Financial Officer since March 2007; Treasurer since November 2006; Assistant Treasurer, September 2004-November 2006.
|
|
Head of Fund Treasury and Tax (December 2006-present), Grantham, Mayo, Van Otterloo & Co. LLC.
|
|
|
|
|
Carolyn Haley
DOB: 07/12/1966
|
|
Assistant Treasurer and Chief Accounting Officer
|
|
Assistant Treasurer, June 2009-March 2013 and since September 2013; Chief Accounting Officer since September 2013.
|
|
Fund Administrator, Grantham, Mayo, Van Otterloo & Co. LLC (May 2009-March 2013, June 2013-present); Treasurer and Chief Compliance Officer, Hambrecht & Quist Capital Management LLC (April 2007-April 2009).
|
|
|
|
|
John L. Nasrah
DOB: 05/27/1977
|
|
Assistant Treasurer and Chief Tax Officer
|
|
Since March 2007.
|
|
Fund Administrator, Grantham, Mayo, Van Otterloo & Co. LLC (September 2004-present).
|
|
|
|
|
Betty Chang
DOB: 12/26/1972
|
|
Assistant Treasurer
|
|
Since September 2013.
|
|
Fund Administrator, Grantham, Mayo, Van Otterloo & Co. LLC (July 2010-present); Assistant Treasurer (June 2009-July 2010), Manager, Fund Administration and Regulatory Affairs (2006-2009), Hambrecht & Quist Capital Management
LLC.
|
|
|
|
|
Carly Condron
DOB: 03/04/1984
|
|
Assistant Treasurer
|
|
Since September 2013.
|
|
Fund Administrator, Grantham, Mayo, Van Otterloo & Co. LLC (December 2009-present); Senior Accountant, Renaissance HealthCare (February 2009-December 2009); Auditor/Senior Auditor, Deloitte & Touche (September 2006-February
2009).
|
|
|
|
|
Mahmoodur Rahman
DOB: 11/30/1967
|
|
Assistant Treasurer
|
|
Since September 2007.
|
|
Fund Administrator, Grantham, Mayo, Van Otterloo & Co. LLC (April 2007-present); Vice President and Senior Tax Manager, Massachusetts Financial Services Company (January 2000-April 2007).
|
|
|
|
|
Brian Kadehjian
DOB: 09/16/1974
|
|
Treasury Officer
|
|
Since September 2013.
|
|
Fund Administrator, Grantham, Mayo, Van Otterloo & Co. LLC (April 2002-present).
|
76
|
|
|
|
|
|
|
Name and Date of
Birth
|
|
Position(s) Held
with the Trust
|
|
Length
of Time Served
|
|
Principal Occupation(s)
During Past 5 Years
1
|
Jason B. Harrison
DOB: 01/29/1977
|
|
Chief Legal Officer, Vice President-Law and Clerk
|
|
Chief Legal Officer since October 2010; Vice President-Law since October 2010; Vice President since November 2006; Clerk since March 2006.
|
|
Legal Counsel, Grantham, Mayo, Van Otterloo & Co. LLC (February 2006-present).
|
|
|
|
|
Megan Bunting
DOB: 03/24/1978
|
|
Vice President and Assistant Clerk
|
|
Since September 2013.
|
|
Legal Counsel, Grantham, Mayo, Van Otterloo & Co. LLC (September 2006-present).
|
|
|
|
|
Meta S. David
DOB: 09/15/1982
|
|
Vice President and Assistant Clerk
|
|
Since September 2013.
|
|
Legal Counsel, Grantham, Mayo, Van Otterloo & Co. LLC (September 2012-present).
|
|
|
|
|
Gregory L. Pottle
DOB: 07/09/1971
|
|
Vice President and Assistant Clerk
|
|
Since November 2006.
|
|
Legal Counsel, Grantham, Mayo, Van Otterloo & Co. LLC (March 2000-present).
|
|
|
|
|
Anne K. Trinque
DOB: 04/15/1978
|
|
Vice President and Assistant Clerk
|
|
Since September 2007.
|
|
Legal Counsel, Grantham, Mayo, Van Otterloo & Co. LLC (January 2007-present).
|
|
|
|
|
John B. McGinty
DOB: 08/11/1962
|
|
Chief Compliance Officer
|
|
Since March 2011.
|
|
Chief Compliance Officer, Grantham, Mayo, Van Otterloo & Co. LLC (July 2009-present); Senior Vice President and Deputy General Counsel (January 2007-July 2009), Fidelity Investments.
|
|
|
|
|
Kenneth Earley
DOB: 09/09/1973
|
|
Anti-Money Laundering Officer
|
|
Since September 2013.
|
|
Compliance Counsel, Grantham, Mayo, Van Otterloo & Co. LLC (May 2011-present); Associate in Financial Services Group, Dechert LLP (May 2007-May 2011).
|
1
|
Each of Messrs. Burnett, Kittredge, Nasrah and Pottle and Mses. Haley and Trinque serve as an officer and/or director of certain pooled investment vehicles of which GMO or an affiliate of GMO serves as the investment
adviser. Each officer listed in the table above, other than Mr. Kittredge, also serves as an officer of GMO Series Trust.
|
Trustees Responsibilities.
Under the provisions of the GMO Declaration of Trust, the Trustees manage the business of the Trust, an open-end
management investment company. The Trustees have all powers necessary or convenient to carry out that responsibility, including the power to engage in securities transactions on behalf of the Trust. Without limiting the foregoing, the Trustees may:
adopt By-Laws not inconsistent with the Declaration of Trust providing for the regulation and management of the affairs of the Trust; amend and repeal By-Laws to the extent that such By-Laws do not reserve that right to the shareholders; fill
vacancies in or remove members of the Board of Trustees (including any vacancies created by an increase in the number of Trustees); remove members of the Board of Trustees with or without cause; elect and remove such officers and appoint and
terminate agents as they consider appropriate; appoint members of
77
the Board of Trustees to one or more committees consisting of two or more Trustees, which may exercise the powers and authority of the Trustees, and terminate any such appointments; employ one or
more custodians of the assets of the Trust and authorize such custodians to employ subcustodians and to deposit all or any part of such assets in a system or systems for the central handling of securities or with a Federal Reserve Bank; retain a
transfer agent or a shareholder servicing agent, or both; provide for the distribution of Shares by the Trust, through one or more principal underwriters or otherwise; set record dates for the determination of Shareholders with respect to various
matters; and in general delegate such authority as they consider desirable to any officer of the Trust, to any committee of the Trustees, and to any agent or employee of the Trust or to any such custodian or underwriter.
Board Leadership Structure and Risk Oversight.
The Board of Trustees is responsible for the general oversight of the GMO Funds affairs and for
assuring that each GMO Fund is managed in the best interests of its shareholders. The Board regularly reviews each GMO Funds investment performance as well as the quality of services provided to the GMO Fund and its shareholders by GMO and its
affiliates, including shareholder servicing. At least annually, the Board reviews and evaluates the fees and operating expenses paid by each GMO Fund for these services and negotiates changes that it deems appropriate. In carrying out these
responsibilities, the Board is assisted by the GMO Funds auditors, independent counsel to the Independent Trustees, and other persons as appropriate, who are selected by and responsible to the Board. In addition, the GMO Funds Chief
Compliance Officer reports directly to the Board.
Currently, all but one of the Trustees are Independent Trustees. The Independent Trustees must vote
separately to approve all financial arrangements and other agreements with the GMO Funds investment adviser, GMO, and other affiliated parties. The role of the Independent Trustees has been characterized as that of a watchdog
charged with oversight of protecting shareholders interests against overreaching and abuse by those who are in a position to control or influence a fund. The Independent Trustees meet regularly as a group in executive session without
representatives of GMO present. An Independent Board Member currently serves as Chairman of the Board of Trustees.
Taking into account the number,
diversity, and complexity of the GMO Funds overseen by the Board of Trustees and the aggregate amount of assets under management in the GMO Funds, the Board has determined that the efficient conduct of its affairs makes it desirable to delegate
responsibility for certain specific matters to committees of the Board. These committees, which are described in more detail below, review and evaluate matters specified in their charters and make recommendations to the Board as they deem
appropriate. Each committee may utilize the resources of the GMO Funds counsel and auditors as well as other persons. The committees meet from time to time, either in conjunction with regular meetings of the Board or otherwise. The membership
and chair of each committee are appointed by the Board upon recommendation of the Governance Committee. The membership and chair of each committee other than the Risk Oversight Committee consists exclusively of Independent Trustees.
The Board of Trustees has determined that this committee structure also allows the Board to focus more effectively on the oversight of risk as part of its
broader oversight of each GMO Funds affairs. While risk management is primarily the responsibility of the GMO Funds investment adviser, GMO, the Board regularly receives reports, including reports from GMO and the GMO Funds Chief
Compliance Officer, regarding investment risks, compliance risks, and certain other risks applicable
78
to the GMO Funds. The Boards committee structure allows separate committees, such as the Audit Committee, Pricing Committee, and Governance Committee, which are discussed in more detail
below under Committees, to focus on different aspects of these risks within the scope of the committees authority and their potential impact on some or all of the GMO Funds, and to discuss with the GMO the ways in which GMO
monitors and controls such risks. The Board has also established a separate Risk Oversight Committee to oversee the management of risks applicable to the GMO Funds, to the extent such risks are not overseen by a separate standing committee of the
Board or by the Board itself.
The Board recognizes that not all risks that may affect the GMO Funds can be identified, that it may not be practical or
cost-effective to eliminate or mitigate certain risks, that it may be necessary to bear certain risks (such as investment-related risks) to achieve a GMO Funds goals, that reports received by the Trustees with respect to risk management
matters are typically summaries of the relevant information, and that the processes, procedures, and controls employed to address risks may be limited in their effectiveness. As a result of the foregoing and other factors, risk management oversight
by the Board and by the Committees is subject to substantial limitations.
Committees
The Board of Trustees has the authority to establish committees, which may exercise the power and authority of the Trustees to the extent the Board determines.
The committees assist the Board of Trustees in performing its functions and duties under the 1940 Act and Massachusetts law.
The Board of Trustees
currently has established four standing committees: the Audit Committee, the Pricing Committee, the Risk Oversight Committee, and the Governance Committee. During the fiscal year ended February 28, 2013, the Audit Committee held 3 meetings; the
Pricing Committee held 4 meetings; the Governance Committee held 3 meetings; and the Risk Oversight Committee held 5 meetings.
Audit
Committee.
The Audit Committee (i) oversees the Trusts accounting and financial reporting policies and practices and internal controls over financial reporting; (ii) oversees the quality and objectivity of the Trusts
financial statements and the independent audit of those statements; (iii) appoints, determines the independence and compensation of, and oversees the work performed by the Trusts independent auditors in preparing or issuing an audit
report or related work; (iv) approves all audit and permissible non-audit services provided to the Trust, and certain other persons by the Trusts independent auditors; and (v) acts as a liaison between the Trusts independent
auditors and the Board of Trustees. Mr. Braverman and Mr. Tufano are members of the Audit Committee, and Mr. Glazer is an alternate member of the Audit Committee. Mr. Braverman is the Chairman of the Audit Committee.
Pricing Committee.
The Pricing Committee oversees the valuation of the securities and other assets held by the Funds, reviews and makes
recommendations regarding the Trusts Pricing Policies, and, to the extent required by the Trusts Pricing Policies, determines the fair value of the securities or other assets held by the Funds. Mr. Tufano and Mr. Glazer are
members of the Pricing Committee, and Mr. Braverman is an alternate member of the Pricing Committee. Mr.
79
Tufano is the Chairman of the Pricing Committee.
Risk Oversight Committee.
The Risk Oversight
Committee assists the Board in overseeing the management of risks applicable to the Funds to the extent those risks are not overseen by another standing committee of the Board or by the Board itself (e.g., financial reporting and audit-related
operational or compliance risks, which are overseen by the Audit Committee, valuation-related operational or compliance risks, which are overseen by the Pricing Committee, or legal risks, which are overseen by the Board as a whole) including,
without limitation, investment, operational and compliance risks. All of the Trustees are members of the Risk Oversight Committee, and Messrs. Braverman and Tufano are Co-Chairmen of the Risk Oversight Committee.
Governance Committee.
The Governance Committee oversees general Fund governance-related matters, including making recommendations to the Board of
Trustees relating to governance of the Trust, reviewing possible conflicts of interest and independence issues involving Trustees, considering the skill sets and qualifications of prospective Trustees and to propose to the Board candidates to serve
as Trustees, overseeing the determination that any person serving as legal counsel for the Independent Trustees qualifies as independent legal counsel, as that term is defined in the 1940 Act, and performing any other functions delegated
to it by the Board of Trustees. Mr. Glazer and Mr. Braverman are members of the Governance Committee, and Mr. Tufano is an alternate member of the Governance Committee. Mr. Glazer is the Chairman of the Governance Committee.
As described above under Information About Each Trustees Experience, Qualifications, Attributes or Skills for Board Membership, the
Governance Committee has responsibility for recommending to the Board of Trustees the nomination of candidates for election as Trustees, including identifying, and evaluating the skill sets and qualifications of, potential candidates. Prospective
nominees may be recommended by the current Trustees, the Trusts Officers, GMO, current shareholders, or other sources that the Governance Committee deems appropriate. Candidates properly submitted by shareholders will be considered on the same
basis as candidates recommended by other sources. The Governance Committee has full discretion to reject nominees who are recommended by shareholders.
The Governance Committee considers a variety of qualifications, skills, and other attributes in evaluating potential candidates for nomination to the Board of
Trustees. The attributes considered may include, but are not limited to: (i) relevant industry and related experience, including experience serving on other boards; (ii) skill sets, areas of expertise, abilities, and judgment; and
(iii) availability and commitment to attend meetings and to perform the responsibilities of a Trustee. In evaluating potential candidates, the Governance Committee also considers the overall composition of the Board of Trustees and assesses the
needs of the Board and its committees.
Shareholders may recommend nominees to the Board of Trustees by writing the Board of Trustees, c/o GMO Trust Chief
Compliance Officer, GMO Trust, 40 Rowes Wharf, Boston, Massachusetts 02110. A recommendation must (i) be in writing and signed by the shareholder, (ii) identify the GMO Fund to which it relates, and (iii) identify the class and number
of shares held by the shareholder.
80
Trustee Fund Ownership
The following table sets forth ranges of the current Trustees direct beneficial share ownership in the Fund and the aggregate dollar ranges of their
direct beneficial share ownership in all series of GMO Trust and GMO Series Trust (the Family of Investment Companies) as of December 31, 2013.
|
|
|
|
|
Name
|
|
Dollar Range of
Shares Directly Owned in
the Fund
|
|
Aggregate Dollar Range of Shares
Directly Owned in all
Registered Investment Companies
(whether or not
offered in the
Prospectus) Overseen by Trustee in
Family of Investment Companies
|
INDEPENDENT TRUSTEES
|
|
|
|
|
Donald W. Glazer
|
|
None
|
|
Over $100,000
|
Peter Tufano
|
|
None
|
|
None
|
Paul Braverman
|
|
None
|
|
None
|
INTERESTED TRUSTEE
|
|
|
|
|
Joseph B. Kittredge, Jr.
|
|
None
|
|
$50,001-$100,000
|
The following table sets forth ranges of Mr. Glazers and Mr. Kittredges indirect beneficial share
ownership in the Fund and the aggregate dollar range of their indirect beneficial share ownership in the Family of Investment Companies as of December 31, 2013.
|
|
|
|
|
Name
|
|
Dollar Range of
Shares Indirectly Owned
in the Fund
|
|
Aggregate Dollar Range of Shares
Indirectly Owned in all
Registered Investment Companies
(whether or not
offered in the
Prospectus) Overseen by Trustee in
Family of Investment Companies
|
INDEPENDENT TRUSTEES
|
|
|
|
|
Donald W. Glazer
|
|
$1-$10,000
|
|
Over $100,000
|
INTERESTED TRUSTEE
|
|
|
|
|
Joseph B. Kittredge, Jr.
|
|
$50,001-$100,000
|
|
$50,001-$100,000
|
81
Trustee Ownership of Securities Issued by the Manager or Principal Underwriter
None.
Trustee Ownership of Related Companies
The following table sets forth information about securities owned by the current Independent Trustees and their family members, as of December 31, 2013,
in the Manager, Funds Distributor, LLC, the Funds principal underwriter, or entities directly or indirectly controlling, controlled by, or under common control with the Manager or Funds Distributor, LLC.
|
|
|
|
|
|
|
|
|
|
|
Name of Non-Interested
Trustee
|
|
Name of
Owner(s) and
Relationship
to
Trustee
|
|
Company
|
|
Title of
Class
|
|
Value of
Securities²
|
|
% of Class
|
Donald W. Glazer
|
|
Self
|
|
GMO Multi-Strategy
Fund (Offshore), a
private investment company managed by the Manager
1
|
|
Limited
partnership
interest Class A
|
|
$627,053.89
|
|
0.014%
|
Peter Tufano
|
|
N/A
|
|
None
|
|
N/A
|
|
N/A
|
|
N/A
|
Paul Braverman
|
|
N/A
|
|
None
|
|
N/A
|
|
N/A
|
|
N/A
|
1
|
The Manager may be deemed to control this fund by virtue of its serving as investment manager of the fund and by virtue of its ownership of all the outstanding voting shares of the fund as of
December 31, 2013.
|
2
|
Securities valued as of December 31, 2013.
|
Remuneration.
The Trust has adopted a
compensation policy for its Independent Trustees. Each Independent Trustee receives an annual retainer from the Trust for his services. In addition, each Chairman of the Trusts standing committees and the Chairman of the Board of Trustees
receive an annual fee. Each Independent Trustee also is paid a fee for participating in in-person and telephone meetings of the Board of Trustees and its committees, and a fee for consideration of actions proposed to be taken by written consent. The
Trust reimburses the Independent Trustees for travel expenses incurred in connection with attending Board and committee meetings. The Trust pays no additional compensation for travel time to meetings, attendance at directors educational
seminars or conferences, service on industry or association committees, participation as speakers at directors conferences, or service on special director task forces or subcommittees, although the Trust does reimburse Independent Trustees for
seminar or conference fees and for travel expenses incurred in connection with attendance at seminars or conferences. The Independent Trustees do not receive any employee benefits such as pension or retirement benefits or health insurance.
Other than as set forth in the following table, no Trustee of the Trust received any direct compensation from the Fund Complex or the Fund during the fiscal
year ended February 28, 2013:
82
|
|
|
|
|
|
|
|
|
Donald W.
Glazer, Esq.,
Trustee
|
|
Peter
Tufano,
Trustee
|
|
Paul
Braverman,
Trustee
|
Compensation from the Fund:
|
|
$3,399
|
|
$2,719
|
|
$2,594
|
Pension or Retirement Benefits Accrued as Part of Fund Expenses:
|
|
N/A
|
|
N/A
|
|
N/A
|
Estimated Annual Benefits Upon Retirement:
|
|
N/A
|
|
N/A
|
|
N/A
|
Total Compensation from the Fund Complex:
|
|
$313,345
1
|
|
$251,125
1
|
|
$239,965
1
|
1
|
Reflects actual direct compensation received during the fiscal year ended February 28, 2013 from series of the Fund Complex that had commenced operations on or
before February 28, 2013, which consisted of 54 series of GMO Trust and GMO Series Trust.
|
No officer of the Trust received aggregate
compensation exceeding $60,000 from the Fund during the fiscal year ended February 28, 2013.
Mr. Kittredge does not receive any compensation
from the Fund Complex, but as a member of the Manager will benefit from management, shareholder servicing, administration, and any other fees paid to GMO and its affiliates by the Fund and various other series of the Fund Complex not offered through
the Prospectus. The officers of the Trust do not receive any employee benefits such as pension or retirement benefits or health insurance from the Trust.
The Funds Class III shares will commence operations on or following the date of this SAI, and, therefore, the Fund has not yet offered any Class III
shares for sale. Therefore, as of the date hereof, the Trustees and officers of the Trust as a group owned less than 1% of the Funds outstanding Class III shares.
Code of Ethics.
The Trust and the Manager have each adopted a Code of Ethics pursuant to the requirements of the 1940 Act. Under each Code of Ethics,
personnel are permitted to engage in personal securities transactions only in accordance with specified conditions relating to their position, the identity of the security, the timing of the transaction, and similar factors. Transactions in
securities that may be purchased or held by the Fund are permitted, subject to compliance with each Code. Personal securities transactions must be reported quarterly and broker confirmations must be provided for review.
The non-interested Trustees of the Trust are subject to a separate Code of Ethics for the Independent Trustees pursuant to the requirements of the 1940 Act.
Transactions by the Independent Trustees in securities, including securities that may be purchased or held by the Fund, are permitted, subject to compliance with the Code of Ethics. Pursuant to the Code of Ethics, an Independent Trustee ordinarily
is not required to report his or her personal securities transactions or to identify his or her brokerage accounts to the Fund or its representatives, subject to certain limited exceptions specified in the Code of Ethics.
83
The Funds principal underwriter, which is not affiliated with the Fund or the Manager, also has adopted a
Code of Ethics pursuant to the requirements of the 1940 Act. Transactions in securities effected by the principal underwriters personnel who are designated as Access Persons under the Code of Ethics, including securities that may be
purchased or held by the Fund, are permitted, subject to compliance with the Code of Ethics.
INVESTMENT
ADVISORY AND OTHER SERVICES
Management Contracts
As disclosed in the Prospectus under the heading Management of the Trust, under a Management Contract (the Management Contract) between
the Trust, on behalf of the Fund, and the Manager, subject to such policies as the Trustees of the Trust may determine, the Manager furnishes continuously an investment or asset allocation program, as applicable, for the Fund, and makes investment
decisions on behalf of the Fund and places all orders for the purchase and sale of portfolio securities. Subject to the control of the Trustees, the Manager also manages, supervises, and conducts the other affairs and business of the Trust,
furnishes office space and equipment, provides bookkeeping and certain clerical services, and pays all salaries, fees, and expenses of officers and Trustees of the Trust who are affiliated with the Manager. As indicated under Portfolio
Transactions Brokerage and Research Services, the Trusts portfolio transactions may be placed with broker-dealers who furnish the Manager, at no cost, research, statistical and quotation services of value to the Manager in
advising the Trust or its other clients.
In addition, as disclosed in the Prospectus, the Manager has contractually agreed to waive and/or reimburse
the Fund for specified Fund expenses through at least March 1, 2015.
The Management Contract provides that the Manager shall not be subject to any
liability in connection with the performance of its services in the absence of willful misfeasance, bad faith, gross negligence, or reckless disregard of its obligations and duties.
The Management Contract was approved by the Trustees of the Trust (including a majority of the Trustees who were not interested persons of the
Manager) and by the Funds sole initial shareholder in connection with the organization of the Trust and the establishment of the Fund. Generally, the Management Contract continues in effect for a period of two years from the date of its
execution and continuously thereafter so long as its continuance is approved at least annually by (i) the vote, cast in person at a meeting called for that purpose, of a majority of those Trustees who are not interested persons of
the Manager or the Trust, and by (ii) the majority vote of either the full Board of Trustees or the vote of a majority of the outstanding shares of the relevant Fund. The Management Contract automatically terminates on assignment, and is
terminable on not more than 60 days notice by the Trust to the Manager. In addition, the Management Contract may be terminated on not more than 60 days written notice by the Manager to the Trust.
The Fund pays no fee to the Manager as compensation for the Managers investment management services rendered under the Management Contract. Pursuant to
the Management
84
Contract, the Fund paid the following amounts as Management Fees to the Manager during the last three fiscal years:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross
|
|
|
Reduction
|
|
|
Net
|
|
Year ended 2/28/13
|
|
$
|
0
|
|
|
$
|
0
|
|
|
$
|
0
|
|
Year ended 2/29/12
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
Year ended 2/28/11
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
In the event that the Manager ceases to be the manager of the Fund, the right of the Trust to use the identifying name
GMO may be withdrawn.
Portfolio Management
GMOs Fixed Income Division is responsible for day-to-day investment management of the Fund. The divisions investment professionals work
collaboratively to manage the Funds portfolio, and no one person is primarily responsible for day-to-day management of the Fund.
85
The following table sets forth information about accounts overseen or managed by the senior member of the Fixed
Income Division as of February 28, 2013.
|
|
|
|
|
|
|
|
|
|
|
|
|
Senior Member
|
|
Registered investment companies managed
for which GMO receives a performance-
based fee (including non-GMO mutual
fund subadvisory relationships)
|
|
Other pooled investment vehicles
managed (world-wide) for which GMO
receives
a performance-based fee
|
|
Separate accounts managed (world-wide)
for which GMO receives a performance
-based fee
|
|
|
Number of
accounts
|
|
Total assets
|
|
Number of
accounts
|
|
Total assets
|
|
Number of
accounts
|
|
Total assets
|
Thomas Cooper
|
|
0
|
|
$0
|
|
2
|
|
$1,143,236,409.60
|
|
1
|
|
$335,083,175.32
|
|
|
|
|
Senior Member
|
|
Registered investment companies
managed (including non-GMO mutual
fund subadvisory relationships)
|
|
Other pooled investment vehicles
managed (world-wide)
|
|
Separate accounts managed
(world-wide)
|
|
|
Number of
accounts
1
|
|
Total assets
1
|
|
Number of
accounts
|
|
Total assets
|
|
Number of
accounts
|
|
Total assets
|
Thomas Cooper
|
|
12
|
|
$5,805,125,285.35
|
|
11
|
|
$3,181,744,898.83
|
|
5
|
|
$515,633,140.25
|
1
|
Total assets may include assets invested by other GMO Funds (including GMO Funds not offered through the Prospectus).
|
86
Because the senior member manages other accounts, including accounts that pay higher fees or accounts that pay
performance-based fees, potential conflicts of interest exist, including potential conflicts between the investment strategy of the Fund and the investment strategy of the other accounts managed by the senior member and potential conflicts in the
allocation of investment opportunities between the Fund and the other accounts.
The senior member is a member (partner) of GMO. As of February 28,
2013, the compensation of the senior member consisted of a fixed annual base salary, a partnership interest in the firms profits and, possibly, an additional, discretionary, bonus related to the senior members contribution to GMOs
success. The compensation program does not disproportionately reward outperformance by higher-fee/performance-fee products. Base salary is determined by taking into account current industry norms and market data to ensure that GMO pays a competitive
base salary. The level of partnership interest is determined by taking into account the individuals contribution to GMO and its mission statement. A discretionary bonus also may be paid to recognize specific business contributions and to
ensure that the total level of compensation is competitive with the market. Because each persons compensation is based on his or her individual performance, GMO does not have a typical percentage split among base salary, bonus, and other
compensation. A GMO membership interest is the primary incentive for persons to maintain employment with GMO. GMO believes this is the best incentive to maintain stability of portfolio management personnel.
Senior Member Fund Ownership.
The following table sets forth the dollar range of the senior members direct beneficial share ownership, as
of February 28, 2013, of the Fund:
|
|
|
Name of Senior
Member
|
|
Dollar Range of Shares Directly Owned in the Fund
|
Thomas Cooper
|
|
None
|
The following table sets forth the dollar range of the senior members indirect beneficial share ownership in the Fund,
as of February 28, 2013, by virtue of the senior members direct ownership of shares of certain other GMO Funds that invest in the Fund:
|
|
|
Name of Senior
Member
|
|
Dollar Range of Shares Indirectly Owned in the Fund
|
Thomas Cooper
|
|
Over $1,000,000
|
Custodial Arrangements and Fund Accounting Agents
.
As described in the Prospectus, State Street Bank and
Trust Company (State Street Bank), One Lincoln Street, Boston, Massachusetts 02111, serves as the Trusts custodian and fund accounting agent on behalf of the Fund. As such, State Street Bank holds in safekeeping certificated
securities and cash belonging to the Fund and, in such capacity, is the registered owner of securities in book-entry form belonging to the Fund. Upon instruction, State Street Bank receives and delivers cash and securities of the Fund in connection
with Fund transactions and collects all dividends and other distributions made with respect to Fund portfolio securities. State Street Bank also maintains certain accounts and records of the Trust and calculates the total net asset value, total net
income and net asset value per share of the Fund on a daily basis.
87
Shareholder Service Arrangements
.
As disclosed in the Prospectus, pursuant to the terms of
an Amended and Restated Servicing and Supplemental Support Agreement (the Servicing Agreement) with the Fund, GMO provides direct client service, maintenance, and reporting to Fund shareholders and/or their consultants/agents. The
Servicing Agreement was approved by the Trustees of the Trust (including a majority of the Trustees who are not interested persons of the Manager or the Trust). The Servicing Agreement will continue in effect for a period of more than
one year from the date of its execution only so long as its continuance is approved at least annually by (i) the vote, cast in person at a meeting called for the purpose, of a majority of those Trustees who are not interested
persons of the Manager or the Trust, and (ii) the majority vote of the full Board of Trustees. The Servicing Agreement automatically terminates on assignment (except as specifically provided in the Servicing Agreement) and is terminable
by either party upon not more than 60 days written notice to the other party.
The Trust entered into the Servicing Agreement with GMO on
May 30, 1996. The Funds Class III shares will commence operations on or following the date of this SAI and, therefore, has not yet paid any amounts to GMO pursuant to the terms of the Servicing Agreement as of the date hereof. Once the
Funds Class III shares commence operations, these shares will pay the Manager a Shareholder Service Fee of 0.15% of the average daily net assets attributable to Class III shares.
Independent Registered Public Accounting Firm
.
The Trusts independent registered public accounting firm is PricewaterhouseCoopers
LLP, 125 High Street, Boston, Massachusetts 02110. PricewaterhouseCoopers LLP conducts annual audits of the Trusts financial statements, assists in the preparation of the Funds federal and state income tax returns, consults with the
Trust as to matters of accounting and federal and state income taxation, provides assistance in connection with the preparation of various SEC filings, and consults with the Trust as to certain non-U.S. tax matters.
Distributor
.
Funds Distributor, LLC, 10 High Street, Suite 302, Boston, Massachusetts 02110, serves as the Trusts distributor on
behalf of the Fund. GMO pays all distribution-related expenses of the Fund. Funds Distributor, LLC offers Class III shares of the Fund for sale on a continuous basis and will use all reasonable efforts in connection with distribution of shares of
the Fund.
Counsel
.
Ropes & Gray LLP, Prudential Tower, 800 Boylston Street, Boston, Massachusetts 02199, serves as counsel
to the Trust. Bingham McCutchen LLP, 150 Federal Street, Boston, Massachusetts 02110, serves as independent counsel to the non-interested Trustees of the Trust.
Transfer Agent.
State Street Bank serves as the Trusts transfer agent on behalf of the Fund.
PORTFOLIO TRANSACTIONS
Decisions to buy and sell portfolio securities for the Fund and for each of its other investment advisory clients are made by the Manager with a view to
achieving each clients investment objectives taking into consideration other account-specific factors such as, without limitation, cash flows into or out of the account, current holdings, the accounts benchmark(s), applicable
88
regulatory limitations, liquidity, cash restrictions, applicable transaction documentation requirements, market registration requirements, and/or time constraints limiting the Managers
ability to confirm adequate transaction documentation or seek interpretation of investment guideline ambiguities. Therefore, a particular security may be bought or sold only for certain clients of the Manager even though it could have been bought or
sold for other clients at the same time. Also, a particular security may be bought/sold for one or more clients when one or more other clients are selling/buying the security or taking a short position in the security, including clients invested in
the same investment strategy. Additionally, one of the Managers investment divisions may share investment ideas with one or more other investment divisions and/or may manage a portion of another investment divisions client accounts.
To the extent permitted by applicable law, the Managers compliance policies and procedures and a clients investment guidelines, the Manager may
engage in cross trades where, as investment manager to a client account, the Manager causes that client account to purchase a security directly from (or sell a security directly to) another client account.
In certain cases, the Manager may identify investment opportunities that are suitable for the Fund and one or more private investment companies for which the
Manager or one of its affiliates serves as investment manager, general partner, and/or managing member (GMO Private Funds). In most cases, the Manager receives greater compensation in respect of a GMO Private Fund (including
incentive-based compensation) than it receives in respect of the Fund. In addition, senior members or other portfolio managers frequently have a personal investment in a GMO Private Fund that is greater than such persons investment in the Fund
(or, in some cases, may have no investment in the Fund). The Manager itself also makes investments in GMO Private Funds. To help manage these potential conflicts, the Manager has developed and reviewed with the Trusts Board of Trustees trade
allocation policies that establish a framework for allocating IPOs and other limited opportunities that take into account the needs and objectives of the Fund and the other GMO clients.
Transactions involving the issuance of Fund shares for securities or assets other than cash will be limited to a bona fide reorganization or statutory merger
and to other acquisitions of portfolio securities that meet all of the following conditions: (i) such securities meet the investment objectives and policies of the Fund; (ii) such securities are acquired for investment and not for resale;
and (iii) such securities can be valued pursuant to the Trusts pricing policies.
Brokerage and Research Services
.
Orders
for the purchase or sale of securities may be placed on a principal or agency basis with brokers, in the Managers discretion. In selecting brokers and dealers to effect portfolio transactions for the Fund, the Manager seeks best execution.
Best execution is not based solely on the explicit commission charged by the broker/dealer and, consequently, a broker/dealer effecting a transaction may be paid a commission higher than that charged by another broker/dealer for the same
transaction. Seeking best execution involves the weighing of qualitative as well as quantitative factors, and evaluations of best execution are, to a large extent, possible, if at all, only after multiple trades have been completed. The Manager does
place trades with broker/dealers that provide investment ideas and other research services, even if the relevant broker has not yet demonstrated an ability to effect best execution; however, trading with such a broker (as with any and all brokers)
will typically be curtailed or suspended, in due course, if the Manager is not reasonably satisfied with the quality of trade executions,
89
unless or until the broker has altered its execution capabilities in such a way that the Manager can reasonably conclude that the broker is capable of achieving best execution.
The determination of what may constitute best execution involves a number of considerations in varying degrees of emphasis, including, without limitation, the
overall net economic result to the Fund; the efficiency with which the transaction is effected; access to order flow; the ability of the executing broker/dealer to effect the transaction where a large block is involved; reliability (e.g., lack of
failed trades); availability of the broker/dealer to stand ready to execute possibly difficult transactions in the future; technological capabilities of the broker/dealer, including but not limited to execution technology; the broker/dealers
inventory of securities sought; reported broker flow; post-transaction reporting capabilities; the financial strength and stability of the broker/dealer; past bids and willingness to commit capital in the case of principal trades and the relative
weighting of opportunity costs (i.e., timeliness of execution) by different trading strategies. Additionally, regulations in certain markets, particularly emerging markets, require the Manager to identify and trade with one or a limited number of
brokers on behalf of clients. Most of the foregoing are subjective considerations made in advance of the trade and are not always borne out by the actual execution.
The Managers broker/dealer selection may, in addition to the factors listed above, also be based on research services provided by the broker/dealer. In
seeking best execution and in determining the overall reasonableness of brokerage commissions, the Manager may consider research services received by broker-dealers and therefore, may select or recommend a broker-dealer based on the Managers
interest in receiving the research rather than on the lowest commission charged. The Manager also may direct trades to broker/dealers based in part on the broker/dealers history of providing, and capability to continue providing, pricing
information for securities purchased.
Generally, the Manager determines the overall reasonableness of brokerage commissions paid upon consideration of
the relative merits of a number of factors, which may include: (i) the net economic effect to the Fund; (ii) historical and current commission rates; (iii) the kind and quality of the execution services rendered; (iv) the size
and nature of the transactions effected; and (v) research services received. These factors are considered mostly over multiple transactions covering extended periods of time in varying degrees of emphasis. In some instances, the Manager may
evaluate best execution on principal bids based on the total commissions charged (the bid for handling a trade as a principal trade) because the trades were filled at the price set at an agreed upon time (e.g., previous nights close). In those
cases, any additional impact or cost is represented by the cents per share or basis points paid in addition to a typical commission rate. As discussed above, GMO may select a broker based on its technological capability to execute a
particular trading strategy. Due to the similarities among brokers in technological execution capabilities and commissions paid, GMO may determine to diversify trades among brokers selected on this basis.
In general, the Manager seeks best execution in the execution of foreign exchange transactions by comparing rates across counterparties and selecting the
counterparty that the Manager believes can provide best execution. In certain jurisdictions where it is general market practice (restricted currencies) or under limited circumstances when the Manager believes operational
90
or trading efficiencies may be gained (e.g., income repatriation; trading in some emerging markets), the Manager may arrange standing instructions with the Funds custodian (who may in turn
arrange instructions with a subcustodian) to execute the foreign exchange transaction, subject to the custodians terms and conditions. In the event that the Funds custodian offers more than one program for standing instruction trades,
and if the Fund has granted the Manager discretion to do so, the Manager will select the program it believes is in the best interests of the Fund under the circumstances. The Manager may also determine to select a third party bank or broker/dealer
to execute trades in restricted currencies if the Manager believes that the third party has the ability to provide best execution.
The Manager relies on
the statutory safe harbor in Section 28(e) of the Securities Exchange Act of 1934, as amended (the 1934 Act) because the Manager will frequently use broker/dealers that provide research in all markets and that research is a factor
in evaluating broker/dealers. However, the Manager does not participate in any formal soft dollar arrangements involving third party research (i.e., research provided by someone other than the executing broker/dealer) or the payment of the
Managers out-of-pocket expenses for data or other research services. The research services received by the Manager are limited to the types of research contemplated by Section 28(e) of the 1934 Act. Research services provided by
broker/dealers take various forms, including personal interviews with analysts, written reports, pricing services in respect of securities, and meetings arranged with various sources of information regarding particular issuers (including company
management), industries, governmental policies, specific information about local markets and applicable regulations, economic trends, and other matters. To the extent that services of value are received by the Manager, the Manager receives a benefit
because it does not have to produce or pay for the services itself. Such services furnished to the Manager may be used in furnishing investment or other advice to all or some subset of the Managers clients, including the Fund, and services
received from a broker/dealer that executed transactions for the Fund will not necessarily be used by the Manager specifically in servicing the Fund.
The
Fund has not paid any amounts in brokerage commissions during the three most recent fiscal years or acquired securities of its regular brokers or dealers (as defined in the 1940 Act) or of their parents during the fiscal year ended February 28,
2013.
Due to restrictions under the 1940 Act, it is possible that, as the result of certain affiliations between a broker/dealer or its affiliates and
the Fund, the Manager or the Funds distributor, the Fund may refrain, or be required to refrain, from engaging in principal trades with such broker/dealer. Additionally, the Fund may be restricted in its ability to purchase securities issued
by affiliates of the Funds distributor.
PROXY VOTING POLICIES AND PROCEDURES
The Trust has adopted a proxy voting policy under which responsibility to vote proxies related to its portfolio securities has been delegated to the Manager.
The Board of Trustees of the Trust has reviewed and approved the proxy voting policies and procedures the Manager follows when voting proxies on behalf of the Fund. The Trusts proxy voting policy and the Managers proxy voting policies
and procedures are attached to this SAI as
Appendix B
.
The Managers proxy voting policies on a particular issue may or may not reflect the
views of
91
individual members of the Board of Trustees of the Trust, or a majority of the Board of Trustees.
Information regarding how the Fund voted proxies relating to portfolio securities during the most recent 12-month period ended June 30 will be available
on the Trusts website at http://www.gmo.com and on the Securities and Exchange Commissions website at http://www.sec.gov no later than August 31 of each year.
DISCLOSURE OF PORTFOLIO HOLDINGS
The policy of the Trust is to protect the confidentiality of the Funds portfolio holdings and to prevent inappropriate selective disclosure of those
holdings. The Board of Trustees has approved this policy and material amendments require its approval.
Registered investment companies that are
sub-advised by GMO may be subject to different portfolio holdings disclosure policies, and neither GMO nor the Board of Trustees exercises control over those policies. In addition, separate account clients of GMO have access to their portfolio
holdings and are not subject to the Funds portfolio holdings disclosure policies. Some of the funds that are sub-advised by GMO and some of the separate accounts managed by GMO have substantially similar investment objectives and strategies
and, therefore, potentially similar portfolio holdings.
Neither GMO nor the Fund will receive any compensation or other consideration in connection with
its disclosure of the Funds portfolio holdings.
GMO may disclose the Funds portfolio holdings (together with any other information from which
the Funds portfolio holdings could reasonably be derived, as reasonably determined by GMO) (the Portfolio Holdings Information) to shareholders (including shareholders of record of indirect investments in the Fund through another
fund managed by GMO), qualified potential shareholders as determined by GMO (including qualified potential shareholders of record who are considering an indirect investment in the Fund through another fund managed by GMO), and their consultants and
agents (collectively, Permitted Recipients) by means of the GMO website.
The Prospectus describes the type of information disclosed on
GMOs website, as well as the frequency with which it is disclosed and the lag between the date of the information and the date of its disclosure.
GMO also may make Portfolio Holdings Information available to Permitted Recipients by e-mail, or by any other means in such scope and form and with such
frequency as GMO may reasonably determine, no earlier than the day next following the day on which the Portfolio Holdings Information is posted on the GMO website (provided that the Prospectus describes the nature and scope of the Portfolio Holdings
Information that will be available on the GMO website, when the information will be available and the period for which the information will remain available, and the location on the Funds website where the information will be made available)
or on the same day as a publicly available, routine filing with the SEC that includes the Portfolio Holdings Information. A confidentiality agreement is not required to access Portfolio Holdings Information filed with the SEC as described in the
preceding sentence.
92
GMO also may from time-to-time disclose portfolio holdings information to all shareholders of the Fund and their
consultants and agents (including shareholders of record of indirect investments in the Fund through another fund managed by GMO). Such disclosure may be made by e-mail, written notice or any other means in such scope and form as GMO may reasonably
determine, and generally will not be subject to a confidentiality agreement and will not be required to be posted to GMOs website in advance.
Except as otherwise noted, to receive Portfolio Holdings Information, Permitted Recipients must enter into a confidentiality agreement with GMO and the Trust
that requires that the Portfolio Holdings Information be used solely for purposes determined by senior management of GMO to be in the best interest of the shareholders of the Fund to which the information relates.
In some cases, GMO may disclose to a third party Portfolio Holdings Information that has not been made available to Permitted Recipients on the GMO website or
in a publicly available, routine filing with the SEC. That disclosure may only be made if senior management of GMO determines that it is in the best interests of the shareholders of the Fund to which the information relates. In addition, the third
party receiving the Portfolio Holdings Information must enter into a confidentiality agreement with GMO and the Trust that requires that the Portfolio Holdings Information be used solely for purposes determined by GMO senior management to be in the
best interest of the Funds shareholders.
If GMO becomes aware that a recipient has or is likely to violate the terms of a confidentiality agreement
regarding Portfolio Holdings Information, GMO shall cease providing such information to such recipient.
The procedures pursuant to which GMO may disclose
to a third party Portfolio Holdings Information that has not been made available to Permitted Recipients do not apply to Portfolio Holdings Information provided to entities who provide on-going services to the Fund in connection with its day-to-day
operations and management, including GMO, GMOs affiliates, the Funds custodian and auditor, the Funds pricing service vendors, broker-dealers when requesting bids for or price quotations on securities, brokers in the normal course
of trading on the Funds behalf, and persons assisting the Fund in the voting of proxies. In addition, (i) when an investor indicates that it wants to purchase shares of the Fund in exchange for securities acceptable to GMO, GMO may make
available a list of securities that it would be willing to accept for the Fund, and, from time to time, the securities on the list may overlap with securities currently held by the Fund; and (ii) when the Fund determines to pay redemption
proceeds wholly or partly in-kind with securities, GMO may make available a list of securities it intends to deliver from the Fund.
No provision of this
policy is intended to restrict or prevent the disclosure of Portfolio Holdings Information as may be required by applicable law, rules or regulations.
GMOs General Counsel or Chief Compliance Officer may authorize exceptions to these procedures. Exceptions must be disclosed to the Chief Compliance
Officer of the Trust.
If senior management of GMO identifies a potential conflict with respect to the disclosure of Portfolio Holdings Information
between the interest of the Funds shareholders, on the one hand,
93
and GMO or an affiliated person of GMO or the Fund, on the other, GMO is required to inform the Trusts Chief Compliance Officer of the potential conflict, and the Trusts Chief
Compliance Officer has the power to decide whether, in light of the potential conflict, disclosure should be permitted under the circumstances. The Trusts Chief Compliance Officer also is required to report his decision to the Board of
Trustees.
GMO periodically reports the following information to the Board of Trustees:
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|
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Determinations made by senior management of GMO relating to the use of Portfolio Holdings Information by Permitted Recipients and third parties;
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|
|
The nature and scope of disclosure of Portfolio Holdings Information to third parties;
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Exceptions to the disclosure policy authorized by GMOs General Counsel or Chief Compliance Officer; and
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Any other information the Trustees may request relating to the disclosure of Portfolio Holdings Information.
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Ongoing Arrangements To Make Portfolio Holdings Available
.
Senior management of GMO has authorized disclosure of Portfolio Holdings
Information on an on-going basis (generally, daily, except with respect to PricewaterhouseCoopers LLP, which receives holdings semi-annually and as necessary in connection with the services it provides to the Fund) to the following entities that
provide on-going services to the Fund in connection with its day-to-day operations and management, provided that they agree to, or have a duty to, maintain this information in confidence:
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Name of Recipient
|
|
Purpose of Disclosure
|
State Street Bank and Trust Company
|
|
Custodial and fund accounting services, compliance testing
|
|
|
Boston Global Advisors
|
|
Securities lending services
|
|
|
PricewaterhouseCoopers LLP
|
|
Independent registered public accounting firm
|
|
|
Institutional Shareholder Services Inc. (formerly known as RiskMetrics Group, Inc.)
|
|
Corporate actions services
|
|
|
FactSet
|
|
Data service provider
|
Senior management of GMO has authorized disclosure of Portfolio Holdings Information on an on-going basis (daily) to the
following recipients, provided that they agree or have a duty to maintain this information in confidence and are limited to using the information for the specific purpose for which it was provided:
|
|
|
Name of Recipient
|
|
Purpose of Disclosure
|
Epstein & Associates, Inc.
|
|
Software provider for Code of Ethics monitoring system
|
94
|
|
|
Name of Recipient
|
|
Purpose of Disclosure
|
Financial Models Company Inc.
|
|
Recordkeeping system
|
DESCRIPTION OF THE TRUST AND OWNERSHIP OF SHARES
The Trust, an open-end management investment company, is organized as a Massachusetts business trust under the laws of Massachusetts by an Agreement and
Declaration of Trust (Declaration of Trust) dated June 24, 1985, as amended and restated September 10, 2009, and as such Declaration of Trust may be amended from time to time. A copy of the Declaration of Trust is on file with
the Secretary of The Commonwealth of Massachusetts. The Trust operates as a series investment company that consists of separate series of investment portfolios, each of which is represented by a separate series of shares of beneficial
interest. The Fund is a series of the Trust. The fiscal year for the Fund ends on the last day of February.
Pursuant to the Declaration of Trust, the
Trustees have currently authorized the issuance of an unlimited number of full and fractional shares of forty-four series: Quality Fund; International Intrinsic Value Fund; Currency Hedged International Equity Fund; Foreign Fund; Foreign Small
Companies Fund; International Small Companies Fund; Emerging Markets Fund; Emerging Countries Fund; Tax-Managed International Equities Fund; Domestic Bond Fund; Core Plus Bond Fund; International Bond Fund; Currency Hedged International Bond Fund;
Global Bond Fund; Emerging Country Debt Fund; Alpha Only Fund; Benchmark-Free Allocation Fund; International Equity Allocation Fund; Global Asset Allocation Fund; Global Equity Allocation Fund; Short-Duration Collateral Fund; Taiwan Fund; World
Opportunity Overlay Fund; Alternative Asset Opportunity Fund; Strategic Opportunities Allocation Fund; World Opportunities Equity Allocation Fund; Developed World Stock Fund; International Core Equity Fund; U.S. Core Equity Fund; Short-Duration
Collateral Share Fund; Strategic Fixed Income Fund; International Opportunities Equity Allocation Fund; Special Situations Fund; U.S. Treasury Fund; Asset Allocation Bond Fund; Asset Allocation International Bond Fund; Debt Opportunities Fund; High
Quality Short-Duration Bond Fund; Emerging Domestic Opportunities Fund; Benchmark-Free Fund; Global Focused Equity Fund; Resources Fund; Implementation Fund; and Risk Premium Fund.
Note that U.S. Core Equity Fund and International Core Equity Fund are successors to U.S. Core Fund and International Disciplined Equity Fund, respectively
(each, a Predecessor Fund). Each Predecessor Fund is a former series of GMO Trust.
Interests in each portfolio (GMO Fund) are
represented by shares of the corresponding series. Each share of each series represents an equal proportionate interest, together with each other share, in the corresponding GMO Fund. The shares of such series do not have any preemptive
95
rights. Upon liquidation of a GMO Fund, shareholders of the corresponding series are entitled to share pro rata in the net assets of the GMO Fund available for distribution to shareholders. The
Declaration of Trust also permits the Trustees to charge shareholders directly for custodial, transfer agency, and servicing expenses, but the Trustees have no present intention to make such charges.
The Declaration of Trust also permits the Trustees, without shareholder approval, to subdivide any series of shares into various sub-series or classes of
shares with such dividend preferences and other rights as the Trustees may designate. This power is intended to allow the Trustees to provide for an equitable allocation of the effect of any future regulatory requirements that might affect various
classes of shareholders differently. The Trustees have currently authorized the establishment and designation of up to ten classes of shares for each series of the Trust: Class I Shares, Class II Shares, Class III Shares, Class IV Shares, Class V
Shares, Class VI Shares, Class VII Shares, Class VIII Shares, Class M Shares and Class MF Shares.
The Trustees also may, without shareholder approval,
establish one or more additional separate portfolios for investments in the Trust or merge two or more existing portfolios (i.e., a new fund). Shareholders investments in such a portfolio would be evidenced by a separate series of shares.
The Declaration of Trust provides for the perpetual existence of the Trust. The Trust, however, may be terminated at any time by vote of at least two-thirds
of the outstanding shares of the Trust. While the Declaration of Trust further provides that the Trustees also may terminate the Trust upon written notice to the shareholders, the 1940 Act requires that the Trust receive the authorization of a
majority of its outstanding shares in order to change the nature of its business so as to cease to be an investment company.
On January 31, 2014, the
following shareholders held beneficially (unless otherwise indicated) greater than 25% of the outstanding shares of the Fund. For each shareholder listed that is not an individual, the jurisdiction under the laws of which the shareholder is
organized (if applicable) and any parent company of the shareholder are listed, if known:
|
|
|
|
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Shareholders
|
|
Jurisdiction of
Organization
|
|
Parent
Company
|
GMO Strategic Fixed Income Fund
C/O GMO LLC
40 Rowes Wharf
Boston, MA 02110
|
|
MA
|
|
N/A
|
The above shareholders may be deemed to control their respective series as such term is defined in the
1940 Act.
Shareholders should be aware that to the extent a shareholders investment in the Fund exceeds certain threshold amounts or
percentages, the investment may constitute a reportable acquisition under the Hart-Scott-Rodino Act (HSR) and the shareholder may be required to make a corresponding filing under HSR. HSR regulations are complex and shareholders should
consult their legal advisers about the precise HSR filing consequences of an investment in the Fund.
96
As of January 31, 2014, substantially all of the Funds shares were held by accounts for which the
Manager has investment discretion.
MULTIPLE CLASSES AND MINIMUM INVESTMENTS
The Manager makes all decisions relating to aggregation of accounts for purposes of determining eligibility for the Fund or the various classes of shares
offered by the Fund, as the case may be. When making decisions regarding whether accounts should be aggregated because they are part of a larger client relationship, the Manager considers several factors including, but not limited to, whether: the
multiple accounts are for one or more subsidiaries of the same parent company; the multiple accounts have the same beneficial owner regardless of the legal form of ownership; the investment mandate is the same or substantially similar across the
relationship; the asset allocation strategies are substantially similar across the relationship; GMO reports to the same investment board; the consultant is the same for the entire relationship; GMO services the relationship through a single GMO
relationship manager; the relationships have substantially similar reporting requirements; and/or the relationship can be serviced from a single geographic location.
VOTING RIGHTS
Shareholders are entitled to one vote for each full share held (with fractional votes for fractional shares held) and to vote by individual GMO Fund (to the
extent described below) in the election of Trustees and the termination of the Trust and on other matters submitted to the vote of shareholders. Shareholders vote by individual GMO Fund on all matters except (i) when required by the 1940 Act,
shares are voted in the aggregate and not by individual GMO Fund, and (ii) when the Trustees have determined that the matter affects the interests of more than one GMO Fund, then shareholders of the affected GMO Funds are entitled to vote.
Shareholders of one GMO Fund are not entitled to vote on matters exclusively affecting another GMO Fund including, without limitation, such matters as the adoption of or change in the investment objectives, policies, or restrictions of the other GMO
Fund and the approval of the investment advisory contract of the other GMO Fund. Shareholders of a particular class of shares do not have separate class voting rights except for matters that affect only that class of shares and as otherwise required
by law.
Normally the Trust does not hold meetings of shareholders to elect Trustees except in accordance with the 1940 Act (i) the Trust will hold a
shareholders meeting for the election of Trustees at such time as less than a majority of the Trustees holding office have been elected by shareholders, and (ii) if, as a result of a vacancy in the Board of Trustees, less than two-thirds
of the Trustees holding office have been elected by the shareholders, that vacancy may only be filled by a vote of the shareholders. In addition, Trustees may be removed from office by a written consent signed by the holders of two-thirds of the
outstanding shares and filed with the Trusts custodian or by a vote of the holders of two-thirds of the outstanding shares at a meeting duly called for that purpose, which meeting shall be held upon the written request of the holders of not
less than 10% of the outstanding shares. Upon written request by the holders of at least 1% of the outstanding shares stating that such shareholders wish to communicate with the other shareholders for the purpose of obtaining the signatures
necessary to demand a meeting to consider removal of a Trustee, the Trust has undertaken to provide a list of shareholders or to
97
disseminate appropriate materials (at the expense of the requesting shareholders). Except as set forth above, the Trustees will continue to hold office and may appoint successor Trustees. Voting
rights are not cumulative.
No amendment may be made to the Declaration of Trust without the affirmative vote of a majority of the outstanding shares of
the Trust except (i) to change the Trusts name or to cure technical problems in the Declaration of Trust and (ii) to establish, designate, or modify new and existing series or sub-series of Trust shares or other provisions relating
to Trust shares in response to applicable laws or regulations.
SHAREHOLDER AND TRUSTEE LIABILITY
Under Massachusetts law, shareholders could, under some circumstances, be held personally liable for the obligations of the Trust. However, the Declaration of
Trust disclaims shareholder liability for acts or obligations of the Trust and requires that notice of that disclaimer be given in each agreement, obligation, or instrument entered into or executed by the Trust or the Trustees. The Declaration of
Trust provides for indemnification out of all the property of the Fund for all loss and expense of any shareholder of the Fund held personally liable for the obligations of the Trust. Thus, the risk of a shareholder incurring financial loss on
account of shareholder liability is limited to circumstances in which the disclaimer is inoperative and the Fund in which the shareholder holds shares is unable to meet its obligations.
The Declaration of Trust further provides that the Trustees will not be liable for errors of judgment or mistakes of fact or law. However, nothing in the
Declaration of Trust protects a Trustee against any liability to which the Trustee would otherwise be subject by reason of willful misfeasance, bad faith, gross negligence, or reckless disregard of the duties involved in the conduct of his office.
The By-Laws of the Trust provide for indemnification by the Trust of the Trustees and the officers of the Trust except for any matter as to which any such person did not act in good faith in the reasonable belief that his action was in or not
opposed to the best interests of the Trust. Trustees and officers may not be indemnified against any liability to the Trust or the Trust shareholders to which they would otherwise be subject by reason of willful misfeasance, bad faith, gross
negligence, or reckless disregard of the duties involved in the conduct of their office.
98
BENEFICIAL OWNERS OF 5% OR MORE OF THE FUNDS SHARES
Class III shares of the Fund will commence operations on or following the date of this SAI, and, therefore, no shareholder owns beneficially more than 5% of
the outstanding Class III shares of the Fund as of the date of this SAI.
FINANCIAL STATEMENTS
The Trusts audited financial statements, financial highlights, and report of the independent registered public accounting firm of the Fund, included in
the Annual Report for the fiscal year ended February 28, 2013 for the Fund and filed with the SEC pursuant to Section 30(d) of the 1940 Act and the rules promulgated thereunder, are hereby incorporated in this SAI by reference. The
Trusts unaudited financial statements and financial highlights, included in the Semi-Annual Report for the six months ended August 31, 2013 for the Fund and filed with the SEC pursuant to Section 30(d) of the 1940 Act and the rules
promulgated thereunder, are also hereby incorporated in this SAI by reference. The Funds Annual Report for the fiscal year ended February 28, 2013 was filed electronically with the SEC on Form N-CSR on April 30, 2013 (Accession No.
0001193125-13-187311) and the Funds Semi-Annual Report for the six months ended August 31, 2013 was filed electronically with the SEC on Form N-CSRS on November 5, 2013 (Accession No. 0001193125-13-427780). All unaudited interim
financial statements reflect all adjustments which are, in the opinion of management, necessary to a fair statement of the results for the interim periods presented. In addition, all such adjustments are of a normal recurring nature. Information is
presented for the Funds existing class of shares (which are not offered in this SAI and which the Fund expects to reclassify and redesignate as Class VI shares after the date of this SAI), as this was the only share class of the Fund that had
investment operations during the reporting periods.
99
Appendix B
accordance with Section 12(d)(1)(E) of the 1940 Act, GMO will either (i) seek instructions from a Feeder Funds holders with regard to the voting of all proxies with respect to the
Feeder Funds shares in the corresponding Master Fund and vote such proxies only in accordance with such instructions, or (ii) vote the shares of the corresponding Master Fund held by a Feeder Fund in the same proportion as the vote of all
other holders of the Master Fund.
VII.
Recordkeeping
GMO will maintain records relating to the implementation of these proxy voting policies and procedures, including:
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(1)
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a copy of these policies and procedures which shall be made available to clients, upon request;
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(2)
|
a record of each vote cast (which ISS maintains on GMOs behalf); and
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(3)
|
each written client request for proxy records and GMOs written response to any client request for such records.
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Such proxy voting records shall be maintained for a period of five years.
VIII.
Disclosure
Except as otherwise required by
law, GMO has a general policy of not disclosing to any issuer or third party how GMO or its voting delegate voted a clients proxy.
B-6
Exhibit A
2013 U.S. Proxy Voting Concise Guidelines
December 19, 2012
Institutional Shareholder Services
Inc.
Copyright
©
2012 by ISS
www.issgovernance.com
B-7
ISS 2013 U.S. PROXY VOTING CONCISE GUIDELINES
The policies contained herein are sampling of select, key proxy voting guidelines and are not exhaustive. A full listing of
ISS 2013 proxy voting guidelines can be found at
http://www.issgovernance.com/files/2013lSSUSSummarvGuidelines.pdf
Routine/Miscellaneous
Auditor Ratification
Vote FOR proposals to ratify auditors unless any of the following apply:
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An auditor has a financial interest in or association with the company, and is therefore not independent;
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There is reason to believe that the independent auditor has rendered an opinion that is neither accurate nor indicative of the companys financial position;
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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
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Fees for non-audit services (Other fees) are excessive.
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Non-audit fees are excessive if:
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Non-audit (other) fees > audit fees + audit-related fees + tax compliance/preparation fees.
|
Board of Directors:
Voting on Director Nominees in Uncontested Elections
Votes on director nominees should be determined CASE-BY-CASE.
Four fundamental principles apply when determining votes on director nominees:
1. Board Accountability
Vote AGAINST
1
or WITHHOLD from the entire board of directors (except new nominees
2
, who should be considered CASE-BY-CASE) for the following:
1
|
In general, companies with a plurality vote standard use Withhold as the contrary vote option in director elections; companies with a majority vote standard use Against. However, it will vary by
company and the proxy must be checked to determine the valid contrary vote option for the particular company.
|
ISS 2013 U.S. Proxy Voting Concise
Guidelines
B-8
Problematic Takeover Defenses
Classified Board Structure:
|
1.1.
|
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. All
appropriate nominees (except new) may be held accountable.
|
Director Performance Evaluation:
|
1.2.
|
The board lacks accountability and oversight, coupled with sustained poor performance relative to peers. Sustained poor performance is measured by one- and three-year total shareholder returns in the bottom half of a
companys four-digit GICS industry group (Russell 3000 companies only). Take into consideration the companys five-year total shareholder return and operational metrics. Problematic provisions include but are not limited to:
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A classified board structure;
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A supermajority vote requirement;
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Either a plurality vote standard in uncontested director elections or a majority vote standard with no plurality carve-out for contested elections;
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|
The inability of shareholders to call special meetings;
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|
The inability of shareholders to act by written consent;
|
|
|
|
A dual-class capital structure; and/or
|
|
|
|
A nonshareholder-approved poison pill.
|
Poison Pills:
|
1.3.
|
The companys poison pill has a dead-hand or modified dead-hand feature. Vote AGAINST or WITHHOLD from nominees every year until this feature is removed;
|
|
1.4.
|
The board adopts a poison pill with a term of more than 12 months (long-term pill), or renews any existing pill, including any short-term pill (12 months or less), without shareholder approval. A
commitment or policy that puts a newly adopted pill to a binding shareholder vote may potentially offset an adverse vote recommendation. Review such companies with classified boards every year, and such companies with annually elected boards at
least once every three years, and vote AGAINST or WITHHOLD votes from all nominees if the company still maintains a non-shareholder-approved poison pill; or
|
|
1.5.
|
The board makes a material adverse change to an existing poison pill without shareholder approval.
|
Vote
CASE-BY-CASE on all nominees if:
|
1.6.
|
The board adopts a poison pill with a term of 12 months or less (short-term pill) without shareholder approval, taking into account the following factors:
|
|
|
|
The date of the pills adoption relative to the date of the next meeting of shareholders
i.e
. whether the company had time to put the pill on ballot for shareholder ratification given the circumstances;
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The issuers rationale;
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The issuers governance structure and practices; and
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The issuers track record of accountability to shareholders.
|
Problematic Audit-Related Practices
2
|
A new nominee is any current nominee who has not already been elected by shareholders and who joined the board after the problematic action in question transpired. If ISS cannot determine whether the nominee
joined the board before or after the problematic action transpired, the nominee will be considered a new nominee if he or she joined the board within the 12 months prior to the upcoming shareholder meeting.
|
ISS 2013 U.S. Proxy Voting Concise
Guidelines
B-9
Generally vote AGAINST or WITHHOLD from the members of the Audit Committee if:
|
1.7.
|
The non-audit fees paid to the auditor are excessive (see discussion under
Auditor Ratification
);
|
|
1.8.
|
The company receives an adverse opinion on the companys financial statements from its auditor; or
|
|
1.9.
|
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 CASE-BY-CASE on members of the Audit Committee and potentially the full board if:
|
1.10.
|
Poor accounting practices are identified that rise to a level of serious concern, such as: fraud; misapplication of GAAP; and material weaknesses identified in Section 404 disclosures. Examine the severity,
breadth, chronological sequence and duration, as well as the companys efforts at remediation or corrective actions, in determining whether WITHHOLD/AGAINST votes are warranted.
|
Problematic Compensation Practices/Pay for Performance Misalignment
In the absence of an Advisory Vote on Executive Compensation ballot item or in egregious situations, vote AGAINST or WITHHOLD from the members of the
Compensation Committee and potentially the full board if:
|
1.11.
|
There is a significant misalignment between CEO pay and company performance (
pay for performance
);
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1.12.
|
The company maintains significant
problematic pay practices
;
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1.13.
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The board exhibits a significant level of
poor communication and responsiveness
to shareholders;
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1.14.
|
The company fails to submit one-time
transfers of stock options
to a shareholder vote; or
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1.15.
|
The company fails to fulfill the terms of a
burn rate commitment
made to shareholders.
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Vote
CASE-BY-CASE on Compensation Committee members (or, in exceptional cases, the full board) and the Management Say-on-Pay proposal if:
|
1.16.
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The companys previous say-on-pay proposal received the support of less than 70 percent of votes cast, taking into account:
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The companys response, including:
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Disclosure of engagement efforts with major institutional investors regarding the issues that contributed to the low level of support;
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Specific actions taken to address the issues that contributed to the low level of support;
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Other recent compensation actions taken by the company;
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Whether the issues raised are recurring or isolated;
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The companys ownership structure; and
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Whether the support level was less than 50 percent, which would warrant the highest degree of responsiveness.
|
Governance Failures
Under extraordinary
circumstances, vote AGAINST or WITHHOLD from directors individually, committee members, or the entire board, due to:
|
1.17.
|
Material failures of governance, stewardship, risk oversight
3
, or fiduciary responsibilities at the company;
|
3
|
Examples of failure of risk oversight include, but are not limited to: bribery; large or serial fines or sanctions from regulatory bodies; significant adverse legal judgments or settlements; hedging of company stock; or
significant pledging of company stock.
|
ISS 2013 U.S. Proxy Voting Concise
Guidelines
B-10
|
1.18.
|
Failure to replace management as appropriate; or
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|
1.19.
|
Egregious actions related to a directors service on other boards that raise substantial doubt about his or her ability to effectively oversee management and serve the best interests of shareholders at any company.
|
2. Board Responsiveness:
Vote AGAINST
or WITHHOLD from individual directors, committee members, or the entire board of directors as appropriate if:
|
2.1.
|
For 2013, the board failed to act
4
on a shareholder proposal that received the support of a majority of the shares outstanding the previous year;
|
|
2.2.
|
For 2013, the board failed to act on a shareholder proposal that received the support of a majority of shares cast in the last year and one of the two previous years;
|
|
2.3.
|
For 2014, the board failed to act on a shareholder proposal that received the support of a majority of the shares cast in the previous year;
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|
2.4.
|
The board failed to act on takeover offers where the majority of shares are tendered;
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|
2.5.
|
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 issue(s) that caused the high withhold/against vote; or
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|
2.6.
|
The board implements an advisory vote on executive compensation on a less frequent basis than the frequency that received the majority of votes cast at the most recent shareholder meeting at which shareholders voted on
the say-on-pay frequency.
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Vote CASE-BY-CASE on the entire board if:
|
2.7.
|
The board implements an advisory vote on executive compensation on a less frequent basis than the frequency that received a plurality, but not a majority, of the votes cast at the most recent shareholder meeting at
which shareholders voted on the say-on-pay frequency, taking into account:
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The boards rationale for selecting a frequency that is different from the frequency that received a plurality;
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|
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The companys ownership structure and vote results;
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|
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ISS analysis of whether there are compensation concerns or a history of problematic compensation practices; and
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The previous years support level on the companys say-on-pay proposal.
|
3. Director Independence
Vote AGAINST or WITHHOLD from Inside Directors and Affiliated Outside Directors (per the
Categorization of Directors
) when:
|
3.1.
|
The inside or affiliated outside director serves on any of the three key committees: audit, compensation, or nominating;
|
4
|
Responding to the shareholder proposal will generally mean either full implementation of the proposal or, if the matter requires a vote by shareholders, a management proposal on the next annual ballot to implement the
proposal. Responses that involve less than full implementation will be considered on a case-by-case basis, taking into account:
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The subject matter of the proposal;
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The level of support and opposition provided to the resolution in past meetings;
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Disclosed outreach efforts by the board to shareholders in the wake of the vote;
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|
|
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Actions taken by the board in response to its engagement with shareholders;
|
|
|
|
The continuation of the underlying issue as a voting item on the ballot (as either shareholder or management proposals); and
|
|
|
|
Other factors as appropriate.
|
ISS 2013 U.S. Proxy Voting Concise
Guidelines
B-11
|
3.2.
|
The company lacks an audit, compensation, or nominating committee so that the full board functions as that committee;
|
|
3.3.
|
The company lacks a formal nominating committee, even if the board attests that the independent directors fulfill the functions of such a committee; or
|
|
3.4.
|
Independent directors make up less than a majority of the directors.
|
4. Director Competence
Attendance at Board and Committee Meetings:
|
4.1.
|
Generally vote AGAINST or WITHHOLD from directors (except new nominees, who should be considered CASE-BY-CASE
5
) who attend less than 75 percent of the aggregate of
their board and committee meetings for the period for which they served, unless an acceptable reason for absences is disclosed in the proxy or another SEC filing. Acceptable reasons for director absences are generally limited to the following:
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Medical issues/illness;
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Family emergencies; and
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Missing only one meeting (when the total of all meetings is three or fewer).
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|
4.2.
|
If the proxy disclosure is unclear and insufficient to determine whether a director attended at least 75 percent of the aggregate of his/her board and committee meetings during his/her period of service, vote AGAINST or
WITHHOLD from the director(s) in question.
|
Overboarded Directors:
Vote AGAINST or WITHHOLD from individual directors who:
|
4.3.
|
Sit on more than six public company boards; or
|
|
4.4.
|
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
6
.
|
Proxy Access
ISS
supports proxy access as an important shareholder right, one that is complementary to other best-practice corporate governance features. However, in the absence of a uniform standard, proposals to enact proxy access may vary widely; as such, ISS is
not setting forth specific parameters at this time and will take a case-by-case approach in evaluating these proposals.
Vote CASE-BY-CASE on proposals to
enact proxy access, taking into account, among other factors:
5
|
For new nominees only, schedule conflicts due to commitments made prior to their appointment to the board are considered if disclosed in the proxy or another SEC filing.
|
6
|
Although all of a CEOs subsidiary boards will be counted as separate boards, ISS will not recommend a withhold vote from the CEO of a parent company board or any of the controlled (>50 percent ownership)
subsidiaries of that parent, but will do so at subsidiaries that are less than 50 percent controlled and boards outside the parent/subsidiary relationships.
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ISS 2013 U.S. Proxy Voting Concise
Guidelines
B-12
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Company-specific factors; and
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Proposal-specific factors, including:
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The ownership thresholds proposed in the resolution (i.e., percentage and duration);
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The maximum proportion of directors that shareholders may nominate each year; and
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The method of determining which nominations should appear on the ballot if multiple shareholders submit nominations.
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Proxy ContestsVoting for Director Nominees in Contested Elections
Vote CASE-BY-CASE on the election of directors in contested elections, considering the following factors:
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Long-term financial performance of the target company relative to its industry;
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Managements track record;
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Background to the proxy contest;
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Qualifications of director nominees (both slates);
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Strategic plan of dissident slate and quality of critique against management;
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Likelihood that the proposed goals and objectives can be achieved (both slates);
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Stock ownership positions.
|
When the addition of shareholder nominees to the management card (proxy
access nominees) results in a number of nominees on the management card which exceeds the number of seats available for election, vote CASE-BY-CASE considering the same factors listed above.
Shareholder Rights & Defenses
Poison Pills- Management Proposals to Ratify Poison Pill
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:
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No lower than a 20% trigger, flip-in or flip-over;
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A term of no more than three years;
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|
No dead-hand, slow-hand, no-hand or similar feature that limits the ability of a future board to redeem the pill;
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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.
|
In addition, the rationale for adopting the pill should be thoroughly explained by the company. In
examining the request for the pill, take into consideration the companys existing governance structure, including: board independence, existing takeover defenses, and any problematic governance concerns.
Poison Pills- Management Proposals to Ratify a Pill to Preserve Net Operating Losses (NOLs)
Vote AGAINST proposals to adopt a poison pill for the stated purpose of protecting a companys net operating losses (NOL) if the term of the pill would
exceed the shorter of three years and the exhaustion of the NOL.
Vote CASE-BY-CASE on management proposals for poison pill ratification, considering the
following factors, if the term of the pill would be the shorter of three years (or less) and the exhaustion of the NOL:
ISS 2013 U.S. Proxy Voting Concise
Guidelines
B-13
|
|
|
The ownership threshold to transfer (NOL pills generally have a trigger slightly below 5 percent);
|
|
|
|
Shareholder protection mechanisms (sunset provision, or commitment to cause expiration of the pill upon exhaustion or expiration of NOLs);
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The companys existing governance structure including: board independence, existing takeover defenses, track record of responsiveness to shareholders, and any other problematic governance concerns; and
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Any other factors that may be applicable.
|
Shareholder Ability to Act by Written Consent
Generally vote AGAINST management and shareholder proposals to restrict or prohibit shareholders ability to act by written consent.
Generally vote FOR management and shareholder proposals that provide shareholders with the ability to act by written consent, taking into account the
following factors:
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|
|
Shareholders current right to act by written consent;
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|
|
|
The inclusion of exclusionary or prohibitive language;
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|
|
Investor ownership structure; and
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|
|
Shareholder support of, and managements response to, previous shareholder proposals.
|
Vote CASE-BY-CASE
on shareholder proposals if, in addition to the considerations above, the company has the following governance and antitakeover provisions:
|
|
|
An unfettered
7
right for shareholders to call special meetings at a 10 percent threshold;
|
|
|
|
A majority vote standard in uncontested director elections;
|
|
|
|
No non-shareholder-approved pill; and
|
|
|
|
An annually elected board.
|
CAPITAL/RESTRUCTURING
Common Stock Authorization
Vote FOR proposals to increase
the number of authorized common shares where the primary purpose of the increase is to issue shares in connection with a transaction on the same ballot that warrants support.
Vote AGAINST proposals at companies with more than one class of common stock to increase the number of authorized shares of the class of common stock that has
superior voting rights.
Vote AGAINST proposals to increase the number of authorized common shares if a vote for a reverse stock split on the same ballot
is warranted despite the fact that the authorized shares would not be reduced proportionally.
7
|
Unfettered means no restrictions on agenda items, no restrictions on the number of shareholders who can group together to reach the 10 percent threshold, and only reasonable limits on when a meeting can be
called: no greater than 30 days after the last annual meeting and no greater than 90 prior to the next annual meeting.
|
ISS 2013 U.S. Proxy Voting Concise
Guidelines
B-14
Vote CASE-BY-CASE on all other proposals to increase the number of shares of common stock authorized for
issuance. Take into account company-specific factors that include, at a minimum, the following:
|
|
|
Past Board Performance:
|
|
|
|
The companys use of authorized shares during the last three years
|
|
|
|
Disclosure in the proxy statement of the specific purposes of the proposed increase;
|
|
|
|
Disclosure in the proxy statement of specific and severe risks to shareholders of not approving the request; and
|
|
|
|
The dilutive impact of the request as determined by an allowable increase calculated by ISS (typically 100 percent of existing authorized shares) that reflects the companys need for shares and total shareholder
returns.
|
Dual Class Structure
Generally vote AGAINST proposals to create a new class of common stock unless:
|
|
|
The company discloses a compelling rationale for the dual-class capital structure, such as:
|
|
|
|
The companys auditor has concluded that there is substantial doubt about the companys ability to continue as a going concern; or
|
|
|
|
The new class of shares will be transitory;
|
|
|
|
The new class is intended for financing purposes with minimal or no dilution to current shareholders in both the short term and long term; and
|
|
|
|
The new class is not designed to preserve or increase the voting power of an insider or significant shareholder.
|
Preferred Stock Authorization
Vote FOR proposals to increase the number of authorized preferred shares where the primary purpose of the increase is to issue shares in connection with a
transaction on the same ballot that warrants support.
Vote AGAINST proposals at companies with more than one class or series of preferred stock to
increase the number of authorized shares of the class or series of preferred stock that has superior voting rights.
Vote CASE-BY-CASE on all other
proposals to increase the number of shares of preferred stock authorized for issuance. Take into account company-specific factors that include, at a minimum, the following:
|
|
|
Past Board Performance:
|
|
|
|
The companys use of authorized preferred shares during the last three years;
|
|
|
|
Disclosure in the proxy statement of the specific purposes for the proposed increase;
|
|
|
|
Disclosure in the proxy statement of specific and severe risks to shareholders of not approving the request;
|
|
|
|
In cases where the company has existing authorized preferred stock, the dilutive impact of the request as determined by an allowable increase calculated by ISS (typically 100 percent of existing authorized shares) that
reflects the companys need for shares and total shareholder returns; and
|
|
|
|
Whether the shares requested are blank check preferred shares that can be used for antitakeover purposes.
|
ISS 2013 U.S. Proxy Voting Concise
Guidelines
B-15
Mergers and Acquisitions
Vote CASE-BY-CASE on mergers and acquisitions. Review and evaluate the merits and drawbacks of the proposed transaction, balancing various and sometimes
countervailing factors including:
|
|
|
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 arms-length? Was the process far 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 CIC figure
presented in the ISS Transaction Summary section of this report is an aggregate figure that can in certain cases 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.
|
COMPENSATION
Executive Pay Evaluation
Underlying all evaluations are
five global principles that most investors expect corporations to adhere to in designing and administering executive and director compensation programs:
|
1.
|
Maintain appropriate pay-for-performance alignment, with emphasis on long-term shareholder value: This principle encompasses overall executive pay practices, which must be designed to attract, retain, and appropriately
motivate the key employees who drive shareholder value creation over the long term. It will take into consideration, among other factors, the link between pay and performance; the mix between fixed and variable pay; performance goals; and
equity-based plan costs;
|
|
2.
|
Avoid arrangements that risk pay for failure: This principle addresses the appropriateness of long or indefinite contracts, excessive severance packages, and guaranteed compensation;
|
ISS 2013 U.S. Proxy Voting Concise
Guidelines
B-16
|
3.
|
Maintain an independent and effective compensation committee: This principle promotes oversight of executive pay programs by directors with appropriate skills, knowledge, experience, and a sound process for compensation
decision-making
(e.g.,
including access to independent expertise and advice when needed);
|
|
4.
|
Provide shareholders with clear, comprehensive compensation disclosures: This principle underscores the importance of informative and timely disclosures that enable shareholders to evaluate executive pay practices fully
and fairly;
|
|
5.
|
Avoid inappropriate pay to non-executive directors: This principle recognizes the interests of shareholders in ensuring that compensation to outside directors does not compromise their independence and ability to make
appropriate judgments in overseeing managers pay and performance. At the market level, it may incorporate a variety of generally accepted best practices.
|
Advisory Votes on Executive CompensationManagement Proposals (Management Say-on-Pay)
Vote CASE-BY-CASE on ballot items related to executive pay and practices, as well as certain aspects of outside director compensation.
Vote AGAINST Advisory Votes on Executive Compensation (Management Say-on-PayMSOP) if:
|
|
|
There is a significant misalignment between CEO pay and company performance (
pay for performance
)
;
|
|
|
|
The company maintains significant problematic pay practices;
|
|
|
|
The board exhibits a significant level of poor communication and responsiveness to shareholders.
|
Vote AGAINST
or WITHHOLD from the members of the Compensation Committee and potentially the full board if:
|
|
|
There is no MSOP on the ballot, and an AGAINST vote on an MSOP is warranted due to pay for performance misalignment, problematic pay practices, or the lack of adequate responsiveness on compensation issues raised
previously, or a combination thereof;
|
|
|
|
The board fails to respond adequately to a previous MSOP proposal that received less than 70 percent support of votes cast;
|
|
|
|
The company has recently practiced or approved problematic pay practices, including option repricing or option backdating; or
|
|
|
|
The situation is egregious.
|
Vote AGAINST an equity plan on the ballot if:
|
|
|
A pay for performance misalignment is found, and a significant portion of the CEOs misaligned pay is attributed to non-performance-based equity awards, taking into consideration:
|
|
|
|
Magnitude of pay misalignment;
|
|
|
|
Contribution of non-performance-based equity grants to overall pay; and
|
|
|
|
The proportion of equity awards granted in the last three fiscal years concentrated at the named executive officer (NEO) level.
|
Primary Evaluation Factors for Executive Pay
Pay-for-Performance Evaluation
ISS annually
conducts a pay-for-performance analysis to identify strong or satisfactory alignment between pay and performance over a sustained period. With respect to companies in the Russell 3000 index, this analysis considers the following:
ISS 2013 U.S. Proxy Voting Concise
Guidelines
B-17
|
6.
|
Peer Group
8
Alignment:
|
|
|
|
The degree of alignment between the companys TSR rank and the CEOs total pay rank within a peer group, as measured over one-year and three-year periods (weighted 40/60);
|
|
|
|
The multiple of the CEOs total pay relative to the peer group median.
|
|
7.
|
Absolute Alignment the absolute alignment between the trend in CEO pay and company TSR over the prior five fiscal years i.e., the difference between the trend in annual pay changes and the trend in
annualized TSR during the period.
|
If the above analysis demonstrates significant unsatisfactory long-term pay-for-performance alignment or,
in the case of non-Russell 3000 index companies, misaligned pay and performance are otherwise suggested, our analysis may include any of the following qualitative factors, if they are relevant to the analysis to determine how various pay elements
may work to encourage or to undermine long-term value creation and alignment with shareholder interests:
|
|
|
The ratio of performance- to time-based equity awards;
|
|
|
|
The overall ratio of performance-based compensation;
|
|
|
|
The completeness of disclosure and rigor of performance goals;
|
|
|
|
The companys peer group benchmarking practices;
|
|
|
|
Actual results of financial/operational metrics, such as growth in revenue, profit, cash flow, etc., both absolute and relative to peers;
|
|
|
|
Special circumstances related to, for example, a new CEO in the prior FY or anomalous equity grant practices (e.g., bi-annual awards);
|
|
|
|
Realizable pay compared to grant pay; and
|
|
|
|
Any other factors deemed relevant.
|
Problematic Pay Practices
The focus is on executive compensation practices that contravene the global pay principles, including:
|
|
|
Problematic practices related to non-performance-based compensation elements;
|
|
|
|
Incentives that may motivate excessive risk-taking; and
|
Problematic Pay Practices related to Non-Performance-Based Compensation Elements
Pay elements that are not directly based on performance are generally evaluated CASE-BY-CASE considering the context of a companys overall pay
program and demonstrated pay-for-performance philosophy. Please refer to ISS Compensation FAQ document for detail on specific pay practices that have been identified as potentially problematic and may lead to negative recommendations if they
are deemed to be inappropriate or unjustified relative to executive pay best practices. The list below highlights the problematic practices that carry significant weight in this overall consideration and may result in adverse vote recommendations:
|
|
|
Repricing or replacing of underwater stock options/SARS without prior shareholder approval (including cash buyouts and voluntary surrender of underwater options);
|
|
|
|
Excessive perquisites or tax gross-ups, including any gross-up related to a secular trust or restricted stock vesting;
|
|
|
|
New or extended agreements that provide for:
|
|
|
|
CIC payments exceeding 3 times base salary and average/target/most recent bonus;
|
8
|
The revised peer group is generally comprised of 14-24 companies that are selected using market cap, revenue (or assets for certain financial firms), GICS industry group and companys selected peers GICS
industry group with size constraints, via a process designed to select peers that are closest to the subject company in terms of revenue/assets and industry and also within a market cap bucket that is reflective of the companys.
|
ISS 2013 U.S. Proxy Voting Concise
Guidelines
B-18
|
|
|
CIC severance payments without involuntary job loss or substantial diminution of duties (single or modified single triggers);
|
|
|
|
CIC payments with excise tax gross-ups (including modified gross-ups).
|
Incentives that may
Motivate Excessive Risk-Taking
|
|
|
Multi-year guaranteed bonuses;
|
|
|
|
A single or common performance metric used for short- and long-term plans;
|
|
|
|
Lucrative severance packages;
|
|
|
|
High pay opportunities relative to industry peers;
|
|
|
|
Disproportionate supplemental pensions; or
|
|
|
|
Mega annual equity grants that provide unlimited upside with no downside risk.
|
Factors that potentially
mitigate the impact of risky incentives include rigorous claw-back provisions and robust stock ownership/holding guidelines.
Options Backdating
The following factors should be examined CASE-BY-CASE to allow for distinctions to be made between sloppy plan administration versus
deliberate action or fraud:
|
|
|
Reason and motive for the options backdating issue, such as inadvertent vs. deliberate grant date changes;
|
|
|
|
Duration of options backdating;
|
|
|
|
Size of restatement due to options backdating;
|
|
|
|
Corrective actions taken by the board or compensation committee, such as canceling or re-pricing backdated options, the recouping of option gains on backdated grants; and
|
|
|
|
Adoption of a grant policy that prohibits backdating, and creates a fixed grant schedule or window period for equity grants in the future.
|
Board Communications and Responsiveness
Consider
the following factors CASE-BY-CASE when evaluating ballot items related to executive pay on the boards responsiveness to investor input and engagement on compensation issues:
|
|
|
Failure to respond to majority-supported shareholder proposals on executive pay topics; or
|
|
|
|
Failure to adequately respond to the companys previous say-on-pay proposal that received the support of less than 70 percent of votes cast, taking into account:
|
|
|
|
The companys response, including:
|
|
|
|
Disclosure of engagement efforts with major institutional investors regarding the issues that contributed to the low level of support;
|
|
|
|
Specific actions taken to address the issues that contributed to the low level of support;
|
|
|
|
Other recent compensation actions taken by the company;
|
|
|
|
Whether the issues raised are recurring or isolated;
|
|
|
|
The companys ownership structure; and
|
|
|
|
Whether the support level was less than 50 percent, which would warrant the highest degree of responsiveness.
|
ISS 2013 U.S. Proxy Voting Concise
Guidelines
B-19
Frequency of Advisory Vote on Executive Compensation (Say When on Pay)
Vote FOR annual advisory votes on compensation, which provide the most consistent and clear communication channel for shareholder concerns about
companies executive pay programs.
Voting on Golden Parachutes in an Acquisition, Merger, Consolidation, or Proposed Sale
Vote CASE-BY-CASE on say on Golden Parachute proposals, including consideration of existing change-in-control arrangements maintained with named executive
officers rather than focusing primarily on new or extended arrangements.
Features that may result in an AGAINST recommendation include one or more of the
following, depending on the number, magnitude, and/or timing of issue(s):
|
|
|
Single- or modified-single-trigger cash severance;
|
|
|
|
Single-trigger acceleration of unvested equity awards;
|
|
|
|
Excessive cash severance (>3x base salary and bonus);
|
|
|
|
Excise tax gross-ups triggered and payable (as opposed to a provision to provide excise tax gross-ups);
|
|
|
|
Excessive golden parachute payments (on an absolute basis or as a percentage of transaction equity value); or
|
|
|
|
Recent amendments that incorporate any problematic features (such as those above) or recent actions (such as extraordinary equity grants) that may make packages so attractive as to influence merger agreements that may
not be in the best interests of shareholders; or
|
|
|
|
The companys assertion that a proposed transaction is conditioned on shareholder approval of the golden parachute advisory vote.
|
Recent amendment(s) that incorporate problematic features will tend to carry more weight on the overall analysis. However, the presence of multiple legacy
problematic features will also be closely scrutinized.
In cases where the golden parachute vote is incorporated into a companys advisory vote on
compensation (management say-on-pay), ISS will evaluate the say-on-pay proposal in accordance with these guidelines, which may give higher weight to that component of the overall evaluation.
Equity-Based and Other Incentive 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 companys equity plans is unreasonable;
|
|
|
|
The plan expressly permits repricing;
|
|
|
|
A pay-for-performance misalignment is found;
|
|
|
|
The companys three year burn rate exceeds the burn rate cap of its industry group;
|
|
|
|
The plan has a liberal change-of-control definition; or
|
|
|
|
The plan is a vehicle for problematic pay practices.
|
ISS 2013 U.S. Proxy Voting Concise
Guidelines
B-20
Social/Environmental Issues
Global Approach
Issues covered under the policy include a
wide range of topics, including consumer and product safety, environment and energy, labor standards and human rights, workplace and board diversity, and corporate political issues. While a variety of factors goes into each analysis, the overall
principle guiding all vote recommendations focuses on how the proposal may enhance or protect shareholder value in either the short term or long term.
Generally vote CASE-BY-CASE, taking into consideration whether implementation of the proposal is likely to enhance or protect shareholder value, and in
addition the following will also be considered:
|
|
|
If the issues presented in the proposal are more appropriately or effectively dealt with through legislation or government regulation;
|
|
|
|
If the company has already responded in an appropriate and sufficient manner to the issue(s) raised in the proposal;
|
|
|
|
Whether the proposals request is unduly burdensome (scope, timeframe, or cost) or overly prescriptive;
|
|
|
|
The companys approach compared with any industry standard practices for addressing the issue(s) raised by the proposal;
|
|
|
|
If the proposal requests increased disclosure or greater transparency, whether or not reasonable and sufficient information is currently available to shareholders from the company or from other publicly available
sources; and
|
|
|
|
If the proposal requests increased disclosure or greater transparency, whether or not implementation would reveal proprietary or confidential information that could place the company at a competitive disadvantage.
|
Political Spending & Lobbying Activities
Generally vote AGAINST proposals asking the company to affirm political nonpartisanship in the workplace so long as:
|
|
|
There are no recent, significant controversies, fines or litigation regarding the companys political contributions or trade association spending; and
|
|
|
|
The company has procedures in place to ensure that employee contributions to company-sponsored political action committees (PACs) are strictly voluntary and prohibit coercion.
|
Vote AGAINST proposals to publish in newspapers and other media the companys political contributions. Such publications could present significant cost
to the company without providing commensurate value to shareholders.
Generally vote FOR proposals requesting greater disclosure of a companys
political contributions and trade association spending policies and activities. However, the following will be considered:
|
|
|
The companys current disclosure of policies and oversight mechanisms related to its direct political contributions and payments to trade associations or other groups that may be used for political purposes,
including information on the types of organizations supported and the business rationale for supporting these organizations; and
|
|
|
|
Recent significant controversies, fines, or litigation related to the companys political contributions or political activities.
|
ISS 2013 U.S. Proxy Voting Concise
Guidelines
B-21
Vote AGAINST proposals barring the company from making political contributions. Businesses are affected by
legislation at the federal, state, and local level; barring political 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.
Vote CASE-BY-CASE on proposals requesting information on a
companys lobbying (including direct, indirect, and grassroots lobbying) activities, policies, or procedures, considering:
|
|
|
The companys current disclosure of relevant policies and oversight mechanisms;
|
|
|
|
Recent significant controversies, fines, or litigation regarding the companys lobbying-related activities; and
|
|
|
|
The impact that the public policy issues in question may have on the companys business operations, if specific public policy issues are addressed.
|
Foreign Private Issuers Listed on U.S. Exchanges
Vote AGAINST (or WITHHOLD from) non-independent director nominees at companies which fail to meet the following criteria: a majority-independent board, and the
presence of an audit, a compensation, and a nomination committee, each of which is entirely composed of independent directors.
Where the design and
disclosure levels of equity compensation plans are comparable to those seen at U.S. companies, U.S. compensation policy will be used to evaluate the compensation plan proposals. In all other cases, equity compensation plans will be evaluated
according to ISS International Proxy Voting Guidelines.
All other voting items will be evaluated using ISS International Proxy Voting Guidelines.
Disclosure/Disclaimer
This document and all of the information contained in it, including without limitation all text, data, graphs, and charts (collectively, the
Information) is the property of Institutional Shareholder Services Inc. (ISS), its subsidiaries, or, in some cases third party suppliers.
The
Information has not been submitted to, nor received approval from, the United States Securities and Exchange Commission or any other regulatory body. None of the Information constitutes an offer to sell (or a solicitation of an offer to buy), or a
promotion or recommendation of, any security, financial product or other investment vehicle or any trading strategy, and ISS does not endorse, approve, or otherwise express any opinion regarding any issuer, securities, financial products or
instruments or trading strategies.
The user of the Information assumes the entire risk of any use it may make or permit to be made of the Information.
ISS 2013 U.S. Proxy Voting Concise
Guidelines
B-22
ISS MAKES NO EXPRESS OR IMPLIED WARRANTIES OR REPRESENTATIONS WITH RESPECT TO THE INFORMATION AND EXPRESSLY
DISCLAIMS ALL IMPLIED WARRANTIES (INCLUDING, WITHOUT LIMITATION, ANY IMPLIED WARRANTIES OF ORIGINALITY, ACCURACY, TIMELINESS, NON-INFRINGEMENT, COMPLETENESS, MERCHANTABILITY, AND FITNESS FOR A PARTICULAR PURPOSE) WITH RESPECT TO ANY OF THE
INFORMATION.
Without limiting any of the foregoing and to the maximum extent permitted by law, in no event shall ISS have any liability regarding any of
the Information for any direct, indirect, special, punitive, consequential (including lost profits), or any other damages even if notified of the possibility of such damages. The foregoing shall not exclude or limit any liability that may not by
applicable law be excluded or limited.
ISS 2013 U.S. Proxy Voting Concise
Guidelines
B-23
2013 International Proxy Voting Summary Guidelines
Dec. 19, 2012
Institutional Shareholder Services
Inc.
Copyright
©
2012 by ISS
www.issgovernance.com
B-24
ISS 2013 INTERNATIONAL PROXY VOTING SUMMARY GUIDELINES
Effective for Meetings on or after Feb. 1, 2013
Published Dec. 19, 2012
The following is a
condensed version of the proxy voting recommendations contained in ISS International Proxy Voting Manual. Note that markets covered in this document exclude the U.S., Canada, Western European markets, Australia, New Zealand, and China, which
are presented separately. In addition, ISS has country- and market-specific policies, which are not captured below.
Table of Contents
ISS 2013 International Proxy
Voting Summary Guidelines
B-25
ISS 2013 International Proxy
Voting Summary Guidelines
B-26
1. OPERATIONAL ITEMS
Financial Results/Director and Auditor Reports
Vote FOR approval of financial statements and director and auditor reports, unless:
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There are concerns about the accounts presented or audit procedures used; or
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The company is not responsive to shareholder questions about specific items that should be publicly disclosed.
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Appointment of Auditors and Auditor Fees
Vote FOR the (re)election of auditors and/or proposals authorizing the board to fix auditor fees, unless:
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There are serious concerns about the procedures used by the auditor;
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There is reason to believe that the auditor has rendered an opinion which is neither accurate nor indicative of the companys financial position;
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External auditors have previously served the company in an executive capacity or can otherwise be considered affiliated with the company;
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Name of the proposed auditors has not been published;
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The auditors are being changed without explanation; or
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Fees for non-audit services exceed standard annual audit-related fees (only applies to companies on the MSCI EAFE index and/or listed on any country main index).
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In circumstances where fees for non-audit services include fees related to significant one-time capital structure events (initial public offerings, bankruptcy
emergencies, and spinoffs) and the company makes public disclosure of the amount and nature of those fees, which are an exception to the standard non-audit fee category, then such fees may be excluded from the non-audit fees considered
in determining the ratio of non-audit to audit fees.
For concerns related to the audit procedures, independence of auditors, and/or name of auditors, ISS
may recommend AGAINST the auditor (re)election. For concerns related to fees paid to the auditors, ISS may recommend AGAINST remuneration of auditors if this is a separate voting item; otherwise ISS may recommend AGAINST the auditor election.
Appointment of Internal Statutory Auditors
Vote FOR the appointment or (re)election of statutory auditors, unless:
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There are serious concerns about the statutory reports presented or the audit procedures used;
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Questions exist concerning any of the statutory auditors being appointed; or
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The auditors have previously served the company in an executive capacity or can otherwise be considered affiliated with the company.
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Allocation of Income
Vote FOR approval of the allocation of income, unless:
ISS 2013 International Proxy
Voting Summary Guidelines
B-27
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The dividend payout ratio has been consistently below 30 percent without adequate explanation; or
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The payout is excessive given the companys financial position.
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Stock (Scrip) Dividend Alternative
Vote FOR most stock (scrip) dividend proposals.
Vote AGAINST
proposals that do not allow for a cash option unless management demonstrates that the cash option is harmful to shareholder value.
Amendments to Articles of Association
Vote amendments to the articles of association on a CASE-BY-CASE basis.
Change in Company Fiscal Term
Vote FOR resolutions to change a companys fiscal term unless a companys motivation for the change is to postpone its AGM.
Lower Disclosure Threshold for Stock Ownership
Vote AGAINST resolutions to lower the stock ownership disclosure threshold below 5 percent unless specific reasons exist to implement a lower threshold.
Amend Quorum Requirements
Vote proposals to amend quorum requirements for shareholder meetings on a CASE-BY-CASE basis.
Transact Other Business
Vote AGAINST other business when it appears as a voting item.
ISS 2013 International Proxy
Voting Summary Guidelines
B-28
2. BOARD OF DIRECTORS
Director Elections
Vote FOR
management nominees in the election of directors, unless:
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Adequate disclosure has not been provided in a timely manner;
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There are clear concerns over questionable finances or restatements;
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There have been questionable transactions with conflicts of interest;
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There are any records of abuses against minority shareholder interests; or
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The board fails to meet minimum corporate governance standards.
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Vote FOR individual nominees unless there are
specific concerns about the individual, such as criminal wrongdoing or breach of fiduciary responsibilities.
Vote AGAINST individual directors if
repeated absences at board meetings have not been explained (in countries where this information is disclosed).
Vote on a CASE-BY-CASE basis for
contested elections of directors, e.g. the election of shareholder nominees or the dismissal of incumbent directors, determining which directors are best suited to add value for shareholders.
Vote FOR employee and/or labor representatives if they sit on either the audit or compensation committee
and
are required by law to be on those
committees. Vote AGAINST employee and/or labor representatives if they sit on either the audit or compensation committee, if they are not required to be on those committees.
Vote AGAINST the election of directors at all companies if the name of the nominee is not disclosed in a timely manner prior to the meeting.
Grace period
: Vote FOR the election of directors at all Polish companies and non-index Turkish companies in 2013 even if nominee names are not
disclosed in a timely manner prior to the meeting, but include cautionary language in the research report. Beginning in 2014, vote AGAINST the election of directors at all Polish companies and non-index Turkish companies if nominee names are not
disclosed in a timely manner prior to the meeting.
Under extraordinary circumstances, vote AGAINST individual directors, members of a committee, or the
entire board, due to:
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Material failures of governance, stewardship, risk oversight, or fiduciary responsibilities at the company;
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Failure to replace management as appropriate; or
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Egregious actions related to a directors service on other boards that raise substantial doubt about his or her ability to effectively oversee management and serve the best interests of shareholders at any company.
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[Please see the ISS International Classification of Directors on the following page.]
ISS 2013 International Proxy
Voting Summary Guidelines
B-29
ISS Classification of Directors - International Policy 2013
Executive Director
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Employee or executive of the company;
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Any director who is classified as a non-executive, but receives salary, fees, bonus, and/or other benefits that are in line with the highest-paid executives of the company.
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Non-Independent Non-Executive Director (NED)
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Any director who is attested by the board to be a non-independent NED;
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Any director specifically designated as a representative of a significant shareholder of the company;
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Any director who is also an employee or executive of a significant shareholder of the company;
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Any director who is nominated by a dissenting significant shareholder, unless there is a clear lack of material[5] connection with the dissident, either currently or historically;
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Beneficial owner (direct or indirect) of at least 10 percent of the companys stock, either in economic terms or in voting rights (this may be aggregated if voting power is distributed among more than one member of
a defined group, e.g., family members who beneficially own less than 10 percent individually, but collectively own more than 10 percent), unless market best practice dictates a lower ownership and/or disclosure threshold (and in other special
market-specific circumstances);
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Government representative;
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Currently provides (or a relative[1] provides) professional services[2] to the company, to an affiliate of the company, or to an individual officer of the company or of one of its affiliates in excess of $10,000 per
year;
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Represents customer, supplier, creditor, banker, or other entity with which company maintains transactional/commercial relationship (unless company discloses information to apply a materiality test[3]);
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Any director who has conflicting or cross-directorships with executive directors or the chairman of the company;
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Relative[1] of a current employee of the company or its affiliates;
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Relative[1] of a former executive of the company or its affiliates;
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A new appointee elected other than by a formal process through the General Meeting (such as a contractual appointment by a substantial shareholder);
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Founder/co-founder/member of founding family but not currently an employee;
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Former executive (five-year cooling off period);
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Years of service is generally not a determining factor unless it is recommended best practice in a market and/or in extreme circumstances, in which case it may be considered.[4]
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Any additional relationship or principle considered to compromise independence under local corporate governance best practice guidance.
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Independent NED
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No material[5] connection, either directly or indirectly, to the company (other than a board seat) or the dissenting significant shareholder.
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Employee Representative
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Represents employees or employee shareholders of the company (classified as employee representative but considered a non-independent NED).
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Footnotes:
[1]
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Relative follows the definition of immediate family members which covers spouses, parents, children, stepparents, step-children, siblings, in-laws, and any person (other than a tenant or
employee) sharing the household of any director, nominee for director, executive officer, or significant shareholder of the company.
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ISS 2013 International Proxy
Voting Summary Guidelines
B-30
[2]
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Professional services can be characterized as advisory in nature and generally include the following: investment banking/financial advisory services; commercial banking (beyond deposit services); investment services;
insurance services; accounting/audit services; consulting services; marketing services; and legal services. The case of participation in a banking syndicate by a non-lead bank should be considered a transaction (and hence subject to the associated
materiality test) rather than a professional relationship.
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[3]
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A business relationship may be material if the transaction value (of all outstanding transactions) entered into between the company and the company or organization with which the director is associated is equivalent to
either 1 percent of the companys turnover or 1 percent of the turnover of the company or organization with which the director is associated. OR, A business relationship may be material if the transaction value (of all outstanding financing
operations) entered into between the company and the company or organization with which the director is associated is more than 10 percent of the companys shareholder equity or the transaction value, (of all outstanding financing operations),
compared to the companys total assets, is more than 5 percent.
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[4]
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For example, in continental Europe, directors with a tenure exceeding 12 years will be considered non-independent. In the United Kingdom, Ireland, Hong Kong and Singapore, directors with a tenure exceeding nine years
will be considered non-independent, unless the company provides sufficient and clear justification that the director is independent despite his long tenure.
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[5]
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For purposes of ISS director independence classification, material will be defined as a standard of relationship financial, personal or otherwise that a reasonable person might conclude could
potentially influence ones objectivity in the boardroom in a manner that would have a meaningful impact on an individuals ability to satisfy requisite fiduciary standards on behalf of shareholders.
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Contested Director Elections
For contested elections of directors, e.g. the election of shareholder nominees or the dismissal of incumbent directors, ISS will make its recommendation on a
case-by-case basis, determining which directors are best suited to add value for shareholders.
The analysis will generally be based on, but not limited
to, the following major decision factors:
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Company performance relative to its peers;
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Strategy of the incumbents versus the dissidents;
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Independence of directors/nominees;
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Experience and skills of board candidates;
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Governance profile of the company;
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Evidence of management entrenchment;
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Responsiveness to shareholders;
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Whether a takeover offer has been rebuffed;
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Whether minority or majority representation is being sought.
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When analyzing a contested election of
directors, ISS will generally focus on two central questions: (1) Have the dissidents proved that board change is warranted? And (2) if so, are the dissident board nominees likely to effect positive change (i.e., maximize long-term
shareholder value).
Discharge of Directors
Generally vote FOR the discharge of directors, including members of the management board and/or supervisory board,
unless
there is reliable information
about significant and compelling controversies as to whether the board is fulfilling its fiduciary duties, as evidenced by:
ISS 2013 International Proxy
Voting Summary Guidelines
B-31
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A lack of oversight or actions by board members that invoke shareholder distrust related to malfeasance or poor supervision, such as operating in private or company interest rather than in shareholder interest; or
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Any legal proceedings (either civil or criminal) aiming to hold the board responsible for breach of trust in the past or related to currently alleged actions yet to be confirmed (and not only the fiscal year in
question), such as price fixing, insider trading, bribery, fraud, and other illegal actions; or
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Other egregious governance issues where shareholders will bring legal action against the company or its directors.
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For markets that do not routinely request discharge resolutions (e.g. common law countries or markets where discharge is not mandatory), analysts may voice
concern in other appropriate agenda items, such as approval of the annual accounts or other relevant resolutions, to enable shareholders to express discontent with the board.
Director, Officer, and Auditor Indemnification and Liability Provisions
Vote proposals seeking indemnification and liability protection for directors and officers on a CASE-BY-CASE basis.
Vote AGAINST proposals to indemnify external auditors.
Board Structure
Vote FOR proposals to fix board size.
Vote AGAINST the
introduction of classified boards and mandatory retirement ages for directors.
Vote AGAINST proposals to alter board structure or size in the context of
a fight for control of the company or the board.
ISS 2013 International Proxy
Voting Summary Guidelines
B-32
3. CAPITAL STRUCTURE
Share Issuance Requests
General Issuances
Vote FOR issuance requests with preemptive rights to a maximum of 100 percent over currently issued capital.
Vote FOR issuance requests without preemptive rights to a maximum of 20 percent of currently issued capital.
Specific Issuances
Vote on a CASE-BY-CASE basis on all requests, with or without preemptive rights.
Increases in Authorized Capital
Vote FOR non-specific proposals to increase authorized capital up to 100 percent over the current authorization unless the increase would leave the company
with less than 30 percent of its new authorization outstanding.
Vote FOR specific proposals to increase authorized capital to any amount, unless:
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The specific purpose of the increase (such as a share-based acquisition or merger) does not meet ISS guidelines for the purpose being proposed; or
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The increase would leave the company with less than 30 percent of its new authorization outstanding after adjusting for all proposed issuances.
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Vote AGAINST proposals to adopt unlimited capital authorizations.
Reduction of Capital
Vote FOR proposals to reduce capital for routine accounting purposes unless the terms are unfavorable to shareholders.
Vote proposals to reduce capital in connection with corporate restructuring on a CASE-BY-CASE basis.
Capital Structures
Vote FOR resolutions that seek to maintain or convert to a one-share, one-vote capital structure.
Vote AGAINST requests for the creation or continuation of dual-class capital structures or the creation of new or additional super voting shares.
ISS 2013 International Proxy
Voting Summary Guidelines
B-33
Preferred Stock
Vote FOR the creation of a new class of preferred stock or for issuances of preferred stock up to 50 percent of issued capital unless the terms of the
preferred stock would adversely affect the rights of existing shareholders.
Vote FOR the creation/issuance of convertible preferred stock as long as the
maximum number of common shares that could be issued upon conversion meets ISS guidelines on equity issuance requests.
Vote AGAINST the creation of a new
class of preference shares that would carry superior voting rights to the common shares.
Vote AGAINST the creation of blank check preferred stock unless
the board clearly states that the authorization will not be used to thwart a takeover bid.
Vote proposals to increase blank check preferred
authorizations on a CASE-BY-CASE basis.
Debt Issuance Requests
Vote non-convertible debt issuance requests on a CASE-BY-CASE basis, with or without preemptive rights.
Vote FOR the creation/issuance of convertible debt instruments as long as the maximum number of common shares that could be issued upon conversion meets ISS
guidelines on equity issuance requests.
Vote FOR proposals to restructure existing debt arrangements unless the terms of the restructuring would
adversely affect the rights of shareholders.
Pledging of Assets for Debt
Vote proposals to approve the pledging of assets for debt on a CASE-BY-CASE basis.
Increase in Borrowing Powers
Vote proposals to approve increases in a companys borrowing powers on a CASE-BY-CASE basis.
Share Repurchase Plans
Generally vote FOR market repurchase authorities (share repurchase programs) if the terms comply with the following criteria:
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A repurchase limit of up to 10 percent of outstanding issued share capital (15 percent in U.K./Ireland);
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A holding limit of up to 10 percent of a companys issued share capital in treasury (on the shelf); and
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A duration of no more than five years, or such lower threshold as may be set by applicable law, regulation or code of governance best practice.
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Authorities to repurchase shares in excess of the 10 percent repurchase limit will be assessed on a case-by-case basis. ISS may support such share repurchase
authorities under special circumstances, which are required to be publicly disclosed by
ISS 2013 International Proxy
Voting Summary Guidelines
B-34
the company, provided that, on balance, the proposal is in shareholders interests. In such cases, the
authority must comply with the following criteria:
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A holding limit of up to 10 percent of a companys issued share capital in treasury (on the shelf); and
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A duration of no more than 18 months.
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In markets where it is normal practice not to provide a repurchase
limit, ISS will evaluate the proposal based on the companys historical practice. However, ISS expects companies to disclose such limits and, in the future, may recommend a vote against companies that fail to do so. In such cases, the authority
must comply with the following criteria:
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A holding limit of up to 10 percent of a companys issued share capital in treasury (on the shelf); and
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A duration of no more than 18 months.
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In addition, ISS will recommend AGAINST any proposal where:
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The repurchase can be used for takeover defenses;
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There is clear evidence of abuse;
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There is no safeguard against selective buybacks; and/or
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Pricing provisions and safeguards are deemed to be unreasonable in light of market practice.
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Reissuance of Repurchased Shares
Vote FOR requests to reissue any repurchased shares unless there is clear evidence of abuse of this authority in the past.
Capitalization of Reserves for Bonus Issues/Increase in Par Value
Vote FOR requests to capitalize reserves for bonus issues of shares or to increase par value.
ISS 2013 International Proxy
Voting Summary Guidelines
B-35
4. COMPENSATION
Compensation Plans
Vote
compensation plans on a CASE-BY-CASE basis.
Director Compensation
Vote FOR proposals to award cash fees to non-executive directors unless the amounts are excessive relative to other companies in the country or industry.
Vote non-executive director compensation proposals that include both cash and share-based components on a CASE-BY-CASE basis.
Vote proposals that bundle compensation for both non-executive and executive directors into a single resolution on a CASE-BY-CASE basis.
Vote AGAINST proposals to introduce retirement benefits for non-executive directors.
ISS 2013 International Proxy
Voting Summary Guidelines
B-36
5. OTHER ITEMS
Reorganizations/Restructurings
Vote reorganizations and restructurings on a CASE-BY-CASE basis.
Mergers and Acquisitions
Vote CASE-BY-CASE on mergers and acquisitions taking into account the following:
For every M&A analysis, ISS reviews publicly available information as of the date of the report and evaluates 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, ISS
places emphasis on the offer premium, market reaction, and strategic rationale.
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Market reaction - How has the market responded to the proposed deal? A negative market reaction will cause ISS to scrutinize a deal more closely.
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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.
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Conflicts of interest - Are insiders benefiting from the transaction disproportionately and inappropriately as compared to non-insider shareholders? ISS will consider whether any special interests may have influenced
these directors and officers to support or recommend the merger.
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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.
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Vote AGAINST if the
companies do not provide sufficient information upon request to make an informed voting decision.
Mandatory Takeover Bid Waivers
Vote proposals to waive mandatory takeover bid requirements on a CASE-BY-CASE basis.
Reincorporation Proposals
Vote reincorporation proposals on a CASE-BY-CASE basis.
Expansion of Business Activities
Vote FOR resolutions to expand business activities unless the new business takes the company into risky areas.
ISS 2013 International Proxy
Voting Summary Guidelines
B-37
Related-Party Transactions
In evaluating resolutions that seek shareholder approval on related-party transactions (RPTs), vote on a case-by-case basis, considering factors including, but
not limited to, the following:
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The parties on either side of the transaction;
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The nature of the asset to be transferred/service to be provided;
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The pricing of the transaction (and any associated professional valuation);
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The views of independent directors (where provided);
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The views of an independent financial adviser (where appointed);
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Whether any entities party to the transaction (including advisers) is conflicted; and
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The stated rationale for the transaction, including discussions of timing.
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If there is a transaction that ISS
deemed problematic and that was not put to a shareholder vote, ISS may recommend against the election of the director involved in the related-party transaction or the full board.
Antitakeover Mechanisms
Generally vote AGAINST all antitakeover proposals, unless they are structured in such a way that they give shareholders the ultimate decision on any proposal
or offer.
Shareholder Proposals
Vote all shareholder proposals on a CASE-BY-CASE basis.
Vote
FOR proposals that would improve the companys corporate governance or business profile at a reasonable cost.
Vote AGAINST proposals that limit the
companys business activities or capabilities or result in significant costs being incurred with little or no benefit.
ISS 2013 International Proxy
Voting Summary Guidelines
B-38
Social/Environmental Issues
Global Approach
Issues covered under the policy include a
wide range of topics, including consumer and product safety, environment and energy, labor covered standards and human rights, workplace and board diversity, and corporate political issues. While a variety of factors goes into each analysis, the
overall principle guiding all vote recommendations focuses on how the proposal may enhance or protect shareholder value in either the short term or long term.
Generally vote CASE-BY-CASE, taking into consideration whether implementation of the proposal is likely to enhance or protect shareholder value, and in
addition the following will be considered:
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If the issues presented in the proposal are more appropriately or effectively dealt with through legislation or government regulation;
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If the company has already responded in an appropriate and sufficient manner to the issue(s) raised in the proposal;
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Whether the proposals request is unduly burdensome (scope, timeframe, or cost) or overly prescriptive;
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The companys approach compared with any industry standard practices for addressing the issue(s) raised by the proposal;
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If the proposal requests increased disclosure or greater transparency, whether or not reasonable and sufficient information is currently available to shareholders from the company or from other publicly available
sources; and
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If the proposal requests increased disclosure or greater transparency, whether or not implementation would reveal proprietary or confidential information that could place the company at a competitive disadvantage.
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ISS 2013 International Proxy
Voting Summary Guidelines
B-39
6. Foreign Private Issuers Listed on U.S. Exchanges
Foreign private issuers (FPIs) are defined as companies whose business is administered principally outside the U.S., with more than 50 percent of
assets located outside the U.S.; a majority of whose directors/officers are not U.S. citizens or residents; and a majority of whose outstanding voting shares are held by non-residents of the U.S.
Companies that are incorporated outside of the U.S. and listed solely on U.S. exchanges, where they qualify as FPIs, will be subject to the following policy:
Vote AGAINST (or WITHHOLD from) non-independent director nominees at companies which fail to meet the following criteria: a majority-independent board,
and the presence of an audit, a compensation, and a nomination committee, each of which is entirely composed of independent directors.
Where the design
and disclosure levels of equity compensation plans are comparable to those seen at U.S. companies, U.S. compensation policy will be used to evaluate the compensation plan proposals. In all other cases, equity compensation plans will be evaluated
according to ISS International Proxy Voting Guidelines.
All other voting items will be evaluated using ISS International Proxy Voting
Guidelines.
ISS 2013 International Proxy
Voting Summary Guidelines
B-40
DISCLOSURE/DISCLAIMER
This document and all of the information contained in it, including without limitation all text, data, graphs, and charts (collectively, the
Information) is the property of Institutional Shareholder Services Inc. (ISS), its subsidiaries, or, in some cases third party suppliers.
The Information has not been submitted to, nor received approval from, the United States Securities and Exchange Commission or any other regulatory body. None
of the Information constitutes an offer to sell (or a solicitation of an offer to buy), or a promotion or recommendation of, any security, financial product or other investment vehicle or any trading strategy, and ISS does not endorse, approve or
otherwise express any opinion regarding any issuer, securities, financial products or instruments or trading strategies.
The user of the Information
assumes the entire risk of any use it may make or permit to be made of the Information.
ISS MAKES NO EXPRESS OR IMPLIED WARRANTIES OR REPRESENTATIONS
WITH RESPECT TO THE INFORMATION AND EXPRESSLY DISCLAIMS ALL IMPLIED WARRANTIES (INCLUDING, WITHOUT LIMITATION, ANY IMPLIED WARRANTIES OF ORIGINALITY, ACCURACY, TIMELINESS, NON-INFRINGEMENT, COMPLETENESS, MERCHANTABILITY AND FITNESS FOR A PARTICULAR
PURPOSE) WITH RESPECT TO ANY OF THE INFORMATION.
Without limiting any of the foregoing and to the maximum extent permitted by law, in no event shall ISS
have any liability regarding any of the Information for any direct, indirect, special, punitive, consequential (including lost profits) or any other damages even if notified of the possibility of such damages. The foregoing shall not exclude or
limit any liability that may not by applicable law be excluded or limited.
ISS 2013 International Proxy
Voting Summary Guidelines
B-41
Exhibit B (as amended February 2, 2009)
Modifications to recommendations set forth in the ISS Proxy Voting Manual
Shareholder Ability to Act by Written Consent
Vote FOR
proposals to restrict or prohibit shareholder activity to take action by written consent.
Vote AGAINST proposals to allow or make easier shareholder
action by written consent.
Cumulative Voting
Vote
FOR proposals to eliminate cumulative voting.
Vote AGAINST proposals to restore or provide for cumulative voting.
Incumbent Director Nominees
Vote WITH managements
recommendations regarding incumbent director nominees.
B-42
GMO TRUST