PROSPECT STREET INCOME SHARES INC.
NOTES TO
FINANCIAL STATEMENTS
December 31, 2007
(1) Organization and Operations:
Prospect
Street Income Shares Inc. (the “Fund”) was organized as a corporation in the
state of Maryland on March 19, 1973, and is registered with the Securities and
Exchange Commission as a diversified, closed-end, management investment company
under the Investment Company Act of 1940 (the “1940 Act”). The Fund commenced
operations on May 15, 1973.
Investment Objective:
The
Fund’s investment objective is to provide high current income, with capital
appreciation as a secondary objective.
(2) Significant Accounting Policies:
The
following is a summary of significant accounting policies consistently followed
by the Fund, which are in conformity with those generally accepted in the
investment company industry.
(a) Use of Estimates
The
Fund’s financial statements have been prepared in conformity with accounting
principles generally accepted in the United States of America, which require
the management of the Fund to make estimates and assumptions that affect the
reported amounts of assets and liabilities, the disclosure of contingent assets
and liabilities at the date of the financial statements and the reported
amounts of income and expenses during the reporting period. Actual results
could differ from those estimates.
(b) Valuation of Investments
Investments
for which listed market quotations are readily available are stated at market
value, which is determined by using the last reported sale price or, if no
sales are reported, as in the case of some securities traded over-the-counter,
the last reported bid price. Short-term investments having remaining maturities
of 60 days or less are stated at amortized cost, which approximates market
value.
Other
investments, which comprise the major portion of the Fund’s portfolio holdings,
are primarily non-investment grade corporate debt securities, for which market
quotations are not readily available due to a thinly traded market with a
limited number of market makers. These investments are stated at fair value on
the basis of subjective valuations furnished by an independent pricing service
or broker dealers, subject to review and adjustment by Highland Capital
Management, L.P. (the “Investment Adviser”) based upon quotations obtained from
market makers. The independent pricing service determines value based primarily
on quotations from dealers and brokers, market transactions, accessing data
from quotation services, offering sheets obtained from dealers and various
relationships between similar securities. The independent pricing service
utilizes the last sales price based on odd-lot trades, if available. If such price
is not available, the price furnished is based on round-lot or institutional
size trades. For securities in which there is no independent price from a
pricing service or from round-lot or institutional size trades, they are fair
value priced in good faith pursuant to procedures approved by the Fund’s Board
of Directors (“Board of Directors”).
(c) Security Transactions and Related Investment
Income
Security
transactions are accounted for on the trade date. Realized gains and losses on
investments sold are recorded on the identified cost basis. Interest income and
accretion of discounts are recorded on the accrual basis. Dividend income is
recorded on ex-dividend date. It is the Fund’s policy to place securities on
non-accrual status when collection of interest is doubtful.
(d) Foreign Currency
Foreign
currencies, investments and other assets and liabilities denominated in foreign
currencies are translated into U.S. dollars at the exchange rates using the
current 4:00 p.m. London Time Spot Rate. Fluctuations in the value of the
foreign currencies and other assets and liabilities resulting from changes in
exchange rates, between trade and settlement dates on securities transactions
and between the accrual and payment dates on dividends, interest income and
foreign withholding taxes are recorded as unrealized foreign currency
gains/(losses). Realized gains/(losses) and unrealized appreciation/
14
PROSPECT STREET INCOME SHARES INC.
NOTES TO FINANCIAL STATEMENTS (continued)
(depreciation) on investment
securities and income and expenses are translated on the respective dates of
such transactions. The effect of changes in foreign currency exchange rates on
investments in securities are not segregated in the statement of operations
from the effects of changes in market prices of those securities, but are
included with the net realized and unrealized gain or loss on investment
securities.
(e) Federal Income Taxes
It
is the Fund’s policy to comply with the requirements of Subchapter M of the
Internal Revenue Code of 1986, as amended, applicable to registered investment
companies, and to distribute substantially all of its investment company
taxable income and gains, if any, to its stockholders each year; as such, the
Fund will not be subject to federal income taxes. Gains and losses on sales of
investments are calculated on the identified cost method for both financial
reporting and federal income tax purposes.
Reclassifications
are made to the Fund’s capital accounts for permanent tax differences to
reflect income and gains available for distribution (or available capital loss
carryforwards) under income tax regulations.
For
the fiscal year ended December 31, 2007, permanent differences resulting from
capital loss carryforward expiration, premium reclasses and nondeductable
excise tax paid were identified and reclassified among the components of the
Fund’s net assets as follows:
|
|
|
|
|
|
|
|
|
|
|
Undistributed/(Overdistributed)
Net Investment Income
|
|
Accumulated Net
Realized Gain/(Loss)
|
|
Paid-In
Capital
|
|
|
|
|
|
|
|
|
$
|
31,727
|
|
$
|
1,659,934
|
|
$
|
(1,691,661)
|
|
The
accumulated capital losses available to offset future capital gains, if any,
expire in the amounts indicated below on the following dates:
|
|
|
|
|
|
|
|
|
|
Carryover
Available
|
|
Expiration Date
|
|
|
|
|
|
|
|
|
|
$
|
4,737,419
|
|
|
December
31, 2008
|
|
|
|
|
15,317,739
|
|
|
December
31, 2009
|
|
|
|
|
3,458,710
|
|
|
December
31, 2010
|
|
|
|
|
3,196,740
|
|
|
December
31, 2011
|
|
|
|
|
1,210,721
|
|
|
December
31, 2012
|
|
|
|
|
873,134
|
|
|
December
31, 2013
|
|
|
|
|
|
|
|
|
|
|
|
$
|
28,794,463
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
For the year ended December
31, 2007, the Fund utilized $981,527 and $1,674,934 expired.
At
December 31, 2007, the Fund has elected to defer recognition of $433,161 or net
realized capital losses after October 31, 2007 until January 1, 2008.
In
July 2006, the Financial Accounting Standards Board (“FASB”) released FASB
Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (“FIN
48”). FIN 48 provides guidance on how uncertain tax positions should be
recognized, measured, presented, and disclosed in the financial statements. FIN
48 requires the evaluation of tax positions taken or expected to be taken in
the course of preparing the Fund’s tax returns to determine whether the tax
positions are “more-likely-than-not” of being sustained by the applicable tax
authorities. Tax positions not deemed to satisfy the “more-likely-than-not”
threshold would be recorded as a tax benefit or expense in the current year.
FASB required adoption of FIN 48 for fiscal years beginning after December 15,
2006, and FIN 48 is to be applied to all open tax years as of the effective
date. However, on December 22, 2006, the Securities and Exchange Commission
delayed the required implementation date of FIN 48 for investment management
companies until June 29, 2007. As of June 29, 2007, the Fund adopted FIN 48 for
all subsequent reporting periods and management has determined that there is no
material impact on the financial statements.
15
PROSPECT STREET INCOME SHARES INC.
NOTES TO FINANCIAL STATEMENTS (continued)
As
of December 31, 2007, the cost and related gross unrealized appreciation and
depreciation and the components of distributable earnings on a tax basis are as
follows:
|
|
|
|
|
|
|
Cost of
investments for tax purposes
|
|
$
|
94,145,560
|
|
|
|
|
|
|
|
|
Gross
investment unrealized appreciation for tax purposes
|
|
$
|
1,297,806
|
|
|
|
|
|
|
|
|
Gross
investment unrealized depreciation for tax purposes
|
|
$
|
(8,996,783
|
)
|
|
|
|
|
|
|
|
Net
unrealized depreciation on investments for tax purposes
|
|
$
|
(7,698,977
|
)
|
|
|
|
|
|
|
As
of December 31, 2007, the components of distributable earnings on a tax basis
were as follows:
|
|
|
|
|
|
|
Undistributed
ordinary income
|
|
$
|
1,122,836
|
|
|
|
|
|
|
|
|
Accumulated
capital losses
|
|
$
|
29,227,624
|
|
|
|
|
|
|
|
|
Net
unrealized depreciation
|
|
$
|
(7,699,775
|
)
|
|
|
|
|
|
|
(f) Cash Flow Information
The
Fund invests primarily in corporate debt securities and makes distributions
from net investment income, which are paid in cash or shares of common stock of
the Fund. These activities are reported in the accompanying statements of
changes in net assets, and additional information on cash receipts and cash
payments is presented in the accompanying statement of cash flows.
(g) Cash and Cash Equivalents
The
Fund considers all highly liquid investments purchased with initial maturity
equal to or less than three months to be cash equivalents.
(h) Additional Accounting Standards
In
September 2006, Statement of Financial Accounting Standards No. 157
Fair Value Measurements
(“SFAS 157”) was
issued and is effective for fiscal years beginning after November 15, 2007.
SFAS 157 defines fair value, establishes a framework for measuring fair value
and expands disclosures about fair value measurements. At this time, management
has evaluated the implications of SFAS 157 and concluded that there is no
material impact on the financial statements
(3) Investment Advisory Agreement:
The
Investment Adviser earned $473,658 in investment advisory fees for the year
ended December 31, 2007. Investment advisory fees paid by the Fund to the
Investment Adviser were calculated at 0.50% (on an annual basis) of the average
weekly net asset value, defined as total assets of the Fund less accrued
liabilities and preferred stock. On December 31, 2007, the fee payable to the
Investment Adviser was $115,555, which is included in the accompanying
Statement of Assets and Liabilities. The agreement between the Fund and the
Investment Adviser, however, provides that if the costs and expenses (excluding
interest, advisory fees, taxes, brokerage charges and expenses and
extraordinary costs and expenses and expenses incident to the public offering
of shares other than those offered through the Dividend Reinvestment Plan)
borne by the Fund in any fiscal year exceed 1.50% of average net assets up to
$30,000,000 plus 1.00% of average net assets over $30,000,000, the Investment
Adviser is obligated to reimburse the Fund for any excess pursuant to the
existing advisory agreement. As of December 31, 2007, no such expense
reimbursement was required.
(4) Purchases and Sales of Securities:
For
the year ended December 31, 2007, the aggregate cost of purchases and proceeds
from sales of investment securities, other than U.S. Government obligations and
short-term investments, was approximately $210,227,441 and $204,353,698,
respectively.
16
PROSPECT STREET INCOME SHARES INC.
NOTES TO FINANCIAL STATEMENTS (continued)
The
Investment Adviser and its affiliates manage other accounts, including
registered and private funds and individual accounts that also invest in high
yield fixed-income securities. Although investment decisions for the Fund are
made independently from those of such other accounts, investments of the type
the Fund may make may also be made on behalf of such other accounts. When the
Fund and one or more of such other accounts is prepared to invest in, or
desires to dispose of, the same security, available investments or
opportunities for each will be allocated in a manner believed by the Investment
Adviser to be equitable to the Fund and such other accounts. The Investment
Adviser also may aggregate orders to purchase and sell securities for the Fund
and such other accounts. Although the Investment Adviser believes that, over
time, the potential benefits of participating in volume transactions and
negotiating lower transaction costs should benefit all accounts including the
Fund, in some cases these activities may adversely affect the price paid or
received by the Fund or the size of the position obtained or disposed of by the
Fund.
(5) Certain Transactions:
Certain
officers of the Investment Adviser serve on the Board of Directors of the Fund.
They receive no compensation in this capacity.
Directors
who are not officers or employees of the Investment Adviser receive fees of
$5,000 per year, together with the reimbursement of actual out-of-pocket
expenses incurred relating to board meeting attendance. For the year ended
December 31, 2007, the Fund incurred Board of Directors’ fees and expenses of
$21,689.
Effective
January 1, 2008, each Independent Director receives an annual retainer of
$150,000 payable in quarterly installments and allocated among each portfolio
in the Highland Fund Complex based on relative net assets.
The
“Highland Fund Complex” consists of all of the registered investment companies
and a business development company advised by the Investment Adviser as of the
date of this annual report.
(6) Distributions:
Distributions
on the Fund’s common stock (“Common Stock”) are declared based on annual
projections of the Fund’s net investment income (defined as dividends and
interest income, net of Fund expenses). The Fund plans to pay quarterly
distributions to holders of Common Stock (“Common Stockholders”). As a result
of market conditions or investment decisions, the amount of distributions may
exceed net investment income earned at certain times throughout the period. It
is anticipated that, on an annual basis, the amount of distributions to Common
Stockholders will not exceed net investment income (as defined) allocated to
Common Stockholders for income tax purposes.
For
the year ended December 31, 2007, the tax character of distributions paid by
the Fund to Common Stockholders were as follows:
|
|
|
|
|
|
|
Distributions
from net investment income
|
|
$
|
4,476,200
|
|
|
Distributions
from paid in capital
|
|
|
0
|
|
|
|
|
|
|
|
|
|
|
$
|
4,476,200
|
|
|
|
|
|
|
|
For
the year ended December 31, 2006, the tax character of distributions paid by
the Fund to Common Stockholders were as follows:
|
Distributions
from net investment income
|
|
$
|
4,451,329
|
|
|
Distributions
from paid in capital
|
|
|
0
|
|
|
|
|
|
|
|
|
|
|
$
|
4,451,329
|
|
|
|
|
|
|
|
17
PROSPECT STREET INCOME SHARES INC.
NOTES TO FINANCIAL STATEMENTS (continued)
(7) Preferred Shares
:
On
July 23, 2001, the Fund issued 1,200 shares of Series T Auction Rate Cumulative
Preferred Shares (the “Preferred Shares”), $25,000 liquidation preference, for
a total issuance of $30,000,000. All such Preferred Shares were outstanding as
of December 31, 2007. The Fund may borrow amounts in the future to increase its
use of leverage within the limitations imposed by the 1940 Act. Significant
provisions regarding the Preferred Shares are described below.
Redemption
The
Preferred Shares are not subject to any sinking fund, but are subject to
mandatory redemption under certain circumstances. If the Fund does not timely
cure the failure to meet certain asset coverages, portfolio valuation or timely
filing requirements, the Preferred Shares are subject to mandatory redemption
out of funds legally available in accordance with the Fund’s charter and
applicable law, at a redemption price of $25,000 per Preferred Share plus an
amount equal to accumulated but unpaid dividends thereon, whether or not earned
or declared to the date fixed for redemption. In addition, the Fund at its
option may redeem Preferred Shares having a dividend period of one year or less
at this same redemption price to the extent permitted under the 1940 Act and
Maryland law. Any Preferred Shares repurchased or redeemed by the Fund will be
classified as authorized but unissued Preferred Shares. The Preferred Shares
have no preemptive, exchange or conversion rights. The Fund will not issue any
class of stock senior to or on a parity with the Preferred Shares.
Dividends
The
Preferred Shares pay dividends based on a rate set at auctions, normally held
every seven days. In most instances, dividends are payable every seven days, on
the first business day following the end of the dividend period. The dividend
payment date for special dividend periods of more than seven days is set forth
in the notice designating a special dividend period. At December 31, 2007, the
rate on the Preferred Shares was 5.81%. In general, when the Fund has any
Preferred Shares outstanding, the Fund may not pay any dividend or distribution
in respect of Common Stock unless the Fund has paid all cumulative dividends on
Preferred Shares.
Voting
Rights
The
Fund’s Preferred Shares and Common Stock have equal voting rights of one vote
per share and vote together as a single class. The Preferred Shares and Common
Stock vote as a separate class on certain matters as required under the Fund’s
charter, the 1940 Act and Maryland law.
Liquidation
In
the event of a liquidation of the Fund, whether voluntary or involuntary, the
holders of the Preferred Shares (“Preferred Shareholders”) are entitled to
receive, prior to and in preference to any distribution of any of the assets of
the Fund available for distribution to Common Stockholders, a liquidation
preference in the amount of $25,000 for each share outstanding plus an amount
equal to all dividends thereon, whether or not earned or declared, accumulated
but unpaid to and including the date of final distribution. After the payment
to Preferred Shareholders of the full preferential amounts, Preferred
Shareholders will have no right or claim to any of the remaining assets of the
Fund.
(8)
Securities Loans
The
Fund may make secured loans of its portfolio securities amounting to not more
than one-third of the value of its total assets, thereby realizing additional
income. The risks in lending portfolio securities, as with other extensions of
credit, consist of possible delays in recovery of the securities or possible
loss of rights in the collateral should the borrower fail financially. As a
matter of policy, securities loans are made to unaffiliated broker-dealers
pursuant to agreements requiring that loans be continuously secured by
collateral in cash or short-term debt obligations at least equal at all times
to the value of the securities subject to the loan. The borrower pays to the
Fund an amount equal to any interest or dividends received on securities
subject to the loan. The Fund retains all or a portion of the interest received
on investment of the cash collateral or receives a fee from the borrower. As of
December 31, 2007, the market value of securities loaned by the Fund was
$10,963,900. The loans were secured with cash collateral of $11,583,500.
18
PROSPECT STREET INCOME SHARES INC.
NOTES TO FINANCIAL STATEMENTS (continued)
(9) Unfunded Loan Commitments:
As
of December 31, 2007, the Fund had an unfunded loan commitment to Univision
Communications, Inc. of $50,336, which could be extended at the option of the
borrower, pursuant to the loan agreement.
(10) Disclosure of Significant Risk:
Credit
Risk
Credit
risk is the risk that the issuer of a security owned by the Fund will be unable
to pay the interest or principal when due. The degree of credit risk depends on
both the financial condition of the issuer and the terms of the obligation.
Interest
Rate Risk
Interest
rate risk is the risk that prices of securities owned by the Fund generally
increase when interest rates decline and decrease when interest rates increase.
Foreign
Currency Risk
Foreign
currencies, investments and other assets and liabilities are translated into
U.S. dollars at the exchange rates using the current 4:00 p.m. London Time Spot
Rate. Fluctuations in the value of the foreign currencies and other assets and
liabilities resulting from changes in exchange rates, between trade and
settlement dates on securities transactions and between the accrual and payment
dates on dividends, interest income and foreign withholding taxes, are recorded
as unrealized foreign currency gains/(losses). Realized gains/(losses) and
unrealized appreciation/(depreciation) on investment securities and income and
expenses are translated on the respective dates of such transactions.
(11) Subsequent Event
On
February 20, 2008, the Board of Directors approved an agreement and plan of
reorganization pursuant to which the Fund would transfer its assets to Highland
Credit Strategies Fund (“HCF”), a non-diversified closed-end management investment
company managed by the Investment Adviser, in exchange for newly issued common
shares of HCF (the “Reorganization”). The Reorganization is subject to approval
of stockholders of the Fund and certain other closing conditions and, assuming
such conditions are satisfied, the Reorganization is currently expected to
occur in the summer of 2008.
19
Report of
Independent Registered Public Accounting Firm
To the Stockholders and Board
of Directors of Prospect Street Income Shares Inc.
We
have audited the accompanying statement of assets and liabilities of Prospect
Street Income Shares Inc. (the “Fund”), including the schedule of investments,
as of December 31, 2007, and the related statements of operations and cash
flows for the year then ended, the statements of changes in net assets for each
of the two years in the period then ended, and the financial highlights for
each of the five years in the period then ended. These financial statements and
financial highlights are the responsibility of the Fund’s management. Our
responsibility is to express an opinion on these financial statements and
financial highlights based on our audits.
We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether the
financial statements and financial highlights are free of material
misstatement. The Fund is not required to have, nor were we engaged to perform,
an audit of its internal control over financial reporting. Our audits included
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Fund’s
internal control over financial reporting. Accordingly, we express no such
opinion. An audit also includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation. Our procedures
included confirmation of securities owned as of December 31, 2007, by
correspondence with the custodian and brokers. We believe that our audits
provide a reasonable basis for our opinion.
In
our opinion, the financial statements and financial highlights referred to
above present fairly, in all material respects, the financial position of
Prospect Street Income Shares Inc. as of December 31, 2007, the results of its
operations and its cash flows for the year then ended, the changes in its net
assets for each of the two years in the period then ended, and the financial
highlights for each of the five years in the period then ended, in conformity
with accounting principles generally accepted in the United States of America.
DELOITTE & TOUCHE LLP
February 27, 2008
Dallas, Texas
20
PROSPECT STREET INCOME SHARES INC.
ADDITIONAL INFORMATION (unaudited)
Dividend Reinvestment Plan
If
your Common Stock is registered directly with the Fund or if you hold your
Common Stock with a brokerage firm that participates in the Fund’s Dividend
Reinvestment Plan (the “Plan”), unless you elect by written notice to the Fund
to receive cash distributions, all dividends, including any capital gain
distributions, on your Common Stock will be automatically reinvested by PFPC
Inc. (the “Plan Agent”), in additional Common Stock under the Plan. If you
elect to receive cash distributions, you will receive all distributions in cash
paid by check mailed directly to you by PFPC Inc., as dividend paying agent.
If
you decide to participate in the Plan, the number of shares of Common Stock you
will receive will be determined as follows:
|
|
|
|
|
(1)
|
|
If the shares are trading
at or above net asset value (“NAV”) at the time of valuation, the Fund will
issue new shares at a price equal to the greater of (i) NAV per share on that
date or (ii) 95% of the market price on that date.
|
|
|
|
|
|
(2)
|
|
If these shares are trading
below NAV at the time of valuation, the Plan Agent will receive the dividend
or distribution in cash and will purchase Common Stock in the open market, on
the New York Stock Exchange or elsewhere, for the participants’ accounts. It
is possible that the market price for the Common Stock may increase before
the Plan Agent has completed its purchases. Therefore, the average purchase
price per share paid by the Plan Agent may exceed the market price at the
time of valuation, resulting in the purchase of fewer shares than if the
dividend or distribution had been paid in Common Stock issued by the Fund.
The Plan Agent will use all dividends and distributions received in cash to
purchase Common Stock in the open market within 30 days of the valuation date
except where temporary curtailment or suspension of purchases is necessary to
comply with federal securities laws. Interest will not be paid on any uninvested
cash payments.
|
You
may elect to opt-out of or withdraw from the Plan at any time by giving written
notice to the Plan Agent, or by telephone at (800) 331-1710, in accordance with
such reasonable requirements as the Plan Agent and Fund may agree upon. If you
withdraw or the Plan is terminated, you will receive a certificate for each
whole share in your account under the Plan, and you will receive a cash payment
for any fraction of a share in your account. If you wish, the Plan Agent will
sell your shares and send you the proceeds, minus brokerage commissions.
The
Plan Agent maintains all Common Stockholders’ accounts in the Plan and gives
written confirmation of all transactions in the accounts, including information
you may need for tax records. Common Stock in your account will be held by the
Plan Agent in non-certificated form. The Plan Agent will forward to each
participant any proxy solicitation material and will vote any shares so held
only in accordance with proxies returned to the Fund. Any proxy you receive
will include all Common Stock you have received under the Plan.
There
is no brokerage charge for reinvestment of your dividends or distributions in
Common Stock. However, all participants will pay a pro rata share of brokerage
commissions incurred by the Plan Agent when it makes open market purchases.
Automatically
reinvesting dividends and distributions does not mean that you do not have to
pay income taxes due upon receiving dividends and distributions. Capital gains
and income are realized, although cash is not received by you. Consult your
financial advisor for more information.
If
you hold your Common Stock with a brokerage firm that does not participate in
the Plan, you will not be able to participate in the Plan and any dividend
reinvestment may be effected on different terms than those described above.
The
Fund reserves the right to amend or terminate the Plan if in the judgment of
the Board of Directors the change is warranted. There is no direct service
charge to participants in the Plan; however, the Fund reserves the right to
amend the Plan to include a service charge payable by the participants.
Additional information about the Plan may be obtained by writing PFPC Inc., 301
Bellevue Parkway, Wilmington, Delaware 19809.
21
PROSPECT STREET INCOME SHARES INC.
ADDITIONAL INFORMATION (unaudited) (continued)