STATEMENT OF ADDITIONAL INFORMATION
AUGUST 27, 2002
AS SUPPLEMENTED SEPTEMBER 17, 2002
EATON VANCE INSURED CALIFORNIA MUNICIPAL BOND FUND
THE EATON VANCE BUILDING
255 STATE STREET
BOSTON, MASSACHUSETTS 02109
(800) 225-6265
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TABLE OF CONTENTS
PAGE
Additional Investment Information and Restrictions........................ B-2
Trustees and Officers..................................................... B-8
Investment Advisory and Other Services.................................... B-12
Determination of Net Asset Value.......................................... B-13
Portfolio Trading......................................................... B-14
Taxes..................................................................... B-15
Other Information......................................................... B-18
Independent Auditors...................................................... B-18
Independent Auditors' Report.............................................. B-19
Financial Statements...................................................... B-20
Appendix A: Ratings of Municipal Bonds................................... B-21
Appendix B: Tax Equivalent Yield Table................................... B-26
Appendix C: California and U.S. Territory Information.................... B-27
Appendix D: Description of Insurers...................................... B-52
Appendix E: Performance Related and Comparative Information.............. B-55
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THIS STATEMENT OF ADDITIONAL INFORMATION ("SAI") IS NOT A PROSPECTUS AND IS
AUTHORIZED FOR DISTRIBUTION TO PROSPECTIVE INVESTORS ONLY IF PRECEDED OR
ACCOMPANIED BY THE PROSPECTUS OF EATON VANCE INSURED CALIFORNIA MUNICIPAL BOND
FUND (THE "FUND") DATED AUGUST 27, 2002, AS SUPPLEMENTED FROM TIME TO TIME,
WHICH IS INCORPORATED HEREIN BY REFERENCE. THIS SAI SHOULD BE READ IN
CONJUNCTION WITH SUCH PROSPECTUS, A COPY OF WHICH MAY BE OBTAINED WITHOUT CHARGE
BY CONTACTING YOUR FINANCIAL INTERMEDIARY OR CALLING THE FUND AT 1-800-225-6265.
Capitalized terms used in this SAI and not otherwise defined have the
meanings given them in the Fund's Prospectus.
ADDITIONAL INVESTMENT INFORMATION AND RESTRICTIONS
MUNICIPAL OBLIGATIONS. Municipal obligations are issued to obtain funds for
various public and private purposes. Municipal obligations include long-term
obligations, which are often called municipal bonds, as well as tax-exempt
commercial paper, project notes and municipal notes such as tax, revenue and
bond anticipation notes of short maturity, generally less than three years.
Market rates of interest available with respect to municipal obligations may be
lower than those available with respect to taxable securities, although such
differences may be partially or wholly offset by the effects of federal income
tax on income derived from such taxable securities. While most municipal bonds
pay a fixed rate of interest semi-annually in cash, some bonds pay no periodic
cash interest but instead make a single payment at maturity representing both
principal and interest. Municipal obligations may be issued or subsequently
offered with interest coupons materially greater or less than those then
prevailing, with price adjustments reflecting such deviation.
In general, there are three categories of municipal obligations the interest
on which is exempt from federal income tax and is not a tax preference item for
purposes of the alternative minimum tax ("AMT"): (i) certain "public purpose"
obligations (whenever issued), which include obligations issued directly by
state and local governments or their agencies to fulfill essential governmental
functions; (ii) certain obligations issued before August 8, 1986 for the benefit
of non-governmental persons or entities; and (iii) certain "private activity
bonds" issued after August 7, 1986, which include "qualified Section 501(c)(3)
bonds" or refundings of certain obligations included in the second category.
Interest on certain "private activity bonds" issued after August 7, 1986 is
exempt from regular federal income tax, but is treated as a tax preference item
that could subject the recipient to or increase the recipient's liability for
the AMT. For corporate shareholders, the Fund's distributions derived from
interest on all municipal obligations (whenever issued) is included in "adjusted
current earnings" for purposes of the AMT as applied to corporations (to the
extent not already included in alternative minimum taxable income as income
attributable to private activity bonds). In assessing the federal income tax
treatment of interest on any such obligation, the Fund will rely on an opinion
of the issuer's counsel (when available) obtained by the issuer or other
reliable authority and will not undertake any independent verification thereof.
The two principal classifications of municipal bonds are "general
obligation" and "revenue" bonds. Issuers of general obligation bonds include
states, counties, cities, towns and regional districts. The proceeds of these
obligations are used to fund a wide range of public projects including the
construction or improvement of schools, highways and roads, water and sewer
systems and a variety of other public purposes. The basic security of general
obligation bonds is the issuer's pledge of its faith, credit, and taxing power
for the payment of principal and interest. The taxes that can be levied for the
payment of debt service may be limited or unlimited as to rate and amount.
Revenue bonds are generally secured by the net revenues derived from a
particular facility or group of facilities or, in some cases, from the proceeds
of a special excise or other specific revenue source. Revenue bonds have been
issued to fund a wide variety of capital projects including: electric, gas,
water, sewer and solid waste disposal systems; highways, bridges and tunnels;
port, airport and parking facilities; transportation systems; housing
facilities, colleges and universities and hospitals. Although the principal
security behind these bonds varies widely, many provide additional security in
the form of a debt service reserve fund whose monies may be used to make
principal and interest payments on the issuer's obligations. Housing finance
authorities have a wide range of security including partially or fully insured,
rent subsidized and/or collateralized mortgages, and/or the net revenues from
housing or other public projects. In addition to a debt service reserve fund,
some authorities provide further security in the form of a state's ability
(without legal obligation) to make up deficiencies in the debt service reserve
fund. Lease rental revenue bonds issued by a state or local authority for
capital projects are normally secured by annual lease rental payments from the
state or locality to the authority sufficient to cover debt service on the
authority's obligations. Such payments are usually subject to annual
appropriations by the state or locality. Industrial development and pollution
control bonds, although nominally issued by municipal authorities, are in most
cases revenue bonds and are generally not secured by the taxing power of the
municipality, but are usually secured by the revenues derived by the authority
from payments of the industrial user or users. The Fund may on occasion acquire
revenue bonds which carry warrants or similar rights covering equity securities.
Such warrants or rights may be held indefinitely, but if exercised, the Fund
anticipates that it would, under normal circumstances, dispose of any equity
securities so acquired within a reasonable period of time.
The obligations of any person or entity to pay the principal of and interest
on a municipal obligation are subject to the provisions of bankruptcy,
insolvency and other laws affecting the rights and remedies of creditors, such
as the Federal Bankruptcy Act, and laws, if any, which may be enacted by
Congress or state legislatures extending the time for payment of principal or
interest, or both, or imposing other constraints upon enforcement of such
obligations. There is also the possibility that as a result of litigation or
other conditions the power or ability of any person or entity to pay when due
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principal of and interest on a municipal obligation may be materially affected.
There have been recent instances of defaults and bankruptcies involving
municipal obligations which were not foreseen by the financial and investment
communities. The Fund will take whatever action it considers appropriate in the
event of anticipated financial difficulties, default or bankruptcy of either the
issuer of any municipal obligation or of the underlying source of funds for debt
service. Such action may include retaining the services of various persons or
firms (including affiliates of the Adviser) to evaluate or protect any real
estate, facilities or other assets securing any such obligation or acquired by
the Fund as a result of any such event, and the Fund may also manage (or engage
other persons to manage) or otherwise deal with any real estate, facilities or
other assets so acquired. The Fund anticipates that real estate consulting and
management services may be required with respect to properties securing various
municipal obligations in its portfolio or subsequently acquired by the Fund. The
Fund will incur additional expenditures in taking protective action with respect
to portfolio obligations in default and assets securing such obligations. To
enforce its rights in the event of a default in the payment of interest or
repayment of principal, or both, the Fund may take possession of and manage the
assets or have a receiver appointed to collect and disburse pledged revenues
securing the issuer's obligations on such securities, which may increase the
operating expenses and adversely affect the net asset value of the Fund. Any
income derived from the ownership or operation of such assets may not be
tax-exempt. In addition, the Fund's intention to qualify as a "regulated
investment company" ("RIC") under the Internal Revenue Code of 1986, as amended
(the "Code") may limit the extent to which the Fund may exercise its rights by
taking possession of such assets, because as a regulated investment company, the
Fund is subject to certain limitations on its investments and on the nature of
its income.
The yields on municipal obligations are dependent on a variety of factors,
including purposes of issue and source of funds for repayment, general money
market conditions, general conditions of the municipal bond market, size of a
particular offering, maturity of the obligation and rating of the issue. The
ratings of Moody's, S&P and Fitch represent their opinions as to the quality of
the municipal obligations which they undertake to rate. It should be emphasized,
however, that ratings are based on judgment and are not absolute standards of
quality. Consequently, municipal obligations with the same maturity, coupon and
rating may have different yields while obligations of the same maturity and
coupon with different ratings may have the same yield. In addition, the market
price of municipal obligations will normally fluctuate with changes in interest
rates, and therefore the net asset value of the Fund will be affected by such
changes.
The Fund also may invest up to 20% of the net assets in uninsured municipal
bonds that are entitled to the benefit of an escrow or trust account that
contains securities issued or guaranteed by the U.S. Government or U.S.
Government agencies, backed by the full faith and credit of the United States,
and sufficient in the amount to ensure the payment of interest and principal on
the original interest payment and maturity dates ("collateralized obligations").
These collateralized obligations generally will not be insured and will include,
but are not limited to, municipal bonds that have been advance refunded where
the proceeds of the refunding have been used to buy U.S. Government or U.S.
Government agency securities that are placed in escrow and whose interest or
maturing principal payments, or both, are sufficient to cover the remaining
scheduled debt service on that municipal bond.
STATE CONCENTRATION. The Fund may invest 25% or more of its total assets in
municipal obligations of issuers located in California or the U.S. territories.
When the Fund does so, it will be sensitive to factors affecting California or
the U.S. Territory, such as changes in the economy, decreases in tax collection
or the tax base, legislation which limits taxes and changes in issuer credit
ratings. Factors pertaining to California and U.S. territories are set forth in
Appendix C.
ECONOMIC SECTOR CONCENTRATION. The Fund may invest 25% or more of its total
assets in municipal obligations of issuers in the same economic sector. There
could be economic, business or political developments which might affect all
municipal obligations in a particular economic sector. In particular,
investments in the industrial revenue bonds listed above might involve (without
limitation) the following risks.
Hospital bond ratings are often based on feasibility studies which contain
projections of expenses, revenues and occupancy levels. Among the influences
affecting a hospital's gross receipts and net income available to service its
debt are demand for hospital services, the ability of the hospital to provide
the services required, management capabilities, economic developments in the
service area, efforts by insurers and government agencies to limit rates and
expenses, confidence in the hospital, service area economic developments,
competition, availability and expense of malpractice insurance, Medicaid and
Medicare funding and possible federal legislation limiting the rates of increase
of hospital charges.
Electric utilities face problems in financing large construction programs in
an inflationary period, cost increases and delay occasioned by safety and
environmental considerations (particularly with respect to nuclear facilities),
difficulty in obtaining fuel at reasonable prices and in achieving timely and
adequate rate relief from regulatory commissions, effects of energy conservation
and limitations on the capacity of the capital market to absorb utility debt.
3
Bonds to finance life care facilities are normally secured only by the
revenues of each facility and not by state or local government tax payments,
they are subject to a wide variety of risks. Primarily, the projects must
maintain adequate occupancy levels to be able to provide revenues sufficient to
meet debt service payments. Moreover, since a portion of housing, medical care
and other services may be financed by an initial deposit, it is important that
the facility maintain adequate financial reserves to secure estimated actuarial
liabilities. The ability of management to accurately forecast inflationary cost
pressures is an important factor in this process. The facilities may also be
affected adversely by regulatory cost restrictions applied to health care
delivery in general, particularly state regulations or changes in Medicare and
Medicaid payments or qualifications, or restrictions imposed by medical
insurance companies. They may also face competition from alternative health care
or conventional housing facilities in the private or public sector.
CREDIT QUALITY. While municipal obligations rated investment grade or below
and comparable unrated municipal obligations may have some quality and
protective characteristics, these characteristics can be expected to be offset
or outweighed by uncertainties or major risk exposures to adverse conditions.
Lower rated and comparable unrated municipal obligations are subject to the risk
of an issuer's inability to meet principal and interest payments on the
obligations (credit risk) and may also be subject to greater price volatility
due to such factors as interest rate sensitivity, market perception of the
creditworthiness of the issuer and general market liquidity (market risk). Lower
rated or unrated municipal obligations are also more likely to react to real or
perceived developments affecting market and credit risk than are more highly
rated obligations, which react primarily to movements in the general level of
interest rates.
MUNICIPAL LEASES. The Fund may invest in municipal leases and participations
therein, which arrangements frequently involve special risks. Municipal leases
are obligations in the form of a lease or installment purchase arrangement which
is issued by state or local governments to acquire equipment and facilities.
Interest income from such obligations is generally exempt from local and state
taxes in the state of issuance. "Participations" in such leases are undivided
interests in a portion of the total obligation. Participations entitle their
holders to receive a pro rata share of all payments under the lease. The
obligation of the issuer to meet its obligations under such leases is often
subject to the appropriation by the appropriate legislative body, on an annual
or other basis, of funds for the payment of the obligations. Investments in
municipal leases are thus subject to the risk that the legislative body will not
make the necessary appropriation and the issuer will not otherwise be willing or
able to meet its obligation. Certain municipal lease obligations are illiquid.
ZERO COUPON BONDS. Zero coupon bonds are debt obligations which do not
require the periodic payment of interest and are issued at a significant
discount from face value. The discount approximates the total amount of interest
the bonds will accrue and compound over the period until maturity at a rate of
interest reflecting the market rate of the security at the time of issuance. The
Fund is required to accrue income from zero coupon bonds on a current basis,
even though it does not receive that income currently in cash and the Fund is
required to distribute its income for each taxable year. Thus, the Fund may have
to sell other investments to obtain cash needed to make income distributions.
WHEN-ISSUED SECURITIES. New issues of municipal obligations are sometimes
offered on a "when-issued" basis, that is, delivery and payment for the
securities normally take place within a specified number of days after the date
of the Fund's commitment and are subject to certain conditions such as the
issuance of satisfactory legal opinions. The Fund may also purchase securities
on a when-issued basis pursuant to refunding contracts in connection with the
refinancing of an issuer's outstanding indebtedness. Refunding contracts
generally require the issuer to sell and the Fund to buy such securities on a
settlement date that could be several months or several years in the future. The
Fund may also purchase instruments that give the Fund the option to purchase a
municipal obligation when and if issued.
The Fund will make commitments to purchase when-issued securities only with
the intention of actually acquiring the securities, but may sell such securities
before the settlement date if it is deemed advisable as a matter of investment
strategy. The payment obligation and the interest rate that will be received on
the securities are fixed at the time the Fund enters into the purchase
commitment. When the Fund commits to purchase a security on a when-issued basis
it records the transaction and reflects the value of the security in determining
its net asset value. Securities purchased on a when-issued basis and the
securities held by the Fund are subject to changes in value based upon the
perception of the creditworthiness of the issuer and changes in the level of
interest rates (I.E. appreciation when interest rates decline and depreciation
when interest rates rise). Therefore, to the extent that the Fund remains
substantially fully invested at the same time that it has purchased securities
on a when-issued basis, there will be greater fluctuations in the Fund's net
asset value than if it set aside cash to pay for when-issued securities.
4
REDEMPTION, DEMAND AND PUT FEATURES AND PUT OPTIONS. Issuers of municipal
obligations reserve the right to call (redeem) the bond. If an issuer redeems
securities held by the Fund during a time of declining interest rates, the Fund
may not be able to reinvest the proceeds in securities providing the same
investment return as the securities redeemed. Also, some bonds may have "put" or
"demand" features that allow early redemption by the bondholder. Longer term
fixed-rate bonds may give the holder a right to request redemption at certain
times (often annually after the lapse of an intermediate term). These bonds are
more defensive than conventional long term bonds because they may protect to
some degree against a rise in interest rates.
VARIABLE RATE OBLIGATIONS. The Fund may purchase variable rate obligations.
Variable rate instruments provide for adjustments in the interest rate at
specified intervals (weekly, monthly, semi-annually, etc.). The revised rates
are usually set at the issuer's discretion in which case the investor normally
enjoys the right to "put" the security back to the issuer or his agent. Rate
revisions may alternatively be determined by formula or in some other
contractual fashion. Variable rate obligations normally provide that the holder
can demand payment of the obligation on short notice at par with accrued
interest and which are frequently secured by letters of credit or other support
arrangements provide by banks. To the extent that such letters of credit or
other arrangements constitute an unconditional guarantee of the issuer's
obligations, a bank may be treated as the issuer of a security for the purposes
of complying with the diversification requirements set forth in Section 5(b) of
the 1940 Act and Rule 5b-2 thereunder. The Fund would anticipate using these
bonds as cash equivalents pending longer term investment of its funds.
INVERSE FLOATERS. The Fund currently does not invest in municipal securities
whose interest rates bear an inverse relationship to the interest rate on
another security or the value of an index ("inverse floaters"). An investment in
inverse floaters may involve greater risk than an investment in a fixed rate
bond. Because changes in the interest rate on the other security or index
inversely affect the residual interest paid on the inverse floater, the value of
an inverse floater is generally more volatile than that of a fixed rate bond.
Inverse floaters have interest rate adjustment formulas which generally reduce
or, in the extreme, eliminate the interest paid to a portfolio when short-term
interest rates rise, and increase the interest paid to the Fund when short-term
interest rates fall. Inverse floaters have varying degrees of liquidity, and the
market for these securities is relatively volatile. These securities tend to
underperform the market for fixed rate bonds in a rising interest rate
environment, but tend to outperform the market for fixed rate bonds when
interest rates decline. Shifts in long-term interest rates may, however, alter
this tendency. Although volatile, inverse floaters typically offer the potential
for yields exceeding the yields available on fixed rate bonds with comparable
credit quality and maturity. These securities usually permit the investor to
convert the floating rate to a fixed rate (normally adjusted downward), and this
optional conversion feature may provide a partial hedge against rising rates if
exercised at an opportune time. Inverse floaters are leveraged because they
provide two or more dollars of bond market exposure for every dollar invested.
Although the Fund does not intend initially to invest in inverse floaters, the
Fund may do so at some point in the future. The Fund will provide 30 days'
written notice prior to any change in its policy in investing in inverse
floaters.
INTEREST RATE SWAPS AND FORWARD RATE CONTRACTS. Interest rate swaps involve
the exchange by the Fund with another party of their respective commitments to
pay or receive interest, E.G., an exchange of fixed rate payments for floating
rate payments. The Fund will only enter into interest rate swaps on a net basis,
I.E., the two payment streams are netted out with the Fund receiving or paying,
as the case may be, only the net amount of the two payments. The Fund may also
enter forward rate contracts. Under these contracts, the buyer locks in an
interest rate at a future settlement date. If the interest rate on the
settlement date exceeds the lock rate, the buyer pays the seller the difference
between the two rates. If the lock rate exceeds the interest rate on the
settlement date, the seller pays the buyer the difference between the two rates.
Any such gain received by the Fund would be taxable.
If the other party to an interest rate swap or forward rate contract
defaults, the Fund's risk of loss consists of the net amount of payments that
the Fund is contractually entitled to receive. The net amount of the excess, if
any, of the Fund's obligations over its entitlements will be maintained in a
segregated account by the Fund's custodian. The Fund will not enter into any
interest rate swap or forward rate contract unless the claims-paying ability of
the other party thereto is considered to be investment grade by the investment
adviser. If there is a default by the other party to such a transaction, the
Fund will have contractual remedies pursuant to the agreements related to the
transaction. These instruments are traded in the over-the-counter market.
LIQUIDITY AND PROTECTIVE PUT OPTIONS. The Fund may also enter into a
separate agreement with the seller of a security or some other person granting
the Fund the right to put the security to the seller thereof or the other person
at an agreed upon price. Such agreements are subject to the risk of default by
the other party, although the Fund intends to limit this type of transaction to
institutions (such as banks or securities dealers) which the Adviser believes
present minimal credit risks. The Fund would engage in this type of transaction
to facilitate portfolio liquidity or (if the seller so agrees) to hedge against
rising interest rates. There is no assurance that this kind of put option will
be available to the Fund or that selling institutions will be willing to permit
the Fund to exercise a put to hedge against rising interest rates. The Fund does
not expect to assign any value to any separate put option which may be acquired
to facilitate portfolio liquidity, inasmuch as the value (if any) of the put
will be reflected in the value assigned to the associated security; any put
acquired for hedging purposes would be valued in good faith under methods or
procedures established by the Trustees of the Fund after consideration of all
relevant factors, including its expiration date, the price volatility of the
associated security, the difference between the market price of the associated
5
security and the exercise price of the put, the creditworthiness of the issuer
of the put and the market prices of comparable put options. Interest income
generated by certain bonds having put or demand features may be taxable.
ILLIQUID OBLIGATIONS. At times, a substantial portion of the Fund's assets
may be invested in securities as to which the Fund, by itself or together with
other accounts managed by the Adviser and its affiliates, holds a major portion
or all of such securities. Under adverse market or economic conditions or in the
event of adverse changes in the financial condition of the issuer, the Fund
could find it more difficult to sell such securities when the Adviser believes
it advisable to do so or may be able to sell such securities only at prices
lower than if such securities were more widely held. Under such circumstances,
it may also be more difficult to determine the fair value of such securities for
purposes of computing the Fund's net asset value.
The secondary market for some municipal obligations issued within a state
(including issues which are privately placed with the Fund) is less liquid than
that for taxable debt obligations or other more widely traded municipal
obligations. No established resale market exists for certain of the municipal
obligations in which the Fund may invest. The market for obligations rated below
investment grade is also likely to be less liquid than the market for higher
rated obligations. As a result, the Fund may be unable to dispose of these
municipal obligations at times when it would otherwise wish to do so at the
prices at which they are valued.
SECURITIES LENDING. The Fund may seek to increase its income by lending
portfolio securities to broker-dealers or other institutional borrowers.
Distributions by the Fund of any income realized by the Fund from securities
loans will be taxable. If the management of the Fund decides to make securities
loans, it is intended that the value of the securities loaned would not exceed
30% of the Fund's total assets. Securities lending involves risks of delay in
recovery or even loss of rights on the securities loaned if the borrower fails
financially. The Fund has no present intention of engaging in securities
lending.
FUTURES CONTRACTS AND OPTIONS ON FUTURES CONTRACTS. A change in the level of
interest rates may affect the value of the securities held by the Fund (or of
securities that the Fund expects to purchase). To hedge against changes in rates
or as a substitute for the purchase of securities, the Fund may enter into (i)
futures contracts for the purchase or sale of debt securities and (ii) futures
contracts on securities indices. All futures contracts entered into by the Fund
are traded on exchanges or boards of trade that are licensed and regulated by
the Commodity Futures Trading Commission ("CFTC") and must be executed through a
futures commission merchant or brokerage firm which is a member of the relevant
exchange. The Fund may purchase and write call and put options on futures
contracts which are traded on a United States or foreign exchange or board of
trade. The Fund will be required, in connection with transactions in futures
contracts and the writing of options on futures, to make margin deposits, which
will be held by the Fund's custodian for the benefit of the futures commission
merchant through whom the Fund engages in such futures and options transactions.
Some futures contracts and options thereon may become illiquid under adverse
market conditions. In addition, during periods of market volatility, a commodity
exchange may suspend or limit transactions in an exchange-traded instrument,
which may make the instrument temporarily illiquid and difficult to price.
Commodity exchanges may also establish daily limits on the amount that the price
of a futures contract or futures option can vary from the previous day's
settlement price. Once the daily limit is reached, no trades may be made that
day at a price beyond the limit. This may prevent the Fund from closing out
positions and limiting its losses.
The Fund will engage in futures and related options transactions for BONA
FIDE hedging purposes or non-hedging purposes as defined in or permitted by CFTC
regulations. The Fund will determine that the price fluctuations in the futures
contracts and options on futures used for hedging purposes are substantially
related to price fluctuations in securities held by the Fund or which it expects
to purchase. The Fund will engage in transactions in futures and related options
contracts only to the extent such transactions are consistent with the
requirements of the Code for maintaining its qualification as a RIC for federal
income tax purposes.
ASSET COVERAGE REQUIREMENTS. Transactions involving when-issued securities,
futures contracts and options (other than options that the Fund has purchased),
interest rate swaps or forward rate contracts may expose the Fund to an
obligation to another party. The Fund will not enter into any such transactions
unless it owns either (1) an offsetting ("covered") position in securities or
other options or futures contracts, or (2) cash or liquid securities (such as
readily marketable obligations and money market instruments) with a value
sufficient at all times to cover its potential obligations not covered as
provided in (1) above. The Fund will comply with SEC guidelines regarding cover
for these instruments and, if the guidelines so require, set aside cash or
liquid securities in a segregated account with its custodian in the prescribed
amount. The securities in the segregated account will be marked to market daily.
Assets used as cover or held in a segregated account maintained by the
custodian cannot be sold while the position requiring coverage or segregation is
outstanding unless they are replaced with other appropriate assets. As a result,
the commitment of a large portion of the Fund's assets to segregated accounts or
to cover could impede portfolio management or the Fund's ability to meet
redemption requests or other current obligations.
6
TEMPORARY INVESTMENTS. Under unusual market conditions, the Fund may invest
temporarily in cash or cash equivalents. Cash equivalents are highly liquid,
short-term securities such as commercial paper, certificates of deposit,
short-term notes and short-term U.S. Government obligations. These securities
may be subject to federal income, state income and/or other taxes.
PORTFOLIO TURNOVER. The Fund may sell (and later purchase) securities in
anticipation of a market decline (a rise in interest rates) or purchase (and
later sell) securities in anticipation of a market rise (a decline in interest
rates). In addition, a security may be sold and another purchased at
approximately the same time to take advantage of what the Fund believes to be a
temporary disparity in the normal yield relationship between the two securities.
Yield disparities may occur for reasons not directly related to the investment
quality of particular issues or the general movement of interest rates, such as
changes in the overall demand for or supply of various types of municipal
obligations or changes in the investment objectives of investors. Such trading
may be expected to increase the portfolio turnover rate, which may increase
capital gains and the expenses incurred in connection with such trading. The
Fund cannot accurately predict its portfolio turnover rate, but it is
anticipated that the annual portfolio turnover rate will generally not exceed
100% (excluding turnover of securities having a maturity of one year or less). A
100% annual turnover rate could occur, for example, if all the securities held
by the Fund were replaced once in a period of one year. A high turnover rate
(100% or more) necessarily involves greater expenses to the Fund.
INVESTMENT RESTRICTIONS. The following investment restrictions of the Fund
are designated as fundamental policies and as such cannot be changed without the
approval of the holders of a majority of the Fund's outstanding voting
securities, which as used in this SAI means the lesser of (a) 67% of the shares
of the Fund present or represented by proxy at a meeting if the holders of more
than 50% of the outstanding shares are present or represented at the meeting or
(b) more than 50% of outstanding shares of the Fund. As a matter of fundamental
policy the Fund may not:
(1) Borrow money, except as permitted by the 1940 Act;
(2) Issue senior securities, as defined in the 1940 Act, other than (i)
preferred shares which immediately after issuance will have asset coverage
of at least 200%, (ii) indebtedness which immediately after issuance will
have asset coverage of at least 300%, or (iii) the borrowings permitted by
investment restriction (1) above;
(3) Purchase securities on margin (but the Fund may obtain such
short-term credits as may be necessary for the clearance of purchases and
sales of securities). The purchase of investment assets with the proceeds of
a permitted borrowing or securities offering will not be deemed to be the
purchase of securities on margin;
(4) Underwrite securities issued by other persons, except insofar as it
may technically be deemed to be an underwriter under the Securities Act of
1933 in selling or disposing of a portfolio investment;
(5) Make loans to other persons, except by (a) the acquisition of loan
interests, debt securities and other obligations in which the Fund is
authorized to invest in accordance with its investment objective and
policies, (b) entering into repurchase agreements, and (c) lending its
portfolio securities;
(6) Purchase or sell real estate, although it may purchase and sell
securities which are secured by interests in real estate and securities of
issuers which invest or deal in real estate. The Fund reserves the freedom
of action to hold and to sell real estate acquired as a result of the
ownership of securities;
(7) Purchase or sell physical commodities or contracts for the purchase
or sale of physical commodities. Physical commodities do not include futures
contracts with respect to securities, securities indices or other financial
instruments;
(8) Invest more than 25% of its total assets in issuers in any one
industry.
For purposes of the Fund's investment restrictions, the determination of the
"issuer" of a municipal obligation which is not a general obligation bond will
be made by the Adviser on the basis of the characteristics of the obligation and
other relevant factors, the most significant of which is the source of funds
committed to meeting interest and principal payments of such obligation.
The Fund may borrow money as a temporary measure for extraordinary or
emergency purposes, including the payment of dividends and the settlement of
securities transactions which otherwise might require untimely dispositions of
Fund securities. The 1940 Act currently requires that the Fund have 300% asset
coverage with respect to all borrowings other than temporary borrowings.
7
For purposes of construing restriction (8), securities of the U.S.
Government, its agencies, or instrumentalities are not considered to represent
industries. Municipal obligations backed by the credit of a governmental entity
are also not considered to represent industries. However, municipal obligations
backed only by the assets and revenues of non-governmental users may for this
purpose be deemed to be issued by such non-governmental users. The foregoing 25%
limitation would apply to these issuers. As discussed in the Prospectus and this
SAI, the Fund may invest more than 25% of its total assets in certain economic
sectors, such as revenue bonds, housing, hospitals and other health care
facilities, and industrial development bonds. The Fund reserves the right to
invest more than 25% of total assets in each of these sectors.
The Fund has adopted the following nonfundamental investment policy which
may be changed by the Trustees without approval of the Fund's shareholders. As a
matter of nonfundamental policy, the Fund may not make short sales of securities
or maintain a short position, unless at all times when a short position is open
it either owns an equal amount of such securities or owns securities convertible
into or exchangeable, without payment of any further consideration, for
securities of the same issue as, and equal in amount to, the securities sold
short.
Upon Board of Trustee approval, the Fund may invest more than 10% of its
total assets in one or more other management investment companies (or may invest
in affiliated investment companies) to the extent permitted by the 1940 Act and
rules thereunder.
Whenever an investment policy or investment restriction set forth in the
Prospectus or this SAI states a maximum percentage of assets that may be
invested in any security or other asset or describes a policy regarding quality
standards, such percentage limitation or standard shall be determined
immediately after and as a result of the Fund's acquisition of such security or
asset. Accordingly, any later increase or decrease resulting from a change in
values, assets or other circumstances will not compel the Fund to dispose of
such security or other asset. Notwithstanding the foregoing, the Fund must
always be in compliance with the borrowing policies set forth above.
TRUSTEES AND OFFICERS
The Trustees of the Fund are responsible for the overall management and
supervision of the affairs of the Fund. The Trustees and officers of the Fund
are listed below. Except as indicated, each individual has held the office shown
or other offices in the same company for the last five years. The business
address of each Trustee and officer is The Eaton Vance Building, 255 State
Street, Boston, Massachusetts 02109. As used in this SAI, "EVC" refers to Eaton
Vance Corp., "EV" refers to Eaton Vance, Inc., "BMR" refers to Boston Management
and Research and "EVD" refers to Eaton Vance Distributors, Inc. EVC is the
corporate parent of Eaton Vance. EV is the corporate trustee of Eaton Vance.
NUMBER OF
PORTFOLIOS
TERM OF IN FUND
POSITION(S) OFFICE AND PRINCIPAL COMPLEX
WITH THE LENGTH OF OCCUPATION(S) DURING OVERSEEN BY OTHER
NAME AND AGE FUND SERVICE PAST FIVE YEARS TRUSTEE(1) DIRECTORSHIPS HELD
-------------------- ------------ ------------ ---------------------------- ------------ ------------------
INTERESTED TRUSTEES
Jessica M. Bibliowicz Trustee(2) Since President and Chief 174 None
DOB: 11/28/59 7/25/02 3 Years Executive Officer of
National Financial Partners
(financial services company)
(since April 1999).
President and Chief
Operating Officer of John A.
Levin & Co. (registered
investment adviser) (July
1997 to April 1999) and a
Director of Baker, Fentress
& Company which owns John A.
Levin & Co. (July 1997 to
April 1999). Formerly,
Executive Vice President of
Smith Barney Mutual Funds.
Ms. Bibliowicz is an
interested person because of
her affiliation with a
brokerage firm.
James B. Hawkes Vice Since 7/8/02 Chairman, President and 179 Director of EVC,
DOB: 11/9/41 President 3 Years Chief Executive Officer of EV and EVD
and BMR, Eaton Vance and their
Trustee(3) corporate parent and trustee
(EVC and EV); Vice President
8
of EVD. President or officer
of 179 investment companies
in the Eaton Vance Fund
Complex. Mr. Hawkes is an
interested person because of
his positions with BMR,
Eaton Vance and EVC, who are
affiliates of the Fund.
NONINTERESTED TRUSTEES
Donald R. Dwight Trustee(2) Since President of Dwight 179 Trustee/Director
DOB: 3/26/31 7/25/02 Partners, Inc. (a corporate of the Royce
3 Years relations and communications Funds(consisting
company). of 17 portfolios)
Samuel L. Hayes, III Trustee(3) Since Jacob H. Schiff Professor of 179 Director of
DOB: 2/23/35 7/25/02 Investment Banking Emeritus, Tiffany & Co.
3 Years Harvard University Graduate (specialty
School of Business retailer) and
Administration. Telect, Inc.
(telecommunication
services company)
Norton H. Reamer Trustee(4) Since President, Unicorn 179 None
DOB: 9/21/35 7/25/02 Corporation (an investment
3 Years and financial advisory
services company) (since
September 2000). Chairman,
Hellman, Jordan Management
Co., Inc. (an investment
management company) (since
November 2000). Advisory
Director of Berkshire
Capital Corporation
(investment banking firm)
(since June 2002). Formerly
Chairman of the Board,
United Asset Management
Corporation (a holding
company owning institutional
investment management firms)
and Chairman, President and
Director, UAM Funds (mutual
funds).
Lynn A. Stout Trustee(4) Since Professor of Law, University 173 None
DOB: 9/14/56 7/25/02 of California at Los Angeles
3 Years School of Law (since July
2001). Formerly, Professor
of Law, Georgetown
University Law Center.
----------
(1) Includes both master and feeder funds in master-feeder structure.
(2) Class I Trustee whose term expires in 2003.
(3) Class II Trustee whose term expires in 2004.
(4) Class III Trustee whose term expires in 2005.
9
PRINCIPAL OFFICERS WHO ARE NOT TRUSTEES
TERM OF OFFICE
POSITION(S) AND LENGTH OF
NAME AND AGE WITH FUND SERVICE PRINCIPAL OCCUPATIONS DURING PAST FIVE YEARS
--------------------- --------- -------------- --------------------------------------------
Cynthia Clemson Vice President Since 7/8/02 Vice President of Eaton Vance and BMR.
DOB: 3/2/63 Officer of 16 investment companies managed
by Eaton Vance or BMR.
Thomas J. Fetter President Since 7/8/02 Vice President of Eaton Vance and BMR.
DOB: 8/20/43 Officer of 116 investment companies managed
by Eaton Vance or BMR.
Robert B. MacIntosh Vice President Since 7/8/02 Vice President of Eaton Vance and BMR.
DOB: 1/22/57 Officer of 115 investment companies managed
by Eaton Vance or BMR.
Alan R. Dynner Secretary Since 7/8/02 Vice President, Secretary and Chief Legal
DOB: 10/10/40 Officer of BMR, Eaton Vance, EVD and EVC.
Officer of 179 investment companies managed
by Eaton Vance or BMR.
James L. O'Connor Treasurer Since 7/8/02 Vice President of BMR, Eaton Vance and EVD.
DOB: 4/1/45 Officer of 179 investment companies managed
by Eaton Vance or BMR.
The Nominating Committee of the Board of Trustees of the Fund is comprised
of the Trustees who are not "interested persons" of the Fund as that term is
defined under the 1940 Act ("noninterested Trustees"). The purpose of the
Committee is to recommend to the Board nominees for the position of
noninterested Trustee and to assure that at least a majority of the Board of
Trustees is comprised of noninterested Trustees of the Fund. The Trustees will,
when a vacancy exists or is anticipated, consider any nominee for Trustee
recommended by a shareholder if such recommendation is submitted to the Trustees
in writing and contains sufficient background information concerning the
individual to enable a proper judgment to be made as to such individual's
qualifications.
Messrs. Dwight (Chairman), Hayes and Reamer are members of the Audit
Committee of the Board of Trustees of the Fund. The Audit Committee's functions
include making recommendations to the Trustees regarding the selection and
performance of the independent accountants, and reviewing matters relative to
accounting and auditing practices and procedures, accounting records, and the
internal accounting controls, of the Fund, and certain service providers.
Messrs. Dwight, Hayes and Reamer and Ms. Stout are members of the Special
Committee of the Board of Trustees of the Fund. The purpose of the Special
Committee is to consider, evaluate and make recommendations to the full Board of
Trustees concerning (i) all contractual arrangements with service providers to
the Fund, including investment advisory, administrative, transfer agency,
custodial and fund accounting and distribution services, and (ii) all other
matters in which Eaton Vance or its affiliates has any actual or potential
conflict of interest with the Fund.
As of the date of this SAI, the Committees had not held any meetings.
In reviewing the approval of the investment advisory agreement between the
Fund and the investment adviser, the noninterested Trustees considered, among
other things, the following:
o A report comparing the fees and expenses of the Fund to a peer group of
funds;
o Information on the relevant peer group(s) of funds and appropriate
indices;
o The economic outlook and the general investment outlook in the relevant
investment markets;
o Eaton Vance's results and financial condition and the overall
organization of the investment adviser;
o Arrangements regarding the distribution of Fund shares;
o The procedures used to determine the fair value of the Fund's assets;
o The allocation of brokerage, including allocations to soft dollar
brokerage and allocations to firms that sell Eaton Vance fund shares;
10
o Eaton Vance's management of the relationship with the custodian,
subcustodians and fund accountants;
o The resources devoted to Eaton Vance's compliance efforts undertaken on
behalf of the funds it manages and the record of compliance with the
investment policies and restrictions and with policies on personal
securities transactions;
o The quality nature, cost and character of the administrative and other
non-investment management services provided by Eaton Vance and its
affiliates;
o Investment management staffing;
o Operating expenses (including transfer agency expenses) to be paid to
third parties; and
o Information to be provided to investors, including Fund's shareholders.
In addition to the factors mentioned above, the noninterested Trustees also
reviewed the level of the investment adviser's profits in respect of the
management of the Eaton Vance funds, including the Fund. The noninterested
Trustees considered the profits realized by Eaton Vance and its affiliates in
connection with the operation of the Fund. The noninterested Trustees also
considered Eaton Vance's profit margins in comparison with available industry
data.
The noninterested Trustees did not consider any single factor as controlling
in determining whether or not to approve the investment advisory agreement(s).
Nor are the items described herein all encompassing of the matters considered by
the noninterested Trustees. In assessing the information provided by Eaton Vance
and its affiliates, the noninterested Trustees also took into consideration the
benefits to shareholders of investing in a fund that is part of large family of
funds which provides a large variety of shareholder services.
Based on their consideration of all factors that it deemed material and
assisted by the advice of its independent counsel, the noninterested Trustees
concluded that the approval of the investment advisory agreement(s), including
the fee structure (described herein) is in the interests of shareholders.
SHARE OWNERSHIP. The following table shows the dollar range of equity
securities beneficially owned by each Trustee in the Fund and all Eaton Vance
Funds overseen by the Trustee as of December 31, 2001.
AGGREGATE DOLLAR RANGE
OF EQUITY SECURITIES
DOLLAR RANGE OF OWNED IN ALL REGISTERED
EQUITY SECURITIES FUNDS OVERSEEN BY
OWNED IN THE TRUSTEE IN THE EATON
NAME OF TRUSTEE FUND VANCE FUND COMPLEX
--------------- ---- ------------------
INTERESTED TRUSTEES
Jessica M. Bibliowicz........ None $10,001-- $50,000
James B. Hawkes.............. None over $100,000
NONINTERESTED TRUSTEES
Donald R. Dwight............. None over $100,000
Samuel L. Hayes, III......... None over $100,000
Norton H. Reamer............. None over $100,000
Lynn A. Stout................ None $10,001-- $50,000
As of December 31, 2001, no noninterested Trustee or any of their immediate
family members owned beneficially or of record any class of securities of EVC,
EVD or any person controlling, controlled by or under common control with EVC or
EVD.
During the calendar years ended December 31, 2000 and December 31, 2001, no
noninterested Trustee (or their immediate family members) had:
1. Any direct or indirect interest in Eaton Vance, EVC, EVD or any
person controlling, controlled by or under common control with EVC or EVD;
2. Any direct or indirect material interest in any transaction or series
of similar transactions with (i) the Trust or any Fund; (ii) another fund
managed by EVC, distributed by EVD or a person controlling, controlled by or
under common control with EVC or EVD; (iii) EVC or EVD; (iv) a person
11
controlling, controlled by or under common control with EVC or EVD; or (v)
an officer of any of the above; or
3. Any direct or indirect relationship with (i) the Trust or any Fund;
(ii) another fund managed by EVC, distributed by EVD or a person
controlling, controlled by or under common control with EVC or EVD; (iii)
EVC or EVD; (iv) a person controlling, controlled by or under common control
with EVC or EVD; or (v) an officer of any of the above.
During the calendar years ended December 31, 2000 and December 31, 2001, no
officer of EVC, EVD or any person controlling, controlled by or under common
control with EVC or EVD served on the Board of Directors of a company where a
noninterested Trustee of the Fund or any of their immediate family members
served as an officer.
Trustees of the Fund who are not affiliated with the Adviser may elect to
defer receipt of all or a percentage of their annual fees in accordance with the
terms of a Trustees Deferred Compensation Plan (the "Trustees' Plan"). Under the
Trustees' Plan, an eligible Trustee may elect to have his deferred fees invested
by the Fund in the shares of one or more funds in the Eaton Vance Family of
Funds, and the amount paid to the Trustees under the Trustees' Plan will be
determined based upon the performance of such investments. Deferral of Trustees'
fees in accordance with the Trustees' Plan will have a negligible effect on the
Fund's assets, liabilities, and net income per share, and will not obligate the
Fund to retain the services of any Trustee or obligate the Fund to pay any
particular level of compensation to the Trustee. The Fund does not have a
retirement plan for its Trustees.
The fees and expenses of the noninterested Trustees of the Fund are paid by
the Fund. (The Trustees of the Fund who are members of the Eaton Vance
organization receive no compensation from the Fund.) During the Fund's fiscal
year ending October 31, 2002, it is anticipated that the noninterested Trustees
of the Fund will earn the following compensation in their capacities as Trustee.
For the year ended December 31, 2001, the noninterested Trustees earned the
following compensation set forth below in their capacities as Trustees from the
funds in the Eaton Vance fund complex (1).
SOURCE OF JESSICA M. DONALD R. SAMUEL L. NORTON H. LYNN A.
COMPENSATION BIBLIOWICZ DWIGHT HAYES, III REAMER STOUT
Fund*................. $ 200 $ 200 $ 200 $ 200 $ 200
Fund Complex.......... $160,000 $ 162,500(2) $170,000 $160,000 $ 160,000(3)
----------
* Estimated
(1) As of August 1, 2002, the Eaton Vance fund complex consisted of 179
registered investment companies or series thereof.
(2) Includes $60,000 of deferred compensation.
(3) Includes $16,000 of deferred compensation.
INVESTMENT ADVISORY AND OTHER SERVICES
Eaton Vance, its affiliates and its predecessor companies have been managing
assets of individuals and institutions since 1924 and of investment companies
since 1931. They maintain a large staff of experienced fixed-income and equity
investment professionals to service the needs of their clients. The fixed-income
division focuses on all kinds of taxable investment-grade and high-yield
securities, tax-exempt investment-grade and high-yield securities, and U.S.
Government securities. The equity division covers stocks ranging from blue chip
to emerging growth companies. Eaton Vance and its affiliates act as adviser to a
family of mutual funds, and individual and various institutional accounts,
including corporations, hospitals, retirement plans, universities, foundations
and trusts.
The Fund will be responsible for all of its costs and expenses not expressly
stated to be payable by Eaton Vance under the Advisory Agreement or
Administration Agreement. Such costs and expenses to be borne by the Fund
include, without limitation: custody and transfer agency fees and expenses,
including those incurred for determining net asset value and keeping accounting
books and records; expenses of pricing and valuation services; the cost of share
certificates; membership dues in investment company organizations; expenses of
acquiring, holding and disposing of securities and other investments; fees and
expenses of registering under the securities laws, stock exchange listing fees
and governmental fees; rating agency fees and preferred share remarketing
expenses; expenses of reports to shareholders, proxy statements and other
expenses of shareholders' meetings; insurance premiums; printing and mailing
expenses; interest, taxes and corporate fees; legal and accounting expenses;
compensation and expenses of Trustees not affiliated with Eaton Vance; expenses
of conducting repurchase offers for the purpose of repurchasing Fund shares; and
investment advisory and administration fees. The Fund will also bear expenses
incurred in connection with any litigation in which the Fund is a party and any
legal obligation to indemnify its officers and Trustees with respect thereto, to
the extent not covered by insurance.
12
The Investment Advisory Agreement continues in effect to March 31, 2004 and
from year to year so long as such continuance is approved at least annually (i)
by the vote of a majority of the noninterested Trustees of the Fund or of the
Adviser cast in person at a meeting specifically called for the purpose of
voting on such approval and (ii) by the Board of Trustees of the Fund or by vote
of a majority of the outstanding interests of the Fund. The Fund's
Administration Agreement continues in effect from year to year so long as such
continuance is approved at least annually by the vote of a majority of the
Fund's Trustees. Each agreement may be terminated at any time without penalty on
sixty (60) days' written notice by the Trustees of the Fund or Eaton Vance, as
applicable, or by vote of the majority of the outstanding shares of the Fund.
Each agreement will terminate automatically in the event of its assignment. Each
agreement provides that, in the absence of willful misfeasance, bad faith, gross
negligence or reckless disregard of its obligations or duties to the Fund under
such agreements on the part of Eaton Vance, Eaton Vance shall not be liable to
the Fund for any loss incurred, to the extent not covered by insurance.
Eaton Vance is a business trust organized under Massachusetts law. Eaton
Vance, Inc. ("EV") serves as trustee of Eaton Vance. EV is a subsidiary of Eaton
Vance Corporation ("EVC"), a Maryland corporation and publicly-held holding
company. EVC through its subsidiaries and affiliates engages primarily in
investment management, administration and marketing activities. The Directors of
EVC are James B. Hawkes, John G. L. Cabot, Thomas E. Faust, Jr., Leo I. Higdon,
Jr., John M. Nelson, Vincent M. O'Reilly and Ralph Z. Sorenson. All shares of
the outstanding Voting Common Stock of EVC are deposited in a Voting Trust, the
Voting Trustees of which are Messrs. James B. Hawkes, Thomas E. Faust, Jr.,
Jeffrey P. Beale, Alan R. Dynner, Thomas J. Fetter, Scott H. Page, Duncan W.
Richardson, William M. Steul, Payson F. Swaffield, Michael W. Weilheimer and
Wharton P. Whitaker (all of whom are officers of Eaton Vance). The Voting
Trustees have unrestricted voting rights for the election of Directors of EVC.
All of the outstanding voting trust receipts issued under said Voting Trust are
owned by certain of the officers of BMR and Eaton Vance who are also officers,
or officers and Directors of EVC and EV. As indicated under "Trustees and
Officers", all of the officers of the Fund (as well as Mr. Hawkes who is also a
Trustee) hold positions in the Eaton Vance organization.
EVC and its affiliates and their officers and employees from time to time
have transactions with various banks, including the custodian of the Fund, IBT.
It is Eaton Vance's opinion that the terms and conditions of such transactions
were not and will not be influenced by existing or potential custodial or other
relationships between the Fund and such banks.
CODE OF ETHICS. The investment adviser and the Fund have adopted a Code of
Ethics governing personal securities transactions. Under the Code, Eaton Vance
employees may purchase and sell securities (including securities held by the
Fund) subject to certain pre-clearance and reporting requirements and other
procedures.
INVESTMENT ADVISORY SERVICES. Under the general supervision of the Fund's
Board of Trustees, Eaton Vance will carry out the investment and reinvestment of
the assets of the Fund, will furnish continuously an investment program with
respect to the Fund, will determine which securities should be purchased, sold
or exchanged, and will implement such determinations. Eaton Vance will furnish
to the Fund investment advice and provide related office facilities and
personnel for servicing the investments of the Fund. Eaton Vance will compensate
all Trustees and officers of the Fund who are members of the Eaton Vance
organization and who render investment services to the Fund, and will also
compensate all other Eaton Vance personnel who provide research and investment
services to the Fund.
ADMINISTRATIVE SERVICES. Under the Administration Agreement, Eaton Vance is
responsible for managing the business affairs of the Fund, subject to the
supervision of the Fund's Board of Trustees. Eaton Vance will furnish to the
Fund all office facilities, equipment and personnel for administering the
affairs of the Fund. Eaton Vance will compensate all Trustees and officers of
the Fund who are members of the Eaton Vance organization and who render
executive and administrative services to the Fund, and will also compensate all
other Eaton Vance personnel who perform management and administrative services
for the Fund. Eaton Vance's administrative services include recordkeeping,
preparation and filing of documents required to comply with federal and state
securities laws, supervising the activities of the Fund's custodian and transfer
agent, providing assistance in connection with the Trustees' and shareholders'
meetings, providing services in connection with quarterly repurchase offers and
other administrative services necessary to conduct the Fund's business.
DETERMINATION OF NET ASSET VALUE
The net asset value per Share of the Fund is determined no less frequently
than weekly, generally on the last day of the week that the New York Stock
Exchange (the "Exchange") is open for trading, as of the close of regular
trading on the Exchange (normally 4:00 p.m. New York time). The Fund's net asset
value per Share is determined by Investors Bank & Trust Company ("IBT"), in the
manner authorized by the Trustees of the Fund. Net asset value is computed by
dividing the value of the Fund's total assets, less its liabilities by the
number of shares outstanding.
13
Inasmuch as the market for municipal obligations is a dealer market with no
central trading location or continuous quotation system, it is not feasible to
obtain last transaction prices for most municipal obligations held by the Fund,
and such obligations, including those purchased on a when-issued basis, will
normally be valued on the basis of valuations furnished by a pricing service.
The pricing service uses information with respect to transactions in bonds,
quotations from bond dealers, market transactions in comparable securities,
various relationships between securities, and yield to maturity in determining
value. Taxable obligations for which price quotations are readily available
normally will be valued at the mean between the latest available bid and asked
prices. Open futures positions on debt securities are valued at the most recent
settlement prices, unless such price does not reflect the fair value of the
contract, in which case the positions will be valued by or at the direction of
the Trustees. Other assets are valued at fair value using methods determined in
good faith by the Trustees.
PORTFOLIO TRADING
Decisions concerning the execution of portfolio security transactions,
including the selection of the market and the executing firm, are made by the
Adviser. The Adviser is also responsible for the execution of transactions for
all other accounts managed by it. The Adviser places the portfolio security
transactions of the Fund and of all other accounts managed by it for execution
with many firms. The Adviser uses its best efforts to obtain execution of
portfolio security transactions at prices which are advantageous to the Fund and
at reasonably competitive spreads or (when a disclosed commission is being
charged) at reasonably competitive commission rates. In seeking such execution,
the Adviser will use its best judgment in evaluating the terms of a transaction,
and will give consideration to various relevant factors, including without
limitation the full range and quality of the executing firm's services, the
value of the brokerage and research services provided, the responsiveness of the
firm to the Adviser, the size and type of the transaction, the nature and
character of the market for the security, the confidentiality, speed and
certainty of effective execution required for the transaction, the general
execution and operational capabilities of the executing firm, the reputation,
reliability, experience and financial condition of the firm, the value and
quality of the services rendered by the firm in this and other transactions, and
the reasonableness of the spread or commission, if any.
Municipal obligations, including state obligations, purchased and sold by
the Fund are generally traded in the over-the-counter market on a net basis
(I.E., without commission) through broker-dealers and banks acting for their own
account rather than as brokers, or otherwise involve transactions directly with
the issuer of such obligations. Such firms attempt to profit from such
transactions by buying at the bid price and selling at the higher asked price of
the market for such obligations, and the difference between the bid and asked
price is customarily referred to as the spread. The Fund may also purchase
municipal obligations from underwriters, and dealers in fixed price offerings,
the cost of which may include undisclosed fees and concessions to the
underwriters. On occasion it may be necessary or appropriate to purchase or sell
a security through a broker on an agency basis, in which case the Fund will
incur a brokerage commission. Although spreads or commissions on portfolio
security transactions will, in the judgment of the Adviser, be reasonable in
relation to the value of the services provided, spreads or commissions exceeding
those which another firm might charge may be paid to firms who were selected to
execute transactions on behalf of the Fund and the Adviser's other clients for
providing brokerage and research services to the Adviser.
As authorized in Section 28(e) of the Securities Exchange Act of 1934, a
broker or dealer who executes a portfolio transaction on behalf of the Fund may
receive a commission which is in excess of the amount of commission another
broker or dealer would have charged for effecting that transaction if the
Adviser determines in good faith that such compensation was reasonable in
relation to the value of the brokerage and research services provided. This
determination may be made on the basis of that particular transaction or on the
basis of overall responsibilities which the Adviser and its affiliates have for
accounts over which they exercise investment discretion. In making any such
determination, the Adviser will not attempt to place a specific dollar value on
the brokerage and research services provided or to determine what portion of the
commission should be related to such services. Brokerage and research services
may include advice as to the value of securities, the advisability of investing
in, purchasing, or selling securities, and the availability of securities or
purchasers or sellers of securities; furnishing analyses and reports concerning
issuers, industries, securities, economic factors and trends, portfolio strategy
and the performance of accounts; effecting securities transactions and
performing functions incidental thereto (such as clearance and settlement); and
the "Research Services" referred to in the next paragraph.
It is a common practice of the investment advisory industry and of the
advisers of investment companies, institutions and other investors to receive
research, analytical, statistical and quotation services, data, information and
other services, products and materials which assist such advisers in the
performance of their investment responsibilities ("Research Services") from
broker-dealer firms which execute portfolio transactions for the clients of such
advisers and from third parties with which such broker-dealers have
arrangements. Consistent with this practice, the Adviser receives Research
Services from many broker-dealer firms with which the Adviser places the Fund's
transactions and from third parties with which these broker-dealers have
arrangements. These Research Services include such matters as general economic,
political, business and market information, industry and company reviews,
evaluations of securities and portfolio strategies and transactions, proxy
voting data and analysis services, technical analysis of various aspects of the
securities market, recommendations as to the purchase and sale of securities and
other portfolio transactions, financial, industry and trade publications, news
14
and information services, pricing and quotation equipment and services, and
research oriented computer hardware, software, data bases and services. Any
particular Research Service obtained through a broker-dealer may be used by the
Adviser in connection with client accounts other than those accounts which pay
commissions to such broker-dealer. Any such Research Service may be broadly
useful and of value to the Adviser in rendering investment advisory services to
all or a significant portion of its clients, or may be relevant and useful for
the management of only one client's account or of a few clients' accounts, or
may be useful for the management of merely a segment of certain clients'
accounts, regardless of whether any such account or accounts paid commissions to
the broker-dealer through which such Research Service was obtained. The advisory
fee paid by the Fund is not reduced because the Adviser receives such Research
Services. The Adviser evaluates the nature and quality of the various Research
Services obtained through broker-dealer firms and attempts to allocate
sufficient portfolio security transactions to such firms to ensure the continued
receipt of Research Services which the Adviser believes are useful or of value
to it in rendering investment advisory services to its clients.
The Fund and the Adviser may also receive Research Services from
underwriters and dealers in fixed-price offerings, which Research Services are
reviewed and evaluated by the Adviser in connection with its investment
responsibilities. The investment companies sponsored by the Adviser or its
affiliates may allocate trades in such offerings to acquire information relating
to the performance, fees and expenses of such companies and other mutual funds,
which information is used by the Trustees of such companies to fulfill their
responsibility to oversee the quality of the services provided by various
entities, including the Adviser, to such companies. Such companies may also pay
cash for such information.
Subject to the requirement that the Adviser shall use its best efforts to
seek and execute portfolio security transactions at advantageous prices and at
reasonably competitive spreads or commission rates, the Adviser is authorized to
consider as a factor in the selection of any broker-dealer firm with whom
portfolio orders may be placed the fact that such firm has sold or is selling
shares of the Fund or of other investment companies sponsored by the Adviser.
This policy is not inconsistent with a rule of the National Association of
Securities Dealers, Inc. ("NASD"), which rule provides that no firm which is a
member of the NASD shall favor or disfavor the distribution of shares of any
particular investment company or group of investment companies on the basis of
brokerage commissions received or expected by such firm from any source.
Municipal obligations considered as investments for the Fund may also be
appropriate for other investment accounts managed by the Adviser or its
affiliates. Whenever decisions are made to buy or sell securities by the Fund
and one or more of such other accounts simultaneously, the Adviser will allocate
the security transactions (including "hot" issues) in a manner which it believes
to be equitable under the circumstances. As a result of such allocations, there
may be instances where the Fund will not participate in a transaction that is
allocated among other accounts. If an aggregated order cannot be filled
completely, allocations will generally be made on a pro rata basis. An order may
not be allocated on a pro rata basis where, for example: (i) consideration is
given to portfolio managers who have been instrumental in developing or
negotiating a particular investment; (ii) consideration is given to an account
with specialized investment policies that coincide with the particulars of a
specific investment; (iii) pro rata allocation would result in odd-lot or de
minimis amounts being allocated to a portfolio or other client; or (iv) where
the Adviser reasonably determines that departure from a pro rata allocation is
advisable. While these aggregation and allocation policies could have a
detrimental effect on the price or amount of the securities available to the
Fund from time to time, it is the opinion of the Trustees of the Fund that the
benefits from the Adviser's organization outweigh any disadvantage that may
arise from exposure to simultaneous transactions.
TAXES
The following discussion of federal income tax matters is based on the
advice of Kirkpatrick & Lockhart LLP, counsel to the Fund. The Fund has elected
to be treated and intends to qualify each year as a RIC under the Code.
Accordingly, the Fund intends to satisfy certain requirements relating to
sources of its income and diversification of its assets and to distribute
substantially all of its net income (including tax-exempt income) and net
short-term and long-term capital gains (after reduction by any available capital
loss carryforwards) in accordance with the timing requirements imposed by the
Code, so as to maintain its RIC status and to avoid paying any federal income or
excise tax. To the extent it qualifies for treatment as a RIC and satisfies the
above-mentioned distribution requirements, the Fund will not be subject to
federal income tax on income paid to its shareholders in the form of dividends
or capital gain distributions.
In order to avoid incurring a federal excise tax obligation, the Code
requires that the Fund distribute (or be deemed to have distributed) by December
31 of each calendar year (i) at least 98% of its ordinary income (not including
tax-exempt income) for such year, (ii) at least 98% of its capital gain net
income (which is the excess of its realized capital gains over its realized
capital losses), generally computed on the basis of the one-year period ending
on October 31 of such year, after reduction by any available capital loss
carryforwards and (iii) 100% of any income and capital gains from the prior year
(as previously computed) that were not paid out during such year and on which
the Fund paid no federal income tax. Under current law, provided that the Fund
qualifies as a RIC for federal income tax purposes, the Fund should not be
liable for any income, corporate excise or franchise tax in the Commonwealth of
Massachusetts.
15
If the Fund does not qualify as a RIC for any taxable year, the Fund's
taxable income will be subject to corporate income taxes, and all distributions
from earnings and profits, including distributions of net capital gain (if any),
will be taxable to the shareholder as ordinary income. In addition, in order to
requalify for taxation as a RIC, the Fund may be required to recognize
unrealized gains, pay substantial taxes and interest, and make certain
distributions.
The Fund's investment in zero coupon and certain other securities will cause
it to realize income prior to the receipt of cash payments with respect to these
securities. Such income will be accrued daily by the Fund and, in order to avoid
a tax payable by the Fund, the Fund may be required to liquidate securities that
it might otherwise have continued to hold in order to generate cash so that the
Fund may make required distributions to its shareholders.
Investments in lower-rated or unrated securities may present special tax
issues for the Fund to the extent that the issuers of these securities default
on their obligations pertaining thereto. The Code is not entirely clear
regarding the federal income tax consequences of the Fund's taking certain
positions in connection with ownership of such distressed securities.
Distributions by the Fund of net tax-exempt interest income that are
properly designated as "exempt-interest dividends" may be treated by
shareholders as interest excludable from gross income under Section 103(a) of
the Code. In order for the Fund to be entitled to pay exempt-interest dividends
to its shareholders, the Fund must and intends to satisfy certain requirements,
including the requirement that, at the close of each quarter of its taxable
year, at least 50% of the value of its total assets consists of obligations the
interest on which is exempt from regular federal income tax under Code Section
103(a). Interest on certain municipal obligations is treated as a tax preference
item for purposes of the AMT. In addition, corporate shareholders must include
the full amount of exempt-interest dividends in computing the preference items
for the purposes of the AMT. Shareholders of the Fund are required to report
tax-exempt interest on their federal income tax returns.
Tax-exempt distributions received from the Fund are taken into account in
determining, and may increase, the portion of social security and certain
railroad retirement benefits that may be subject to federal income tax.
Interest on indebtedness incurred or continued by a shareholder to purchase
or carry shares of the Fund is not deductible to the extent it is deemed related
to the Fund's distributions of tax-exempt interest. Further, entities or persons
who are "substantial users" (or persons related to "substantial users") of
facilities financed by industrial development or private activity bonds should
consult their tax advisers before purchasing shares of the Fund. "Substantial
user" is defined in applicable Treasury regulations to include a "non-exempt
person" who regularly uses in its trade or business a part of a facility
financed from the proceeds of industrial development bonds, and the same
definition should apply in the case of private activity bonds.
Any recognized gain or income attributable to market discount on long-term
tax-exempt municipal obligations (I.E., obligations with a term of more than one
year) purchased after April 30, 1993 (except to the extent of a portion of the
discount attributable to original issue discount), is taxable as ordinary
income. A long-term debt obligation is generally treated as acquired at a market
discount if purchased after its original issue at a price less than (i) the
stated principal amount payable at maturity, in the case of an obligation that
does not have original issue discount or (ii) in the case of an obligation that
does have original issue discount, the sum of the issue price and any original
issue discount that accrued before the obligation was purchased, subject to a DE
MINIMIS exclusion.
From time to time proposals have been introduced before Congress for the
purpose of restricting or eliminating the federal income tax exemption for
interest on certain types of municipal obligations, and it can be expected that
similar proposals may be introduced in the future. Under federal tax legislation
enacted in 1986, the federal income tax exemption for interest on certain
municipal obligations was eliminated or restricted. As a result of such
legislation, the availability of municipal obligations for investment by the
Fund and the value of the securities held by it may be affected.
In the course of managing its investments, the Fund may realize some
short-term and long-term capital gains (and/or losses) as well as other taxable
income. Any distributions by the Fund of such capital gains (after reduction by
any capital loss carryforwards) or other taxable income would be taxable to
shareholders of the Fund. However, it is expected that such amounts, if any,
would normally be insubstantial in relation to the tax-exempt interest earned by
the Fund and allocated to the Fund.
The Fund's investments in options, futures contracts, hedging transactions,
forward contracts (to the extent permitted) and certain other transactions will
be subject to special tax rules (including mark-to-market, constructive sale,
straddle, wash sale, short sale and other rules), the effect of which may be to
accelerate income to the Fund, defer Fund losses, cause adjustments in the
holding periods of Fund securities, convert capital gain into ordinary income
and convert short-term capital losses into long-term capital losses. These rules
could therefore affect the amount, timing and character of distributions to
investors. The Fund may have to limit its activities in options and futures
contracts in order to enable it to maintain its RIC status.
16
Any loss realized upon the sale or exchange of Fund shares with a tax
holding period of 6 months or less will be disallowed to the extent of any
distributions treated as tax-exempt interest with respect to such shares, and if
the loss exceeds the disallowed amount, will be treated as a long-term capital
loss to the extent of any distributions treated as long-term capital gain with
respect to such shares. In addition, all or a portion of a loss realized on a
redemption or other disposition of Fund shares may be disallowed under "wash
sale" rules to the extent the shareholder acquires other shares of the same Fund
(whether through the reinvestment of distributions or otherwise) within the
period beginning 30 days before the redemption of the loss shares and ending 30
days after such date. Any disallowed loss will result in an adjustment to the
shareholder's tax basis in some or all of the other shares acquired.
Sales charges paid upon a purchase of shares cannot be taken into account
for purposes of determining gain or loss on a sale of the shares before the 91st
day after their purchase to the extent a sales charge is reduced or eliminated
in a subsequent acquisition of shares of the Fund (or of another fund) pursuant
to the reinvestment or exchange privilege. Any disregarded amounts will result
in an adjustment to the shareholder's tax basis in some or all of any other
shares acquired.
Dividends and distributions on the Fund's shares are generally subject to
federal income tax as described herein to the extent they do not exceed the
Fund's realized income and gains, even though such dividends and distributions
may economically represent a return of a particular shareholder's investment.
Such distributions are likely to occur in respect of shares purchased at a time
when the Fund's net asset value reflects gains that are either unrealized, or
realized but not distributed. Such realized gains may be required to be
distributed even when the Fund's net asset value also reflects unrealized
losses. Certain distributions declared in October, November or December and paid
in the following January will be taxed to shareholders as if received on
December 31 of the year in which they were declared.
Amounts paid by the Fund to individuals and certain other shareholders who
have not provided the Fund with their correct taxpayer identification number
("TIN") and certain certifications required by the Internal Revenue Service (the
"IRS") as well as shareholders with respect to whom the Fund has received
certain information from the IRS or a broker, may be subject to "backup"
withholding of federal income tax arising from the Fund's taxable dividends and
other distributions as well as the proceeds of redemption transactions
(including repurchases and exchanges), at a rate of up to 30% for amounts paid
during 2002 and 2003. An individual's TIN is generally his or her social
security number.
The foregoing discussion does not address the special tax rules applicable
to certain classes of investors, such as tax-exempt entities, foreign investors,
insurance companies and financial institutions. Shareholders should consult
their own tax advisers with respect to special tax rules that may apply in their
particular situations, as well as the state, local, and, where applicable,
foreign tax consequences of investing in the Fund.
If the Fund issues preferred shares, the Fund will designate dividends made
to holders of Shares and to holders of those preferred shares in accordance with
each class's proportionate share of each item of Fund income (such as tax-exempt
interest, net capital gains and other taxable income).
The Fund is not appropriate for non-U.S. investors or as a retirement plan
investment.
STATE AND LOCAL TAXES. The exemption of interest income for federal income
tax purposes does not necessarily result in exemption under the income or other
tax laws of any state or local taxing authority. Shareholders of the Fund may be
exempt from state and local taxes on distributions of tax-exempt interest income
derived from obligations of the state and/or municipalities of the state in
which they are resident, but taxable generally on income derived from
obligations of other jurisdictions. The Fund will report annually to
shareholders the percentages representing the proportionate ratio of its net
tax-exempt income earned in each state.
In the opinion of special California tax counsel, Sidley Austin Brown & Wood
LLP, under California law, dividends paid by the Fund are exempt from California
personal income tax applicable to individuals who reside in California to the
extent such dividends are derived from interest payment on California municipal
obligations and municipal obligations issued by certain U.S. Territories and
provided that at least 50% of the assets of the Fund at the close of each
quarter of its taxable year are invested in obligations the interest on which is
exempt under either federal or California law from taxation by the state of
California. This opinion assumes and relies upon the Fund's qualification as a
regulated investment company under federal income tax law.
Under the California personal income tax, distributions of short-term
capital gains are treated as ordinary income, and distributions of long-term
capital gains are treated as long-term capital gains taxable at ordinary income
rates. Exempt-interest dividends paid to a corporate shareholder subject to
California state corporate franchise tax will be taxable as ordinary income.
17
The foregoing briefly summarizes some of the important federal income tax
and California personal income tax consequences to Shareholders of investing in
Shares, reflects the federal and California income tax laws as of the date of
this Prospectus, and does not address special tax rules applicable to certain
types of investors, such as corporate and foreign investors. Investors should
consult their tax advisors regarding other federal, state or local tax
considerations that may be applicable in their particular circumstances,
including state alternative minimum tax as well as any proposed tax law changes.
The foregoing discussion does not address the special tax rules applicable
to certain classes of investors, such as insurance companies and financial
institutions.
Shareholders should consult their own tax advisers with respect to special
tax rules that may apply in their particular situations, as well as the state or
local tax consequences of investing in the Fund.
OTHER INFORMATION
The Fund is an organization of the type commonly known as a "Massachusetts
business trust." Under Massachusetts law, shareholders of such a trust may, in
certain circumstances, be held personally liable as partners for the obligations
of the trust. The Declaration of Trust contains an express disclaimer of
shareholder liability in connection with the Fund property or the acts,
obligations or affairs of the Fund. The Declaration of Trust also provides for
indemnification out of the Fund property of any shareholder held personally
liable for the claims and liabilities to which a shareholder may become subject
by reason of being or having been a shareholder. Thus, the risk of a shareholder
incurring financial loss on account of shareholder liability is limited to
circumstances in which the Fund itself is unable to meet its obligations. The
Fund has been advised by its counsel that the risk of any shareholder incurring
any liability for the obligations of the Fund is remote.
The Declaration of Trust provides that the Trustees will not be liable for
errors of judgment or mistakes of fact or law, but nothing in the Declaration of
Trust protects a Trustee against any liability to the Fund or its shareholders
to which he 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. Voting rights are not cumulative, which means that the
holders of more than 50% of the shares voting for the election of Trustees can
elect 100% of the Trustees and, in such event, the holders of the remaining less
than 50% of the shares voting on the matter will not be able to elect any
Trustees.
The Declaration of Trust provides that no person shall serve as a Trustee if
shareholders holding 2/3 of the outstanding shares have removed him from that
office either by a written declaration filed with the Fund's custodian or by
votes cast at a meeting called for that purpose. The Declaration of Trust
further provides that the Trustees of the Fund shall promptly call a meeting of
the shareholders for the purpose of voting upon a question of removal of any
such Trustee or Trustees when requested in writing so to do by the record
holders of not less than 10 per centum of the outstanding shares.
The Fund's Prospectus and this SAI do not contain all of the information set
forth in the Registration Statement that the Fund has filed with the SEC. The
complete Registration Statement may be obtained from the SEC upon payment of the
fee prescribed by its Rules and Regulations.
INDEPENDENT AUDITORS
Deloitte & Touche LLP, Boston, Massachusetts, are the independent auditors
for the Fund, providing audit services, tax return preparation, and assistance
and consultation with respect to the preparation of filings with the SEC.
18
INDEPENDENT AUDITORS' REPORT
To the Trustees and Shareholder of
Eaton Vance Insured California Municipal Bond Fund:
We have audited the accompanying statement of assets and liabilities of
Eaton Vance Insured California Municipal Bond Fund (the "Fund") as of August 19,
2002. This financial statement is the responsibility of the Fund's management.
Our responsibility is to express an opinion on this financial statement based on
our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our opinion, such statement of assets and liabilities presents fairly, in
all material respects, the financial position of Eaton Vance Insured California
Municipal Bond Fund as of August 19, 2002 in conformity with generally accepted
accounting principles.
Boston, Massachusetts
August 20, 2002
19
EATON VANCE INSURED CALIFORNIA MUNICIPAL BOND FUND
STATEMENT OF ASSETS AND LIABILITIES
AUGUST 19, 2002
ASSETS
Cash....................................................... $ 100,000
Offering costs............................................. $ 300,000
---------
Total assets............................................... $ 400,000
=========
LIABILITIES
Accrued offering costs..................................... $ 300,000
---------
Total liabilities.......................................... $ 300,000
=========
Net assets applicable to 6,666.67 common shares of
beneficial interests issued and outstanding................ $ 100,000
=========
NET ASSET VALUE AND OFFERING PRICE PER SHARE............... $ 15.00
==========
NOTES TO FINANCIAL STATEMENT
NOTE 1: ORGANIZATION
The Fund was organized as a Massachusetts business trust on July 8, 2002,
and has been inactive since that date except for matters relating to its
organization and registration as a non-diversified, closed-end management
investment company under the Investment Company Act of 1940, as amended, and the
Securities Act of 1933, as amended, and the sale of 6,666.67 common shares to
Eaton Vance Management, the Fund's Investment Adviser.
Eaton Vance Management, or an affiliate, has agreed to pay all
organizational expenses and offering costs (other than sales loads) that exceed
$0.03 per common share.
The Fund's investment objective is to provide current income exempt from
federal income tax, including alternative minimum tax, and California personal
income tax.
NOTE 2: ACCOUNTING POLICIES
The Fund's financial statements are prepared in accordance with accounting
principles generally accepted in the United States of America which require the
use of management estimates. Actual results may differ from those estimates.
The Fund's share of offering costs will be recorded as a reduction of the
proceeds from the sale of common shares upon the commencement of Fund
operations. The offering costs reflected above assume the sale of 10,000,000
common shares.
NOTE 3: INVESTMENT MANAGEMENT AGREEMENT
Pursuant to an investment advisory agreement between the Adviser and the
Fund, the Fund has agreed to pay an investment advisory fee, payable on a
monthly basis, at an annual rate of 0.65% of the average weekly gross assets of
the Fund. Gross assets of the Fund shall be calculated by deducting accrued
liabilities of the Fund not including the amount of any preferred shares
outstanding or the principal amount of any indebtedness for money borrowed.
In addition, the Adviser has contractually agreed to reimburse the Fund for
fees and expenses during the first 8 years of operations. These reductions range
from 0.32% of the average weekly gross assets during the first year of
operations, declining to 0.08% of the average weekly gross assets during the
eighth year. The Adviser has not agreed to reimburse the Fund for any portion of
its fees and expenses beyond this time.
Eaton Vance serves as the administrator of the Fund, but currently receives
no compensation for providing administrative services to the Fund.
NOTE 4: FEDERAL INCOME TAXES
The Fund intends to comply with the requirements of the Internal Revenue
Code applicable to regulated investment companies and to distribute all of its
taxable income, if any, and tax-exempt income, including any net realized gain
on investments.
20
APPENDIX A
DESCRIPTION OF SECURITIES RATINGS+
MOODY'S INVESTORS SERVICE, INC.
MUNICIPAL BONDS
Aaa: Bonds which are rated Aaa are judged to be of the best quality. They
carry the smallest degree of investment risk and are generally referred to as
"gilt edged." Interest payments are protected by a large or by an exceptionally
stable margin and principal is secure. While the various protective elements are
likely to change, such changes as can be visualized are most unlikely to impair
the fundamentally strong position of such issues.
Aa: Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are generally known as
high grade bonds. They are rated lower than the best bonds because margins of
protection may not be as large as in Aaa securities or fluctuation of protective
elements may be of greater amplitude or there may be other elements present
which make the long term risk appear somewhat larger than the Aaa securities.
A: Bonds which are rated A possess many favorable investment attributes and
are to be considered as upper-medium-grade obligations. Factors giving security
to principal and interest are considered adequate, but elements may be present
which suggest a susceptibility to impairment sometime in the future.
Baa: Bonds which are rated Baa are considered as medium-grade obligations
(i.e., they are neither highly protected nor poorly secured). Interest payments
and principal security appear adequate for the present but certain protective
elements may be lacking or may be characteristically unreliable over any great
length of time. Such bonds lack outstanding investment characteristics and in
fact have speculative characteristics as well.
Ba: Bonds which are rated Ba are judged to have speculative elements; their
future cannot be considered as well-assured. Often the protection of interest
and principal payments may be very moderate and thereby not well safeguarded
during other good and bad times over the future. Uncertainty of position
characterizes bonds in this class.
B: Bonds which are rated B generally lack characteristics of the desirable
investment. Assurance of interest and principal payments or of maintenance of
other terms of the contract over any long period of time may be small.
Caa: Bonds which are rated Caa are of poor standing. Such issues may be in
default or there may be present elements of danger with respect to principal or
interest.
Ca: Bonds which are rated Ca represent obligations which are speculative in
a high degree. Such issues are often in default or have other marked
shortcomings.
C: Bonds which are rated C are the lowest rated class of bonds, and issues
so rated can be regarded as having extremely poor prospects of ever attaining
any real investment standing.
-------------------
+ The ratings indicated herein are believed to be the most recent ratings
available at the date of this SAI for the securities listed. Ratings are
generally given to securities at the time of issuance. While the rating
agencies may from time to time revise such ratings, they undertake no
obligation to do so, and the ratings indicated do not necessarily represent
ratings which would be given to these securities on the date of the Fund's
fiscal year end.
ABSENCE OF RATING: Where no rating has been assigned or where a rating has
been suspended or withdrawn, it may be for reasons unrelated to the quality of
the issue.
Should no rating be assigned, the reason may be one of the following:
1. An application for rating was not received or accepted.
2. The issue or issuer belongs to a group of securities or companies that
are not rated as a matter of policy.
21
3. There is a lack of essential data pertaining to the issue or issuer.
4. The issue was privately placed, in which case the rating is not
published in Moody's publications.
Suspension or withdrawal may occur if new and material circumstances arise,
the effects of which preclude satisfactory analysis; if there is no longer
available reasonable up-to-date data to permit a judgment to be formed; if a
bond is called for redemption; or for other reasons.
NOTE: Moody's applies numerical modifiers, 1, 2 and 3 in each generic rating
classification from Aa through B in its municipal bond rating system. The
modifier 1 indicates that the security ranks in the higher end of its generic
rating category; the modifier 2 indicates a mid-range ranking; and the modifier
3 indicates that the issue ranks in the lower end of its generic rating
category.
MUNICIPAL SHORT-TERM OBLIGATIONS
MIG/VMIG RATINGS U.S. SHORT-TERM RATINGS: In municipal debt issuance, there
are three rating categories for short-term obligations that are considered
investment grade. These ratings are designated as Moody's Investment Grade (MIG)
and are divided into three levels -- MIG 1 through MIG 3.
In addition, those short-term obligations that are of speculative quality
are designated SG, or speculative grade.
In the case of variable rate demand obligations (VRDOs), a two-component
rating is assigned. The first element represents Moody's evaluation of the
degree of risk associated with scheduled principal and interest payments. The
second element represents Moody's evaluation of the degree of risk associated
with the demand feature, using the MIG rating scale.
The short-term rating assigned to the demand feature of VRDOs is designated
as VMIG. When either the long- or short- term aspect of a VRDO is not rated,
that piece is designated NR, e.g., Aaa/NR or NR/VMIG 1.
MIG ratings expire at note maturity. By contrast, VMIG rating expirations
will be a function of each issue's specific structural or credit features.
MIG 1/VMIG 1: This designation denotes superior credit quality. Excellent
protection is afforded by established cash flows, highly reliable liquidity
support, or demonstrated broad-based access to the market for refinancing.
MIG 2/VMIG 2: This designation denotes strong credit quality. Margins of
protection are ample, although not as large as in the preceding group.
MIG 3/VMIG 3: This designation denotes acceptable credit quality. Liquidity
and cash-flow protection may be narrow, and market access for refinancing is
likely to be less well-established.
SG: This designation denotes speculative-grade credit quality. Debt
instruments in this category in this category may lack sufficient margins of
protection.
STANDARD & POOR'S RATINGS GROUP
INVESTMENT GRADE
AAA: Debt rated AAA has the highest rating assigned by S&P. Capacity to pay
interest and repay principal is extremely strong.
AA: Debt rated AA has a very strong capacity to pay interest and repay
principal and differs from the highest rated issues only in small degree.
A: Debt rated A has a strong capacity to pay interest and repay principal
although it is somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions than debt in higher rated categories.
BBB: Debt rated BBB is regarded as having an adequate capacity to pay
interest and repay principal. Whereas it normally exhibit adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal for
debt in this category than in higher rated categories.
22
SPECULATIVE GRADE
Debt rated BB, B, CCC, CC and C is regarded as having predominantly
speculative characteristics with respect to capacity to pay interest and repay
principal. BB indicates the least degree of speculation and C the highest. While
such debt will likely have some quality and protective characteristics, these
are outweighed by large uncertainties or major exposures to adverse conditions.
BB: Debt rated BB has less near-term vulnerability to default than other
speculative issues. However, it faces major ongoing uncertainties or exposure to
adverse business, financial, or economic conditions which could lead to
inadequate capacity to meet timely interest and principal payments. The BB
rating category is also used for debt subordinated to senior debt that is
assigned an actual or implied BBB-- rating.
B: Debt rated B has a greater vulnerability to default but currently has the
capacity to meet interest payments and principal repayments. Adverse business,
financial, or economic conditions will likely impair capacity or willingness to
pay interest and repay principal. The B rating category is also used for debt
subordinated to senior debt that is assigned an actual or implied BB or BB--
rating.
CCC: Debt rated CCC has a currently identifiable vulnerability to default,
and is dependent upon favorable business, financial, and economic conditions to
meet timely payment of interest and repayment of principal. In the event of
adverse business, financial, or economic conditions, it is not likely to have
the capacity to pay interest and repay principal. The CCC rating category is
also used for debt subordinated to senior debt that is assigned an actual or
implied B or B-- rating.
CC: The rating CC is typically applied to debt subordinated to senior debt
which is assigned an actual or implied CCC debt rating.
C: The rating C is typically applied to debt subordinated to senior debt
which is assigned an actual or implied CCC-- debt rating. The C rating may be
used to cover a situation where a bankruptcy petition has been filed, but debt
service payments are continued.
C1: The Rating C1 is reserved for income bonds on which no interest is being
paid.
D: Debt rated D is in payment default. The D rating category is used when
interest payments or principal payments are not made on the date due even if the
applicable grace period has not expired, unless S&P believes that such payments
will be made during such grace period. The D rating also will be used upon the
filing of a bankruptcy petition if debt service payments are jeopardized.
PLUS (+) OR MINUS (--): The ratings from AA to CCC may be modified by the
addition of a plus or minus sign to show relative standing within the major
rating categories.
P: The letter "p" indicates that the rating is provisional. A provisional
rating assumes the successful completion of the project being financed by the
debt being rated and indicates that payment of debt service requirements is
largely or entirely dependent upon the successful and timely completion of the
project. This rating, however, while addressing credit quality subsequent to
completion of the project, makes no comment on the likelihood of, or the risk of
default upon failure of such completion. The investor should exercise his own
judgment with respect to such likelihood and risk.
L: The letter "L" indicates that the rating pertains to the principal amount
of those bonds to the extent that the underlying deposit collateral is insured
by the Federal Deposit Insurance Corp. and interest is adequately
collateralized. In the case of certificates of deposit, the letter "L" indicates
that the deposit, combined with other deposits being held in the same right and
capacity, will be honored for principal and accrued pre-default interest up to
the federal insurance limits within 30 days after closing of the insured
institution or, in the event that the deposit is assumed by a successor insured
institution, upon maturity.
NR: NR indicates no rating has been requested, that there is insufficient
information on which to base a rating, or that S&P does not rate a particular
type of obligation as a matter of policy.
MUNICIPAL NOTES
S&P note ratings reflect the liquidity concerns and market access risks
unique to notes. Notes due in 3 years or less will likely receive a note rating.
Notes maturing beyond 3 years will most likely receive a long-term debt rating.
The following criteria will be used in making that assessment:
o Amortization schedule (the larger the final maturity relative to other
maturities the more likely it will be treated as a note).
23
o Sources of payment (the more dependent the issue is on the market for
its refinancing, the more likely it will be treated as a note).
Note rating symbols are as follows:
SP-1: Strong capacity to pay principal and interest. Those issues
determined to possess very strong characteristics will be given a plus (+)
designation.
SP-2: Satisfactory capacity to pay principal and interest, with some
vulnerability to adverse financial and economic changes over the term of
the notes.
SP-3: Speculative capacity to pay principal and interest.
FITCH RATINGS
INVESTMENT GRADE BOND RATINGS
AAA: Bonds considered to be investment grade and of the highest credit
quality. The obligor has an exceptionally strong ability to pay interest and
repay principal, which is unlikely to be affected by reasonably foreseeable
events.
AA: Bonds considered to be investment grade and of very high credit quality.
The obligor's ability to pay interest and repay principal is very strong,
although not quite as strong as bonds rated `AAA'. Because bonds rated in the
`AAA' and `AA' categories are not significantly vulnerable to foreseeable future
developments, short-term debt of these issuers is generally rated `F-1+'.
A: Bonds considered to be investment grade and of high credit quality. The
obligors ability to pay interest and repay principal is considered to be strong,
but may be more vulnerable to adverse changes in economic conditions and
circumstances than bonds with higher ratings.
BBB: Bonds considered to be investment grade and of satisfactory credit
quality. The obligor's ability to pay interest and repay principal is considered
to be adequate. Adverse changes in economic conditions and circumstances,
however, are more likely to have adverse impact on these bonds, and therefore,
impair timely payment. The likelihood that the ratings of these bonds will fall
below investment grade is higher than for bonds with higher ratings.
HIGH YIELD BOND RATINGS
BB: Bonds are considered speculative. The obligor's ability to pay interest
and repay principal may be affected over time by adverse economic changes.
However, business and financial alternatives can be identified that could assist
the obligor in satisfying its debt service requirements.
B: Bonds are considered highly speculative. While bonds in this class are
currently meeting debt service requirements, the probability of continued timely
payment of principal and interest reflects the obligor's limited margin of
safety and the need for reasonable business and economic activity throughout the
life of the issue.
CCC: Bonds have certain identifiable characteristics which, if not remedied,
may lead to default. The ability to meet obligations requires an advantageous
business and economic environment.
CC: Bonds are minimally protected. Default in payment of interest and/or
principal seems probable over time.
C: Bonds are in imminent default in payment of interest or principal.
DDD, DD AND D: Bonds are in default on interest and/or principal payments.
Such bonds are extremely speculative and should be valued on the basis of their
ultimate recovery value in liquidation or reorganization of the obligor. `DDD'
represents the highest potential for recovery on these bonds, and `D' represents
the lowest potential for recovery.
24
PLUS (+) OR MINUS (--): The ratings from AA to C may be modified by the
addition of a plus or minus sign to indicate the relative position of a credit
within the rating category.
NR: Indicates that Fitch does not rate the specific issue.
CONDITIONAL: A conditional rating is premised on the successful completion
of a project or the occurrence of a specific event.
INVESTMENT GRADE SHORT-TERM RATINGS
Fitch's short-term ratings apply to debt obligations that are payable on
demand or have original maturities of generally up to three years, including
commercial paper, certificates of deposit, medium-term notes, and municipal and
investment notes.
F-1+: Exceptionally Strong Credit Quality. Issues assigned this rating are
regarded as having the strongest degree of assurance for timely payment.
F-1: Very Strong Credit Quality. Issues assigned this rating reflect an
assurance of timely payment only slightly less in degree than issues rated
`F-1+'.
F-2: Good Credit Quality. Issues carrying this rating have a satisfactory
degree of assurance for timely payment, but the margin of safety is not as great
as the `F-1+' and `F-1' categories.
F-3: Fair Credit Quality. Issues carrying this rating have characteristics
suggesting that the degree of assurance for timely payment is adequate, however,
near-term adverse change could cause these securities to be rated below
investment grade.
* * * * * * * *
NOTES: Bonds which are unrated expose the investor to risks with respect to
capacity to pay interest or repay principal which are similar to the risks of
lower-rated speculative bonds. The Fund is dependent on the Investment Adviser's
judgment, analysis and experience in the evaluation of such bonds.
Investors should note that the assignment of a rating to a bond by a rating
service may not reflect the effect of recent developments on the issuer's
ability to make interest and principal payments.
DESCRIPTION OF THE INSURANCE CLAIMS-PAYING ABILITY RATINGS OF STANDARD & POOR'S
RATINGS GROUP AND MOODY'S INVESTORS SERVICE, INC.
An S&P insurance claims-paying ability rating is an assessment of an
operating insurance company's financial capacity to meet obligations under an
insurance policy in accordance with the terms. An insurer with an insurance
claims-paying ability of AAA has the highest rating assigned by S&P. Capacity to
honor insurance contracts is adjudged by S&P to be extremely strong and highly
likely to remain so over a long period of time. A Moody's insurance
claims-paying ability rating is an opinion of the ability of an insurance
company to repay punctually senior policy holder obligations and claims. An
insurer with an insurance claims-paying ability rating of Aaa is adjudged by
Moody's to be of the best quality. In the opinion of Moody's, the policy
obligations of an insurance company with an insurance claims-paying ability
rating of Aaa carry the smallest degree of credit risk and, while the financial
strength of the these companies is likely to change, such changes as can be
visualized are most unlikely to impair the company's fundamentally strong
position.
An insurance claims-paying ability rating by S&P or Moody's does not
constitute an opinion on an specific contract in that such an opinion can only
be rendered upon the review of the specific insurance contract. Furthermore, an
insurance claims-paying ability rating does not take in account deductibles,
surrender or cancellation penalties or the timeliness of payment; nor does it
address the ability of a company to meet nonpolicy obligations (I.E., debt
contracts).
The assignment of ratings by S&P and Moody's to debt issues that are fully
or partially supported by insurance policies, contracts, or guarantees is a
separate process from the determination of claims-paying ability ratings. The
likelihood of a timely flow of funds from the insurer to the trustee for the
bondholders is a key element in the rating determination of such debt issues.
25
APPENDIX B
TAX EQUIVALENT YIELD TABLE
The table below gives the approximate yield a taxable security must earn at
various income brackets to produce after-tax yields equivalent to those of
tax-exempt bonds yielding from 4% to 7% under the 2002 regular federal income
tax and California personal income tax rates applicable to individuals.
COMBINED FEDERAL AND TAX-EXEMPT YIELD
CALIFORNIA STATE TAX RATES ------------------------------------------------------------------
SINGLE RETURN JOINT RETURN FEDERAL STATE BLENDED 4.0% 4.5% 5.0% 5.5% 6.0% 6.5% 7.0%
----------------------------------- -------- ------- ------- ------- ------- ------- ------- ------- ------- ------
(TAXABLE INCOME)** IS EQUIVALENT TO A FULLY TAXABLE YIELD OF
$21,504-- $43,007-- 15.0% 6.00% 20.10% 5.01% 5.63% 6.26% 6.88% 7.51% 8.14% 8.76%
$27,950 $46,700
$27,951-- $46,701-- 27.0% 6.00% 31.38% 5.83% 6.56% 7.29% 8.02% 8.74% 9.47% 10.20%
$30,298 $60,596
$30,299-- $60,599-- 27.0% 8.00% 32.84% 5.96% 6.70% 7.44% 8.19% 8.93% 9.68% 10.42%
$38,291 $76,582
$38,292-- $76,583-- 27.0% 9.30% 33.79% 6.04% 6.80% 7.55% 8.31% 9.06% 9.82% 10.57%
$67,700 $112,850
$67,751-- $112,851-- 30.0% 9.30% 36.51% 6.30% 7.09% 7.88% 8.66% 9.45% 10.24% 11.03%
$141,250 $171,950
$141,251-- $171,951-- 35.0% 9.30% 41.05% 6.78% 7.63% 8.48% 9.33% 10.18% 11.03% 11.87%
$307,050 $307,050
Over $307,050 Over $307,050 38.6% 9.30% 44.31% 7.18% 8.08% 8.98% 9.88% 10.77% 11.67% 12.57%
----------
** Net amount subject to federal personal income tax after deductions and
exemptions.
The above indicated federal income tax brackets do not take into account the
effect of a reduction in the deductibility of itemized deductions generally for
individual taxpayers with adjusted gross income in excess of $137,300. The tax
brackets also do not show the effects of phaseout of personal exemptions for
single filers with adjusted gross income in excess of $103,000 and joint filers
with adjusted gross income in excess of $206,000. The effective tax brackets and
equivalent taxable yields of those taxpayers will be higher than those indicated
above.
The combined federal and California tax brackets are calculated using the
highest California tax rate applicable within each bracket. Taxpayers may have
lower combined tax brackets and taxable equivalent yields than indicated above.
The combined tax brackets assume that California taxes are itemized deductions
for federal income tax purposes. Investors who do not itemize deductions on
their federal income tax return will have a higher combined bracket and higher
taxable equivalent yield than those indicated above. The applicable federal tax
rates within the brackets are 15%, 27%, 30%, 35.0% and 38.6%, over the same
ranges of income.
Yields shown are for illustration purposes only and are not meant to
represent the Fund's actual yield. No assurance can be given that the Fund will
achieve any specific tax-exempt yield. While it is expected that the Fund will
invest principally in obligations the interest from which is exempt from the
regular federal income tax and California State personal income taxes, other
income received by the Fund may be taxable. The table does not take into account
state or local taxes, if any, payable on Fund distributions. It should also be
noted that the interest earned on certain "private activity bonds", while exempt
from the regular federal income tax, is treated as a tax preference item which
could subject the recipient to the AMT. The illustrations assume that the AMT is
not applicable and do not take into account any tax credits that may be
available.
The information set forth above is as of the date of this SAI. Subsequent
tax law changes could result in prospective or retroactive changes in the tax
brackets, tax rates, and tax-equivalent yields set forth above. Investors should
consult their tax adviser for additional information.
26
APPENDIX C
CALIFORNIA AND U.S. TERRITORY INFORMATION
The following is a summary of certain selected information relating to the
economy and finances of California (hereinafter the "State" or "California") and
the U.S. territories listed below. It is not a discussion of any specific
factors that may affect any particular issuer of municipal securities. The
information is not intended to be comprehensive and does not include all of the
economic and financial information, such as certain information pertaining to
budgets, receipts and disbursements, about California or such U.S. territories
that would ordinarily be included in various public documents issued thereby,
such as an official statement prepared in accordance with issuance of general
obligation bonds of California or such U.S. territories. Such an official
statement, together with any updates or supplements thereto, generally may be
obtained upon request to the budget or equivalent office of California or such
U.S. territories. The information below is derived from selected public
documents of the type described above and has not been independently verified by
the Fund.
CALIFORNIA
GENERAL ECONOMIC CONDITIONS
The economy of California is the largest among the 50 states and is one of
the largest in the world, having major components in high technology, trade,
entertainment, agriculture, manufacturing, tourism, construction and services.
California's economy slipped into a moderate recession in early 2001, losing
249,300 jobs between January and November of 2001. The recession was
concentrated in the state's high-tech sector and tourism industry. The latter
was hit hard by the September 11 terrorist attacks. From November 2001 to April
2002, employment grew by 46,300 jobs, as the state began to recover. But the
recovery has been slow so far, and unemployment continues to rise. Unemployment
has risen from 4.7 percent in February 2001 to 6.4 percent in April 2002. (See
"Current State Budget" below.)
California's July 1, 2001 population of nearly 35 million represented over
12 percent of the total United States population.
California's population is concentrated in metropolitan areas. As of the
April 1, 2000 census 97 percent of the State's population resided in the 25
Metropolitan Statistical Areas in the State. As of July 1, 2000, the five-county
Los Angeles area accounted for 48 percent of the State's population with over
16.0 million residents and the 10-county San Francisco Bay Area represented 21
percent of the State's population with a population of over 7.0 million.
Non-farm employment this year is likely to be up about 1.0 percent from
2001. Further growth is projected in 2003, the year's average growth expected to
be 2.7 percent. The unemployment rate -- a lagging indicator -- is forecast to
edge up to 6.4 percent this year from a 6.0 percent average in 2001, and then
decline to 5.7 percent in 2003.
Construction trends are expected to be mixed. Low interest rates and a large
backlog of unmet demand should encourage further gains in new residential
construction, with 153,000 new units forecast to be authorized by building
permits in 2002, up from 149,000 in 2001. Next year, homebuilding is expected to
decline to 148,000 units.
Although California has avoided the commercial construction excesses of the
1980s, slower job growth, coupled with new supply already under construction,
will result in rising commercial and retail vacancy rates, which in turn will
discourage new construction starts. After several years of strong double-digit
growth, nonresidential permit values (not adjusted for inflation) are expected
to slow this year, but edge back up in 2003.
27
The weakness in personal income growth in the current year is assumed to be
primarily driven by a drop in capital gains as well as due to lower reduced
stock option income. Capital gains for the 2001 tax year are estimated to have
decreased by 60 percent to $47 billion, and are projected to slowly recover with
a 5 percent increase in 2002. Stock options are estimated to have dropped by
almost 45 percent, to $44 billion in 2001 and are forecast to decline by another
30 percent in 2002, to $31 billion.
PRIOR FISCAL YEARS' FINANCIAL RESULTS
The combination of resurging exports, a strong stock market, and a
rapidly-growing economy in 1999 and early 2000 resulted in strong growth in
General Fund revenues during fiscal year 1999-2000. Currently, however, both the
nation and the State are experiencing an economic downturn.
2000-2001 FISCAL YEAR BUDGET. The 2000-2001 Budget Act (the "2000 Budget
Act"), signed by the Governor on June 30, 2000, was enacted on time for the
second consecutive year. The spending plan assumed General Fund revenues and
transfers of $73.9 billion, a 3.8 percent increase over 1999-2000 estimates. The
2000 Budget Act appropriated $78.8 billion from the General Fund, a 17.3 percent
increase over 1999-2000 and reflected the use of $5.5 billion from the State
budget reserve available from surpluses in the prior year. In order not to place
undue pressure on future budget years, about $7.0 billion of the increased
spending in 2000-2001 was for one-time expenditures and investments.
At the time the 2000 Budget Act was signed, the Department of Finance
estimated the June 30, 2001 State budget reserve balance to be $1.781 billion.
In addition, the Governor held back $500 million as a set-aside for litigation
costs. The Governor vetoed just over $1 billion in General Fund and special fund
appropriations from the Budget approved by the Legislature, in order to achieve
the budget reserve. Because of the State's strong cash position, the State
announced that it would not undertake a revenue anticipation note borrowing in
2000-2001.
The 2000 Budget Act included special fund expenditures of $15.6 billion, and
bond fund expenditures of $5.0 billion. Special fund revenues were estimated at
$16.5 billion.
CURRENT STATE BUDGET
BACKGROUND. The 2001-2002 Governor's Budget, released January 10, 2001
estimated 2001-2002 General Fund revenues and transfers to be about $79.4
billion and proposed $82.9 billion in expenditures, utilizing a portion of the
surplus expected from 2000-2001. The Governor proposed budget reserves in
2001-2002 of $2.4 billion, including $500 million for unplanned litigation
costs.
The May Revision to the 2001-2002 Governor's Budget disclosed a reversal of
the recent General Fund financial trend, as a result of the slowdown in economic
growth in the State starting in the first quarter of 2001 and, most
particularly, the steep drop in stock market levels since early 2000. The Fiscal
Year 2001-2002 Budget Act projects General Fund revenues in 2001-2002 will be
about $75.1 billion, a drop of $2.9 billion from revised 2000-2001 estimates.
Most of the drop is attributed to the personal income tax, which reflects both
slower job and wage growth and a severe decline in capital gains and stock
option income, which is included in personal income tax statistics.
FISCAL YEAR 2001-2002 BUDGET ACT. The Fiscal Year 2001-2002 Budget Act (the
"2001 Budget Act") was signed by the Governor on July 26, 2001, almost four
weeks after the start of the fiscal year. The Governor vetoed almost $500
million General Fund expenditures from the budget passed by the Legislature. The
spending plan for 2001-2002 included General Fund expenditures of $78.8 billion,
a reduction of $1.3 billion from the prior year. This could be accomplished
without serious program cuts because such a large part of the 2000 Budget Act
comprised one-time expenditures. The spending plan utilized more than half of
28
the budget surplus as of June 30, 2001, but still left a projected balance in
the Special Fund for Economic Uncertainties at June 30, 2002 of $2.6 billion,
the largest appropriated reserve in State history. The 2001 Budget Act assumed
that, during the course of the fiscal year, the $6.2 billion advanced by the
General Fund to the Department of Water Resources for power purchases will be
repaid with interest. See "Recent Developments Regarding Natural Gas and
Electricity" below.
The 2001 Budget Act also included special fund expenditures of $21.3 billion
and bond fund expenditures of $3.2 billion. The State issued $5.7 billion of
revenue anticipation notes on October 4, 2001 as part of its cash management
program.
Some of the important features of the 2001 Budget Act were the following:
1. Proposition 98 per pupil spending was increased by 4.9 percent to $7,002.
Total General Fund spending of $32.4 billion for K-12 education fully funds
enrollment and cost of living increases and also provides additional funding for
a number of programs, such as teacher and principal training programs,
instructional and student achievement improvement programs, energy cost
assistance, and high-tech high schools.
2. Higher education funding was increased to allow for enrollment increases
at both the University of California and the California State University system
with no fee increases. Additional funding was also provided for 3 percent
student growth at community colleges.
3. Health, welfare and social services generally were fully funded for
anticipated caseload growth. The 2001 Budget Act adopted an Administration
proposal to utilize $402 million of tobacco litigation settlement payments to
fund certain health programs.
4. In addition to $4.3 billion of continuing tax relief, the 2001 Budget Act
contained about $125 million in new General Fund tax relief, primarily for
senior citizens property tax assistance and certain new tax credits aimed at
rural areas and agricultural equipment. As noted above, the Legislature modified
the law permitting a 0.25 percent cut in the state sales tax rate if the General
Fund reserve exceeds three percent of revenues in the current fiscal year. This
change was not expected to impact the 2001-2002 fiscal year.
5. The 2001 Budget Act altered the six-year transportation funding plan
started in the 2000-2001 fiscal year. The Legislature postponed for two years
the transfer of sales taxes on gasoline to support transportation programs, and
this transfer will take place during the 2003-2004 to 2007-2008 fiscal years. As
a result, $2.5 billion of these sales tax revenues will remain in the General
Fund over the 2001-2002 and 2002-2003 fiscal years. To allow all current
projects to remain on schedule through 2002-2003, the legislation authorized
certain internal loans from other transportation accounts. Part of the 2001
Budget Act compromise was an agreement to place on the March 2002 statewide
ballot a constitutional amendment which would make permanent, after 2007-2008,
the dedication of sales taxes on gasoline to transportation purposes. The
constitutional amendment was approved on March 5, 2002 by 69.1% of voters in the
State voting for the dedication.
6. The 2001 Budget Act provided significant assistance to local governments
including $232.6 million for the COPS and county juvenile justice crime
prevention programs, $209 million for mental health and social services, $154
million for street and road maintenance, $124 million for various public safety
programs and $34 million for environmental protection.
2002-2003 PROPOSED GOVERNOR'S BUDGET. The Proposed 2002-2003 Governor's
Budget, released on January 10, 2002 (the "2002-2003 Governor's Budget"),
projected a fall-off in General Fund revenues due to the national economic
recession combined with the stock market decline, which began in mid-2000.
Personal Income Tax receipts, which include stock option and capital gains
realizations, are particularly impacted by the slowing economy and stock market
29
decline. As a result, the Governor projected a combined budget gap for 2001-2002
and 2002-2003 of approximately $12.5 billion.
The May Revision to the 2002 Governor's Budget (the "May Revision")
projected further deterioration in revenues of $9.5 billion and additional costs
of $1.6 billion over the 2001-2002 and 2002-2003 fiscal years. As a result, the
combined budget gap for 2001-2002 and 2002-2003 rose from the $12.5 billion
estimated in January to $23.6 billion.
The May Revision projected revenues from the three largest sources of tax
revenue (personal income, sales and use and corporation) to be about $61.1
billion in 2001-2002. This is $3.8 billion lower than projected in the 2002
Governor's Budget ($64.9 billion) and $11.7 billion lower than the final
estimates for 2000-2001. Most of the decline in projected tax revenues is
attributable to the personal income tax. Total revenues and transfers, projected
to be $73.8 billion in 2001-2002, include the repayment of $6.7 billion from the
sale of Department of Water Resources Revenue Bonds and other sources to repay
General Fund loans with interest. The Power Bonds were originally expected to be
sold in June 2002. However, the cash flows now show that the sale is anticipated
to occur by the end of October, 2002. See "Recent Developments Regarding Natural
Gas and Electricity." The May Revision projected major General Fund tax revenues
of $70.6 billion and total General Fund revenues and transfers of $78.6 billion
for 2002-2003.
In early June, actual receipts reported by the State Controller's Office for
the month of May were $372 million below forecast, on a fund cash basis. This
was attributable to an overstated estimate of fund cash by the Department of
Finance for the month in the range of $344 million. The Department of Finance
bases its budgetary revenue forecast on receipts on the Agency cash basis, not
fund cash basis. Therefore, these lower receipts on a cash basis do not
translate into a significant change in budgetary revenues.
The Governor proposed to close the $23.6 billion budget gap through a
combination of spending reductions and revenue proposals, as well as the maximum
fiscally responsible level of fund shifts, loans, accelerations, transfers and
deferrals:
1. Expenditure reductions in the 2001-2002 and 2002-2003 fiscal years (from
currently budgeted and projected expenditures based on current programs)
totaling about $7.597 billion. This includes the proposals made by the Governor
in November 2001, which were substantially enacted by the Legislature.
2. The receipt of $4.5 billion in 2002-2003 from the securitization (sale)
of a large portion of the State's future receipt of payment from tobacco
companies from the settlement of litigation against those companies.
3. A total of $1.729 billion in loans from various funds, including $1.095
billion from transportation funds.
4. The shift of $1.327 billion of expenditures from the General Fund to
other funding sources, such as special funds and proposed future bond funds.
5. General Fund savings of $1.276 billion in 2002-2003 from a temporary
reduction in the Vehicle License Fee offset level from 67.5 percent to 25
percent for the 2003 calendar year only.
6. The receipt of $1.2 billion additional revenues in 2002-2003 from a
two-year suspension of the net operating loss provisions in current law.
7. General Fund savings of $1.149 billion from a one-month deferral of
certain education disbursements from 2001-2002 to July 2002. This total includes
$76 million for the Instructional Time and Staff Development Reform Program, $61
million for the Standardized Testing and Reporting Program, $39 million for
Beginning Teacher Support and Assistance, $713 million for Targeted Instruction
30
Improvement Block Grant, $144 million for High Achieving/Improving Schools, and
$116 million for community colleges.
8. General Fund savings of $1.083 billion ($223 million in 2001-2002 and
$860 million in 2002-2003) from the Treasurer's Debt Restructuring Plan to
amortize the State's long-term debt to more closely approximate level annual
debt service costs rather than the level annual principal. The plan also
includes the issuance of refunding debt to pay selected maturities of general
obligation bonds due between February 2002 and June 2004.
9. Anticipated increases in federal funding for health and human services
programs, security/bioterrorism and other areas totaling about $1.081 billion.
10. Additional revenue of $938 million in 2002-2003 due to Federal Tax
Conformity ($432 million) and Tax Compliance ($506 million). The former is
comprised of a new proposal to change California tax law to conform with federal
tax law regarding accounting for bad debt reserves for large banks as well as
the pension and individual retirement account conformity package included in the
Governor's Budget, which was passed by the Legislature and signed by the
Governor on May 8, 2002. The latter is comprised of various proposals such as
waiving penalties and interest on delinquent accounts, increasing collections
activities, ensuring proper auditing of tax credits and improving the
effectiveness of the tax protest and settlement programs.
11. Accelerations and transfers from other funds to the General Fund
totaling $1.287 billion.
12. Additional revenues of $475 million in 2002-2003 from a 50-cent increase
in the tobacco excise tax.
All of these proposals are subject to consideration by the Legislature and,
in some cases, action by other bodies, such as the federal government. The final
outcome of these proposals will be known in the upcoming months.
Despite the challenge represented by the severe revenue decline and the
budget gap, the May Revision contains the following major components:
1. The May Revision proposed a 4.8 percent increase in K-12 funding for
2002-2003 above the revised 2001-2002 estimates. This would provide funding for
K-12 schools above the minimum requirement under Proposition 98 at the Test 2
level, fully funding statutory growth and cost-of-living adjustments. Total
Proposition 98 expenditures for education would be about $7,186 per pupil, an
increase from the estimated level of $6,618 for 2001-2002. In addition, the May
Revision preserves funding for key education initiatives including teacher
development and recruitment, instructional materials, class size reduction,
assisting low performing schools, and before and after school care expansion.
2. Although the May Revision proposes to reduce funding for higher education
by 0.6 percent in 2002-2003 compared to the revised estimates for 2001-2002, the
proposed reductions are intended to have no direct effect on core classroom
instructional needs. In spite of budget constraints, the May Revision provides
full funding for enrollment increases at the University of California,
California State University and the Community Colleges. The May Revision also
continues funding for the new University of California campus at Merced,
scheduled to open in the fall of 2004.
3. The Governor proposed a total of $30 billion in new general obligation
bonds for local school construction and higher education facilities to be
included in amounts of $10 billion each on the 2002, 2004 and 2006 statewide
ballots. Almost all of the last voted bond authorization, $9.2 billion approved
in 1998, has been allocated.
4. Youth and adult corrections expenditures will be reduced by 3.7 percent
from the previous year, reflecting slowing inmate population growth, while
31
protecting public safety. Health and human services expenditures will be reduced
by 5.3 percent, while providing health insurance coverage for children and
critical care programs for seniors. Combined expenditures for other programs,
such as transportation, resources, environmental protection, general government
and tax relief, will be reduced by 4.2 percent in the aggregate. Many capital
outlay projects currently funded out of the General Fund are proposed to be
funded with bond funding.
5. In addition to the 6,600 positions eliminated since 1999, the May
Revision proposes to eliminate an additional 4,000 state government positions.
The first priority for elimination in each department will be vacant positions
not required to maintain critical public health and safety functions. A process
will be established for the elimination of filled positions in accordance with
state laws, regulations and Memoranda of Understanding with represented
employees.
FISCAL YEAR 2002-2003 BUDGET ACT. The Fiscal Year 2002-2003 Budget Act (the
"2002 Budget Act") was signed by the Governor on September 5, 2002, almost nine
weeks after the start of the fiscal year. The spending plan for 2002-2003
includes General Fund expenditures of $76.7 billion, a reduction of $141 million
from Fiscal Year 2001-2002. The 2002 Budget Act contains a reserve of $1.035
billion.
The 2002 Budget Act closed the $23.6 billion budget gap between expenditures
and revenues (the "Budget Gap") through a combination of program reductions,
loans, fund shifts, accelerations and transfers and modest tax changes. Program
reductions and the receipt of funds from the tobacco securitization settlement
account for approximately 50 percent of the approach to close the Budget Gap.
The following are important changes to the proposals contained in the May
Revision to close the Budget Gap:
1. A total of $2.028 billion in loans from various funds, an increase from
the $1.729 proposed in the May Revision.
2. General Fund savings of $1.728 billion from a one-month deferral of
certain education disbursements, an increase from the $1.149 billion proposed in
the May Revision.
3. The General Fund savings of $1.276 billion in 2002-2003 from a temporary
reduction in the Vehicle License Fee offset level proposed in the May Revision
was not included in the 2002-2003 Budget Act to address the Budget Gap.
The 2002 Budget Act contains the following notable changes since the May
Revision:
1. The 2002 Budget Act increases K-12 funding to $30.8 billion, a 2.1
percent increase from the May Revision; and
2. The 2002 Budget Act eliminates 7,000 State government positions, an
increase of 4,000 positions from the May Revision.
Complete text of the 2002 Budget Act may be found at the website of the
Department of Finance, WWW.DOF.CA.GOV, under the heading "California Budget."
FUTURE BUDGETS
It cannot be predicted what actions will be taken in the future by the State
Legislature and the Governor to deal with changing State revenues and
expenditures. The State budget will be affected by national and State economic
conditions and other factors.
RATINGS
As of March 2002, the following ratings for the State of California general
obligation bonds have been received from Moody's Investors Service, Inc.
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("Moody's"), Standard & Poor's, a division of The McGraw-Hill Companies, Inc.
("S&P") and Fitch, Inc. ("Fitch"):
FITCH MOODY'S S&P
----- ------- ---
AA A1 A+
Currently, the State's rating outlook with Moody's and S&P remains negative
and its rating with Fitch remains on rating watch -- negative.
These ratings apply to the State only and are not indicative of the ratings
assigned to local governments, such as counties, cities, school districts and
other local agencies.
Any explanation of the significance of such ratings may be obtained only
from the rating agency furnishing such ratings. There is no assurance that such
ratings will continue for any given period of time or that they will not be
revised downward or withdrawn entirely if, in the judgment of the particular
rating agency, circumstances so warrant.
RECENT DEVELOPMENTS REGARDING NATURAL GAS AND ELECTRICITY
During the past year California has experienced difficulties with the prices
and supplies of natural gas and electricity in much of the State. These
difficulties are likely to continue for several years. The State Department of
Finance believes there is potential for economic disruption if power supplies
are interrupted, and that longer term business investment and location decisions
may be adversely affected by potential disruptions.
Shortages of electricity available within the service areas of California's
three investor-owned utilities (the "Utilities") have resulted in the need to
implement rotating electricity blackouts, affecting millions of Californians, on
several occasions since the start of 2001. Following the first incidence of such
blackouts in January 2001, the Governor proclaimed a state of emergency to exist
in California under the California Emergency Services Act (the "Emergency
Services Act") on the basis that the electricity available from California's
Utilities was insufficient to prevent widespread and prolonged disruption of
electric service in California. The Governor directed the State Department of
Water Resources ("DWR") to enter into contracts and arrangements for the
purchase and sale of electric power as necessary to assist in mitigating the
effects of the emergency (the "Power Supply Program"). Following the Governor's
proclamation under the Emergency Services Act, the Power Supply Program was
further authorized by the enactment of legislation (Chapter 4 and 9, First
Extraordinary Session of 2001, hereafter referred to as the "Power Supply Act")
and the adoption of related orders by the California Public Utilities Commission
("CPUC").
DWR began selling electricity to 10 million retail electric customers in
California in January 2001. DWR purchases power from wholesale supplies under
long-term contracts and in short-term and spot market transactions. DWR
electricity is delivered to the customers through the transmission and
distribution systems of the Utilities and payments from the customers are
collected for DWR by the Utilities pursuant to servicing arrangements ordered by
the CPUC. The DWR power supply program is expected to supply the shortfall (the
"net short") between the amount of electricity required by customers of the
Utilities and the amount of electricity furnished to customers by the Utilities
until December 31, 2002. The Governor and the CPUC are developing plans for the
provision of the net short after 2002, including plans to enable each of the
Utilities to be able to furnish the portion of the net short not provided by
DWR's long-term contracts (the "residual net short"). Alternatively, it is
possible that the authorization of DWR to provide the residual net short will be
extended by legislation or that another State agency will be authorized to
develop a successor program.
DWR's Power Supply Program has been financed by unsecured loans from the
General Fund (and certain other funds) of the State, plus retail customer
payments received by DWR. As of May 31, 2002, DWR had, since the start of the
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program on January 17, 2001, incurred power purchase obligations and
administrative expenses aggregating slightly more than $13 billion, of which
$6.2 billion was advanced from the General Fund (of which $116 million has
already been repaid) and $5.2 billion was paid from retail customer payments
received by the DWR. Advances from the General Fund ceased in June 2001 after
DWR arranged secured loans from banks and other financial institutions (the
"Interim Loans"), providing net proceeds aggregating approximately $4.1 billion.
Pursuant to the Power Supply Act, DWR plans to issue approximately $11
billion of revenue bonds to fund its Power Purchase Program (or provide
long-term financing for costs that have been financed on an interim basis with
advances from the General Fund of the State and an interim loan from certain
lenders). The revenue bonds will be repaid from a dedicated revenue stream
derived from retail end use customer payments for electricity. Completion of the
DWR bond sale is dependant on a number of factors. The timing of the bond sale
is uncertain but DWR expects it to occur in 2002. The State may make additional
loans or other advances from the State General Fund to support the Power Supply
Program subsequent to the issuance of the DWR revenue bonds. Alternative sources
of additional funding for the power supply program (if needed) would be rate
increases and additional revenue bonds or other obligations. The principal
amount of revenue bonds that can be issued by DWR may not exceed $13.4 billion.
The terms of the Interim Loans require that the DWR revenue bond proceeds be
used to prepay the Interim Loans before being used to repay the State loans or
to pay expenses of the Power Supply Program. Unless the Interim Loans are
prepaid, Interim Loan principal is payable in eleven quarterly installments
commencing on April 30, 2002. Currently, there is $3.8 billion outstanding.
Interest is payable at variable rates tied to market indices. Interest was
capitalized through February 2002, and thereafter principal and interest are
payable solely from revenues from power sales and other funds of the Power
Supply Program after provision is made for the payment of power purchase costs
and other operating expenses of the Power Supply Program. The Interim Loans are
not a general obligation of the State and are not repayable from or secured by
the General Fund. The loan agreement does not provide for acceleration of the
Interim Loans if DWR is not in compliance with the terms of the loan agreement.
DWR's current revenue requirement includes amounts sufficient to pay scheduled
Interim Loan debt service until a new revenue requirement can be implemented.
Delays in issuing the DWR revenue bonds would in turn delay the DWR's
planned loan repayments to the General Fund and may require additional loans
from the General Fund. If State loans to the DWR affect available resources to
pay for normal State operations, the State could issue short-term obligations to
maintain adequate cash reserves. The State has issued short-term obligations in
the past to meet its cash flow needs.
On April 6, 2001, Pacific Gas & Electric ("PG&E"), a Utility, filed for
voluntary protection under Chapter 11 of the federal Bankruptcy Code. The
bankruptcy proceedings (hereafter the "PG&E Bankruptcy") are pending in U.S.
Bankruptcy Court in San Francisco, California. During the PG&E Bankruptcy, it is
anticipated that PG&E's operations will continue under current management, while
the Bankruptcy Court decides on the allocation of PG&E's available cash flow and
assets among its various creditors. The State has filed numerous claims as a
creditor of PG&E, including, but not limited to, claims for income and property
taxes, regulatory fees, fines and penalties and environmental fees, fines and
penalties. PG&E or other parties to the PG&E Bankruptcy may seek to have the
Bankruptcy Court take actions that affect prices charged to end users for
electricity or affect existing contracts for purchase or sale of electricity.
Bankruptcies involving large and complex companies typically take several years
to conclude. PG&E's parent company, PG&E Corp., has not filed for bankruptcy
protection. On September 20, 2001, PG&E filed its reorganization plan with the
Bankruptcy Court. The plan seeks an extensive restructuring of PG&E's business
and the transfer of certain of its assets, including its electric and gas
transmission assets, to newly created limited liability companies. PG&E has also
filed the plan at FERC, the Securities and Exchange Commission and the Nuclear
Regulatory Commission seeking their approval of the elements under their
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jurisdiction. On November 27, 2001, the CPUC filed its opposition to the PG&E
disclosure statement describing the reorganization plan. On February 27, 2002,
the CPUC filed a term sheet on an alternate plan of reorganization. The
Bankruptcy Judge accepted the term sheet, and ordered the CPUC to file a plan of
reorganization and disclosure statement by April 15, 2002 with no date set for a
hearing. On April 3, 2002, PG&E filed an amended disclosure statement and plan
of reorganization. A hearing on PG&E's amended plan of reorganization was held
on April 11, 2002. On April 15, 2002, the CPUC filed an alternate plan of
reorganization and disclosure statement. Both plans have been submitted to the
creditors for voting. The Bankruptcy Judge has scheduled July 17, 2002, as the
date for filing objections for both plans and August 12, 2002 as the date by
which creditors must return their ballots accepting or rejecting the plans. The
votes have not yet been counted. On August 23, 2002, the CPUC and the creditors'
committee reached an agreement to ask the Bankruptcy Judge to reopen the vote
and let creditors consider a revised version of the CPUC plan.
Southern California Edison ("SCE"), a Utility, has not sought protection of
or been forced into bankruptcy, although this may change in the future. SCE has
entered into a Memorandum of Understanding with the Governor designed to
strengthen its financial condition.
All three Utilities have applications pending before the CPUC seeking
authorization to increase rates further to recover past losses and increase
future revenues. On October 2, 2001, SCE and the CPUC announced the proposed
settlement of certain pending litigation which is intended to allow SCE to
recover from ratepayers a substantial portion of its accumulated debts. The
settlement was approved by the federal District Court on October 5, 2001. A
consumer group has appealed that decision. The group's motions for stay of
judgment pending appeal have been denied by both the District Court (on remand)
and the appellate court. Oral argument on that appeal occurred on March 7, 2002,
but the Court has not yet ruled. SCE had previously indicated that it might seek
bankruptcy law protection if the Legislature did not enact legislation to assist
its financial recovery. See "Pending Litigation" below for a discussion of
related lawsuits. The amount and timing of further rate increases for
electricity supplied by DWR and the Utilities may be affected by a number of
factors, including rehearings and appeals of the applicable CPUC orders and the
PG&E Bankruptcy.
A number of lawsuits have been filed concerning various aspects of the
current energy situation. These include disputes over rates set by the CPUC;
responsibility for electricity and natural gas purchases made by the Utilities
and the California Independent System Operator (the "ISO"); continuing
obligations of certain small power generators; and antitrust and fraud claims
against various parties. (See "Pending Litigation" below for a discussion of
certain of these lawsuits and further discussion of the PG&E Bankruptcy.)
California imports a substantial amount of its natural gas. Limited gas
transmission pipeline capacity into California and a major pipeline break in New
Mexico during the summer of 2000, coupled with increases in wholesale prices for
natural gas in the United States, have resulted in substantial price increases
that are being passed on to business and residential consumers. Also, local
municipalities and governmental entities are paying increased service costs,
which might negatively impact their budgets. Pipeline expansion is planned but
will not be complete for several years. Nationwide, relatively high prices for
natural gas are likely to persist for several years. Supplies of natural gas in
northern and central California are also being affected by the financial
difficulty of the utility company serving that region. Shortages of natural gas
supplies could adversely affect the economy, and particularly generation of
electricity, much of which is fueled by natural gas.
Since January 2001, the Governor and Legislature have implemented a number
of steps through new laws and Executive Orders to respond to the energy problems
in the State. These steps include expediting power plant construction and other
means of increasing electricity supplies, implementing vigorous energy
conservation programs, and entering into long-term power supply and natural gas
supply contracts to reduce reliance on spot markets. The Governor believes the
35
combination of these steps, along with moderate temperatures, allowed the State
to avoid any electricity interruptions during the peak summer energy demand
season.
While the State expects that over time the measures described above, coupled
with conservation, load management and improved energy efficiency, will continue
to enable the State to avoid disruptions of the supply of electricity to the
public, and will maintain lower wholesale power prices and ultimately promote
the financial recovery of the Utilities, the situation continues to be fluid and
subject to many uncertainties. There can be no assurance that there will not be
future disruptions in power supplies or related developments which could
adversely affect the State's economy, and which could in turn affect State
revenues, or the health and comfort of its citizens. Further, the PG&E
Bankruptcy interjects a new party, the federal Bankruptcy Court, into the making
of decisions regarding future electricity costs and the role of PG&E. There can
be no assurance that there will not be future disruptions in energy supplies or
related developments that could adversely affect the State's and local
governments' economies, the State's business climate and that could in turn
affect State and local revenues.
LOCAL GOVERNMENTS
The primary units of local government in California are the counties,
ranging in population from 1,200 (Alpine) to over 9,800,000 (Los Angeles).
Counties are responsible for providing many basic services, including indigent
healthcare, welfare, jails and public safety in unincorporated areas. There are
also about 478 incorporated cities and thousands of special districts formed for
education, utility and other services. The fiscal condition of local governments
has been constrained since the enactment of "Proposition 13" in 1978 and other
constitutional amendments, which reduced and limited the future growth of
property taxes and limited the ability of local governments to impose "special
taxes" (those devoted to a specific purpose) without two-thirds voter approval.
Counties, in particular, have had fewer options to raise revenues than many
other local governmental entities, and have been required to maintain many
services.
In the aftermath of Proposition 13, the State provided aid to local
governments from the General Fund to make up some of the loss of property tax
moneys, including taking over the principal responsibility for funding local
K-12 schools and community colleges. During the recession of the early 1990s,
the Legislature eliminated most of the remaining components of the
post-Proposition 13 aid to local government entities other than K-14 education
districts, by requiring cities and counties to transfer some of their property
tax revenues to school districts. However, the Legislature also has provided
additional funding sources (such as sales taxes) and reduced certain mandates
for local services. Local governments sued the State (Sonoma County, et al. v.
Commission on State Mandates, et al.) over these transfers. The appeals court
denied the plaintiffs' position and the subsequent appeal was not heard by the
State Supreme Court.
Since then the State has also provided additional funding to counties and
cities through various programs. The 2001 Budget Act and related legislation
provide assistance to local governments, including $357 million for various
local public safety programs, including the Citizens' Option for Public Safety
("COPS") program to support local front-line law enforcement, sheriffs'
departments for jail construction and operations, and district attorneys for
prosecution, $154 million for deferred maintenance of local streets and roads,
$60 million in assistance for housing, $209 million for mental health and social
services and $34 million for environmental protection. For 2002-2003 the State
proposes to continue to provide $121.3 million for the COPS program,
approximately $134 million for deferred maintenance of local streets and roads,
$38 million for environmental protection and hundreds of millions for health and
human services. Nevertheless, the energy situation may have an impact on whether
these moneys are actually allocated to the local governments. (See "Recent
Developments Regarding Natural Gas and Electricity" above.)
The economies of various local governments may be negatively affected by the
energy situation in California. (See "Recent Developments Regarding Natural Gas
and Electricity" above.) Additionally, for the majority of local governments
that do not have publicly owned utilities, the increased charges for power will
36
have budgetary impact, but the degree of that impact cannot be ascertained at
this time.
The entire Statewide welfare system was changed in response to the change in
federal welfare law in 1996. The federal block grant formula established in 1996
is operative through federal fiscal year 2002. Under the revised basic State
welfare system, California Work Opportunity and Responsibility to Kids
("CalWORKs"), counties are given flexibility to develop their own plans,
consistent with State law, to implement Welfare-to-Work and to administer many
of its elements and their costs for administrative and support services are
capped at 1996-1997 levels. Counties are also given financial incentives if, at
the individual county level or statewide, the CalWORKs program produces savings
associated with specified Welfare-to-Work outcomes. Under Ca1WORKs, counties
will still be required to provide "general assistance" aid to certain persons
who cannot obtain welfare from other programs.
Administration of the CalWORKs program is largely at the county level, and
the counties receive financial incentives for success in this program. Beginning
in 2000-2001, county performance incentive earnings are subject to Budget Act
appropriation. Counties will have earned $1.2 billion through the end of
2001-2002, but have only spent $186.6 million through December 2001. Because the
Department of Social Services (the "DSS") has allocated $1.1 billion to
counties, the majority of this funding currently resides in county bank
accounts.
Recently, the federal government formally notified the DSS that the State is
in violation of the federal Cash Management Act in drawing down federal
Temporary Assistance for Needy Families ("TANF") dollars for fiscal incentive
purposes that were not going to be immediately spent by the counties. TANF is a
federal block grant program with lifetime time limits on TANF recipients, work
requirements and other welfare reform changes. Under the Cash Management Act,
TANF funds are to remain at the federal level until such time as a state is
going to actually expend those funds. The DSS plans to recover the $600 million
that is expected to remain unexpended by the counties. The May Revision to the
2002 Governor's Budget proposes to use $169.2 million as a funding source in
2002-2003 to maintain CalWORKS funding within available resources and $120
million to fund a one-time augmentation to CalWORKS employment services. The
remaining, $310.8 million will be appropriated to counties for 2002-2003. In
addition to $97 million in incentives earned prior to 2000-2001, $169.2 million
may need to be paid to counties in the future. The $120 million would not need
to be paid back because the counties would be required to waive their
entitlement to these incentive funds as a condition for receipt of the one-time
employment services augmentation.
Welfare caseloads have declined considerably with the implementation of the
CalWORKs program. The 2002-2003 CalWORKS caseload is projected to be 524,000, up
from 507,000 cases in 2001-2002. This represents a major improvement from the
rapid growth of the early 1990s, when caseload peaked at 921,000 cases in
1994-1995. The longer-term impact of the Law and CalWORKS is being evaluated by
the RAND Corporation, with a series of reports to be furnished and the final
report to be released in 2002.
The 2001-2002 CalWORKs budget reflects that California has met the
federally-mandated work participation requirements for federal fiscal years
1997, 1998, 1999, and 2000. Having met that goal, the federally-imposed
maintenance-of-effort ("MOE") level for California was reduced from 80 percent
of the federal fiscal year 1994 baseline expenditures for the former Aid to
Families with Dependent Children ("AFDC") program ($2.9 billion) to 75 percent
($2.7 billion). It is expected that California will continue to meet the work
participation goal in federal fiscal year 2001 and beyond. In addition, it is
assumed that California will receive a TANF High Performance Bonus award of $20
million in 2001-2002. This bonus will be awarded to states for their successes
in moving welfare recipients to work and sustaining their participation in the
workforce during federal fiscal year 2001. California also received a TANF High
Performance Bonus Award in 1999-2000 and 2000-2001 based upon the State's
success during federal fiscal years 1999 and 2000 respectively.
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In 2002-2003 it is anticipated that California will continue to meet, but
not exceed, the federally-required $2.7 billion combined State and county MOE
requirement. The May Revision includes total CalWORKs-related expenditures of
$7.4 billion for 2002-2003, including child care transfer amounts for the
Department of Education and the general TANF Block Grant reserve.
Authorization for the TANF program ends September 30, 2002. For the TANF
program to continue, the U.S. Congress must pass, and the President must sign,
legislation reauthorizing the program prior to that date. Although
reauthorization could simply involve extending the funding period, it is more
likely that Congress and the President will consider several key policy changes.
It is unknown at this time how California's TANF funding will be affected by
reauthorization.
Historically, funding for the State's trial court system was divided between
the State and the counties. In 1997, legislation consolidated the trial court
funding at the State level in order to streamline the operation of the courts,
provide a dedicated revenue source and relieve fiscal pressure on the counties.
Since then, the county general purpose contribution for court operations was
reduced by $415 million and cities are retaining $68 million in fine and penalty
revenue previously remitted to the State. The State's trial court system will
receive approximately $1.7 billion in State resources and $475 million in
resources from the counties in 2002-2003.
TOBACCO LITIGATION. In late 1998, the State signed a settlement agreement
with the four major cigarette manufacturers. The State agreed to drop its
lawsuit and not to sue in the future for monetary damages. Tobacco manufacturers
agreed to billions of dollars in payments and restrictions in marketing
activities. Under the settlement agreement, the tobacco manufacturers agreed to
pay California governments a total of approximately $25 billion (subject to
adjustments) over a period of 25 years. Beyond 2025, payments of approximately
$900 million per year will continue in perpetuity. Under a separate Memorandum
of Understanding, half of the moneys will be paid to the State and half to local
governments (all counties and the cities of San Diego, Los Angeles, San
Francisco and San Jose). During Fiscal Year 2000-2001, the General Fund received
$386 million in settlement payments. The 2001 Budget Act forecasts payments to
the State totaling $488 million in 2001-2002 of which $86 million will go to the
General Fund and the balance will be in a special fund to pay certain healthcare
costs and debt service payments for a Tobacco Settlement securitization. The
2001 Budget Act forecasts payments to the State totaling $474 million in
2002-2003, which will be deposited in a special fund to pay certain healthcare
costs and debt service payments for a tobacco settlement securitization.
The specific amount to be received by the State and local governments is
subject to adjustment. Details in the settlement agreement allow reduction of
the tobacco companies' payments because of certain types of federal legislation,
or decreases in cigarette sales. Settlement payments can increase due to
inflation or increases in cigarette sales. The "second annual" payment, received
in April 2002, was 15.3 percent lower than the base settlement amount due to
reduced sales. Future payment estimates have been reduced by a similar
percentage. In the event that any of the tobacco companies goes into bankruptcy,
the State could seek to terminate the agreement with respect to those companies
filing bankruptcy actions, thereby reinstating all claims against those
companies. The State may then pursue those claims in the bankruptcy litigation,
or as otherwise provided by law. Also, several parties have brought a lawsuit
challenging the settlement and seeking damages. (See "Constitutional and
Statutory Limitations; Future Initiatives; Pending Litigation" below.)
CONSTITUTIONAL AND STATUTORY LIMITATIONS; FUTURE INITIATIVES; PENDING LITIGATION
CONSTITUTIONAL AND STATUTORY LIMITATIONS. Article XIII A of the California
Constitution (which resulted from the voter-approved Proposition 13 in 1978)
limits the taxing powers of California public agencies. Article XIII A provides
that the maximum ad valorem tax on real property cannot exceed one percent of
the "full cash value" of the property and effectively prohibits the levying of
any other ad valorem tax on real property for general purposes. However, on June
3, 1986, Proposition 46, an amendment to Article XIII A, was approved by the
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voters of the State of California, creating a new exemption under Article XIII A
permitting an increase in ad valorem taxes on real property in excess of 1
percent for bonded indebtedness approved by two-thirds of the voters voting on
the proposed indebtedness and (as a result of a constitutional amendment
approved by California voters on November 7, 2000) on bonded indebtedness for
school facilities and equipment approved by 55 percent of the voters voting on
the bond measure, subject to certain restrictions. "Full cash value" is defined
as "the county assessor's valuation of real property as shown on the 1975-1976
tax bill under `full cash value' or, thereafter, the appraised value of real
property when purchased, newly constructed, or a change in ownership has
occurred after the 1975 assessment." The "full cash value" is subject to annual
adjustment to reflect increases (not to exceed two percent) or decreases in the
consumer price index or comparable local data, or to reflect reductions in
property value caused by damage, destruction or other factors.
On November 7, 2000, voters approved Proposition 39 called the "Smaller
Classes, Safer Schools and Financial Accountability Act" (the "Smaller Classes
Act"). The Smaller Classes Act amends Section 1 of Article XIII A, Section 18 of
Article XVI of the California Constitution and Section 47614 of the California
Education Code. Effective upon its passage, the newly added Section 18(b) of
Article XVI Allows an alternative means of seeking voter approval for bonded
indebtedness by 55 percent of the vote, rather than the two-thirds majority
required under Section 18 of Article XVI of the Constitution. The reduced 55
percent voter requirement applies only if the bond measure submitted to the
voters includes certain restrictions, identifications and certifications.
Section 1(b)(3) of Article XIII A has been added to except from the one percent
ad valorem tax limitation under Section 1(a) of Article XIII A of the
Constitution levies to pay bonds approved by 55 percent of the voters subject to
the restrictions with respect to the ballot measure.
The Legislature enacted AB 1908, Chapter 44, which became effective upon
passage of Proposition 39. AB 1908 amends various sections of the Education
Code. Under amendments to Sections 15268 and 15270 of the Education Code, the
following limits on ad valorem taxes apply in any single election: (1) for a
school district, indebtedness shall not exceed $30 per $100,000 of taxable
property; (2) for a unified school district, indebtedness shall not exceed $60
per $100,000 of taxable property; and (3) for a community college district,
indebtedness shall not exceed $25 per $100,000 of taxable property. Finally, AB
1908 requires that a citizens' oversight committee must be appointed who will
review the use of the bond funds and inform the public about their proper usage
and perform annual audits.
Article XIII B of the California Constitution limits the amount of
appropriations of the State and of the local governments to the amount of
appropriations of the entity for the prior year, adjusted for changes in the
cost of living, population and the services that local governments have
financial responsibility for providing. To the extent that the revenues of the
State and/or local governments exceed their appropriations, the excess revenues
must be rebated to the public either directly or through a tax decrease.
Expenditures for voter-approved debt service costs are not included in the
appropriations limit.
At the November 8, 1988 general election, California voters approved an
initiative known as Proposition 98. Proposition 98 changed State funding of
public education below the university level and the operation of the state
appropriations limit, primarily by guaranteeing K-14 schools a minimum share of
General Fund revenues.
Proposition 98 permits the Legislature by two-thirds vote of both houses,
with the Governor's concurrence, to suspend the K-14 schools' minimum funding
formula for a one-year period. Proposition 98 also contains provisions
transferring certain State tax revenues in excess of the Article XIII B limit to
K-14 schools.
During the recession in the early 1990's, General Fund revenues for several
years were less than originally projected, so that the original Proposition 98
appropriations turned out to be higher than the minimum percentage provided in
the law. The Legislature responded to these developments by designating the
39
"extra" Proposition 98 payments in one year as a "loan" from future years'
Proposition 98 entitlements and also intended that the "extra" payments would
not be included in the Proposition 98 "base" for calculating future years'
entitlements. By implementing these actions, per-pupil funding from Proposition
98 sources stayed almost constant at approximately $4,200 from the 1991-1992
Fiscal Year to the 1993-1994 Fiscal Year.
In 1992, a lawsuit was filed, called California Teachers' Association v.
Gould, that challenged the validity of these off-budget loans. The settlement of
this case, finalized in July 1996, provides, among other things, that both the
State and K-14 schools share in the repayment of prior years' emergency loans to
schools. Of the total $1.76 billion in loans, the State is repaying $935 million
by forgiveness of the amount owed, while schools are repaying $825 million. The
State's share of the repayment is reflected as an appropriation above the
current Proposition 98 base calculation. The schools' share of the repayment
counts either as appropriations that count toward satisfying the Proposition 98
guarantee, or as appropriations from "below" the current base. Repayments are
spread over the eight-year period of the 1994-1995 Fiscal Year through the
2001-2002 Fiscal Year to mitigate any adverse fiscal impact.
Increased General Fund revenues, above initial budget projections, in the
1994-1995 through 2000-2001 Fiscal Years along with policy decisions to increase
K-14 appropriations have resulted in retroactive increases in Proposition 98
appropriations from subsequent Fiscal Years' budgets. Because of the State's
increasing revenues and emphasis on improving education resources, per-pupil
funding at the K-12 level has increased by more than 65.2 percent from the level
in place in 1994-1995, to an estimated $7,186 per pupil in 2002-2003.
Although total revenues (General Fund subject to the State Appropriations
Limit (the "SAL") and local property taxes) have increased steadily since
1994-95, the projected level of General Fund SAL revenue has declined by over
$3.5 billion and $3.4 billion for 2001-2002 and 2002-2003, respectively, since
the 2002-2003 Governor's Budget. The estimate of the guarantee has increased
$1.184 billion since the Governor's Budget due primarily to increases in the
California per capita personal income and average daily attendance. In response
to the lower revised revenues for 2001-2002 and 2002-2003, and the increase in
the Proposition 98 guarantee in the budget year, the May Revision proposes to
defer $1.149 billion of undisbursed 2001-2002 appropriations. To further address
the overall fiscal situation in the current year, the May Revision proposes to
reappropriate over $503 million in unspent Proposition 98 funds from prior years
to backfill an identical decrease to the 2001-2002 Proposition 98 appropriation
level. The reductions in 2001-2002 Proposition 98 appropriations leave the total
appropriation at $5.5 billion above the Test 3 guarantee level.
The revenue projection for 2002-2003 exceeds the revised 2001-2002 estimates
by approximately $5.9 billion. The General Fund share of the guarantee will
increase approximately $2.7 billion, from $29.5 billion in 2001-2002 to $32.2
billion in 2002-2003. Total funding for K-14 education provides a funding level
of approximately $47.2 billion ($7,186 per K-12 pupil), an increase of nine
percent compared to the revised 2001-2002 level.
On November 5, 1996 voters approved Proposition 218 called the "Right to
Vote on Taxes Act" which incorporates Articles XIII C and XIII D into the
California Constitution. Those provisions enact limitations on the ability of
local government agencies to impose or raise various taxes, fees, charges and
assessments without voter approval. Certain "general taxes" imposed after
January 1, 1995 must be approved by voters in order to remain in effect. In
addition, Article XIII C clarifies the right of local voters to reduce taxes,
fees, assessments, or charges through local initiatives. There are a number of
ambiguities concerning the Proposition and its impact on local governments and
their bonded debt that will require interpretation by the courts or the State
Legislature. Proposition 218 does not affect the State or its ability to levy or
collect taxes.
At the November 1998 election, voters approved Proposition 2. This
proposition requires the General Fund to repay loans made from certain
transportation special accounts (such as the State Highway Account) at least
40
once per fiscal year, or up to 30 days after adoption of the annual budget act.
Since the General Fund may reborrow from the transportation accounts soon after
the annual repayment is made the proposition is not expected to have any adverse
impact on the State's cash flow.
Because of the complexities of Article XIII B, the ambiguities and possible
inconsistencies in its terms, the applicability of its exceptions and exemptions
and the impossibility of predicting future appropriations, the Fund cannot
predict the impact of this or related legislation on the bonds in the Fund's
portfolios. Other Constitutional amendments affecting State and local taxes and
appropriations have been proposed from time to time. If any such initiatives are
adopted, the State could be pressured to provide additional financial assistance
to local governments or appropriate revenues as mandated by such initiatives.
Propositions such as Proposition 98 and others that may be adopted in the future
may place increasing pressure on the State's budget over future years,
potentially reducing resources available for other State programs, especially to
the extent the Article XIII B spending limit would restrain the State's ability
to fund such other programs by raising taxes.
The voters of California adopted a statutory initiative ("Proposition 62")
at the November 4, 1986 election. Proposition 62, as enacted in the California
Government Code, among other things, generally (1) requires that any tax for
general governmental purposes imposed by local governmental entities be approved
by resolution or ordinance adopted by two-thirds vote of the governmental
agency's legislative body and by a majority of the electorate of the
governmental entity and (2) requires that any special tax (defined as taxes
levied for other than general governmental purposes) imposed by a local
governmental entity be approved by a two-thirds vote of the voters within that
jurisdiction.
Following its adoption by the voters, various provisions of Proposition 62
were declared unconstitutional at the appellate court level and in reliance on
such decisions many local governments imposed taxes without compliance with the
specified voter approval requirements of Proposition 62. On September 28, 1995,
however, the California Supreme Court, in SANTA CLARA COUNTY LOCAL
TRANSPORTATION AUTHORITY V. GUARDINO, upheld the constitutionality of the
portion of Proposition 62 requiring voter approval as a condition precedent to
the imposition of taxes by a local government.
On June 4, 2001, in HOWARD JARVIS TAXPAYERS ASSOCIATION V. CITY OF LA HABRA,
the California Supreme Court disapproved a December 15, 1997 holding in McBreaty
v. City of Brawley in which the State Court of Appeals concluded that the
three-year statute of limitations applicable to taxes subject to Proposition 62
requirements ran from the date of the Guardino decision. The Supreme Court held
that a local governmental entity's continued imposition and collection of a tax
without voter approval was an ongoing or continuous violation of Proposition 62
and that the validity of a tax measure may be challenged within the statutory
period after any collection of the tax, regardless of whether more than three
years had passed since the tax measure was adopted. Thus, each time an
unconstitutional tax is collected, the statute of limitations is triggered
again.
As a result of this ruling, absent the application of a different statute of
limitations, a tax originally imposed in violation of Proposition 62
requirements is potentially subject to court challenge within three years of its
collection. Various California local governments may be subject to challenge
under the LA HABRA ruling. Should a challenge be successful, Proposition 62
provides that the portion of the one percent general ad valorem property tax
levy allocated to that local government is reduced by $1 for every $1 in revenue
attributable to the improperly imposed tax for each year that such tax is
collected. The practical applicability of this provision has not been
determined. Future litigation and legislation may resolve some or all of the
issues raised by the GUARDINO AND CITY OF LA HABRA decisions.
FUTURE INITIATIVES. Articles XIII A, XIII B, XIII C and XIII D were each
adopted as measures that qualified for the ballot pursuant to the State's
initiative process. From time to time, other initiative measures could be
41
adopted that could affect revenues of the State or public agencies within the
State.
PENDING LITIGATION. The State of California is a party to numerous legal
proceedings, many of which normally occur in governmental operations. Some of
the more significant lawsuits pending against the State are described below.
The State is a defendant in PATERNO V. STATE OF CALIFORNIA, a coordinated
action involving 3,000 plaintiffs seeking recovery for damages caused by the
Yuba River flood of February 1986. The trial court found liability in inverse
condemnation and awarded damages of $500,000 to a sample of plaintiffs. The
State's potential liability to the remaining plaintiffs ranges from $800 million
to $1.5 billion. In 1992, the State and plaintiffs filed appeals. In August
1999, the court of appeal issued a decision reversing the trial court's judgment
against the State and remanding the case for retrial on the inverse condemnation
cause of action. The California Supreme Court denied plaintiffs' petition for
review. By "Intended Decision" dated September 11, 2001, following a four-month
bench trial, the judge ruled that the 3,000 plaintiffs take nothing from the
State or its co-defendant, Reclamation District 784. Plaintiffs have appealed.
Appellant's Opening Brief is due August 23, 2002.
On June 24, 1998, plaintiffs in Howard Jarvis Taxpayers Association et al.
v. Kathleen Connell filed a complaint for certain declaratory and injunctive
relief challenging the authority of the State Controller to make payments from
the State Treasury in the absence of a State budget. On July 21, 1998, the trial
court issued a preliminary injunction prohibiting the State Controller from
paying moneys from the State Treasury for Fiscal Year 1998-1999, with certain
limited exceptions, in the absence of a State budget. The preliminary
injunction, among other things, prohibited the State Controller from making any
payments pursuant to any continuing appropriation. On July 22 and July 27, 1998,
various employee unions that had intervened in the case appealed the trial
court's preliminary injunction and asked the court of appeal to stay the
preliminary injunction. On July 28, 1998, the court of appeal granted the
unions' requests and stayed the preliminary injunction pending the court of
appeal's decision on the merits of the appeal. On August 5, 1998, the court of
appeal denied the plaintiffs' request to reconsider the stay. Also on July 22,
1998, the State Controller asked the California Supreme Court to immediately
stay the trial court's preliminary injunction and to overrule the order granting
the preliminary injunction on the merits. On July 29, 1998, the Supreme Court
transferred the State Controller's request to the court of appeal. On May 29,
2002, the court of appeal upheld the Controller's authority to make payments
pursuant to continuing appropriations in the absence of a state budget. Thus,
the Controller may make payments of principal and interest on state bonds.
However, the Court of Appeal held that absent an adopted budget or emergency
appropriation, the State Controller could not disburse certain Proposition 98
moneys. This ruling could result in the State suspending certain Proposition 98
payments to school districts for Fiscal Year 2002-2003 if the State does not
adopt a budget or pass an emergency appropriation in order to make such
payments. In prior years the State has enacted an emergency appropriation in the
absence of an adopted budget in order to disburse Proposition 98 moneys to the
State's school districts.
In COUNTY OF ORANGE V. ORANGE COUNTY ASSESSMENT APPEALS BOARD #3; BEZAIRE,
ET. AL., REAL PARTIES IN INTEREST, the Superior Court of Orange County has
determined that the Orange County assessor's office received property taxes from
two taxpayers in excess of the amounts collectable under Article XIIIA of the
California Constitution (sometimes referred to as "Proposition 13"). The
plaintiffs' legal claim focuses on the constitutionality of the practice of the
Orange County assessor's office to increase or "recapture" the assessed values
of real properties that temporarily decline and then increase in value. The
plaintiffs are also seeking the certification of their action as a class action.
Pending the determination of certain class certification issues, the court's
decision is not final. Should the court's determination become final, it will
bind only the County of Orange and its assessor's office. However, indirect
effects of a final determination that the contested assessment practices are
contrary to Proposition 13, could result in costs to the State in an aggregate
amount in excess of $400 million.
42
In January of 1997, California experienced major flooding with preliminary
estimates of property damage of approximately $1.6 to $2.0 billion. In MCMAHON
V. STATE, a substantial number of plaintiffs have joined suit against the State,
local agencies, and private companies and contractors seeking compensation for
the damages they suffered as a result of the 1997 flooding. After various
pre-trial proceedings, the State filed its answer to the plaintiffs' complaint
in January 2000. The State is defending the action.
The State has been involved in three refund actions, CALIFORNIA ASSN. OF
RETAIL TOBACCONISTS (CART), ET AL. V. BOARD OF EQUALIZATION ET AL., CIGARETTES
CHEAPER! ET AL. V. BOARD OF EQUALIZATION, ET AL. AND MCLANE/SUNEAST, ET AL. V.
BOARD OF EQUALIZATION, ET AL., that challenge the constitutionality of
Proposition 10, which the voters passed in 1998 to establish the Children and
Families Commission and local county commissions and to fund early childhood
development programs. CART AND CIGARETTES CHEAPER! allege that Proposition 10,
which increases the excise tax on tobacco products, violates 11 sections of the
California Constitution and related provisions of law. McLane/Suneast challenges
only the "double tax" aspect of Proposition 10. Trial of these three
consolidated cases commenced on September 15, 2000 and concluded on November 15,
2000. A final statement of decision was issued on December 7, 2000, and judgment
in favor of all defendants as to all 30 consolidated counts was entered on
January 9, 2001. The CART plaintiffs and CIGARETTES CHEAPER! plaintiffs timely
appealed these and all other issues. Respondents filed their brief on July 5,
2002. Reply briefs are due September 3, 2002. Due to the facial challenge, there
is exposure as to the entire $750 million per year collected under Proposition
10 together with interest, which could amount to several billion dollars by the
time the cases are finally resolved.
In CHARLES DAVIS, ET AL. V. CALIFORNIA HEALTH AND HUMAN SERVICES AGENCY, ET
AL., the plaintiffs have brought a class action under a number of federal acts,
including the Americans with Disabilities Act, seeking declaratory and
injunctive relief, alleging that persons who are institutionalized with
disabilities at a San Francisco-run 1,200-bed skilled nursing facility (Laguna
Honda) who require long term care should be assessed as to whether they can be
treated at home or in community-based facilities, and then provided appropriate
care. The State has filed an answer. At this early stage in the proceedings, it
is difficult to assess the financial impact of a judgment against the State.
Should the plaintiffs prevail, however, the State's liability could exceed $400
million. The State is defending this action.
In STEPHEN SANCHEZ, ET AL. V. GRANTLAND JOHNSON, ET AL., the plaintiffs have
brought a class action in federal District Court for the Northern District of
California, seeking declaratory and injunctive relief, alleging, in part, that
provider rates for community-based services for developmentally disabled
individuals are discriminatory under the Americans with Disabilities Act, and
violate the Social Security Act, the Civil Rights Act and the Rehabilitation
Act, because they result in unnecessary institutionalization of developmentally
disabled persons. The State has filed a responsive pleading and is contesting
this case. At this early stage in the proceedings, it is difficult to assess the
financial impact of a judgment against the State. Should the plaintiffs prevail,
however, the State's liability could exceed $400 million.
A number of lawsuits have been commenced concerning various aspects of the
current energy situation. These include disputes over rates set by the CPUC;
responsibility for the electricity and natural gas purchases made by the
Utilities and the ISO and the just and reasonable nature of certain of DWR's
long-term power purchase contracts. Except for the consolidated actions
challenging the Governor's authority to commandeer "block forward contracts"
referred to below, these actions do not seek a judgment against the State's
General Fund, and in some cases neither the State nor the DWR is even a party to
these actions. However, these cases may have an impact on the price or supply of
energy in California, or impact the timing of the sale of the DWR revenue bonds
expected to occur in 2002.
More than thirty market participants filed claims aggregating over $1
billion for compensation from the State as a result of the Governor's
43
commandeering of block forward contracts by Executive Orders in February 2001.
The Victim Compensation and Government Claims Board was divested of jurisdiction
to hear these claims as a result of a petition for writ of mandate by claimants
the California Power Exchange ("CalPX"), PG&E and Reliant. The issue of whether
and to what extent compensation is due is now before the Sacramento County
Superior Court in a declaratory relief action filed by the State, PEOPLE V. ACN
ENERGY, INC., ET AL. (O1AS05497), which names as defendants those market
participants which the State believes might claim compensation as a result of
the Governor's actions. Pending inverse condemnation actions against the State
by the CalPX (Los Angeles County Superior Court No. BC 254509), PG&E (San
Francisco City and County Superior Court No. 322921) and Reliant (Los Angeles
County Superior Court No. BC 254563) have been joined with the declaratory
relief action in JUDICIAL COUNCIL COORDINATION PROCEEDING NO. 4203, the
Sacramento County Superior Court. The applicable Bankruptcy Courts have granted
relief from the automatic stay of bankruptcy to enable the parties to prosecute
and defend to final judgment the claims pertaining to PG&E and the Ca1PX.
In DUKE ENERGY TRADING AND MARKETING V. DAVIS, ET AL. (U.S. District Court,
C.D. Cal.), the plaintiff challenges the Governor's orders commandeering SCE and
PG&E block forward market contracts held by the California Power Exchange on the
ground that the orders violated the Supremacy Clause and other constitutional
provisions. Duke Energy seeks a temporary restraining order ("TRO") and an
injunction barring the Governor from taking any action against Duke Energy under
the authority of the Executive Orders and a declaration that Duke Energy has no
obligation to deliver power under the block forward contracts. The hearing on
the TRO, seeking an order restraining the ISO from requiring the energy producer
to supply energy under the contracts, was taken off calendar. Pursuant to an
interim settlement, Duke Energy delivered power to the DWR through April 30,
2001. On April 30, 2001, the U.S. district court granted Governor Davis' motion
to dismiss plaintiff's complaint based on Eleventh Amendment immunity and denied
plaintiff's motions for partial summary judgment to certify final judgment. On
May 4, 2001, Duke Energy dismissed its claims in the district court against
co-defendant, the Power Exchange, without prejudice and filed its notice of
appeal to the Ninth Circuit Court of Appeal. The United States Court of Appeals
for the Ninth Circuit found that the EX PARTE Young exception to the Eleventh
Amendment applied and that the Governor's interference with the block forward
contracts' security provisions was preempted by the federal scheme established
by FERC. The Governor's petition for certiorari in the United States Supreme
Court was denied on May 30, 2002.
In PACIFIC GAS AND ELECTRIC COMPANY V. THE CALIFORNIA DEPARTMENT OF WATER
RESOURCES, ET AL. (Sacramento County Superior Court, 01CS01200) PG&E contends
that when DWR reached the determination that its revenue requirement for 2001-02
was "just and reasonable" (a determination the Power Supply Act authorizes DWR
to make), DWR failed to follow the California Administrative Procedure Act (the
"APA"). On June 7, 2002, the superior court issued a judgment finding that DWR
had failed to follow the APA in making its "just and reasonable" determination,
and commanded DWR to follow the procedures mandated by the APA before making any
"just and reasonable" determination. The court's order also stated that its
ruling does not in any way affect any action taken by the CPUC, including the
enforcement and collection of certain existing rates and charges based on a CPUC
order implementing cost recovery of DWR's 2001-02 revenue requirement (CPUC
Decision 02-02-052, dated February 21, 2002, and mailed February 22, 2002). This
matter may be appealed during the 60 days following the notice of entry of
judgment. DWR has not yet determined whether to appeal this decision. The
California Supreme Court denied a petition filed by DWR in this same case
seeking review of an earlier decision of the superior court denying DWR's motion
for judgment on the pleadings.
In CARBONEAU V. STATE OF CALIFORNIA ET AL., filed on November 9, 2001 in
Sacramento Superior Court (01AS06848), the plaintiffs make factual allegations
that include, among others, that certain named defendants who participated in
the negotiation of certain long-term contracts had conflicts of interest. The
plaintiffs plead, among other things, that in negotiating these power contracts,
defendants engaged in unfair business practices and violated anti-trust laws.
Plaintiffs seek declaratory and injunctive relief as well as damages, with a
44
main objective being to have all electricity contracts entered into by the DWR
since January 2001 declared void as against public policy. On May 17, 2002, the
Superior Court issued a tentative ruling granting the State's demurrer of
plaintiffs' complaint, without leave to amend.
In MCCLINTOCK, ET. AL. V. BUDHRAJA, DWR, ET. AL., filed May 1, 2002, in Los
Angeles County Superior Court (GC029447), plaintiffs, including eight members of
the California State Legislature, allege a DWR consultant involved in
negotiating certain of the long-term power contracts had a conflict of interest,
and as a result certain of the long-term contracts are void. The plaintiffs
seek, among other things, to restrain or enjoin DWR's performance under the
long-term power contracts, a declaration that the contracts are void, an order
of restitution to the General Fund of amounts paid by the State to power
providers, and an order of restitution to the General Fund of amounts paid by
the State to power providers with knowledge of the conflict.
In MILLAR V. ALLEGHENY ENERGY, ET. AL., filed May 13, 2002, in San Francisco
City and County Superior Court (407867), plaintiff alleges that the sellers who
entered into certain of the long-term power contracts engaged in unfair business
acts and practices, and seeks to enjoin the enforcement of certain terms and
conditions of the long-term power contracts and restitution of moneys wrongfully
obtained by the power providers. DWR is named solely as a "nominal defendant,"
and restitution is not sought from DWR or the State.
In SEMPRA ENERGY RESOURCES V. DEPARTMENT OF WATER RESOURCES, filed May 29,
2002, in San Diego County Superior Court (789291), plaintiff seeks declaratory
relief as to the respective rights and duties of plaintiff and DWR under the
long-term energy contract between the parties. Plaintiff claims that it is not
in breach of that contract, and that moreover, its actions would not constitute
a material breach entitling DWR to suspend its performance under the contract.
At the time the California energy market was deregulated, the CPUC froze IOU
rates at levels then thought to be sufficient to permit the Utilities an
opportunity to recover certain pre-deregulation costs from their customers. SCE
and PG&E have alleged that these rates are insufficient to permit recovery of
FERC-tariffed power purchase costs, and have sought to have the rate freeze
lifted. The CPUC has not lifted the rate freeze, and the two Utilities have
filed separate actions alleging that the CPUC refusal violates the filed rate
doctrine and various constitutional provisions.
PACIFIC GAS AND ELECTRIC V. LYNCH is pending in the United States District
Court, Northern District of California (C 01-3023 VRW). Both plaintiff and
defendants have filed motions for summary judgment, which were heard on May 24,
2002. The court took the matters under submission. If required, a trial has been
scheduled for January of 2003.
SOUTHERN CALIFORNIA EDISON V. LYNCH is now pending in the United States
Court of Appeals for the Ninth Circuit (01-56879, 01-56993 and 01-57020,
consolidated). The CPUC and SCE had reached settlement, and that settlement had
been approved by the district court. The district court had also denied motions
of several electricity generators to intervene in opposition of the settlement.
The electricity generators and a consumer group have appealed the settlement and
the order denying intervention. Oral argument was heard on March 4, 2002, and
the matter was submitted. The court has not entered a decision.
PG&E filed an adversary proceeding in bankruptcy court (see "Recent
Developments Regarding Natural Gas and Electricity" above) to prevent the CPUC
from implementing or enforcing any order that requires PG&E to make certain
transfers between certain regulatory accounts which track PG&E revenues and
costs. PG&E asserts that such an order would have the effect of extending the
rate freeze presently in effect, and delaying the time when PG&E can seek rates
sufficient to recover its costs of obtaining power. The bankruptcy court
dismissed this complaint with prejudice and denied PG&E's motion for preliminary
injunction. Cross-appeals are pending in the United States District Court, in
PACIFIC GAS AND ELECTRIC COMPANY (PG&E) V. LYNCH, U.S. District Court, Northern
45
District of California (01-2490 VRW). All briefing has been submitted. PACIFIC
GAS AND ELECTRIC BANKRUPTCY.
On April 6, 2001, PG&E filed a voluntary Chapter 11 bankruptcy petition in
United States Bankruptcy Court for the Northern District of California, San
Francisco Division (In re Pacific Gas and Electric, United States Bankruptcy
Court, N.D. Cal.). The State has filed numerous claims as a creditor of PG&E,
including, but not limited to, claims for income and property taxes, regulatory
fees, fines and penalties, and environmental fees, fines and penalties. The
bankruptcy proceedings are pending.
DWR has filed administrative claims for post-petition purchases of
electricity on PG&E's behalf, arising from the sale of electric energy or
services for the customers of PG&E for the period April 7, 2001, through
December 31, 2001, in an estimated amount of approximately $311.5 million.
Claims for amounts due for January, 2002, and beyond, if any, may be filed. DWR
has also filed claims for pre-petition power-related matters in the estimated
amount of approximately $225 million.
PG&E's proposed plan of reorganization seeks an extensive restructuring of
PG&E's business and the transfer of certain of its assets, including its
electric and gas transmission assets, to newly created limited liability
companies on the theory that the Bankruptcy Code preempts state law. The plan
states that PG&E will seek to establish conditions to PG&E's resumption of its
responsibility for the power currently being provided its customers by DWR, and
a ruling to prohibit it from accepting an assignment of any of DWR's long-term
power purchase contracts. The court ruled that PG&E must amend its plan to
remove relief that is contrary to the State's sovereign immunity or prove that
the State has waived its sovereign immunity, and that PG&E must proceed on an
implied preemption theory, rather than on an express preemption theory. PG&E has
appealed the bankruptcy court's decision in the United States District Court,
Northern District of California (IN RE PACIFIC GAS AND ELECTRIC COMPANY, CASE
NO. 3:02-CV-01550 (VRW)) on two separate grounds, and the CPUC and state
agencies have cross-appealed and objected to the appeal. The CPUC and state
agencies' motion to dismiss the appeal is scheduled to be heard on June 13,
2002.
PG&E filed a second amended plan and disclosure statement, and, in response
to an order of the court, filed a further amended disclosure statement. The
court has approved PG&E's disclosure statement, which will be sent to creditors
concurrently with the disclosure statement of the alternative plan of
reorganization filed on April 15, 2002, by the CPUC. Both plans have been
submitted to the creditors for voting. The Bankruptcy Judge has scheduled July
17, 2002 as the date for filing objections for both plans and August 12, 2002 as
the date by which creditors must return their ballots accepting or rejecting the
plans.
PG&E has also requested that the bankruptcy court deny implementation of the
"Servicing Agreement" with DWR. The Servicing Agreement, provides the procedural
mechanisms for PG&E to supply distribution and billing services to allow DWR to
deliver its power to retail end users and receive payment therefor. PG&E
contends that the CPUC order is tantamount to a diversion of the assets of the
bankruptcy estate, which would be detrimental to the estate and its
reorganization efforts. DWR and the CPUC filed oppositions to the motion on
various grounds. Because of developments at the CPUC, PG&E must amend its motion
if the matter is to be heard by the bankruptcy court. The matter has been
postponed indefinitely.
The California Power Exchange (the "PX") served as an independent,
non-profit entity responsible for administering the competitive wholesale
electricity market in California. After a December 2000 FERC order permitting
the Utilities to purchase and sell other than through the PX, PX operations
slowed dramatically and the PX suspended trading on January 31, 2001. The PX
filed for protection under Chapter 11 of the Bankruptcy Code on March 9, 2001
(United States Bankruptcy Court, Central District of California, No.
LA01-16577-ES). The Bankruptcy Court approved the fifth amended disclosure
statement filed by the Participant's Committee on June 28, 2002, and has
46
scheduled September 23, 2002, as the date for the hearing on the confirmation of
the plan. The estimated combined total of claims in two claimant classes that
pertain to the Utilities and the ISO is $2.9 billion.
OBLIGATIONS OF OTHER ISSUERS
OTHER ISSUERS OF CALIFORNIA MUNICIPAL OBLIGATIONS. There are a number of
State agencies, instrumentalities and political subdivisions of the State that
issue Municipal Obligations, some of which may be conduit revenue obligations
payable from payments from private borrowers. These entities are subject to
various economic risks and uncertainties, and the credit quality of the
securities issued by them may vary considerably from the credit quality of
obligations backed by the full faith and credit of the State.
STATE ASSISTANCE. Property tax revenues received by local governments
declined more than 50% following passage of Proposition 13. Subsequently, the
California Legislature enacted measures to provide for the redistribution of the
State's General Fund surplus to local agencies, the reallocation of certain
State revenues to local agencies and the assumption of certain governmental
functions by the State to assist municipal issuers to raise revenues. Total
local assistance from the State's General Fund was budgeted at approximately 75%
of General Fund expenditures in recent years, including the effect of
implementing reductions in certain aid programs. To reduce State General Fund
support for school districts, the 1992-93 and 1993-94 Budget Acts caused local
governments to transfer $3.9 billion of property tax revenues to school
districts, representing loss of the post-Proposition 13 "bailout" aid. Local
governments have in return received greater revenues and greater flexibility to
operate health and welfare programs.
In 1997, a new program provided for the State to substantially take over
funding for local trial courts (saving cities and counties some $400 million
annually). For 2001-02, the State has provided over $350 million to support
local law enforcement costs. The current fiscal crisis may result in some
reductions in these payments in 2002-03.
To the extent the State should be constrained by its Article XIIIB
appropriations limit, or its obligation to conform to Proposition 98, or other
fiscal considerations, the absolute level, or the rate of growth, of State
assistance to local governments may continue to be reduced. Any such reductions
in State aid could compound the serious fiscal constraints already experienced
by many local governments, particularly counties. Los Angeles County, the
largest in the State, was forced to make significant cuts in services and
personnel, particularly in the health care system, in order to balance its
budget in FY1995-96 and FY1996-97. Orange County, which emerged from Federal
Bankruptcy Court protection in June 1996, has significantly reduced county
services and personnel, and faces strict financial conditions following large
investment fund losses in 1994 which resulted in bankruptcy. The recent economic
slowdown in the State, with its corresponding reduction in State and local
revenues, will put additional pressure on local government finances in the
coming years.
Counties and cities may face further budgetary pressures as a result of
changes in welfare and public assistance programs, which were enacted in August,
1997 in order to comply with the federal welfare reform law. Generally, counties
play a large role in the new system, and are given substantial flexibility to
develop and administer programs to bring aid recipients into the workforce.
Counties are also given financial incentives if either at the county or
statewide level, the "Welfare-to-Work" programs exceed minimum targets; counties
are also subject to financial penalties for failure to meet such targets.
Counties remain responsible to provide "general assistance" for able-bodied
indigents who are ineligible for other welfare programs. The long-term financial
impact of the new CalWORKs system on local governments is still unknown.
ASSESSMENT BONDS. California Municipal Obligations which are assessment
bonds may be adversely affected by a general decline in real estate values or a
slowdown in real estate sales activity. In many cases, such bonds are secured by
land which is undeveloped at the time of issuance but anticipated to be
47
developed within a few years after issuance. In the event of such reduction or
slowdown, such development may not occur or may be delayed, thereby increasing
the risk of a default on the bonds. Because the special assessments or taxes
securing these bonds are not the personal liability of the owners of the
property assessed, the lien on the property is the only security for the bonds.
Moreover, in most cases the issuer of these bonds is not required to make
payments on the bonds in the event of delinquency in the payment of assessments
or taxes, except from amounts, if any, in a reserve fund established for the
bonds.
CALIFORNIA LONG TERM LEASE OBLIGATIONS. Based on a series of court
decisions, certain long-term lease obligations, though typically payable from
the general fund of the State or a municipality, are not considered
"indebtedness" requiring voter approval. Such leases, however, are subject to
"abatement" in the event the facility being leased is unavailable for beneficial
use and occupancy by the municipality during the term of the lease. Abatement is
not a default, and there may be no remedies available to the holders of the
certificates evidencing the lease obligation in the event abatement occurs. The
most common cases of abatement are failure to complete construction of the
facility before the end of the period during which lease payments have been
capitalized and uninsured casualty losses to the facility (e.g., due to
earthquake). In the event abatement occurs with respect to a lease obligation,
lease payments may be interrupted (if all available insurance proceeds and
reserves are exhausted) and the certificates may not be paid when due. Although
litigation is brought from time to time which challenges the constitutionality
of such lease arrangements, the California Supreme Court issued a ruling in
August, 1998 which reconfirmed the legality of these financing methods.
OTHER CONSIDERATIONS
The repayment of industrial development securities secured by real property
may be affected by California laws limiting foreclosure rights of creditors.
Securities backed by health care and hospital revenues may be affected by
changes in State regulations governing cost reimbursements to health care
providers under Medi-Cal (the State's Medicaid program), including risks related
to the policy of awarding exclusive contracts to certain hospitals.
Limitations on ad valorem property taxes may particularly affect "tax
allocation" bonds issued by California redevelopment agencies. Such bonds are
secured solely by the increase in assessed valuation of a redevelopment project
area after the start of redevelopment activity. In the event that assessed
values in the redevelopment project decline (e.g., because of a major natural
disaster such as an earthquake), the tax increment revenue may be insufficient
to make principal and interest payments on these bonds. Both Moody's and S&P
suspended ratings on California tax allocation bonds after the enactment of
Articles XIIIA and XIIIB, and only resumed such ratings on a selective basis.
Proposition 87, approved by California voters in 1988, requires that all
revenues produced by a tax rate increase go directly to the taxing entity which
increased such tax rate to repay that entity's general obligation indebtedness.
As a result, redevelopment agencies (which, typically, are the issuers of tax
allocation securities) no longer receive an increase in tax increment when taxes
on property in the project area are increased to repay voter-approved bonded
indebtedness.
The effect of these various constitutional and statutory changes upon the
ability of California municipal securities issuers to pay interest and principal
on their obligations remains unclear. Furthermore, other measures affecting the
taxing or spending authority of California or its political subdivisions may be
approved or enacted in the future. Legislation has been or may be introduced
which would modify existing taxes or other revenue-raising measures or which
either would further limit or, alternatively, would increase the abilities of
state and local governments to impose new taxes or increase existing taxes. It
48
is not possible, at present, to predict the extent to which any such legislation
will be enacted. Nor is it possible, at present, to determine the impact of any
such legislation on California Municipal Obligations in which the Fund may
invest, future allocations of state revenues to local governments or the
abilities of state or local governments to pay the interest on, or repay the
principal of, such California Municipal Obligations.
Substantially all of California is within an active geologic region subject
to major seismic activity. Northern California in 1989 and Southern California
in 1994 experienced major earthquakes causing billions of dollars in damages.
The federal government provided more than $13 billion in aid for both
earthquakes, and neither event has had any long-term negative economic impact.
Any California Municipal Obligation in the Fund could be affected by an
interruption of revenues because of damaged facilities, or, consequently, income
tax deductions for casualty losses or property tax assessment reductions.
Compensatory financial assistance could be constrained by the inability of (i)
an issuer to have obtained earthquake insurance coverage rates; (ii) an insurer
to perform on its contracts of insurance in the event of widespread losses; or
(iii) the federal or State government to appropriate sufficient funds within
their respective budget limitations.
49
U.S. TERRITORIES
PUERTO RICO. Puerto Rico has a diversified economy dominated by the
manufacturing and service sectors. The North American Free Trade Agreement
("NAFTA"), which became effective January 1, 1994, has led to loss of lower wage
jobs such as textiles, but economic growth in other areas, particularly tourism,
pharmaceuticals, construction and the high technology areas have compensated for
that loss
The Commonwealth of Puerto Rico differs from the states in its relationship
with the federal government. Most federal taxes, except those such as social
security taxes that are imposed by mutual consent, are not levied in Puerto
Rico. Section 936 of the Code has provided a tax credit for certain qualified
U.S. corporations electing "possessions corporation" status. However, in 1993,
Section 936 was amended to provide for two alternative limitations on the
Section 936 credit attributable to certain active business income. The first
limitation was based on the economic activity of the Section 936 possessions
corporation. The second limited the credit to a specified percentage of the
credit allowed under prior law. In 1996, Section 936 credit was repealed except
that the credit attributable to possessions source business income with respect
to certain existing credit claimants was subjected to a phase out over a ten
year period (subject to additional caps).
Also in 1996, a new Section 30A was added to the Code. Section 30A permits a
"qualifying domestic corporation" that meets certain gross income tests to claim
a credit against the federal income tax in an amount equal to the portion of the
tax which is attributable to the taxable income from sources outside of the
United States, from the active conduct of a trade or business in Puerto Rico or
from the sale of substantially all the assets used in such a trade or business.
Section 30A will be phased out by January 1, 2006. The Governor of Puerto Rico
proposed that Congress permanently extend Section 30A until the Puerto Rican
economy achieves certain economic improvements. To date, however, no action has
been taken.
During the mid and late 1990s the Commonwealth of Puerto Rico benefited from
a robust U.S. economy, more aggressive tax collections and low oil prices. This
created an expanded employment base, job growth, reduction in unemployment,
increase in tourism spending, real GDP growth in the 3.1% to 3.5% range over the
last 5 fiscal years and significant increases in General Fund cash balances from
fiscal year end 1997 to fiscal year end 1999. These factors, combined with
minimal negative impact to date from the 1996 federal legislation phasing out
Section 936 tax benefits to Puerto Rico subsidiaries of U.S. corporations,
created a positive outlook for the credit in the late 1990s. Despite the fact
that there have been some high profile U.S. companies that have left the island
partially due to the Section 936 phase out, many corporations have elected to
convert to controlled foreign corporation ("CFC") status, which allows them to
delay federal income taxes until the income is distributed to U.S. shareholders.
50
In fiscal year 2000, the outlook on the credit turned negative due to the
slowdown in the U.S. economy (88% of Puerto Rico's exports go to the U.S.),
uncertainty regarding increasing oil prices, failure of the government to reign
in health care costs, expense overruns in education and a decreasing rate of
employment growth. As a result, the General Fund recorded a $268 million deficit
in fiscal year 2000 due to increased education and health care spending.
A new administration, the Popular Democratic Party that favors Puerto Rico's
commonwealth status over a potential statehood status, took office in January,
2001. It was not long before they realized the presence of continued fiscal
stress and estimated a fiscal year 2001 budget shortfall of $700 million. The
shortfall was stated to be caused by weakened revenue growth due to the slowing
pace of employment and a softening U.S. economy.
The major key to maintaining Puerto Rico's external ratings (Baa1/A- from
Moody's and S&P, respectively) is the ability of the government to balance
fiscal year 2002 performance after lackluster fiscal year 2001 results which
necessitated deficit financing. Complicating matters is the uncertainty
surrounding the negative effects on tourism caused by September 11th terrorist
attacks and the scope and duration of the continued slowdown in the U.S.
economy.
THE U.S. VIRGIN ISLANDS. The United States Virgin Islands ("USVI") is
heavily reliant on the tourism industry, with roughly 43% of non-agricultural
employment in tourist-related trade and services. The tourism industry is
economically sensitive and would likely be adversely affected by a recession in
either the United States or Europe. The attacks of September 11, 2001 will
likely have an adverse affect on tourism, the extent of which is unclear. An
important component of the USVI revenue base is the federal excise tax on rum
exports. Tax revenues rebated by the federal government to the USVI provide the
primary security of many outstanding USVI bonds. Since more than 90% of the rum
distilled in the USVI is distilled at one plant, any interruption in its
operations (as occurred after Hurricane Hugo in 1989) would adversely affect
these revenues. The last major hurricane to impact the USVI was Hurricane
Marilyn on September 15, 1995. Consequently, there can be no assurance that rum
exports to the United States and the rebate of tax revenues to the USVI will
continue at their present levels. The preferential tariff treatment the USVI rum
industry currently enjoys could be reduced under NAFTA. Increased competition
from Mexican rum producers could reduce USVI rum imported to the U.S.,
decreasing excise tax revenues generated. The USVI is periodically hit by
hurricanes. Several hurricanes have caused extensive damage, which has had a
negative impact on revenue collections. There is currently no rated, unenhanced
Virgin Islands debt outstanding (although there is unrated debt outstanding). In
addition, eventual elimination of the Section 936 tax credit for those companies
with operations in USVI may lead to slower growth in the future.
GUAM. The U.S. territory of Guam derives a substantial portion of its
economic base from Japanese tourism. With a reduced U.S. military presence on
the island, Guam has relied more heavily on tourism in past years. During 1998,
the Japanese recession combined with the impact of typhoon Paka resulted in a
budget deficit of $21 million. With hotels alone accounting for 8.5% of Guam's
employment and Japanese tourists comprising 86% of total visitor arrivals, the
Japanese recession and depreciation of the yen versus the dollar earlier this
year have had a negative impact on the island's economy in 1998. Based on these
factors, S&P downgraded Guam's rating to BBB-- from BBB with a negative outlook
on May 26, 1999. Although total visitors improved in 1999 and 2000, they were
weakened by economic slowdowns and the effects of the September 11th terrorist
attacks in 2001. These negative trends have had an unfavorable effect on Guam's
financial position with consistent general fund deficits from 1997-1999 and a
small surplus in 2000. Fiscal year 2001 is expected to be worse than fiscal year
2000. Guam also has a high debt burden. These factors caused S&P to downgrade
Guam's rating to BB (below investment grade) from BBB-- on March 25, 2002. Guam
is not rated by Moody's.
51
APPENDIX D
DESCRIPTION OF INSURERS
The following information relates to the Fund and supplements the
information contained under "Additional Information about Investment Policies --
Insurance."
IN GENERAL. Insured obligations held by the Fund will be insured as to their
scheduled payment of principal and interest under (i) an insurance policy
obtained by the issuer or underwriter of the obligation at the time of its
original issuance ("Issue Insurance"), (ii) an insurance policy obtained by the
Fund or a third party subsequent to the obligation's original issuance
("Secondary Market Insurance") or (iii) a municipal insurance policy purchased
by the Fund ("Portfolio Insurance"). The Fund anticipates that all or
substantially all of its insured obligations will be subject to Issue Insurance
or Secondary Market Insurance. Although the insurance feature reduces certain
financial risks, the premiums for Portfolio Insurance (which, if purchased by
the Fund, are paid from the Fund's assets) and the higher market price paid for
obligations covered by Issue Insurance or Secondary Market Insurance reduce the
Fund's current yield.
Insurance will cover the timely payment of interest and principal on
obligations and will be obtained from insurers with a claims-paying ability
rated Aaa by Moody's or AAA by S&P or Fitch. Obligations insured by any insurer
with such a claims-paying ability rating will generally carry the same rating or
credit risk as the insurer. See Appendix A for a brief description of Moody's,
Fitch's and S&P's claims-paying ability ratings. Such insurers must guarantee
the timely payment of all principal and interest on obligations as they become
due. Such insurance may, however, provide that in the event of non-payment of
interest or principal when due with respect to an insured obligation, the
insurer is not obligated to make such payment until a specified time period has
lapsed (which may be 30 days or more after it has been notified by the Fund that
such non-payment has occurred). For these purposes, a payment of principal is
due only at final maturity of the obligation and not at the time any earlier
sinking fund payment is due. While the insurance will guarantee the timely
payment of principal and interest, it does not guarantee the market value of the
obligations or the net asset value of the Fund.
Obligations are generally eligible to be insured under Portfolio Insurance
if, at the time of purchase by the Fund, they are identified separately or by
category in qualitative guidelines furnished by the mutual fund insurer and are
in compliance with the aggregate limitations on amounts set forth in such
guidelines. Premium variations are based, in part, on the rating of the
obligations being insured at the time the Fund purchases the obligations. The
insurer may prospectively withdraw particular obligations from the
classifications of securities eligible for insurance or change the aggregate
amount limitation of each issue or category of eligible obligations. The insurer
must, however, continue to insure the full amount of the obligations previously
acquired which the insurer has indicated are eligible for insurance, so long as
they continue to be held by the Fund. The qualitative guidelines and aggregate
amount limitations established by the insurer from time to time will not
necessarily be the same as those the Fund would use to govern selection of
obligations for the Fund. Therefore, from time to time such guidelines and
limitations may affect investment decisions in the event the Fund's securities
are insured by Portfolio Insurance.
For Portfolio Insurance that terminates upon the sale of the insured
security, the insurance does not have any effect on the resale value of such
security. Therefore, the Fund will generally retain any insured obligations
which are in default or, in the judgment of the Investment Adviser, are in
significant risk of default and place a value on the insurance. This value will
be equal to the difference between the market value of the defaulted insured
obligations and the market value of similar obligations which are not in
default. As a result, the Investment Adviser may be unable to manage the
securities held by the Fund to the extent the Fund holds defaulted insured
obligations, which will limit its ability in certain circumstances to purchase
other obligations. While a defaulted insured obligation is held by the Fund, the
Fund will continue to pay the insurance premium thereon but will also collect
interest payments from the insurer and retain the right to collect the full
amount of principal from the insurer when the insured obligation becomes due.
The Fund expects that the market value of a defaulted insured obligation covered
by Issue Insurance or Secondary Market Insurance will generally be greater than
the market value of an otherwise comparable defaulted obligation covered by
Portfolio Insurance.
The Fund may also invest in obligations that are secured by an escrow or
trust account which contains securities issued or guaranteed by the U.S.
Government, its agencies or instrumentalities, that are backed by the full faith
and credit of the United States, and sufficient in amount to ensure the payment
of interest on and principal of the secured California obligation
("collateralized obligations"). Collateralized obligations generally are
regarded as having the credit characteristics of the underlying U.S. Government,
agency or instrumentality securities. These obligations will not be subject to
Issue Insurance, Secondary Market Insurance or Portfolio Insurance. Accordingly,
despite the existence of these credit support characteristics, these obligations
will not be considered to be insured obligations for purposes of the Fund's
policy of investing at least 80% of its net assets in insured obligations.
52
PRINCIPAL INSURERS. Currently, Municipal Bond Investors Assurance
Corporation ("MBIA"), Financial Guaranty Insurance Company ("FGIC"), AMBAC
Indemnity Corporation ("AMBAC"), ACA, Radian Asset Assurance ("Radian"), XL
Capital Assurance ("XL Capital"), CDC IXIS Financial Guaranty North America,
Inc. ("CIFG NA"), and Financial Security Assurance Corp., together with its
affiliated insurance companies -- Financial Security Assurance International
Inc. and Financial Security Assurance of Oklahoma, Inc. (collectively, "FSA"),
are considered to have a high claims-paying ability and, therefore, are eligible
insurers for the Fund's obligations. Additional insurers may be added without
further notification. The following information concerning these eligible
insurers is based upon information provided by such insurers or information
filed with certain state insurance regulators. Neither the Fund has
independently verified such information and make no representations as to the
accuracy and adequacy of such information or as to the absence of material
adverse changes subsequent to the date thereof.
MBIA is a monoline financial guaranty insurance company created from an
unincorporated association (the Municipal Bond Insurance Association), through
which its members wrote municipal bond insurance on a several and joint-basis
through 1986. On January 5, 1990, MBIA acquired all of the outstanding stock of
Bond Investors Group, Inc., the parent of Bond Investors Guaranty Insurance
Company ("BIG"), which has subsequently changed its name to MBIA Insurance Corp.
of Illinois. Through a reinsurance agreement, BIG ceded all of its net insured
risks, as well as its related unearned premium and contingency reserves, to
MBIA. MBIA issues municipal bond insurance policies guarantying the timely
payment of principal and interest on new municipal bond issues and leasing
obligations of municipal entities, secondary market insurance of such
instruments and insurance on such instruments held in unit investment trusts and
mutual funds. As of December 31, 2001, MBIA had total assets of approximately
$16.12 billion and qualified statutory capital of approximately $4.8 billion.
MBIA has a claims-paying ability rating of "AAA" by S&P and "Aaa" by Moody's.
Financial Guaranty Insurance Corporation, a wholly owned subsidiary of FGIC
Corporation, which is a wholly owned subsidiary of General Electric Capital
Corporation, is an insurer of municipal securities, including new issues,
securities held in unit investment trusts and mutual funds, and those traded on
secondary markets. The investors in FGIC Corporation are not obligated to pay
the debts of or claims against FGIC. As of December 31, 2000, FGIC had total
assets of approximately $2.75 billion and qualified statutory capital of
approximately $1.99 billion. FGIC has a claims-paying ability rating of "AAA" by
S&P and Fitch, and "Aaa" by Moody's.
AMBAC, a wholly owned subsidiary of AMBAC Inc., is a monoline insurance
company whose policies guaranty the payment of principal and interest on
municipal obligations issues. As of December 31, 2001, AMBAC had assets of
approximately $12.26 billion and qualified statutory capital of approximately
$3.26 billion. AMBAC has a claims-paying ability rating of "AAA" by S&P and
"Aaa" by Moody's.
ACA is a Maryland domiciled financial insurance company. ACA is the primary
subsidiary of American Access Capital Holding Inc. ACA carries a single A
rating. Total claims paying resources were $383 million in 2001, with total
statutory capital of $120.8 million. Soft capital totaled $135 million, though a
loss coverage agreement with ACE American Insurance Co., (rated A). ACA insures
primarily in the municipal and CDO market and acts as the manager/originator of
CDO issues.
Radian is a wholly owned subsidiary of Radian Group Inc. Radian is rated AA
by S&P and Fitch and provides financial guaranty insurance and reinsurance for
debt and asset backed securities. Radian was formerly known as Asset Guarantee
Company and was purchased by Radian Group for $518 million in February 2001. As
of December 31, 2001, Radian had assets of $381 million and statutory capital of
$169.8 million.
XL Capital is a new AAA rated financial guarantor and a wholly owned
subsidiary of property casualty insurer XL Capital Ltd. XL Capital began
transactions in January of 2001 and is rated AAA / Aaa by Moody's and S&P
respectively. It is currently capitalized with $100 million and cedes 90% of its
exposure to XL Financial Assurance a Bermuda based subsidiary of XL Capital Ltd.
XL Financial Assurance has $274 million in hard capital and $100 million in stop
loss protection. Beyond this XL Financial Assurance further guarantees 100% of
XL Capital exposure with $2.7 billion in shareholders equity. XL Capital has $88
million in assets and through its parent and subsidiary agreements XL Capital
has $1 billion in qualified statutory capital.
CIFG NA is a new financial Guarantor rated AAA from Fitch, Moody's and S&P.
CIFG NA is a subsidiary of CDC IXIS Financial Guaranty ("CIFG"), which is a
subsidiary of CIFG Holding, which is in turn owned by parent company CDC IXIS.
CDC IXIS is a French domiciled corporation with a broad spectrum of insurance
related businesses. CIFG recently entered the bond insurance business with two
companies, CIFG Europe and CIFG NA. CIFG is capitalized with $280 million in
cash, with CIFG NA holding $100 million in cash. CDC IXIS backs the two entities
with $220 million in the form of a subordinated loan agreement. Over 75% of CIFG
NA's business will be passed on through a reinsurance policy to CIFG. Combining
all capital, CIFG NA will have claims paying resources of $500 million.
53
FSA purchased Capital Guaranty Insurance Company including its book of
business and reserves effective December 20, 1995. FSA is a monoline insurer
whose policies guaranty the timely payment of principal and interest on new
issue and secondary market issue municipal securities transactions, among other
financial obligations. As of December 31, 2001, FSA had total assets of
approximately $4.3 billion and qualified statutory capital of approximately
$1.52 billion. FSA has a claims-paying ability rating of "AAA" by S&P and "Aaa"
by Moody's. On March 14, 2000, Dexia, Europe's largest municipal lender with
assets in excess of $230 billion announced that it had signed a definitive
agreement providing for the acquisition of FSA Holdings, holding company for
FSA, Inc. Dexia acquired the company in the second quarter of 2000, for $2.6
billion in cash, or $76 per share.
54
APPENDIX E
PERFORMANCE RELATED & COMPARATIVE INFORMATION
[EATON VANCE LOGO]
EATON VANCE INSURED MUNICIPAL BOND FUNDS PHOTO OF BRIDGE]
INSURED NATIONAL (EIM*)
INSURED CALIFORNIA (EVM*)
INSURED NEW YORK (ENX*)
--------------------------------------------------------------------------------
(*) AMEX symbol
AT LEAST 80% AAA-RATED & INSURED 100% EXEMPT FROM AMT
o Attractive Monthly Income Exempt from Federal Income Tax, Federal
Alternative Minimum Tax and, Where Applicable, State and Local Taxes
o Quality Of Professionally Managed, 100% Investment-Grade Portfolios
o At Least 80% of Assets Invested in Obligations AAA-Rated and Insured as
to Timely Payment of Interest and Principal
o Emphasis on Current Yield and on Seeking Undervalued Securities to
Enhance Total Return
o Quality Diversifier with Potential for Reducing Overall Portfolio Risk
o American Stock Exchange Listing Provides Daily Liquidity
Initial Public Offering
August 2002
55
WHY INVEST IN AN EATON VANCE
INSURED MUNICIPAL BOND FUND NOW?
1. INSURED MUNICIPALS REPRESENT UNCOMMON VALUE IN THE CURRENT MARKET ENVIRONMENT
Over the past 10 years, insured municipal bond yields have averaged
approximately 90% of yields on 30-year U.S. Treasury bonds. At June 30, 2002, a
representative tax-exempt insured municipal bond was yielding more than 95% of
the taxable yield of a 30-Year U.S. Treasury bond. With such exceptional tax-
free yields available, why pay taxes on your investment earnings?
Source: MUNICIPAL MARKET ADVISORS. The chart compares the yield of a 30-year,
AAA-rated general obligation insured municipal bond with that of a 30-year U.S.
Treasury bond. Unlike the Funds, these bonds carry no management fees, account
charges or other expenses. U.S. Treasury bonds offer a government guarantee as
to timely payment of interest and repayment of principal on maturity; income is
tax-exempt at the state and local level. Insured municipal bonds are not
guaranteed by the U.S. Government. In addition to general obligation bonds,
insured municipal obligations can include revenue bonds. Past performance is no
guarantee of future results.
YIELD RELATIONSHIP OF 30-YEAR GENERAL OBLIGATION
INSURED MUNICIPAL BOND TO 30-YEAR TREASURY BOND
CURRENT: 95.6%
AVERAGE: 90.1%
[LINE GRAPH]
2. ATTRACTIVE TAXABLE EQUIVALENT YIELDS
o By investing in an Eaton Vance Insured Municipal Bond Fund, your
after-tax income can be higher because the income paid is largely free
of regular federal income tax and 100% exempt from federal alternative
minimum tax. For State Funds, income is largely free of state and local
taxes, too, for residents of the applicable state. Depending on your tax
bracket, a tax-free investment can make a significant difference, and it
can be especially important for people in higher brackets.
o For example, the current yield from a 30-year insured municipal bond is
5.27%, which is equivalent to an 8.58% taxable yield. The current yield
from a taxable 30-year U.S. Treasury Bond is 5.51%.
Consult your tax advisor.
Source: MUNICIPAL MARKET ADVISORS. As of 6/30/02. Based on maximum federal
income tax rate of 38.6%. The current yield of a 30-year insured municipal bond
is not indicative of the yield of any of the Eaton Vance Insured Municipal Bond
Funds. Past performance is no guarantee of future results.
DETERMINE YOUR TAX-FREE ADVANTAGE
NATIONAL (EIM*)
IN A TAX-FREE YIELD OF
TAX -------------------------------------------------------------
BRACKET 5.50% 5.75% 6.00% 6.25% 6.50%
----------- --------- --------- --------- --------- -------
EQUALS A TAXABLE INVESTMENT YIELDING
15.00% 6.47% 6.76% 7.06% 7.35% 7.65%
27.00 7.53 7.88 8.22 8.56 8.90
30.00 7.86 8.21 8.57 8.93 9.29
35.00 8.46 8.85 9.23 9.62 10.00
38.60 8.96 9.36 9.77 10.18 10.59
56
DOUBLE TAX FREE FOR RESIDENTS OF CALIFORNIA(1) (EVM*)
A TAX-FREE YIELD OF
IN ----------------------------------------------------------------
TAX
BRACKET 5.50% 5.75% 6.00% 6.25% 6.50%
---------- --------- --------- --------- --------- -------
EQUALS A TAXABLE INVESTMENT YIELDING
22.91% 7.13% 7.46% 7.78% 8.11% 8.43%
33.79 8.31 8.68 9.06 9.44 9.82
36.51 8.66 9.06 9.45 9.84 10.24
41.05 9.33 9.75 10.18 10.60 11.03
44.31 9.88 10.33 10.77 11.22 11.67
DOUBLE TAX FREE FOR RESIDENTS OF
NEW YORK(2) (ENX*)
A TAX-FREE YIELD OF
IN -------------------------------------------------
TAX
BRACKET 5.50% 5.75% 6.00% 6.25% 6.50%
---------- --------- --------- --------- --------- -------
EQUALS A TAXABLE INVESTMENT YIELDING
20.82% 6.95% 7.26% 7.58% 7.89% 8.21%
32.00 8.09 8.46 8.82 9.19 9.56
34.80 8.43 8.82 9.20 9.59 9.97
39.45 9.08 9.50 9.91 10.32 10.74
42.81 9.62 10.05 10.49 10.93 11.36
TRIPLE TAX FREE FOR RESIDENTS OF
N.Y. CITY(3) (ENX*)
A TAX-FREE YIELD OF
IN
TAX
BRACKET 5.50% 5.75% 6.00% 6.25% 6.50%
----------- -------- --------- --------- --------- -------
EQUALS A TAXABLE INVESTMENT YIELDING
23.87% 7.22% 7.55% 7.88% 8.21% 8.54%
34.66 8.42 8.80 9.18 9.57 9.95
37.35 8.78 9.18 9.58 9.98 10.37
41.82 9.45 9.88 10.31 10.74 11.17
45.05 10.01 10.46 10.92 11.37 11.83
----------
(*) AMEX symbol.
The tax brackets shown are based on 2002 federal and state income tax rates.
Actual tax brackets may be higher due to the phaseout of personal exemptions and
limitations on the deductibility of itemized deductions over certain ranges of
income. The tables assume deductibility of state taxes on the federal return.
Your actual bracket will vary, depending on your income, exemptions and
deductions. Consult your tax advisor. Tax-free yields shown are for illustration
purposes only and are not meant to represent or predict actual results of an
investment in any of the Eaton Vance Insured Municipal Bond Funds. The lower
your combined federal and state tax rate, the less you can take advantage of
tax-free investing, which can be seen by comparing the taxable equivalent yields
at a given tax-free yield level for different tax brackets. The tables do not
take into account the effects of capital gains taxes. In addition, the Funds may
invest in securities that are not exempt from federal or state income taxes,
although they do not intend to do so to a significant degree. Source: Eaton
Vance.
(1) Combined tax brackets are based on 2002 federal income tax rates and
the highest 2002 California state tax rate applicable to each bracket.
(2) Combined tax brackets are based on 2002 federal income tax rates and
the highest 2002 New York state tax rate applicable to each bracket.
(3) Combined tax brackets are based on 2002 federal income tax rates and
the highest 2002 New York state and New York City tax rates applicable to
each bracket, plus the New York City surcharge.
57
WHY INVEST IN AN EATON VANCE
INSURED MUNICIPAL BOND FUND NOW?
3. HIGH-QUALITY INSURED PORTFOLIOS
Each Eaton Vance Insured Municipal Bond Fund invests 100% of its assets in
investment-grade municipal securities. At least 80% of assets are invested in
municipal obligations of the highest investment grade (Aaa/AAA) and insured as
to the timely payment of interest and principal. Insurance does not protect the
market value of such obligations or the net asset value of the Fund.
As rated by Moody's Investors Service, Inc., Standard & Poor's Ratings Group
or by Fitch Rating or, if unrated, determined by Eaton Vance to be of comparable
quality.
4. AVOID THE ALTERNATIVE MINIMUM TAX
The federal alternative minimum tax (AMT) was originally devised to reduce
certain deductions for high-income taxpayers and to make everyone with
significant income pay some federal income tax. Because it is not indexed for
inflation, over time, the AMT has affected more and more taxpayers. As a result,
an insured municipal bond portfolio 100% exempt from AMT may hold significant
appeal to a rising number of filers who are, or may be, subject to the AMT.
THE IMPACT OF THE ALTERNATIVE MINIMUM TAX (AMT)
TAX PAID
RETURNS FILED (BILLIONS OF NOMINAL
YEAR (MILLIONS) $)
------ ------------- --------------------
1990....................... 0.1 $ 0.8
2001....................... 1.5 $ 6.4
2010....................... 17.0 $ 38.2
Sources: For historical data, Internal Revenue Service, Statistics of Income
Bulletin, various issues, and Economic Report of the President (2001); for
projections, Congressional Budget Office (2001); Rebelein and Tempalski (2001)
(AMT numbers); Zaffino (2000) (individual income tax total). Figures for 2001
and 2010 are projections.
5. THE CLOSED-END STRUCTURE PROVIDES AN EFFECTIVE WAY OF INVESTING IN MUNICIPAL
BONDS
Closed-end funds can remain fully invested, are not subject to inflows and
outflows of assets and can utilize a leveraged capital structure, which provides
greater flexibility in portfolio management than open-end mutual funds,
resulting in the potential for enhanced returns.
Sources: THOMSON WEALTH MANAGEMENT; LIPPER INC. Returns are as of 6/30/02.
Closed-end fund returns are based on the market returns of approximately 90
national leveraged and non-leveraged closed-end municipal funds. Open-end fund
returns are based on the NAV returns of 48 national, non-leveraged, open-end,
insured front-load funds. Past performance is no guarantee of future results. It
is not possible to invest directly in an index or average. Unlike the Funds,
indices carry no management fees, account charges or other expenses. The Eaton
Vance Insured Municipal Bond Funds will not seek to match the composition or
performance of any such indices or averages. Performance of the various indices
or averages should not be viewed as indicative of any of the Eaton Vance Insured
Municipal Bond Funds. Total return is affected by changes in current yield, net
asset value and market performance.
AVERAGE ANNUAL TOTAL RETURNS
[BAR GRAPH]
THOMSON LIPPER OPEN-END
CLOSE-END MUNICIPAL INSURED MUNICIPAL DEBT
NATIONAL INDEX FUNDS AVERAGE
-------------- -------------
1 Year.................. 7.32 5.87
3 Years................. 6.60 5.55
5 Years................. 6.14 5.13
10 Years................ 7.01 5.91
58
6. PORTFOLIO DIVERSIFIER WITH POTENTIAL FOR REDUCING RISK
Historically, when stocks have declined, insured municipal bonds have often
gone up in value. Adding an insured municipal bond fund to an overall portfolio
may help lower overall investment risk.
Source: LIPPER INC. Returns are as of 6/30/02. Insured municipal bond returns
are those of the Lehman Brothers Insured Municipal Bond Index, an unmanaged
index that is a broad measure of performance of insured, investment-grade
municipal bonds with maturities of at least one year. The S&P 500 Composite
Index is an unmanaged index of 500 common stocks commonly used as a measure of
U.S. stock market performance. It is not possible to invest directly in an
index. Unlike the Funds, indices carry no management fees, account charges or
other expenses. The Eaton Vance Insured Municipal Bond Funds will not seek to
match the composition or performance of any such indices. Performance of an
index should not be viewed as indicative of that of any of the Eaton Vance
Insured Municipal Bond Funds. Past performance is no guarantee of future
results.
AVERAGE ANNUAL TOTAL RETURNS
[BAR GRAPH]
LEHMAN BROTHER INSURED S&P 500
MUNICIPAL BOND INDEX COMPOSITE INDEX
-------------------- ---------------
1 Year...................... 7.19 -17.98
3 Years..................... 6.93 - 9.17
5 Years..................... 6.45 3.67
10 Years.................... 6.87 11.42
Shares of the Eaton Vance Insured Municipal Bond Funds are not insured by
the FDIC and are not deposits or other obligations of, or guaranteed by, any
depository institution. Shares are subject to investment risks, including
possible loss of principal invested.
INSURED MUNICIPAL BOND YIELDS ARE OVER 95%* OF THOSE FROM LONG-TERM TREASURIES.
WHY PAY TAXES?
(*) At 6/30/02
KEY FEATURES
o ATTRACTIVE TAX-EXEMPT MONTHLY INCOME-EACH EATON VANCE INSURED MUNICIPAL
BOND FUND IS DESIGNED TO PROVIDE INCOME FREE FROM REGULAR FEDERAL INCOME
TAX, FEDERAL ALTERNATIVE MINIMUM TAX AND, FOR STATE FUNDS, STATE AND
LOCAL TAXES FOR RESIDENTS OF THAT STATE.
o QUALITY OF PROFESSIONALLY MANAGED, INVESTMENT-GRADE PORTFOLIOS-EACH FUND
INVESTS AT LEAST 80% OF ITS ASSETS IN MUNICIPAL OBLIGATIONS OF THE
HIGHEST INVESTMENT-GRADE (Aaa/AAA).
o PREDOMINANTLY INSURED-EACH FUND INVESTS AT LEAST 80% OF ITS ASSETS IN
MUNICIPAL OBLIGATIONS INSURED AS TO THE TIMELY PAYMENT OF INTEREST AND
PRINCIPAL.
o EMPHASIS ON CURRENT YIELD AND VALUE INVESTING MAY MEAN ENHANCED TOTAL
RETURN -- TO ENHANCE PERFORMANCE, THE FUNDS SEEK INSURED MUNICIPAL BONDS
THAT ARE UNDERVALUED IN THE MARKETPLACE AND WHICH MAY OFFER THE
POTENTIAL FOR HIGHER TOTAL RETURNS. THERE IS NO ASSURANCE THE FUNDS'
OBJECTIVES WILL BE ATTAINED.
o PREMIER ADVISER-EATON VANCE HAS BEEN MANAGING MUNICIPAL BOND FUNDS SINCE
1978.
o DAILY LIQUIDITY-- THE FUNDS EXPECT TO BE LISTED ON THE AMERICAN STOCK
EXCHANGE.
59
EATON VANCE INSURED MUNICIPAL BOND FUNDS
INVESTMENT-GRADE PORTFOLIOS 100% EXEMPT FROM FEDERAL ALTERNATIVE MINIMUM TAX
AIRPORTS -- SCHOOLS -- ROADWAYS -- BRIDGES -- MEDICAL FACILITIES
OBJECTIVE: The Eaton Vance Insured Municipal Bond Funds are newly organized
closed-end investment companies that seek to provide current income exempt from
regular federal income tax, federal alternative minimum tax and, for state
funds, state and local taxes.* They invest primarily in the highest quality
municipal bonds which are insured as to the payment of interest and principal.
Municipal bonds are debt obligations issued by or on behalf of the states,
territories and possessions of the U.S. and District of Columbia and their
political subdivisions, agencies, or instrumentalities, the interest on which is
exempt from regular federal income tax and, where applicable, state and local
taxes. These securities are used to finance public projects, like building
schools, highways, hospitals and bridges. By investing in municipal bonds, you
invest in our nation's future and in a better quality of life.
(*) A portion of each Eaton Vance Insured Municipal Bond Fund's income may be
subject to federal income and/or state and local taxes. Investors in New
York and California who purchase the appropriate State Fund for their state
of residency will receive income exempt from both federal and respective
state and, where applicable, local taxes. Distributions of any taxable net
investment income and net short-term capital gains are taxable as ordinary
income.
INVESTMENT APPROACH
o Under normal market conditions, at least 80% of each Fund's assets will
be invested in municipal debt obligations insured** as to principal and
interest payments by insurers having claims-paying ability rated
Aaa/AAA.
o At least 80% of assets will be invested in municipal securities of the
highest investment grade at the time of investment (i.e., rated Aaa by
Moody's Investor Service, Inc., or AAA by either Standard & Poor's
Ratings Group or by Fitch Rating) or, if unrated, determined by Eaton
Vance to be of comparable quality. The Funds' investments in unrated
obligations will be more dependent on the expertise and analytical
abilities of Eaton Vance than investments in rated obligations.
[PHOTO OF OVERPASS]
o Up to 20% of each Fund's assets will be invested in investment-grade
municipal obligations (i.e., rated below Aaa/AAA, but no lower than
Baa/BBB by Moody's, Standard & Poor's or Fitch) and unrated municipal
obligations considered to be of comparable quality by Eaton Vance and/or
municipal obligations that are uninsured.
----------
(**) Insurance does not protect the market value of such obligations or the net
asset value of the Fund.
ADVANTAGES OF A PROFESSIONALLY MANAGED MUNICIPAL FUND
Beyond providing ready access to a broad market of securities,
professionally managed funds, like the Eaton Vance Insured Municipal Bond Funds,
offer investors many attractive advantages over purchasing individual insured
municipal bonds, including monthly income, diversification by different issuers
and daily liquidity.
Perhaps more important are the advantages of active management by dedicated
municipal bond specialists who concentrate full time on seeking opportunities in
the municipal bond market.
[PHOTO OF AIRPLANE]
Investors should be aware that individual bonds, when held to maturity,
offer both a fixed principal value and rate of return. Conversely, a bond fund
does not offer a fixed rate of return and shares, when sold, may be worth more
or less than their original cost.
VALUE INVESTING
Eaton Vance has one of the strongest teams of research analysts, traders and
portfolio managers in the industry devoted exclusively to analyzing municipal
securities, including insured municipal bonds. The team's goal is to find
municipal bonds of high quality that have been undervalued in the marketplace
60
due to differing dynamics in individual sectors of the municipal bond market,
municipal bond supply, and the structure of individual bonds, especially in
regard to maturities, coupons, and call dates. The Eaton Vance team of
professionals constantly monitors historical and current yield spreads to find
relative value in the marketplace.
This research capability is key to identifying trends which impact the
yield-spread relationships of all bonds, including those in the insured sector.
A MANAGED FUND OR BONDS?
COMPARE THESE FEATURES
MANAGED INDIVIDUAL
TAX-FREE MUNICIPAL
FUND BONDS
---- -----
Monthly Income.................................... / NO
--
Professional Management........................... / NO
--
In-Depth Market Analysis.......................... / NO
--
Liquidity......................................... / NOT ALWAYS
----------
Diversification Among Different Issuers*.......... / NO
--
Free Dividend & Capital Gain Reinvestment......... / NO
--
Potential for Increased Income Through Leverage... / NO
--
Low-Cost Access................................... / NO
--
Investors should be aware that individual bonds, when held to maturity,
offer both a fixed principal value and rate of return. Conversely, a bond fund
does not offer a fixed rate of return and shares, when sold, may be worth more
or less than their original cost.
(*) The Eaton Vance Insured Municipal Bond Funds are "non-diversified" for
purposes of the Investment Company Act of 1940. See Risks.
THE CLOSED-END FUND ADVANTAGE
Closed-end funds have greater flexibility than open-end funds, including the
ability to remain more fully invested and to use financial leverage. The ability
to borrow at short-term tax-exempt rates and invest at generally higher
long-term tax-exempt rates enables closed-end funds, like the Eaton Vance
Insured Municipal Bond Funds, to offer investors enhanced yield potential over
other municipal investments. Investors searching for yield may find the Funds'
taxable-equivalent yield potential compelling. In addition, the Funds'
closed-end structure is a benefit because it protects the Funds from the
continuous inflow and outflow of assets that can complicate portfolio
management.
[PHOTO OF FREEWAY]
HIGHER YIELD POTENTIAL
Each Fund expects to utilize financial leverage by issuing preferred stock
(on which the Fund will pay a generally lower short-term tax-exempt yield) and
investing the proceeds at typically higher long-term tax-exempt yields.
Each Fund intends to utilize financial leverage initially of up to
approximately 38% of its total assets (including the amount obtained through
leverage). Each may also utilize other transactions, such as purchasing
when-issued securities and futures contracts, which may have the effect of
leverage.
Although the Funds' leveraged capital structure offers the opportunity for
increased current income, it also involves risks. See Risks.
AMERICAN STOCK EXCHANGE LISTING
To provide daily liquidity, the Funds have applied for listing of their
shares on the AMEX. (See proposed symbols on the taxable equivalent yield
tables.) The shares of closed-end funds frequently trade at a discount to net
asset value. This risk may be greater for investors selling their shares shortly
after completion of the public offering. See Risks.
61
EXPERIENCED PORTFOLIO MANAGEMENT
Eaton Vance was one of the first municipal bond fund managers, having
managed such funds since 1978. Eaton Vance's 22-person municipal bond team
includes five portfolio managers, three traders and nine credit specialists, who
are responsible for managing approximately $7 billion in municipal securities.*
Eaton Vance has one of the strongest teams of research analysts in the industry
devoted exclusively to analyzing municipal securities. With 41 open-end and 10
closed-end municipal bond funds under supervision, the team has experience
managing a wide range of municipal securities. The emphasis on research and
continuing credit analysis on each portfolio holding enables Eaton Vance's
portfolio managers to take advantage of yield and capital appreciation
opportunities generated through investment research.
PREMIER INVESTMENT ADVISER
Eaton Vance Management, a subsidiary of Eaton Vance Corp., is the Funds'
investment adviser. Eaton Vance, its affiliates and predecessor companies have
been managing assets of individuals and institutions since 1924 and managing
investment companies since 1931. Eaton Vance and it affiliates currently have
over $56 billion* in assets under management.
----------
(*) At 6/30/02
RISKS
Before investing, consult your investment representative about how the Funds
differ from other investment companies regarding credit risk, liquidity, charges
and expenses, and other issues of importance. Please read the prospectus
carefully, especially Investment Objective, Policies and Risks.
NO OPERATING HISTORY -- Each Fund is a closed-end investment company with no
operating history. Each is designed for long-term investors, not as a trading
vehicle.
INTEREST RATE AND MARKET RISK -- Prices of municipal obligations tend to
fall as interest rates rise. Securities with longer maturities or durations tend
to fluctuate more in price in response to changes in market interest rates. A
decline in the prices of the municipal obligations owned by a Fund would cause a
decline in the net asset value of the Fund, which could adversely affect the
trading price of the Fund's Shares. This risk is usually greater among municipal
obligations with longer maturities or durations. Although each Fund has no
policy governing the maturities or durations of its investments, each Fund
expects (other things being equal) to invest in a portfolio of longer-term
securities, which means it will be subject to greater market risk than a fund
investing solely in shorter-term securities. Market risk is often greater among
certain types of debt securities, such as zero-coupon bonds, which do not make
regular interest payments. As interest rates change, these bonds often fluctuate
in price more than coupon bonds that make regular interest payments. Because
each Fund may invest in these types of securities, it may be subject to greater
market risk than a fund investing only in current interest paying securities.
INCOME RISK -- Income investors receive is based primarily on interest each
Fund earns from its investments, which can vary widely over the short and long
term. If long-term interest rates drop, investors' income from the Fund over
time could drop as well if the Fund purchases securities with lower interest
coupons.
CALL RISK -- If interest rates fall, issuers of callable bonds with high
coupons may call (prepay) their bonds before maturity. During declining interest
rates, each Fund is likely to replace a called security with a lower-yielding
one, decreasing the Fund's dividends and possibly affecting the market price of
Shares. Similar risks exist when the Fund invests the proceeds from matured or
traded municipal obligations at market interest rates that are below the Fund's
current earning's rate.
CREDIT RISK -- Credit risk is the risk that one or more municipal bonds in a
Fund's portfolio will decline in price, or fail to pay interest or principal
when due, because the issuer of the bond experiences a decline in its financial
status.
LIQUIDITY RISK -- Each Fund may invest in securities for which there is no
readily available trading market or which are otherwise illiquid. The Fund may
not be able to readily dispose of such securities at prices approximating those
at which it could sell such securities if they were more widely traded. As a
result of such illiquidity, the Fund may have to sell other investments or
engage in borrowing to meet its obligations. Limited liquidity could affect the
market price of the securities, thereby adversely affecting the Fund's net asset
value and ability to make dividend distributions.
62
MUNICIPAL BOND MARKET -- Certain obligations in which the Funds will invest
will not be registered with the Securities and Exchange Commission or any state
securities commission and generally will not be listed on any national
securities exchange. Therefore, the amount of public information available about
portfolio securities will be limited, and the performance of the Funds is more
dependent on the analytical abilities of Eaton Vance than would be so for an
investment company investing primarily in registered or exchange-listed
securities.
EFFECTS OF LEVERAGE -- The use of leverage through issuance of preferred
shares by each Fund creates an opportunity for increased net income, but, at the
same time, creates special risks. There can be no assurance that a leveraging
strategy will be successful during any period in which it is employed. Each Fund
intends to use leverage to provide the holders of Shares with a potentially
higher return. Leverage creates risks for holders of Shares, including the
likelihood of greater volatility of net asset value and market price of the
Shares and the risk that fluctuations in dividend rates on any preferred shares
may affect the return to Shareholders. It is anticipated that preferred share
dividends will be based on the yields of short-term municipal obligations, while
the proceeds of any preferred share offering will be invested in longer-term
municipal obligations, which typically have higher yields. To the extent the
income derived from securities purchased with funds received from leverage
exceeds the cost of leverage, a Fund's return will be greater than if leverage
had not been used. Conversely, if the income from the securities purchased with
such funds is not sufficient to cover the cost of leverage, the return to a Fund
will be less than if leverage had not been used, and therefore the amount
available for distribution to Shareholders as dividends and other distributions
will be reduced. In the latter case, Eaton Vance in its best judgment may
nevertheless determine to maintain the Fund's leveraged position if it deems
such action to be appropriate.
In addition, under current federal income tax law, each Fund is required to
allocate a portion of any net realized capital gains or other taxable income to
holders of preferred shares. The terms of any preferred shares are expected to
require the Fund to pay to any preferred shareholders additional dividends
intended to compensate the preferred shareholders for taxes payable on any
capital gains or other taxable income allocated to the preferred shares. Any
such additional dividends will reduce the amount available for distribution to
the Shareholders. The fee paid to Eaton Vance will be calculated on the basis of
the Fund's gross assets, including proceeds from the issuance of preferred
shares, so the fees will be higher when leverage is utilized.
Each Fund currently intends to seek an investment grade rating on any
preferred shares from a rating agency. The Fund may be subject to investment
restrictions of the rating agency as a result. These restrictions may impose
asset coverage or portfolio composition requirements that are more stringent
than those imposed on the Fund by the Investment Company Act of 1940, as
amended. It is not anticipated that these covenants or guidelines will impede
Eaton Vance in managing each Fund's portfolio in accordance with its investment
objective and policies.
MUNICIPAL BOND INSURANCE -- In the event Moody's, S&P or Fitch (or all of
them) should downgrade its assessment of the claims-paying ability of a
particular insurer, it (or they) could also be expected to downgrade the ratings
assigned to municipal bonds insured by such insurer, and municipal bonds insured
under Portfolio Insurance issued by such insurer also would be of reduced
quality in the Fund's portfolio. Any such downgrade could have an adverse impact
on the net asset value and market price of a Fund's Shares. In addition, to the
extent a Fund employs Portfolio Insurance, the Fund may be subject to certain
restrictions on investments imposed by guidelines of the insurance companies
issuing such Portfolio Insurance. Each Fund does not expect these guidelines to
prevent Eaton Vance from managing the Fund's portfolio in accordance with the
Fund's investment objective and policies.
Insurance relates specifically to the payment of interest and principal on
the bonds in the Funds' portfolios and not to the market value of those bonds or
the share prices of the Funds, which will fluctuate with the market and, at the
time of sale, may be worth more or less than the original investment. No
representation is made as to any insurer's ability to meet its commitments.
CONCENTRATION -- The National Fund may invest 25% or more of its total
assets in municipal obligations of issuers located in the same state (or in a
U.S. Territory) or in the same economic sector, such as revenue obligations of
health care facilities, hospitals or airports. This may make the Fund more
susceptible to adverse economic, political or regulatory occurrences affecting a
particular state, territory or economic sector.
Each State Insured Municipal Bond Fund primarily invests in municipal
obligations of issuers located in its relevant state and may invest 25% or more
of its total assets in municipal obligations of issuers located in the same U.S.
territory or in the same economic sector, such as revenue obligations of health
care facilities, hospitals or airports. This may make a Fund more susceptible to
adverse economic, political or regulatory occurrences affecting that respective
state, a particular territory or economic sector.
ANTI-TAKEOVER PROVISIONS -- Each Fund's Declaration of Trust includes
provisions that could have the effect of limiting the ability of other persons
or entities to acquire control of such Fund or to change the composition of its
Board of Trustees.
63
ADDITIONAL INVESTMENT PRACTICES -- The Funds may use investment practices
that involve special considerations, including purchasing futures contracts and
shares of other closed-end funds. This may result in the Fund earning taxable
income or gains.
MARKET PRICE OF SHARES -- Shares of closed-end investment companies often
trade at a discount from their net asset value, and the Funds' shares may
likewise trade at a discount. The trading price of each Fund's shares may be
less than the public offering price. This risk may be greater for investors who
sell their shares in a relatively short period after completion of the public
offering.
NON-DIVERSIFICATION -- With respect to up to 50% of its assets, each Fund
will be able to invest more than 5% (but not more than 25%) of the value of its
total assets in the obligations of any single issuer. To the extent that a
relatively high percentage of assets is invested in obligations of a limited
number of issuers, each Fund may be more susceptible than a more widely
diversified investment company to any single economic, political or regulatory
occurrence.
The information contained herein and in each preliminary prospectus is
incomplete and may be changed. We may not sell these securities until each of
the registration statements filed with the Securities and Exchange Commission is
effective. This document is not an offer to sell these securities and is not
soliciting offers to buy each of these securities in any state where the offer
or sale is not permitted. This is not an offering, which may only be made by a
final prospectus. The final prospectus for each Fund should be read carefully
before you invest or send money. The Funds involve a number of risks, including
the risk of leverage, trading discount and default. The Funds may differ from
other investment companies in terms of credit risk, liquidity, charges and
expenses, and other important issues.
Consult the preliminary prospectus for each Eaton Vance Insured Municipal
Bond Fund for more complete information, including risk considerations, charges
and expenses. Preliminary prospectuses are available on request from your
financial advisor, or you may obtain a copy from each Fund by calling
1-800-225-6265.
(C) Eaton Vance -- The Eaton Vance Building -- 255 State Street -- Boston, MA
02109 -- www.eatonvance.com Salomon Smith Barney Inc.
WHY BUY BONDS?
o POSITIVE ECONOMIC ENVIRONMENT -- Interest rate outlook remains neutral --
Economic growth in the US is moderate -- Inflation, which is key to bond market
performance, is benign, and the current outlook is excellent because of
productivity gains, low wage pressures and continuing competitiveness within
industry.
o ATTRACTIVE YIELDS -- Bond yields in general are attractive relative to those
from short-term, income-producing vehicles.
o OPPORTUNITY FOR REALLOCATION -- With the fall-off in the stock market many
portfolios need to diversify against risk by shifting some assets to
income-producing investments.
o FAVORABLE DEMOGRAPHICS -- The aging baby boom generation is hitting its peak
earning years, and many boomers should be looking to shelter investment income.
1403-7/02 CE-IMBFCB
64
EATON VANCE INSURED CALIFORNIA MUNICIPAL BOND FUND
STATEMENT OF ADDITIONAL INFORMATION
AUGUST 27, 2002
AS SUPPLEMENTED SEPTEMBER 17, 2002
INVESTMENT ADVISER AND ADMINISTRATOR
Eaton Vance Management
24 Federal Street
Boston, MA 02110
CUSTODIAN
Investors Bank & Trust Company
200 Clarendon Street
Boston, MA 02116
TRANSFER AGENT
PFPC Inc.
P.O. Box 43027
Providence, RI 02940-3027
(800) 331-1710
INDEPENDENT AUDITORS
Deloitte & Touche LLP
200 Berkeley Street
Boston, MA 02116