FILE NOS. 333-160595 AND 811-22311
AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON APRIL 15, 2011
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM N-1A
REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933
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Post-Effective Amendment No. 7
REGISTRATION STATEMENT UNDER THE INVESTMENT COMPANY ACT OF 1940
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Amendment No. 9
SCHWAB STRATEGIC TRUST
(Exact Name of Registrant as Specified in Charter)
211 Main Street, San Francisco, California 94105
(Address of Principal Executive Offices) (Zip code)
(800) 648-5300
(Registrants Telephone Number, including Area Code)
Marie Chandoha
211 Main Street, San Francisco, California 94105
(Name and Address of Agent for Service)
Copies of communications to:
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David Lekich, Esq.
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Douglas P. Dick, Esq.
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Charles Schwab Investment Management, Inc.
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Dechert LLP
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211 Main Street
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1775 I Street, N.W.
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SF211MN-05-491
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Washington, D.C. 20006-2401
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San Francisco, CA 94105
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It is proposed that this filing will become effective (check appropriate box)
Immediately upon filing pursuant to paragraph (b)
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On (date), pursuant to paragraph (b)
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60 days after filing pursuant to paragraph (a)(1)
On (date), pursuant to paragraph (a)(1)
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75 days after filing pursuant to paragraph (a)(2)
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On (date) pursuant to paragraph (a)(2) of Rule 485
If appropriate, check the following box:
This post-effective amendment designates a new effective date for a previously filed post-effective amendment.
Schwab Fixed-Income ETFs
(SCHWAB ETFS LOGO)
Prospectus
July __, 2011
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Schwab U.S. Aggregate Bond ETF
TM
SCHZ
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Principal U.S. Listing Exchange: NYSE Arca, Inc.
As with all exchange traded funds, the Securities and
Exchange Commission (SEC) has not approved these securities
or passed on whether the information in this prospectus is
adequate and accurate. Anyone who indicates otherwise is
committing a federal crime.
(CHARLES SCHWAB LOGO)
Schwab Fixed-Income ETFs
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Fund summaries
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Fund details
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Schwab U.S. Aggregate Bond ETF
TM
Ticker Symbol:
SCHZ_
Investment objective
The funds goal is to track as closely as possible, before fees and expenses, the total return of
the Barclays Capital U.S. Aggregate Bond Index
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Fund fees and expenses
This table describes the fees and expenses you may pay if you buy and hold shares of the fund. The
table does not reflect brokerage commissions you may incur when buying or selling fund shares.
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Shareholder fees
(fees paid directly from your investment)
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None
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Annual fund operating expenses
(expenses that you pay each year as a % of the value of your
investment)
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Management fees
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0.XX
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Other expenses
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None
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Total annual fund operating expenses
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0.XX
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Example
This example is intended to help you compare the cost of investing in the fund with the cost of
investing in other funds. The example assumes that you invest $10,000 in the fund for the time
periods indicated and then redeem all of your shares at the end of those time periods. The example
also assumes that your investment has a 5% return each year and that the funds total annual
operating expenses remain the same. This example does not reflect any brokerage commissions you may
incur when buying or selling fund shares. Your actual costs may be higher or lower.
Expenses on a $10,000 investment
Portfolio turnover
The fund pays transaction costs, such as commissions, when it buys and sells securities (or turns
over its portfolio). A higher portfolio turnover may indicate higher transaction costs and may
result in higher taxes when fund shares are held in a taxable account. These costs, which are not
reflected in the total annual fund operating expenses or in the example, affect the funds
performance. The fund is new and therefore does not have a historical portfolio turnover rate.
Principal investment strategies
To pursue its goal, the fund generally invests in securities that are included in the index.
The
index is a broad based benchmark measuring the performance of the U.S. investment grade, taxable
bond market, including U.S. Treasuries, government-related and corporate bonds, mortgage
pass-through securities, commercial mortgage-backed securities, and asset-backed securities that
are publicly available for sale in the United States. To be eligible for inclusion in the index,
securities must be fixed rate, non-convertible, U.S. dollar denominated with at least $250 million
or more of outstanding face value and have one or more years remaining to maturity. The index
excludes certain types of securities, including state and local government series bonds, structured
notes embedded with swaps or other special features, private placements, floating rate securities,
inflation linked bonds and Eurobonds. The index is market capitalization weighted and the
securities in the index are updated on the last business day of each month. As of June __, 2011,
there were approximately _____ securities in the index.
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Index ownership
©
Barclays Capital Inc. 2011. All rights reserved. The
Schwab U.S. Aggregate Bond ETF is not sponsored, endorsed, sold or promoted by Barclays
Capital. Barclays Capital does not make any representation regarding the advisability of
investing in shares of the fund.
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It is the funds policy that under normal circumstances it will invest at least 90% of its net
assets in securities included in the index, including TBA Transactions, as defined below. Under
normal circumstances, the fund may invest up to 10% of its net assets in securities not included in
its index. The principal types of these investments include those that the adviser believes will
help the fund track the index, such as investments in (a) securities that are not represented in
the index but the adviser anticipates will be added to or removed from the index; (b) high-quality
liquid short-term investments, such as securities issued by the U.S. government, its agencies or
instrumentalities, including obligations that are not guaranteed by the U.S. Treasury, and
obligations that are issued by private issuers that are guaranteed as to principal or interest by
the U.S. government, its agencies or instrumentalities, (c) investment companies, including money
market funds, and (d) derivatives, principally futures contracts. The fund may use futures
contracts and other derivatives primarily to help manage interest rate exposure. The fund may also
invest in cash and cash equivalents and lend its securities to minimize the difference in
performance that naturally exists between an index fund and its corresponding index.
Because it is not possible or practical to purchase all of the securities in the index, the funds
investment adviser will seek to track the total return of the index by using statistical sampling
techniques. These techniques involve investing in a limited number of index securities that, when
taken together, are expected to perform similarly to the index as a whole. These techniques are
based on a variety of factors, including interest rate and yield curve risk, maturity exposures,
industry, sector and issuer weights, credit quality, , and other risk factors and characteristics.
The fund generally expects that its portfolio will hold less than the total number of securities in
the index, but reserves the right to hold as many securities as it believes necessary to achieve
the funds investment objective. The fund generally expects that its weighted average effective
duration will closely correspond to the weighted average effective duration of the index, which as
of June __, 2011 was ___ years.
As of June __, 2011 approximately __% of the bonds represented in the index were U.S. fixed-rate
agency mortgage pass-through securities. U.S. fixed rate agency mortgage pass-through securities
are securities issued by entities such as the Government National Mortgage Association (GNMA), the
Federal National Mortgage Association (FNMA), and the Federal Home Loan Mortgage Corporation
(FHLMC) that are backed by pools of mortgages. Most transactions in fixed-rate mortgage
pass-through securities occur through standardized contracts for future delivery in which the exact
mortgage pools to be delivered are not specified until a few days prior to settlement, and are
often referred to as to be announced transactions or TBA Transactions. In a TBA Transaction,
the buyer and seller agree upon general trade parameters such as agency, settlement date, par
amount and price. The actual pools delivered generally are determined two days prior to settlement
date; however, it is not anticipated that the fund will receive the pools, but will instead
participate in rolling TBA transactions. The fund anticipates that it may enter into such
contracts on a regular basis. The fund, pending settlement of such contracts, will invest its
assets in high-quality liquid short-term instruments, including Treasury securities and shares of
money market mutual funds. The fund will assume its pro rata share of the fees and expenses of any
money market fund that it may invest in, in addition to the funds own fees and expenses.
The fund will concentrate its investments (i.e., hold 25% or more of its total assets) in a
particular industry, group of industries or sector to approximately the same extent that its index
is so concentrated. For purposes of this limitation, securities of the U.S. government (including
its agencies and instrumentalities), and repurchase agreements collateralized by U.S. government
securities are not considered to be issued by members of any industry.
The adviser seeks to achieve, over time, a correlation between the funds performance and that of
its index, before fees and expenses, of 95% or better. However, there can be no guarantee that the
fund will achieve a high degree of correlation with the index. A number of factors may affect the
funds ability to achieve a high correlation with its index, including the degree to which the fund
uses a sampling technique. The correlation between the performance of the fund and its index may
also diverge due to transaction costs, asset valuations, timing variances, and differences between
the funds portfolio and the index resulting from legal restrictions (such as diversification
requirements) that apply to the fund but not to the index.
Principal risks
The fund is subject to risks, any of which could cause an investor to lose money. The funds
principal risks include:
Market Risk.
Bond markets rise and fall daily. As with any investment whose performance is tied to
these markets, the value of your investment in the fund will fluctuate, which means that you could
lose money.
Investment Style Risk.
The fund is not actively managed. Therefore, the fund follows the securities
included in the index during upturns as well as downturns. Because of its indexing strategy, the
fund does not take steps to reduce market exposure or to lessen the effects of a declining market.
In addition, because of the funds expenses, the funds total return is normally below that of the
index.
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Interest Rate Risk.
Interest rates will rise and fall over time. During periods when interest rates
are low, the funds yield and total return also may be low. The longer the funds duration, the
more sensitive to interest rate movements its share price is likely to be.
Credit Risk.
The fund is subject to the risk that a decline in the credit quality of a portfolio
investment could cause the fund to lose money or underperform. The fund could lose money if the
issuer or guarantor of a portfolio investment fails to make timely principal or interest payments
or otherwise honor its obligations. The negative perceptions of an issuers ability to make such
payments could also cause the price of that investment to decline. The credit quality of the funds
portfolio holdings can change rapidly in certain market environments and any default on the part of
a single portfolio investment could cause the funds share price or yield to fall Certain of
the U.S. government securities in which the fund may invest are issued by government-sponsored
entities and are not backed by the full faith and credit of the United States government, which
means they are neither issued nor guaranteed by the U.S. Treasury. If the government-sponsored
entity is unable to meet its obligations it could adversely impact the funds share price or yield.
Sampling Index Tracking Risk.
The fund will not fully replicate the index and may hold
securities not included in the index. As a result, the fund is subject to the risk that the
advisers investment management strategy, the implementation of which is subject to a number of
constraints, may not produce the intended results. Because the fund uses a sampling approach, it
may not track the return of the index as well as it would if the fund purchased all of the
securities in its benchmark.
Tracking Error Risk.
As an index fund, the fund seeks to track the performance of its benchmark
index, although it may not be successful in doing so. The divergence between the performance of
the fund and its benchmark index, positive or negative, is called tracking error. Tracking error
can be caused by many factors and it may be significant.
Prepayment and Extension Risk.
Certain of the funds investments are subject to the risk that the
securities may be paid off earlier or later than expected. Either situation could cause the fund to
hold securities paying lower-than-market rates of interest, which could hurt the funds yield or
share price.
Non-U.S. Issuer Risk.
The fund may invest in U.S.-registered, dollar-denominated bonds of non-U.S.
corporations, governments, agencies and supra-national entities. The funds investments in bonds of
non-U.S. issuers may involve certain risks that are greater than those associated with investments
in securities of U.S. issuers. These include risks of adverse changes in foreign economic,
political, regulatory and other conditions; differing accounting, auditing, financial reporting and
legal standards and practices; differing securities market structures; and higher transaction
costs. These risks may be heightened in connection with investments in emerging markets.
Derivatives Risk.
The funds use of derivative instruments involves risks different from, or
possibly greater than, the risks associated with investing directly in securities and other
traditional investments and could cause the fund to lose more than the principal amount invested.
In addition, investments in derivatives may involve leverage, which means a small percentage of
assets invested in derivatives can have a disproportionately larger impact on the fund.
Mortgage-Backed and Mortgage Pass-Through Securities Risk
. Certain of the mortgage-backed
securities in which the fund may invest are not backed by the full faith and credit of the U.S.
government and there can be no assurance that the U.S. government would provide financial support
to its agencies or instrumentalities where it was not obligated to do so. Mortgage-backed
securities tend to increase in value less than other debt securities when interest rates decline,
but are subject to similar risk of decline in market value during periods of rising interest rates.
Because of prepayment and extension risk, mortgage-backed securities react differently to changes
in interest rates than other bonds. Small movements in interest ratesboth increases and
decreasesmay quickly and significantly affect the value of certain mortgage-backed securities.
Transactions in mortgage pass-through securities primarily occur through TBA transactions, as
described in the Principal investment strategies section above. Default by or bankruptcy of a
counterparty to a TBA Transaction would expose the fund to possible losses because of an adverse
market action, expenses, or delays in connection with the purchase or sale of the pools of mortgage
pass-through securities specified in the TBA Transaction.
Liquidity Risk.
A particular investment may be difficult to purchase or sell. The fund may be
unable to sell illiquid securities at an advantageous time or price.
Securities Lending Risk.
Securities lending involves the risk of loss of rights in the collateral
or delay in recovery of the collateral if the borrower fails to return the security loaned or
becomes insolvent.
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Concentration Risk.
To the extent that the funds or the indexs portfolio is concentrated in the
securities of issuers in a particular market, industry, group of industries, sector or asset class,
the fund may be adversely affected by the performance of those securities, may be subject to
increased price volatility and may be more susceptible to adverse economic, market, political or
regulatory occurrences affecting that market, industry, group of industries, sector or asset class.
Market Trading Risk.
Although fund shares are listed on national securities exchanges, there can be
no assurance that an active trading market for fund shares will develop or be maintained. If an
active market is not maintained, investors may find it difficult to buy or sell fund shares.
Shares of the Fund May Trade at Prices Other Than NAV.
Fund shares may be bought and sold in the
secondary market at market prices. Although it is expected that the market price of the shares of
the fund will approximate the funds net asset value (NAV), there may be times when the market
price and the NAV vary significantly. You may pay more than NAV when you buy shares of the fund in
the secondary market, and you may receive less than NAV when you sell those shares in the secondary
market.
Lack of Governmental Insurance or Guarantee.
An investment in the fund is not a bank deposit and it
is not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other
government agency.
For more information on the risks of investing in the fund please see the Fund details section in
the prospectus.
Performance
The fund is new and therefore does not have a performance history. Once the fund has completed a
full calendar year of operations a bar chart and table will be included that will provide some
indication of the risks of investing in the fund by showing the variability of the funds returns
and comparing the funds performance to the index.
Investment adviser
Charles Schwab Investment Management, Inc.
Portfolio managers
Matthew Hastings, CFA,
a managing director and portfolio manager of the investment adviser, has
day-to-day responsibility for the co-management of the fund. He has managed the fund since 2011.
Steven Chan, CFA,
a portfolio manager of the investment adviser, has day-to-day responsibility for
the co-management of the fund. He has managed the fund since 2011.
Brandon Matsui, CFA,
a portfolio manager of the investment adviser, has day-to-day responsibility
for the co-management of the fund. He has managed the fund since 2011.
Steven Hung,
a managing director and portfolio manager of the investment adviser, has day-to-day
responsibility for the co-management of the fund. He has managed the fund since 2011.
Alfonso Portillo, Jr.,
a managing director and portfolio manager of the investment adviser,
has day-to-day responsibility for the
co-management of the fund. He has managed the fund since 2011.
Purchase and sale of fund shares
The fund issues and redeems shares at its NAV only in large blocks of shares, typically 200,000
shares or more (Creation Units). These transactions are usually in exchange for a basket of
securities included in the index and an amount of cash. As a practical matter, only institutions or
large investors purchase or redeem Creation Units. Except when aggregated in Creation Units, shares
of the fund are not redeemable securities.
Individual shares of the fund trade on national securities exchanges and elsewhere during the
trading day and can only be bought and sold at market prices throughout the trading day through a
broker-dealer. Because fund shares trade at market prices rather than NAV, shares may trade at a
price greater than NAV (premium) or less than NAV (discount).
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Tax information
Dividends and capital gains distributions received from the fund will generally be taxable as
ordinary income or capital gains, unless you are investing through an IRA, 401(k) or other
tax-advantaged account.
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About the fund
The fund described in this Prospectus is advised by Charles Schwab Investment Management, Inc.
(CSIM or the investment adviser). The fund is an exchange-traded fund (ETF). ETFs are funds
that trade like other publicly-traded securities. The fund is an index fund and is designed to
track the performance of an index. Because the composition of an index tends to be comparatively
stable, index funds historically have shown low portfolio turnover compared to actively managed
funds.
This strategy distinguishes an index fund from an actively managed fund. Instead of choosing
investments for the fund based on portfolio managements judgment, an index is used to determine
which securities the fund should own.
Unlike shares of a mutual fund, shares of the fund are listed on a national securities exchange and
trade at market prices that change throughout the day. The market price for the funds shares may
be different from its net asset value per share or NAV. The fund has its own CUSIP number and
trades on the NYSE Arca, Inc. under the following ticker:
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Schwab U.S. Aggregate Bond ETF
TM
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SCHZ
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The fund issues and redeems shares at its NAV only in large blocks of shares, typically at least
200,000 shares or more (Creation Units). These transactions are usually in exchange for a basket
of securities and an amount of cash. As a practical matter, only institutions or large investors
purchase or redeem Creation Units. Except when aggregated in Creation Units, shares of the fund are
not redeemable securities.
A note to retail investors
Shares can be purchased directly from the fund only in exchange for a basket of securities that is
expected to be worth ten million or more dollars. Most individual investors, therefore, will not be
able to purchase shares directly from the fund. Instead, these investors will purchase shares in
the secondary market through a brokerage account or with the assistance of a broker. Thus, some of
the information contained in this Prospectus such as information about purchasing and redeeming
shares from the fund and references to transaction fees imposed on purchases and redemptions is
not relevant to most individual investors. Shares purchased or sold through a brokerage account or
with the assistance of a broker may be subject to brokerage commissions and charges.
Except as explicitly described otherwise, the investment objective, the benchmark index and the
investment policies of the fund may be changed without shareholder approval.
The funds performance will fluctuate over time and, as with all investments, future performance
may differ from past performance.
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Fund details
Investment objectives, strategies and risks
Schwab U.S. Aggregate Bond ETF
TM
Investment objective
The funds goal is to track as closely as possible, before fees and expenses, the total return of
the Barclays Capital U.S. Aggregate Bond Index
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The funds
investment objective is not fundamental and therefore may be changed by the funds board of
trustees without shareholder approval.
Index
The funds benchmark index is comprised of U.S. investment grade, taxable fixed income securities,
including U.S. Treasuries, government-related and corporate bonds, mortgage pass-through
securities, commercial mortgage-backed securities, and asset-backed securities that are publicly
available for sale in the United States.
To be eligible for inclusion in the index, securities
must be fixed rate, non-convertible, U.S. dollar denominated with at least $250 million or more of
outstanding face value and have one or more years remaining to maturity. Asset backed securities
must have a minimum deal size of $500 million and a minimum tranche size of $25 million. For
commercial mortgage backed securities, the original aggregate transaction must have a minimum deal
size of $500 million and a minimum tranche size of $25 million; the aggregate outstanding
transaction sizes must be at least $300 million to remain in the index. The securities must be
denominated in U.S. dollars and must be fixed rate and non-convertible. The index excludes certain
types of securities, including state and local governments series bonds, structured notes embedded
with swaps or other special features, private placements, floating rate securities, inflation
linked bonds, and Eurobonds. The index is market capitalization weighted and the securities in the
index are updated on the last business day of each month. As of June __, 2011, there were
approximately _____ securities in the index.
Investment strategy
It is the funds policy that under normal circumstances it will invest at least 90% of its net
assets in securities included in the index , including TBA Transactions, as defined below.
Under normal circumstances, the fund may invest up to 10% of its net assets in securities not
included in its index. The principal types of these investments include those that the adviser
believes will help the fund track the index, such as investments in (a) securities that are not
represented in the index but the adviser anticipates will be added to or removed from the index;
(b) high-quality liquid short-term investments, such as securities issued by the U.S. government,
its agencies or instrumentalities, including obligations that are not guaranteed by the U.S.
Treasury, and obligations that are issued by private issuers that are guaranteed as to principal or
interest by the U.S. government, its agencies or instrumentalities, (c) investment companies,
including money market funds, and (d) derivatives, principally futures contracts. The fund may use
futures contracts and other derivatives primarily to help manage interest rate exposure. The fund
may also invest in cash and cash equivalents and lend its securities to minimize the difference in
performance that naturally exists between an index fund and its corresponding index.
Because it is not possible or practical to purchase all of the stocks in the index, the funds
investment adviser will seek to track the total return of the index by using statistical sampling
techniques. These techniques involve investing in a limited number of index securities that, when
taken together, are expected to perform similarly to the index as a whole. These techniques are
based on a variety of factors, including interest rate and yield curve risk, maturity exposures,
industry, sector and issuer weights, credit quality, and other risk factors and characteristics.
The fund generally expects that its portfolio will hold less than the total number of securities in
the index, but reserves the right to hold as many securities as it believes necessary to achieve
the funds investment objective. The fund generally expects that its weighted average effective
duration will closely correspond to the weighted average effective duration of the index, which as
of June __, 2011 was _____ years.
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Index ownership
©
Barclays Capital Inc. 2011. All rights reserved. The
Schwab U.S. Aggregate Bond ETF is not sponsored, endorsed, sold or promoted by Barclays
Capital. Barclays Capital does not make any representation regarding the advisability of
investing in shares of the fund.
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As of June __, 2011 approximately __% of the bonds represented in the index were U.S. fixed-rate
agency mortgage pass-through securities. U.S. fixed rate agency mortgage pass-through securities
are securities issued by entities such as the Government National Mortgage Association (GNMA), the
Federal National Mortgage Association (FNMA), and the Federal Home Loan Mortgage Corporation
(FHLMC) that are backed by pools of mortgages. Most transactions in fixed-rate mortgage
pass-through securities occur
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through standardized contracts for future delivery in which the exact mortgage pools to be
delivered are not specified until a few days prior to settlement, and are often referred to as to
be announced transactions or TBA Transactions. In a TBA Transaction, the buyer and seller
agree upon general trade parameters such as agency, settlement date, par amount and price. The
actual pools delivered generally are determined two days prior to settlement date; however, it is
not anticipated that the fund will receive the pools, but will instead participate in rolling TBA
transactions. The fund anticipates that it may enter into such contracts on a regular basis. The
fund, pending settlement of such contracts, will invest its assets in high-quality liquid
short-term instruments, including Treasury securities and shares of money market mutual funds. The
fund will assume its pro rata share of the fees and expenses of any money market fund that it may
invest in, in addition to the funds own fees and expenses.
The fund will concentrate its investments (i.e., hold 25% or more of its total assets) in a
particular industry, group of industries or sector to approximately the same extent that its index
is so concentrated. For purposed of this limitation, securities of the U.S. government (including
its agencies and instrumentalities), and repurchase agreements collateralized by U.S. government
securities are not considered to be issued by members of any industry.
The adviser seeks to achieve, over time, a correlation between the funds performance and that of
its index, before fees and expenses, of 95% or better. However, there can be no guarantee that the
fund will achieve a high degree of correlation with the index. A number of factors may affect the
funds ability to achieve a high correlation with its index, including the degree to which the fund
uses a sampling technique. The correlation between the performance of the fund and its index may
also diverge due to transaction costs, asset valuations, timing variances, and differences between
the funds portfolio and the index resulting from legal restrictions (such as diversification
requirements) that apply to the fund but not to the index.
Principal investment risks
The fund is subject to risks, any of which could cause an investor to lose money.
Market Risk.
Bond markets rise and fall daily. As with any investment whose performance is tied to
these markets, the value of your investment in the fund will fluctuate, which means that you could
lose money.
Investment Style Risk.
The fund is not actively managed. Therefore, the fund follows the securities
included in the index during upturns as well as downturns. Because of its indexing strategy, the
fund does not take steps to reduce market exposure or to lessen the effects of a declining market.
In addition, because of the funds expenses, the funds total return is normally below that of the
index.
Interest Rate Risk.
The fund is subject to the risk that interest rates rise and fall over time. As
with any investment whose yield reflects current interest rates, the funds yield will change over
time. During periods when interest rates are low, the funds yield (and total return) also may be
low. Changes in interest rates also may affect the funds share price: a sharp rise in interest
rates could cause the funds share price to fall. The longer the funds duration, the more
sensitive to interest rate movements its share price is likely to be.
Credit Risk.
The fund is subject to the risk that a decline in the credit quality of a portfolio
investment could cause the fund to lose money or underperform. The fund could lose money if the
issuer of a portfolio investment fails to make timely principal or interest payments or otherwise
honor its obligations. The negative perceptions of an issuers ability to make such payments could
also cause the price of that investment to decline. The credit quality of the funds portfolio
holdings can change rapidly in certain market environments and any default on the part of a single
portfolio investment could cause the funds share price or yield to fall.
The fund will invest a portion of its assets in U.S. Government securities issued by the U.S.
Treasury, which are guaranteed by the full faith and credit of the U.S. Government, and may also
invest in securities that are not guaranteed or insured by the U.S. Government. Issuers of
securities such as Fannie Mae, Freddie Mac and the Federal Home Loan Banks (FHLB) maintain limited
lines of credit with the U.S. Treasury. Other securities, such as obligations issued by the Federal
Farm Credit Banks Funding Corporation (FFCB), are supported solely by the credit of the issuer.
There can be no assurance that the U.S. government will provide financial support to securities of
its agencies and instrumentalities if it is not obligated to do so under law. Also, any government
guarantees on securities the fund owns do not extend to shares of the fund itself. Any default on
the part of a portfolio investment could cause the funds share price or yield to fall.
On September 7, 2008, the U.S. Treasury announced a federal takeover of Fannie Mae and Freddie Mac,
placing the two federal instrumentalities in conservatorship. The actions of the U.S. Treasury are
intended to ensure that Fannie Mae and Freddie Mac maintain a positive net worth and meet their
financial obligations, preventing mandatory triggering of receivership. No assurance can be given
that the U.S. Treasury initiatives will be successful.
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Prepayment and Extension Risk.
The funds investments are subject to the risk that the securities
may be paid off earlier or later than expected. Either situation could cause the fund to hold
securities paying lower-than-market rates of interest, which could hurt the funds yield or share
price. In addition, rising interest rates tend to extend the duration of certain fixed income
securities, making them more sensitive to changes in interest rates. As a result, in a period of
rising interest rates, the fund may exhibit additional volatility. This is known as extension risk.
When interest rates decline, borrowers may pay off their fixed income securities sooner than
expected. This can reduce the returns of the fund because the fund will have to reinvest that money
at the lower prevailing interest rates. This is known as prepayment risk.
Sampling Index Tracking Risk.
The fund will not fully replicate the index and may hold securities
not included in the index. As a result, the fund is subject to the risk that the advisers
investment management strategy, the implementation of which is subject to a number of constraints,
may not produce the intended results. Because the fund uses a sampling approach it may not track
the return of the index as well as it would if the fund purchased all of the equity securities in
the index.
Tracking Error Risk.
As an index fund, the fund seeks to track the performance of its benchmark
index, although it may not be successful in doing so. The divergence between the performance of
the fund and its benchmark index, positive or negative, is called tracking error. Tracking error
can be caused by many factors and it may be significant. For example, the fund may not invest in
certain securities in its benchmark index, match the securities weighting to the benchmark, or the
fund may invest in securities not in the index due to regulatory, operational, custodial, or
liquidity constraints; corporate transactions; asset valuations; transaction costs and timing; tax
considerations; and index rebalancing, which may result in tracking error. The fund may attempt to
offset the effects of not being invested in certain index securities by making substitute
investments, but these efforts may not be successful. In addition, cash flows into and out of the
fund, operating expenses, and trading costs all affect the ability of the fund to match the
performance of its benchmark index, because the benchmark index does not have to manage cash flows
and does not incur any costs.
Mortgage-Backed and Mortgage Pass-Through Securities Risk
. Certain of the mortgage-backed
securities in which the fund may invest are not backed by the full faith and credit of the U.S.
government and there can be no assurance that the U.S. government would provide financial support
to its agencies or instrumentalities where it was not obligated to do so. Mortgage-backed
securities tend to increase in value less than other debt securities when interest rates decline,
but are subject to similar risk of decline in market value during periods of rising interest rates.
Because of prepayment and extension risk, mortgage-backed securities react differently to changes
in interest rates than other bonds. Small movements in interest ratesboth increases and
decreasesmay quickly and significantly affect the value of certain mortgage-backed securities.
Transactions in mortgage pass-through securities primarily occur through TBA transactions, as
described in the Principal investment strategies section above. Default by or bankruptcy of a
counterparty to a TBA Transaction would expose the fund to possible losses because of an adverse
market action, expenses, or delays in connection with the purchase or sale of the pools of mortgage
pass-through securities specified in the TBA Transaction.
Non-U.S. Issuer Risk.
The fund may invest in U.S.-registered, dollar-denominated bonds of non-U.S.
corporations, governments, agencies and supra-national entities. Investments in bonds of
non-U.S. issuers involve certain risks that are more significant than those associated with
investments in securities of U.S. issuers. These include risks of adverse changes in foreign
economic, political, regulatory and other conditions. . In certain countries, non-U.S. issuers may
be subject to less governmental regulation than U.S. issuers and legal remedies available to
investors may be more limited than those available with respect to investments in the United
States. The securities of some foreign companies may be less liquid and at times more volatile than
securities of comparable U.S. companies. Moreover, individual foreign economies may differ
favorably or unfavorably from the U.S. economy in such respects as growth of gross national
product, rate of inflation, capital reinvestment, resource self-sufficiency and balance of payments
position, and the prices of foreign bonds and the U.S. bonds have, at times, moved in
opposite directions. Changes to the financial condition or credit rating of a non-U.S. issuer may
also adversely affect the value of the non-U.S. securities held by the fund.
Derivatives Risk.
The principal types of derivatives used by the fund are futures contracts. A
futures contract is an agreement to buy or sell a financial instrument at a specific price on a
specific day. The funds use of derivative instruments involves risks different from, or possibly
greater than, the risks associated with investing directly in securities and other traditional
investments. Certain of these risks, such as leverage risk, market risk and liquidity risk, are
discussed elsewhere in this section. The funds use of derivatives is also subject to credit risk,
liquidity risk, lack of availability risk, valuation risk, correlation risk and tax risk. Credit
risk is the risk that the counterparty to a derivative transaction may not fulfill its contractual
obligations. Lack of availability risk is the risk that suitable derivative transactions may not be
available in all circumstances for risk management or other purposes. Valuation risk is the risk
that a particular derivative may be valued incorrectly. Correlation risk is the risk that changes
in the value of the derivative may not correlate perfectly with the underlying asset, rate or
index. Tax risk is the risk that the use of derivatives may cause the fund to realize higher
amounts of short-term capital gain. These risks could cause the fund to lose more than the
principal amount invested.
11
Liquidity Risk.
Liquidity risk exists when particular investments are difficult to purchase or
sell. The market for certain investments may become illiquid due to specific adverse changes in the
conditions of a particular issuer or under adverse market or economic conditions independent of the
issuer. The funds investments in illiquid securities may reduce the returns of the fund because it
may be unable to sell the illiquid securities at an advantageous time or price. Further,
transactions in illiquid securities may entail transaction costs that are higher than those for
transactions in liquid securities.
Leverage Risk
. Certain fund transactions, such as derivatives, may give risk to a form of
leverage and may expose the fund to greater risk. Leverage tends to magnify the effect of any
decrease or increase in the value of the funds portfolio securities. The use of leverage may cause
the fund to liquidate portfolio positions when it would not be advantageous to do to satisfy its
obligations
Securities Lending Risk.
The fund may lend its portfolio securities to brokers, dealers, and other
financial institutions provided a number of conditions are satisfied, including that the loan is
fully collateralized. When the fund lends portfolio securities, its investment performance will
continue to reflect changes in the value of the securities loaned, and the fund will also receive a
fee or interest on the collateral. Securities lending involves the risk of loss of rights in the
collateral or delay in recover of the collateral if the borrower fails to return the security
loaned or becomes insolvent. The fund will also bear the risk of any decline in value of securities
acquired with cash collateral. The fund may pay lending fees to a party arranging the loan.
Concentration Risk
. To the extent that the funds or the indexs portfolio is concentrated in the
securities of issuers in a particular market, industry, group of industries, sector or asset class,
the fund may be adversely affected by the performance of those securities, may be subject to
increased price volatility and may be more susceptible to adverse economic, market, political or
regulatory occurrences affecting that market, industry, group of industries, sector or asset class.
Market Trading Risk.
Although fund shares are listed on national securities exchanges, there can be
no assurance that an active trading market for fund shares will develop or be maintained. If an
active market is not maintained, investors may find it difficult to buy or sell fund shares.
Trading of shares of the fund on a stock exchange may be halted if exchange officials deem such
action appropriate, if the fund is delisted, or if the activation of marketwide circuit breakers
halts stock trading generally. If the funds shares are delisted, the fund may seek to list its
shares on another market, merge with another ETF, or redeem its shares at NAV.
Shares of the Fund May Trade at Prices Other Than NAV.
As with all ETFs, fund shares may be bought
and sold in the secondary market at market prices. Although it is expected that the market price of
the shares of the fund will approximate the funds NAV, there may be times when the market price
and the NAV vary significantly. Thus, you may pay more than NAV when you buy shares of the fund in
the secondary market, and you may receive less than NAV when you sell those shares in the secondary
market.
The market price of fund shares during the trading day, like the price of any exchange-traded
security, includes a bid/ask spread charged by the exchange specialist, market makers or other
participants that trade the fund shares. The bid/ask spread on ETF shares is likely to be larger on
ETFs that are traded less frequently. In addition, in times of severe market disruption, the
bid/ask spread can increase significantly. At those times, fund shares are most likely to be traded
at a discount to NAV, and the discount is likely to be greatest when the price of shares is falling
fastest, which may be the time that you most want to sell your shares. The adviser believes that,
under normal market conditions, large market price discounts or premiums to NAV will not be
sustained because of arbitrage opportunities.
Lack of Governmental Insurance or Guarantee.
An investment in the fund is not a bank deposit and it
is not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other
government agency.
Portfolio holdings
A description of the funds policies and procedures with respect to the disclosure of the funds
portfolio securities is available in the Statement of Additional Information.
12
Fund management
The investment adviser for the Schwab Fixed-Income ETFs is Charles Schwab Investment Management,
Inc. (CSIM or the adviser), 211 Main Street, San Francisco, CA 94105. Founded in 1989, the firm
today serves as investment adviser for all of the Schwab Funds
®
, Laudus
Funds
®
and Schwab ETFs
tm
. The firm has more than $___ billion under
management. (All figures on this page are as of 6/30/11.)
As the investment adviser, the firm oversees the asset management and administration of the fund.
As compensation for these services, the firm receives a management fee from the fund, expressed as
a percentage of each funds average daily net assets.
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Schwab U.S. Aggregate Bond ETF
TM
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0.__%
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A discussion regarding the basis for the Board of Trustees approval of the funds investment
advisory agreement will be available in the funds first annual and/or semi-annual report.
Pursuant to the Investment Advisory Agreement between the adviser and the fund, the adviser will
pay the operating expenses of the fund, excluding interest expense, taxes, any brokerage expenses,
and extraordinary or non-routine expenses.
Matthew Hastings, CFA,
a managing director and portfolio manager of the investment adviser, has
day-to-day responsibility for the co-management of the fund. He joined the firm in 1999 and has
worked in fixed-income asset management since 1996.
Steven Chan, CFA,
a portfolio manager of the investment adviser, has day-to-day responsibility for
the co-management of the fund. He joined the firm in 1996 and has been performing portfolio
analytic and operational support since 2004 prior to moving to his current role in 2007.
Brandon Matsui, CFA,
a portfolio manager of the investment adviser, has day-to-day responsibility
for the co-management of the fund. He joined the firm in June 2010. Prior to joining the firm, he
was an associate portfolio manager at a large financial services firm for one year. Prior to that,
he was a risk analytics manager of institutional investor accounts at a large investment management
firm for four years.
Steven Hung,
a managing director and portfolio manager of the investment adviser, has day-to-day
responsibility for the co-management of the funds. He joined the firm in 1998 and has worked in
fixed-income asset management since 1999.
Alfonso Portillo, Jr.,
a managing director and portfolio manager of the investment adviser,
has day-to-day responsibility for the co-management of the fund. He joined the firm in 2007 and has
worked in fixed-income and asset management since 1996.
Additional information about the portfolio managers compensation, other accounts managed by
the portfolio managers and the portfolio managers ownership of securities in the fund is available
in the Statement of Additional Information.
Distributor.
The funds Distributor is SEI Investments Distribution Co. The Distributor, located at
1 Freedom Valley Drive, Oaks, PA 19456, is a broker-dealer registered with the Securities and
Exchange Commission (SEC). The Distributor distributes Creation Units for the fund and does not
maintain a secondary market in shares of the fund.
13
Investing in the fund
On the following pages, you will find information on buying and selling shares. Most investors will
invest in the fund by placing orders through their brokerage account at Charles Schwab & Co., Inc.
(Schwab) or an account with another broker/dealer or other intermediary. Authorized Participants
(as defined in Purchase and redemption of creation units, below) may invest directly in the fund
by placing orders for Creation Units through the funds Distributor (direct orders). Helpful
information on taxes is included as well.
Shares of the fund trade on national securities exchanges and elsewhere during the trading day and
can be bought and sold throughout the trading day like other shares of publicly traded securities.
When buying or selling shares through a broker most investors will incur customary brokerage
commissions and charges. In addition, you may incur the cost of the spread that is, any
difference between the bid price and the ask price.
Shares of the fund trade under the following trading symbol:
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Schwab U.S. Aggregate Bond ETF
TM
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SCHZ_
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Shares of the fund may be acquired or redeemed directly from the fund only in Creation Units or
multiples thereof, as discussed in the Creation and redemption section below. Once created,
shares of the fund trade in the secondary market in amounts less than a Creation Unit. The fund
does not impose any minimum investment for shares of the fund purchased on an exchange or in the
secondary market. Except when aggregated in Creation Units, shares are not redeemable by the fund.
Share trading prices
As with other types of securities, the trading prices of shares in the secondary market can be
affected by market forces such as supply and demand, economic conditions and other factors. The
price you pay or receive when you buy or sell your shares in the secondary market may be more (a
premium) or less (a discount) than the NAV of such shares.
The approximate value of shares of the fund is disseminated every fifteen seconds throughout the
trading day by the national securities exchange on which the fund is listed or by other information
providers. This approximate value should not be viewed as a real-time update of the NAV, because
the approximate value may not be calculated in the same manner as the NAV, which is computed once
per day. The approximate value generally is determined by using current market quotations and/or
price quotations obtained from broker-dealers that may trade in the portfolio securities held by
the fund. The fund and adviser are not involved in, or responsible for, the calculation or
dissemination of the approximate value and make no warranty as to its accuracy.
Determination of net asset value
The NAV of the funds shares is calculated as of the close of regular trading on the New York Stock
Exchange, generally 4:00 p.m. Eastern time, on each day the NYSE is open for trading (each, a
Business Day). NAV per share is calculated by dividing the funds net assets by the number of the
funds shares outstanding.
In valuing their securities, the fund uses market values if they are readily available. In cases
where market values are not readily available, the fund may value securities based on fair values
developed using methods approved by the funds Board of Trustees (described below). When valuing
fixed income securities with remaining maturities of more than 60 days,
the funds use the value of the security provided by pricing services. The pricing services may
value fixed income securities
at an evaluated price by employing methodologies that use actual market transactions,
broker-supplied valuations, or other
methodologies designed to identify the market value for such securities. When valuing fixed income
securities with
remaining maturities of 60 days or less, a fund may use the securitys amortized cost, which
approximates the securitys
market value.
The funds Board of Trustees has adopted procedures, which include fair value methodologies, to
fair value the funds securities when market prices are not readily available or are unreliable.
For example, the fund may fair value a security when a security is de-listed or its trading is
halted or suspended; when a securitys primary pricing source is unable or unwilling to provide a
price; when a securitys primary trading market is closed during regular market hours; or when a
securitys value is materially affected by events occurring after the close of the securitys
primary trading market. By fair valuing securities whose prices may have been affected by events
occurring after the close of trading, the fund seeks to establish prices that investors might
expect to realize upon the current
14
sales of these securities. The funds fair value methodology seeks to ensure that the prices at
which the funds shares are purchased and redeemed are fair and do not result in dilution of
shareholder interest or other harm to shareholders. Generally, when fair valuing a security, the
fund will take into account all reasonably available information that may be relevant to a
particular valuation including, but not limited to, fundamental analytical data regarding the
issuer, information relating to the issuers business, recent trades or offers of the security,
general and specific market conditions and the specific facts giving rise to the need to fair value
the security. The fund makes fair value determinations in good faith and in accordance with the
fair value methodologies included in the Board adopted valuation procedures. Due to the subjective
and variable nature of fair value pricing, there can be no assurance that the fund could obtain the
fair value assigned to the security upon the sale of such security.
Transactions in fund shares will be priced at NAV only if you purchase or redeem shares directly
from the fund in Creation Units. Fund shares that are purchased or sold on a national securities
exchange will be effected at prevailing market prices, which may be higher or lower than NAV, and
may be subject to brokerage commissions and charges. As described below, purchases and redemptions
of Creation Units will be priced at the NAV next determined after receipt of the purchase or
redemption order.
Purchase and redemption of creation units
Creation and redemption
The shares that trade in the secondary market are created at NAV. The fund issues and redeems
shares only in Creation Units, which are large blocks of shares, typically at least 200,000 shares
or more. Only institutional investors, who have entered into an authorized participant agreement
(known as Authorized Participants) may purchase or redeem Creation Units. Creation Units
generally are issued and redeemed in exchange for a specified basket of securities approximating
the holdings of the fund and a designated amount of cash. Each Business Day, prior to the opening
of trading, the fund publishes the specific securities and designated amount of cash included in
that days basket for the fund through the National Securities Clearing Corporation (NSCC) or
other method of public dissemination. The fund reserves the right to accept or pay out a basket of
securities or cash that differs from the published basket. The prices at which creations and
redemptions occur are based on the next calculation of NAV after an order is received and deemed
acceptable by the Distributor. Orders from Authorized Participants to create or redeem Creation
Units will only be accepted on a Business Day and are also subject to acceptance by the fund and
the Distributor.
Creations and redemptions must be made by an Authorized Participant or through a firm that is
either a member of the Continuous Net Settlement System of the NSCC or a Depository Trust Company
participant, and in each case, must have executed an agreement with the Distributor with respect to
creations and redemptions of Creation Unit aggregations. More information about the procedures
regarding creation and redemption of Creation Units is included in the funds Statement of
Additional Information (SAI).
Authorized participants and the continuous offering of shares
Because new shares may be created and issued on an ongoing basis, at any point during the life of
the fund, a distribution, as such term is used in the Securities Act of 1933 (Securities Act),
may be occurring. Broker-dealers and other persons are cautioned that some activities on their part
may, depending on the circumstances, result in them being deemed participants in a distribution in
a manner that could render them statutory underwriters and subject to the prospectus-delivery and
liability provisions of the Securities Act. Nonetheless, any determination of whether one is an
underwriter must take into account all the relevant facts and circumstances of each particular
case.
Broker-dealers should also note that dealers who are not underwriters, but are participating in a
distribution (as contrasted to ordinary secondary transactions), and thus dealing with shares that
are part of an unsold allotment within the meaning of Section 4(3)(C) of the Securities Act,
would be unable to take advantage of the prospectus delivery exemption provided by Section 4(3) of
the Securities Act. For delivery of prospectuses to exchange members, the prospectus delivery
mechanism of Rule 153 under the Securities Act is only available with respect to transactions on a
national securities exchange.
Creation and redemption transaction fees for creation units
The fund may impose a creation transaction fee and a redemption transaction fee to offset transfer
and other transaction costs associated with the issuance and redemption of Creation Units. The
creation and redemption transaction fees applicable to the fund is listed below. The standard
creation transaction fee is charged to each purchaser on the day such purchaser creates a Creation
Unit. The standard fee is a single charge and will be the amount indicated below regardless of the
number of Creation Units purchased by an investor on the same day. Similarly, the standard
redemption transaction fee will be the amount indicated regardless of the number of Creation Units
redeemed that day. The fund does not charge a standard creation or redemption transaction fee, but
may do so in the future. Purchasers and redeemers of Creation Units for cash will be subject to an
additional variable charge up to the maximum
15
amount shown in the table below. This additional variable charge will offset the transaction costs
to the fund of buying or selling portfolio securities. In addition, purchasers and redeemers of
shares in Creation Units are responsible for payment of the costs of transferring securities to or
out of the fund. From time to time, the adviser may cover the cost of any transaction fees when
believed to be in the best interests of the funds.
The following table shows, as of July __, 2011, the approximate value of one Creation Unit of the
fund, including the standard and maximum additional creation and redemption transaction fee. These
fees are payable only by investors who purchase shares directly from the fund. Retail investors who
purchase shares through their brokerage account will not pay these fees. Investors who use the
services of a broker or other such intermediary may pay fees for such services.
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Standard
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Maximum
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Maximum
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Approximate Value
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Creation/Redemption
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Additional Creation
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Additional Redemption
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Name of Fund
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of One Creation Unit
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Transaction Fee
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Transaction Fee*
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Transaction Fee*
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Schwab U.S. Aggregate Bond
ETF
TM
|
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$
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$
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3.0
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%
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2.0
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%
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*
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As a percentage of total amount invested or redeemed.
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Transaction policies
Policy regarding short-term or excessive trading.
The fund has adopted policies and procedures with
respect to frequent purchases and redemptions of Creation Units. However, because the fund is an
ETF, only Authorized Participants are authorized to purchase and redeem shares directly with the
fund. Because purchase and redemption transactions with Authorized Participants are an essential
part of the ETF process and help keep ETF trading prices in line with NAV, the fund accommodates
frequent purchases and redemptions by Authorized Participants. Frequent purchases and redemptions
for cash may increase index tracking error and portfolio transaction costs and may lead to
realization of capital gains. Frequent in-kind creations and redemptions do not give rise to these
concerns. The fund reserves the right to reject any purchase order at any time.
The fund reserves the right to impose restrictions on disruptive, excessive, or short-term trading.
Such trading is defined by the fund as purchases and sales of fund shares in amounts and frequency
determined by the fund to be significant and in a pattern of activity that can potentially be
detrimental to the fund and its shareholders, such as by diluting the value of the shareholders
holdings, increasing fund transaction costs, disrupting portfolio management strategy, incurring
unwanted taxable gains, or forcing funds to hold excess levels of cash. The fund may reject
purchase or redemption orders in such instances. The fund also imposes a transaction fee on
Creation Unit transactions that is designed to offset the funds transfer and other transaction
costs associated with the issuance and redemption of the Creation Units. Although the fund has
adopted policies and procedures designed to discourage disruptive, excessive or short-term trading,
there can be no guarantee that the fund will be able to identify and restrict investors that engage
in such activities or eliminate the risks associated with such activities. In addition, the
decisions to restrict trading are inherently subjective and involve judgment in their application.
The fund may amend these policies and procedures in response to changing regulatory requirements or
to enhance their effectiveness.
Investments by Registered Investment Companies.
Section 12(d)(1) of the Investment Company Act of
1940 restricts investments by registered investment companies in the securities of other investment
companies, including shares of the fund. Registered investment companies are permitted to invest in
the fund beyond the limits set forth in section 12(d)(1), subject to certain terms and conditions
set forth in an SEC exemptive order issued to the Schwab Strategic Trust, including that such
investment companies enter into an agreement with the fund.
Distributions and taxes
Any investment in the fund typically involves several tax considerations.
The information below is
meant as a general summary for U.S. citizens and residents. Because each persons tax situation is
different, you should consult your tax advisor about the tax implications of your investment in the
fund. You also can visit the Internal Revenue Service (IRS) web site at www.irs.gov.
As a shareholder, you are entitled to your share of the dividends and gains your fund earns.
Dividends from net investment income, if any, are generally declared and paid monthly for the fund.
Distributions of net realized capital gains, if any, generally are declared and paid once a year,
although the fund may do so more frequently as determined by the Board of Trustees. Although it is
not generally expected, if the funds distributions exceed its realized taxable income and capital
gains during a taxable year, then all or a portion of the distributions made during that year may
be characterized as a return of capital to shareholders. A return of capital distribution generally
will not be taxable but will reduce the shareholders cost basis and result in a higher capital
gain or lower capital
16
loss when those shares on which the distribution was received are sold. The fund reserves the right
to declare special distributions if, in its reasonable discretion, such action is necessary or
advisable to preserve its status as a regulated investment company or to avoid imposition of income
or excise taxes on undistributed income or realized gains. Dividends and other distributions on
shares of the fund are distributed on a pro rata basis to beneficial owners of such shares. During
the fourth quarter of the year, typically in early November, an estimate of the funds year-end
distributions, if any, may be made available on the funds website www.schwabetfs.com/prospectus.
Unless you are investing through an IRA, 401(k) or other tax-advantaged retirement account, your
fund distributions generally have tax consequences.
The funds net investment income and short-term
capital gains are distributed as dividends and will be taxable as ordinary income. Other capital
gain distributions are taxable as long-term capital gains, regardless of how long you have held
your shares in the fund. Distributions generally are taxable in the tax year in which they are
declared, whether you reinvest them or take them in cash.
Generally, any sale of your shares is a taxable event.
A sale of your shares may give rise to a
gain or loss. In general, any gain or loss realized upon a taxable disposition of shares will be
treated as long-term capital gain or loss if the shares have been held for more than one year.
Otherwise, the gain or loss on the taxable disposition of shares will be treated as short-term
capital gain or loss. Absent further legislation, the reduced maximum rates on qualified dividend
income and long-term capital gains will cease to apply to taxable years beginning after December
31, 2012. Any loss realized upon a taxable disposition of shares held for six months or less will
be treated as long-term, rather than short-term, to the extent of any long-term capital gain
distributions received (or deemed received) by you with respect to the shares. All or a portion of
any loss realized upon a taxable disposition of shares will be disallowed if you purchase other
substantially identical shares within 30 days before or after the disposition. In such a case, the
basis of the newly purchased shares will be adjusted to reflect the disallowed loss.
At the beginning of every year, the fund provides shareholders with information detailing the tax
status of any distributions the fund paid during the previous calendar year.
Schwab customers also
receive information on distributions and transactions in their monthly account statements.
If you are investing through a taxable account and purchase shares of the fund just before it
declares a distribution, you may receive a portion of your investment back as a taxable
distribution. This is because when the fund makes a distribution, the share price is reduced by the
amount of the distribution. You can avoid buying a dividend, as it is often called, by finding
out if a distribution is imminent and waiting until afterwards to invest. Of course, you may decide
that the opportunity to gain a few days of investment performance outweighs the tax consequences of
buying a dividend.
Taxes on creation and redemption of creation units
An Authorized Participant who exchanges securities for Creation Units generally will recognize a
gain or a loss equal to the difference between the market value of the Creation Units at the time
of the exchange and the sum of the exchangers aggregate basis in the securities surrendered and
the cash component paid. A person who redeems Creation Units will generally recognize a gain or
loss equal to the difference between the exchangers basis in the Creation Units and the sum of the
aggregate market value of the securities and the amount of cash received for such Creation Units.
The Internal Revenue Service, however, may assert that a loss realized upon an exchange of
securities for Creation Units cannot be deducted currently under the rules governing wash sales,
or on the basis that there has been no significant change in economic position. Persons exchanging
securities for Creation Units should consult a tax advisor with respect to whether wash sale rules
apply and when a loss might be deductible.
Any capital gain or loss realized upon a redemption (or creation) of Creation Units is generally
treated as long-term capital gain or loss if the funds shares (or securities surrendered) have
been held for more than one year and as short-term capital gain or loss if the shares (or
securities surrendered) have been held for one year or less.
If you purchase or redeem Creation Units, you will be sent a confirmation statement showing how
many shares you purchased or sold and at what price. Persons purchasing or redeeming Creation Units
should consult their own tax advisors with respect to the tax treatment of any creation or
redemption transaction.
17
Index provider
CSIM has entered into a license agreement with Barclays Capital Inc. to use the index. Fees
payable under the license agreement are paid by CSIM. Barclays Capital Inc. has no obligation to
continue to provide the index to CSIM beyond the term of the license agreement.
Disclaimers
The Schwab U.S. Aggregate Bond ETF
TM
(the fund) is not sponsored, endorsed,
sold or promoted by Barclays Capital. Barclays Capital makes no representation or warranty, express
or implied, to the owners of the fund or any member of the public regarding the advisability of
investing in securities generally or in the funds particularly or the ability of a Barclays Capital
Index to track general bond market performance. Barclays Capitals only relationship to Charles
Schwab Investment Management, Inc., the funds investment manager (CSIM), and the fund is the
licensing of the Barclays Capital Index which is determined, composed and calculated by Barclays
Capital without regard to CSIM or the fund. Barclays Capital has no obligation to take the needs of
CSIM, the fund, or the owners of the fund into consideration in determining, composing or
calculating the Barclays Capital Index. Barclays Capital is not responsible for and has not
participated in the determination of the timing of, prices at, or quantities of the fund to be
issued. Barclays Capital has no obligation or liability in connection with the administration,
marketing or trading of the fund.
BARCLAYS CAPITAL SHALL HAVE NO LIABILITY TO THE FUNS OR TO THIRD PARTIES FOR THE QUALITY, ACCURACY
AND/OR COMPLETENESS OF THE INDEX OR ANY DATA INCLUDED THEREIN OR FOR INTERRUPTIONS IN THE DELIVERY
OF THE INDEX. BARCLAYS CAPITAL MAKES NO WARRANTY, EXPRESS OR IMPLIED, AS TO RESULTS TO BE OBTAINED
BY CSIM, THE OWNERS OF THE FUND OR ANY OTHER PERSON OR ENTITY FROM THE USE OF THE INDEX OR ANY DATA
INCLUDED THEREIN IN CONNECTION WITH THE RIGHTS LICENSED OR FOR ANY OTHER USE. BARCLAYS CAPITAL
MAKES NO EXPRESS OR IMPLIED WARRANTIES, AND HEREBY EXPRESSLY DISCLAIMS ALL WARRANTIES OF
MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE WITH RESPECT TO THE INDEX OR ANY DATA
INCLUDED THEREIN. BARCLAYS CAPITAL SHALL NOT BE LIABLE FOR ANY DAMAGES, INCLUDING, WITHOUT
LIMITATION, ANY INDIRECT OR CONSEQUENTIAL DAMAGES, RESULTING FROM THE USE OF THE INDEX OR ANY DATA
INCLUDED THEREIN.
Shares of the fund are not sponsored, endorsed or promoted by NYSE Arca, Inc. NYSE Arca makes no
representation or warranty, express or implied, to the owners of the shares of the fund or any
member of the public regarding the ability of the fund to track the total return performance of its
underlying index or the ability of the underlying index to track stock or bond market performance.
NYSE Arca is not responsible for, nor has it participated in, the determination of the compilation
or the calculation of any underlying index, nor in the determination of the timing of, prices of,
or quantities of shares of the fund to be issued, nor in the determination or calculation of the
equation by which the shares are redeemable. NYSE Arca has no obligation or liability to owners of
the shares of the fund in connection with the administration, marketing or trading of the shares of
the fund.
NYSE Arca shall have no liability for damages, claims, losses or expenses caused by any errors,
omissions, or delays in calculating or disseminating any current index or portfolio value; the
current value of the portfolio of securities required to be deposited to the fund; the amount of
any dividend equivalent payment or cash distribution to holders of shares of the fund; net asset
value; or other information relating to the creation, redemption or trading of shares of the fund,
resulting from any negligent act or omission by NYSE Arca, or any act, condition or cause beyond
the reasonable control of NYSE Arca, including, but not limited to, an act of God; fire; flood;
extraordinary weather conditions; war; insurrection; riot; strike; accident; action of government;
communications or power failure; equipment or software malfunction; or any error, omission or delay
in the reporting of transactions in one or more underlying securities. NYSE Arca makes no warranty,
express or implied, as to results to be obtained by any person or entity from the use of any
underlying index or data included therein and NYSE Arca makes no express or implied warranties, and
disclaims all warranties of merchantability or fitness for a particular purpose with respect to
shares of the fund or any underlying index or data included therein.
The fund and CSIM do not guarantee the accuracy and/or the completeness of the index or any data
included therein and shall have no liability for any errors, omissions, or interruptions therein.
The funds and CSIM make no warranty, express or implied, as to results to be obtained by the fund,
or any other person or entity from the use of the index or any data included therein. The fund and
CSIM make no express or implied warranties, and expressly disclaims all warranties, of
merchantability or fitness for a particular purpose or use with respect to the indexes or any data
included therein. Without limiting any of the foregoing, in no event shall the fund and CSIM have
any liability for any lost profits or indirect, punitive, special or consequential damages
(including lost profits), even if notified of the possibility of such damages.
18
To learn more
This prospectus contains important information on the fund and should be read and kept for
reference. You also can obtain more information from the following sources.
Annual and semi-annual reports,
which are mailed to current fund investors, contain more
information about the funds holdings and detailed financial information about the fund. Annual
reports also contain information from the funds managers about strategies, recent market
conditions and trends and their impact on fund performance.
The
Statement of Additional Information (SAI)
includes a more detailed discussion of investment
policies and the risks associated with various investments. The SAI is incorporated by reference
into the prospectus, making it legally part of the prospectus.
For a free copy of any of these documents or to request other information or ask questions about
the fund, call Schwab ETFs
Tm
at 1-800-435-4000. In addition, you may visit
Schwab ETFs web site at www.schwabetfs.com/prospectus for a free copy of a prospectus, SAI or an
annual or semi-annual report.
The SAI, the funds annual and semi-annual reports and other related materials are available from
the EDGAR Database on the SECs web site (http://www.sec.gov). You can obtain copies of this
information, after paying a duplicating fee, by sending a request by e-mail to publicinfo@sec.gov
or by writing the Public Reference Section of the SEC, Washington, D.C. 20549-1520. You can also
review and copy information about the fund, including the funds SAI, at the SECs Public Reference
Room in Washington, D.C. Call 1-202-551-8090 for information on the operation of the SECs Public
Reference Room.
SEC File Number
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REGxxxxxFLT-00
Schwab Fixed-Income ETFs
Prospectus
July __, 2011
(CHARLES SCHWAB LOGO)
20
STATEMENT OF ADDITIONAL INFORMATION
Schwab Fixed-Income ETFs
Schwab U.S. Aggregate Bond ETF
TM
SCHZ
Principal U.S. Listing Exchange: NYSE Arca, Inc.
July , 2011
The Statement of Additional Information (SAI) is not a prospectus. It should be read in conjunction
with the funds prospectus, dated July 8, 2011 (as amended from time to time). To obtain a free
copy of the prospectus, please contact Schwab ETFs at 1-800-435-4000. For TDD service call
1-800-345-2550. The prospectus also may be available on the Internet at:
http://www.schwabetfs.com/prospectus.
The fund is a series of the Schwab Strategic Trust (the trust). The fund is part of the Schwab
complex of funds.
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REG56975-01
INVESTMENT OBJECTIVES, STRATEGIES, RISKS AND LIMITATIONS
Investment Objectives
The Schwab U.S. Aggregate Bond ETF
TM
seeks to track as closely as possible,
before fees and expenses, the total return of the Barclays Capital U.S. Aggregate BondIndex. The
funds investment objective is not fundamental and therefore may be changed by the funds board of
trustees without shareholder approval. There is no guarantee the fund will achieve its investment
objectives.
Description of Benchmark Index
The Schwab U.S. Aggregate Bond ETFs benchmark index, the Barclays Capital U.S. Aggregate Bond
Index, is comprised of U.S. investment grade, taxable fixed income securities, including U.S.
Treasuries, government-related and corporate bonds, mortgage pass-through securities, commercial
mortgage-backed securities, and asset-backed securities that are publicly available for sale in the
United States. To be eligible for inclusion in the index, securities must be fixed rate,
non-convertible, U.S. dollar denominated with at least $250 million or more of outstanding face
value and have one or more years remaining to maturity. Asset backed securities must have a
minimum deal size of $500 million and a minimum tranche size of $25 million. For commercial
mortgage backed securities, the original aggregate transaction must have a minimum deal size of
$500 million and a minimum tranche size of $25 million; the aggregate outstanding transaction sizes
must be at least $300 million to remain in the index. The securities must be denominated in U.S.
dollars and must be fixed rate and non-convertible. The index excludes certain types of
securities, including state and local governments series bonds, structured notes embedded with
swaps or other special features, private placements, floating rate securities, inflation-linked
bonds and Eurobonds. The index is market capitalization weighted and the securities in the index
are updated on the last business day of each month. As of June __, 2011, there were approximately
_____ securities in the index.
Index Providers and Disclaimers
The fund is not sponsored, endorsed, sold or promoted by Barclays Capital. Barclays Capital makes
no representation or warranty, express or implied, to the owners of the fund or any member of the
public regarding the advisability of investing in securities generally or in the fund particularly
or the ability of a Barclays Capital Index to track general bond market performance. Barclays
Capitals only relationship to the fund and the investment adviser is the licensing of each
Barclays Capital Index which is determined, composed and calculated by Barclays Capital without
regard to the fund and the investment adviser. Barclays Capital has no obligation to take the needs
of the fund, the investment adviser, or the owners of the funs into consideration in determining,
composing or calculating a Barclays Capital Index. Barclays Capital is not responsible for and has
not participated in the determination of the timing of, prices at, or quantities of the shares of
the fund to be issued. Barclays Capital has no obligation or liability in connection with the
administration, marketing or trading of the fund.
BARCLAYS CAPITAL SHALL HAVE NO LIABILITY TO THE FUND OR TO THIRD PARTIES FOR THE QUALITY, ACCURACY
AND/OR COMPLETENESS OF THE INDEX OR ANY DATA INCLUDED THEREIN OR FOR INTERRUPTIONS IN THE DELIVERY
OF THE INDEX . BARCLAYS CAPITAL MAKES NO WARRANTY, EXPRESS OR IMPLIED, AS TO RESULTS TO BE
OBTAINED BY THE FUND, OWNERS OF THE FUND OR ANY OTHER PERSON OR ENTITY FROM THE USE OF THE INDEX OR
ANY DATA INCLUDED THEREIN IN CONNECTION WITH THE RIGHTS LICENSED OR FOR ANY OTHER USE. BARCLAYS
CAPITAL MAKES NO EXPRESS OR IMPLIED WARRANTIES, AND HEREBY EXPRESSLY DISCLAIMS ALL WARRANTIES OF
MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE WITH RESPECT TO THE INDEX OR ANY DATA
INCLUDED THEREIN. BARCLAYS CAPITAL SHALL NOT BE LIABLE FOR ANY DAMAGES, INCLUDING, WITHOUT
LIMITATION, ANY INDIRECT OR CONSEQUENTIAL DAMAGES, RESULTING FROM THE USE OF THE INDEX OR ANY DATA
INCLUDED THEREIN.
Shares of the fund are not sponsored, endorsed or promoted by NYSE Arca Inc. NYSE Arca makes no
representation or warranty, express or implied, to the owners of the shares of the fund or any
member of the public regarding the ability of the fund to track the total return performance of any
underlying index or the ability of the underlying index to track stock or bond market performance.
NYSE Arca is not responsible for, nor has it
participated in, the determination of the compilation or the calculation of an underlying index,
nor in the determination of the timing of, prices of, or quantities of shares of the fund to be
issued, nor in the determination or calculation of the equation by which the shares are redeemable.
NYSE Arca has no obligation or liability to owners of the shares of the funds in connection with
the administration, marketing or trading of the shares of the fund.
2
NYSE Arca shall have no liability for damages, claims, losses or expenses caused by any errors,
omissions, or delays in calculating or disseminating any current index or portfolio value the
current value of the portfolio of securities required to be deposited to the fund; the amount of
any dividend equivalent payment or cash distribution to holders of shares of the fund; net asset
value; or other information relating to the creation, redemption or trading of shares of the fund,
resulting from any negligent act or omission by NYSE Arca, or any act, condition or cause beyond
the reasonable control of NYSE Arca, including, but not limited to, an act of God; fire; flood;
extraordinary weather conditions; war; insurrection; riot; strike; accident; action of government;
communications or power failure; equipment or software malfunction; or any error, omission or delay
in the reporting of transactions in one or more underlying securities. NYSE Arca makes no warranty,
express or implied, as to results to be obtained by any person or entity from the use of any
underlying index or data included therein and NYSE Arca makes no express or implied warranties, and
disclaims all warranties of merchantability or fitness for a particular purpose with respect to
shares of the fund or any underlying index or data included therein.
Fund Investment Policies
The Schwab U.S. Aggregate Bond ETF
TM
will, under normal circumstances, invest
at least 90% of its net assets in the securities of its benchmark index. TBA transactions (defined
below) are included within the above noted investment policy. This investment policy may be
changed by the funds Board without shareholder approval. The fund will notify its shareholders at
least 60 days before changing this policy. For purposes of this policy, net assets mean net assets
plus the amount of any borrowings for investment purposes.
A substantial portion of the bonds represented in the index are U.S. fixed-rate mortgage
pass-through securities. These securities are issued by entities such as the Government National
Mortgage Association (GNMA) and the Federal National Mortgage Association (FNMA or Fannie
Mae) that are backed by pools of mortgages. Most transactions in fixed-rate mortgage pass-through
securities occur through standardized contracts for future delivery in which the exact mortgage
pools to be delivered are not specified until a few days prior to settlement. The fund expects to
enter into such contracts on a regular basis. The fund, pending settlement of such contracts, will
invest its assets in high-quality, liquid short-term instruments, including U.S. Treasury
securities and shares of money market funds. The fund will assume its pro rata share of the fess
and expenses of any money market fund in which it may invest, in addition to the funds own fees
and expenses.
Investments, Risks and Limitations
The following investment strategies, risks and limitations supplement those set forth in the
prospectus and may be changed without shareholder approval unless otherwise noted. Also, policies
and limitations that state a maximum percentage of assets that may be invested in a security or
other asset, or that set forth a quality standard, shall be measured immediately after and as a
result of the funds acquisition of such security or asset unless otherwise noted. Thus, except
with respect to limitations on borrowing and futures contracts, any subsequent change in values,
net assets or other circumstances does not require the fund to sell an investment if it could not
then make the same investment.
Principal Investment Strategy Investments
Unless otherwise indicated, the following investments may be used as part of each funds
principal investment strategy.
Concentration
means that substantial amounts of assets are invested in a particular industry or
group of industries. Concentration increases investment exposure to industry risk. For example, the
automobile industry may have a greater exposure to a single factor, such as an increase in the
price of oil, which may adversely affect the sale of automobiles and, as a result, the value of the
industrys securities. As part of the funds principal investment strategy, the fund will not
concentrate its investments in a particular industry or group of industries, except that the fund
will concentrate to approximately the same extent that its benchmark index concentrates in the
securities of such particular industry or group of industries. For purposed of this limitation,
securities of the U.S. government
(including its agencies and instrumentalities), and repurchase agreements collateralized by U.S.
government securities are not considered to be issued by members of any industry.
Debt Securities
are obligations issued by domestic and foreign entities, including governments and
corporations, to raise money. They are basically IOUs, but are commonly referred to as bonds or
money market securities. These securities normally require the issuer to pay a fixed, variable or
floating rate of interest on the amount of money borrowed (the principal) until it is paid back
upon maturity.
Debt securities experience price changes when interest rates change. For example, when interest
rates fall, the prices of debt securities generally rise. Also, issuers may pre-pay their
outstanding debts and issue new ones paying lower interest rates. This is especially true for
bonds with sinking fund provisions, which commit the issuer to set aside a certain amount of money
to cover timely
3
repayment of principal and typically allow the issuer to annually repurchase
certain of its outstanding bonds from the open market or at a pre-set call price.
Conversely, in a rising interest rate environment, prepayment on outstanding debt securities
generally will not occur. This is known as extension risk and may cause the value of debt
securities to depreciate as a result of the higher market interest rates. Typically,
longer-maturity securities react to interest rate changes more severely than shorter-term
securities (all things being equal), but generally offer greater rates of interest.
Debt securities also are subject to the risk that the issuers will not make timely interest and/or
principal payments or fail to make them at all. This is called credit risk. Corporate debt
securities (bonds) tend to have higher credit risk generally than U.S. government debt securities.
Debt securities also may be subject to price volatility due to market perception of future interest
rates, the creditworthiness of the issuer and general market liquidity (market risk).
Investment-grade debt securities are considered medium- or/and high-quality securities, although
some still possess varying degrees of speculative characteristics and risks.
Corporate bonds
are debt securities issued by corporations. Although a higher return is
expected from corporate bonds, these securities, while subject to the same general risks as U.S.
government securities, are subject to greater credit risk than U.S. government securities. Their
prices may be affected by the perceived credit quality of their issuer.
Investment-grade bonds
. The fund will generally limit its investments in debt securities
to those that are rated investment-grade, which means that the securities are rated by at least one
Nationally Recognized Statistical Rating Organization (NRSRO), such as Standard & Poors
Corporation, Moodys Investors Service, Fitch, Inc. or Dominion Bond Rating Service, in one of the
four highest rating categories (within which there may be sub-categories or gradations indicating
relative standing). See Appendix Ratings of Investment Securities. The ratings of NRSROs
represent their opinions as to the quality of the securities. It should be emphasized, however,
that these ratings are general and are not absolute standards of quality. Consequently, obligations
with the same rating, maturity and interest rate may have different market prices. Further, NRSROs
may have conflicts of interest relating to the issuance of a credit rating and such conflicts may
affect the integrity of the credit rating process or the methodologies used to develop credit
ratings for securities. Such conflicts may include, but are not limited to, NRSROs being paid by
issuers or underwriters to determine the credit ratings with respect to the securities they issue
or underwrite, NRSROs being paid by issuers and underwriters for services in addition to the NRSROs
determination of credit ratings; allowing persons with the NRSRO to directly own securities or
money market instruments of, or having other direct ownership interests in, issuers or obligors
subject to a credit rating determined by the NRSRO; and allowing persons within the NRSRO to have a
business relationship that is more than an arms length ordinary course of business relationship
with issuers or obligors subject to a credit rating determined by the NRSRO.
In addition, credit 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 given to securities at issuance do not necessarily represent ratings that would be
given to these securities on a particular subsequent date. Accordingly, investors should note that
the assignment of a rating to a security by a rating service may not reflect the effect of recent
developments on the issuers ability to make interest and principal payments.
Delayed-Delivery and Forward Commitment Transactions
involve purchasing and selling securities on a
delayed-delivery or forward basis. A delayed-delivery agreement is a contract for the purchase or
sale of one or more securities to be delivered on an agreed future settlement date. A forward
commitment agreement is a contract for the purchase or sale of one or more securities at a
specified price, with delivery and cash settlement on an agreed specified future date. When
purchasing securities on a delayed-delivery or forward basis, the fund assumes the rights and risks
of ownership, including the risk of price and yield fluctuations. Typically, no interest will
accrue to the fund until the security is delivered. The fund will earmark or segregate appropriate
liquid assets to cover its delayed-delivery purchase obligations. When the fund sells a security
on a delayed-delivery or forward basis, the fund does not participate in further gains or losses
with respect to that security. If the other party to a delayed-delivery transaction fails to
deliver or pay for the securities, the fund could suffer losses.
Diversification
involves investing in a wide range of securities and thereby spreading and reducing
the risks of investment. The fund is a series of an open-end investment management company with
limited redeemability. The fund is a diversified exchange traded funds. Diversification does not
eliminate the risk of market loss.
Exchange Traded Funds
(ETFs) are investment companies that typically are registered under the
Investment Company Act of 1940 (1940 Act) as open-end fund as is the funds case or unit
investment trusts (UITs). ETFs are actively traded on national securities exchanges and are
generally based on specific domestic and foreign market indices. Shares of an ETF may be bought and
sold through
4
the day at market prices, which may be higher or lower than the shares net asset
value. An index-based ETF seeks to track the performance of an index holding in its portfolio
either the contents of the index or a representative sample of the securities in the index. Because
ETFs are based on an underlying basket of stocks or an index, they are subject to the same market
fluctuations as these types of securities in volatile market swings. ETFs, like mutual funds, have
expenses associated with their operation, including advisory fees. When the fund invests in an ETF,
in addition to directly bearing expenses associated with its own operations, it will bear a pro
rata portion of the ETFs expenses. As with any exchange listed security, ETF shares purchased in
the secondary market are subject to customary brokerage charges.
Non-U.S. Issuer Risk
.
The fund will invest in U.S. dollar-denominated debt securities of non-U.S.
issuers to the extent that such securities are included in the funds index. Foreign securities
involve additional risks because they are issued by foreign entities, including foreign
governments, banks, corporations or because they are traded principally overseas. Foreign
securities in which the fund may invest include foreign entities that are not subject to uniform
accounting, auditing and financial reporting standards, practices and requirements comparable to
those applicable to U.S. corporations. In addition, there may be less publicly available
information about foreign entities. Foreign economic, political and legal developments could have
more dramatic effects on the value of foreign securities. For example, conditions within and
around foreign countries, such as the possibility of expropriation or confiscatory taxation,
political or social instability, diplomatic developments, change of government or war could affect
the value of foreign investments. Moreover, individual foreign economies may differ favorably or
unfavorably from the U.S. economy in such respects as growth of gross national product, rate of
inflation, capital reinvestment, resource self-sufficiency and balance of payments position.
Foreign securities typically have less volume and are generally less liquid and more volatile than
securities of U.S. companies. There may be difficulties in obtaining or enforcing judgments
against foreign issuers as well. These factors and others may increase the risks with respect to
the liquidity of the fund, and its ability to meet a large number of shareholder redemption
requests.
The funds investments in emerging markets can be considered speculative, and therefore may offer
higher potential for gains and losses than investments in developed markets of the world. With
respect to an emerging country, there may be a greater potential for nationalization, expropriation
or confiscatory taxation, political changes, government regulation, social instability or
diplomatic developments (including war) which could affect adversely the economies of such
countries or investments in such countries. The economies of developing countries generally are
heavily dependent upon international trade and, accordingly, have been and may continue to be
adversely affected by trade barriers, exchange or currency controls, managed adjustments in
relative currency values and other protectionist measures imposed or negotiated by the countries
with which they trade.
In addition to the risks of investing in emerging market country debt securities, the funds
investment in government or government-related securities of emerging market countries and
restructured debt instruments in emerging
markets are subject to special risks, including the inability or unwillingness to repay principal
and interest, requests to reschedule or restructure outstanding debt, and requests to extend
additional loan amounts. The fund may have limited recourse in the event of default on such debt
instruments.
Illiquid Securities
generally are any securities that cannot be disposed of promptly and in the
ordinary course of business within seven days at approximately the amount at which the fund has
valued the instruments. The liquidity of the funds investments is monitored under the supervision
and direction of the Board of Trustees. The fund may not invest more than 15% of its net assets in
illiquid securities. In the event that a subsequent change in net assets or other circumstances
cause the fund to exceed this limitation, the fund will take steps to bring the aggregate amount of
illiquid instruments back within the limitations as soon as reasonably practicable.
In making liquidity determinations before purchasing a particular security, the Adviser considers a
number of factors including, but not limited to: the nature and size of the security; the number of
dealers that make a market in the security; and data which indicates that a securitys price has
not changed for a period of a week or longer. After purchase, it is the Advisers policy to
maintain awareness of developments in the marketplace that could cause a change in a securitys
liquid or illiquid status. Investments currently not considered liquid include repurchase
agreements not maturing within seven days and certain restricted securities.
Indexing Strategies
involve tracking the securities represented in, and therefore the performance
of, an index. The fund normally will invest primarily in the securities of its index. Moreover, the
fund seeks to invest so that its portfolio performs similarly to that of its index. The fund will
seek to achieve, over time, a correlation between the funds performance and that of its index,
before fees and expenses, of 0.95 or better; however, there can be no guarantee that the fund will
achieve a high degree of correlation with the index. Correlation for the fund is calculated daily,
according to a mathematical formula (R-squared) which measures correlation between the funds
portfolio and benchmark index returns. A perfect correlation of 1.0 is unlikely as the fund incurs
operating and trading expenses unlike its index.
5
Interest Rates
may rise and fall over time, and debt securities will experience price changes when
interest rates change. For example, when interest rates fall, the prices of debt securities
generally rise. If interest rates move sharply higher, the value of the funds debt securities
could be adversely impacted and the fund could lose money. The value of debt securities in the fund
can be expected to vary inversely with changes in prevailing interest rates. In general, debt
securities with longer maturities will tend to react to interest rate changes more severely than
shorter-term debt securities, but will generally offer greater rates of interest.
During periods of rising interest rates, the average life of certain debt securities is extended
because of slower than expected principal payments. This may lock in below-market interest rates
and extend the duration of these debt securities, making them more sensitive to changes in interest
rates. This is known as extension risk and may cause the value of debt securities to depreciate as
a result of the higher market interest rates.
Money Market Securities
are high-quality, short term debt securities that may be issued by entities
such as the U.S. government, corporations and financial institutions (like banks). Money market
securities include commercial paper, certificates of deposit, bankers acceptances, notes and time
deposits. Certificates of deposit and time deposits are issued against funds deposited in a banking
institution for a specified period of time at a specified interest rate. Bankers acceptances are
credit instruments evidencing a banks obligation to pay a draft drawn on it by a customer. These
instruments reflect the obligation both of the bank and of the drawer to pay the full amount of the
instrument upon maturity. Commercial paper consists of short term, unsecured promissory notes
issued to finance short term credit needs.
Money market securities pay fixed, variable or floating rates of interest and are generally subject
to credit and interest rate risks. The maturity date or price of and financial assets
collateralizing a security may be structured in order to make it qualify as or act like a money
market security. These securities may be subject to greater credit and
interest rate risks than other money market securities because of their structure. Money market
securities may be issued with puts or sold separately, sometimes called demand features or
guarantees, which are agreements that allow the buyer to sell a security at a specified price and
time to the seller or put provider. When the fund buys a put, losses could occur as a result of
the costs of the put or if it exercises its rights under the put and the put provider does not
perform as agreed.
The fund may keep a portion of its assets in cash for business operations. To reduce the effect
this otherwise uninvested cash would have on its performance, the fund may invest in money market
securities. The fund may also invest in money market securities to the extent it is consistent with
its investment objective.
Bankers Acceptances
or notes are credit instruments evidencing a banks obligation to pay
a draft drawn on it by a customer. These instruments reflect the obligation both of the bank and
of the drawer to pay the full amount of the instrument upon maturity. The fund will invest only in
bankers acceptances of banks that have capital, surplus and undivided profits in the aggregate in
excess of $100 million.
Certificates of Deposit
or time deposits are issued against funds deposited in a banking
institution for a specified period of time at a specified interest rate. The fund will invest only
in certificates of deposit of banks that have capital, surplus and undivided profits in the
aggregate in excess of $100 million.
Commercial Paper
consists of short term, promissory notes issued by banks, corporations and
other institutions to finance short term credit needs. These securities generally are discounted
but sometimes may be interest bearing. Commercial paper, which also may be unsecured, is subject to
credit risk.
Fixed Time Deposits
are bank obligations payable at a stated maturity date and bearing
interest at a fixed rate. Fixed time deposits may be withdrawn on demand by the investor, but may
be subject to early withdrawal penalties, which vary depending upon market conditions and the
remaining maturity of the obligation. There are no contractual restrictions on the right to
transfer a beneficial interest in a fixed time deposit to a third party, although there is no
market for such deposits. The fund will not invest in fixed time deposits, which (1) are not
subject to prepayment or (2) provide for withdrawal penalties upon prepayment (other than overnight
deposits) if, in the aggregate, more than 15% of its net assets would be invested in such deposits,
repurchase agreements maturing in more than seven days and other illiquid assets.
6
Promissory Notes
are written agreements committing the maker or issuer to pay the payee a
specified amount either on demand or at a fixed date in the future, with or without interest.
These are sometimes called negotiable notes or instruments and are subject to credit risk. Bank
notes are notes used to represent obligations issued by banks in large denominations.
Mortgage-Backed Securities
(MBS) and other
Asset-Backed Securities
may be purchased by the fund.
MBS represent participations in mortgage loans, and include pass-through securities. MBS may be
issued or guaranteed by U.S. government agencies or instrumentalities, such as the Government
National Mortgage Association (GNMA or Ginnie Mae) and the Federal National Mortgage
Association (FNMA or Fannie Mae) or the Federal Home Loan Mortgage Corporation (FHLMC or
Freddie Mac).
The National Housing Act authorized GNMA to guarantee the timely payment of principal and interest
on securities backed by a pool of mortgages insured by the Federal Housing Administration (FHA) or
guaranteed by the Veterans Administration (VA). The GNMA guarantee is backed by the full faith and
credit of the U.S. Government. The GNMA is also empowered to borrow without limitation from the
U.S. Treasury if necessary to make any payments required under its guarantee.
GNMA-guaranteed securities are mortgage securities which evidence an undivided interest in a
pool or pools of mortgages. GNMA Certificates that the fund may purchase are the modified
pass-through type, which entitle the holder to receive timely payment of all interest and
principal payments due on the mortgage pool, net of fees paid to the issuer and GNMA, regardless
of whether or not the mortgagor actually makes the payment. The GNMA guarantee on such certificates
guarantees on investors principal investment in such certificates. Accordingly, the funds principal
investments in such certificates is protected against loss due to foreclosure on the pools
underlying mortgages, except to the extent that the fund has purchased the certificates above par
in the secondary market.
The average life of a mortgage-backed security is likely to be substantially shorter than the
original maturity of the mortgages underlying the securities. Scheduled payments and prepayments
of principal by mortgagors and mortgage foreclosures will usually result in the return of the
greater part of principal investment long before the maturity of the mortgages in the pool.
FHLMC was created in 1970 to promote development of a nationwide secondary market in conventional
residential mortgages. The FHLMC issues two types of mortgage pass-through securities (FHLMC
Certificates): mortgage participation certificates (PCs) and guaranteed mortgage certificates
(GMCs). PCs resemble GNMA Certificates in that each PC represents a pro rata share of all interest
and principal payments made and owed on the underlying pool. The FHLMC guarantees timely monthly
payment of interest on PCs and the ultimate payment of principal, but its issues are not backed by
the full faith and credit of the U.S. Government.
GMCs also represent a pro rata interest in a pool of mortgages. However, these instruments pay
interest semi-annually and return principal once a year in guaranteed minimum payments. The
expected average life of these securities is approximately 10 years. The FHLMC guarantee is not
backed by the full faith and credit of the U.S. Government.
FNMA was established in 1938 to create a secondary market in mortgages the FHA insures. FNMA
issues guaranteed mortgage pass-through certificates (FNMA Certificates). FNMA Certificates
resemble GNMA Certificates in that each FNMA Certificate represents a pro rata share of all
interest and principal payments made and owed on the underlying pool. FNMA guarantees timely
payment of interest and principal on FNMA Certificates. The FNMA guarantee is not backed by the
full faith and credit of the U.S. Government.
For more information on securities issued by Fannie Mae and Freddie Mac, see U.S. Government
Securities.
Asset-backed Securities
(ABS) have structural characteristics similar to MBS. ABS
represent direct or indirect participation in assets such as automobile loans, credit card
receivables, trade receivables, home equity loans (which sometimes are categorized as MBS) or other
financial assets. Therefore, repayment depends largely on the cash flows generated by the assets
backing the securities. The credit quality of most ABS depends primarily on the credit quality of
the assets underlying such securities, how well the entity issuing the security is insulated from
the credit risk of the originator or any other affiliated entities, and the amount and quality of
any credit enhancement of the securities. Payments or distributions of principal and interest on
ABS may be supported by credit enhancements including letters of credit, an insurance guarantee,
reserve funds and overcollateralization. Asset-backed securities also may be debt instruments,
which are also known as collateralized obligations and are generally issued as the debt of a
special purpose entity, such as a trust, organized solely for the purpose of owning such assets and
issuing debt obligations.
Commercial Mortgage-Backed Securities
include securities that reflect an interest in, and
are secured by, mortgage loans on commercial real property. The market for commercial
mortgage-backed securities developed more recently and in terms of total
7
outstanding principal
amount of issues is relatively small compared to the market for residential single-family MBS.
Many of the risks of investing in commercial MBS reflect the risks of investing in the real estate
securing the underlying mortgage loans. These risks reflect the effects of local and other
economic conditions on real estate markets, the ability of tenants to make loan payments, and the
ability of a property to attract and retain tenants. Commercial MBS may be less liquid and exhibit
greater price volatility than other types of mortgage- or asset-backed securities.
Mortgage Dollar Rolls
.
The fund may enter into mortgage dollar rolls, in which the fund would sell
MBS for delivery in the current month and simultaneously contract to purchase substantially similar
securities on a specified future date. While the fund would forego principal and interest paid on
the MBS during the roll period, the fund would be compensated by the difference between the current
sales price and the lower price for the future purchase as well as by any interest earned on the
proceeds of the initial sale. The fund also could be compensated through the receipt of fee income
equivalent to a lower forward price. At the time the fund would enter into a mortgage dollar roll,
it would set aside permissible liquid assets earmarked or in a segregated account to secure its
obligation for the forward commitment to buy MBS. Mortgage dollar roll transactions may be
considered a borrowing by the fund.
The mortgage dollar rolls entered into by the fund may be used as transactions in which the fund
will maintain an offsetting position in high-quality liquid short-term investments. Since the fund
will receive interest on the securities in which it invests the transaction proceeds, such
transactions may involve a form of leverage. However, since such securities will be high quality
and short duration, the investment adviser believes that such transactions present lower risks to
the fund than those associated with other types of leverage. There can be no assurance that the
funds use of the cash it receives from a mortgage dollar roll will provide a positive return.
Mortgage Pass-Through Securities.
The term U.S. agency mortgage pass-through security refers to
a category of pass-through securities backed by pools of mortgages and issued by one of several
U.S. government-sponsored entities, such as GNMA, FNMA, or FHLMC. In the basic mortgage
pass-through structure, mortgages with similar issuer, term and coupon characteristics are
collected and aggregated into a pool consisting of multiple mortgage loans. The pool is assigned
a CUSIP number and undivided interests in the pool are traded and sold as pass-through securities.
The holder of the security is entitles to a pro rata share of principal and interest payments
(including unscheduled prepayments) from the poll of mortgage loans.
An investment in a specific pool of pass-through securities requires an analysis of the specific
prepayment risk of mortgages within the covered pool (since mortgagors typically have the option to
prepay their loans). The level of prepayments on a pool of mortgage securities is difficult to
predict and can impact the subsequent cash flows, value and yield of the mortgage pool. In
addition, when trading specific mortgage pools, precise execution, delivery and settlement
arrangements must be negotiated for each transaction. These factors combine to make trading in
mortgage pools somewhat cumbersome relative to other fund investments.
For these reasons, the fund seeks to obtain exposure to U.S. agency mortgage pass-through
securities through the use of to-be-announced or TBA transactions. TBA refers to a commonly
used mechanism for the forward settlement of U.S. agency mortgage pass-through securities, and not
to a separate type of mortgage-backed security. Most transactions in the fixed-rate mortgage
pass-through securities occur through the use of TBA transactions. TBA transactions are generally
conducted in accordance with widely-accepted guidelines that establish commonly observed terms and
conditions for execution, settlement and delivery. In a TBA transaction, the buyer and seller
decided on general trade parameters, such as agency, settlement date, par amount and price. The
actual pools delivered generally are determined two days prior to settlement date. The fund may
use TBA transactions in several ways. For example, the fund anticipates that it will regularly
enter into TBA agreements and roll over such agreements prior to the settlement date stipulated
in such agreements. This type of TBA transaction is sometimes knows as a TBA roll. In a TBA
roll, the fund generally will sell the obligation to purchase the pools stipulated in the TBA
agreement prior to the stipulated settlement date and will enter into a new TBA agreement for
future delivery of pools of mortgage pass-through securities. In addition, the fund may enter into
TBA agreements and settle such transactions on the stipulated settlement date by accepting actual
receipt or delivery of the pools of mortgage pass-through securities stipulate din the TBA
agreement.
Default by or bankruptcy of a counterparty to a TBA transaction would expose the fund to possible
loss because of adverse market action, expenses or delays in connection with the purchase or sale
of the pools of mortgage pass-through securities specified in the TBA transaction. To help
minimize this risk, the fund will enter into TBA transactions only with established counterparties
(such as major broker-dealers) and the funds investment adviser will monitor the creditworthiness
of such counterparties. The fund may also acquire interests in mortgage pools through means other
than TBA transactions.
8
The funds use of TBA rolls may cause the fund to experience higher portfolio turnover, higher
transaction costs and to pay higher capital gain distributions to shareholders, which may be
taxable, than if it acquired exposure to mortgage pools through means other than TBA transactions.
The fund intends to invest cash pending settlement of any TBA transactions in U.S. treasury
securities, money market instruments, repurchase agreements, or other high-quality, liquid
short-term instruments, including money market funds.
Securities Lending
of portfolio securities is a common practice in the securities industry. The
fund may engage in security lending arrangements. For example, the fund may receive cash
collateral, and it may invest it in short term, interest-bearing obligations, but will do so only
to the extent that it will not lose the tax treatment available to
regulated investment companies. Lending portfolio securities involves risks that the borrower may
fail to return the securities or provide additional collateral. Also, voting rights with respect to
the loaned securities may pass with the lending of the securities.
The fund may loan portfolio securities to qualified broker-dealers or other institutional investors
provided: (1) the loan is secured continuously by collateral consisting of U.S. government
securities, letters of credit, cash or cash equivalents or other appropriate instruments maintained
on a daily marked-to-market basis in an amount at least equal to the current market value of the
securities loaned; (2) the fund may at any time call the loan and obtain the return of the
securities loaned; (3) the fund will receive any interest or dividends paid on the loaned
securities; and (4) the aggregate market value of securities loaned will not at any time exceed
one-third of the total assets of the fund, including collateral received from the loan (at market
value computed at the time of the loan).
Although voting rights with respect to loaned securities pass to the borrower, the lender retains
the right to recall a security (or terminate a loan) for the purpose of exercising the securitys
voting rights. Efforts to recall such securities promptly may be unsuccessful, especially for
foreign securities or thinly traded securities such as small-cap stocks. In addition, because
recalling a security may involve expenses to the fund, it is expected that the fund will do so only
where the items being voted upon are, in the judgment of the investment adviser, either material to
the economic value of the security or threaten to materially impact the issuers corporate
governance policies or structure.
Securities of Other Investment Companies
.
Investment companies generally offer investors the
advantages of diversification and professional investment management, by combining shareholders
money and investing it in securities such as stocks, bonds and money market instruments. Investment
companies include: (1) open-end funds (commonly called mutual funds) that issue and redeem their
shares on a continuous basis; (2) closed-end funds that offer a fixed number of shares, and are
usually listed on an exchange; and (3) unit investment trusts that generally offer a fixed number
of redeemable shares. Certain open-end funds, closed-end funds and unit investment trusts are
traded on exchanges.
Investment companies may make investments and use techniques designed to enhance their performance.
These may include delayed-delivery and when-issued securities transactions; swap agreements; buying
and selling futures contracts, illiquid, and/or restricted securities and repurchase agreements;
and borrowing or lending money and/or portfolio securities. The risks of investing in a particular
investment company will generally reflect the risks of the securities in which it invests and the
investment techniques it employs. Also, investment companies charge fees and incur expenses.
The fund may buy securities of other investment companies, including those of foreign issuers, in
compliance with the requirements of federal law or any SEC exemptive order. The fund may invest in
investment companies that are not registered with the SEC or privately placed securities of
investment companies (which may or may not be registered), such as hedge funds and offshore funds.
Unregistered funds are largely exempt from the regulatory requirements that apply to registered
investment companies. As a result, unregistered funds may have a greater ability to make
investments, or use investment techniques, that offer a higher potential investment return (for
example, leveraging), but which may carry high risk. Unregistered funds, while not regulated by the
SEC like registered funds, may be indirectly supervised by the financial institutions (e.g.,
commercial and investment banks) that may provide them with loans or other sources of capital.
Investments in unregistered funds may be difficult to sell, which could cause a fund selling an
interest in an unregistered fund to lose money. For example, many hedge funds require their
investors to hold their investments for at least one year.
Federal law restricts the ability of one registered investment company to invest in another. As a
result, the extent to which the fund may invest in another investment company may be limited. With
respect to investments in certain other investment companies (most typically ETFs), the funds may
rely on an exemption from the limitations of the 1940 Act granted by the SEC to such other
investment companies that restrict the amount of securities of such other underlying funds a fund
may hold, provided that certain conditions are met. The conditions requested by the SEC were
designed to address certain abuses perceived to be associated with funds of funds,
9
including
unnecessary costs (such as sales loads, advisory fees and administrative costs), and undue
influence by a fund of funds over the underlying fund. The conditions apply only when a fund and
its affiliates in the aggregate own more than 3% of the outstanding shares of any one underlying
fund.
Under the terms of the exemptive order, the fund and its affiliates may not control a
non-affiliated underlying fund. Under the 1940 Act, any person who owns beneficially, either
directly or through one or more controlled companies, more than 25% of the voting securities of a
company is assumed to control that company. This limitation is measured at the time the investment
is made.
U.S. Government Securities
are issued by the U.S. Treasury or issued or guaranteed by the U.S.
government or any of its agencies or instrumentalities. Not all U.S. government securities are
backed by the full faith and credit of the United States. Some U.S. government securities, such as
those issued by the Federal National Mortgage Association (known as Fannie Mae), Federal Home Loan
Mortgage Corporation (known as Freddie Mac), the Student Loan Marketing Association (known as
Sallie Mae), and the Federal Home Loan Banks, are supported by a line of credit the issuing entity
has with the U.S. Treasury. Others are supported solely by the credit of the issuing agency or
instrumentality such as obligations issued by the Federal Farm Credit Banks Funding Corporation.
There can be no assurance that the U.S. government will provide financial support to U.S.
government securities of its agencies and instrumentalities if it is not obligated to do so under
law. Of course U.S. government securities, including U.S. Treasury securities, are among the safest
securities, however, not unlike other debt securities, they are still sensitive to interest rate
changes, which will cause their yields and prices to fluctuate.
On September 7, 2008, the U.S. Treasury announced a federal takeover of Fannie Mae and Freddie Mac,
placing the two federal instrumentalities in conservatorship. Under the takeover, the U.S. Treasury
agreed to acquire $1 billion of senior preferred stock of each instrumentality and obtained
warrants for the purchase of common stock of each instrumentality. Under these Senior Preferred
Stock Purchase Agreements (SPAs), the U.S. Treasury has pledged to provide up to $100 billion per
instrumentality as needed, including the contribution of cash capital to the instrumentalities in
the event their liabilities exceed their assets. On May 6, 2009, the U.S. Treasury increased its
maximum commitment to each instrumentality under the SPAs to $200 billion per instrumentality. On
December 24, 2009, the U.S. Treasury further amended the SPAs to allow the cap on Treasurys
funding commitment to increase as necessary to accommodate any cumulative reduction in Fannie Maes
and Freddie Macs net worth through the end of 2012. At the conclusion of 2012, the remaining U.S.
Treasury commitment will then be fully available to be drawn per the terms of the SPAs. In December
2009, the U.S. Treasury also amended the SPAs to provide Fannie Mae and Freddie Mac with some
additional flexibility to meet the requirement to reduce their mortgage portfolios.
The actions of the U.S. Treasury are intended to ensure that Fannie Mae and Freddie Mac maintain a
positive net worth and meet their financial obligations preventing mandatory triggering of
receivership. No assurance can be given that the U.S. Treasury initiatives will be successful.
Non-Principal Investment Strategy Investments
The following investments may be used as part of each funds non-principal investment
strategy:
Borrowing
.
The fund may borrow money from banks or through the Schwab Funds interfund borrowing and
lending facility (as described below) for any purpose in an amount up to 1/3 of the funds total
assets (not including temporary borrowings). The fund may also borrow for temporary or emergency
purposes; for example, the fund may borrow at times to meet redemption requests rather than sell
portfolio securities to raise the necessary cash. A borrowing is presumed to be for temporary or
emergency purposes if it is (a) not in excess of 5% of a funds total assets; (b) repaid by the
fund within 60 days; and (c) not extended or renewed. Provisions of the 1940 Act, as amended,
require the fund to maintain continuous asset coverage (that is, total assets including borrowings,
less liabilities exclusive of borrowings) of 300% of the amount borrowed, with an exception for
temporary borrowings. If the 300% asset coverage should decline as a result of market fluctuations
or other reasons, the fund may be required to sell some of its portfolio holdings within three days
(not including Sundays and holidays) to reduce the debt and restore the 300% asset coverage, even
though it may be disadvantageous from an investment standpoint to sell securities at that time.
The funds borrowings will be subject to interest costs. Borrowing can also involve leveraging when
securities are purchased with the borrowed money. Leveraging creates interest expenses that can
exceed the income from the assets purchased with the borrowed money. In addition, leveraging may
magnify changes in the net asset value of
the funds shares and in its portfolio yield. The fund will earmark or segregate assets to cover
such borrowings in accordance with positions of the Securities and Exchange Commission (SEC). If
assets used to secure a borrowing decrease in value, the fund may be required to pledge additional
collateral to avoid liquidation of those assets.
10
The fund may establish lines-of-credit (lines) with certain banks by which it may borrow funds
for temporary or emergency purposes. A borrowing is presumed to be for temporary or emergency
purposes if it is repaid by the fund within 60 days and is not extended or renewed. The fund may
use the lines to meet large or unexpected redemptions that would otherwise force the fund to
liquidate securities under circumstances which are unfavorable to the funds remaining
shareholders. The fund will pay a fee to the bank for using the lines.
Build America Bonds
offer an alternative form of financing to state and local governments whose
primary means for accessing the capital markets has historically been through the issuance of
tax-free municipal bonds. The Build America Bond program allows state and local governments to
issue taxable bonds for capital projects and to receive direct federal subsidy payment from the
Treasury Department for a portion of their borrowing costs. There are two types of Build American
Bonds. The first type of Build America Bond provides a federal subsidy through federal tax credits
to investors in the bonds in an amount equal to 35% of the total coupon interest payable by the
issuer on taxable governmental bonds (net of the tax credit), which represents a federal subsidy of
the state or local governmental issuer equal to approximately 25% of the total return to the
investor. The second type provides a federal subsidy through a refundable tax credit paid to
stqate or local governmental issuers by the Treasury Department and the IRS in an amount equal to
35% (or 45% in the case of Recovery Zone Economic Development Bonds) of the total coupon interest
payable to investors in these taxable bonds.
Issuance of Build America Bonds ceased on December 31, 2010. Outstanding Build America Bonds will
continue to be eligible for the federal interest rate subsidy, which continues for the life of the
bonds. The fund will purchase and hold Build America Bonds to the extent that such bonds are
included in the funds benchmark index.
Capital Securities
are certain subordinated bank securities. They are bank obligations that fall
below senior unsecured debt and deposits in liquidation. A banks capital comprises share capital
reserves and a series of hybrid instruments also known as capital securities. These securities are
used to augment equity Tier 1 and are usually in the form of subordinated debt. A capital security
has to adhere to supervisory guidelines concerning its characteristics such as amount, maturity,
subordination and deferral language in order to count as capital. Regulators across the world tend
to look toward the Bank for International Settlements (BIS) for guidance in setting the capital
adequacy framework for banks. Regulators use these guidelines to place limits on the proportions
and type of capital (including capital securities) allowed to make up the capital base. Capital
adequacy requires not just a certain quantity of capital but certain types in relationship to the
nature of a banks assets. Capital securities may be denominated in U.S. or local currency.
Derivative Instruments
are commonly defined to include securities or contracts whose values depend
on (or derive from) the value of one or more other assets such as securities, currencies, or
commodities. These other assets are commonly referred to as underlying assets. The principal
types of derivatives used by the fund are futures contracts. The fund may use futures contracts
and other derivatives primarily to help manage interest rate exposure. Additional risk management
strategies include investment techniques designed to facilitate the sale of portfolio securities,
manage the average duration of the portfolio or create or alter exposure to certain asset classes.
The fund may allocate up to 10% of its net assets to derivatives investments.
Futures Contracts
are instruments that represent an agreement between two parties that
obligates one party to buy, and the other party to sell, specific instruments at an agreed-upon
price on a stipulated future date. In the case of futures contracts relating to an index or
otherwise not calling for physical delivery at the close of the transaction, the parties usually
agree to deliver the final cash settlement price of the contract. The fund may purchase and sell
futures contracts based on securities, securities indices, interest rates, or any other futures
contracts traded on U.S. exchanges . Consistent with CFTC regulations, the trust has claimed an
exclusion from the definition of the term commodity pool operator under the Commodity Exchange
Act and, therefore, is not subject to registration or regulation as a pool operator under the
Commodity Exchange Act.
The fund must maintain a small portion of its assets in cash to process certain shareholder
transactions in and out of it and to pay its expenses. To help manage interest rate exposure, the
fund may purchase futures contracts. Such
transactions also allow the funds cash balance to produce a return similar to that of the
underlying security or index on which the futures contract is based. The fund may enter into
futures contracts for other reasons as well.
When buying or selling futures contracts, the fund must place a deposit with its broker equal to a
fraction of the contract amount. This amount is known as initial margin and must be in the form
of liquid debt instruments, including cash, cash-equivalents and U.S. government securities.
Subsequent payments to and from the broker, known as variation margin may be made daily, if
necessary, as the value of the futures contracts fluctuate. This process is known as
marking-to-market. The margin amount will be returned to the
11
fund upon termination of the futures
contracts assuming all contractual obligations are satisfied. Because margin requirements are
normally only a fraction of the amount of the futures contracts in a given transaction, futures
trading can involve a great deal of leverage. To avoid this, the fund will earmark or segregate
assets for any outstanding futures contracts as may be required under the federal securities laws.
While the fund intends to purchase and sell futures contracts to simulate full investment, there
are risks associated with these transactions. Adverse market movements could cause the fund to
experience substantial losses when buying and selling futures contracts. Of course, barring
significant market distortions, similar results would have been expected if the fund had instead
transacted in the underlying securities directly. There also is the risk of losing any margin
payments held by a broker in the event of its bankruptcy. Additionally, the fund incurs transaction
costs (i.e., brokerage fees) when engaging in futures trading. To the extent the fund also invests
in futures to simulate full investment, these same risks apply.
Futures contracts normally require actual delivery or acquisition of an underlying security or cash
value of an index on the expiration date of the contract. In most cases, however, the contractual
obligation is fulfilled before the date of the contract by buying or selling, as the case may be,
identical futures contracts. Such offsetting transactions terminate the original contracts and
cancel the obligation to take or make delivery of the underlying securities or cash. There may not
always be a liquid secondary market at the time the fund seeks to close out a futures position. If
the fund is unable to close out its position and prices move adversely, the fund would have to
continue to make daily cash payments to maintain its margin requirements. If the fund had
insufficient cash to meet these requirements it may have to sell portfolio securities at a
disadvantageous time or incur extra costs by borrowing the cash. Also, the fund may be required to
make or take delivery and incur extra transaction costs buying or selling the underlying
securities. The fund seeks to reduce the risks associated with futures transactions by buying and
selling futures contracts that are traded on national exchanges or for which there appears to be a
liquid secondary market.
With respect to futures contracts that are not legally required to cash settle, the fund may
cover the open position by setting aside or earmarking liquid assets in an amount equal to the
market value of the futures contracts. With respect to futures contracts that are required to cash
settle, however, the fund is permitted to set aside or earmark liquid assets in an amount equal to
the funds daily marked to market (net) obligation, if any, (in other words, the funds daily net
liability, if any) rather than the market value of the futures contracts. By setting aside assets
or earmarking equal to only its net obligation under cash-settled futures, the fund will have the
ability to employ leverage to a greater extent than if the fund were required to set aside or
earmark assets equal to the full market value of the futures contract.
Fixed Rate Capital Securities
(FRCSs) are hybrid securities that combine the features of both
corporate bonds and preferred stock. FRCSs pay dividends monthly or quarterly. FRCSs are listed
on major exchanges and, also, trade on the OTC markets. FRCSs are generally issued by large
corporations and are rated by NRSOs. FRCSs bear the creditworthiness of the corporate issuer,
generally have a stated maturity (20 to 49 years) and, unlike preferred stock, are fully taxable.
There are currently three types of FRCSs offered in the marketplace: direct subordinate FRCSs which
are offered directly by a corporation and zero coupon partnership preferred and trust preferred
FRCS which are issued indirectly by a corporation through a conduit financing vehicle. FRCSs
generally rank senior to common stock and preferred stock in a corporations capital structure, but
have a lower security claim than the issuers corporate bonds. FRCSs generally offer higher yields
than corporate bonds or agency securities, but they carry more risks than the higher lien debt. In
addition to risks commonly associated with other fixed income securities, FRCSs are subject to
certain additional risks. Many FRCSs include a special event redemption option, allowing the
issuer to redeem the securities at the liquidation value if a tax law change disallows the
deductibility of payments by the issuers parent company, or subjects the issue to taxation
separate from the parent company. FRCSs permit the deferral of payments (without declaring
default) if the issuer experiences financial difficulties.
Payments may be suspended for some stipulated period, usually up to five years. If the issuer
defers payments, the deferred income continues to accrue for tax purposes, even though the investor
does not receive cash payments. Such deferrals can only occur if the parent company stops all other
stock dividend payments on both common and preferred stock classes. The treatment of investment
income from trust and debt securities for federal tax purposes is uncertain and may vary depending
on whether the possibility of the issuer deferring payments is, or is not, considered a remote
contingency.
High Yield Bonds
.
The fund generally will not invest in debt securities rated below
investment-grade, which are sometimes referred to as high yield bonds or junk bonds. However,
the fund may purchase and hold high yield bonds to the extent that the securities are included in
the funds benchmark index.
High-yield bonds are frequently issued by companies without long track records of sales and
earnings, or by those of questionable credit strength, and are more speculative and volatile
(though typically higher yielding) than investment grade bonds. Adverse
12
economic developments could
disrupt the market for high yield securities, and severely affect the ability of issuers,
especially highly-leveraged issuers, to service their debt obligations or to repay their
obligations upon maturity.
Also, the secondary market for high yield securities at times may not be as liquid as the secondary
market for higher-quality debt securities. As a result, the investment adviser could find it
difficult to sell these securities or experience difficulty in valuing certain high yield
securities at certain times. Prices realized upon the sale of such lower rated securities, under
these circumstances, may be less than the prices at which a fund purchased them.
High yield securities are more likely to react to developments affecting interest rates and market
and credit risk than are more highly rated securities, which primarily react to movements in the
general level of interest rates. When economic conditions appear to be deteriorating, medium- to
lower-quality debt securities may decline in value more than higher-quality debt securities due to
heightened concern over credit quality, regardless of prevailing interest rates. Prices for high
yield securities also could be affected by legislative and regulatory developments. These laws
could adversely affect a funds net asset value and investment practices, the secondary market
value for high yield securities, the financial condition of issuers of these securities and the
value of outstanding high yield securities.
Interfund Borrowing and Lending
.
The fund may borrow money from and/or lend money to other
funds/portfolios in the Schwab complex. All loans are for temporary or emergency purposes and the
interest rates to be charged will be the average of the overnight repurchase agreement rate and the
short term bank loan rate. All loans are subject to numerous conditions designed to ensure fair and
equitable treatment of all participating funds/portfolios. These conditions include, for example,
that the funds participation in the credit facility must be consistent with its investment
policies and limitations and organizational documents; no fund may lend to another fund through the
interfund lending facility if the loan would cause the aggregate outstanding loans through the
credit facility to exceed 15% of the lending funds current net assets at the time of the loan; and
that the funds interfund loans to any one fund shall not exceed 5% of the lending funds net
assets. With respect to the fund discussed in this SAI, by lending to another fund the fund may
forego gains which could have been made had those assets been invested in securities of its
applicable underlying index. The interfund lending facility is subject to the oversight and
periodic review of the Board of Trustees.
Repurchase Agreements
are instruments under which a buyer acquires ownership of certain securities
(usually U.S. government securities) from a seller who agrees to repurchase the securities at a
mutually agreed-upon time and price, thereby determining the yield during the buyers holding
period. Any repurchase agreements the fund enters into will involve the fund as the buyer and banks
or broker-dealers as sellers. The period of repurchase agreements is usually short from
overnight to one week, although the securities collateralizing a repurchase agreement may have
longer maturity dates. Default by the seller might cause the fund to experience a loss or delay in
the liquidation of the collateral securing the repurchase agreement. The fund also may incur
disposition costs in liquidating the collateral. In the event of a bankruptcy or other default of a
repurchase agreements seller, the fund might incur expenses in enforcing its rights, and could
experience losses, including a decline in the value of the underlying securities and loss of
income. The fund will make payment under a repurchase agreement only upon physical delivery or
evidence of book entry transfer of the collateral to the account of its custodian bank. Repurchase
agreements are the economic equivalents of loans.
Restricted Securities
are securities that are subject to legal restrictions on their sale.
Restricted securities may be considered to be liquid if an institutional or other market exists for
these securities. In making this determination, the fund, under the direction and supervision of
the Board of Trustees will take into account various factors, including: (1) the frequency of
trades and quotes for the security; (2) the number of dealers willing to purchase or sell the
security and the number of potential purchasers; (3) dealer undertakings to make a market in the
security; and (4) the nature of the security and marketplace trades (e.g., the time needed to
dispose of the security, the method of soliciting offers and the mechanics of transfer). To the
extent the fund invests in restricted securities that are deemed liquid, its general level of
illiquidity may be increased if qualified institutional buyers become uninterested in purchasing
these securities.
Sinking Funds
may be established by bond issuers to set aside a certain amount of money to cover
timely repayment of bondholders principal raised through a bond issuance. By creating a sinking
fund, the issuer is able to spread repayment of principal to numerous bondholders while reducing
reliance on its then current cash flows. A sinking fund also may allow the issuer to annually
repurchase certain of its outstanding bonds from the open market or repurchase certain of its bonds
at a call price named in a bonds sinking fund provision. This call provision will allow bonds to
be prepaid or called prior to a bonds maturity. The likelihood of this occurring is substantial
during periods of falling interest rates.
[Step-Coupons
are debt securities that do not make regular cash interest payments. Step-coupon
securities are sold at a deep discount to their face value. Because such securities do not pay
current cash income, the price of these securities can be volatile when interest
13
rates fluctuate.
While these securities do not pay current cash income, federal income tax law requires the holders
of step-coupon securities to include in income each year the portion of the original issue discount
(or deemed discount) and other non-cash income on such securities accruing that year. To continue
to qualify as a regulated investment company or RIC under the Internal Revenue Code and avoid a
certain excise tax, the fund may be required to distribute a portion of such discount and income
and may be required to dispose of other portfolio securities, which may occur in periods of adverse
market prices, in order to generate cash to meet these distribution requirements.]
Variable and Floating Rate Debt Securities
pay an interest rate, which is adjusted either
periodically or at specific intervals or which floats continuously according to a formula or
benchmark. Although these structures generally are intended to minimize the fluctuations in value
that occur when interest rates rise and fall, some structures may be linked to a benchmark in such
a way as to cause greater volatility to the securitys value.
Some variable rate securities may be combined with a put or demand feature (variable rate demand
securities) that entitles the holder to the right to demand repayment in full or to resell at a
specific price and/or time. While the demand feature is intended to reduce credit risks, it is not
always unconditional and may be subject to termination if the issuers credit rating falls below
investment grade or if the issuer fails to make payments on other debt. While most variable-rate
demand securities allow the fund to exercise its demand rights at any time, some such securities
may only allow the fund to exercise its demand rights at certain times, which reduces the liquidity
usually associated with this type of security. The fund could suffer losses in the event that the
demand feature provider, usually a bank, fails to meet its obligation to pay the demand
Additional Investment Information
Maturity of Investments
will generally be determined using the portfolio securities final maturity
dates. However for certain securities, maturity will be determined using the securitys effective
maturity date. Except as discussed below, the effective maturity date for a security subject to a
put or demand feature is the demand date, unless the security is a variable- or floating-rate
security. If it is a variable-rate security, its effective maturity date is the earlier of its
demand date or next interest rate change date. For variable rate securities not subject to a put or
demand feature and floating-rate securities, the effective maturity date is the next interest rate
change date. For an interest rate swap agreement, its effective maturity would be equal to the
difference in the effective maturity of the interest rates swapped. Securities being hedged with
futures contracts may be deemed to have a longer maturity, in the case of purchases of future
contracts, and a shorter maturity, in the case of sales of futures contracts, than they would
otherwise be deemed to have. In addition, a security that is subject to redemption at the option of
the issuer on a particular date (call date), which is prior to, or in lieu of, the securitys
stated maturity, may be deemed to mature on the call date rather than on its stated maturity date.
The call date of a security will be used to calculate average
portfolio maturity when the investment adviser reasonably anticipates, based upon information
available to it, that the issuer will exercise its right to redeem the security. The average
portfolio maturity of the fund is dollar-weighted based upon the amortized cost of the funds
securities at the time of the calculation.
Duration
was developed as a more precise alternative to the concept of maturity. Traditionally, a
debt obligations maturity has been used as a proxy for the sensitivity of the securitys price to
changes in interest rates (which is the interest rate risk or volatility of the security).
However, maturity measures only the time until a debt obligation provides its final payment, taking
no account of the pattern of the securitys payments prior to maturity. In contrast, duration
incorporates a bonds yield, coupon interest payments, final maturity, call and put features and
prepayment exposure into one measure. Duration is the magnitude of the change in the price of a
bond relative to a given change in market interest rates. Duration management is one of the
fundamental tools used by the investment adviser.
Duration is a measure of the expected life of a debt obligation on a present value basis. Duration
takes the length of the time intervals between the present time and the time that the interest and
principal payments are scheduled or, in the case of a callable bond, the time the principal
payments are expected to be received, and weights them by the present values of the cash to be
received at each future point in time. For debt obligations with interest payments occurring prior
to the payment of principal, duration will usually be less than maturity. In general, all else
being equal, the lower the stated or coupon rate of the interest of a fixed income security, the
longer the duration of the security; conversely, the higher the stated or coupon rate of a fixed
income security, the shorter the duration of the security.
For example, if a mutual fund holds long futures contracts or call option positions, it will
lengthen the duration of that funds portfolio. Holding short futures or put options will shorten
the duration of a mutual funds portfolio. A swap agreement on an asset or group of assets may
affect the duration of the portfolio depending on the attributes of the swap. For example, if the
swap agreement provides a
14
floating rate of return in exchange for a fixed rate of return, the
duration of a mutual fund will be modified to reflect the duration attributes of a similar security
that the mutual fund is permitted to buy.
There are some situations where even the standard duration calculation does not properly reflect
the interest rate exposure of a security. For example, floating- and variable-rate securities often
have final maturities of ten or more years; however, their interest rate exposure corresponds to
the frequency of the coupon reset. Another example where the interest rate exposure is not properly
captured by maturity is mortgage pass-through securities. The stated final maturity of such
securities is generally 30 years, but current prepayment rates are more critical in determining the
securities interest rate exposure. Finally, the duration of the debt obligation may vary over time
in response to changes in interest rates and other market factors.
Investment Limitations
The investment limitations below may be changed only by vote of a majority of the outstanding
voting securities of the fund.
Under the 1940 Act, a vote of a majority of the outstanding voting
securities of a fund means the affirmative vote of the lesser of (1) more than 50% of the
outstanding shares of the fund or (2) 67% or more of the shares present at a shareholders meeting
if more than 50% of the outstanding shares are represented at the meeting in person or by proxy.
EACH FUND MAY NOT:
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1)
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Purchase securities of an issuer, except as consistent with the maintenance of its
status as an open-end diversified company under the 1940 Act, the rules or regulations
thereunder or any exemption therefrom, as such statute, rules or regulations may be amended
or interpreted from time to time.
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2)
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Concentrate investments in a particular industry or group of industries, as
concentration is defined under the 1940 Act, the rules or regulations thereunder or any
exemption therefrom, as such statute, rules or regulations may be amended or interpreted
from time to time, except that the fund may concentrate its investments to approximately
the same extent that the index the fund is designed to track concentrates in the securities
of such particular industry or group of industries and the fund may invest without
limitation in (a)
securities issued or guaranteed by the U.S. government, its agencies or instrumentalities,
and (b) tax-exempt obligations of state or municipal governments and their political
subdivisions.
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3)
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Purchase or sell commodities, commodities contracts or real estate, lend or borrow
money, issue senior securities, underwrite securities issued by others, or pledge, mortgage
or hypothecate any of its assets, except as permitted or not prohibited by the 1940 Act or
the rules or regulations thereunder or any exemption therefrom, as such statute, rules or
regulations may be amended or interpreted from time to time.
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THE FOLLOWING DESCRIPTIONS OF THE 1940 ACT MAY ASSIST INVESTORS IN UNDERSTANDING THE CURRENT
APPLICATION OF THE ABOVE POLICIES AND RESTRICTIONS, BUT SUCH DESCRIPTIONS ARE NOT PART OF THE ABOVE
POLICIES AND RESTRICTIONS.
BORROWING. The 1940 Act restricts an investment company from borrowing (including pledging,
mortgaging or hypothecating assets) in excess of 33 1/3% of its total assets (not including
temporary borrowings). Transactions that are fully collateralized in a manner that does not involve
the prohibited issuance of a senior security within the meaning of Section 18(f) of the 1940 Act,
shall not be regarded as borrowings for the purposes of a funds investment restriction.
CONCENTRATION. The SEC has defined concentration as investing 25% or more of an investment
companys total assets in an industry or group of industries, with certain exceptions such as with
respect to investments in obligations issued or guaranteed by the U.S. Government or its agencies
and instrumentalities, or tax-exempt obligations of state or municipal governments and their
political subdivisions.
DIVERSIFICATION. Under the 1940 Act and the rules, regulations and interpretations thereunder, a
diversified company, as to 75% of its total assets, may not purchase securities of any issuer
(other than obligations of, or guaranteed by, the U.S. government or its agencies, or
instrumentalities or securities of other investment companies) if, as a result, more than 5% of its
total assets would be invested in the securities of such issuer, or more than 10% of the issuers
voting securities would be held by a fund.
LENDING. Under the 1940 Act, an investment company may only make loans if expressly permitted by
its investment policies.
15
REAL ESTATE. The 1940 Act does not directly restrict an investment companys ability to invest
in real estate, but does require that every investment company have the fundamental investment
policy governing such investments. Each fund has adopted the fundamental policy that would permit
direct investment in real estate. However, each fund has a non-fundamental investment limitation
that prohibits it from investing directly in real estate. This non-fundamental policy may be
changed only by vote of a funds Board of Trustees.
SENIOR SECURITIES. Senior securities may include any obligation or instrument issued by an
investment company evidencing indebtedness. The 1940 Act generally prohibits a fund from issuing
senior securities, although it provides allowances for certain borrowings and certain other
investments, such as short sales, reverse repurchase agreements, and firm commitment agreements,
when such investments are covered or with appropriate earmarking or segregation of assets to
cover such obligations.
UNDERWRITING. Under the 1940 Act, underwriting securities involves an investment company purchasing
securities directly from an issuer for the purpose of selling (distributing) them or participating
in any such activity either directly or indirectly. Under the 1940 Act, a diversified fund may not
make any commitment as underwriter, if immediately thereafter the amount of its outstanding
underwriting commitments, plus the value of its investments in securities of issuers (other than
investment companies) of which it owns more than 10% of the outstanding voting securities, exceeds
25% of the value of its total assets.
THE FOLLOWING ARE NON-FUNDAMENTAL INVESTMENT POLICIES AND RESTRICTIONS, AND MAY BE CHANGED BY THE
BOARD OF TRUSTEES.
THE FUND MAY NOT:
1)
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Invest more than 15% of its net assets in illiquid securities.
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2)
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Sell securities short unless it owns the security or the right to obtain the security or
equivalent securities, or unless it covers such short sale as required by current SEC rules
and interpretations (transactions in futures contracts, options and other derivative
instruments are not considered selling securities short).
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3)
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Purchase securities on margin, except such short term credits as may be necessary for the
clearance of purchases and sales of securities and provided that margin deposits in connection
with futures contracts, options on futures or other derivative instruments shall not
constitute purchasing securities on margin.
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4)
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Borrow money except that the fund may (i) borrow money from banks or through an interfund
lending facility, if any, and engage in reverse repurchase agreements with any party provided
that such borrowings and reverse repurchase agreements in combination do not exceed 33 1/3% of
its total assets, including the amount borrowed (but not including temporary or emergency
borrowings not exceeding 5%); and (ii) may borrow an additional amount up to 5% of its assets
for temporary or emergency purposes..
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5)
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Lend any security or make any other loan if, as a result, more than 33 1/3% of its total
assets would be lent to other parties (this restriction does not apply to purchases of debt
securities or repurchase agreements).
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6)
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Purchase securities (other than securities issued or guaranteed by the U.S. government, its
agencies or instrumentalities or tax-exempt obligations of state or municipal governments and
their political subdivisions) if, as a result of such purchase, 25% or more of the value of
its total assets would be invested in any industry or group of industries except that each
fund may concentrate its investments to approximately the same extent that the index the fund
is designed to track concentrates in the securities of a particular industry or group of
industries.
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7)
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Purchase or sell physical commodities or commodity contracts based on physical commodities or
invest in unmarketable interests in real estate limited partnerships or invest directly in
real estate. For the avoidance of doubt, the foregoing policy does not prevent the fund from,
among other things, (i) purchasing marketable securities of companies that deal in real estate
or interests therein (including REITs); (ii) purchasing marketable securities of companies
that deal in physical commodities or interests therein; and (iii) purchasing, selling and
entering into futures contracts (including futures contracts on indices of securities,
interest rates and currencies), options on futures contracts (including futures contracts on
indices of securities, interest rates and currencies), warrants, swaps, forward contracts,
foreign currency spot and forward contracts or other derivative instruments.
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Policies and investment limitations that state a maximum percentage of assets that may be invested
in a security or other asset, or that set forth a quality standard shall be measured immediately
after and as a result of the funds acquisition of such security or asset, unless otherwise noted.
Except with respect to limitations on borrowing and futures and option contracts, any subsequent
change in net assets or other circumstances does not require the fund to sell an investment if it
could not then make the same investment. With respect to the limitation on illiquid securities, in
the event that a subsequent change in net assets or other circumstances cause the fund
16
to exceed its limitation, the fund will take steps to bring the aggregate amount of illiquid
instruments back within the limitations as soon as reasonably practicable.
CONTINUOUS OFFERING
The fund offers and issues shares at their net asset value per share or NAV only in aggregations of
a specified number of shares (Creation Units). The method by which Creation Units are created and
trade may raise certain issues under applicable securities laws. Because new Creation Units are
issued and sold by the fund on an ongoing basis, at any point a distribution, as such term is
used in the Securities Act of 1933 the (Securities Act), may occur. Broker-dealers and other
persons are cautioned that some activities on their part may, depending on the circumstances,
result in their being deemed participants in a distribution in a manner that could render them
statutory underwriters and subject them to the prospectus delivery requirement and liability
provisions of the Securities Act.
For example, a broker-dealer firm or its client may be deemed a statutory underwriter if it takes
Creation Units after placing an order with the funds distributor, breaks them down into
constituent shares, and sells such shares directly to customers, or if it chooses to couple the
creation of a supply of new shares with an active selling effort involving solicitation of
secondary market demand for shares. A determination of whether one is an underwriter for purposes
of the Securities Act must take into account all the facts and circumstances pertaining to the
activities of the broker-dealer or its client in the particular case, and the examples mentioned
above should not be considered a complete description of all the activities that could lead to
categorization as an underwriter.
Broker-dealer firms should also note that dealers who are not underwriters but are effecting
transactions in shares, whether or not participating in the distribution of shares, generally are
required to deliver a prospectus. This is because the prospectus delivery exemption in Section 4(3)
of the Securities Act is not available in respect of such transactions as a result of Section 24(d)
of the 1940 Act. Firms that incur a prospectus delivery obligation with respect to shares of the
fund are reminded that, pursuant to Rule 153 under the Securities Act, a prospectus delivery
obligation under Section 5(b)(2) of the Securities Act owed to an exchange member in connection
with the sale on an exchange is satisfied by the fact that the prospectus is available at the
exchange upon request. The prospectus delivery mechanism provided in Rule 153 is only available
with respect to transactions on an exchange.
MANAGEMENT OF THE FUNDS
The fund is overseen by a Board of Trustees. The trustees are responsible for protecting
shareholder interests. The trustees regularly meet to review the investment activities, contractual
arrangements and the investment performance of the fund. The fund is new, and therefore the
trustees did not meet with respect to the fund during the trusts most recent fiscal year.
Certain trustees are interested persons. A trustee is considered an interested person of the
trust under the 1940 Act if he or she is an officer, director, or an employee of Charles Schwab
Investment Management, Inc. (CSIM) or Charles Schwab & Co., Inc. (Schwab). A trustee also may
be considered an interested person of the trust under the 1940 Act if he or she owns stock of The
Charles Schwab Corporation, a publicly traded company and the parent company of CSIM.
As used herein the term Family of Investment Companies collectively refers to The Charles Schwab
Family of Funds, Schwab Investments, Schwab Annuity Portfolios, Schwab Capital Trust and Schwab
Strategic Trust which, as of June 30, 2011, included 77 funds.
The tables below provide information about the trustees and officers for the trusts, which includes
the funds, in this SAI. The Fund Complex includes The Charles Schwab Family of Funds, Schwab
Investments, Schwab Capital Trust, Schwab Strategic Trust, Schwab Annuity Portfolios, Laudus Trust,
and Laudus Institutional Trust. As of June 30, 2011, the Fund Complex included 86 funds. The
address of each individual listed below is 211 Main Street, San Francisco, California 94105.
17
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NUMBER
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NAME, YEAR OF BIRTH, AND
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OF
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POSITION(S) WITH THE TRUST;
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PORTFOLIOS
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OTHER DIRECTORSHIPS HELD
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(TERM OF OFFICE AND
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PRINCIPAL OCCUPATION(S)
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IN FUND
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BY
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LENGTH OF
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DURING PAST FIVE
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COMPLEX
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TRUSTEE DURING THE PAST
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TIME SERVED
1
)
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YEARS
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OVERSEEN
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FIVE YEARS
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Independent Trustees:
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Robert W. Burns
1959
(Trustee of Schwab Strategic
Trust since 2009)
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Retired. Consulting
Managing Director,
PIMCO (investment
adviser) (January 2003
December 2008);
Managing Director,
PIMCO (February 1999
December 2002);
President and Trustee,
PIMCO Funds and PIMCO
Variable Insurance
Trust (investments)
(February 1994 May
2005).
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13
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Independent Director
and Chairman of
Corporate
Governance/Nominating
Committee, PS Business
Parks, Inc. (2005
present).
Trustee and member of
Nominating/Corporate
Governance Committee,
PIMCO Funds (investment
company consisting of
84 portfolios) (1997
2008).
Trustee and member of
Nominating/Corporate
Governance Committee,
PIMCO Variable
Insurance Trust
(investment company
consisting of 16
portfolios) (1997
2008).
Trustee and Chairman,
PIMCO Strategic Global
Government Fund
(investment company
consisting of one
portfolio) (2006
2008).
Trustee, PCIM Fund,
Inc. (investment
company consisting of
one portfolio) (1997
2008).
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Mark A. Goldfarb
1952
(Trustee of Schwab Strategic
Trust since 2009)
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Founder and Managing
Director, SS&G
Financial Services
(financial services)
(May 1987 present).
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13
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None.
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Charles A. Ruffel
1956
(Trustee of Schwab Strategic
Trust since 2009)
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Advisor (June 2008
present) and Chief
Executive Officer
(January 1998
January 2008), Asset
International, Inc.
(publisher of
financial services
information); Managing
Partner and
Co-Founder, Kudu
Advisors, LLC
(financial services)
(June 2008
present).
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13
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None.
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Interested Trustee:
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Walter W. Bettinger II
2
1960
(Trustee of Schwab Strategic
Trust since 2009)
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As of October 2008,
President and Chief
Executive Officer,
Charles Schwab & Co.,
Inc., and The Charles
Schwab Corporation.
Since May 2008,
Director, Charles
Schwab & Co., Inc. and
Schwab Holdings, Inc.
Since 2006, Director,
Charles Schwab Bank.
Until October 2008,
President and Chief
Operating Officer,
Charles Schwab & Co.,
Inc. and The Charles
Schwab Corporation.
From 2004 through
2007, Executive Vice
President and
President, Schwab
Investor Services.
From 2004 through
2005, Executive Vice
President and Chief
Operating Officer,
Individual Investor
Enterprise, and from
2002 through 2004,
Executive Vice
President, Corporate
Services.
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86
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None.
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18
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NAME, YEAR OF BIRTH, AND
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POSITION(S) WITH THE TRUST;
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(TERM OF OFFICE AND LENGTH OF
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PRINCIPAL OCCUPATIONS DURING THE PAST FIVE
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TIME SERVED
3
)
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YEARS
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OFFICERS
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Marie Chandoha
1961
President and Chief Executive Officer
(Officer of Schwab Strategic Trust since 2010)
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Executive Vice President, Charles Schwab & Co., Inc. (Sept.
2010 present); Director, President and Chief Executive
Officer (Dec. 2010 present), Chief Investment Officer
(Sept. 2010 present), Charles Schwab Investment
Management, Inc.; President and Chief Executive Officer,
Schwab Funds, Laudus Funds and Schwab ETFs (Dec. 2010
present); Global Head of Fixed Income Business Division,
BlackRock, Inc. (formerly Barclays Global Investors) (March
2007 August 2010); Co-Head and Senior Portfolio Manager,
Wells Capital Management (June 1999 March 2007).
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George Pereira
1964
Treasurer and Principal Financial Officer
(Officer of Schwab Strategic Trust since
2009.)
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Senior Vice President and Chief Financial Officer (November
2004 present), Chief Operating Officer (Jan. 2011
present), Charles Schwab Investment Management, Inc.;
Treasurer and Chief Financial Officer, Laudus Funds (2006
present); Treasurer and Principal Financial Officer, Schwab
Funds (Nov. 2004 present) and Schwab ETFs (Oct. 2009
present); Director, Charles Schwab Worldwide Fund, PLC and
Charles Schwab Asset Management (Ireland) Limited (Sept.
2002 present); Treasurer, Chief Financial Officer and
Chief Accounting Officer, Excelsior Funds Inc., Excelsior
Tax-Exempt Funds, Inc., and Excelsior Funds Trust (June
2006- June 2007).
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Catherine MacGregor
1964
Vice President
(Officer of Schwab Strategic Trust since
2009.)
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Vice President, Charles Schwab & Co., Inc., Charles Schwab
Investment Management, Inc. (July 2005-present); Vice
President (Dec. 2005-present), Chief Legal Officer and Clerk
(March 2007-present), Laudus Funds; Vice President and
Assistant Clerk, Schwab Funds (June 2007 present) and
Schwab ETFs (Oct. 2009-present).
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Michael Haydel
1972
Vice President
(Officer of Schwab Strategic Trust since
2009.)
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Vice President, Asset Management Client Services, Charles
Schwab & Co., Inc. (2004-present); Vice President (Sept.
2005-present), Anti-Money Laundering Officer (Oct. 2005-Feb.
2009), Laudus Funds; Vice President, Schwab Funds (June 2007
present) and Schwab ETFs (Oct. 2009-present).
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1
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Trustees remain in office until they resign, retire or are removed by shareholder vote.
The Schwab Funds
®
retirement policy requires that independent trustees elected
after January 1, 2000 retire at age 72 or after twenty years as a trustee, whichever comes
first. In addition, the Schwab Funds retirement policy also requires any independent trustee
of the Schwab Funds who also serves as an independent trustee of the Laudus Funds to retire
from the Boards of the Schwab Funds upon their required retirement date from either the Boards
of Trustees of the Schwab Funds or the Laudus Funds, whichever comes first.
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2
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Mr. Bettinger is an Interested Trustee because he is an employee of Schwab and/or the
investment adviser. In addition to his employment with the investment adviser and Schwab, Mr.
Bettinger also owns stock of The Charles Schwab Corporation.
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3
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The President, Treasurer and Secretary hold office until their respective successors are
chosen and qualified or until he or she sooner dies, resigns, is removed or becomes
disqualified. Each of the other officers serves at the pleasure of the Board.
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19
Board of Trustees Leadership Structure and Risk Oversight
The Board of Trustees of the trust is responsible for oversight of the management of the fund,
which includes oversight of service providers to the fund, such as the funds investment adviser.
The Chairman of the Board of Trustees, Walter W. Bettinger, II, is Chief Executive Officer of The
Charles Schwab Corporation and an interested person of the fund as that term is defined in the
Investment Company Act of 1940. The fund does not have a single lead independent trustee. The
Board of Trustees is comprised of a super-majority (75 percent) of trustees who are not interested
persons of the fund (i.e., independent trustees). There is an Audit and Compliance Committee of
the Board that is chaired by an independent trustee and comprised solely of independent trustees.
The Audit and Compliance Committee chair presides at Committee meetings, participates in
formulating agendas for those meetings, and coordinates with management to serve as a liaison
between the independent trustees and management on matters within the scope of the responsibilities
of the Committee as set forth in its Board-approved charter. The fund has determined that this
leadership structure is appropriate given the specific characteristics and circumstances of the
fund. The fund made this determination in consideration of, among other things, the fact that the
independent trustees of the fund constitute a super-majority of the Board, the number of funds
overseen by the Board, and the total number of trustees on the Board.
Like most mutual funds, fund management and its other service providers have responsibility for
day-to-day risk management for the funds. The Board, as part of its overall oversight
responsibilities for fund operations, oversees the risk management efforts of fund management and
service providers with respect to the fund. The Boards role in the risk oversight of the fund,
fund management and the funds service providers consists of monitoring risks identified during
regular and special reports to the Audit and Compliance Committee of the Board, as well as regular
and special reports to the full Board. In addition to monitoring such risks, the Audit and
Compliance Committee and the Board oversee efforts by management and service providers to manage
risks to which the fund may be exposed. For example, the Audit and Compliance Committee meets with
the funds Chief Compliance Officer and Chief Financial Officer and receives regular reports
regarding compliance risks, operational risks and risks related to the valuation and liquidity of
portfolio securities. The Investment Oversight Committee and the full Board meets with portfolio
managers and other members of management and receives reports regarding investment risks of the
portfolios and risks related to distribution of the funds shares. From their review of these
reports and discussions with management, the Committees and Board receive information about the
material risks of the fund and about how management and service providers mitigate those risks.
The Board recognizes that not all risks that may affect the fund can be identified nor can
processes and controls be developed to eliminate or mitigate the occurrence or effects of certain
risks; some risks are simply beyond the reasonable control of the fund, its management, and its
service providers. Although the risk oversight functions of the Board, and the risk management
policies of fund management and fund service providers, are designed to be effective, there is no
guarantee that they will eliminate or mitigate all risks. In addition, it may be necessary to bear
certain risks (such as investment-related risks) to achieve the funds investment objective. As a
result of the foregoing and other factors, the funds ability to manage risk is subject to
significant limitations.
Individual Trustee Qualifications
The Board has concluded that each of the trustees should initially and continue to serve on the
board because of (i) their ability to review and understand information about the funds provided to
them by management, to identify and request other information they may deem relevant to the
performance of their duties, to question management regarding material factors bearing on the
management of the funds, and to exercise their business judgment in a manner that serves the best
interests of the funds shareholders and (ii) the trustees experience, qualifications, attributes
and skills as described below.
The Board has concluded that Mr. Bettinger should serve as trustee of the funds because of the
experience he has gained as president and chief executive officer of The Charles Schwab
Corporation, his knowledge of and experience in the financial services industry, and the experience
he has gained serving as trustee of the funds since 2009 and of the Schwab Funds since 2008.
The Board has concluded that Mr. Burns should serve as trustee of the funds because of the
experience he gained serving as a former managing director of a mutual fund management company and
former president and trustee of certain mutual funds managed by that company, his experience in and
knowledge of the financial services industry, and the experience he has gained serving as trustee
of the funds since 2009.
The Board has concluded that Mr. Goldfarb should serve
as trustee of the funds because of the experience he has gained as founder of a
financial services and independent public accounting firm, his experience
in and knowledge of public company accounting and auditing, and the experience
he has gained serving as trustee of the funds since 2009.
20
The Board has concluded that Mr. Ruffel should serve as trustee of the funds because of the
experience he gained as the founder and former chief executive officer of a publisher and
information services firm specializing in the retirement plan industry, his experience in and
knowledge of the financial services industry, and the experience he has gained serving as trustee
of the funds since 2009.
In its periodic assessment of the effectiveness of the Board, the Board considers the complementary
individual skills and experience of the individual trustees primarily in the broader context of the
Boards overall composition so that the Board, as a body, possesses the appropriate (and
appropriately diverse) skills and experience to oversee the business of the funds. Moreover,
references to the qualifications, attributes and skills of trustees are pursuant to requirements of
the Securities and Exchange Commission, do not constitute holding out of the Board or any trustee
as having any special expertise or experience, and shall not be deemed to impose any greater
responsibility or liability on any such person or on the Board by reason thereof.
Trustee Committees
The Board of Trustees has established certain committees and adopted Committee charters with
respect to those committees, each as
described below. The trust has a standing Audit and Compliance Committee. The function of the Audit
and Compliance Committee is to provide oversight responsibility for the integrity of the trusts
financial reporting processes and compliance policies, procedures and processes, and for the
trusts overall system of internal controls. This Committee is comprised of all of the Independent
Trustees. The charter directs that the Audit and Compliance Committee must meet 4 times annually,
with additional meetings as the Audit and Compliance Committee deems appropriate. The Committee met
4 times during the most recent fiscal year.
The trust also has a Nominating Committee that is composed of all the Independent Trustees, which
meets as often as deemed appropriate by the Nominating Committee for the primary purpose of
selecting and nominating candidates to serve as members of the Board of Trustees. The Nominating
Committee does not have a policy with respect to consideration of candidates for Trustee submitted
by shareholders. However, if the Nominating Committee determined that it would be in the best
interests of the trust to fill a vacancy on the Board of Trustees, and a shareholder submitted a
candidate for consideration by the Board of Trustees to fill the vacancy, the Nominating Committee
would evaluate that candidate. The charter directs that the Nominating Committee meet at such times
and with such frequency as is deemed necessary or appropriate by the Nominating Committee. The
Committee did not meet during the most recent fiscal year.
Trustee Compensation
The following table provides estimated trustee compensation for the fiscal year ending December 31,
2011. Certain information provided relates to the Fund Complex, which included 86 funds as of June
30, 2011.
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|
|
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|
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|
|
|
|
|
|
Pension or
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|
|
|
|
|
|
|
|
Retirement
|
|
($)
|
|
|
|
|
|
|
Benefits
|
|
Estimated Total
|
|
|
|
|
|
|
Accrued as
|
|
Compensation
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|
|
|
|
|
|
Part of Fund
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|
from
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Name of Trustee
|
|
Aggregate Compensation from the Trust*
|
|
Expenses
|
|
Fund Complex
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Interested Trustee
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|
|
|
|
|
|
|
|
|
|
|
|
Walter W. Bettinger II
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|
$
|
0
|
|
|
|
N/A
|
|
|
$
|
0
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Independent Trustees
|
|
|
|
|
|
|
|
|
|
|
|
|
Robert W. Burns
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|
$
|
50,000
|
|
|
|
N/A
|
|
|
$
|
50,000
|
|
Mark A. Goldfarb
|
|
$
|
50,000
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|
|
|
N/A
|
|
|
$
|
50,000
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|
Charles A Ruffel
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|
$
|
50,000
|
|
|
|
N/A
|
|
|
$
|
50,000
|
|
|
|
|
*
|
|
Estimated total compensation based on a full fiscal year for all funds of the trust.
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21
Securities Beneficially Owned By Each Trustee
The following tables provide each trustees equity ownership of the fund and ownership of all
registered investment companies overseen by each trustee in the Family of Investment Companies as
of June 30, 2011. As of June 30, 2011, the Family of Investment Companies included 77 funds.
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|
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Dollar Range of Trustee Ownership
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|
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of Equity Securities in the Funds
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Schwab
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|
Aggregate Dollar
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|
|
|
|
|
Schwab
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|
Intermediate-
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|
Range of Trustee
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|
|
Schwab U.S.
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|
Short-Term
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|
Term U.S.
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|
Ownership in the
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|
|
TIPS
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U.S. Treasury
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|
Treasury
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Family of Investment
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Name of Trustee
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ETF
|
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ETF
|
|
ETF
|
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Companies
|
Interested Trustee
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Walter W. Bettinger II
|
|
None
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|
None
|
|
None
|
|
Over $100,000
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Independent Trustees
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Robert W. Burns
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|
None
|
|
None
|
|
None
|
|
None
|
Mark A. Goldfarb
|
|
None
|
|
None
|
|
None
|
|
None
|
Charles A Ruffel
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|
None
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None
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None
|
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None
|
Code of Ethics
The fund, the investment adviser and the distributor have adopted Codes of Ethics as required under
the 1940 Act. Subject to certain conditions or restrictions, the Codes of Ethics permit the
trustees, directors, officers or advisory representatives of the fund or the investment adviser or
the directors or officers of the distributor to buy or sell directly or indirectly securities for
their own accounts. This includes securities that may be purchased or held by the fund. Securities
transactions by some of these individuals may be subject to prior approval of each entitys Chief
Compliance Officer or alternate. Most securities transactions are subject to quarterly reporting
and review requirements.
CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES
As of June 30, 2011, the officers and trustees of the trust, as a group, owned, of record or
beneficially, less than 1% of the outstanding voting securities of the fund.
As of June 30, 2011, no persons or entities owned, of record or beneficially, more than 5% of the
outstanding voting securities of the fund.
INVESTMENT ADVISORY AND OTHER SERVICES
Investment Adviser
CSIM, a wholly owned subsidiary of The Charles Schwab Corporation, 211 Main Street, San Francisco
CA 94105, serves as the funds investment adviser pursuant to an Investment Advisory Agreements
(Advisory Agreement) between it and the trust. Charles R. Schwab is the founder, Chairman and
Director of The Charles Schwab Corporation. As a result of his ownership and interests in The
Charles Schwab Corporation, Mr. Schwab may be deemed to be a controlling person of CSIM.
Advisory Agreement
The funds Advisory Agreement must be specifically approved initially for a 2 year term, and after
the expiration of the 2 year term, at least annually thereafter (1) by the vote of the trustees or
by a vote of the shareholders of the fund, and (2) by the vote of a majority of the trustees who
are not parties to the Advisory Agreement or interested persons of any party (the Independent
Trustees), cast in person at a meeting called for the purpose of voting on such approval.
Each year, the Board of Trustees will call and hold a meeting to decide whether to renew the
Advisory Agreement between the trust and CSIM with respect to any existing funds in the trust. In
preparation for the meeting, the Board requests and reviews a wide variety of materials provided by
the funds investment adviser, as well as extensive data provided by third parties.
22
As described below, the investment adviser is entitled to receive a fee from the fund, payable
monthly, for its advisory and administrative services to the fund. The fund is new and has not yet
paid any fees to CSIM. As compensation for these services, the firm receives a management fee from
the fund is expressed as a percentage of the funds average daily net assets.
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FUND
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FEE
|
Schwab U.S. Aggregate Bond ETF
sm
|
|
0.XX%
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Pursuant to the Advisory Agreement, the Adviser is responsible for substantially all expenses of
the fund, including the cost of transfer agency, custody, fund administration, legal, audit and
other services, but excluding interest expense and taxes, brokerage expenses, and extraordinary or
non-routine expenses.
Distributor
SEI Investments Distribution Co. (the Distributor) is the principal underwriter and distributor
of shares of the fund. Its principal address is 1 Freedom Valley Drive, Oaks, PA 19456. The
Distributor has entered into an agreement with the trust pursuant to which it distributes shares of
the funds (the Distribution Agreement). The Distributor continually distributes shares of the
funds on a best effort basis. The Distributor has no obligation to sell any specific quantity of
fund shares. The Distribution Agreement will continue for two years from its effective date and is
renewable annually thereafter in accordance with the 1940 Act. Shares are continuously offered for
sale by the fund through the Distributor only in Creation Units, as described in the funds
prospectus. Shares in less than Creation Units are not distributed by the Distributor. The
Distributor is a broker-dealer registered under the Securities Exchange Act of 1934 and a member of
the Financial Industry Regulatory Authority. The Distributor is not affiliated with the trust,
CSIM, or any stock exchange.
The Distribution Agreement provides that it may be terminated at any time, without the payment of
any penalty, on at least sixty (60) days prior written notice to the other party. The Distribution
Agreement will terminate automatically in the event of its assignment (as defined in the 1940
Act).
Transfer Agent
State Street Bank and Trust Company, One Lincoln Street, Boston, Massachusetts 02111, serves as the
funds transfer agent. As part of these services, the firm maintains records pertaining to the
sale, redemption and transfer of the funds shares.
Custodian and Fund Accountants
State Street Bank and Trust Company, One Lincoln Street, Boston, Massachusetts 02111, serves as
custodian and accountant for the fund.
The custodian is responsible for the daily safekeeping of securities and cash held or sold by the
fund. The funds accountant maintains all books and records related to the funds transactions.
Independent Registered Public Accounting Firm
The funds independent registered public accounting firm, PricewaterhouseCoopers, LLP, audits and
reports on the annual financial statements of the fund and reviews certain regulatory reports and
the funds federal income tax return. They also perform other professional, accounting, auditing,
tax and advisory services when the trust engages them to do so. Their address is 3 Embarcadero
Center, San Francisco, CA 94111-4004.
Legal Counsel
Dechert LLP represents the trust with respect to certain legal matters.
PORTFOLIO MANAGERS
Other Accounts
. Each portfolio manager (collectively referred to as the Portfolio
Managers) is responsible for the day-to-day management of certain other accounts, as listed below.
The accounts listed below are not subject to a performance-based advisory fee. The information
below is provided as of June 1, 2011.
23
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Registered Investment
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|
|
|
|
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Companies
|
|
|
|
|
|
|
(this amount does not include
|
|
|
|
|
|
|
the funds in this Statement of
|
|
Other Pooled
|
|
|
|
|
Additional Information)
|
|
Investment Vehicles
|
|
Other Accounts
|
|
|
Number of
|
|
|
|
|
|
Number of
|
|
Total
|
|
Number of
|
|
|
Name
|
|
Accounts
|
|
Total Assets
|
|
Accounts
|
|
Assets
|
|
Accounts
|
|
Total Assets
|
Matthew Hastings
|
|
|
|
|
|
$
|
|
|
|
|
0
|
|
|
$
|
0
|
|
|
|
0
|
|
|
$
|
0
|
|
Steven Chan
|
|
|
|
|
|
$
|
|
|
|
|
0
|
|
|
$
|
0
|
|
|
|
0
|
|
|
$
|
0
|
|
Brandon Matsui
|
|
|
|
|
|
$
|
|
|
|
|
0
|
|
|
$
|
0
|
|
|
|
0
|
|
|
$
|
0
|
|
Steven Hung
|
|
|
|
|
|
$
|
|
|
|
|
0
|
|
|
$
|
0
|
|
|
|
0
|
|
|
$
|
0
|
|
Alfonso Portillo
|
|
|
|
|
|
$
|
|
|
|
|
0
|
|
|
$
|
0
|
|
|
|
0
|
|
|
$
|
0
|
|
Conflicts of Interest
. A Portfolio Managers management of other accounts may give
rise to potential conflicts of interest in connection with its management of the funds
investments, on the one hand, and the investments of the other accounts, on the other. These other
accounts include separate accounts and other mutual funds advised by CSIM (collectively, the Other
Managed Accounts). The Other Managed Accounts might have similar investment objectives as the
fund, track the same index the fund tracks or otherwise hold, purchase, or sell securities that are
eligible to be held, purchased, or sold by the funds. While the Portfolio Managers management of
Other Managed Accounts may give rise to the potential conflicts of interest listed below, CSIM does
not believe that the conflicts, if any, are material or, to the extent any such conflicts are
material, CSIM believes it has adopted policies and procedures that are designed to manage those
conflicts in an appropriate way.
Knowledge of the Timing and Size of Fund Trades
. A potential conflict of interest may arise as a
result of the Portfolio Managers day-to-day management of the fund. Because of their positions
with the fund, the Portfolio Managers know the size, timing, and possible market impact of fund
trades. It is theoretically possible that the Portfolio Managers could use this information to the
advantage of the Other Managed Accounts they manage and to the possible detriment of the fund.
However, CSIM has adopted policies and procedures reasonably designed to allocate investment
opportunities on a fair and equitable basis over time. Moreover, with respect to an index fund,
which seeks to track its benchmark index, much of this information is publicly available. When it
is determined to be in the best interest of both accounts, the Portfolio Managers may aggregate
trade orders for the Other Managed Accounts, excluding Schwab Personal Portfolio Managed Accounts,
with those of the fund. All aggregated orders are subject to CSIMs aggregation and allocation
policy and procedures, which provide, among other things, that (i) a Portfolio Manager will not
aggregate orders unless he or she believes such aggregation is consistent with his or her duty to
seek best execution; (ii) no account will be favored over any other account; (iii) each account
that participates in an aggregated order will participate at the average security price with all
transaction costs shared on a pro-rata basis; and (iv) if the aggregated order cannot be executed
in full, the partial execution is allocated pro-rata among the participating accounts in accordance
with the size of each accounts order.
Investment Opportunities
. A potential conflict of interest may arise as a result of the Portfolio
Managers management of the fund and Other Managed Accounts which, in theory, may allow them to
allocate investment opportunities in a way that favors the Other Managed Accounts over the fund,
which conflict of interest may be exacerbated to the extent that CSIM or the Portfolio Managers
receive, or expect to receive, greater compensation from their management of the Other Managed
Accounts than the fund. Notwithstanding this theoretical conflict of interest, it is CSIMs policy
to manage each account based on its investment objectives and related restrictions and, as
discussed above, CSIM has adopted policies and procedures reasonably designed to allocate
investment opportunities on a fair and equitable basis over time and in a manner consistent with
each accounts investment objectives and related restrictions. For example, while the Portfolio
Managers may buy for an Other Managed Account securities that differ in identity or quantity from
securities bought for the fund or refrain from purchasing securities for an Other Managed Account
that they are otherwise buying for the fund in an effort to outperform its specific benchmark, such
an approach might not be suitable for the fund given its investment objectives and related
restrictions.
Compensation.
Schwab compensates each CSIM Portfolio Manager for his or her management of
the fund. Each portfolio managers compensation consists of a fixed annual (base) salary and a
discretionary bonus. The base salary is determined considering compensation payable for a similar
position across the investment management industry and an evaluation of the individual portfolio
managers overall performance such as the portfolio managers contribution to the firms overall
investment process, being good corporate citizens, and contributions to the firms asset growth and
business relationships. The discretionary bonus is determined in accordance with the CSIM Equity
and Fixed Income Portfolio Management Incentive Plan (the Plan), which is designed to reward
consistent and superior investment performance relative to established benchmarks and/or industry
peer groups. The Plan is an annual incentive plan that, at the discretion of Executive Management,
provides quarterly advances against the corporate component of the Plan at a fixed rate that is
standard for the employees level. Meanwhile, the portion of the incentive tied to fund performance
is paid in its entirety following the end of the Plan year (i.e. the Plan does not provide advances
against the portion of the Plan tied to fund performance) at managements discretion based on their
determination of whether funds are available under the Plan as well as factors
24
such as the portfolio managers contribution to the firms overall investment process, being good
corporate citizens, and contribution to the firms asset growth and business relationships.
The Plan consists of two independent funding components: fund investment performance and Schwabs
corporate performance. 75% of the funding is based on fund investment performance and 25% of the
funding is based on Schwabs corporate performance. Funding is pooled into separate incentive
pools (one for Fixed Income portfolio managers, one for Equity portfolio managers, and one for
Money Fund portfolio managers) and then allocated to the plan participants by CSIM senior
management. This allocation takes into account fund performance as well as the portfolio managers
leadership, teamwork, and contribution to CSIM goals and objectives.
|
|
Fund Investment Performance
|
|
|
|
Investment Performance will be determined based on the funds performance relative to one of the
following criteria: industry peer group/category, established benchmark or risk adjusted
performance measure. The peer group/category or benchmark will be determined by the CSIM Peer
Group Committee comprised of officer representation from CSIM Product Development, Fund
Administration and Schwab Center for Financial Research (SCFR) and approved by CSIMs President
and CSIMs Chief Investment Officer. The CSIM Peer Group Committee reviews peer groups and
category classification on a regular basis in advance of each performance period. Peer groups
and category rankings will be based on the statistical analysis. Performance relative to the
funds benchmark will be measured on a sliding scale that will compensate Portfolio Managers more
to the extent the funds performance exceeds the benchmark.
|
|
|
|
At the close of the year, the funds performance will be determined by its 1-year and/or
1 and 3-year percentile standing within its designated peer group using standard statistical
methods approved by CSIM senior management. Relative position and the respective statistical
method used to determine percentile standing will result in a single performance percentile
number for the fund to allow for comparisons over time and between funds. As each
participant may manage and/or support a number of funds, there will be several fund
performance percentiles for each participant that may be considered in arriving at the
incentive compensation annual payout.
|
|
|
Schwab Corporate Performance
|
|
|
|
CSCs corporate plan (the Corporate Plan) is an annual plan, which provides for discretionary
awards aligned with company and individual performance. Funding for the Corporate Plan is
determined at the conclusion of the calendar year using a payout rate that is applied to the
Schwabs earnings per share. The exact payout rate will vary and will be determined by Executive
Management and recommended to the Compensation Committee of the Board of Directors of CSC for
final approval. Funding will be capped at 200% of the Corporate Plan.
|
|
|
|
Incentive Allocation
|
|
|
|
At year-end, the full-year funding for both components of the Plan will be pooled together. This
total pool will then be allocated to plan participants by CSIM senior management based on their
assessment of a variety of performance factors. Factors considered in the allocation process will
include, but are not limited to, fund performance relative to benchmarks, individual performance
against key objectives, contribution to overall group results, team work, and collaboration
between Analysts and Portfolio Managers.
|
The Portfolio Managers compensation is not based on the value of the assets held in a funds
portfolio. Messrs. Hastings, Chan, and Matsui are compensated under the CSIM Equity and Fixed
Income Portfolio Management Incentive Plan.
Ownership of Fund Shares.
Because the fund has not commenced operations prior to the date of this
SAI, no information regarding the Portfolio Managers beneficial ownership of shares of the fund
has been included. This information will appear in a future version of the SAI.
BROKERAGE ALLOCATION AND OTHER PRACTICES
Portfolio Turnover
For reporting purposes, the funds portfolio turnover rate is calculated by dividing the value of
purchases or sales of portfolio securities for the fiscal year, whichever is less, by the monthly
average value of portfolio securities the fund owned during the fiscal
25
year. When making the calculation, all securities whose maturities at the time of acquisition were
one year or less (short-term securities) are excluded.
A 100% portfolio turnover rate would occur, for example, if all portfolio securities (aside from
short-term securities) were sold and either repurchased or replaced once during the fiscal year.
Typically, funds with high turnover (such as 100% or more) tend to generate higher capital gains
and transaction costs, such as brokerage commissions. Because this is a new fund there is no
portfolio turnover rate.
Portfolio Holdings Disclosure
The funds Board of Trustees has approved policies and procedures that govern the timing and
circumstances regarding the disclosure of funds portfolio holdings information to shareholders and
third parties. These policies and procedures are designed to ensure that disclosure of information
regarding the funds portfolio securities is in the best interests of funds shareholders, and
include procedures to address conflicts between the interests of the funds shareholders, on the
one hand, and those of the funds investment adviser, principal underwriter or any affiliated
person of the fund, its investment adviser, or its principal underwriter, on the other. Pursuant to
such procedures, the Board has authorized the president of the fund to authorize the release of the
funds portfolio holdings, as necessary, in conformity with the foregoing principles.
The Board exercises on-going oversight of the disclosure of fund portfolio holdings by overseeing
the implementation and enforcement of the funds policies and procedures by the Chief Compliance
Officer and by considering reports and recommendations by the Chief Compliance Officer concerning
any material compliance matters. The Board will receive periodic updates, at least annually,
regarding entities who may receive portfolio holdings information not available to other current or
prospective fund shareholders in connection with the dissemination of information necessary for
transactions in Creation Units, as contemplated by the exemptive relief and as discussed below.
The fund discloses its complete portfolio holdings schedule in public filings with the SEC within
60-80 days after the end of each fiscal quarter and will provide that information to shareholders
as required by federal securities laws and regulations thereunder. The fund may, however,
voluntarily disclose all or part of its portfolio holdings other than in connection with the
creation/redemption process, as discussed above, in advance of required filings with the SEC,
provided that such information is made generally available to all shareholders and other interested
parties in a manner that is consistent with the above policy for disclosure of portfolio holdings
information. Such information may be made available through a publicly-available website or other
means that make the information available to all likely interested parties contemporaneously.
The fund may disclose portfolio holdings information to certain persons and entities prior to and
more frequently than the public disclosure of such information (early disclosure). The president
of the fund may authorize early disclosure of portfolio holdings information to such parties at
differing times and/or with different lag times provided that (a) the president of the fund
determines that the disclosure is in the best interests of the fund and that there are no conflicts
of interest between the funds shareholders and funds adviser and distributor; and (b) the
recipient is, either by contractual agreement or otherwise by law, required to maintain the
confidentiality of the information.
In addition, the funds service providers including, without limitation, the investment adviser,
distributor, the custodian, fund accountant, transfer agent, auditor, proxy voting service
provider, pricing information venders, publisher, printer and mailing agent may receive early
disclosure of portfolio holdings information as frequently as daily in connection with the services
they perform for the funds. Service providers will be subject to a duty of confidentiality with
respect to any portfolio holdings information whether imposed by the provisions of the service
providers contract with the trust or by the nature of its relationship with the trust.
Further, each business day, the funds portfolio holdings information is provided to the
Distributor or other agent for dissemination through the facilities of the National Securities
Clearing Corporation (NSCC) and/or other fee-based subscription services to NSCC members and/or
subscribers to those other fee-based subscription services, including Authorized Participants (as
defined below), and to entities that publish and/or analyze such information in connection with the
process of purchasing or redeeming Creation Units or trading shares of fund in the secondary
market. This information typically reflects the funds anticipated holdings on the following
business day.
In addition, the fund discloses its portfolio holdings and the percentages they represent of the
funds net assets at least monthly, and as often as each day the fund is open for business, at
www.schwabetfs.com/prospectus.
26
Portfolio holdings information made available in connection with the creation/redemption process
may be provided to other entities that provide services to the fund in the ordinary course of
business after it has been disseminated to the NSCC.
The funds policies and procedures prohibit the fund, the funds investment adviser or any related
party from receiving any compensation or other consideration in connection with the disclosure of
portfolio holdings information.
The fund may disclose non-material information including commentary and aggregate information about
the characteristics of the funds in connection with or relating to the fund or its portfolio
securities to any person if such disclosure is for a legitimate business purpose, such disclosure
does not effectively result in the disclosure of the complete portfolio securities of the fund
(which can only be disclosed in accordance with the above requirements), and such information does
not constitute material non-public information. Such disclosure does not fall within the portfolio
securities disclosure requirements outlined above.
Whether the information constitutes material non-public information will be made on a good faith
determination, which involves an assessment of the particular facts and circumstances. In most
cases commentary or analysis would be immaterial and would not convey any advantage to a recipient
in making a decision concerning the fund. Commentary and analysis includes, but is not limited to,
the allocation of the fund portfolio securities and other investments among various asset classes,
sectors, industries, and countries, the characteristics of the stock components and other
investments of the fund, the attribution of fund returns by asset class, sector, industry and
country, and the volatility characteristics of the funds.
Portfolio Transactions
The investment adviser makes decisions with respect to the purchase and sale of portfolio
securities on behalf of the fund. The investment adviser is responsible for implementing these
decisions, including the negotiation of commissions and the allocation of principal business and
portfolio brokerage. Purchases and sales of securities on a stock exchange or certain riskless
principal transactions placed on NASDAQ are typically effected through brokers who charge a
commission for their services. Purchases and sales of fixed income securities may be transacted
with the issuer, the issuers underwriter, or a dealer. The fund does not usually pay brokerage
commissions on purchases and sales of fixed income securities, although the price of the securities
generally includes compensation, in the form of a spread or a mark-up or mark-down, which is not
disclosed separately. The prices the fund pays to underwriters of newly-issued securities usually
include a commission paid by the issuer to the underwriter. Transactions placed through dealers who
are serving as primary market makers reflect the spread between the bid and asked prices. The money
market securities in which the fund may invest are traded primarily in the over-the-counter market
on a net basis and do not normally involve either brokerage commissions or transfer taxes. It is
expected that the cost of executing portfolio securities transactions of the fund will primarily
consist of dealer spreads and brokerage commissions.
The investment adviser seeks to obtain the best execution for the funds portfolio transactions.
The investment adviser may take a number of factors into account in selecting brokers or dealers to
execute these transactions. Such factors may include, without limitation, the following: execution
price; brokerage commission or dealer spread; size or type of the transaction; nature or character
of the markets; clearance or settlement capability; reputation; financial strength and stability of
the broker or dealer; efficiency of execution and error resolution; block trading capabilities;
willingness to execute related or unrelated difficult transactions in the future; order of call;
ability to facilitate short selling; provision of additional brokerage or research services or
products. In addition, the investment adviser has incentive sharing arrangements with certain
unaffiliated brokers who guarantee market-on-close pricing: on a day when such a broker executes
transactions at prices better, on aggregate, than market-on-close prices, that broker may receive,
in addition to his or her standard commission, a portion of the net difference between the actual
execution prices and corresponding market-on-close prices for that day.
The investment adviser may cause the fund to pay a higher commission than otherwise obtainable from
other brokers or dealers in return for brokerage or research services or products if the investment
adviser believes that such commission is reasonable in relation to the services provided. In
addition to agency transactions, the investment adviser may receive brokerage and research services
or products in connection with certain riskless principal transactions, in accordance with
applicable SEC and other regulatory guidelines. In both instances, these services or products may
include: economic, industry, or company research reports or investment recommendations;
subscriptions to financial publications or research data compilations; compilations of securities
prices, earnings, dividends, and similar data; computerized databases; quotation equipment and
services; research or analytical computer software and services; products or services that assist
in effecting transactions, including services of third-party computer systems developers directly
related to research and brokerage activities; and effecting securities transactions and performing
functions incidental thereto (such as clearance and settlement). The investment adviser may use
research services furnished by brokers or dealers in servicing all
27
fund accounts, and not all services may necessarily be used in connection with the account that
paid commissions or spreads to the broker or dealer providing such services.
The investment adviser may receive a service from a broker or dealer that has both a research and
a non-research use. When this occurs, the investment adviser will make a good faith allocation,
under all the circumstances, between the research and non-research uses of the service. The
percentage of the service that is used for research purposes may be paid for with fund commissions
or spreads, while the investment adviser will use its own funds to pay for the percentage of the
service that is used for non-research purposes. In making this good faith allocation, the
investment adviser faces a potential conflict of interest, but the investment adviser believe that
the costs of such services may be appropriately allocated to their anticipated research and
non-research uses.
The investment adviser may purchase for fund, new issues of securities in a fixed price offering.
In these situations, the seller may be a member of the selling group that will, in addition to
selling securities, provide the investment adviser with research services, in accordance with
applicable rules and regulations permitting these types of arrangements. Generally, the seller will
provide research credits in these situations at a rate that is higher than that which is
available for typical secondary market transactions. These arrangements may not fall within the
safe harbor of Section 28(e) of the Securities Exchange Act of 1934.
The investment adviser may place orders directly with electronic communications networks or other
alternative trading systems. Placing orders with electronic communications networks or other
alternative trading systems may enable the fund to trade directly with other institutional holders.
At times, this may allow the fund to trade larger blocks than would be possible trading through a
single market maker.
The investment adviser may aggregate securities sales or purchases among two or more clients. The
investment adviser will not aggregate transactions unless it believes such aggregation is
consistent with its duty to seek best execution for each affected client and is consistent with the
terms of the investment advisory agreement for such client. In any single transaction in which
purchases and/or sales of securities of any issuer for the account of the fund are aggregated with
other accounts managed by the investment adviser, the actual prices applicable to the transaction
will be averaged among the accounts for which the transaction is effected, including the account of
the fund.
In determining when and to what extent to use Schwab or any other affiliated broker-dealer as its
broker for executing orders for the funds on securities exchanges, the investment adviser follows
procedures, adopted by the funds Board of Trustees, that are designed to ensure that affiliated
brokerage commissions (if relevant) are reasonable and fair in comparison to unaffiliated brokerage
commissions for comparable transactions. The Board reviews the procedures annually and approves and
reviews transactions involving affiliated brokers quarterly.
PROXY VOTING
The Board of Trustees of the trust has delegated the responsibility for voting proxies to CSIM
through their Advisory Agreement. The Trustees have adopted CSIMs Proxy Voting Policy and
Procedures with respect to proxies voted on behalf of the funds portfolios. For a description of
CSIMs Proxy Voting Policy and Procedures, see the Appendix Proxy Voting Policy and Procedures.
The trust is required to disclose annually the funds complete proxy voting record on Form N-PX.
The funds proxy voting record for the most recent 12 month period ended June 30th will be
available by visiting the Schwab website at www.schwabetfs.com/prospectus. The funds Form N-PX
will also be available on the SECs website at www.sec.gov.
Brokerage Commissions
The fund is new and, therefore, for each of the last three fiscal years, the fund paid no brokerage
commissions.
Regular Broker-Dealers
The funds regular broker-dealers during its most recent fiscal year are: (1) the ten
broker-dealers that received the greatest dollar amount of brokerage commissions from the fund; (2)
the ten broker-dealers that engaged as principal in the largest dollar amount of portfolio
transactions; and (3) the ten broker-dealers that sold the largest dollar amount of the funds
shares. The fund is new and, therefore, has not purchased securities issued by any regular
broker-dealers.
28
DESCRIPTION OF THE TRUST
The fund is a series of Schwab Strategic Trust, an open-end investment management company organized
as a Delaware statutory trust on January 27, 2009.
The Declaration of Trust provides for the perpetual existence of the Trust. The Trust may, however,
be terminated at any time by vote of at least two-thirds of the outstanding shares of each series
of the Trust or by the vote of the Trustees.
Shareholders are entitled to one vote for each full share held (with fractional votes for
fractional shares held) and will vote (to the extent provided on the Declaration of Trust) in the
election of Trustees and the termination of the Trust and on other matters submitted to the vote of
shareholders. Shareholders will vote by individual series on all matters except (i) when required
by the 1940 Act, shares shall be voted in the aggregate and not by individual series and (ii) when
the Trustees have determined that the matter affects only the interests of one or more series, then
only shareholders of such series shall be entitled to vote thereon. Shareholders of one series
shall not be entitled to vote on matters exclusively affecting another series, such matters
including, without limitation, the adoption of or change in any fundamental policies or
restrictions of the other series and the approval of the investment advisory contracts of the other
series.
There will normally be no meetings of shareholders for the purpose of electing Trustees, except
that in accordance with the 1940 Act (i) the Trust will hold a shareholders meeting for the
election of Trustees at such time as less than a majority of the Trustees holding office have been
elected by shareholders, and (ii) if, as a result of a vacancy in the Board of Trustees, less than
two-thirds of the Trustees holding office have been elected by the shareholders, that vacancy may
only be filled by a vote of the shareholders. In addition, Trustees may be removed from office by a
written consent signed by the holders of two-thirds of the outstanding shares and filed with the
Trusts custodian or by a vote of the holders of two-thirds of the outstanding shares at a meeting
duly called for the purpose, which meeting shall be held upon the written request of the holders of
not less than 10% of the outstanding shares. Except as set forth above, the Trustees shall continue
to hold office and may appoint successor Trustees. Voting rights are not cumulative.
The Trust may, without shareholder vote, restate, amend or otherwise supplement the Declaration of
Trust. Shareholders shall have the right to vote on any amendment that could affect their right to
vote, any amendment to the Amendments section, any amendment for which shareholder vote may be
required by applicable law or by the Trusts registration statement filed with the SEC, and on any
amendment submitted to them by the Trustees.
Any series of the Trust may reorganize or merge with one or more other series of the Trust or
another investment company. Any such reorganization or merger shall be pursuant to the terms and
conditions specified in an agreement and plan of reorganization authorized and approved by the
Trustees and entered into by the relevant series in connection therewith. In addition, such
reorganization or merger may be authorized by vote of a majority of the Trustees then in office
and, to the extent permitted by applicable law, without the approval of shareholders of any series.
Shareholders wishing to submit proposals for inclusion in a proxy statement for a future
shareholder meeting should send their written submissions to the Trust at 1 Freedom Valley Drive,
Oaks, PA 19456. Proposals must be received a reasonable time in advance of a proxy solicitation to
be included. Submission of a proposal does not guarantee inclusion in a proxy statement because
proposals must comply with certain federal securities regulations.
PURCHASE, REDEMPTION AND PRICING OF SHARES
CREATION AND REDEMPTION OF CREATION UNITS
The fund is open each day that the New York Stock Exchange (NYSE) is open (Business Days). The
NYSEs trading session is normally conducted from 9:30 a.m. Eastern time until 4:00 p.m. Eastern
time, Monday through Friday, although some days, such as in advance of and following holidays, the
NYSEs trading session closes early. The following holiday closings are currently scheduled for
2009-2010: New Years Day, Martin Luther King Jr. Day, Presidents Day, Good Friday, Memorial Day,
Independence Day, Labor Day, Thanksgiving Day and Christmas Day. Only orders that are received and
deemed acceptable by the Distributor no later than the time specified by the Trust will be executed
that day at the funds share price calculated that day. On any day that the NYSE closes early, the
fund reserves the right to advance the time by which purchase and redemption orders must be
received by the Distributor that day to be executed that day at that days share price.
29
Creation
. The trust issues and sells shares of the funds only in Creation Units on a continuous
basis through the Distributor, without a sales load, at the NAV next determined after receipt, on
any Business Day, for an order received and deemed acceptable by the Distributor.
Fund Deposit
. The consideration for purchase of Creation Units of the fund may consist of (i) the
in-kind deposit of a designated portfolio of securities closely approximating the holdings of the
fund (the Deposit Securities), and an amount of cash denominated in U.S. Dollars (the Cash
Component) computed as described below. Together, the Deposit Securities and the Cash Component
constitute the Fund Deposit, which represents the minimum initial and subsequent investment
amount for a Creation Unit of the fund.
The fund may accept a basket of money market instruments, non-U.S. currency or cash denominated in
U.S. dollars that differs from the composition of the published basket. The fund may permit or
require the consideration for Creation Units to consist solely of cash or non-U.S. currency. The
fund may permit or require the substitution of an amount of cash denominated in U.S. Dollars (i.e.,
a cash in lieu amount) to be added to the Cash Component to replace any Deposit Security. For
example, the trust reserves the right to permit or require a cash in lieu amount where the
delivery of the Deposit Security by the Authorized Participant (as described below) would be
restricted under the securities laws or where the delivery of the Deposit Security to the
Authorized Participant would result in the disposition of the Deposit Security by the Authorized
Participant becoming restricted under the securities laws, or in certain other situations.
The Cash Component is sometimes also referred to as the Balancing Amount. The Cash Component
serves the function of compensating for any differences between the NAV per Creation Unit and the
value of the Deposit Securities. If the Cash Component is a positive number (i.e., the NAV per
Creation Unit exceeds the value of the Deposit Securities), the creator will deliver the Cash
Component. If the Cash Component is a negative number (i.e., the NAV per Creation Unit is less than
the value of the Deposit Securities), the creator will receive the Cash Component. Computation of
the Cash Component excludes any stamp duty tax or other similar fees and expenses payable upon
transfer of beneficial ownership of the Deposit Securities, which shall be the sole responsibility
of the Authorized Participant.
The identity and amount of Deposit Securities and Cash Component for the fund changes as the
composition of the funds portfolio changes and as rebalancing adjustments and corporate action
events are reflected from time to time by CSIM with a view to the investment objective of the fund.
The composition of the Deposit Securities may also change in response to adjustments to the
weighting or composition of the component securities of the funds benchmark index. The fund also
reserves the right to include or remove Deposit Securities from the basket in contemplation of
index rebalancing changes.
The fund or its agent, through the NSCC or otherwise, makes available on each Business Day, prior
to the opening of business on the NYSE Arca, Inc. Exchange (currently 9:30 a.m., Eastern time), the
current Fund Deposit for the fund. Such Deposit Securities are applicable, subject to any
adjustments, in order to effect creations of Creation Units of the fund until such time as the
next-announced composition of the Deposit Securities is made available.
Procedures for Creation of Creation Units
. To be eligible to place orders with the Distributor and
to create a Creation Unit of a fund, an entity must be a Depository Trust Company (DTC)
participant, such as a broker-dealer, bank, trust company, clearing corporation or certain other
organization, some of whom (and/or their representatives) own DTC (each a DTC Participant). DTC
acts as securities depositary for the shares. The DTC Participant must have executed an agreement
with the Distributor with respect to creations and redemptions of Creation Units (Participant
Agreement). A DTC Participant that has executed a Participant Agreement is referred to as an
Authorized Participant. Investors should contact the Distributor for the names of Authorized
Participants that have signed a Participant Agreement. All shares of the fund, however created,
will be entered on the records of DTC in the name of DTC or its nominee and deposited with, or on
behalf of, DTC.
All orders to create shares must be placed for one or more Creation Units. Orders must be
transmitted by an Authorized Participant pursuant to procedures set forth in the Participant
Agreement. The date on which an order to create Creation Units (or an order to redeem Creation
Units, as discussed below) is placed is referred to as the Transmittal Date. Orders must be
transmitted by an Authorized Participant by telephone or other transmission method acceptable to
the Distributor pursuant to procedures set forth in the Participant Agreement, as described below.
Economic or market disruptions or changes, or telephone or other communication failure, may impede
the ability to reach the Distributor or an Authorized Participant.
On days when the New York Stock Exchange or U.S. or non-U.S. bond markets close earlier than
normal, the fund may require purchase orders to be placed earlier in the day. All questions as to
the number of Deposit Securities to be delivered, and the validity,
30
form and eligibility (including time of receipt) for the deposit of any tendered securities, will
be determined by the trust, whose determination shall be final and binding.
If the Distributor does not receive both the required Deposit Securities and the Cash Component by
the specified time on the settlement date, the trust may cancel or revoke acceptance of such order.
Upon written notice to the Distributor, such canceled or revoked order may be resubmitted the
following Business Day using the Fund Deposit as newly constituted to reflect the then current NAV
of a fund. The delivery of Creation Units so created generally will occur no later than the
settlement date.
Creation Units may be created in advance of receipt by the trust of all or a portion of the
applicable Deposit Securities as described below. In these circumstances, the initial deposit will
have a value greater than the NAV of the shares on the date the order is placed since, in addition
to available Deposit Securities, U.S. cash (or an equivalent amount of non-U.S. currency) must be
deposited in an amount equal to the sum of (i) the Cash Component, plus (ii) at least 110% , which
the trust may change from time to time, of the market value of the undelivered Deposit Securities
(the Additional Cash Deposit) with the fund pending delivery of any missing Deposit Securities.
The Authorized Participant must deposit with the custodian the appropriate amount of federal funds
by 10:00 a.m. New York time (or such other time as specified by the trust) on the settlement date.
If the Distributor does not receive the Additional Cash Deposit in the appropriate amount by such
time, then the order may be deemed to be rejected and the Authorized Participant
shall be liable to the fund for losses, if any, resulting therefrom. An additional amount of U.S.
cash (or an equivalent amount of non-U.S. currency) shall be required to be deposited with the
Distributor, pending delivery of the missing Deposit Securities to the extent necessary to maintain
the Additional Cash Deposit with the trust in an amount at least equal to 110% or 115% as required,
which the trust may change from time to time, of the daily marked to market value of the missing
Deposit Securities. To the extent that missing Deposit Securities are not received by the specified
time on the settlement date, or in the event a marked-to-market payment is not made within one
Business Day following notification by the Distributor that such a payment is required, the trust
may use the cash on deposit to purchase the missing Deposit Securities. The Authorized Participant
will be liable to the trust for the costs incurred by the trust in connection with any such
purchases. These costs will be deemed to include the amount by which the actual purchase price of
the Deposit Securities exceeds the market value of such Deposit Securities on the transmittal date
plus the brokerage and related transaction costs associated with such purchases. The trust will
return any unused portion of the Additional Cash Deposit once all of the missing Deposit Securities
have been properly received by the Distributor or purchased by the trust and deposited into the
trust. In addition, a transaction fee, as listed below, will be charged in all cases.
Acceptance of Orders for Creation Units
. The trust reserves the absolute right to reject or revoke
acceptance of a creation order transmitted to it by the Distributor in respect of the fund. For
example, the trust may reject or revoke acceptance of an order, if (i) the order does not conform
to the procedures set forth in the Participant Agreement; (ii) the investor(s), upon obtaining the
shares ordered, would own 80% or more of the currently outstanding shares of the fund; (iii) the
Deposit Securities delivered are not as disseminated through the facilities of the NSCC for that
date by the fund as described above; (iv) acceptance of the Deposit Securities would have certain
adverse tax consequences to the fund; (v) acceptance of the Fund Deposit would, in the opinion of
counsel, be unlawful; (vi) acceptance of the Fund Deposit would otherwise, in the discretion of the
trust or CSIM, have an adverse effect on the trust or the rights of beneficial owners; or (vii) in
the event that circumstances outside the control of the trust, the custodian, the Distributor or
CSIM make it for all practical purposes impossible to process creation orders. Examples of such
circumstances include natural disaster, war, revolution; public service or utility problems such as
fires, floods, extreme weather conditions and power outages resulting in telephone, telecopy and
computer failures; market conditions or activities causing trading halts; systems failures
involving computer or other information systems affecting the trust, CSIM, the Distributor, DTC,
NSCC, custodian (or sub-custodian) or any other participant in the creation process, and similar
extraordinary events. The Distributor shall notify a prospective creator of a Creation Unit and/or
the Authorized Participant acting on behalf of the creator of a Creation Unit of its rejection of
the order of such person. The trust, custodian (or sub-custodian) and the Distributor are under no
duty, however, to give notification of any defects or irregularities in the delivery of Fund
Deposits nor shall any of them incur any liability for the failure to give any such notification.
Creation/Redemption Transaction Fee
. The fund may impose a Transaction Fee on investors
purchasing or redeeming Creation Units. The Transaction Fee will be limited to amounts that have
been determined by CSIM to be appropriate. The purpose of the Transaction Fee is to protect the
existing shareholders of the fund from the dilutive costs associated with the purchase and
redemption of Creation Units. Where the fund permits cash creations (or redemptions) or cash in
lieu of depositing one or more Deposit Securities, the purchaser (or redeemer) may be assessed a
higher Transaction Fee to offset the transaction cost to the fund of buying (or selling) those
particular Deposit Securities. Every purchaser of a Creation Unit will receive a prospectus that
contains disclosure about the Transaction Fee, including the maximum amount of the additional
variable Transaction Fee charged by the funds.
The following table sets forth the standard and additional variable creation/redemption transaction
fee for the fund.
31
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Maximum
|
|
Maximum
|
|
|
Approximate Value
|
|
Standard
|
|
Additional
|
|
Additional
|
|
|
of One
|
|
Creation/Redemption
|
|
Creation
|
|
Redemption
|
Name of Fund
|
|
Creation Unit
|
|
Transaction Fee
|
|
Transaction Fee*
|
|
Transaction Fee*
|
Schwab U.S. Aggregate Bond ETF
|
|
$
|
_________
|
|
|
$
|
____
|
|
|
|
3.0
|
%
|
|
|
2.0
|
%
|
|
|
|
*
|
|
As a percentage of the total amount invested or redeemed.
|
Placement of Redemption Orders
. The process to redeem Creation Units works much like the process to
purchase Creation Units, but in reverse. Orders to redeem Creation Units of the fund must be
delivered through an Authorized Participant. Investors other than Authorized Participants are
responsible for making arrangements for a redemption request to be made through an Authorized
Participant. Orders must be accompanied or followed by the requisite number of shares of the fund
specified in such order, which delivery must be made to the Distributor no later than 10:00 a.m.
New York time on the next Business Day following the Transmittal Date. All other procedures set
forth in the Participant Agreement must be properly followed.
The funds securities received on redemption will generally correspond pro rata, to the extent
practicable, to the securities in the funds portfolio. Fund securities received on redemption may
not be identical to Deposit Securities that are applicable to creations of Creation Units. An
Authorized Participant submitting a redemption request is deemed to represent to the trust that it
(or its client) (i) owns outright or has full legal authority and legal beneficial right to tender
for redemption the requisite number of fund shares to be redeemed and can receive the entire
proceeds of the redemption, and (ii) the fund shares to be redeemed have not been loaned or pledged
to another party nor are they the subject of a repurchase agreement, securities lending agreement
or such other arrangement that would preclude the delivery of such fund shares to the trust. The
trust reserves the right to verify these representations at its discretion, but will typically
require verification with respect to a redemption request from a fund in connection with higher
levels of redemption activity and/or short interest in the fund. If the Authorized Participant,
upon receipt of a verification request, does not provide sufficient verification of its
representations as determined by the trust, the redemption request will not be considered to have
been received in proper form and may be rejected by the trust.
To the extent contemplated by an Authorized Participants agreement, in the event the Authorized
Participant has submitted a redemption request but is unable to transfer all or part of the
Creation Units to be redeemed to the Distributor, the Distributor will nonetheless accept the
redemption request in reliance on the undertaking by the Authorized Participant to deliver the
missing shares as soon as possible. Such undertaking shall be secured by the Authorized
Participants delivery and maintenance of collateral consisting of cash having a value (marked to
market daily) at least equal to 110%, which CSIM may change from time to time, of the value of the
missing shares.
The current procedures for collateralization of missing shares require, among other things, that
any cash collateral shall be in the form of U.S. dollars (or, at the discretion of the trust,
non-U.S. currency in an equivalent amount) in immediately-available funds and shall be held by the
custodian and marked to market daily. The fees of the custodian (and any sub-custodians) in respect
of the delivery, maintenance and redelivery of the cash collateral shall be payable by the
Authorized Participant. The trust, on behalf of the fund, is permitted to purchase the missing
shares or acquire the Deposit Securities and the Cash Component underlying such shares at any time
and will subject the Authorized Participant to liability for any shortfall between the cost to the
trust of purchasing such shares, Deposit Securities or Cash Component and the value of the
collateral.
If the requisite number of shares of the fund is not delivered on the Transmittal Date as described
above the fund may reject or revoke acceptance of the redemption request. If it is not possible to
effect deliveries of the Fund Securities, the trust may in its discretion exercise its option to
redeem such shares in U.S. cash and the redeeming Authorized Participant will be required to
receive its redemption proceeds in cash. In addition, an investor may request a redemption in cash
that the fund may, in its sole discretion, permit. In either case, the investor will receive a cash
payment equal to the NAV of its shares based on the NAV of shares of a fund next determined after
the redemption request is received (minus a redemption transaction fee and additional charge for
requested cash redemptions specified above, to offset the trusts brokerage and other transaction
costs associated with the disposition of Fund Securities).
Redemptions of shares for Fund Securities will be subject to compliance with applicable federal and
state securities laws and the funds (whether or not it otherwise permits cash redemptions) reserves
the right to redeem Creation Units for cash to the extent that the trust could not lawfully deliver
specific Fund Securities upon redemptions or could not do so without first registering the Fund
Securities under such laws.
32
The funds will not suspend or postpone redemption beyond seven days, except as permitted under
Section 22(e) of the 1940 Act or pursuant to exemptive relief obtained by the trust. Section 22(e)
provides that the right of redemption may be suspended or the date of payment postponed with
respect to the fund (1) for any period during which the NYSE is closed (other than customary
weekend and holiday closings); (2) for any period during which trading on the NYSE is suspended or
restricted; (3) for any period during which an emergency exists as a result of which disposal of
the shares of the funds portfolio securities or determination of its net asset value is not
reasonably practicable; or (4) in such other circumstance as is permitted by the SEC.
Pricing of Shares
Each business day, the fund calculates its share price, or NAV, as of the close of the NYSE
(generally, 4 p.m. Eastern time). This means that NAVs are calculated using the values of the
funds portfolio securities as of the close of the NYSE. Such values are required to be determined
in one of two ways: securities for which market quotations are readily available are required to be
valued at current market value; and securities for which market quotations are not readily
available are required to be valued at fair value using procedures approved by the Board of
Trustees.
The fund uses approved pricing services to provide values for its portfolio securities. Current
market values are generally determined by the approved pricing services as follows: generally
securities traded on exchanges are valued at the last-quoted sales price on the exchange on which
such securities are primarily traded, or, lacking any sales, at the mean between the bid and ask
prices; generally securities traded in the over-the-counter market are valued at the last reported
sales price that day, or, if no sales are reported, at the mean between the bid and ask prices.
Generally securities listed on the NASDAQ National Market System are valued in accordance with the
NASDAQ Official Closing Price. In addition, securities that are primarily traded on foreign
exchanges are generally valued at the preceding closing values of such securities on their
respective exchanges with these values then translated into U.S. dollars at the current exchange
rate. Fixed income securities normally are valued based on valuations provided by approved pricing
services. Securities may be fair valued pursuant to procedures approved by the funds Board of
Trustees when a security is de-listed or its trading is halted or suspended; when a securitys
primary pricing source is unable or unwilling to provide a price; when a securitys primary trading
market is closed during regular market hours; or when a securitys value is materially affected by
events occurring after the close of the securitys primary trading market. The Board of Trustees
regularly reviews fair value determinations made by the funds pursuant to the procedures.
NOTE: Transactions in fund shares will be priced at NAV only if you purchase or redeem shares
directly from a fund in Creation Units. Fund shares are purchased or sold on a national securities
exchange at market prices, which may be higher (premium) or lower (discount) than NAV.
TAXATION
Federal Tax Information for the Funds
This discussion of federal income tax consequences is based on the Code and the regulations issued
thereunder as in effect on the date of this Statement of Additional Information. New legislation,
as well as administrative changes or court decisions, may significantly change the conclusions
expressed herein, and may have a retroactive effect with respect to the transactions contemplated
herein.
It is the funds policy to qualify for taxation as a regulated investment company (RIC) by
meeting the requirements of Subchapter M of the Code. By qualifying as a RIC, the fund expects to
eliminate or reduce to a nominal amount the federal income tax to which it is subject. If the fund
does not qualify as a RIC under the Code, it will be subject to federal income tax on its net
investment income and any net realized capital gains. In addition, the fund could be required to
recognize unrealized gains, pay substantial taxes and interest, and make substantial distributions
before requalifying as a RIC.
The fund is treated as a separate entity for federal income tax purposes and is not combined with
the trusts other funds. The fund intends to qualify as a RIC so that it will be relieved of
federal income tax on that part of its income that is distributed to shareholders. To qualify for
treatment as a RIC, the fund must distribute annually to its shareholders at least 90% of its
investment company taxable income (generally, net investment income plus the excess, if any, of net
short-term capital gain over net long-term capital losses) and also must meet several additional
requirements. Among these requirements are the following: (i) at least 90% of the funds gross
income each taxable year must be derived from dividends, interest, payments with respect to
securities loans, and gains from the sale or other disposition of stock, securities or foreign
currencies, or other income derived with respect to its business of investing in such stock or
securities or currencies and net income derived from an interest in a qualified publicly traded
partnership; (ii) at the close of each quarter of the funds taxable year, at least 50% of the
value of its total assets must be represented by cash and cash items, U.S. Government securities,
securities of other RICs and other securities, with such other securities limited, in respect of
any one issuer, to
33
an amount that does not exceed 5% of the value of the funds assets and that does not represent
more than 10% of the outstanding voting securities of such issuer; and (iii) at the close of each
quarter of the funds taxable year, not more than 25% of the value of its assets may be invested in
securities (other than U.S. Government securities or the securities of other RICs) of any one
issuer or of two or more issuers and which are engaged in the same, similar, or related trades or
businesses if the fund owns at least 20% of the voting power of such issuers, or the securities of
one or more qualified publicly traded partnerships.
Certain master limited partnerships may qualify as qualified publicly traded partnerships for
purposes of the Subchapter M diversification rules described above. To do so, the master limited
partnership must satisfy two requirements during the taxable year. First, the interests of such
partnership either must be traded on an established securities market or must be readily tradable
on a secondary market (or the substantial equivalent thereof). Second, the partnership must meet
the 90% gross income requirements for the exception from treatment as a corporation with gross
income other than income consisting of dividends, interest, payments with respect to securities
loans, or gains from the sale or other disposition of stock or securities or foreign currencies, or
other income derived with respect to its business of investing in such stock securities or
currencies.
The Code imposes a non-deductible excise tax on RICs that do not distribute in a calendar year
(regardless of whether they otherwise have a non-calendar taxable year) an amount equal to 98.7% of
their ordinary income (as defined in the Code) for the calendar year plus 98.2% of their net
capital gain for the one-year period ending on October 31 of such calendar year, plus any
undistributed amounts from prior years. The non-deductible excise tax is equal to 4% of the
deficiency. For the foregoing purposes, the fund is treated as having distributed any amount on
which it is subject to income tax for any taxable year ending in such calendar year. The fund may
in certain circumstances be required to liquidate fund investments to make sufficient distributions
to avoid federal excise tax liability at a time when the investment adviser might not otherwise
have chosen to do so, and liquidation of investments in such circumstances may affect the ability
of the fund to satisfy the requirements for qualification as a RIC.
The funds transactions in futures contracts certain other investment activities may be restricted
by the Code and are subject to special tax rules. In a given case, these rules may accelerate
income to the fund, defer its losses, cause adjustments in the holding periods of the funds
assets, convert short-term capital losses into long-term capital losses or otherwise affect the
character of the funds income. These rules could therefore affect the amount, timing and character
of distributions to shareholders. The fund will endeavor to make any available elections pertaining
to these transactions in a manner believed to be in the best interest of the fund and its
shareholders.
The fund is required for federal income tax purposes to mark-to-market and recognize as income for
each taxable year its net unrealized gains and losses on certain futures contracts as of the end of
the year as well as those actually realized during the year. Gain or loss from futures and options
contracts on broad-based indexes required to be marked to market will be 60% long-term and 40%
short-term capital gain or loss. Application of this rule may alter the timing and character of
distributions to shareholders. The fund may be required to defer the recognition of losses on
futures contracts to the extent of any unrecognized gains on offsetting positions held by the fund.
It is anticipated that any net gain realized from the closing out of futures or options contracts
will be considered gain from the sale of securities and therefore will be qualifying income for
purposes of the 90% requirement described above. The fund distributes to shareholders at least
annually any net capital gains that have been recognized for federal income tax purposes, including
unrealized gains at the end of the funds fiscal year on futures or options transactions. Such
distributions are combined with distributions of capital gains realized on the funds other
investments and shareholders are advised on the nature of the distributions.
With respect to investments in zero coupon securities which are sold at original issue discount
(OID) and thus do not make periodic cash interest payments, the fund will be required to include
as part of its current income the imputed interest on such obligations even though the fund has not
received any interest payments on such obligations during that period. Because the fund distributes
all of its net investment income to its shareholders, the fund may have to sell fund securities to
distribute such imputed income which may occur at a time when the adviser would not have chosen to
sell such securities and which may result in taxable gain or loss.
Special federal income tax rules apply to the inflation-indexed bonds. Generally, all stated
interest on such bonds is taken into income by the fund under its regular method of accounting for
interest income. The amount of a positive inflation adjustment, which results in an increase in the
inflation-adjusted principal amount of the bond, is treated as OID. The OID is included in the
funds gross income ratably during the period ending with the maturity of the bond, under the
general OID inclusion rules. The amount of the funds OID in a taxable year with respect to a bond
will increase the funds taxable income for such year without a corresponding receipt of cash,
until the bond matures. As a result, as noted above, the fund may need to raise cash by selling
portfolio investments, which may occur at a time when the adviser would not have chosen to sell
such securities and which may result in capital gains to a fund and additional capital gain
distributions to fund shareholders. The amount of negative inflation adjustment, which results in a
decrease in the inflation-adjusted principal amount of the bond, reduces the amount of interest
(including stated, interest, OID, and market discount, if any) otherwise includible in the funds
income with respect to the bond for the taxable year.
Any market discount recognized on a bond is taxable as ordinary income. A market discount bond is a
bond acquired in the secondary market at a price below redemption value or adjusted issue price if
issued with original issue discount. Absent an election by the fund
34
to include the market discount in income as it accrues, gain on the funds position of such an
obligation will be treated as ordinary income rather than capital gain to the extent of the accrued
market discount.
Federal Income Tax Information for Shareholders
The discussion of federal income taxation presented below supplements the discussion in the funds
prospectus and only summarizes some of the important federal tax considerations generally affecting
shareholders of the fund. Accordingly, prospective investors (particularly those not residing or
domiciled in the United States) should consult their own tax advisors regarding the consequences of
investing in the fund.
Any dividends declared by the fund in October, November or December and paid the following January
are treated, for tax purposes, as if they were received by shareholders on December 31 of the year
in which they were declared. In general, distributions by the fund of investment company taxable
income (including net short-term capital gains), if any, whether received in cash or additional
shares, will be taxable to you as ordinary income. It is expected that any portion of these
distributions will be eligible to be treated as qualified dividend income which is eligible in
certain circumstances for reduced maximum tax rates to individuals.
A portion of these distributions may be treated as qualified dividend income (eligible for the
reduced maximum rate to individuals of 15% (reduced rates apply to individuals in lower tax
brackets)) to the extent that the fund receives qualified dividend income. Qualified dividend
income is, in general, dividend income from taxable domestic corporations and certain foreign
corporations (e.g., foreign corporations incorporated in a possession of the United States or in
certain countries with a comprehensive tax treaty with the United States, or the stock of which is
readily tradable on an established securities market in the United States). A dividend will not be
treated as qualified dividend income to the extent that (i) the shareholder has not held the shares
of the fund on which the dividend was paid for more than 60 days during the 121-day period that
begins on the date that is 60 days before the date on which the shares of the fund become
ex-dividend with respect to such dividend (and the fund also satisfies those holding period
requirements with respect to the securities it holds that paid the dividends distributed to the
shareholder), (ii) the shareholder is under an obligation (whether pursuant to a short sale or
otherwise) to make related payments with respect to substantially similar or related property, or
(iii) the shareholder elects to treat such dividend as investment income under section 163(d)(4)(B)
of the Internal Revenue Code. Dividends received by the fund from a REIT or another RIC may be
treated as qualified dividend income only to the extent the dividend distributions are attributable
to qualified dividend income received by such REIT or RIC.
Distributions from net capital gain (if any) that are designated as capital gains dividends are
taxable as long-term capital gains without regard to the length of time the shareholder has held
shares of the fund. However, if you receive a capital gains dividend with respect to fund shares
held for six months or less, any loss on the sale or exchange of those shares shall, to the extent
of the capital gains dividend, be treated as a long-term capital loss. Long-term capital gains also
will be taxed at a maximum rate of 15%. Absent further legislation, the maximum 15% tax rate on
qualified dividend income and long-term capital gains will cease to apply to taxable years
beginning after December 31, 2012.
The fund will inform you of the amount of your ordinary income dividends and capital gain
distributions, if any, at the time they are paid and will advise you of their tax status for
federal income tax purposes, including what portion of the distributions will be qualified dividend
income, shortly after the close of each calendar year.
If the fund makes a distribution to a shareholder in excess of the funds current and accumulated
earnings and profits in any taxable year, the excess distribution will be treated as a return of
capital to the extent of the shareholders tax basis in its shares, and thereafter, as capital
gain. A return of capital is not taxable, but reduces a shareholders tax basis in its shares, thus
reducing any loss or increasing any gain on a subsequent taxable disposition by the shareholder of
its shares.
For corporate investors in the fund, dividend distributions the fund designates to be from
dividends received from qualifying domestic corporations will be eligible for the 70% corporate
dividends-received deduction to the extent they would qualify if the fund were a regular
corporation. Distributions by the fund also may be subject to state, local and foreign taxes, which
may differ from the federal income tax treatment described above.
A sale of shares in the fund may give rise to a gain or loss. In general, any gain or loss realized
upon a taxable disposition of shares will be treated as long-term capital gain or loss if the
shares have been held for more than one year. Otherwise, the gain or loss on the taxable
disposition of shares will be treated as short-term capital gain or loss. Under current law, the
maximum tax rate on long-term capital gains available to non-corporate shareholders is generally
15% for taxable years beginning before January 1, 2013. Any loss realized upon a taxable
disposition of shares held for six months or less will be treated as long-term, rather than
short-term, to the
35
extent of any long-term capital gain distributions received (or deemed received) by the shareholder
with respect to the shares. All or a portion of any loss realized upon a taxable disposition of
shares will be disallowed if other substantially identical shares of the fund are purchased within
30 days before or after the disposition. In such a case, the basis of the newly purchased shares
will be adjusted to reflect the disallowed loss.
An Authorized Participant who exchanges securities for Creation Units generally will recognize a
gain or a loss. The gain or loss will be equal to the difference between the market value of the
Creation Units at the time and the sum of the exchangers aggregate basis in the securities
surrendered plus the amount of cash paid for such Creation Units. A person who redeems Creation
Units will generally recognize a gain or loss equal to the difference between the exchangers basis
in the Creation Units and the sum of the aggregate market value of any securities received plus the
amount of any cash received for such Creation Units. The Internal Revenue Service, however, may
assert that a loss realized upon an exchange of securities for Creation Units cannot be deducted
currently under the rules governing wash sales, or on the basis that there has been no
significant change in economic position.
Any capital gain or loss realized upon the creation of Creation Units will generally be treated as
long-term capital gain or loss if the securities exchanged for such Creation Units have been held
for more than one year. Any capital gain or loss realized upon the redemption of Creation Units
will generally be treated as long-term capital gain or loss if the shares comprising the Creation
Units have been held for more than one year. Otherwise, such capital gains or losses will be
treated as short-term capital gains or losses.
Certain tax-exempt shareholders, including qualified pension plans, individual retirement accounts,
salary deferral arrangements, 401(k)s, and other tax-exempt entities, generally are exempt from
federal income taxation except with respect to their unrelated business taxable income (UBTI).
Under current law, each fund generally serves to block UBTI from being realized by their tax-exempt
shareholders. However, notwithstanding the foregoing, tax-exempt shareholders could realize UBTI by
virtue of its investment in the fund where, for example, (i) the fund invests in REITs that hold
residual interests in real estate mortgage investment conduits (REMICs) or (ii) share in the fund
constitutes debt-financed property in the hands of the tax-exempt shareholder within the meaning of
section 514(b) of the Code, a tax-exempt shareholder could realize UBTI by virtue of its investment
in the Fund. Charitable remainder trusts are subject to special rules and should consult their tax
advisors. There are no restrictions preventing the fund from holding investments in REITs that hold
residual interests in REMICs, and the fund may do so. The Internal Revenue Service has issued
recent guidance with respect to these issues and prospective shareholders, especially charitable
remainder trusts, are strongly encouraged to consult with their tax advisors regarding these
issues.
The fund has the right to reject an order to for Creation Units if the purchaser (or group of
purchasers) would, upon obtaining the shares so ordered, own 80% or more of the outstanding shares
of the fund and if, pursuant to section 351 of the Code, the respective fund would have a basis in
the deposit securities different from the market value of such securities on the date of deposit.
The fund also has the right to require information necessary to determine beneficial Share
ownership for purposes of the 80% determination.
Dividends paid by the fund to shareholders who are nonresident aliens or foreign entities will be
subject to a 30% United States withholding tax unless a reduced rate of withholding or a
withholding exemption is provided under applicable treaty law to the extent derived from investment
income and short-term capital gain (other than qualified short-term capital gain described below)
or unless such income is effectively connected with a U.S. trade or business carried on through a
permanent establishment in the United States. Nonresident shareholders are urged to consult their
own tax advisors concerning the applicability of the United States withholding tax and the proper
withholding form(s) to be submitted to the fund. A non-U.S. shareholder who fails to provide an
appropriate Internal Revenue Service Form W-8 may be subject to backup withholding at the
appropriate rate.
The fund may, under certain circumstances, designate all or a portion of a dividend as an
interest-related dividend that if received by a nonresident alien or foreign entity generally
would be exempt from the 30% U.S. withholding tax, provided that certain other requirements are
met. The fund may also, under certain circumstances, designate all or a portion of a dividend as a
qualified short-term capital gain dividend which if received by a nonresident alien or foreign
entity generally would be exempt from the 30% U.S. withholding tax, unless the foreign person is a
nonresident alien individual present in the United States for a period or periods aggregating 183
days or more during the taxable year. In the case of Shares held through an intermediary, the
intermediary may withhold even if the fund designates the payment as qualified net interest income
or qualified short-term capital gain. Non-U.S. shareholders should contact their intermediaries
with respect to the application of these rules to their accounts. The provisions relating to
dividends to foreign persons would apply to dividends with respect to taxable years of the funds
beginning after December 31, 2004 and before January 1, 2012.
The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) makes non-U.S. persons subject
to U.S. tax on disposition of a U.S. real property interest as if he or she were a U.S. person.
Such gain is sometimes referred to as FIRPTA gain. The Internal
36
Revenue Code provides a look-through rule for distributions of FIRPTA gain by a RIC if all of the
following requirements are met: (i) the RIC is classified as a qualified investment entity (a
qualified investment entity includes a RIC if, in general, more than 50% of the RICs assets
consists of interests in REITs and U.S. real property holding corporations); and (ii) you are a
non-U.S. shareholder that owns more than 5% of the funds shares at any time during the one-year
period ending on the date of the distribution. If these conditions are met, fund distributions to
you are treated as gain from the disposition of a U.S. real property interest (USRPI), causing
the distribution to be subject to U.S. withholding tax at a rate of 35%, and requiring that you
file a nonresident U.S. income tax return. Also, such gain may be subject to a 30% branch profits
tax in the hands of a non-U.S. shareholder that is a corporation. Even if a non-U.S. shareholder
does not own more than 5% of a funds shares, fund distributions to you that are attributable to
gain from the sale or disposition of a USRPI will be taxable as ordinary dividends subject to
withholding at a 30% or lower treaty rate.
The funds investments in REITs may require the fund to pass-through certain excess inclusion
income as unrelated business taxable income (UBTI). Tax-exempt investors sensitive to UBTI
are strongly encouraged to consult their tax advisers prior to investment in the fund regarding
this issue and recent IRS pronouncements regarding the treatment of such income in the hands of
such investors
Disclosure for Non-U.S. Shareholders
The fund will be required in certain cases to withhold at
the applicable withholding rate and remit to the U.S. Treasury the withheld amount of taxable
dividends paid to any shareholder who (1) fails to provide a correct taxpayer identification number
certified under penalty of perjury; (2) is subject to withholding by the Internal Revenue Service
for failure to properly report all payments of interest or dividends; (3) fails to provide a
certified statement that he or she is not subject to backup withholding; or (4) fails to provide
a certified statement that he or she is a U.S. person (including a U.S. resident alien). Backup
withholding is not an additional tax and any amounts withheld may be credited against the
shareholders ultimate U.S. tax liability.
Foreign shareholders (i.e., nonresident alien individuals and foreign corporations, partnerships,
trusts and estates) are generally subject to U.S. withholding tax at the rate of 30% (or a lower
tax treaty rate) on distributions derived from net investment income and short-term capital gains;
provided, however, that for the funds taxable year beginning after December 31, 2004 and not
beginning after December 31, 2011, interest related dividends and short-term capital gain dividends
generally will not be subject to U.S. withholding taxes. Distributions to foreign shareholders of
such short-term capital gain dividends, of long-term capital gains and any gains from the sale or
other disposition of shares of the fund generally are not subject to U.S. taxation, unless the
recipient is an individual who either (1) meets the Codes definition of resident alien or (2) is
physically present in the U.S. for 183 days or more per year. Different tax consequences may result
if the foreign shareholder is engaged in a trade or business within the United States. In addition,
the tax consequences to a foreign shareholder entitled to claim the benefits of a tax treaty may be
different than those described above. Foreign shareholders may also be subject to U.S. estate
taxes with respect to shared in the fund.
Under U.S. Treasury regulations, if a shareholder recognizes a loss of $2 million or more for an
individual shareholder or $10 million or more for a corporate shareholder, the shareholder must
file with the Internal Revenue Service a disclosure statement on Form 8886. Direct shareholders of
portfolio securities are in many cases excepted from this reporting requirement, but under current
guidance, shareholders of a RIC such as the fund are not excepted. Future guidance may extend the
current exception from this reporting requirement to shareholders of most or all RICs. The fact
that a loss is reportable under these regulations does not affect the legal determination of
whether the taxpayers treatment of the loss is proper. Shareholders should consult their tax
advisors to determine the applicability of these regulations in light of their individual
circumstances.
Shareholders are urged to consult their tax advisors as to the state and local tax rules affecting
investments in the fund.
37
APPENDIX RATINGS OF INVESTMENT SECURITIES
From time to time, the fund may report the percentage of its assets that fall into the rating
categories set forth below.
BONDS
Moodys Investors Service
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 some time 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 both 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.
Standard & Poors Corporation
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 debt 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 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 exhibits 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.
Speculative Grade
Debt rated BB and B is regarded as having predominantly speculative characteristics with
respect to capacity to pay interest and repay principal. While such debt will likely have some
quality and protective characteristics, these are outweighed by large uncertainties or major risk
exposures to adverse conditions.
38
BB
Debt rated BB has less near-term vulnerability to default than other speculative grade debt.
However, it faces major ongoing uncertainties or exposure to adverse business, financial, or
economic conditions that 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 rate B has greater vulnerability to default but presently has the capacity to meet
interest payments and principal repayments. Adverse business, financial, or economic conditions
would likely impair capacity or willingness to pay interest and repay principal. The B rating
category also is used for debt subordinated to senior debt that is assigned an actual or implied
BB or BB- rating.
Fitch, Inc.
Investment Grade Bond
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 obligors 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 F1+.
|
|
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 obligors 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.
|
Speculative grade bond
BB
|
|
Bonds are considered speculative. The obligors ability to pay
interest and repay principal may be affected over time by
adverse economic changes. However, business and financial
alternatives can be identified which 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 obligors limited margin of safety and
the need for reasonable business and economic activity
throughout the life of the issue.
|
Dominion Bond Rating Service
Bond and Long Term Debt Rating Scale
As is the case with all DBRS rating scales, long term debt ratings are meant to give an indication
of the risk that the borrower will not fulfill its full obligations in a timely manner with respect
to both interest and principal commitments. DBRS ratings do not take factors such as pricing or
market risk into consideration and are expected to be used by purchasers as one part of their
investment process. Every DBRS rating is based on quantitative and qualitative considerations that
are relevant for the borrowing entity.
AAA: Highest Credit Quality
AA: Superior Credit Quality
A: Satisfactory Credit Quality
BBB: Adequate Credit Quality
BB: Speculative
B: Highly Speculative
CCC: Very Highly Speculative
39
CC: Very Highly Speculative
C: Very Highly Speculative
AAA
Bonds rated AAA are of the highest credit quality, with exceptionally strong protection for
the timely repayment of principal and interest. Earnings are considered stable, the structure of
the industry in which the entity operates is strong, and the outlook for future profitability is
favorable. There are few qualifying factors present which would detract from the performance of the
entity, the strength of liquidity and coverage ratios is unquestioned and the entity has
established a creditable track record of superior performance. Given the extremely tough definition
which DBRS has established for this category, few entities are able to achieve a AAA rating.
AA
Bonds rated AA are of superior credit quality, and protection of interest and principal is
considered high. In many cases, they differ from bonds rated AAA only to a small degree. Given the
extremely tough definition which DBRS has for the AAA category (which few companies are able to
achieve), entities rated AA are also considered to be strong credits which typically exemplify
above-average strength in key areas of consideration and are unlikely to be significantly affected
by reasonably foreseeable events.
A
Bonds rated A are of satisfactory credit quality. Protection of interest and principal is
still substantial, but the degree of strength is less than with AA rated entities. While a
respectable rating, entities in the A category are considered to be more susceptible to adverse
economic conditions and have greater cyclical tendencies than higher rated companies.
BBB
Bonds rated BBB are of adequate credit quality. Protection of interest and principal is
considered adequate, but the entity is more susceptible to adverse changes in financial and
economic conditions, or there may be other adversities present which reduce the strength of the
entity and its rated securities.
BB
Bonds rated BB are defined to be speculative, where the degree of protection afforded
interest and principal is uncertain, particularly during periods of economic recession. Entities in
the BB area typically have limited access to capital markets and additional liquidity support and,
in many cases, small size or lack of competitive strength may be additional negative
considerations.
B
Bonds rated B are highly speculative and there is a reasonably high level of uncertainty
which exists as to the ability of the entity to pay interest and principal on a continuing basis in
the future, especially in periods of economic recession or industry adversity.
CCC
/
CC
/
C
Bonds rated in any of these categories are very highly speculative and are in
danger of default of interest and principal. The degree of adverse elements present is more severe
than bonds rated B. Bonds rated below B often have characteristics which, if not remedied, may
lead to default. In practice, there is little difference between the C to CCC categories, with
CC and C normally used to lower ranking debt of companies where the senior debt is rated in the
CCC to B range.
D
This category indicates Bonds in default of either interest or principal.
(
high
,
low
) grades are used to indicate the relative standing of a credit within a particular
rating category. The lack of one of these designations indicates a rating which is essentially in
the middle of the category. Note that high and low grades are not used for the AAA category.
COMMERCIAL PAPER AND SHORT-TERM DEBT RATING SCALE
Dominion Bond Rating Service
As is the case with all DBRS rating scales, commercial paper ratings are meant to give an
indication of the risk that the borrower will not fulfill its obligations in a timely manner. DBRS
ratings do not take factors such as pricing or market risk into consideration and are expected to
be used by purchasers as one part of their investment process. Every DBRS rating is based on
quantitative and qualitative considerations which are relevant for the borrowing entity.
R-1: Prime Credit Quality
R-2: Adequate Credit Quality
R-3: Speculative
40
All three DBRS rating categories for short term debt use high, middle or low as subset grades
to designate the relative standing of the credit within a particular rating category. The following
comments provide separate definitions for the three grades in the Prime Credit Quality area, as
this is where ratings for active borrowers in Canada continue to be heavily concentrated.
R-1 (high)
Short term debt rated R-1 (high) is of the highest credit quality, and indicates an
entity which possesses unquestioned ability to repay current liabilities as they fall due. Entities
rated in this category normally maintain strong liquidity positions, conservative debt levels and
profitability which is both stable and above average. Companies achieving an R-1 (high) rating
are normally leaders in structurally sound industry segments with proven track records, sustainable
positive future results and no substantial qualifying negative factors. Given the extremely tough
definition which DBRS has established for an R-1 (high), few entities are strong enough to
achieve this rating.
R-1 (middle)
Short term debt rated R-1 (middle) is of superior credit quality and, in most
cases, ratings in this category differ from R-1 (high) credits to only a small degree. Given the
extremely tough definition which DBRS has for the R-1 (high) category (which few companies are
able to achieve), entities rated R-1 (middle) are also considered strong credits which typically
exemplify above average strength in key areas of consideration for debt protection.
R-1 (low)
Short term debt rated R-1 (low) is of satisfactory credit quality. The overall
strength and outlook for key liquidity, debt and profitability ratios is not normally as favorable
as with higher rating categories, but these considerations are still respectable. Any qualifying
negative factors which exist are considered manageable, and the entity is normally of sufficient
size to have some influence in its industry.
R-2 (high)
,
R-2 (middle)
,
R-2 (low)
Short term debt rated R-2 is of adequate credit quality
and within the three subset grades, debt protection ranges from having reasonable ability for
timely repayment to a level which is considered only just adequate. The liquidity and debt ratios
of entities in the R-2 classification are not as strong as those in the R-1 category, and the
past and future trend may suggest some risk of maintaining the strength of key ratios in these
areas. Alternative sources of liquidity support are considered satisfactory; however, even the
strongest liquidity support will not improve the commercial paper rating of the issuer. The size of
the entity may restrict its flexibility, and its relative position in the industry is not typically
as strong as an R-1 credit. Profitability trends, past and future, may be less favorable,
earnings not as stable, and there are often negative qualifying factors present which could also
make the entity more vulnerable to adverse changes in financial and economic conditions.
R-3 (high)
,
R-3 (middle)
,
R-3 (low)
Short term debt rated R-3 is speculative, and within
the three subset grades, the capacity for timely payment ranges from mildly speculative to
doubtful. R-3 credits tend to have weak liquidity and debt ratios, and the future trend of these
ratios is also unclear. Due to its speculative nature, companies with R-3 ratings would normally
have very limited access to alternative sources of liquidity. Earnings would typically be very
unstable, and the level of overall profitability of the entity is also likely to be low. The
industry environment may be weak, and strong negative qualifying factors are also likely to be
present.
SHORT TERM NOTES AND VARIABLE RATE DEMAND OBLIGATIONS
Moodys Investors Service
Short term notes/variable rate demand obligations bearing the designations MIG-1/VMIG-1 are
considered to be of the best quality, enjoying strong protection from established cash flows,
superior liquidity support or demonstrated broad-based access to the market for refinancing.
Obligations rated MIG-2/VMIG-3 are of high quality and enjoy ample margins of protection although
not as large as those of the top rated securities.
Standard & Poors Corporation
An S&P SP-1 rating indicates that the subject securities issuer has a strong capacity to pay
principal and interest. Issues determined to possess very strong safety characteristics are given a
plus (+) designation. S&Ps determination that an issuer has a satisfactory capacity to pay
principal and interest is denoted by an SP-2 rating.
Fitch, Inc.
Obligations supported by the highest capacity for timely repayment are rated F1+. An F1 rating
indicates that the obligation is supported by a very strong capacity for timely repayment.
Obligations rated F2 are supported by a good capacity for timely repayment, although adverse
changes in business, economic, or financial conditions may affect this capacity.
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COMMERCIAL PAPER
Moodys Investors Service
Prime-1 is the highest commercial paper rating assigned by Moodys. Issuers (or related supporting
institutions) of commercial paper with this rating are considered to have a superior ability to
repay short term promissory obligations. Issuers (or related supporting institutions) of securities
rated Prime-2 are viewed as having a strong capacity to repay short term promissory obligations.
This capacity will normally be evidenced by many of the characteristics of issuers whose commercial
paper is rated Prime-1 but to a lesser degree.
Standard & Poors Corporation
A Standard & Poors Corporation (S&P) A-1 commercial paper rating indicates a strong degree of
safety regarding timely payment of principal and interest. Issues determined to possess
overwhelming safety characteristics are denoted A-1+. Capacity for timely payment on commercial
paper rated A-2 is satisfactory, but the relative degree of safety is not as high as for issues
designated A-1.
Fitch, Inc.
F1+ is the highest category, and indicates the strongest degree of assurance for timely payment.
Issues rated F1 reflect an assurance of timely payment only slightly less than issues rated F1+.
Issues assigned an F2 rating have a satisfactory degree of assurance for timely payment, but the
margin of safety is not as great as for issues in the first two rating categories.
42
Page 1 of 5
Appendix Proxy Voting Policies and Procedures
Charles Schwab Investment Management, Inc.
The Charles Schwab Family of Funds
Schwab Investments
Schwab Capital Trust
Schwab Annuity Portfolios
Laudus Trust
Laudus Institutional Trust
Schwab Strategic Trust
Proxy Voting Policy and Procedures
As of April 2011
Charles Schwab Investment Management, Inc. (CSIM), as an investment adviser, is generally
responsible for voting proxies with respect to the securities held in accounts of investment
companies and other clients for which it provides discretionary investment management services.
CSIMs Proxy Committee exercises and documents CSIMs responsibility with regard to voting of
client proxies (the Proxy Committee). The Proxy Committee is composed of representatives of
CSIMs Fund Administration, Legal, and Portfolio Management Departments, and chaired by CSIMs
Deputy Chief Investment Officer or his/her delegate. The Proxy Committee reviews and, as
necessary, may amend periodically these Procedures to address new or revised proxy voting policies
or procedures. The policies stated in these Proxy Voting Policy and Procedures (the CSIM Proxy
Procedures) pertain to all of CSIMs clients.
The Boards of Trustees (the Trustees) of The Charles Schwab Family of Funds, Schwab Investments,
Schwab Capital Trust, and Schwab Annuity Portfolios ( Schwab Funds) have delegated the
responsibility for voting proxies to CSIM through their respective Investment Advisory and
Administration Agreements. In addition, the Boards of Trustees (the Trustees) of Laudus Trust
and Laudus Institutional Trust (Laudus Funds) and the Schwab Strategic Trust (Schwab ETFs;
collectively, the Schwab Funds, the Laudus Funds and the Schwab ETFs are the Funds) have
delegated the responsibility for voting proxies to CSIM through their respective investment
advisory and administration agreements. The Trustees have adopted these Proxy Procedures with
respect to proxies voted on behalf of the various Schwab Funds, Laudus Funds, and Schwab ETFs
portfolios. CSIM will present amendments to the Trustees for approval. However, there may be
circumstances where the Proxy Committee deems it advisable to amend the Proxy Procedures between
regular Schwab Funds, Laudus Funds and Schwab ETFs Board meetings. In such cases, the Trustees
will be asked to ratify any changes at the next regular meeting of the Board.
To assist CSIM in its responsibility for voting proxies and the overall proxy voting process, CSIM
has retained Glass Lewis & Co. (Glass Lewis) as an expert in the proxy voting and corporate
governance area. The services provided by Glass Lewis include in-depth research, global issuer
analysis, and voting recommendations as well as vote execution, reporting and record keeping.
Page 2 of 5
Proxy Voting Policy
For investment companies and other clients for which CSIM exercises its responsibility for voting
proxies, it is CSIMs policy to vote proxies in the manner that CSIM and the Proxy Committee
believes will maximize the economic benefit to CSIMs clients. In furtherance of this policy, the
Proxy Committee has received and reviewed Glass Lewis written proxy voting policies and procedures
(Glass Lewis Proxy Procedures) and has determined that Glass Lewis Proxy Procedures are
consistent with the CSIM Proxy Procedures and CSIMs fiduciary duty with respect to its clients.
The Proxy Committee has also implemented custom policies as set forth below. The Proxy Committee
will review any material amendments to Glass Lewis Proxy Procedures to determine whether such
procedures continue to be consistent with the CSIM Proxy Voting Procedures, and CSIMs fiduciary
duty with respect to its clients.
Except under each of the circumstances described below, the Proxy Committee will delegate to Glass
Lewis responsibility for voting proxies, including timely submission of votes, on behalf of CSIMs
clients in accordance with Glass Lewis Proxy Procedures.
For proxy issues, that the Proxy Committee or the applicable portfolio manager or other relevant
portfolio management staff believe raise significant concerns with respect to the accounts of CSIM
clients, the Proxy Committee will review the analysis and recommendation of Glass Lewis. Examples
of factors that could cause a matter to raise significant concerns include, but are not limited to:
issues whose outcome has the potential to materially affect the companys industry, or regional or
national economy, and matters which involve broad public policy developments which may similarly
materially affect the environment in which the company operates. The Proxy Committee also will
solicit input from the assigned portfolio manager and other relevant portfolio management staff for
the particular portfolio security. After evaluating all such recommendations, the Proxy Committee
will decide how to vote the shares and will instruct Glass Lewis to vote consistent with its
decision. The Proxy Committee has the ultimate responsibility for making the determination of how
to vote the shares to seek to maximize the value of that particular holding.
With respect to proxies of an affiliated mutual fund, the Proxy Committee will vote such proxies in
the same proportion as the vote of all other shareholders of the fund (
i.e.
, echo vote), unless
otherwise required by law. When required by law or applicable exemptive order, the Proxy Committee
will also echo vote proxies of an unaffiliated mutual fund. For example, certain exemptive
orders issued to the Schwab Funds by the Securities and Exchange Commission and Section 12(d)(1)(F)
of the Investment Company Act of 1940, as amended, require the Schwab Funds, under certain
circumstances, to echo vote proxies of registered investment companies that serve as underlying
investments of the Schwab Funds. When not required to echo vote, the Proxy Committee will
delegate to Glass Lewis responsibility for voting proxies of an unaffiliated mutual fund in
accordance with Glass Lewis Proxy Procedures, subject to the custom policies set forth below.
Page 3 of 5
In addition, with respect to holdings of The Charles Schwab Corporation (CSC) (ticker symbol:
SCHW), the Proxy Committee will vote such proxies in the same proportion as the vote of all other
shareholders of CSC (
i.e.
, echo vote), unless otherwise required by law.
Exceptions from Glass Lewis Proxy Procedures
: The Proxy Committee has reviewed the
particular policies set forth in Glass Lewis Proxy Procedures and has determined that the
implementation of the following custom policies is consistent with CSIMs fiduciary duty to its
clients:
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Independent Chairman
: With respect to shareholder proposals requiring that a
company chairmans position be filled by an independent director, the Proxy Committee has
instructed Glass Lewis to vote with management on such proposal unless the company does not
meet the applicable minimum total shareholder return threshold, as calculated below. In
cases where a company fails to meet the threshold, the Proxy Committee has instructed Glass
Lewis to vote the shareholder proposals requiring that the chairmans position be filled by
an independent director in accordance with Glass Lewis Proxy Procedures. In cases where a
company is a registered investment company, the Proxy Committee has instructed Glass Lewis
to vote with management on such proposal. Additionally, with respect to the election of a
director who serves as the governance committee chair (or, in the absence of a governance
committee, the chair of the nominating committee), the Proxy Committee has instructed Glass
Lewis to vote for the director in cases where the company chairmans position is not filled
by an independent director and an independent lead or presiding director has not been
appointed.
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Classified Boards
: With respect to shareholder proposals declassifying a
staggered board in favor of the annual election of directors, the Proxy Committee has
instructed Glass Lewis to vote with management on such proposal unless the company does not
meet the applicable minimum total shareholder return threshold, as calculated below. In
cases where a company fails to meet the threshold, the Proxy Committee has instructed Glass
Lewis to vote the shareholder proposals declassifying a staggered board in favor of the
annual election of directors in accordance with Glass Lewis Proxy Procedures.
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Glass Lewis uses a three-year total return performance methodology to calculate the applicable
minimum total shareholder return threshold. For Russell 3000 Index constituents, if a companys
total annual shareholder return is in the bottom 25% of Russell 3000 constituent companies total
annual shareholder returns for three consecutive years, the company will be deemed not to have met
the threshold. For companies not in the Russell 3000 Index, the universe of companies used for the
minimum total shareholder return threshold calculation is all Glass Lewis covered companies
outside of the Russell 3000 Index.
If Glass Lewis does not provide an analysis or recommendation for voting a particular proxy measure
or measures, (1) two members of the Proxy Committee, including at least one representative from
Portfolio Management, in consultation with the Chair of the Proxy Committee or his/her designee,
may decide how to vote such proxy, or (2) the Proxy Committee may meet to decide how to vote such
proxy.
Page 4 of 5
Conflicts of Interest
. Except as described above for proxies solicited by affiliated funds
or CSC and the exceptions to Glass Lewis Proxy Procedures, proxy issues that present material
conflicts of interest between CSIM, and/or any of its affiliates, and CSIMs clients, CSIM will
delegate to Glass Lewis responsibility for voting such proxies in accordance with Glass Lewis
Proxy Procedures,. The CSIM Legal Department is responsible for developing procedures to identify
material conflicts of interest.
Voting Foreign Proxies
. CSIM has arrangements with Glass Lewis for voting proxies.
However, voting proxies with respect to shares of foreign securities may involve significantly
greater effort and corresponding cost than voting proxies with respect to domestic securities, due
to the variety of regulatory schemes and corporate practices in foreign countries with respect to
proxy voting. Problems voting foreign proxies may include the following:
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proxy statements and ballots written in a foreign language;
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untimely and/or inadequate notice of shareholder meetings;
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restrictions of foreigners ability to exercise votes;
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requirements to vote proxies in person;
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requirements to provide local agents with power of attorney to facilitate
CSIMs voting instructions.
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In consideration of the foregoing issues, Glass Lewis uses its best-efforts to vote foreign
proxies. As part of its ongoing oversight, the Proxy Committee will monitor the voting of foreign
proxies to determine whether all reasonable steps are taken to vote foreign proxies. If the Proxy
Committee determines that the cost associated with the attempt to vote outweighs the potential
benefits clients may derive from voting, the Proxy Committee may decide not to attempt to vote. In
addition, certain foreign countries impose restrictions on the sale of securities for a period of
time before and/or after the shareholder meeting. To avoid these trading restrictions, the Proxy
Committee instructs Glass Lewis not to vote such foreign proxies.
Securities Lending Programs
. Certain of the Funds enter into securities lending
arrangements with lending agents to generate additional revenue for their portfolios. In securities
lending arrangements, any voting rights that accompany the loaned securities generally pass to the
borrower of the securities, but the lender retains the right to recall a security and may then
exercise the securitys voting rights. In order to vote the proxies of securities out on loan, the
securities must be recalled prior to the established record date. CSIM will use its best efforts to
recall a Funds securities on loan and vote such securities proxies if (a) the proxy relates to a
special meeting of shareholders of the issuer (as opposed to the issuers annual meeting of
shareholders), or (b) the Fund owns more than 5% of the outstanding shares of the issuer. Further,
it is CSIMs policy to use its best efforts to recall securities on loan and vote such securities
proxies if CSIM determines that the proxies involve a material event affecting the loaned
securities. CSIM may utilize third-party service providers to assist it in identifying and
evaluating whether an event is material. CSIM may also recall securities on loan and vote such
securities proxies in its discretion.
Sub-Advisory Relationships
. Where CSIM has delegated day-to-day investment management
responsibilities to an investment adviser, CSIM may delegate proxy voting responsibility to such
Page 5 of 5
investment adviser. Each sub-adviser to whom proxy voting responsibility has been delegated will
be required to review all proxy solicitation material and to exercise the voting rights associated
with the securities it has been allocated in the best interest of each investment company and its
shareholders, or other client. Prior to delegating the proxy voting responsibility, CSIM will
review each sub-advisers proxy voting policy to determine whether it belives that each
sub-advisers proxy voting policy is generally consistent with the maximization of economic
benefits to the investment company or other client.
Reporting and Record Retention
CSIM will maintain, or cause Glass Lewis to maintain, records that identify the manner in which
proxies have been voted (or not voted) on behalf of CSIM clients. CSIM will comply with all
applicable rules and regulations regarding disclosure of its or its clients proxy voting records
and procedures.
CSIM will retain all proxy voting materials and supporting documentation as required under the
Investment Advisers Act of 1940 and the rules and regulations thereunder.
PROXY PAPER GUIDELINES
2011 PROXY SEASON
AN OVERVIEW OF THE GLASS LEWIS APPROACH TO INTERNATIONAL PROXY ADVICE
UNITED STATES
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Copyright 2011 Glass, Lewis & Co., LLC
4
I.
A Board of Directors That Serves the Interests of Shareholders
ELECTION OF DIRECTORS
The purpose of Glass Lewis proxy research and advice is to facilitate shareholder voting in
favor of governance structures that will drive performance, create shareholder value and maintain a
proper tone at the top. Glass Lewis looks for talented boards with a record of protecting
shareholders and delivering value over the medium- and long-term. We believe that boards working to
protect and enhance the best interests of shareholders are independent, have directors with diverse
backgrounds, have a record of positive performance, and have members with a breadth and depth of
relevant experience.
Independence
The independence of directors, or lack thereof, is ultimately demonstrated through the
decisions they make. In assessing the independence of directors, we will take into consideration,
when appropriate, whether a director has a track record indicative of making objective decisions.
Likewise, when assessing the independence of directors we will also examine when a directors
service track record on multiple boards indicates a lack of objective decision-making. Ultimately,
we believe the determination of whether a director is independent or not must take into
consideration both compliance with the applicable independence listing requirements as well as
judgments made by the director.
We look at each director nominee to examine the directors relationships with the company, the
companys executives, and other directors. We do this to evaluate whether personal, familial, or
financial relationships (not including director compensation) may impact the directors decisions.
We believe that such relationships make it difficult for a director to put shareholders interests
above the directors or the related partys interests. We also believe that a director who owns
more than 20% of a company can exert disproportionate influence on the board and, in particular,
the audit committee.
Thus, we put directors into three categories based on an examination of the type of relationship
they have with the company:
Independent Director An independent director has no material financial, familial or other current
relationships with the company, its executives, or other board members, except for board service
and standard fees paid for that service. Relationships that existed within three to five
years
1
before the inquiry are usually considered current for purposes of this test.
In our view, a director who is currently serving in an interim management position should be
considered an insider, while a director who previously served in an interim management position for
less than one year and is no longer serving in such capacity is considered independent. Moreover, a
director who previously served in an interim management position for over one year and is no longer
serving in such capacity is considered an affiliate for five years following the date of his/her
resignation or departure from the interim management position. Glass Lewis applies a
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NASDAQ originally proposed a five-year look-back period but both it and
the NYSE ultimately settled on a three-year look-back prior to finalizing their rules. A five-year
standard is more appropriate, in our view, because we believe that the unwinding of conflicting
relationships between former management and board members is more likely to be complete and final
after five years. However, Glass Lewis does not apply the five-year look-back period to directors
who have previously served as executives of the company on an interim basis for less than one year.
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Copyright
2011 Glass, Lewis & Co., LLC
5
three-year look-back period to all directors who have an affiliation with the company other
than former employment, for which we apply a five-year look-back.
Affiliated Director An affiliated director has a material financial, familial or other
relationship with the company or its executives, but is not an employee of the company.
2
This includes directors whose employers have a material financial relationship with the
company.
3
In addition, we view a director who owns or controls 20% or more of the
companys voting stock as an affiliate.
We view 20% shareholders as affiliates because they typically have access to and involvement with
the management of a company that is fundamentally different from that of ordinary shareholders.
More importantly, 20% holders may have interests that diverge from those of ordinary holders, for
reasons such as the liquidity (or lack thereof) of their holdings, personal tax issues, etc.
Definition of Material: A material relationship is one in which the dollar value exceeds:
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$50,000 (or where no amount is disclosed) for directors who are paid for a
service they have agreed to perform for the company, outside of their service as
a director, including professional or other services; or
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$120,000 (or where no amount is disclosed) for those directors employed by a
professional services firm such as a law firm, investment bank, or consulting
firm where the company pays the firm, not the individual, for services. This
dollar limit would also apply to charitable contributions to schools where a
board member is a professor; or charities where a director serves on the board
or is an executive;
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and any aircraft and real estate dealings
between the company and the directors firm; or
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1% of either companys consolidated gross revenue for other business relationships (e.g.,
where the director is an executive officer of a company that provides services or products to
or receives services or products from the company).
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Definition of Familial: Familial relationships include a persons spouse, parents, children,
siblings, grandparents, uncles, aunts, cousins, nieces, nephews, in-laws, and anyone (other than
domestic employees) who shares such persons home. A director is an affiliate if the director has a
family member who is employed by the company and who receives compensation of $120,000 or more per
year or the compensation is not disclosed.
Definition of Company: A company includes any parent or subsidiary in a group with the company or
any entity that merged with, was acquired by, or acquired the company.
Inside Director An inside director simultaneously serves as a director and as an employee of the
company. This category may include a chairman of the board who acts as an employee of the company
or is paid as an employee of the company. In our view, an inside director who derives a greater
amount of income as a result of affiliated transactions with the company rather than
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If a company classifies one of its
non-employee directors as non-independent, Glass Lewis will classify that
director as an affiliate.
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We allow a five-year grace period for former
executives of the company or merged companies who have consulting agreements
with the surviving company. (We do not automatically recommend voting against
directors in such cases for the first five years.) If the consulting agreement
persists after this five-year grace period, we apply the materiality thresholds
outlined in the definition of material.
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We will generally take into consideration
the size and nature of such charitable entities in relation to the companys
size and industry along with any other relevant factors such as the directors
role at the charity. However, unlike for other types of related party
transactions, Glass Lewis generally does not apply a look-back period to
affiliated relationships involving charitable contributions; if the
relationship ceases, we will consider the director to be independent.
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through compensation paid by the company (i.e., salary, bonus, etc. as a company employee) faces a
conflict between making decisions that are in the best interests of the company versus those in the
directors own best interests. Therefore, we will recommend voting against such a director.
Voting Recommendations on the Basis of Board Independence
Glass Lewis believes a board will be most effective in protecting shareholders interests if
it is at least two-thirds independent. We note that each of the Business Roundtable, the Conference
Board, and the Council of Institutional Investors advocates that two-thirds of the board be
independent. Where more than one-third of the members are affiliated or inside directors, we
typically
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recommend voting against some of the inside and/or affiliated directors in
order to satisfy the two-thirds threshold.
However, where a director serves on a board as a representative (as part of his or her basic
responsibilities) of an investment firm with greater than 20% ownership, we will generally consider
him/her to be affiliated but will not recommend voting against unless (i) the investment firm has
disproportionate board representation or (ii) the director serves on the audit committee.
In the case of a less than two-thirds independent board, Glass Lewis strongly supports the
existence of a presiding or lead director with authority to set the meeting agendas and to lead
sessions outside the insider chairmans presence.
In addition, we scrutinize avowedly independent chairmen and lead directors. We believe that they
should be unquestionably independent or the company should not tout them as such.
Committee Independence
We believe that
only
independent directors should serve on a companys audit, compensation,
nominating, and governance committees.
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We typically recommend that shareholders vote
against any affiliated or inside director seeking appointment to an audit, compensation,
nominating, or governance committee, or who has served in that capacity in the past year.
Independent Chairman
Glass Lewis believes that separating the roles of CEO (or, more rarely, another executive
position) and chairman creates a better governance structure than a combined CEO/chairman position.
An executive manages the business according to a course the board charts. Executives should report
to the board regarding their performance in achieving goals the board set. This is needlessly
complicated when a CEO chairs the board, since a CEO/chairman presumably will have a significant
influence over the board.
It can become difficult for a board to fulfill its role of overseer and policy setter when a CEO/
chairman controls the agenda and the boardroom discussion. Such control can allow a CEO to have an
entrenched position, leading to longer-than-optimal terms, fewer checks on management,
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With a staggered board, if the affiliates or
insiders that we believe should not be on the board are not up for election, we
will express our concern regarding those directors, but we will not recommend
voting against the other affiliates or insiders who are up for election just to
achieve two-thirds independence. However, we will consider recommending voting
against the directors subject to our concern at their next election if the
concerning issue is not resolved.
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We will recommend voting against an audit
committee member who owns 20% or more of the companys stock, and we believe
that there should be a maximum of one director (or no directors if the
committee is comprised of less than three directors) who owns 20% or more of
the companys stock on the compensation, nominating, and governance committees.
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less scrutiny of the business operation, and limitations on independent, shareholder-focused
goal-setting by the board.
A CEO should set the strategic course for the company, with the boards approval, and the board
should enable the CEO to carry out the CEOs vision for accomplishing the boards objectives.
Failure to achieve the boards objectives should lead the board to replace that CEO with someone in
whom the board has confidence.
Likewise, an independent chairman can better oversee executives and set a pro-shareholder agenda
without the management conflicts that a CEO and other executive insiders often face. Such oversight
and concern for shareholders allows for a more proactive and effective board of directors that is
better able to look out for the interests of shareholders.
Further, it is the boards responsibility to select a chief executive who can best serve a company
and its shareholders and to replace this person when his or her duties have not been appropriately
fulfilled. Such a replacement becomes more difficult and happens less frequently when the chief
executive is also in the position of overseeing the board.
We recognize that empirical evidence regarding the separation of these two roles remains
inconclusive. However, Glass Lewis believes that the installation of an independent chairman is
almost always a positive step from a corporate governance perspective and promotes the best
interests of shareholders. Further, the presence of an independent chairman fosters the creation of
a thoughtful and dynamic board, not dominated by the views of senior management. Encouragingly,
many companies appear to be moving in this directionone study even indicates that less than 12
percent of incoming CEOs in 2009 were awarded the chairman title, versus 48 percent as recently as
2002.
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Another study finds that 40 percent of S&P 500 boards now separate the CEO and
chairman roles, up from 23 percent in 2000, although the same study found that only 19 percent of
S&P 500 chairs are independent, versus 9 percent in 2005.
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We do not recommend that shareholders vote against CEOs who chair the board. However, we typically
encourage our clients to support separating the roles of chairman and CEO whenever that question is
posed in a proxy (typically in the form of a shareholder proposal), as we believe that it is in the
long-term best interests of the company and its shareholders.
Performance
The most crucial test of a boards commitment to the company and its shareholders lies in the
actions of the board and its members. We look at the performance of these individuals as directors
and executives of the company and of other companies where they have served.
Voting Recommendations on the Basis of Performance
We disfavor directors who have a record of not fulfilling their responsibilities to
shareholders at any company where they have held a board or executive position. We typically
recommend voting against:
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Ken Favaro, Per-Ola Karlsson and Gary
Neilson. CEO Succession 2000-2009: A Decade of Convergence and Compression.
Booz & Company (from Strategy+Business, Issue 59, Summer 2010).
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Spencer Stuart Board Index, 2010, p. 4.
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1. A director who fails to attend a minimum of 75% of board and applicable committee meetings,
calculated in the aggregate.
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2. A director who belatedly filed a significant form(s) 4 or 5, or who has a pattern of late
filings if the late filing was the directors fault (we look at these late filing situations on a
case-by-case basis).
3. A director who is also the CEO of a company where a serious and material restatement has
occurred after the CEO had previously certified the pre-restatement financial statements.
4. A director who has received two against recommendations from Glass Lewis for identical reasons
within the prior year at different companies (the same situation must also apply at the company
being analyzed).
5. All directors who served on the board if, for the last three years, the companys performance
has been in the bottom quartile of the sector and the directors have not taken reasonable steps to
address the poor performance.
Audit Committees and Performance
Audit committees play an integral role in overseeing the financial reporting process because
[v]ibrant and stable capital markets depend on, among other things, reliable, transparent, and
objective financial information to support an efficient and effective capital market process. The
vital oversight role audit committees play in the process of producing financial information has
never been more important.
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When assessing an audit committees performance, we are aware that an audit committee does not
prepare financial statements, is not responsible for making the key judgments and assumptions that
affect the financial statements, and does not audit the numbers or the disclosures provided to
investors. Rather, an audit committee member monitors and oversees the process and procedures that
management and auditors perform. The 1999 Report and Recommendations of the Blue Ribbon Committee
on Improving the Effectiveness of Corporate Audit Committees stated it best:
A proper and well-functioning system exists, therefore, when the three main groups responsible for
financial reporting the full board including the audit committee, financial management including
the internal auditors, and the outside auditors form a three legged stool that supports
responsible financial disclosure and active participatory oversight. However, in the view of the
Committee, the audit committee must be first among equals in this process, since the audit
committee is an extension of the full board and hence the ultimate monitor of the process.
Standards for Assessing the Audit Committee
For an audit committee to function effectively on investors behalf, it must include members
with sufficient knowledge to diligently carry out their responsibilities. In its audit and
accounting
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However, where a director has served for
less than one full year, we will typically not recommend voting against for
failure to attend 75% of meetings. Rather, we will note the poor attendance
with a recommendation to track this issue going forward. We will also refrain
from recommending to vote against directors when the proxy discloses that the
director missed the meetings due to serious illness or other extenuating
circumstances.
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Audit Committee Effectiveness What Works
Best. PricewaterhouseCoopers. The Institute of Internal Auditors Research
Foundation. 2005.
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recommendations, the Conference Board Commission on Public Trust and Private Enterprise said
members of the audit committee must be independent and have both knowledge and experience in
auditing financial matters.
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We are skeptical of audit committees where there are members that lack expertise as a Certified
Public Accountant (CPA), Chief Financial Officer (CFO) or corporate controller or similar experience.
While we will not necessarily vote against members of an audit committee when such expertise is
lacking, we are more likely to vote against committee members when a problem such as a restatement
occurs and such expertise is lacking.
Glass Lewis generally assesses audit committees against the decisions they make with respect to
their oversight and monitoring role. The quality and integrity of the financial statements and
earnings reports, the completeness of disclosures necessary for investors to make informed
decisions, and the effectiveness of the internal controls should provide reasonable assurance that
the financial statements are materially free from errors. The independence of the external auditors
and the results of their work all provide useful information by which to assess the audit
committee.
When assessing the decisions and actions of the audit committee, we typically defer to its judgment
and would vote in favor of its members, but we would recommend voting against the following members
under the following circumstances:
1. All members of the audit committee when options were backdated, there is a lack of adequate
controls in place, there was a resulting restatement, and disclosures indicate there was a lack of
documentation with respect to the option grants.
2. The audit committee chair, if the audit committee does not have a financial expert or the
committees financial expert does not have a demonstrable financial background sufficient to
understand the financial issues unique to public companies.
3. The audit committee chair, if the audit committee did not meet at least 4 times during the year.
4. The audit committee chair, if the committee has less than three members.
5. Any audit committee member who sits on more than three public company audit committees, unless
the audit committee member is a retired CPA, CFO, controller or has similar experience, in which
case the limit shall be four committees, taking time and availability into consideration including
a review of the audit committee members attendance at all board and committee meetings.
6. All members of an audit committee who are up for election and who served on the committee at the
time of the audit, if audit and audit-related fees total one-third or less of the total fees billed
by the auditor.
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Commission on Public Trust and Private
Enterprise. The Conference Board. 2003.
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Where the recommendation is to vote against
the committee chair but the chair is not up for election because the board is
staggered, we do not recommend voting against the members of the committee who
are up for election; rather, we will simply express our concern with regard to
the committee chair.
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Glass Lewis may exempt certain audit
committee members from the above threshold if, upon further analysis of
relevant factors such as the directors experience, the size, industry-mix and
location of the companies involved and the directors attendance at all the
companies, we can reasonably determine that the audit committee member is
likely not hindered by multiple audit committee commitments.
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7. The audit committee chair when tax and/or other fees are greater than audit and audit-related fees paid to the auditor for more than one year in a row (in which case we also recommend
against ratification of the auditor).
8. All members of an audit committee where non-audit fees include fees for tax services (including,
but not limited to, such things as tax avoidance or shelter schemes) for senior executives of the
company. Such services are now prohibited by the PCAOB.
9. All members of an audit committee that reappointed an auditor that we no longer consider to be
independent for reasons unrelated to fee proportions.
10. All members of an audit committee when audit fees are excessively low, especially when compared
with other companies in the same industry.
11. The audit committee chair
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if the committee failed to put auditor ratification on the
ballot for shareholder approval. However, if the non-audit fees or tax fees exceed audit plus
audit-related fees in either the current or the prior year, then Glass Lewis will recommend voting
against the entire audit committee.
12. All members of an audit committee where the auditor has resigned and reported that a section
10A
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letter has been issued.
13. All members of an audit committee at a time when material accounting fraud occurred at the
company.
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14. All members of an audit committee at a time when annual and/or multiple quarterly financial
statements had to be restated, and any of the following factors apply:
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The restatement involves fraud or manipulation by insiders;
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The restatement is accompanied by an SEC inquiry or investigation;
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The restatement involves revenue recognition;
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The restatement results in a greater than 5% adjustment to costs of goods sold, operating
expense, or operating cash flows; or
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The restatement results in a greater than 5% adjustment to net income, 10% adjustment to assets or
shareholders equity, or cash flows from financing or investing activities.
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15. All members of an audit committee if the company repeatedly fails to file its financial reports
in a timely fashion. For example, the company has filed two or more quarterly or annual financial
statements late within the last 5 quarters.
16. All members of an audit committee when it has been disclosed that a law enforcement agency has
charged the company and/or its employees with a violation of the Foreign Corrupt Practices Act
(FCPA).
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In all cases, if the chair of the committee
is not specified, we recommend voting against the director who has been on the
committee the longest.
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Auditors are required to report all
potential illegal acts to management and the audit committee unless they are
clearly inconsequential in nature. If the audit committee or the board fails to
take appropriate action on an act that has been determined to be a violation of
the law, the independent auditor is required to send a section 10A letter to
the SEC. Such letters are rare and therefore we believe should be taken
seriously.
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Recent research indicates that revenue
fraud now accounts for over 60% of SEC fraud cases, and that companies that
engage in fraud experience significant negative abnormal stock price
declinesfacing bankruptcy, delisting, and material asset sales at much higher
rates than do non-fraud firms (Committee of Sponsoring Organizations of the
Treadway Commission. Fraudulent Financial Reporting: 1998-2007. May 2010).
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17. All members of an audit committee when the company has aggressive accounting policies and/or
poor disclosure or lack of sufficient transparency in its financial statements.
18. All members of the audit committee when there is a disagreement with the auditor and the
auditor resigns or is dismissed.
19. All members of the audit committee if the contract with the auditor specifically limits the
auditors liability to the company for damages.
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20. All members of the audit committee who served since the date of the companys last annual
meeting, and when, since the last annual meeting, the company has reported a material weakness that
has not yet been corrected, or, when the company has an ongoing material weakness from a prior year
that has not yet been corrected.
We also take a dim view of audit committee reports that are boilerplate, and which provide little
or no information or transparency to investors. When a problem such as a material weakness,
restatement or late filings occurs, we take into consideration, in forming our judgment with
respect to the audit committee, the transparency of the audit committee report.
Compensation Committee Performance
Compensation committees have the final say in determining the compensation of executives. This
includes deciding the basis on which compensation is determined, as well as the amounts and types
of compensation to be paid. This process begins with the hiring and initial establishment of
employment agreements, including the terms for such items as pay, pensions and severance
arrangements. It is important in establishing compensation arrangements that compensation be
consistent with, and based on the long-term economic performance of, the businesss long-term
shareholders returns.
Compensation committees are also responsible for the oversight of the transparency of compensation.
This oversight includes disclosure of compensation arrangements, the matrix used in assessing pay
for performance, and the use of compensation consultants. In order to ensure the independence of
the compensation consultant, we believe the compensation committee should only engage a
compensation consultant that is not also providing any services to the company or management apart
from their contract with the compensation committee. It is important to investors that they have
clear and complete disclosure of all the significant terms of compensation arrangements in order to
make informed decisions with respect to the oversight and decisions of the compensation committee.
Finally, compensation committees are responsible for oversight of internal controls over the
executive compensation process. This includes controls over gathering information used to determine
compensation, establishment of equity award plans, and granting of equity awards. Lax controls can
and have contributed to conflicting information being obtained, for example through the use of
nonobjective consultants. Lax controls can also contribute to improper awards of compensation such
as through granting of backdated or spring-loaded options, or granting of bonuses when triggers for
bonus payments have not been met.
Central to understanding the actions of a compensation committee is a careful review of the
Compensation Discussion and Analysis (CD&A) report included in each companys proxy. We review the
CD&A in our evaluation of the overall compensation practices of a company,
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The Council of Institutional Investors.
Corporate Governance Policies, p. 4, April 5, 2006; and Letter from Council
of Institutional Investors to the AICPA, November 8, 2006.
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as overseen by the compensation committee. The CD&A is also integral to the evaluation of
compensation proposals at companies, such as advisory votes on executive compensation, which allow
shareholders to vote on the compensation paid to a companys top executives.
In our evaluation of the CD&A, we examine, among other factors, the following:
1. The extent to which the company uses appropriate performance goals and metrics in determining
overall compensation as an indication that pay is tied to performance.
2. How clearly the company discloses performance metrics and goals so that shareholders may make an
independent determination that goals were met.
3. The extent to which the performance metrics, targets and goals are implemented to enhance
company performance and encourage prudent risk-taking.
4. The selected peer group(s) so that shareholders can make a comparison of pay and performance
across the appropriate peer group.
5. The extent to which the company benchmarks compensation levels at a specific percentile of its
peer group along with the rationale for selecting such a benchmark.
6. The amount of discretion granted management or the compensation committee to deviate from
defined performance metrics and goals in making awards, as well as the appropriateness of the use
of such discretion.
We provide an overall evaluation of the quality and content of a companys executive compensation
policies and procedures as disclosed in a CD&A as either good, fair or poor.
We evaluate compensation committee members on the basis of their performance while serving on the
compensation committee in question, not for actions taken solely by prior committee members who are
not currently serving on the committee. At companies that provide shareholders with non-binding
advisory votes on executive compensation (Say-on-Pay), we will use the Say-on-Pay proposal as the
initial, primary means to express dissatisfaction with the companys compensation polices and
practices rather than recommending voting against members of the compensation committee (except in
the most egregious cases).
When assessing the performance of compensation committees, we will recommend voting against for the
following:
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1. All members of the compensation committee who are up for election and served at the time of poor
pay-for-performance (e.g., a company receives an F grade in our pay- for-performance analysis) when
shareholders are not provided with an advisory vote on executive compensation at the annual
meeting.
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Where the recommendation is to vote against
the committee chair and the chair is not up for election because the board is
staggered, we do not recommend voting against any members of the committee who
are up for election; rather, we will simply express our concern with regard to
the committee chair.
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Where there are multiple CEOs in one year,
we will consider not recommending against the compensation committee but will
defer judgment on compensation policies and practices until the next year or a
full year after arrival of the new CEO. In addition, if a company provides
shareholders with a Say-on-Pay proposal and receives an F grade in our pay-for-performance model, we will recommend that shareholders only vote against the
Say-on-Pay proposal rather than the members of the compensation committee,
unless the company exhibits egregious practices. However, if the company
receives successive F grades, we will then recommend against the members of the
compensation committee in addition to recommending voting against the
Say-on-Pay proposal.
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2. Any member of the compensation committee who has served on the compensation committee of at
least two other public companies that received F grades in our pay-for- performance model and who
is also suspect at the company in question.
3. The compensation committee chair if the company received two D grades in consecutive years in
our pay-for-performance analysis, and if during the past year the Company performed the same as or
worse than its peers.
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4. All members of the compensation committee (during the relevant time period) if the company
entered into excessive employment agreements and/or severance agreements.
5. All members of the compensation committee when performance goals were changed (i.e., lowered)
when employees failed or were unlikely to meet original goals, or performance- based compensation
was paid despite goals not being attained.
6. All members of the compensation committee if excessive employee perquisites and benefits were
allowed.
7. The compensation committee chair if the compensation committee did not meet during the year, but
should have (e.g., because executive compensation was restructured or a new executive was hired).
8. All members of the compensation committee when the company repriced options or completed a self
tender offer without shareholder approval within the past two years.
9. All members of the compensation committee when vesting of in-the-money options is accelerated or
when fully vested options are granted.
10. All members of the compensation committee when option exercise prices were backdated. Glass
Lewis will recommend voting against an executive director who played a role in and participated in
option backdating.
11. All members of the compensation committee when option exercise prices were spring- loaded or
otherwise timed around the release of material information.
12. All members of the compensation committee when a new employment contract is given to an
executive that does not include a clawback provision and the company had a material restatement,
especially if the restatement was due to fraud.
13. The chair of the compensation committee where the CD&A provides insufficient or unclear
information about performance metrics and goals, where the CD&A indicates that pay is not tied to
performance, or where the compensation committee or management has excessive discretion to alter
performance terms or increase amounts of awards in contravention of previously defined targets.
14. All members of the compensation committee during whose tenure the committee failed to implement
a shareholder proposal regarding a compensation-related issue, where the proposal received the
affirmative vote of a majority of the voting shares at a shareholder
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In cases where the company received two D
grades in consecutive years, but during the past year the company performed
better than its peers or improved from an F to a D grade year over year, we
refrain from recommending to vote against the compensation chair. In addition,
if a company provides shareholders with a Say-on-Pay proposal in this instance,
we will consider voting against the advisory vote rather than the compensation
committee chair unless the company exhibits unquestionably egregious practices.
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meeting, and when a reasonable analysis suggests that the compensation committee (rather than the
governance committee) should have taken steps to implement the request.
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Nominating and Governance Committee Performance
The nominating and governance committee, as an agency for the shareholders, is responsible for
the governance by the board of the company and its executives. In performing this role, the board
is responsible and accountable for selection of objective and competent board members. It is also
responsible for providing leadership on governance policies adopted by the company, such as
decisions to implement shareholder proposals that have received a majority vote.
Consistent with Glass Lewis philosophy that boards should have diverse backgrounds and members
with a breadth and depth of relevant experience, we believe that nominating and governance
committees should consider diversity when making director nominations within the context of each
specific company and its industry. In our view, shareholders are best served when boards make an
effort to ensure a constituency that is not only reasonably diverse on the basis of age, race,
gender and ethnicity, but also on the basis of geographic knowledge, industry experience and
culture.
Regarding the nominating and or governance committee, we will recommend voting against the
following:
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1. All members of the governance committee
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during whose tenure the board failed to
implement a shareholder proposal with a direct and substantial impact on shareholders and their
rights i.e., where the proposal received enough shareholder votes (at least a majority) to allow
the board to implement or begin to implement that proposal.
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Examples of these types of
shareholder proposals are majority vote to elect directors and to declassify the board.
2. The governance committee chair,
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when the chairman is not independent and an
independent lead or presiding director has not been appointed.
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We note that each of the
Business Roundtable, The Conference Board, and the Council of Institutional Investors advocates
that two-thirds of the board be independent.
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In all other instances (i.e. a
non-compensation-related shareholder proposal should have been implemented) we
recommend that shareholders vote against the members of the governance
committee.
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Where we would recommend to vote against
the committee chair but the chair is not up for election because the board is
staggered, we do not recommend voting against any members of the committee who
are up for election; rather, we will simply express our concern regarding the
committee chair.
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If the board does not have a governance
committee (or a committee that serves such a purpose), we recommend voting
against the entire board on this basis.
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Where a compensation-related shareholder
proposal should have been implemented, and when a reasonable analysis suggests
that the members of the compensation committee (rather than the governance
committee) bear the responsibility for failing to implement the request, we
recommend that shareholders only vote against members of the compensation
committee.
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If the committee chair is not specified, we
recommend voting against the director who has been on the committee the
longest. If the longest-serving committee member cannot be determined, we will
recommend voting against the longest- serving board member serving on the
committee.
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We believe that one independent individual
should be appointed to serve as the lead or presiding director. When such a
position is rotated among directors from meeting to meeting, we will recommend
voting against as if there were no lead or presiding director.
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3. In the absence of a nominating committee, the governance committee chair when there are less
than five or the whole nominating committee when there are more than 20 members on the board.
4. The governance committee chair, when the committee fails to meet at all during the year.
5. The governance committee chair, when for two consecutive years the company provides what we
consider to be inadequate related party transaction disclosure (i.e. the nature of such
transactions and/or the monetary amounts involved are unclear or excessively vague, thereby
preventing an average shareholder from being able to reasonably interpret the independence status
of multiple directors above and beyond what the company maintains is compliant with SEC or
applicable stock-exchange listing requirements).
Regarding the nominating committee, we will recommend voting against the following:
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1. All members of the nominating committee, when the committee nominated or renominated an
individual who had a significant conflict of interest or whose past actions demonstrated a lack of
integrity or inability to represent shareholder interests.
2. The nominating committee chair, if the nominating committee did not meet during the year, but
should have (i.e., because new directors were nominated or appointed since the time of the last
annual meeting).
3. In the absence of a governance committee, the nominating committee chair
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when the
chairman is not independent, and an independent lead or presiding director has not been
appointed.
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4. The nominating committee chair, when there are less than five or the whole nominating committee
when there are more than 20 members on the board.
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5. The nominating committee chair, when a director received a greater than 50% against vote the
prior year and not only was the director not removed, but the issues that raised shareholder
concern were not corrected.
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Board-level Risk Management Oversight
Glass Lewis evaluates the risk management function of a public company board on a strictly
case-by-case basis. Sound risk management, while necessary at all companies, is particularly
important at financial firms which inherently maintain significant exposure to financial risk. We
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Where we would recommend to vote against the
committee chair but the chair is not up for election because the board is
staggered, we do not recommend voting against any members of the committee who
are up for election; rather, we will simply express our concern regarding the
committee chair.
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If the committee chair is not specified, we
will recommend voting against the director who has been on the committee the
longest. If the longest-serving committee member cannot be determined, we will
recommend voting against the longest-serving board member on the committee.
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In the absence of both a governance and a
nominating committee, we will recommend voting against the chairman of the
board on this basis.
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In the absence of both a governance and a
nominating committee, we will recommend voting against the chairman of the
board on this basis.
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Considering that shareholder discontent
clearly relates to the director who received a greater than 50% against vote
rather than the nominating chair, we review the validity of the issue(s) that
initially raised shareholder concern, follow- up on such matters, and only
recommend voting against the nominating chair if a reasonable analysis suggests
that it would be most appropriate. In rare cases, we will consider recommending
against the nominating chair when a director receives a substantial (i.e., 25%
or more) vote against based on the same analysis.
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believe such financial firms should have a chief risk officer reporting directly to the board
and a dedicated risk committee or a committee of the board charged with risk oversight. Moreover,
many non-financial firms maintain strategies which involve a high level of exposure to financial
risk. Similarly, since many non-financial firm have significant hedging or trading strategies,
including financial and non-financial derivatives, those firms should also have a chief risk
officer and a risk committee.
Our views on risk oversight are consistent with those expressed by various regulatory bodies. In
its December 2009 Final Rule release on Proxy Disclosure Enhancements, the SEC noted that risk
oversight is a key competence of the board and that additional disclosures would improve investor
and shareholder understanding of the role of the board in the organizations risk management
practices. The final rules, which became effective on February 28, 2010, now explicitly require
companies and mutual funds to describe (while allowing for some degree of flexibility) the boards
role in the oversight of risk.
When analyzing the risk management practices of public companies, we take note of any significant
losses or writedowns on financial assets and/or structured transactions. In cases where a company
has disclosed a sizable loss or writedown, and where we find that the companys board-level risk
committee contributed to the loss through poor oversight, we would recommend that shareholders vote
against such committee members on that basis. In addition, in cases where a company maintains a
significant level of financial risk exposure but fails to disclose any explicit form of board-level
risk oversight (committee or otherwise)
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, we will consider recommending to vote against
the chairman of the board on that basis. However, we generally would not recommend voting against a
combined chairman/CEO except in egregious cases.
Experience
We find that a directors past conduct is often indicative of future conduct and performance.
We often find directors with a history of overpaying executives or of serving on boards where
avoidable disasters have occurred appearing at companies that follow these same patterns. Glass
Lewis has a proprietary database of every officer and director serving at 8,000 of the most widely
held U.S. companies. We use this database to track the performance of directors across companies.
Voting Recommendations on the Basis of Director Experience
We typically recommend that shareholders vote against directors who have served on boards or
as executives of companies with records of poor performance, inadequate risk oversight,
overcompensation, audit-or accounting-related issues, and/or other indicators of
mismanagement or actions against the interests of shareholders.
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Likewise, we examine the backgrounds of those who serve on key board committees to ensure that they
have the required skills and diverse backgrounds to make informed judgments about the subject
matter for which the committee is responsible.
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A committee responsible for risk management
could be a dedicated risk committee, or another board committee, usually the
audit committee but occasionally the finance committee, depending on a given
companys board structure and method of disclosure. At some companies, the
entire board is charged with risk management.
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We typically apply a three-year look-back to
such issues and also research to see whether the responsible directors have
been up for election since the time of the failure, and if so, we take into
account the percentage of support they received from shareholders.
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Other Considerations
In addition to the three key characteristics independence, performance, experience that we
use to evaluate board members, we consider conflict-of-interest issues in making voting
recommendations.
Conflicts of Interest
We believe board members should be wholly free of identifiable and substantial conflicts of
interest, regardless of the overall level of independent directors on the board. Accordingly, we
recommend that shareholders vote against the following types of affiliated or inside directors:
1. A CFO who is on the board: In our view, the CFO holds a unique position relative to financial
reporting and disclosure to shareholders. Because of the critical importance of financial
disclosure and reporting, we believe the CFO should report to the board and not be a member of it.
2. A director who is on an excessive number of boards: We will typically recommend voting against a
director who serves as an executive officer of any public company while serving on more than two
other public company boards and any other director who serves on more than six public company
boards typically receives an against recommendation from Glass Lewis. Academic literature suggests
that one board takes up approximately 200 hours per year of each members time. We believe this
limits the number of boards on which directors can effectively serve, especially executives at
other companies.
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Further, we note a recent study has shown that the average number of
outside board seats held by CEOs of S&P 500 companies is 0.6, down from 0.9 in 2005 and 1.4 in
2000.
35
3. A director, or a director who has an immediate family member, providing consulting or other
material professional services to the company: These services may include legal, consulting, or
financial services. We question the need for the company to have consulting relationships with its
directors. We view such relationships as creating conflicts for directors, since they may be forced
to weigh their own interests against shareholder interests when making board decisions. In
addition, a companys decisions regarding where to turn for the best professional services may be
compromised when doing business with the professional services firm of one of the companys
directors.
4. A director, or a director who has an immediate family member, engaging in airplane, real estate,
or similar deals, including perquisite-type grants from the company, amounting to more than
$50,000: Directors who receive these sorts of payments from the company will have to make
unnecessarily complicated decisions that may pit their interests against shareholder interests.
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Our guidelines are similar to the standards
set forth by the NACD in its Report of the NACD Blue Ribbon Commission on
Director Professionalism, 2001 Edition, pp. 14-15 (also cited approvingly by
the Conference Board in its Corporate Governance Best Practices: A Blueprint
for the Post-Enron Era, 2002, p. 17), which suggested that CEOs should not
serve on more than 2 additional boards, persons with full-time work should not
serve on more than 4 additional boards, and others should not serve on more
than six boards.
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Spencer Stuart Board Index, 2010, p. 8.
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5. Interlocking directorships: CEOs or other top executives who serve on each others boards create
an interlock that poses conflicts that should be avoided to ensure the promotion of shareholder
interests above all else.
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6. All board members who served at a time when a poison pill was adopted without shareholder
approval within the prior twelve months.
Size of the Board of Directors
While we do not believe there is a universally applicable optimum board size, we do believe
boards should have at least five directors to ensure sufficient diversity in decision-making and to
enable the formation of key board committees with independent directors. Conversely, we believe
that boards with more than 20 members will typically suffer under the weight of too many cooks in
the kitchen and have difficulty reaching consensus and making timely decisions. Sometimes the
presence of too many voices can make it difficult to draw on the wisdom and experience in the room
by virtue of the need to limit the discussion so that each voice may be heard.
To that end, we typically recommend voting against the chairman of the nominating committee at a
board with fewer than five directors. With boards consisting of more than 20 directors, we
typically recommend voting against all members of the nominating committee (or the governance
committee, in the absence of a nominating committee).
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Controlled Companies
Controlled companies present an exception to our independence recommendations. The boards
function is to protect shareholder interests; however, when an individual or entity owns more than
50% of the voting shares, the interests of the majority of shareholders
are
the interests of that
entity or individual. Consequently, Glass Lewis does not apply our usual two-thirds independence
rule and therefore we will not recommend voting against boards whose composition reflects the
makeup of the shareholder population.
Independence Exceptions
The independence exceptions that we make for controlled companies are as follows:
1. We do not require that controlled companies have boards that are at least two-thirds
independent. So long as the insiders and/or affiliates are connected with the controlling entity,
we accept the presence of non-independent board members.
2. The compensation committee and nominating and governance committees do not need to consist
solely of independent directors.
a. We believe that standing nominating and corporate governance committees at controlled companies
are unnecessary. Although having a committee charged with the duties of searching for, selecting,
and nominating independent directors can be
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We do not apply a look-back period for this
situation. The interlock policy applies to both public and private companies.
We will also evaluate multiple board interlocks among non-insiders (i.e.
multiple directors serving on the same boards at other companies), for evidence
of a pattern of poor oversight.
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The Conference Board, at p. 23 in its report
Corporate Governance Best Practices, Id., quotes one of its roundtable
participants as stating, [w]hen youve got a 20 or 30 person corporate board,
its one way of assuring that nothing is ever going to happen that the CEO
doesnt want to happen.
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beneficial, the unique composition of a controlled companys shareholder base makes such committees
weak and irrelevant.
b. Likewise, we believe that independent compensation committees at controlled companies are
unnecessary. Although independent directors are the best choice for approving and monitoring senior
executives pay, controlled companies serve a unique shareholder population whose voting power
ensures the protection of its interests. As such, we believe that having affiliated directors on a
controlled companys compensation committee is acceptable. However, given that a controlled company
has certain obligations to minority shareholders we feel that an insider should not serve on the
compensation committee. Therefore, Glass Lewis will recommend voting against any insider (the CEO
or otherwise) serving on the compensation committee.
3. Controlled companies do not need an independent chairman or an independent lead or presiding
director. Although an independent director in a position of authority on the board such as
chairman or presiding director can best carry out the boards duties, controlled companies serve
a unique shareholder population whose voting power ensures the protection of its interests.
4. Where an individual or entity owns more than 50% of a companys voting power but the company is
not a controlled company as defined by relevant listing standards, we apply a lower independence
requirement of a majority of the board but keep all other standards in place. Similarly, where an
individual or entity holds between 20-50% of a companys voting power, but the company is
not
controlled and there is not a majority owner, we will allow for proportional representation on
the board and committees (excluding the audit committee) based on the individual or entitys
percentage of ownership.
Size of the Board of Directors
We have no board size requirements for controlled companies.
Audit Committee Independence
We believe that audit committees should consist solely of independent directors. Regardless of
a companys controlled status, the interests of all shareholders must be protected by ensuring the
integrity and accuracy of the companys financial statements. Allowing affiliated directors to
oversee the preparation of financial reports could create an insurmountable conflict of interest.
Exceptions for Recent IPOs
We believe companies that have recently completed an initial public offering (IPO) should be
allowed adequate time to fully comply with marketplace listing requirements as well as to meet
basic corporate governance standards. We believe a one-year grace period immediately following the
date of a companys IPO is sufficient time for most companies to comply with all relevant
regulatory requirements and to meet such corporate governance standards. Except in egregious cases,
Glass Lewis refrains from issuing voting recommendations on the basis of corporate governance best
practices (eg. board independence, committee membership and structure, meeting attendance, etc.)
during the one-year period following an IPO.
However, in cases where a board implements a poison pill preceding an IPO, we will consider voting
against the members of the board who served during the period of the poison pills adoption if the
board (i) did not also commit to submit the poison pill to a shareholder vote within 12 months of
the IPO
Copyright 2011 Glass, Lewis & Co., LLC
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or (ii) did not provide a sound rationale for adopting the pill and the pill does not expire in
three years or less. In our view, adopting such an anti-takeover device unfairly penalizes future
shareholders who (except for electing to buy or sell the stock) are unable to weigh in on a matter
that could potentially negatively impact their ownership interest. This notion is strengthened when
a board adopts a poison pill with a 5-10 year life immediately prior to having a public shareholder
base so as to insulate management for a substantial amount of time while postponing and/or avoiding
allowing public shareholders the ability to vote on the pills adoption. Such instances are
indicative of boards that may subvert shareholders best interests following their IPO.
Mutual Fund Boards
Mutual funds, or investment companies, are structured differently from regular public
companies (i.e., operating companies). Typically, members of a funds adviser are on the board and
management takes on a different role from that of regular public companies. Thus, we focus on a
short list of requirements, although many of our guidelines remain the same.
The following mutual fund policies are similar to the policies for regular public companies:
1. Size of the board of directors: The board should be made up of between five and twenty
directors.
2. The CFO on the board: Neither the CFO of the fund nor the CFO of the funds registered
investment adviser should serve on the board.
3. Independence of the audit committee: The audit committee should consist solely of independent
directors.
4. Audit committee financial expert: At least one member of the audit committee should be
designated as the audit committee financial expert.
The following differences from regular public companies apply at mutual funds:
1. Independence of the board: We believe that three-fourths of an investment companys board
should be made up of independent directors. This is consistent with a proposed SEC rule on
investment company boards. The Investment Company Act requires 40% of the board to be independent,
but in 2001, the SEC amended the Exemptive Rules to require that a majority of a mutual fund board
be independent. In 2005, the SEC proposed increasing the independence threshold to 75%. In 2006, a
federal appeals court ordered that this rule amendment be put back out for public comment, puffing
it back into proposed rule status. Since mutual fund boards play a vital role in overseeing the
relationship between the fund and its investment manager, there is greater need for independent
oversight than there is for an operating company board.
2. When the auditor is not up for ratification: We do not recommend voting against the audit
committee if the auditor is not up for ratification because, due to the different legal structure
of an investment company compared to an operating company, the auditor for the investment company
(i.e., mutual fund) does not conduct the same level of financial review for each investment company
as for an operating company.
3. Non-independent chairman: The SEC has proposed that the chairman of the fund board be
independent. We agree that the roles of a mutual funds chairman and CEO should be separate.
Although we believe this would be best at all companies, we recommend voting against the chairman
of an investment companys nominating committee as well as the chairman of the board if the
chairman and CEO of a mutual fund are the same person and the fund does not have an independent
lead or presiding director. Seven former SEC commissioners support the
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appointment of an independent chairman and we agree with them that an independent board chairman
would be better able to create conditions favoring the long-term interests of fund shareholders
than would a chairman who is an executive of the adviser. (See the comment letter sent to the SEC
in support of the proposed rule at http://sec.gov/rules/proposed/s70304/ s70304-179.pdf)
DECLASSIFIED BOARDS
Glass Lewis favors the repeal of staggered boards and the annual election of directors. We
believe staggered boards are less accountable to shareholders than boards that are elected
annually. Furthermore, we feel the annual election of directors encourages board members to focus
on shareholder interests.
Empirical studies have shown: (i) companies with staggered boards reduce a firms value; and (ii)
in the context of hostile takeovers, staggered boards operate as a takeover defense, which
entrenches management, discourages potential acquirers, and delivers a lower return to target
shareholders.
In our view, there is no evidence to demonstrate that staggered boards improve shareholder returns
in a takeover context. Research shows that shareholders are worse off when a staggered board blocks
a transaction. A study by a group of Harvard Law professors concluded that companies whose
staggered boards prevented a takeover reduced shareholder returns for targets ... on the order of
eight to ten percent in the nine months after a hostile bid was announced.
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When a
staggered board negotiates a friendly transaction, no statistically significant difference in
premiums occurs.
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Further, one of those same professors found that charter-based
staggered boards reduce the market value of a firm by 4% to 6% of its market capitalization and
that staggered boards bring about and not merely reflect this reduction in market
value.
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A subsequent study reaffirmed that classified boards reduce shareholder value,
finding that the ongoing process of dismantling staggered boards, encouraged by institutional
investors, could well contribute to increasing shareholder wealth.
41
Shareholders have increasingly come to agree with this view. In 2010 approximately 72% of S&P 500
companies had declassified boards, up from approximately 51% in 2005.
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Clearly, more
shareholders have supported the repeal of classified boards. Resolutions relating to the repeal of
staggered boards garnered on average over 70% support among shareholders in 2008, whereas in 1987,
only 16.4% of votes cast favored board declassification.
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Given the empirical evidence suggesting staggered boards reduce a companys value and the
increasing shareholder opposition to such a structure, Glass Lewis supports the declassification of
boards and the annual election of directors.
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Lucian Bebchuk, John Coates IV, Guhan
Subramanian, The Powerful Antitakeover Force of Staggered Boards: Further
Findings and a Reply to Symposium Participants, 55
Stanford Law Review
885-917
(2002), page 1.
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Id. at 2 (Examining a sample of
seventy-three negotiated transactions from 2000 to 2002, we find no systematic
benefits in terms of higher premia to boards that have [staggered
structures].).
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Lucian Bebchuk, Alma Cohen, The Costs of
Entrenched Boards (2004).
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Lucian Bebchuk, Alma Cohen and Charles C.Y.
Wang, Staggered Boards and the Wealth of Shareholders: Evidence from a Natural
Experiment, SSRN: http://ssrn.com/abstract=1706806 (2010), p. 26.
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Spencer Stuart Board Index, 2010, p. 14
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Lucian Bebchuk, John Coates IV and Guhan
Subramanian, The Powerful Antitakeover Force of Staggered Boards: Theory,
Evidence, and Policy,
54 Stanford Law Review
887-951 (2002).
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MANDATORY DIRECTOR RETIREMENT PROVISIONS
Director Term and Age Limits
Glass Lewis believes that director age and term limits typically are not in shareholders best
interests. Too often age and term limits are used by boards as a crutch to remove board members who
have served for an extended period of time. When used in that fashion, they are indicative of a
board that has a difficult time making tough decisions.
Academic literature suggests that there is no evidence of a correlation between either length of
tenure or age and director performance. On occasion, term limits can be used as a means to remove a
director for boards that are unwilling to police their membership and to enforce turnover. Some
shareholders support term limits as a way to force change when boards are unwilling to do so.
While we understand that age limits can be a way to force change where boards are unwilling to make
changes on their own, the long-term impact of age limits restricts experienced and potentially
valuable board members from service through an arbitrary means. Further, age limits unfairly imply
that older (or, in rare cases, younger) directors cannot contribute to company oversight.
In our view, a directors experience can be a valuable asset to shareholders because of the
complex, critical issues that boards face. However, we support periodic director rotation to ensure
a fresh perspective in the boardroom and the generation of new ideas and business strategies. We
believe the board should implement such rotation instead of relying on arbitrary limits. When
necessary, shareholders can address the issue of director rotation through director elections.
We believe that shareholders are better off monitoring the boards approach to corporate governance
and the boards stewardship of company performance rather than imposing inflexible rules that dont
necessarily correlate with returns or benefits for shareholders.
However, if a board adopts term/age limits, it should follow through and not waive such limits. If
the board waives its term/age limits, Glass Lewis will consider recommending shareholders vote
against the nominating and/or governance committees, unless the rule was waived with sufficient
explanation, such as consummation of a corporate transaction like a merger.
REQUIRING TWO OR MORE NOMINEES PER BOARD SEAT
In an attempt to address lack of access to the ballot, shareholders sometimes propose that the
board give shareholders a choice of directors for each open board seat in every election. However,
we feel that policies requiring a selection of multiple nominees for each board seat would
discourage prospective directors from accepting nominations. A prospective director could not be
confident either that he or she is the boards clear choice or that he or she would be elected.
Therefore, Glass Lewis generally will vote against such proposals.
SHAREHOLDER ACCESS
Shareholders have continuously sought a way to have a significant voice in director elections
in recent years. While most of these efforts have centered on regulatory change at the SEC,
Congress and the Obama Administration have successfully placed Proxy Access in the spotlight of
the U.S. Governments most recent corporate-governance-related financial reforms.
In July 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer
Protection Act (the Dodd-Frank Act). The Dodd-Frank Act provides the SEC with the authority to
adopt rules permitting shareholders to use issuer proxy solicitation materials to nominate director
candidates.
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The SEC received over 500 comments regarding its proposed proxy access rule, some of which
questioned the agencys authority to adopt such a rule. Nonetheless, in August 2010 the SEC adopted
final Rule 14a-11, which under certain circumstances, gives shareholders (and shareholder groups)
who have collectively held at least 3% of the voting power of a companys securities continuously
for at least three years, the right to nominate up to 25% of a boards directors and have such
nominees included on the companys ballot and described (in up to 500 words per nominee) in its
proxy statement.
While final Rule 14a-11 was originally scheduled to take effect on November 15, 2010, on October 4,
2010, the SEC announced that it would delay the rules implementation following the filing of a
lawsuit by the U.S. Chamber of Commerce and the Business Roundtable on September 29, 2010. As a
result, it is unlikely shareholders will have the opportunity to vote on access proposals during
the 2011 proxy season.
MAJORITY VOTE FOR THE ELECTION OF DIRECTORS
In stark contrast to the failure of shareholder access to gain acceptance, majority voting for
the election of directors is fast becoming the
de facto
standard in corporate board elections. In
our view, the majority voting proposals are an effort to make the case for shareholder impact on
director elections on a company-specific basis.
While this proposal would not give shareholders the opportunity to nominate directors or lead to
elections where shareholders have a choice among director candidates, if implemented, the proposal
would allow shareholders to have a voice in determining whether the nominees proposed by the board
should actually serve as the overseer-representatives of shareholders in the boardroom. We believe
this would be a favorable outcome for shareholders.
During 2010, Glass Lewis tracked just under 35 proposals to require a majority vote to elect
directors at annual meetings in the U.S., a slight decline from 46 proposals in 2009, but a sharp
contrast to the 147 proposals tracked during 2006. The general decline in the number of proposals
being submitted was a result of many companies adopting some form of majority voting, including
approximately 71% of companies in the S&P 500 index, up from 56% in 2008.
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During 2009
these proposals received on average 59% shareholder support (based on for and against votes), up
from 54% in 2008.
The plurality vote standard
Today, most US companies still elect directors by a plurality vote standard. Under that
standard, if one shareholder holding only one share votes in favor of a nominee (including himself,
if the director is a shareholder), that nominee wins the election and assumes a seat on the
board. The common concern among companies with a plurality voting standard was the possibility that
one or more directors would not receive a majority of votes, resulting in failed elections. This
was of particular concern during the 1980s, an era of frequent takeovers and contests for control
of companies.
Advantages of a majority vote standard
If a majority vote standard were implemented, a nominee would have to receive the support of a
majority of the shares voted in order to be elected. Thus, shareholders could collectively vote to
reject a director they believe will not pursue their best interests. We think that this minimal
amount of protection for shareholders is reasonable and will not upset the corporate structure nor
reduce the willingness of qualified shareholder-focused directors to serve in the future.
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We believe that a majority vote standard will likely lead to more attentive directors. Occasional
use of this power will likely prevent the election of directors with a record of ignoring
shareholder interests in favor of other interests that conflict with those of investors. Glass
Lewis will generally support proposals calling for the election of directors by a majority vote
except for use in contested director elections.
In response to the high level of support majority voting has garnered, many companies have
voluntarily taken steps to implement majority voting or modified approaches to majority voting.
These steps range from a modified approach requiring directors that receive a majority of withheld
votes to resign (e.g., Ashland Inc.) to actually requiring a majority vote of outstanding shares to
elect directors (e.g., Intel).
We feel that the modified approach does not go far enough because requiring a director to resign is
not the same as requiring a majority vote to elect a director and does not allow shareholders a
definitive voice in the election process. Further, under the modified approach, the corporate
governance committee could reject a resignation and, even if it accepts the resignation, the
corporate governance committee decides on the directors replacement. And since the modified
approach is usually adopted as a policy by the board or a board committee, it could be altered by
the same board or committee at any time.
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II. Transparency and Integrity of Financial Reporting
AUDITOR RATIFICATION
The auditors role as gatekeeper is crucial in ensuring the integrity and transparency of the
financial information necessary for protecting shareholder value. Shareholders rely on the auditor
to ask tough questions and to do a thorough analysis of a companys books to ensure that the
information provided to shareholders is complete, accurate, fair, and that it is a reasonable
representation of a companys financial position. The only way shareholders can make rational
investment decisions is if the market is equipped with accurate information about a companys
fiscal health. As stated in the October 6, 2008 Final Report of the Advisory Committee on the
Auditing Profession to the U.S. Department of the Treasury:
The auditor is expected to offer critical and objective judgment on the financial matters under
consideration, and actual and perceived absence of conflicts is critical to that expectation. The
Committee believes that auditors, investors, public companies, and other market participants must
understand the independence requirements and their objectives, and that auditors must adopt a
mindset of skepticism when facing situations that may compromise their independence.
As such, shareholders should demand an objective, competent and diligent auditor who performs at or
above professional standards at every company in which the investors hold an interest. Like
directors, auditors should be free from conflicts of interest and should avoid situations requiring
a choice between the auditors interests and the publics interests. Almost without exception,
shareholders should be able to annually review an auditors performance and to annually ratify a
boards auditor selection. Moreover, in October 2008, the Advisory Committee on the Auditing
Profession went even further, and recommended that to further enhance audit committee oversight
and auditor accountability ... disclosure in the company proxy statement regarding shareholder
ratification [should] include the name(s) of the senior auditing partner(s) staffed on the
engagement.
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Voting Recommendations on Auditor Ratification
We generally support managements choice of auditor except when we believe the auditors
independence or audit integrity has been compromised. Where a board has not allowed shareholders to
review and ratify an auditor, we typically recommend voting against the audit committee chairman.
When there have been material restatements of annual financial statements or material weakness in
internal controls, we usually recommend voting against the entire audit committee.
Reasons why we may not recommend ratification of an auditor include:
1. When audit fees plus audit-related fees total less than the tax fees and/or other non-audit
fees.
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Final Report of the Advisory Committee on
the Auditing Profession to the U.S. Department of the Treasury. p. VIII:20,
October 6, 2008.
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2. Recent material restatements of annual financial statements, including those resulting in the
reporting of material weaknesses in internal controls and including late filings by the company
where the auditor bears some responsibility for the restatement or late filing.
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3. When the auditor performs prohibited services such as tax-shelter work, tax services for the CEO
or CFO, or contingent-fee work, such as a fee based on a percentage of economic benefit to the
company.
4. When audit fees are excessively low, especially when compared with other companies in the same
industry.
5. When the company has aggressive accounting policies.
6. When the company has poor disclosure or lack of transparency in its financial statements.
7. Where the auditor limited its liability through its contract with the company or the audit
contract requires the corporation to use alternative dispute resolution procedures.
8. We also look for other relationships or concerns with the auditor that might suggest a conflict
between the auditors interests and shareholder interests.
We typically support audit-related proposals regarding mandatory auditor rotation when the proposal
uses a reasonable period of time (usually not less than 5-7 years).
PENSION ACCOUNTING ISSUES
A pension accounting question often raised in proxy proposals is what effect, if any,
projected returns on employee pension assets should have on a companys net income. This issue
often arises in the executive-compensation context in a discussion of the extent to which pension
accounting should be reflected in business performance for purposes of calculating payments to
executives.
Glass Lewis believes that pension credits should not be included in measuring income that is used
to award performance-based compensation. Because many of the assumptions used in accounting for
retirement plans are subject to the companys discretion, management would have an obvious conflict
of interest if pay were tied to pension income. In our view, projected income from pensions does
not truly reflect a companys performance.
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An auditor does not audit interim financial
statements. Thus, we generally do not believe that an auditor should be opposed
due to a restatement of interim financial statements unless the nature of the
misstatement is clear from a reading of the incorrect financial statements.
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III. The Link Between Compensation and Performance
Glass Lewis carefully reviews the compensation awarded to senior executives, as we believe
that this is an important area in which the boards priorities are revealed. Glass Lewis strongly
believes executive compensation should be linked directly with the performance of the business the
executive is charged with managing. We believe the most effective compensation arrangements provide
for an appropriate mix of performance-based short- and long-term incentives in addition to base
salary.
Glass Lewis believes that comprehensive, timely and transparent disclosure of executive pay is
critical to allowing shareholders to evaluate the extent to which the pay is keeping pace with
company performance. When reviewing proxy materials, Glass Lewis examines whether the company
discloses the performance metrics used to determine executive compensation. We recognize
performance metrics must necessarily vary depending on the company and industry, among other
factors, and may include items such as total shareholder return, earning per share growth, return
on equity, return on assets and revenue growth. However, we believe companies should disclose why
the specific performance metrics were selected and how the actions they are designed to incentivize
will lead to better corporate performance.
Moreover, it is rarely in shareholders interests to disclose competitive data about individual
salaries below the senior executive level. Such disclosure could create internal personnel discord
that would be counterproductive for the company and its shareholders. While we favor full
disclosure for senior executives and we view pay disclosure at the aggregate level (e.g., the
number of employees being paid over a certain amount or in certain categories) as potentially
useful, we do not believe shareholders need or will benefit from detailed reports about individual
management employees other than the most senior executives.
ADVISORY VOTE ON EXECUTIVE COMPENSATION (SAY-ON-PAY)
On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer
Protection Act (the Dodd-Frank Act), providing for sweeping financial and governance reforms. One
of the most important reforms is found in Section 951(a) of the Dodd-Frank Act, which requires
companies to hold an advisory vote on executive compensation at the first shareholder meeting that
occurs six months after enactment (January 21, 2011). Further, since section 957 of the Dodd-Frank
Act prohibits broker discretionary voting in connection with shareholder votes with respect to
executive compensation, beginning in 2011 a majority vote in support of advisory votes on executive
compensation may become more difficult for companies to obtain.
This practice of allowing shareholdes a non-binding vote on a companys compensation report is
standard practice in many non-US countries, and has been a requirement for most companies in the
United Kingdom since 2003 and in Australia since 2005. Although Say-on-Pay proposals are
non-binding, a high level of against or abstain votes indicate substantial shareholder concern
about a companys compensation policies and procedures.
Given the complexity of most companies compensation programs, Glass Lewis applies a highly nuanced
approach when analyzing advisory votes on executive compensation. We review each companys
compensation on a case-by-case basis, recognizing that each company must be examined in the context
of industry, size, maturity, performance, financial condition, its historic pay for performance
practices, and any other relevant internal or external factors.
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We believe that each company should design and apply specific compensation policies and
practices that are appropriate to the circumstances of the company and, in particular, will attract
and retain competent executives and other staff, while motivating them to grow the companys
long-term shareholder value.
Where we find those specific policies and practices serve to reasonably align compensation with
performance, and such practices are adequately disclosed, Glass Lewis will recommend supporting the
companys approach. If, however, those specific policies and practices fail to demonstrably link
compensation with performance, Glass Lewis will generally recommend voting against the say-on-pay
proposal.
Glass Lewis focuses on four main areas when reviewing Say-on-Pay proposals:
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The overall design and structure of the Companys executive compensation program including
performance metrics;
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The quality and content of the Companys disclosure;
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The quantum paid to executives; and
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The link between compensation and performance as indicated by the Companys current and past
pay-for-performance grades
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We also review any significant changes or modifications, and rationale for such changes, made to
the Companys compensation structure or award amounts, including base salaries.
Say-on-Pay Voting Recommendations
In cases where we find deficiencies in a companys compensation programs design,
implementation or management, we will recommend that shareholders vote against the Say-on-Pay
proposal. Generally such instances include evidence of a pattern of poor pay-for-performance
practices (i.e., deficient or failing pay for performance grades), unclear or questionable
disclosure regarding the overall compensation structure (e.g., limited information regarding
benchmarking processes, limited rationale for bonus performance metrics and targets, etc.),
questionable adjustments to certain aspects of the overall compensation structure (e.g., limited
rationale for significant changes to performance targets or metrics, the payout of guaranteed
bonuses or sizable retention grants, etc.), and/or other egregious compensation practices.
Although not an exhaustive list, the following issues when weighed together may cause Glass Lewis
to recommend voting against a say-on-pay vote:
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Inappropriate peer group and/or benchmarking issues
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Inadequate or no rationale for changes to peer groups
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Egregious or excessive bonuses, equity awards or severance payments, including golden handshakes
and golden parachutes
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Guaranteed bonuses
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Targeting overall levels of compensation at higher than median without adequate justification
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Bonus or long-term plan targets set at less than mean or negative performance levels
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Performance targets not sufficiently challenging, and/or providing for high potential payouts
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Performance targets lowered, without justification
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Discretionary bonuses paid when short- or long-term incentive plan targets were not met
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Executive pay high relative to peers not justified by outstanding company performance
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The terms of the long-term incentive plans are inappropriate (please see Long-Term Incentives below)
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In the instance that a company has simply failed to provide sufficient disclosure of its policies,
we may recommend shareholders vote against this proposal solely on this basis, regardless of the
appropriateness of compensation levels.
In the case of companies that maintain poor compensation policies year after year without any
showing they took steps to address the issues, we may also recommend that shareholders vote against
the chairman and/or additional members of the compensation committee. We may also recommend voting
against the compensation committee based on the practices or actions of its members, such as
approving large one-off payments, the inappropriate use of discretion, or sustained poor pay for
performance practices.
Short-Term Incentives
A short-term bonus or incentive (STI) should be demonstrably tied to performance. Whenever
possible, we believe a mix of corporate and individual performance measures is appropriate. We
would normally expect performance measures for STIs to be based on internal financial measures such
as net profit after tax, EPS growth and divisional profitability as well as non-financial factors
such as those related to safety, environmental issues, and customer satisfaction. However, we
accept variations from these metrics if they are tied to the Companys business drivers.
Further, the target and potential maximum awards that can be achieved under STI awards should be
disclosed. Shareholders should expect stretching performance targets for the maximum award to be
achieved. Any increase in the potential maximum award should be clearly justified to shareholders.
Glass Lewis recognizes that disclosure of some measures may include commercially confidential
information. Therefore, we believe it may be reasonable to exclude such information in some cases
as long as the company provides sufficient justification for non-disclosure. However, where a
short-term bonus has been paid, companies should disclose the extent to which performance has been
achieved against relevant targets, including disclosure of the actual target achieved.
Where management has received significant STIs but short-term performance as measured by such
indicators as increase in profit and/or EPS growth over the previous year
prima facie
appears to be
poor or negative, we believe the company should provide a clear explanation why these significant
short- term payments were made.
Long-Term Incentives
Glass Lewis recognizes the value of equity-based incentive programs. When used appropriately,
they can provide a vehicle for linking an executives pay to company performance, thereby aligning
their interests with those of shareholders. In addition, equity-based compensation can be an
effective way to attract, retain and motivate key employees.
There are certain elements that Glass Lewis believes are common to most well-structured long-term
incentive (LTI) plans. These include:
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No re-testing or lowering of performance conditions
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Performance metrics that cannot be easily manipulated by management
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Two or more performance metrics
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At least one relative performance metric that compares the companys performance to a relevant
peer group or index
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Performance periods of at least three years
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Stretching metrics that incentivize executives to strive for outstanding performance
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Individual limits expressed as a percentage of base salary
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Performance measures should be carefully selected and should relate to the specific
business/industry in which the company operates and, especially, the key value drivers of the
companys business.
Glass Lewis believes that measuring a companys performance with multiple metrics serves to provide
a more complete picture of the companys performance than a single metric, which may focus too much
management attention on a single target and is therefore more susceptible to manipulation. External
benchmarks should be disclosed and transparent, such as total shareholder return (TSR) against a
well-selected sector index, peer group or other performance hurdle. The rationale behind the
selection of a specific index or peer group should be disclosed. Internal benchmarks (e.g. earnings
per share growth) should also be disclosed and transparent, unless a cogent case for
confidentiality is made and fully explained.
We also believe shareholders should evaluate the relative success of a companys compensation
programs, particularly existing equity-based incentive plans, in linking pay and performance in
evaluating new LTI plans to determine the impact of additional stock awards. We will therefore
review the companys pay-for-performance grade, see below for more information, and specifically
the proportion of total compensation that is stock-based.
Pay for Performance
Glass Lewis believes an integral part of a well-structured compensation package is a
successful link between pay and performance. Therefore, Glass Lewis developed a proprietary
pay-for-performance model to evaluate the link between pay and performance of the top five
executives at US companies. Our model benchmarks these executives pay and company performance
against four peer groups and across seven performance metrics. Using a forced curve and a school
letter-grade system, we grade companies from A-F according to their pay-for-performance linkage.
The grades guide our evaluation of compensation committee effectiveness and we generally recommend
voting against compensation committee of companies with a pattern of failing our
pay-for-performance analysis.
We also use this analysis to inform our voting decisions on say-on-pay proposals. As such, if a
company receives a failing grade from our proprietary model, we are likely to recommend
shareholders to vote against the say-on-pay proposal. However, there may be exceptions to this rule
such as when a company makes significant enhancements to its compensation programs.
Recoupment (Clawback) Provisions
Section 954 of the Dodd-Frank Act requires the SEC to create a rule requiring listed companies
to adopt policies for recouping certain compensation during a three-year look-back period. The rule
applies to incentive-based compensation paid to current or former executives if the company is
required to prepare an accounting restatement due to erroneous data resulting from material
non-compliance with any financial reporting requirements under the securities laws.
These recoupment provisions are more stringent than under Section 304 of the Sarbanes-Oxley Act in
three respects: (i) the provisions extend to current or former executive officers rather than only
to the
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CEO and CFO; (ii) it has a three-year look-back period (rather than a twelve-month look-back
period); and (iii) it allows for recovery of compensation based upon a financial restatement due to
erroneous data, and therefore does not require misconduct on the part of the executive or other
employees.
Frequency of Say-on-Pay
The Dodd-Frank Act also requires companies to allow shareholders a non-binding vote on the
frequency of say-on-pay votes, i.e. every one, two or three years. Additionally, Dodd-Frank
requires companies to hold such votes on the frequency of say-on-pay votes at least once every six
years.
We believe companies should submit say-on-pay votes to shareholders every year. We believe that the
time and financial burdens to a company with regard to an annual vote are relatively small and
incremental and are outweighed by the benefits to shareholders through more frequent
accountability. Implementing biannual or triennial votes on executive compensation limits
shareholders ability to hold the board accountable for its compensation practices through means
other than voting against the compensation committee. Unless a company provides a compelling
rationale or unique circumstances for say-on-pay votes less frequent than annually, we will
generally recommend that shareholders support annual votes on compensation.
Vote on Golden Parachute Arrangements
The Dodd-Frank Act also requires companies to provide shareholders with a separate non-binding
vote on approval of golden parachute compensation arrangements in connection with certain
change-in- control transactions. However, if the golden parachute arrangements have previously been
subject to a say-on-pay vote which shareholders approved, then this required vote is waived.
Glass Lewis believes the narrative and tabular disclosure of golden parachute arrangements will
benefit all shareholders. Glass Lewis will analyze each golden parachute arrangement on a
case-by-case basis, taking into account, among other items: the ultimate value of the payments, the
tenure and position of the executives in question, and the type of triggers involved (single vs
double).
EQUITY-BASED COMPENSATION PLAN PROPOSALS
We believe that equity compensation awards are useful, when not abused, for retaining
employees and providing an incentive for them to act in a way that will improve company
performance. Glass Lewis evaluates option- and other equity-based compensation plans using a
detailed model and analytical review.
Equity-based compensation programs have important differences from cash compensation plans and
bonus programs. Accordingly, our model and analysis takes into account factors such as plan
administration, the method and terms of exercise, repricing history, express or implied rights to
reprice, and the presence of evergreen provisions.
Our analysis is quantitative and focused on the plans cost as compared with the businesss
operating metrics. We run twenty different analyses, comparing the program with absolute limits we
believe are key to equity value creation and with a carefully chosen peer group. In general, our
model seeks to determine whether the proposed plan is either absolutely excessive or is more than
one standard deviation away from the average plan for the peer group on a range of criteria,
including dilution to shareholders and the projected annual cost relative to the companys
financial performance. Each of the twenty analyses (and their constituent parts) is weighted and
the plan is scored in accordance with that weight.
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In our analysis, we compare the programs expected annual expense with the businesss operating
metrics to help determine whether the plan is excessive in light of company performance. We also
compare the option plans expected annual cost to the enterprise value of the firm rather than to
market capitalization because the employees, managers and directors of the firm contribute to the
creation of enterprise value but not necessarily market capitalization (the biggest difference is
seen where cash represents the vast majority of market capitalization). Finally, we do not rely
exclusively on relative comparisons with averages because, in addition to creeping averages serving
to inflate compensation, we believe that academic literature proves that some absolute limits are
warranted.
We evaluate equity plans based on certain overarching principles:
1. Companies should seek more shares only when needed.
2. Requested share amounts should be small enough that companies seek shareholder approval every
three to four years (or more frequently).
3. If a plan is relatively expensive, it should not grant options solely to senior executives and
board members.
4. Annual net share count and voting power dilution should be limited.
5. Annual cost of the plan (especially if not shown on the income statement) should be reasonable
as a percentage of financial results and should be in line with the peer group.
6. The expected annual cost of the plan should be proportional to the businesss value.
7. The intrinsic value that option grantees received in the past should be reasonable compared with
the businesss financial results.
8. Plans should deliver value on a per-employee basis when compared with programs at peer
companies.
9. Plans should not permit re-pricing of stock options.
10. Plans should not contain excessively liberal administrative or payment terms.
11. Selected performance metrics should be challenging and appropriate, and should be subject to
relative performance measurements.
12. Stock grants should be subject to minimum vesting and/or holding periods sufficient to ensure
sustainable performance and promote retention.
Option Exchanges
Glass Lewis views option repricing plans and option exchange programs with great skepticism.
Shareholders have substantial risk in owning stock and we believe that the employees, officers, and
directors who receive stock options should be similarly situated to align their interests with
shareholder interests.
We are concerned that option grantees who believe they will be rescued from underwater options
will be more inclined to take unjustifiable risks. Moreover, a predictable pattern of repricing or
exchanges substantially alters a stock options value because options that will practically never
expire deeply out of the money are worth far more than options that carry a risk of expiration.
In short, repricings and option exchange programs change the bargain between shareholders and
employees after the bargain has been struck. Re-pricing is tantamount to re-trading.
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There is one circumstance in which a repricing or option exchange program is acceptable: if
macroeconomic or industry trends, rather than specific company issues, cause a stocks value to
decline dramatically and the repricing is necessary to motivate and retain employees. In this
circumstance, we think it fair to conclude that option grantees may be suffering from a risk that
was not foreseeable when the original bargain was struck. In such a circumstance, we will
recommend supporting a repricing only if the following conditions are true:
(i) officers and board members cannot not participate in the program;
(ii) the stock decline mirrors the market or industry price decline in terms of timing and
approximates the decline in magnitude;
(iii) the exchange is value-neutral or value-creative to shareholders using very conservative
assumptions and with a recognition of the adverse selection problems inherent in voluntary
programs; and
(iv) management and the board make a cogent case for needing to motivate and retain existing
employees, such as being in a competitive employment market.
Option Backdating, Spring-Loading, and Bullet-Dodging
Glass Lewis views option backdating, and the related practices of spring-loading and
bullet-dodging, as egregious actions that warrant holding the appropriate management and board
members responsible. These practices are similar to re-pricing options and eliminate much of the
downside risk inherent in an option grant that is designed to induce recipients to maximize
shareholder return.
Backdating an option is the act of changing an options grant date from the actual grant date to an
earlier date when the market price of the underlying stock was lower, resulting in a lower exercise
price for the option. Glass Lewis has identified over 270 companies that have disclosed internal or
government investigations into their past stock-option grants.
Spring-loading is granting stock options while in possession of material, positive information that
has not been disclosed publicly. Bullet-dodging is delaying the grants of stock options until after
the release of material, negative information. This can allow option grants to be made at a lower
price either before the release of positive news or following the release of negative news,
assuming the stocks price will move up or down in response to the information. This raises a
concern similar to that of insider trading, or the trading on material non-public information.
The exercise price for an option is determined on the day of grant, providing the recipient with
the same market risk as an investor who bought shares on that date. However, where options were
backdated, the executive or the board (or the compensation committee) changed the grant date
retroactively. The new date may be at or near the lowest price for the year or period. This would
be like allowing an investor to look back and select the lowest price of the year at which to buy
shares.
A 2006 study of option grants made between 1996 and 2005 at 8,000 companies found that option
backdating can be an indication of poor internal controls. The study found that option backdating
was more likely to occur at companies without a majority independent board and with a long-serving
CEO; both factors, the study concluded, were associated with greater CEO influence on the companys
compensation and governance practices.
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Where a company granted backdated options to an executive who is also a director, Glass Lewis will
recommend voting against that executive/director, regardless of who decided to make the award. In
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Lucian Bebchuk, Yaniv Grinstein and Urs Peyer. LUCKY CEOs. November, 2006.
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addition, Glass Lewis will recommend voting against those directors who either approved or
allowed the backdating. Glass Lewis feels that executives and directors who either benefited from
backdated options or authorized the practice have breached their fiduciary responsibility to
shareholders.
Given the severe tax and legal liabilities to the company from backdating, Glass Lewis will
consider recommending voting against members of the audit committee who served when options were
backdated, a restatement occurs, material weaknesses in internal controls exist and disclosures
indicate there was a lack of documentation. These committee members failed in their responsibility
to ensure the integrity of the companys financial reports.
When a company has engaged in spring-loading or bullet-dodging, Glass Lewis will consider
recommending voting against the compensation committee members where there has been a pattern of
granting options at or near historic lows. Glass Lewis will also recommend voting against
executives serving on the board who benefited from the spring-loading or bullet-dodging.
162(m) Plans
Section 162(m) of the Internal Revenue Code allows companies to deduct compensation in excess
of $1 million for the CEO and the next three most highly compensated executive officers, excluding
the CFO, upon shareholder approval of the excess compensation. Glass Lewis recognizes the value of
executive incentive programs and the tax benefit of shareholder-approved incentive plans.
We believe the best practice for companies is to provide robust disclosure to shareholders so that
they can make fully-informed judgments about the reasonableness of the proposed compensation plan.
To allow for meaningful shareholder review, we prefer that disclosure should include specific
performance metrics, a maximum award pool, and a maximum award amount per employee. We also believe
it is important to analyze the estimated grants to see if they are reasonable and in line with the
companys peers.
We typically recommend voting against a 162(m) plan where: a company fails to provide at least a
list of performance targets; a company fails to provide one of either a total pool or an individual
maximum; or the proposed plan is excessive when compared with the plans of the companys peers.
The companys record of aligning pay with performance (as evaluated using our proprietary pay-for-
performance model) also plays a role in our recommendation. Where a company has a record of setting
reasonable pay relative to business performance, we generally recommend voting in favor of a plan
even if the plan caps seem large relative to peers because we recognize the value in special pay
arrangements for continued exceptional performance.
As with all other issues we review, our goal is to provide consistent but contextual advice given
the specifics of the company and ongoing performance. Overall, we recognize that it is generally
not in shareholders best interests to vote against such a plan and forgo the potential tax benefit
since shareholder rejection of such plans will not curtail the awards; it will only prevent the tax
deduction associated with them.
Director Compensation Plans
Glass Lewis believes that non-employee directors should receive reasonable and appropriate
compensation for the time and effort they spend serving on the board and its committees. Director
fees should be competitive in order to retain and attract qualified individuals. But excessive fees
represent a financial cost to the company and threaten to compromise the objectivity and
independence of non-employee directors. Therefore, a balance is required. We will consider
recommending supporting compensation plans that include option grants or other equity-based awards
that help to align the
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interests of outside directors with those of shareholders. However, equity grants to directors
should not be performance-based to ensure directors are not incentivized in the same manner as
executives but rather serve as a check on imprudent risk-taking in executive compensation plan
design.
Glass Lewis uses a proprietary model and analyst review to evaluate the costs of equity plans
compared to the plans of peer companies with similar market capitalizations. We use the results of
this model to guide our voting recommendations on stock-based director compensation plans.
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IV.
Governance Structure
and the Shareholder Franchise
ANTI-TAKEOVER MEASURES
Poison Pills (Shareholder Rights Plans)
Glass Lewis believes that poison pill plans are not generally in shareholders best interests.
They can reduce management accountability by substantially limiting opportunities for corporate
takeovers. Rights plans can thus prevent shareholders from receiving a buy-out premium for their
stock. Typically we recommend that shareholders vote against these plans to protect their financial
interests and ensure that they have an opportunity to consider any offer for their shares,
especially those at a premium.
We believe boards should be given wide latitude in directing company activities and in charting the
companys course. However, on an issue such as this, where the link between the shareholders
financial interests and their right to consider and accept buyout offers is substantial, we believe
that shareholders should be allowed to vote on whether they support such a plans implementation.
This issue is different from other matters that are typically left to board discretion. Its
potential impact on and relation to shareholders is direct and substantial. It is also an issue in
which management interests may be different from those of shareholders; thus, ensuring that
shareholders have a voice is the only way to safeguard their interests.
In certain circumstances, we will support a poison pill that is limited in scope to accomplish a
particular objective, such as the closing of an important merger, or a pill that contains what we
believe to be a reasonable qualifying offer clause. We will consider supporting a poison pill plan
if the qualifying offer clause includes the following attributes: (i)The form of offer is not
required to be an all-cash transaction; (ii) the offer is not required to remain open for more than
90 business days; (iii) the offeror is permitted to amend the offer, reduce the offer, or otherwise
change the terms; (iv) there is no fairness opinion requirement; and (v) there is a low to no
premium requirement. Where these requirements are met, we typically feel comfortable that
shareholders will have the opportunity to voice their opinion on any legitimate offer.
NOL Poison Pills
Similarly, Glass Lewis may consider supporting a limited poison pill in the unique event that
a company seeks shareholder approval of a rights plan for the express purpose of preserving Net
Operating Losses (NOLs). While companies with NOLs can generally carry these losses forward to
offset future taxable income, Section 382 of the Internal Revenue Code limits companies ability to
use NOLs in the event of a change of ownership.
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In this case, a company may adopt or
amend a poison pill (NOL pill) in order to prevent an inadvertent change of ownership by multiple
investors purchasing small chunks of stock at the same time, and thereby preserve the ability to
carry the NOLs forward. Often such NOL pills have trigger thresholds much lower than the common 15%
or 20% thresholds, with some NOL pill triggers as low as 5%.
Glass Lewis evaluates NOL pills on a strictly case-by-case basis taking into consideration, among
other factors, the value of the NOLs to the company, the likelihood of a change of ownership based
on the size
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Section 382 of the Internal Revenue Code refers to a change of ownership of more than 50 percentage points by one or
more 5% shareholders within a three-year period. The statute is intended to
deter the trafficking of net operating losses.
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of the holding and the nature of the larger shareholders, the trigger threshold and whether
the term of the plan is limited in duration (i.e., whether it contains a reasonable sunset
provision) or is subject to periodic board review and/or shareholder ratification. However, we will
recommend that shareholders vote against a proposal to adopt or amend a pill to include NOL
protective provisions if the company has adopted a more narrowly tailored means of preventing a
change in control to preserve its NOLs. For example, a company may limit share transfers in its
charter to prevent a change of ownership from occurring.
Furthermore, we believe that shareholders should be offered the opportunity to vote on any adoption
or renewal of a NOL pill regardless of any potential tax benefit that it offers a company. As such,
we will consider recommending voting against those members of the board who served at the time when
an NOL pill was adopted without shareholder approval within the prior twelve months and where the
NOL pill is not subject to shareholder ratification.
Fair Price Provisions
Fair price provisions, which are rare, require that certain minimum price and procedural
requirements be observed by any party that acquires more than a specified percentage of a
corporations common stock. The provision is intended to protect minority shareholder value when an
acquirer seeks to accomplish a merger or other transaction which would eliminate or change the
interests of the minority stockholders. The provision is generally applied against the acquirer
unless the takeover is approved by a majority of continuing directors and holders of a majority,
in some cases a supermajority as high as 80%, of the combined voting power of all stock entitled to
vote to alter, amend, or repeal the above provisions.
The effect of a fair price provision is to require approval of any merger or business combination
with an interested stockholder by 51% of the voting stock of the company, excluding the shares
held by the interested stockholder. An interested stockholder is generally considered to be a
holder of 10% or more of the companys outstanding stock, but the trigger can vary.
Generally, provisions are put in place for the ostensible purpose of preventing a back-end merger
where the interested stockholder would be able to pay a lower price for the remaining shares of the
company than he or she paid to gain control. The effect of a fair price provision on shareholders,
however, is to limit their ability to gain a premium for their shares through a partial tender
offer or open market acquisition which typically raise the share price, often significantly. A fair
price provision discourages such transactions because of the potential costs of seeking shareholder
approval and because of the restrictions on purchase price for completing a merger or other
transaction at a later time.
Glass Lewis believes that fair price provisions, while sometimes protecting shareholders from abuse
in a takeover situation, more often act as an impediment to takeovers, potentially limiting gains
to shareholders from a variety of transactions that could significantly increase share price. In
some cases, even the independent directors of the board cannot make exceptions when such exceptions
may be in the best interests of shareholders. Given the existence of state law protections for
minority shareholders such as Section 203 of the Delaware Corporations Code, we believe it is in
the best interests of shareholders to remove fair price provisions.
REINCORPORATION
In general, Glass Lewis believes that the board is in the best position to determine the
appropriate jurisdiction of incorporation for the company. When examining a management proposal to
reincorporate to a different state or country, we review the relevant financial benefits, generally
related to improved corporate tax treatment, as well as changes in corporate governance provisions,
especially those relating
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to shareholder rights, resulting from the change in domicile. Where the financial benefits are
de
minimis
and there is a decrease in shareholder rights, we will recommend voting against the
transaction.
However, costly, shareholder-initiated reincorporations are typically not the best route to achieve
the furtherance of shareholder rights. We believe shareholders are generally better served by
proposing specific shareholder resolutions addressing pertinent issues which may be implemented at
a lower cost, and perhaps even with board approval. However, when shareholders propose a shift into
a jurisdiction with enhanced shareholder rights, Glass Lewis examines the significant ways would
the Company benefit from shifting jurisdictions including the following:
1. Is the board sufficiently independent?
2. Does the Company have anti-takeover protections such as a poison pill or classified board in
place?
3. Has the board been previously unresponsive to shareholders (such as failing to implement a
shareholder proposal that received majority shareholder support)?
4. Do shareholders have the right to call special meetings of shareholders?
5. Are there other material governance issues at the Company?
6. Has the Companys performance matched or exceeded its peers in the past one and three years?
7. How has the Company ranked in Glass Lewis pay-for-performance analysis during the last three
years?
8. Does the company have an independent chairman?
We note, however, that we will only support shareholder proposals to change a companys place of
incorporation in exceptional circumstances.
AUTHORIZED SHARES
Glass Lewis believes that adequate capital stock is important to a companys operation. When
analyzing a request for additional shares, we typically review four common reasons why a company
might need additional capital stock:
(i) Stock Split We typically consider three metrics when evaluating whether we think a stock
split is likely or necessary: The historical stock pre-split price, if any; the current price
relative to the companys most common trading price over the past 52 weeks; and some absolute
limits on stock price that, in our view, either always make a stock split appropriate if desired by
management or would almost never be a reasonable price at which to split a stock.
(ii) Shareholder Defenses Additional authorized shares could be used to bolster takeover defenses
such as a poison pill. Proxy filings often discuss the usefulness of additional shares in
defending against or discouraging a hostile takeover as a reason for a requested increase. Glass
Lewis is typically against such defenses and will oppose actions intended to bolster such defenses.
(iii) Financing for Acquisitions We look at whether the company has a history of using stock for
acquisitions and attempt to determine what levels of stock have typically been required to
accomplish such transactions. Likewise, we look to see whether this is discussed as a reason for
additional shares in the proxy.
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(iv) Financing for Operations We review the companys cash position and its ability to secure
financing through borrowing or other means. We look at the companys history of capitalization and
whether the company has had to use stock in the recent past as a means of raising capital.
Issuing additional shares can dilute existing holders in limited circumstances. Further, the
availability of additional shares, where the board has discretion to implement a poison pill, can
often serve as a deterrent to interested suitors. Accordingly, where we find that the company has
not detailed a plan for use of the proposed shares, or where the number of shares far exceeds those
needed to accomplish a detailed plan, we typically recommend against the authorization of
additional shares.
While we think that having adequate shares to allow management to make quick decisions and
effectively operate the business is critical, we prefer that, for significant transactions,
management come to shareholders to justify their use of additional shares rather than providing a
blank check in the form of a large pool of unallocated shares available for any purpose.
ADVANCE NOTICE REQUIREMENTS FOR SHAREHOLDER BALLOT PROPOSALS
We typically recommend that shareholders vote against proposals that would require advance
notice of shareholder proposals or of director nominees.
These proposals typically attempt to require a certain amount of notice before shareholders are
allowed to place proposals on the ballot. Notice requirements typically range between three to six
months prior to the annual meeting. Advance notice requirements typically make it impossible for a
shareholder who misses the deadline to present a shareholder proposal or a director nominee that
might be in the best interests of the company and its shareholders.
We believe shareholders should be able to review and vote on all proposals and director nominees.
Shareholders can always vote against proposals that appear with little prior notice. Shareholders,
as owners of a business, are capable of identifying issues on which they have sufficient
information and ignoring issues on which they have insufficient information. Setting arbitrary
notice restrictions limits the opportunity for shareholders to raise issues that may come up after
the window closes.
VOTING STRUCTURE
Cumulative Voting
Cumulative voting increases the ability of minority shareholders to elect a director by
allowing shareholders to cast as many shares of the stock they own multiplied by the number of
directors to be elected. As companies generally have multiple nominees up for election, cumulative
voting allows shareholders to cast all of their votes for a single nominee, or a smaller number of
nominees than up for election, thereby raising the likelihood of electing one or more of their
preferred nominees to the board. It can be important when a board is controlled by insiders or
affiliates and where the companys ownership structure includes one or more shareholders who
control a majority-voting block of company stock.
Glass Lewis believes that cumulative voting generally acts as a safeguard for shareholders by
ensuring that those who hold a significant minority of shares can elect a candidate of their
choosing to the board. This allows the creation of boards that are responsive to the interests of
all shareholders rather than just a small group of large holders.
However, academic literature indicates that where a highly independent board is in place and the
company has a shareholder-friendly governance structure, shareholders may be better off without
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cumulative voting. The analysis underlying this literature indicates that shareholder returns
at firms with good governance structures are lower and that boards can become factionalized and
prone to evaluating the needs of special interests over the general interests of shareholders
collectively.
We review cumulative voting proposals on a case-by-case basis, factoring in the independence of the
board and the status of the companys governance structure. But we typically find these proposals
on ballots at companies where independence is lacking and where the appropriate checks and balances
favoring shareholders are not in place. In those instances we typically recommend in favor of
cumulative voting.
Where a company has adopted a true majority vote standard (i.e., where a director must receive a
majority of votes cast to be elected, as opposed to a modified policy indicated by a resignation
policy only), Glass Lewis will recommend voting against cumulative voting proposals due to the
incompatibility of the two election methods. For companies that have not adopted a true majority
voting standard but have adopted some form of majority voting, Glass Lewis will also generally
recommend voting against cumulative voting proposals if the company has not adopted antitakeover
protections and has been responsive to shareholders.
Where a company has not adopted a majority voting standard and is facing both a shareholder
proposal to adopt majority voting and a shareholder proposal to adopt cumulative voting, Glass
Lewis will support only the majority voting proposal. When a company has both majority voting and
cumulative voting in place, there is a higher likelihood of one or more directors not being elected
as a result of not receiving a majority vote. This is because shareholders exercising the right to
cumulate their votes could unintentionally cause the failed election of one or more directors for
whom shareholders do not cumulate votes.
Supermajority Vote Requirements
Glass Lewis believes that supermajority vote requirements impede shareholder action on ballot
items critical to shareholder interests. An example is in the takeover context, where supermajority
vote requirements can strongly limit the voice of shareholders in making decisions on such crucial
matters as selling the business. This in turn degrades share value and can limit the possibility of
buyout premiums to shareholders. Moreover, we believe that a supermajority vote requirement can
enable a small group of shareholders to overrule the will of the majority shareholders. We believe
that a simple majority is appropriate to approve all matters presented to shareholders.
TRANSACTION OF OTHER BUSINESS
at an annual or special meeting of shareholders
We typically recommend that shareholders not give their proxy to management to vote on any
other business items that may properly come before the annual meeting. In our opinion, granting
unfettered discretion is unwise.
ANTI-GREENMAIL PROPOSALS
Glass Lewis will support proposals to adopt a provision preventing the payment of greenmail,
which would serve to prevent companies from buying back company stock at significant premiums from
a certain shareholder. Since a large or majority shareholder could attempt to compel a board into
purchasing its shares at a large premium, the anti-greenmail provision would generally require that
a majority of shareholders other than the majority shareholder approve the buyback.
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MUTUAL FUNDS: INVESTMENT POLICIES AND ADVISORY AGREEMENTS
Glass Lewis believes that decisions about a funds structure and/or a funds relationship with
its investment advisor or sub-advisors are generally best left to management and the members of the
board, absent a showing of egregious or illegal conduct that might threaten shareholder value. As
such, we focus our analyses of such proposals on the following main areas:
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The terms of any amended advisory or sub-advisory agreement;
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Any changes in the fee structure paid to the investment advisor; and
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Any material changes to the funds investment objective or strategy.
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We generally support amendments to a funds investment advisory agreement absent a material change
that is not in the best interests of shareholders. A significant increase in the fees paid to an
investment advisor would be reason for us to consider recommending voting against a proposed
amendment to an investment advisory agreement. However, in certain cases, we are more inclined to
support an increase in advisory fees if such increases result from being performance-based rather
than asset-based. Furthermore, we generally support sub-advisory agreements between a funds
advisor and sub-advisor, primarily because the fees received by the sub-advisor are paid by the
advisor, and not by the fund.
In matters pertaining to a funds investment objective or strategy, we believe shareholders are
best served when a funds objective or strategy closely resembles the investment discipline
shareholders understood and selected when they initially bought into the fund. As such, we
generally recommend voting against amendments to a funds investment objective or strategy when the
proposed changes would leave shareholders with stakes in a fund that is noticeably different than
when originally contemplated, and which could therefore potentially negatively impact some
investors diversification strategies.
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V. Compensation, Environmental, Social and Governance Shareholder Initiatives
Glass Lewis typically prefers to leave decisions regarding day-to-day management and policy
decisions, including those related to social, environmental or political issues, to management and
the board, except when there is a clear link between the proposal and value enhancement or risk
mitigation. We feel strongly that shareholders should not attempt to micromanage the company, its
businesses or its executives through the shareholder initiative process. Rather, we believe
shareholders should use their influence to push for governance structures that protect shareholders
and promote director accountability. Shareholders should then put in place a board they can trust
to make informed decisions that are in the best interests of the business and its owners, and then
hold directors accountable for management and policy decisions through board elections. However, we
recognize that support of appropriately crafted shareholder initiatives may at times serve to
promote or protect shareholder value.
To this end, Glass Lewis evaluates shareholder proposals on a case-by-case basis. We generally
recommend supporting shareholder proposals calling for the elimination of, as well as to require
shareholder approval of, antitakeover devices such as poison pills and classified boards. We
generally recommend supporting proposals likely to increase and/or protect shareholder value and
also those that promote the furtherance of shareholder rights. In addition, we also generally
recommend supporting proposals that promote director accountability and those that seek to improve
compensation practices, especially those promoting a closer link between compensation and
performance.
The following is a discussion of Glass Lewis approach to certain common shareholder resolutions.
We note that the following is not an exhaustive list of all shareholder proposals.
COMPENSATION
Glass Lewis carefully reviews executive compensation since we believe that this is an
important area in which the boards priorities and effectiveness are revealed. Executives should be
compensated with appropriate base salaries and incentivized with additional awards in cash and
equity only when their performance and that of the company warrants such rewards. Compensation,
especially when also in line with the compensation paid by the companys peers, should lead to
positive results for shareholders and ensure the use of appropriate incentives that drives those
results over time.
However, as a general rule, Glass Lewis does not believe shareholders should be involved in the
approval and negotiation of compensation packages. Such matters should be left to the boards
compensation committee, which can be held accountable for its decisions through the election of
directors. Therefore, Glass Lewis closely scrutinizes shareholder proposals relating to
compensation to determine if the requested action or disclosure has already accomplished or
mandated and whether it allows sufficient, appropriate discretion to the board to design and
implement reasonable compensation programs.
Disclosure of Individual Compensation
Glass Lewis believes that disclosure of information regarding compensation is critical to
allowing shareholders to evaluate the extent to which a companys pay is based on performance.
However, we recognize that the SEC currently mandates significant executive compensation
disclosure. In some cases, providing information beyond that which is required by the SEC, such as
the details of individual employment agreements of employees below the senior level, could create
internal personnel tension or put the company at a competitive disadvantage, prompting employee
poaching by competitors. Further,
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it is difficult to see how this information would be beneficial to shareholders. Given these
concerns, Glass Lewis typically does not believe that shareholders would benefit from additional
disclosure of individual compensation packages beyond the significant level that is already
required; we therefore typically recommend voting against shareholder proposals seeking such
detailed disclosure. We will, however, review each proposal on a case by basis, taking into account
the companys history of aligning executive compensation and the creation of shareholder value.
Linking Pay with Performance
Glass Lewis views performance-based compensation as an effective means of motivating
executives to act in the best interests of shareholders. In our view, an executives compensation
should be specific to the company and its performance, as well as tied to the executives
achievements within the company.
However, when firms have inadequately linked executive compensation and company performance we will
consider recommending supporting reasonable proposals seeking that a percentage of equity awards be
tied to performance criteria. We will also consider supporting appropriately crafted proposals
requesting that the compensation committee include multiple performance metrics when setting
executive compensation, provided that the terms of the shareholder proposal are not overly
prescriptive. Though boards often argue that these types of restrictions unduly hinder their
ability to attract talent we believe boards can develop an effective, consistent and reliable
approach to remuneration utilizing a wide range (and an appropriate mix) of fixed and
performance-based compensation.
Retirement Benefits & Severance
As a general rule, Glass Lewis believes that shareholders should not be involved in the
approval of individual severance plans. Such matters should be left to the boards compensation
committee, which can be held accountable for its decisions through the election of its director
members.
However, when proposals are crafted to only require approval if the benefit exceeds 2.99 times the
amount of the executives base salary plus bonus, Glass Lewis typically supports such requests.
Above this threshold, based on the executives average annual compensation for the most recent five
years, the company can no longer deduct severance payments as an expense, and thus shareholders are
deprived of a valuable benefit without an off setting incentive to the executive. We believe that
shareholders should be consulted before relinquishing such a right, and we believe implementing
such policies would still leave companies with sufficient freedom to enter into appropriate
severance arrangements.
Following the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-
Frank), the SEC proposed rules that would require that public companies hold advisory shareholder
votes on compensation arrangements and understandings in connection with merger transactions, also
known as golden parachute transactions. However, the SEC has not finalized the rules in time for
the 2011 proxy season and therefore we expect to continue to see shareholder proposals on merger-triggered severance agreements as well as those not related to mergers.
Bonus Recoupments (Clawbacks)
We believe it is prudent for boards to adopt detailed and stringent policies whereby, in the
event of a restatement of financial results, the board will review all performance related bonuses
and awards made to senior executives during the period covered by a restatement and will, to the
extent feasible, recoup such bonuses to the extent that performance goals were not achieved. While
the Dodd-Frank Act mandates that all companies adopt clawback policies that will require companies
to develop a policy to recover compensation paid to current and former executives erroneously paid
during the three
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year prior to a restatement, the SEC has yet to finalize the relevant rules. As a result, we expect
to see shareholder proposals regarding clawbacks in the upcoming proxy season.
When examining proposals requesting that companies adopt recoupment policies, Glass Lewis will
first review any relevant policies currently in place. When the board has already committed to a
proper course, and the current policy covers the major tenets of the proposal, we see no need for
further action. Further, in some instances, shareholder proposals may call for board action that
contravenes legal obligations under existing employment agreements. In other cases proposals may
excessively limit the boards ability to exercise judgment and reasonable discretion, which may or
may not be warranted, depending on the specific situation of the company in question. We believe it
is reasonable that a mandatory recoupment policy should only affect senior executives and those
directly responsible for the companys accounting errors.
We note that where a company is entering into a new executive employment contract that does not
include a clawback provision and the company has had a material restatement in the recent past,
Glass Lewis will recommend voting against the responsible members of the compensation committee.
The compensation committee has an obligation to shareholders to include reasonable controls in
executive contracts to prevent payments in the case of inappropriate behavior.
Golden Coffins
Glass Lewis does not believe that the payment of substantial, unearned posthumous compensation
provides an effective incentive to executives or aligns the interests of executives with those of
shareholders. Glass Lewis firmly believes that compensation paid to executives should be clearly
linked to the creation of shareholder value. As such, Glass Lewis favors compensation plans
centered on the payment of awards contingent upon the satisfaction of sufficiently stretching and
appropriate performance metrics. The payment of posthumous unearned and unvested awards should be
subject to shareholder approval, if not removed from compensation policies entirely. Shareholders
should be skeptical regarding any positive benefit they derive from costly payments made to
executives who are no longer in any position to affect company performance.
To that end, we will consider supporting a reasonably crafted shareholder proposal seeking to
prohibit, or require shareholder approval of, the making or promising of any survivor benefit
payments to senior executives estates or beneficiaries. We will not recommend supporting proposals
that would, upon passage, violate existing contractual obligations or the terms of compensation
plans currently in effect.
Retention of Shares until Retirement
We strongly support the linking of executive pay to the creation of long-term sustainable
shareholder value and therefore believe shareholders should encourage executives to retain some
level of shares acquired through equity compensation programs to provide continued alignment with
shareholders. However, generally we do not believe that requiring senior executives to retain all
or an unduly high percentage of shares acquired through equity compensation programs following the
termination of their employment is the most effective or desirable way to accomplish this goal.
Rather, we believe that restricting executives ability to exercise all or a supermajority of
otherwise vested equity awards until they leave the company may hinder the ability of the
compensation committee to both attract and retain executive talent. In our view, otherwise
qualified and willing candidates could be dissuaded from accepting employment if he/she believes
that his/her compensation could be dramatically affected by financial results unrelated to their
own personal performance or tenure at the company. Alternatively, an overly strict policy could
encourage existing employees to quit in order to realize the value locked in their incentive
awards. As such, we will not typically recommend supporting proposals requiring the
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retention of significant amounts of equity compensation following termination of employment at
target firms.
Tax Gross-Ups
Tax gross-ups can act as an anti-takeover measure, as larger payouts to executives result in
larger gross-ups, which could artificially inflate the ultimate purchase price under a takeover or
merger scenario. Additionally, gross-ups can result in opaque compensation packages where
shareholders are unlikely to be aware of the total compensation an executive may receive. Further,
we believe that in instances where companies have severance agreements in place for executives,
payments made pursuant to such arrangements are often large enough to soften the blow of any
additional excise taxes. Finally, such payments are not performance based, providing no incentive
to recipients and, if large, can be a significant cost to companies.
Given the above, we will typically recommend supporting proposals requesting that a compensation
committee adopt a policy that it will not make or promise to make to its senior executives any tax
gross-up payments, except those applicable to management employees of the company generally, such
as a relocation or expatriate tax equalization policy.
Linking Executive Pay to Environmental and Social Criteria
We recognize that a companys involvement in environmentally sensitive and labor-intensive
industries influences the degree to which a firms overall strategy must weigh environmental and
social concerns. However, we also understand that the value generated by incentivizing executives
to prioritize environmental and social issues is difficult to quantify and therefore measure, and
necessarily varies among industries and companies.
When reviewing such proposals seeking to tie executive compensation to environmental or social
practices, we will review the target firms compliance with (or contravention of) applicable laws
and regulations, and examine any history of environmental and social related concerns including
those resulting in material investigations, lawsuits, fines and settlements. We will also review
the firms current compensation policies and practice. However, with respect to executive
compensation, Glass Lewis generally believes that such policies should be left to the compensation
committee.
GOVERNANCE
Declassification of the Board
Glass Lewis believes that classified boards (or staggered boards) do not serve the best
interests of shareholders. Empirical studies have shown that: (i) companies with classified boards
may show a reduction in firm value; (ii) in the context of hostile takeovers, classified boards
operate as a takeover defense, which entrenches management, discourages potential acquirers and
delivers less return to shareholders; and (iii) companies with classified boards are less likely to
receive takeover bids than those with single class boards. Annual election of directors provides
increased accountability and requires directors to focus on the interests of shareholders. When
companies have classified boards shareholders are deprived of the right to voice annual opinions on
the quality of oversight exercised by their representatives.
Given the above, Glass Lewis believes that classified boards are not in the best interests of
shareholders and will continue to recommend shareholders support proposals seeking their repeal.
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Right of Shareholders to Call a Special Meeting
Glass Lewis strongly believes that shareholders should have the ability to call meetings of
shareholders between annual meetings to consider matters that require prompt attention. However, in
order to prevent abuse and waste of corporate resources by a small minority of shareholders, we
believe that shareholders representing at least a sizable minority of shares must support such a
meeting prior to its calling. Should the threshold be set too low, companies might frequently be
subjected to meetings whose effect could be the disruption of normal business operations in order
to focus on the interests of only a small minority of owners. Typically we believe this threshold
should not fall below 10-15% of shares, depending on company size.
In our case-by-case evaluations, we consider the following:
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Company size
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Shareholder base in both percentage of ownership and type of shareholder (e.g., hedge fund,
activist investor, mutual fund, pension fund, etc.)
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Responsiveness of board and management to shareholders evidenced by progressive shareholder
rights policies (e.g., majority voting, declassifying boards, etc.) and reaction to shareholder
proposals
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Company performance and steps taken to improve bad performance (e.g., new executives/ directors,
spin-offs, etc.)
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Existence of anti-takeover protections or other entrenchment devices
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Opportunities for shareholder action (e.g., ability to act by written consent)
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Existing ability for shareholders to call a special meeting
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Right of Shareholders to Act by Written Consent
Glass Lewis strongly supports shareholders right to act by written consent. The right to act
by written consent enables shareholders to take action on important issues that arise between
annual meetings. However, we believe such rights should be limited to at least the minimum number
of votes that would be necessary to authorize the action at a meeting at which all shareholders
entitled to vote were present and voting.
In addition to evaluating the threshold for which written consent may be used (e.g. majority of
votes cast or outstanding), we will consider the following when evaluating such shareholder
proposals:
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Company size
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Shareholder base in both percentage of ownership and type of shareholder (e.g., hedge fund,
activist investor, mutual fund, pension fund, etc.)
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Responsiveness of board and management to shareholders evidenced by progressive shareholder
rights policies (e.g., majority voting, declassifying boards, etc.) and reaction to shareholder
proposals
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Company performance and steps taken to improve bad performance (e.g., new executives/ directors,
spin offs, etc.)
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Existence of anti-takeover protections or other entrenchment devices
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Opportunities for shareholder action (e.g., ability and threshold to call a special meeting)
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Existing ability for shareholders to act by written consent
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Board Composition
Glass Lewis believes the selection and screening process for identifying suitably qualified
candidates for a companys board of directors is one which requires the judgment of many factors,
including the balance of skills and talents, the breadth of experience and diversity of candidates
and existing board members. Diversity of skills, abilities and points of view can foster the
development of a more creative, effective and dynamic board. In general, however, we do not believe
that it is in the best interests of shareholders for firms to be beholden to arbitrary rules
regarding its board, or committee, composition. We believe such matters should be left to a boards
nominating committee, which is generally responsible for establishing and implementing policies
regarding the composition of the board. Members of this committee may be held accountable through
the director election process. However, we will consider supporting reasonable, well-crafted
proposals to increase board diversity where there is evidence a boards lack of diversity lead to a
decline in shareholder value.
Reimbursement of Solicitation Expenses
Where a dissident shareholder is seeking reimbursement for expenses incurred in waging a
contest or submitting a shareholder proposal and has received the support of a majority of
shareholders, Glass Lewis generally will recommend in favor of reimbursing the dissident for
reasonable expenses. In those rare cases where a shareholder has put his or her own time and money
into organizing a successful campaign to unseat a poorly performing director (or directors) or
sought support for a shareholder proposal, we feel that the shareholder should be entitled to
reimbursement of expenses by other shareholders, via the company. We believe that, in such cases,
shareholders express their agreement by virtue of their majority vote for the dissident (or the
shareholder proposal) and will share in the expected improvement in company performance.
Majority Vote for the Election of Directors
If a majority vote standard were implemented, shareholders could collectively vote to reject a
director they believe will not pursue their best interests. We think that this minimal amount of
protection for shareholders is reasonable and will not upset the corporate structure nor reduce the
willingness of qualified shareholder-focused directors to serve in the future.
We believe that a majority vote standard will likely lead to more attentive directors. Further,
occasional use of this power will likely prevent the election of directors with a record of
ignoring shareholder interests. Glass Lewis will generally support shareholder proposals calling
for the election of directors by a majority vote, except for use in contested director elections.
Cumulative Vote for the Election of Directors
Glass Lewis believes that cumulative voting generally acts as a safeguard for shareholders by
ensuring that those who hold a significant minority of shares can elect a candidate of their
choosing to the board. This allows the creation of boards that are responsive to the interests of
all shareholders rather than just a small group of large holders. However, when a company has both
majority voting and cumulative voting in place, there is a higher likelihood of one or more
directors not being elected as a result of not receiving a majority vote. This is because
shareholders exercising the right to cumulate their votes could unintentionally cause the failed
election of one or more directors for whom shareholders do not cumulate votes.
Given the above, where a company (i) has adopted a true majority vote standard; (ii) has
simultaneously proposed a management-initiated true majority vote standard; or (iii) is
simultaneously the target of a
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true majority vote standard shareholder proposal, Glass Lewis will recommend voting against
cumulative voting proposals due to the potential incompatibility of the two election methods.
For companies that have not adopted a true majority voting standard but have adopted some form of
majority voting, Glass Lewis will also generally recommend voting against cumulative voting
proposals if the company has not adopted antitakeover protections and has been responsive to
shareholders.
Supermajority Vote Requirements
We believe that a simple majority is appropriate to approve all matters presented to
shareholders, and will recommend that shareholders vote accordingly. Glass Lewis believes that
supermajority vote requirements impede shareholder action on ballot items critical to shareholder
interests. In a takeover context supermajority vote requirements can strongly limit the voice of
shareholders in making decisions on crucial matters such as selling the business. These limitations
in turn may degrade share value and can reduce the possibility of buyout premiums for shareholders.
Moreover, we believe that a supermajority vote requirement can enable a small group of shareholders
to overrule the will of the majority of shareholders.
Independent Chairman
Glass Lewis views an independent chairman as better able to oversee the executives and set a
pro- shareholder agenda in the absence of the conflicts that a CEO, executive insider, or close
company affiliate may face. Separating the roles of CEO and chairman may lead to a more proactive
and effective board of directors. The presence of an independent chairman fosters the creation of a
thoughtful and dynamic board, not dominated by the views of senior management. We believe that the
separation of these two key roles eliminates the conflict of interest that inevitably occurs when a
CEO, or other executive, is responsible for self-oversight. As such, we will typically support
reasonably crafted shareholder proposals seeking the installation of an independent chairman at a
target company. However, we will not support proposals that include overly prescriptive definitions
of independent.
ENVIRONMENT
There are significant financial, legal and reputational risks to companies resulting from poor
environmental practices or negligent oversight thereof. We believe part of the boards role is to
ensure that management conducts a complete risk analysis of company operations, including those
that have environmental implications. Directors should monitor managements performance in
mitigating environmental risks attendant with operations in order to eliminate or minimize the
risks to the company and shareholders.
When management and the board have displayed disregard for environmental risks, have engaged in
egregious or illegal conduct, or have failed to adequately respond to current or imminent
environmental risks that threaten shareholder value, we believe shareholders should hold directors
accountable. When a substantial environmental risk has been ignored or inadequately addressed, we
may recommend voting against responsible members of the governance committee, or members of a
committee specifically charged with sustainability oversight.
With respect to environmental risk, Glass Lewis believes companies should actively consider their
exposure to:
Direct environmental risk: Companies should evaluate financial exposure to direct environmental
risks associated with their operations. Examples of direct environmental risks are those associated
with spills, contamination, hazardous leakages, explosions, or reduced water or air quality, among
others. Further, firms should consider their exposure to environmental risks emanating from
systemic change
Copyright 2011 Glass, Lewis & Co., LLC
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over which they may have only limited control, such as insurance companies affected by
increased storm severity and frequency resulting from climate change.
Risk due to legislation/regulation: Companies should evaluate their exposure to shifts or potential
shifts in environmental regulation that affect current and planned operations. Regulation should be
carefully monitored in all jurisdictions within which the company operates. We look closely at
relevant and proposed legislation and evaluate whether the company has responded appropriately.
Legal and reputational risk: Failure to take action on important issues may carry the risk of
damaging negative publicity and potentially costly litigation. While the effect of high-profile
campaigns on shareholder value may not be directly measurable, in general we believe it is prudent
for firms to evaluate social and environmental risk as a necessary part in assessing overall
portfolio risk.
If there is a clear showing that a company has inadequately addressed these risks, Glass Lewis may
consider supporting appropriately crafted shareholder proposals requesting increased disclosure,
board attention or, in limited circumstances, specific actions. In general, however, we believe
that boards and management are in the best position to address these important issues, and will
only rarely recommend that shareholders supplant their judgment regarding operations.
Climate Change and Green House Gas Emission Disclosure
Glass Lewis will consider recommending a vote in favor of a reasonably crafted proposal to
disclose a companys climate change and/or greenhouse gas emission strategies when (i) a company
has suffered financial impact from reputational damage, lawsuits and/or government investigations,
(ii) there is a strong link between climate change and its resultant regulation and shareholder
value at the firm, and/ or (iii) the company has inadequately disclosed how it has addressed
climate change risks. Further, we will typically recommend supporting proposals seeking disclosure
of greenhouse gas emissions at companies operating in carbon- or energy- intensive industries, such
basic materials, integrated oil and gas, iron and steel, transportation, utilities, and
construction. We are not inclined, however, to support proposals seeking emissions reductions, or
proposals seeking the implementation of prescriptive policies relating to climate change.
Sustainability Report
When evaluating requests that a firm produce a sustainability report, we will consider, among
other things:
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The financial risk to the company from the firms environmental practices and/or regulation;
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The relevant companys current level of disclosure;
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The level of sustainability information disclosed by the firms peers;
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The industry in which the firm operates;
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The level and type of sustainability concerns/controversies at the relevant firm, if any;
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The time frame within which the relevant report is to be produced; and
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The level of flexibility granted to the board in the implementation of the proposal.
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In general, we believe that firms operating in extractive industries should produce sustainability
reports, and will recommend a vote for reasonably crafted proposals requesting that such a report
be produced; however, as with all shareholder proposals, we will evaluate sustainability report
requests on a case by case basis.
Copyright 2011 Glass, Lewis & Co., LLC
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Oil Sands
The procedure required to extract usable crude from oil sands emits significantly more
greenhouse gases than do conventional extraction methods. In addition, development of the oil sands
has a deleterious effect on the local environment, such as Canadas boreal forests which sequester
significant levels of carbon. We believe firms should strongly consider and evaluate exposure to
financial, legal and reputational risks associated with investment in oil sands.
We believe firms should adequately disclose their involvement in the oil sands, including a
discussion of exposure to sensitive political and environmental areas. Firms should broadly outline
the scope of oil sands operations, describe the commercial methods for producing oil, and discuss
the management of greenhouse gas emissions. However, we believe that detailed disclosure of
investment assumptions could unintentionally reveal sensitive information regarding operations and
business strategy, which would not serve shareholders interest. We will review all proposals
seeking increased disclosure of oil sands operations in the above context, but will typically not
support proposals seeking cessation or curtailment of operations.
Sustainable Forestry
Sustainable forestry provides for the long-term sustainable management and use of trees and
other non-timber forest products. Retaining the economic viability of forests is one of the tenets
of sustainable forestry, along with encouraging more responsible corporate use of forests.
Sustainable land use and the effective management of land are viewed by some shareholders as
important in light of the impact of climate change. Forestry certification has emerged as a way
that corporations can address prudent forest management. There are currently several primary
certification schemes such as the Sustainable Forestry Initiative (SFI) and the Forest
Stewardship Council (FSC).
There are nine main principles that comprise the SFI: (I) sustainable forestry; (ii) responsible
practices; (iii) reforestation and productive capacity; (iv) forest health and productivity; (v)
long-term forest and soil productivity; (vi) protection of water resources; (vii) protection of
special sites and biodiversity; (viii) legal compliance; and (ix) continual improvement.
The FSC adheres to ten basic principles: (i) compliance with laws and FSC principles; (ii) tenure
and use rights and responsibilities; (iii) indigenous peoples rights; (iv) community relations and
workers rights; (v) benefits from the forest; (vi) environmental impact; (vii) management plan;
(viii) monitoring and assessment; (ix) maintenance of high conservation value forests; and (x)
plantations.
Shareholder proposals regarding sustainable forestry have typically requested that the firm comply
with the above SFI or FSC principles as well as to assess the feasibility of phasing out the use of
uncertified fiber and increasing the use of certified fiber. We will evaluate target firms current
mix of certified and uncertified paper and the firms general approach to sustainable forestry
practices, both absolutely and relative to its peers but will only support proposals of this nature
when we believe that the proponent has clearly demonstrated that the implementation of this
proposal is clearly linked to an increase in shareholder value.
SOCIAL ISSUES
Non-Discrimination Policies
Companies with records of poor labor relations may face lawsuits, efficiency-draining
turnover, poor employee performance, and/or distracting, costly investigations. Moreover, as an
increasing number of companies adopt inclusive EEO policies, companies without comprehensive
policies may face damaging
Copyright 2011 Glass, Lewis & Co., LLC
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recruitment, reputational and legal risks. We believe that a pattern of making financial
settlements as a result of lawsuits based on discrimination could indicate investor exposure to
ongoing financial risk. Where there is clear evidence of employment practices resulting in negative
economic exposure, Glass Lewis may support shareholder proposals addressing such risks.
MacBride Principles
To promote peace, justice and equality regarding employment in Northern Ireland, Dr. Sean
MacBride, founder of Amnesty International and Nobel Peace laureate, proposed the following equal
opportunity employment principles:
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Increasing the representation of individuals from underrepresented religious groups in the
workforce including managerial, supervisory, administrative, clerical and technical jobs;
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Adequate security for the protection of minority employees both at the workplace and while
traveling to and from work;
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The banning of provocative religious or political emblems from the workplace;
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All job openings should be publicly advertised and special recruitment efforts should be made to
attract applicants from underrepresented religious groups;
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Layoff, recall, and termination procedures should not, in practice, favor particular religious
groupings;
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The abolition of job reservations, apprenticeship restrictions, and differential employment
criteria, which discriminate on the basis of religion or ethnic origin;
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The development of training programs that will prepare substantial numbers of current minority
employees for skilled jobs, including the expansion of existing programs and the creation of new
programs to train, upgrade, and improve the skills of minority employees;
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The establishment of procedures to assess, identify and actively recruit minority employees with
potential for further advancement; and
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The appointment of senior management staff member to oversee the companys affirmative action
efforts and setting up of timetables to carry out affirmative action principles.
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Proposals requesting the implementation of the above principles are typically proposed at firms
that operate, or maintain subsidiaries that operate, in Northern Ireland. In each case, we will
examine the companys current equal employment opportunity policy and the extent to which the
company has been subject to protests, fines, or litigation regarding discrimination in the
workplace, if any. Further, we will examine any evidence of the firms specific record of labor
concerns in Northern Ireland.
Human Rights
Glass Lewis believes explicit policies set out by companies boards of directors on human
rights provides shareholders with the means to evaluate whether the company has taken steps to
mitigate risks from its human rights practices. As such, we believe that it is prudent for firms to
actively evaluate risks to shareholder value stemming from global activities and human rights
practices along entire supply chains. Findings and investigations of human rights abuses can
inflict, at a minimum, reputational damage on targeted companies and have the potential to
dramatically reduce shareholder value. This is particularly true for companies operating in
emerging market countries in extractive industries and in politically unstable regions. As such,
while we typically rely on the expertise of the board on these important
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policy issues, we recognize that, in some instances, shareholders could benefit from increased
reporting or further codification of human rights policies.
Military and US Government Business Policies
Glass Lewis believes that disclosure to shareholders of information on key company endeavors
is important. However, we generally do not support resolutions that call for shareholder approval
of policy statements for or against government programs, most of which are subject to thorough
review by the federal government and elected officials at the national level. We also do not
support proposals favoring disclosure of information where similar disclosure is already mandated
by law, unless circumstances exist that warrant the additional disclosure.
Foreign Government Business Policies
Where a corporation operates in a foreign country, Glass Lewis believes that the company and
board should maintain sufficient controls to prevent illegal or egregious conduct with the
potential to decrease shareholder value, examples of which include bribery, money laundering,
severe environmental violations or proven human rights violations. We believe that shareholders
should hold board members, and in particular members of the audit committee and CEO, accountable
for these issues when they face reelection, as these concerns may subject the company to financial
risk. In some instances, we will support appropriately crafted shareholder proposals specifically
addressing concerns with the target firms actions outside its home jurisdiction.
Health Care Reform Principles
Health care reform in the United States has long been a contentious political issue and Glass
Lewis therefore believes firms must evaluate and mitigate the level of risk to which they may be
exposed regarding potential changes in health care legislation. Over the last several years, Glass
Lewis has reviewed multiple shareholder proposals requesting that boards adopt principles for
comprehensive health reform, such as the following based upon principles reported by the Institute
of Medicine:
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Health care coverage should be universal;
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Health care coverage should be continuous;
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Health care coverage should be affordable to individuals and families;
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The health insurance strategy should be affordable and sustainable for society; and
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Health insurance should enhance health and well-being by promoting access to high-quality care
that is effective, efficient, safe, timely, patient-centered and equitable.
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In general, Glass Lewis believes that individual corporate board rooms are not the appropriate
forum in which to address evolving and contentious national policy issues. The adoption of a narrow
set of principles could limit the boards ability to comply with new regulation or to appropriately
and flexibly respond to health care issues as they arise. As such, barring a compelling reason to
the contrary, we typically do not support the implementation of national health care reform
principles at the company level.
Tobacco
Glass Lewis recognizes the contentious nature of the production, procurement, marketing and
selling of tobacco products. We also recognize that tobacco companies are particularly susceptible
to reputational and regulatory risk due to the nature of its operations. As such, we will consider
supporting uniquely
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tailored and appropriately crafted shareholder proposals requesting increased information or the
implementation of suitably broad policies at target firms on a case-by-case basis. However, we
typically do not support proposals requesting that firms shift away from, or significantly alter,
the legal production or marketing of core products.
Reporting Contributions and Political Spending
While corporate contributions to national political parties and committees controlled by
federal officeholders are prohibited under federal law, corporations can legally donate to state
and local candidates, organizations registered under 26 USC Sec. 527 of the Internal Revenue Code
and state-level political committees. There is, however, no standardized manner in which companies
must disclose this information. As such, shareholders often must search through numerous campaign
finance reports and detailed tax documents to ascertain even limited information. Corporations also
frequently use trade associations, which are not required to report funds they receive for or spend
on political activity, as a means for corporate political action.
Further, in 2010 the Citizens United v. Federal Election Commission decision by the Supreme Court
affirmed that corporations are entitled to the same free speech laws as individuals and that it is
legal for a corporation to donate to political causes without monetary limit. While the decision
did not remove bans on direct contributions to candidates, companies are now able to contribute
indirectly, and substantially, to candidates through political organizations. Therefore, it appears
companies will enjoy greater latitude in their political actions by this recent decision.
When evaluating whether a requested report would benefit shareholders, Glass Lewis seeks answers to
the following three key questions:
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Is the Companys disclosure comprehensive and readily accessible?
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How does the Companys political expenditure policy and disclosure compare to its peers?
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What is the Companys current level of oversight?
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Glass Lewis will consider supporting a proposal seeking increased disclosure of corporate political
expenditure and contributions if the firms current disclosure is insufficient, or if the firms
disclosure is significantly lacking compared to its peers. We will also consider voting for such
proposals when there is evidence of inadequate board oversight. Given that political donations are
strategic decisions intended to increase shareholder value and have the potential to negatively
affect the company, we believe the board should either implement processes and procedures to ensure
the proper use of the funds or closely evaluate the process and procedures used by management. We
will also consider supporting such proposals when there is verification, or credible allegations,
that the company is mismanaging corporate funds through political donations. If Glass Lewis
discovers particularly egregious actions by the company, we will consider recommending voting
against the governance committee members or other responsible directors.
Animal Welfare
Glass Lewis believes that it is prudent for management to assess potential exposure to
regulatory, legal and reputational risks associated with all business practices, including those
related to animal welfare. A high profile campaign launched against a company could result in
shareholder action, a reduced customer base, protests and potentially costly litigation. However,
in general, we believe that the board and management are in the best position to determine policies
relating to the care and use of animals. As such, we will typically vote against proposals seeking
to eliminate or limit board discretion
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regarding animal welfare unless there is a clear and documented link between the boards policies
and the degradation of shareholder value.
Internet Censorship
Legal and ethical questions regarding the use and management of the Internet and the worldwide
web have been present since access was first made available to the public almost twenty years ago.
Prominent among these debates are the issues of privacy, censorship, freedom of expression and
freedom of access. Glass Lewis believes that it is prudent for management to assess its potential
exposure to risks relating to the internet management and censorship policies. As has been seen at
other firms, perceived violation of user privacy or censorship of Internet access can lead to
high-profile campaigns that could potentially result in decreased customer bases or potentially
costly litigation. In general, however, we believe that management and boards are best equipped to
deal with the evolving nature of this issue in various jurisdictions of operation.
This document sets forth the proxy voting policy and guidelines of Glass, Lewis & Co., LLC. The
policies included herein have been developed based on Glass Lewis experience with proxy voting
and corporate governance issues and are not tailored to any specific person. Moreover, these
guidelines are not intended to be exhaustive and do not include all potential voting issues. The
information included herein is reviewed periodically and updated or revised as necessary. Glass
Lewis is not responsible for any actions taken or not taken on the basis of this information. This
document may not be reproduced or distributed in any manner without the written permission of
Glass Lewis.
Copyright
© 2011 Glass, Lewis & Co., llc. All Rights Reserved.
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San Francisco, CA 94104
Tel: +1 415-678-4110
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New York
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48 Wall Street
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Tel: +1 212-797-3777
Fax: +1 212-980-4716
Australia
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261 George Street
Sydney NSW 2000
Australia
Tel: +61 2 9299 9266
Fax: +61 2 9299 1866
France
Glass Lewis International, Ltd.
27 rue Monge
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Tel: +33 9 54 88 99 10
Fax: +33 1 77 72 26 27
Switzerland
Via Pazzalino 25
6962 Lugano Viganello
Switzerland
Phone: +41 76 346 0673
Fax: +41 91 260 6182
Please direct general inquiries to info@glasslewis.com
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PROXY PAPER GUIDELINES
2011 PROXY SEASON
AN OVERVIEW OF THE GLASS LEWIS APPROACH TO INTERNATIONAL PROXY ADVICE
UNITED STATES
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Please note: Glass Lewis creates separate proxy voting policies designed specifically for each individual country.
The following is a distillation of the various country-specific policies.
Copyright 2011 Glass, Lewis & Co., LLC
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I. ELECTION OF DIRECTORS
BOARD OF DIRECTORS
Boards are put in place to represent shareholders and protect their interests. Glass Lewis
seeks boards with a proven record of protecting shareholders and delivering value over the medium-
and long-term. In our view, boards working to protect and enhance the best interests of
shareholders typically include some independent directors (the percentage will vary by local market
practice and regulations), boast a record of positive performance, have directors with diverse
backgrounds, and appoint directors with a breadth and depth of experience.
BOARD COMPOSITION
When companies disclose sufficient relevant information, we look at each individual on the
board and examine his or her relationships with the company, the companys executives and with
other board members. The purpose of this inquiry is to determine whether pre-existing personal,
familial or financial relationships are likely to impact the decisions of that board member. Where
the company does not disclose the names and backgrounds of director nominees with sufficient time
in advance of the shareholder meeting to evaluate their independence and performance, we will
consider recommending abstaining on the directors election.
We vote in favor of governance structures that will drive positive performance and enhance
shareholder value. The most crucial test of a boards commitment to the company and to its
shareholders is the performance of the board and its members. The performance of directors in their
capacity as board members and as executives of the company, when applicable, and in their roles at
other companies where they serve is critical to this evaluation.
We believe a director is independent if he or she has no material financial, familial or other
current relationships with the company, its executives or other board members except for service on
the board and standard fees paid for that service. Relationships that have existed within the
three-five years prior to the inquiry are usually considered to be current for purposes of this
test.
In our view, a director is affiliated if he or she has a material financial, familial or other
relationship with the company or its executives, but is not an employee of the company. This
includes directors whose employers have a material financial relationship with the Company. This
also includes a director who owns or controls 25% or more of the companys voting stock.
We define an inside director as one who simultaneously serves as a director and as an employee of
the company. This category may include a chairman of the board who acts as an employee of the
company or is paid as an employee of the company.
Although we typically vote for the election of directors, we will recommend voting against
directors for the following reasons:
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A director who attends less than 75% of the board and applicable committee meetings.
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A director who is also the CEO of a company where a serious restatement has occurred after the
CEO certified the pre-restatement financial statements.
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We also feel that the following conflicts of interest may hinder a directors performance and will
therefore recommend voting against a:
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CFO who presently sits on the board.
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Copyright 2011 Glass, Lewis & Co., LLC
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Director who presently sits on an excessive number of boards.
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Director, or a director whose immediate family member, provides material professional services to
the company at any time during the past five years.
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Director, or a director whose immediate family member, engages in airplane, real estate or other
similar deals, including perquisite type grants from the company.
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Director with an interlocking directorship.
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SLATE ELECTIONS
In some countries, companies elect their board members as a slate, whereby shareholders are
unable to vote on the election of each individual director, but rather are limited to voting for or
against the board as a whole. If significant issues exist concerning one or more of the nominees,
we will recommend voting against the entire slate of directors.
BOARD COMMITTEE COMPOSITION
We believe that independent directors should serve on a companys audit, compensation,
nominating and governance committees. We will support boards with such a structure and encourage
change where this is not the case.
REVIEW OF RISK MANAGEMENT CONTROLS
We believe companies, particularly financial firms, should have a dedicated risk committee, or
a committee of the board charged with risk oversight, as well as a chief risk officer who reports
directly to that committee, not to the CEO or another executive. In cases where a company has
disclosed a sizable loss or writedown, and where a reasonable analysis indicates that the companys
board-level risk committee should be held accountable for poor oversight, we would recommend that
shareholders vote against such committee members on that basis. In addition, in cases where a
company maintains a significant level of financial risk exposure but fails to disclose any explicit
form of board-level risk oversight (committee or otherwise), we will consider recommending to vote
against the chairman of the board on that basis.
CLASSIFIED BOARDS
Glass Lewis favors the repeal of staggered boards in favor of the annual election of
directors. We believe that staggered boards are less accountable to shareholders than annually
elected boards. Furthermore, we feel that the annual election of directors encourages board members
to focus on protecting the interests of shareholders.
Copyright 2011 Glass, Lewis & Co., LLC
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II. FINANCIAL REPORTING
ACCOUNTS AND REPORTS
Many countries require companies to submit the annual financial statements, director reports
and independent auditors reports to shareholders at a general meeting. Shareholder approval of
such a proposal does not discharge the board or management. We will usually recommend voting in
favor of these proposals except when there are concerns about the integrity of the
statements/reports. However, should the audited financial statements, auditors report and/or
annual report not be published at the writing of our report, we will recommend that shareholders
abstain from voting on this proposal.
INCOME ALLOCATION (DISTRIBUTION OF DIVIDEND)
In many countries, companies must submit the allocation of income for shareholder approval. We
will generally recommend voting for such a proposal. However, we will give particular scrutiny to
cases where the companys dividend payout ratio is exceptionally low or excessively high relative
to its peers and the company has not provided a satisfactory explanation. We generally recommend
abstaining from dividends with payout ratios of less than 10% or more than 200%.
APPOINTMENT OF AUDITORS AND AUTHORITY TO SET FEES
We believe that role of the auditor is crucial in protecting shareholder value. Like
directors, auditors should be free from conflicts of interest and should assiduously avoid
situations that require them to make choices between their own interests and the interests of the
shareholders.
We generally support managements recommendation regarding the selection of an auditor and support
granting the board the authority to fix auditor fees except in cases where we believe the
independence of an incumbent auditor or the integrity of the audit has been compromised.
However, we recommend voting against ratification of the auditor and/or authorizing the board to
set auditor fees for the following reasons:
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When audit fees added to audit-related fees total less than one-third of total fees.
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When there have been any recent restatements or late filings by the company where the auditor
bears some responsibility for the restatement or late filing (e.g., a restatement due to a
reporting error).
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When the company has aggressive accounting policies.
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When the company has poor disclosure or lack of transparency in financial statements.
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When there are other relationships or issues of concern with the auditor that might suggest a
conflict between the interest of the auditor and the interests of shareholders.
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When the company is changing auditors as a result of a disagreement between the company and the
auditor on a matter of accounting principles or practices, financial statement disclosure or
auditing scope or procedures.
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Copyright 2011 Glass, Lewis & Co., LLC
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III. COMPENSATION
COMPENSATION REPORT/COMPENSATION POLICY
We will usually recommend voting against approval of the compensation report or policy when
any of the following occur:
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Executives are employed without service contracts;
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Service contracts provide for notice periods longer than one year;
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Service contracts provide for the enhancement of employment terms or compensation rights in
excess of one year in the event of a change of control;
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Payments have been made or longer-term obligations entered into (including pension obligations)
to compensate an executive who has voluntary left the company and this has not been fully disclosed
and justified;
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Ex gratia or other non-contractual payments have been made and the reasons for making the
payments have not been fully explained or the explanation is unconvincing; or
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Egregious or excessive bonuses, equity awards or severance payments.
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LONG TERM INCENTIVE PLANS
Glass Lewis recognizes the value of equity-based incentive programs. When used appropriately,
they can provide a vehicle for linking an employees pay to a companys performance, thereby
aligning their interests with those of shareholders. Tying a portion of an employees compensation
to the performance of the Company provides an incentive to maximize share value. In addition,
equity-based compensation is an effective way to attract, retain and motivate key employees.
In order to allow for meaningful shareholder review, we believe that incentive programs should
generally include: (i) specific and appropriate performance goals; (ii) a maximum award pool; and
(iii) a maximum award amount per employee. In addition, the payments made should be reasonable
relative to the performance of the business and total compensation to those covered by the plan
should be in line with compensation paid by the Companys peers.
PERFORMANCE-BASED EQUITY COMPENSATION
Glass Lewis believes in performance-based equity compensation plans for senior executives. We
feel that executives should be compensated with equity when their performance and that of the
company warrants such rewards. While we do not believe that equity-based compensation plans for all
employees need to be based on overall company performance, we do support such limitations for
grants to senior executives (although even some equity-based compensation of senior executives
without performance criteria is acceptable, such as in the case of moderate incentive grants made
in an initial offer of employment).
Boards often argue that such a proposal would hinder them in attracting talent. We believe that
boards can develop a consistent, reliable approach, as boards of many companies have, that would
still attract executives who believe in their ability to guide the company to achieve its targets.
We generally recommend that shareholders vote in favor of performance-based option requirements.
Copyright 2011 Glass, Lewis & Co., LLC
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There should be no retesting of performance conditions for all share- and option- based
incentive schemes. We will generally recommend that shareholders vote against performance-based
equity compensation plans that allow for re-testing.
DIRECTOR COMPENSATION
Glass Lewis believes that non-employee directors should receive compensation for the time and
effort they spend serving on the board and its committees. In particular, we support compensation
plans that include equity-based awards, which help to align the interests of outside directors with
those of shareholders. Director fees should be reasonable in order to retain and attract qualified
individuals.
Glass Lewis compares the costs of these plans to the plans of peer companies with similar market
capitalizations in the same country to help inform its judgment on this issue.
RETIREMENT BENEFITS FOR DIRECTORS
We will typically recommend voting against proposals to grant retirement benefits to
non-executive directors. Such extended payments can impair the objectivity and independence of
these board members. Directors should receive adequate compensation for their board service through
initial and annual fees.
LIMITS ON EXECUTIVE COMPENSATION
As a general rule, Glass Lewis believes that shareholders should not be involved in setting
executive compensation. Such matters should be left to the boards compensation committee. We view
the election of directors, and specifically those who sit on the compensation committee, as the
appropriate mechanism for shareholders to express their disapproval or support of board policy on
this issue. Further, we believe that companies whose pay-for-performance is in line with their
peers should be granted the flexibility to compensate their executives in a manner that drives
growth and profit.
However, Glass Lewis favors performance-based compensation as an effective means of motivating
executives to act in the best interests of shareholders. Performance-based compensation may be
limited if a chief executives pay is capped at a low level rather than flexibly tied to the
performance of the company.
ADVISORY VOTES ON COMPENSATION
We closely review companies remuneration practices and disclosure as outlined in company
filings to evaluate management-submitted advisory compensation vote proposals. In evaluating these
proposals, which can be binding or non-binding depending on the country, we examine how well the
company has disclosed information pertinent to its compensation programs, the extent to which
overall compensation is tied to performance, the performance metrics selected by the company and
the levels of remuneration in comparison to company performance and that of its peers.
Copyright 2011 Glass, Lewis & Co., LLC
7
IV. GOVERNANCE STRUCTURE
AMENDMENTS TO THE ARTICLES OF ASSOCIATION
We will evaluate proposed amendments to a companys articles of association on a case-by-case
basis. We are opposed to the practice of bundling several amendments under a single proposal
because it prevents shareholders from evaluating each amendment on its own merits. In such cases,
we will analyze each change individually and will recommend voting for the proposal only when we
believe that the amendments are in the best interests of shareholders.
ANTI-TAKEOVER MEASURES
Poison Pills (Shareholder Rights Plans)
Glass Lewis believes that poison pill plans generally are not in the best interests of
shareholders. Specifically, they can reduce management accountability by substantially limiting
opportunities for corporate takeovers. Rights plans can thus prevent shareholders from receiving a
buy-out premium for their stock.
We believe that boards should be given wide latitude in directing the activities of the company and
charting the companys course. However, on an issue such as this where the link between the
financial interests of shareholders and their right to consider and accept buyout offers is so
substantial, we believe that shareholders should be allowed to vote on whether or not they support
such a plans implementation.
In certain limited circumstances, we will support a limited poison pill to accomplish a particular
objective, such as the closing of an important merger, or a pill that contains what we believe to
be a reasonable qualifying offer clause.
INCREASE IN AUTHORIZED SHARES
Glass Lewis believes that adequate capital stock is important to the operation of a company.
We will generally support proposals when a company could reasonably use the requested shares for
financing, stock splits and stock dividends. While we think that having adequate shares to allow
management to make quick decisions and effectively operate the business is critical, we prefer
that, for significant transactions, management come to shareholders to justify their use of
additional shares rather than providing a blank check in the form of large pools of unallocated
shares available for any purpose.
In general, we will support proposals to increase authorized shares up to 100% of the number of
shares currently authorized unless, after the increase the company would be left with less than 30
% of its authorized shares outstanding.
ISSUANCE OF SHARES
Issuing additional shares can dilute existing holders in limited circumstances. Further, the
availability of additional shares, where the board has discretion to implement a poison pill, can
often serve as a deterrent to interested suitors. Accordingly, where we find that the company has
not disclosed a detailed plan for use of the proposed shares, or where the number of shares
requested are excessive, we typically recommend against the issuance. In the case of a private
placement, we will also consider whether the company is offering a discount to its share price.
Copyright 2011 Glass, Lewis & Co., LLC
8
In general, we will support proposals to issue shares (with pre-emption rights) when the requested
increase is the lesser of (i) the unissued ordinary share capital; or (ii) a sum equal to one-third
of the issued ordinary share capital. This authority should not exceed five years. In some
countries, if the proposal contains a figure greater than one-third, the company should explain the
nature of the additional amounts.
We will also generally support proposals to suspend pre-emption rights for a maximum of 5% of the
issued ordinary share capital of the company. If the proposal contains a figure greater than 5%,
the company should provide an explanation. This authority should not exceed five years, or less for
some countries.
REPURCHASE OF SHARES
We will recommend voting in favor of a proposal to repurchase shares when the plan includes
the following provisions: (i) a maximum number of shares which may be purchased (typically not more
than 15% of the issued share capital); and (ii) a maximum price which may be paid for each share
(as a percentage of the market price).
SUPERMAJORITY VOTE REQUIREMENTS
Glass Lewis favors a simple majority voting structure. Supermajority vote requirements act as
impediments to shareholder action on ballot items that are critical to our interests. One key
example is in the takeover context where supermajority vote requirements can strongly limit
shareholders input in making decisions on such crucial matters as selling the business.
Copyright 2011 Glass, Lewis & Co., LLC
9
V. ENVIRONMENTAL AND SOCIAL RISK
We believe companies should actively evaluate risks to long-term shareholder value stemming
from exposure to environmental and social risks and should incorporate this information into their
overall business risk profile. In addition, we believe companies should consider their exposure to
changes in environmental or social regulation with respect to their operations as well as related
legal and reputational risks. Companies should disclose to shareholders both the nature and
magnitude of such risks as well as steps they have taken or will take to mitigate those risks.
When we identify situations where shareholder value is at risk, we may recommend voting in favor of
a reasonable and well-targeted shareholder proposal if we believe supporting the proposal will
promote disclosure of and/or mitigate significant risk exposure. In limited cases where a company
has failed to adequately mitigate risks stemming from environmental or social practices, we will
recommend shareholders vote against: (i) ratification of board and/or management acts; (ii)
approving a companys accounts and reports and/or; (iii) directors (in egregious cases).
Copyright 2011 Glass, Lewis & Co., LLC
10
This document sets forth the proxy voting policy and guidelines of Glass, Lewis & Co.,
LLC. The
policies included herein have been developed based on Glass Lewis experience with proxy
voting
and corporate governance issues and are not tailored to any specific person. Moreover, these
guidelines are not intended to be exhaustive and do not include all potential voting issues. The
information included herein is reviewed periodically and updated or revised as necessary. Glass
Lewis is not responsible for any actions taken or not taken on the basis of this information. This
document may not be reproduced or distributed in any manner without the written permission of
Glass Lewis.
Copyright © 2011 Glass, Lewis & Co., llc. All Rights Reserved.
San Francisco
Headquarters Glass, Lewis & Co., LLC One Sansome Street Suite 3300 San Francisco, CA 94104 Tel: +1 415-678-4110 Tel: +1 888-800-7001 Fax: +1 415-357-0200
New York
Glass, Lewis & Co., LLC 48 Wall Street 15th Floor New York, N.Y. 10005 Tel: +1 212-797-3777 Fax: +1 212-980-4716
Australia
CGI Glass Lewis Pty Limited Suite 8.01, Level 8, 261 George St Sydney NSW 2000 Australia Tel: +61 2 9299 9266 Fax: +61 2 9299 1866
Switzerland
Glass Lewis International, Ltd. Via Pazzalino 25 6962 Lugano Viganello Switzerland Phone: +41 76 346 0673 Fax: +41 91 260 6182
Please direct general inquiries to info@glasslewis.com
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PART C: OTHER INFORMATION
ITEM 28. EXHIBITS.
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(a)(1)
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Certificate of Trust, dated January 27, 2009, of Schwab Strategic Trust (the Registrant or the Trust) is
incorporated by reference to Exhibit (a)(1) of the Registrants Registration Statement, filed July 15, 2009.
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(a)(2)
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Registrants Amended and Restated Agreement and Declaration of Trust, dated October 12, 2009, is incorporated by
reference to Exhibit (a)(3) of Pre-Effective Amendment No. 2 of the Registrants Registration Statement, filed
October 27, 2009 (hereinafter referred to as Pre-Effective Amendment No. 2).
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(b)
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Registrants By-Laws, dated January 26, 2009, is incorporated by reference to Exhibit (b) of the Registrants
Registration Statement, filed July 15, 2009.
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(c)
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Reference is made to Article 5 of the Registrants Agreement and Declaration of Trust.
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(d)(1)
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Advisory Agreement between the Registrant and Charles Schwab Investment Management, Inc., dated October 12,
2009, is incorporated by reference to Exhibit (d) of Post-Effective Amendment No. 1 of the Registrants
Registration Statement, filed April 21, 2010 (hereinafter referred to as PEA No. 1).
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(d)(2)
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Amendment, dated July 26, 2010, to the Advisory Agreement between the Registrant and Charles Schwab Investment
Management, Inc., dated October 12, 2009, is incorporated by reference to Exhibit (d)(2) of Post-Effective
Amendment No. 3 of the Registrants Registration Statement, filed July 23, 2010 (hereinafter referred to as PEA
No. 3)
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(d)(3)
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Amendment, dated December 17, 2010, to the Advisory Agreement between the Registrant and Charles Schwab
Investment Management, Inc., dated October 12, 2009, is filed herewith.
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(e)(1)
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Distribution Agreement between the Registrant and SEI Investments Distribution Co. is incorporated by reference
to Exhibit (e) of PEA No. 1.
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(e)(2)
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Amendment, dated July 26, 2010, to Distribution Agreement between the Registrant and SEI Investments
Distribution Co., dated October 12, 2009, is incorporated by reference to Exhibit (e)(2) of PEA No. 3.
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(e)(3)
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Amendment, dated December 17, 2010, to Distribution Agreement between the Registrant and SEI Investments
Distribution Co., dated October 12, 2009, is filed herewith.
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(f)
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Not applicable.
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(g)(1)
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Custodian Agreement between the Registrant and State Street Bank and Trust Company, dated October 17, 2005, is
incorporated by reference to Exhibit (g)(1) of Pre-Effective Amendment No. 1 of Registrants Registration
Statement, filed October 7, 2009 (hereinafter referred to as Pre-Effective Amendment No. 1).
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(g)(2)
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Amendment, dated October 8, 2009,to the Custodian Agreement between the Registrant and State Street Bank and
Trust Company, dated October 17, 2005 is incorporated by reference to Exhibit (g)(2) of PEA No. 1.
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(g)(3)
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Amendment, dated July 26, 2010, to the Custodian Agreement between the Registrant and State Street Bank and
Trust Company, dated October 17, 2005, filed September 24, 2010 (hereafter referred to as PEA No. 4) is
incorporated by reference to Exhibit (g)(3) of PEA No. 4.
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(g)(4)
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Amendment, dated December 17, 2010, to the Custodian Agreement between the Registrant and State Street Bank and
Trust Company, dated October 17, 2005, is filed herewith.
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(h)(1)
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Administration Agreement between the Registrant and Charles Schwab Investment Management, Inc, dated October 12,
2009, is incorporated by reference to Exhibit (h)(1) of Pre-Effective Amendment No. 1.
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2
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(h)(1)(a)
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Amendment, dated July 26, 2010, to the Administration Agreement between the Registrant and Charles Schwab
Investment Management, Inc., dated October 12, 2009, is incorporated by reference to Exhibit (h)(8) of PEA No. 3
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(h)(1)(b)
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Amendment, dated December 17, 2010, to the Administration Agreement between the Registrant and Charles Schwab
Investment Management, Inc., dated October 12, 2009, is filed herewith.
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(h)(2)
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Transfer Agency Agreement between the Registrant and State Street Bank and Trust Company, dated October 8, 2009,
is incorporated by reference to Exhibit (h)(2) of Pre-Effective Amendment No. 1.
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(h)(2)(a)
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Amendment, dated July 26, 2010, to the Transfer Agency Agreement between the Registrant and State Street Bank
and Trust Company, dated October 8, 2009, filed September 24, 2010 is incorporated by reference to Exhibit
(h)(9) of PEA No. 4.
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(h)(2)(b)
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Amendment, dated December 17, 2010, to the Transfer Agency Agreement between the Registrant and State Street
Bank and Trust Company, dated October 8, 2009, is filed herewith.
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(h)(3)
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Authorized Participant Agreement is incorporated by reference to Exhibit (h)(3) of Pre-Effective Amendment No. 1.
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(h)(4)
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Master Fund Accounting and Services Agreement between the Registrant and State Street Bank and Trust Company,
dated October 1, 2005, is incorporated by reference to Exhibit (h)(4) of Pre-Effective Amendment No. 1.
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(h)(4)(a)
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Amendment, dated October 8, 2009, to the Master Fund Accounting and Services Agreement between the Registrant
and State Street Bank and Trust Company, dated October 1, 2005, is incorporated by reference to Exhibit (h)(5)
of PEA No. 1.
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(h)(4)(b)
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Amendment, dated July 26, 2010, to the Master Fund Accounting and Services Agreement between the Registrant and
State Street Bank and Trust Company, dated October 1, 2005, filed September 24, 2010 is incorporated by
reference to Exhibit (g)(10) of PEA No. 4.
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(h)(4)(c)
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Amendment, dated December 17, 2010, to the Master Fund Accounting and Services Agreement between the Registrant
and State Street Bank and Trust Company, dated October 1, 2005, is filed herewith.
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(h)(5)
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Sub-Administration Agreement between the Charles Schwab Investment Management, Inc. and State Street Bank and
Trust Company, dated October 1, 2005, is incorporated by reference to Exhibit (h)(6) of Pre-Effective Amendment
No. 1.
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(h)(5)(a)
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Amendment, dated October 8, 2009, to the Sub-Administration Agreement between the Charles Schwab Investment
Management Company, Inc. and State Street Bank and Trust Company, dated October 1, 2005, is incorporated by
reference to Exhibit (h)(7) of PEA No. 1.
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(h)(5)(b)
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Amendment, dated July 26, 2010 to the Sub-Administration Agreement between the Charles Schwab Investment
Management Company, Inc. and State Street Bank and Trust Company, dated October 1, 2005, filed September 24,
2010 is incorporated by reference to Exhibit (g)(11) of PEA No. 4.
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(h)(5)(c)
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Amendment, dated December 17, 2010, to the Sub-Administration Agreement between the Charles Schwab Investment
Management Company, Inc. and State Street Bank and Trust Company, dated October 1, 2005, is filed herewith.
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(i)
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To be filed by amendment.
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(j)(1)
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To be filed by amendment.
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(j)(2)
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Power of Attorney of Walter W. Bettinger is is incorporated by reference to Exhibit (j)(2 of Post-Effective
Amendment No. 5 of Registrants Registration Statement, filed December 8, 2010 (hereinafter referred to as PEA
No. 5)
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(j)(3)
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Power of Attorney of Robert W. Burns is is incorporated by reference to Exhibit (j)(3) of PEA No. 5.
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(j)(4)
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Power of Attorney of Charles A. Ruffel is is incorporated by reference to Exhibit (j)(4) of PEA No. 5.
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3
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(j)(5)
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Power of Attorney of Mark A. Goldfarb is is incorporated by reference to Exhibit (j)(5) of PEA No. 5.
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(j)(6)
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Power of Attorney of Marie Chandoha is is incorporated by reference to Exhibit (j)(6) of PEA No. 5.
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(j)(7)
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Power of Attorney of George Pereira is is incorporated by reference to Exhibit (j)(7) of PEA No. 5.
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(j)(8)
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Resolution Approving Power of Attorney filed September 24, 2010 is incorporated by reference to Exhibit (j)(8)
of PEA No. 4.
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(k)
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Not applicable.
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(l)
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None.
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(m)
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Not applicable.
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(n)
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Not applicable.
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(o)
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Not applicable.
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(p)(1)
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Joint Code of Ethics for the Registrant and Charles Schwab Investment Management, Inc. dated July 1, 2010 is
incorporated by reference to Exhibit (p)(1) of PEA No. 3.
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(p)(2)
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Code of Ethics of SEI Investments Distribution Co. is incorporated by reference to Exhibit (p)(2) of
Pre-Effective Amendment No. 1.
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ITEM 29. PERSONS CONTROLLED BY OR UNDER COMMON CONTROL WITH THE REGISTRANT.
Not Applicable.
ITEM 30. INDEMNIFICATION.
Reference is made to Article VII of Registrants Declaration of Trust (Exhibit (a) filed
October 27, 2009) and Article 11 of Registrants By-Laws (Exhibit (b) filed July 15, 2009).
Insofar as indemnification for liability arising under the Securities Act of 1933 may be
permitted to trustees, officers and controlling persons of the Registrant pursuant to the foregoing
provisions, or otherwise, the Registrant has been advised that in the opinion of the Securities and
Exchange Commission such indemnification is against public policy as expressed in the Act and is,
therefore, unenforceable. In the event that a claim for indemnification against such liabilities
(other than the payment by the Registrant of expenses incurred or paid by a trustee, officer or
controlling person of the Registrant in the successful defense of any action, suit or proceeding)
is asserted by such trustee, officer or controlling person in connection with the securities being
registered, the Registrant will, unless in the opinion of its counsel the matter has been settled
by controlling precedent, submit to a court of appropriate jurisdiction the question whether such
indemnification by it is against public policy as expressed in the Act and will be governed by the
final adjudication of such issue.
ITEM 31. BUSINESS AND OTHER CONNECTIONS OF INVESTMENT ADVISER.
The Registrants investment adviser, Charles Schwab Investment Management, Inc. (CSIM), a
Delaware corporation, organized in October 1989, also serves as the investment manager to Laudus
Institutional Trust, Laudus Trust, Schwab Capital Trust, The Charles Schwab Family of Funds, Schwab
Investments, and Schwab Annuity Portfolios, each an open-end, management investment company. The
principal place of business of the investment adviser is 211 Main Street, San Francisco, CA 94105.
The only business in which the investment adviser engages is that of investment adviser and
administrator to Schwab Capital Trust, The Charles Schwab Family of Funds, Schwab Investments,
Schwab Annuity Portfolios and any other investment companies that Schwab may sponsor in the future,
investment adviser to the Registrant, Laudus Trust and Laudus Institutional Trust and an investment
adviser to certain non-investment company clients.
4
The business, profession, vocation or employment of a substantial nature in which each
director and/or senior or executive officer of CSIM is or has been engaged during the past two
fiscal years is listed below. The name of any company for which any director and/or senior or
executive officer of the investment adviser serves as director, officer, employee, partner or
trustee is also listed below.
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Name and Position with Adviser
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Name of Other Company
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Capacity
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Charles R. Schwab, Chairman and Director
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Charles Schwab & Co., Inc.
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Chairman and Director
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The Charles Schwab Bank, N.A.
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Chairman, Director
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The Charles Schwab Corporation
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Chairman
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Schwab Holdings, Inc.
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Chief Executive Officer
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Schwab International Holdings, Inc.
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Chairman and Chief Executive Officer
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Schwab (SIS) Holdings, Inc. I
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Chairman and Chief Executive Officer
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Charles Schwab Holdings (UK)
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Chairman
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United States Trust Company of New York
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Chairman, Director
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All Kinds of Minds
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Director
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Charles and Helen Schwab Foundation
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Director
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Stanford University
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Trustee
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Marie Chandoha, Director, President and
Chief Executive Officer
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Charles Schwab & Co., Inc.
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Executive Vice President and President,
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Investment Management Services
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Schwab Funds
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President, Chief Executive Officer
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Laudus Funds
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President, Chief Executive Officer
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Schwab ETFs
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President, Chief Executive Officer
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Charles Schwab Worldwide Funds, PLC
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Director
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Charles Schwab Asset Management
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Director
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(Ireland) Limited
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David Lekich, Acting Chief Counsel and Vice
President
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Charles Schwab & Co., Inc.
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Vice President and Associate General
Counsel
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Schwab ETFs
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Assistant Secretary
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Michael Hogan, Chief Compliance Officer
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Schwab Funds
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Chief Compliance Officer
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Schwab ETFs
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Chief Compliance Officer
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Laudus Funds
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Chief Compliance Officer
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Charles Schwab & Co., Inc.
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Senior Vice President and Chief
Compliance Officer
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George Pereira, Senior Vice President, Chief
Financial Officer and Chief Operating
Officer
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Schwab Funds
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Treasurer and Principal Financial Officer
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Laudus Funds
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Treasurer and Chief Financial Officer
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Schwab ETFs
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Treasurer and Principal Financial Officer
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Mutual Fund Division, UST Advisers, Inc.
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Chief Financial Officer
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Charles Schwab Worldwide Funds, PLC
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Director
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Charles Schwab Asset Management
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Director
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(Ireland) Limited
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ITEM 32. PRINCIPAL UNDERWRITERS:
(a) SEI Investments Distribution Co. (the Distributor) is the principal underwriter of the Trust.
(b) Information with respect to each director, officer or partner of each principal underwriter is
as follows. Unless otherwise noted, the business address of each director or officer is 1 Freedom
Valley Drive, Oaks, PA 19456.
5
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Positions and Offices
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Name
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Position and Office with Underwriter
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with Registrant
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William M. Doran
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Director
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None
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Edward D. Loughlin
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Director
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None
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Wayne M. Withrow
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Director
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None
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Kevin Barr
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President & Chief Executive Officer
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None
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Maxine Chou
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Chief Financial Officer, Chief
Operations Officer, &Treasurer
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None
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Karen LaTourette
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Chief Compliance Officer,
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None
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Anti-Money Laundering Officer &
Assistant Secretary
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John C. Munch
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General Counsel & Secretary
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None
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Mark J. Held
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Senior Vice President
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None
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Lori L. White
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Vice President &Assistant Secretary
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None
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John Coary
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Vice President & Assistant Secretary
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None
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John Cronin
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Vice President
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None
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Robert Silvestri
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Vice President
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None
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(5) © None.
ITEM 33. LOCATION OF ACCOUNTS AND RECORDS.
All accounts, books and other documents required to be maintained by Section 31(a) of the 1940
Act, as amended, and the Rules thereunder will be maintained at the offices of:
1) Schwab Strategic Trust, 211 Main Street, San Francisco, CA 94105
2) Charles Schwab Investment Management, Inc., 211 Main Street, San Francisco, CA 94105
3) Principal Underwriter SEI Investments Distribution Co., 1 Freedom Valley Drive, Oaks, PA
19456
4) Custodian State Street Bank and Trust Company, One Lincoln Street, Boston, MA 02111
5) Transfer Agent State Street Bank and Trust Company, One Lincoln Street, Boston, MA 02111
ITEM 34. MANAGEMENT SERVICES.
None.
ITEM 35. UNDERTAKINGS.
Not applicable.
6
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, as amended (the 1933 Act), and
the Investment Company Act of 1940, as amended, Registrant has duly caused this Post Effective
Amendment No. 7 to be signed on its behalf by the undersigned, thereto duly authorized, in the City
of San Francisco, State of California, on this 14th day of April, 2011.
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SCHWAB STRATEGIC TRUST
Registrant
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Marie Chandoha*
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Marie Chandoha,
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President and Chief Executive Officer
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Pursuant to the requirements of the 1933 Act, this Post-Effective Amendment No. 7 to
Registrants Registration Statement on Form N-1A has been signed below by the following persons in
the capacities indicated this 14th day of April, 2011.
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Signature
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Title
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Walter W. Bettinger, II*
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Chairman and Trustee
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|
Robert W. Burns*
|
|
Trustee
|
|
|
|
|
|
|
Mark A. Goldfarb*
|
|
Trustee
|
|
|
|
|
|
|
Charles A. Ruffel*
|
|
Trustee
|
|
|
|
|
|
|
Marie Chandoha*
|
|
President and Chief Executive Officer
|
|
|
|
|
|
|
George Pereira*
|
|
Treasurer and Principal Financial Officer
|
|
|
|
|
|
|
|
|
*By:
|
|
/s/ Douglas P. Dick
|
|
|
|
|
Douglas P. Dick, Attorney-in-Fact
|
|
|
|
|
Pursuant to Power of Attorney
|
|
|
EXHIBIT INDEX
|
|
|
|
(d)(3)
|
|
Amendment to the Advisory Agreement
|
|
|
|
|
|
(e)(3)
|
|
Amendment to Distribution Agreement
|
|
|
|
|
|
(g)(4)
|
|
Amendment to the Custodian Agreement
|
|
|
|
|
|
(h)(1)(b)
|
|
Amendment to the Administration Agreement
|
|
|
|
|
|
(h)(2)(b)
|
|
Amendment to the Transfer Agency Agreement
|
|
|
|
|
|
(h)(4)(c)
|
|
Amendment to the Master Fund Accounting and Services Agreement
|
|
|
|
|
|
(h)(5)(c)
|
|
Amendment to the Sub-Administration Agreement
|
|
7