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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
Annual Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the year ended December 31, 1998
Commission File Number 0-22491
SMITH BARNEY DIVERSIFIED FUTURES FUND L.P. II
(Exact name of registrant as specified in its charter)
New York 13-3769020
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
c/o Smith Barney Futures Management Inc.
390 Greenwich St. - 1st Fl.
New York, New York 10013
(Address and Zip Code of principal executive offices)
(212) 723-5424
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Units of
Limited
Partnership
Interest
(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
form 10-K [X]
As of February 28, 1999 Limited Partnership Units with an aggregate value of
$1,201.32 were outstanding and held by non-affiliates.
DOCUMENTS INCORPORTED BY REFERENCE
Supplements dated February 1, 1998 and April 30, 1998 to Prospectus dated April
30, 1997.
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PART I
Item 1. Business.
(a) General development of business. Smith Barney Diversified Futures
Fund L.P. II ("Partnership") is a limited partnership organized on May 10, 1994
under the Partnership laws of the State of New York. The Partnership commenced
trading operations on January 17, 1996. The Partnership engages in speculative
trading of commodity interests, including forward contracts on foreign
currencies, commodity options and commodity futures contracts and other
financial instruments, foreign currencies and stock indices.
A Registration Statement on Form S-1 relating to the public offering
became effective on August 21, 1995. Beginning August 21, 1995, 100,000 Units of
Limited Partnership Interest ("Units") were publicly offered at $1,000 per Unit
for a period of ninety days, subject to increase for up to an additional sixty
days at the sole discretion of the General Partner. Between August 21, 1995
(commencement of the offering period) and January 16, 1996, 8,529 Units were
sold at $1,000 per Unit. Proceeds of the offering were held in an escrow account
and were transferred, along with the General Partner's contribution of $87,000
to the Partnership's trading account on January 17, 1996 when the Partnership
commenced trading. Sales of additional Units and additional General Partner's
contributions and redemptions of Units for the year ended December 31, 1998 are
reported in the Statement of Partners' Capital on page F-6 under "Item 8.
Financial Statements and Supplementary Data." The General Partner has agreed to
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make capital contributions, if necessary, so that its general partnership
interest will be equal to the greater of (i) an amount to entitle it to 1% of
each material item of Partnership income, loss, deduction or credit and (ii) the
greater of (a) 1% of the partners' contributions to the Partnership or (b)
$25,000. The Partnership will be liquidated upon the first of the following to
occur: December 31, 2014; the net asset value of a Unit decreases to less than
$400 as of the close of any business day; or under certain circumstances as
defined in the Limited Partnership Agreement of the Partnership (the "Limited
Partnership Agreement"). Smith Barney Futures Management Inc. acts as the
general partner (the "General Partner") of the Partnership. On September 1,
1998, the Partnership's commodity broker, Smith Barney Inc., merged with Salomon
Brothers Inc and changed its name to Salomon Smith Barney Inc. ("SSB"). SSB is
an affiliate of the General Partner. The General Partner is wholly owned by
Salomon Smith Barney Holdings, Inc. ("SSBH"), which is the sole owner of SSB. On
October 8, 1998, Travelers Group Inc. merged with Citicorp Inc. and changed its
name to Citigroup Inc. SSBH is a wholly owned subsidiary of Citigroup Inc.
The Partnership's trading of futures contracts on commodities is done
primarily on United States and foreign commodity exchanges. It engages in such
trading through a commodity brokerage account maintained with SSB.
As of December 31, 1998, all commodity trading decisions are made for the
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Partnership by John W. Henry & Company, Inc. ("JWH"), Millburn Ridgefield
Corporation, Campbell and Company Inc., Willowbridge Associates Inc. and ARA
Portfolio Management Company, L.L.C. (collectively, the "Advisors"). None of the
Advisors is affiliated with the General Partner or SSB. The Advisors are not
responsible for the organization or operation of the Partnership. Chesapeake
Capital Corporation was terminated as an Advisor to the Partnership on January
31, 1998. Campbell & Co. Inc. was added as an Advisor on February 1, 1998.
Pursuant to the terms of the Management Agreements (the "Management
Agreements"), the Partnership is obligated to pay each Advisor: (i) a monthly
management fee equal to 1/6 of 1% (2% per year) of month-end Net Assets (except
that JWH will receive a monthly management fee equal to 1/3 of 1% (4% per year))
of the Partnership allocated to each Advisor as of the end of each month and
(ii) an incentive fee payable quarterly, equal to 20% of the New Trading Profits
(except JWH, which will receive an incentive fee of 15% of New Trading Profits)
(as defined in the Management Agreements) of the Partnership.
The Partnership has entered into a Customer Agreement with SSB (the
"Customer Agreement") which provides that the Partnership will pay SSB a monthly
brokerage fee equal to 2 of 1% of month-end Net Assets allocated to the Advisors
(6% per year) in lieu of brokerage commissions on a per trade basis. SSB also
pays a portion of its brokerage fees to its financial consultants who have sold
Units and who are registered as associated persons with the Commodity Futures
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Trading Commission (the "CFTC"). The Partnership pays for National Futures
Association ("NFA") fees, exchange and clearing fees, give-up and user fees and
floor brokerage fees. Brokerage fees will be paid for the life of the
Partnership, although the rate at which such fees are paid may be changed. The
Customer Agreement between the Partnership and SSB gives the Partnership the
legal right to net unrealized gains and losses.
In addition, SSB pays the Partnership interest on 80% of the average
daily equity maintained in cash in its account during each month at a 30-day
U.S. Treasury bill rate determined weekly by SSB based on the average
non-competitive yield on 3-month U.S. Treasury bills maturing in 30 days from
the date on which such weekly rate is determined. However, SSB began paying
interest to the Partnership only after the amount of interest accrued equaled
the total amount of offering and organizational expenses paid by SSB in
connection with the Partnership's offering plus interest at the prime rate
quoted by The Chase Manhattan Bank.
(b) Financial information about industry segments. The Partnership's
business consists of only one segment, speculative trading of commodity
interests (including, but not limited to, futures contracts, options and forward
contracts on U.S. Treasury Bills, other financial instruments, foreign
currencies, stock indices and physical commodities). The Partnership does not
engage in sales of goods or services. The Partnership's net income (loss) from
operations for the years ended December 31, 1998 and 1997 and for the period
from January 17, 1996 (commencement of trading operations) to December 31, 1996
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is set forth under "Item 6. Selected Financial Data." The Partnership capital as
of December 31, 1998, was $151,797,782.
(c) Narrative description of business.
See Paragraphs (a) and (b) above.
(i) through (x) - Not applicable.
(xi) through (xii) - Not applicable.
(xiii) - The Partnership has no employees.
(d) Financial Information About Foreign and Domestic Operations and
Export Sales. The Partnership does not engage in sales of goods or services, and
therefore this item is not applicable.
Item 2. Properties.
The Partnership does not own or lease any properties. The General
Partner operates out of facilities provided by its affiliate, SSB.
Item 3. Legal Proceedings.
There are no material legal proceedings pending against the Partnership
or the General Partner.
This section describes the major legal proceedings, other than ordinary
routine litigation incidental to the business, to which SSBH, the parent company
of this General Partner or its subsidiaries is a party or to which any of their
property is subject.
In September 1992, Harris Trust and Savings Bank (as trustee for
Ameritech Pension Trust ("APT"), Ameritech Corporation, and an officer of
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Ameritech filed suit against Salomon Brothers Inc. ("SBI") and Salomon Brothers
Realty Corporation ("SBRC") in the U.S. District Court for the Northern District
of Illinois (Harris Trust Savings Bank, not individually but solely as trustee
for the Ameritech Pension Trust, Ameritech Corporation and John A. Edwardson v.
Salomon Brothers Inc and Salomon Brothers Realty Corp.). The second amended
complaint alleges that three purchases by APT from defendants of participation
interests in net cash flow or resale proceeds of three portfolios of motels
owned by Motels of America, Inc. ("MOA"), as well as a fourth purchase by APT of
a similar participation interest with respect to a portfolio of motels owned by
Best Inns, Inc. ("Best"), violated the Employee Retirement Income Security Act
("ERISA"), and that the purchase of the participation interests for the third
MOA portfolio and for the Best portfolio violated the Racketeer Influenced and
Corrupt Organization Act ("RICO") and state law. SBI had acquired the
participation interests in transactions in which it purchased as principal
mortgage notes issued by MOA and Best to finance purchases of motel portfolios;
95% of three such interests and 100% of one such interest were sold to APT for
purchase prices aggregating approximately $20.9 million. Plaintiffs' second
amended complaint seeks (a) judgment on the ERISA claims for the purchase prices
of the four participation interests (approximately $20.9 million), for
rescission and for disgorgement of profits, as well as other relief, and (b)
judgment on the claims brought under RICO and state law in the amount of $12.3
million, with damages trebled to $37 million on the RICO claims and punitive
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damages in excess of $37 million on certain of the state law claims as well as
other relief. The court dismissed the RICO, breach of contract, and unjust
enrichment claims. The court also found that defendants did not qualify as an
ERISA fiduciary and dismissed the claims based on that allegation. Defendants
moved for summary judgment on the sole remaining claim. The motion was denied,
and defendants appealed to the U.S. Court of Appeals for the Seventh Circuit.
Defendants are awaiting a decision.
Both the Department of Labor and the Internal Revenue Service have
advised SBI that they were or are reviewing the transactions in which APT
acquired such participation interests. With respect to the Internal Revenue
Service review, SSBH, SBI and SBRC have consented to extensions of time for the
assessment of excise taxes that may be claimed to be due with respect to the
transactions for the years 1987, 1988 and 1989. In August 1996, the IRS sent
SSBH, SBI and SBRC what appeared to be draft "30-day letters" with respect to
the transactions and SSBH, SBI and SBRC were given an opportunity to comment on
whether the IRS should issue 30-day letters, which would actually commence the
assessment process. In October 1996, SSBH, SBI and SBRC submitted a memorandum
setting forth reasons why the IRS should not issue 30-day letters with respect
to the transactions.
In December 1996, a complaint seeking unspecified monetary damages
was filed by Orange County, California against numerous brokerage firms,
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including Smith Barney, in the U.S. Bankruptcy Court for the Central District of
California (County of Orange et al. v. Bear Stearns & Co. Inc. et al.).
Plaintiff alleges, among other things, that defendants recommended and sold to
plaintiff unsuitable securities and that such transactions were outside the
scope of plaintiff's statutory and constitutional authority (ultra vires).
Defendants' motion for summary judgment was granted with respect to the ultra
vires claims in February 1999. The court allowed the filing of an amended
complaint asserting claims based on alleged breaches of fiduciary duty.
In June 1998, complaints were filed in the U.S. District Court for the
Eastern District of Louisiana in two actions (Board of Liquidations, City Debt
of the City of New Orleans v. Smith Barney Inc. et ano. and The City of New
Orleans v. Smith Barney Inc. et ano.), in which the City of New Orleans seeks a
declaratory judgment that Smith Barney Inc. and another underwriter are
responsible for any damages that the City may incur in the event the Internal
Revenue Service denies tax exempt status to the City's General Obligation
Refunding Bonds Series 1991. The Company filed a motion to dismiss the
complaints in September 1998, and the complaints were subsequently amended. The
Company has filed a motion to dismiss the amended complaints.
In November 1998, a purported class action complaint was filed in the
United States District Court for the Middle District of Florida (Dwight Brock as
Clerk for Collier County v. Merrill Lynch, et al.). The complaint alleges that,
pursuant to a nationwide conspiracy, 17 broker-dealer defendants, including SSB,
charged excessive mark-ups in connection with advanced refunding transactions.
The Company intends to contest this complaint vigorously.
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Environmental Matters
In July 1996, the City and County of Denver ("Denver") enacted an
ordinance imposing a substantial fee on any radioactive waste or
radium-contaminated material disposed of in the City of Denver. Under this
ordinance, Denver assessed a subsidiary of Salomon, the S.W. Shattuck Chemical
Company, Inc. ("Shattuck"), $9.35 million for certain disposal already carried
out. Shattuck sued to enjoin imposition of the fee on constitutional grounds.
The United States also sued, seeking to enjoin imposition of the fee on
constitutional grounds. Denver counterclaimed and moved to add SSBH as a
defendant for past costs. These cases have been consolidated before the U.S.
District Court in Colorado, which granted Shattuck's motion for a preliminary
injunction enjoining Denver from enforcing the ordinance during the pendency of
the litigation. The parties have reached a settlement.
The Company and various subsidiaries have also been named as defendants
in various matters incident to and typical of the businesses in which they are
engaged. These include numerous civil actions, arbitration proceedings and other
matters in which the Company's broker-dealer subsidiaries have been named,
arising in the normal course of business out of activities as a broker and
dealer in securities, as an underwriter of securities, as an investment banker
or otherwise. In the opinion of the Company's management, none of these actions
is expected to have a material adverse effect on the consolidated financial
condition of the Company and its subsidiaries.
Item 4. Submission of Matters to a Vote of Security Holders.
There were no matters submitted to the security holders for a vote
during the last fiscal year covered by this report.
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PART II
Item 5. Market for Registrant's Common Equity and Related Security Holder
Matters.
(a) Market Information. The Partnership has issued no stock.
There is no public market for the Units of Limited
Partnership Interest.
(b) Holders. The number of holders of Units of Limited
Partnership Interest as of December 31, 1998 was 5,887.
(c) Distribution. The Partnership did not declare a
distribution in 1998 or 1997.
(d) Use of Proceeds. For the twelve months ended December
31, 1998, there were additional sales of 38,309.9229
Units totaling $42,074,000 and contributions by the
General Partner representing 283.5082 Unit equivalents
totaling $311,000. Proceeds from the sale of additional
Units are used in the trading of commodity interest
including futures contracts,options and forward contracts.
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Item 6. Selected Financial Data. The Partnership commenced trading operations on
January 17, 1996. Realized and unrealized trading gains (losses), interest
income, net income (loss) and increase (decrease) in net asset value per Unit
for the years ended December 31, 1998 and 1997 and for the period from January
17, 1996 (commencement of trading operations) to December 31, 1996 and total
assets at December 31, 1998, 1997 and 1996 were as follows:
1998 1997 1996
------------- ------------- -------------
Realized and unrealized trading
gains (losses) net of brokerage
commissions and clearing fees
of $8,891,659, $6,257,856 and
$2,169,468, respectively $ 14,064,160 $ (461,654) $ 8,869,618
Interest income 4,818,279 3,634,245 1,190,687
------------- ------------- -------------
$ 18,882,439 $ 3,172,591 $ 10,060,305
============= ============= =============
Net Income (loss) $ 12,979,536 $ (313,824) $ 7,582,653
============= ============= =============
Increase (decrease) in net asset
value per unit $ 95.43 $ (1.30) $ 185.99
============= ============= =============
Total assets $ 154,692,651 $ 113,547,434 $ 56,960,922
============= ============= =============
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
(a) Liquidity. The Partnership does not engage in sales of goods or
services. Its only assets are its equity in its commodity futures trading
account, consisting of cash and cash equivalents, net unrealized appreciation
(depreciation) on open futures contracts and interest receivable. Because of the
low margin deposits normally required in commodity futures trading, relatively
small price movements may result in substantial losses to the Partnership. Such
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substantial losses could lead to a material decrease in liquidity. To minimize
this risk, the Partnership will follow certain policies including:
(1) Partnership funds are invested only in futures contracts which
are traded in sufficient volume to permit, in the opinion of the Advisors, ease
of taking and liquidating positions.
(2) The Partnership will not permit the churning of its commodity
trading accounts.
(3) No Advisor initiates additional positions in any commodity if
such additional positions would result in aggregate positions for all
commodities requiring as margin more than 66-2/3% of the Partnership's assets
allocated to the Advisor.
(4) The Partnership will not employ the trading technique commonly
known as "pyramiding", in which the speculator uses unrealized profits on
existing positions as margin for the purchase or sale of additional positions in
the same or related commodities.
(5) The Partnership will not utilize borrowing except short-term
borrowing if the Partnership takes delivery of any cash commodities.
(6) The Advisor may, from time to time, employ trading strategies
such as spread or straddles on behalf of the Partnership. The term "spread" or
"straddle" describes a commodity futures trading strategy involving the
simultaneous buying and selling of futures contracts on the same commodity but
involving different delivery dates or markets and in which the trader expects to
earn a profit from a widening or narrowing of the difference between the prices
of the two contracts.
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The Partnership is party to financial instruments with off-balance
sheet risk, including derivative financial instruments and derivative commodity
instruments, in the normal course of its business. These financial instruments
include forwards, futures and options, whose value is based upon an underlying
asset, index, or reference rate, and generally represent future commitments to
exchange currencies or cash flows, or to purchase or sell other financial
instruments at specified terms at specified future dates. Each of these
instruments is subject to various risks similar to those relating to the
underlying financial instruments including market and credit risk. The General
Partner monitors and controls the Partnership's risk exposure on a daily basis
through financial, credit and risk management monitoring systems and,
accordingly believes that it has effective procedures for evaluating and
limiting the credit and market risks to which the Partnership is subject. (See
also Item 8. Financial Statements and Supplementary Data., for further
information on financial instrument risk included in the notes to financial
statements.)
Other than the risks inherent in commodity futures trading, the
Partnership knows of no trends demands, commitments, events or uncertainties
which will result in or which are reasonably likely to result in the
Partnership's liquidity increasing or decreasing in any material way. The
Limited Partnership Agreement provides that the General Partner may, at its
discretion, cause the Partnership to cease trading operations and liquidate all
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open positions upon the first to occur of the following: (i) December 31, 2014;
(ii) the vote dissolve the Partnership by limited partners owning more than 50%
of the Units; (iii) assignment by the General Partner of all of its interest in
the Partnership or withdrawal, removal, bankruptcy or any other event that
causes the General Partner to cease to be a general partner under the New York
Revised Limited Partnership Act unless the Partnership is continued as described
in the Limited Partnership Agreement; (iv) Net Asset Value per Unit falls to
less than $400 as of the end of any trading day; or (v) the occurrence of any
event which shall make it unlawful for the existence of the Partnership to be
continued.
(b) Capital resources. (i) The Partnership has made no material
commitments for capital expenditures.
(ii) The Partnership's capital consists of the capital
contributions of the partners as increased or decreased by gains or losses on
commodity trading, and by expenses, interest income, redemptions of Units and
distributions of profits, if any. Gains or losses on commodity futures trading
cannot be predicted. Market moves in commodities are dependent upon fundamental
and technical factors which the Partnership may or may not be able to identify.
Partnership expenses will consist of, among other things, commissions,
management fees and incentive fees. The level of these expenses is dependent
upon the level of trading gains or losses and the ability of the Advisors to
identify and take advantage of price movements in the commodity markets, in
addition to the level of net assets maintained. In addition, the amount of
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interest income payable by SSB is dependent upon interest rates over which the
Partnership has no control.
No forecast can be made as to the level of redemptions in any given
period. Beginning June 30, 1996 a Limited Partner may cause all of his Units to
be redeemed by the Partnership at the Net Asset Value thereof as of the last day
of each month on ten days' written notice to the General Partner. No fee will be
charged for redemptions. For the year ended December 31, 1998, 13,377.6641 Units
were redeemed totaling 15,146,446. For the year ended December 31, 1997,
11,519.2474 Units were redeemed totaling $12,684,088. For the period ended
December 31, 1996, 1,911.1385 Units were redeemed totaling $1,968,649.
The Partnership ceased to offer Units effective March 1, 1998. For
the year ended December 31, 1998, there were additional sales of 38,309.9229
Units totaling $42,074,000 and contributions by the General Partner representing
283.5082 Units equivalents totaling $311,000. For the year ended December 31,
1997, there were additional sales of 61,154.0723 Units totaling $68,708,600 and
contributions by the General Partner representing 505.8725 Unit equivalents
totaling $571,000. For the period ended December 31, 1996, there were additional
sales of 42,034.2002 Units totaling $41,190,000 and contributions by the General
Partner representing 411.0108 Unit equivalents totaling $402,000.
(c) Results of Operations. For the year ended December 31, 1998 the
net asset value per Unit increased 8.5% from $1,123.76 to $1,219.19. For the
year ended December 31, 1997, the net asset value per Unit decreased 0.1% from
$1,125.06 to $1,123.76. For the period from January 17, 1996 (commencement of
trading operations) to December 31, 1996, the net asset value per Unit increased
19.8% from $939.07 to $1,125.06. The net asset value of $939.07 at commencement
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of trading operations is reflective of charging offering and organizational
expenses against the initial capital of the Partnership for financial reporting
purposes.
The Partnership experienced net trading gains of $22,955,819 before
commissions and expenses in 1998. These gains were primarily attributable to
trading in currencies, U.S. and non-U.S. interest rate products and livestock
and were partially offset by losses in grains, metals, softs and indices.
The Partnership experienced net trading gains of $5,796,202 before
commissions and expenses in 1997. These gains were primarily attributable to the
trading of U.S. and non-U.S. interest rates, metals, indices and foreign
currencies. However, these trading gains were partially offset by losses
experienced in the trading of energy, grains, livestock and softs.
The Partnership experienced net trading gains of $11,039,086 before
commissions and expenses in 1996. These gains were primarily attributable to
gains incurred in the trading of interest rates, metals, energy and foreign
currencies. However, these trading gains were partially offset by losses
experienced in the trading of stock indices and agricultural commodity futures.
Commodity futures markets are highly volatile. Broad price
fluctuations and rapid inflation increase the risks involved in commodity
trading, but also increase the possibility of profit. The profitability of the
Partnership depends on the existence of major price trends and the ability of
the Advisors to identify those price trends correctly. Price trends are
influenced by, among other things, changing supply and demand relationships,
weather, governmental, agricultural, commercial and trade programs and policies,
national and international political and economic events and changes in interest
rates. To the extent that market trends exist and the Advisors are able to
identify them, the Partnership expects to increase capital through operations.
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(d) Operational Risk
The Company is directly exposed to market risk and credit
risk, which arise in the normal course of its business activities. Slightly less
direct, but of critical importance, are risks pertaining to operational and back
office support. This is particularly the case in a rapidly changing and
increasingly global environment with increasing transaction volumes and an
expansion in the number and complexity of products in the marketplace. Such
risks include: Operational/Settlement Risk - the risk of financial and
opportunity loss and legal liability attributable to operational problems, such
as inaccurate pricing of transactions, untimely trade execution, clearance
and/or settlement, or the inability to process large volumes of transactions.
The Company is subject to increased risks with respect to its trading activities
in emerging market securities, where clearance, settlement, and custodial risks
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are often greater than in more established markets.
Technological Risk - the risk of loss attributable to technological limitations
or hardware failure that constrain the Company's ability to gather, process, and
communicate information efficiently and securely, without interruption, with
customers, among units within the Company, and in the markets where the Company
participates.
Legal/Documentation Risk - the risk of loss attributable to deficiencies in the
documentation of transactions (such as trade confirmations) and customer
relationships (such as master netting agreements) or errors that result in
noncompliance with applicable legal and regulatory requirements.
Financial Control Risk - the risk of loss attributable to limitations in
financial systems and controls. Strong financial systems and controls ensure
that assets are safeguarded, that transactions are executed in accordance with
management's authorization, and that financial information utilized by
management and communicated to external parties, including the Company's
stockholder, creditors, and regulators, is free of material errors.
Risk of Computer System Failure (Year 2000 Issue)
The Year 2000 issue is the result of existing computers in
many businesses using only two digits to identify a year in the date field.
These computers and programs, often referred to as "information technology,"
were designed and developed without considering the impact of the upcoming
change in the century. If not corrected, many computer applications could fail
or create erroneous results at the Year 2000. Such systems and processes are
dependent on correctly identifying dates in the next century.
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The General Partner administers the business of the
Partnership through various systems and processes maintained by SSBH and SSB. In
addition, the operation of the Partnership is dependent on the capability of the
Partnership's Advisors, the brokers and exchanges through which the Advisors
trade, and other third parties to prepare adequately for the Year 2000 impact on
their systems and processes. The Partnership itself has no systems or
information technology applications relevant to its operations.
The General Partner, SSB, SSBH and their parent organization
Citigroup Inc. have undertaken a comprehensive, firm-wide evaluation of both
internal and external systems (systems related to third parties) to determine
the specific modifications needed to prepare for the year 2000. The combined
Year 2000 program in SSB is expected to cost approximately $140 million over the
four years from 1996 through 1999, and involve over 450 people at the peak
staffing level. SSB expects to complete all compliance and certification work by
June 1999. At this time, over 95% of SSBH systems have completed the correction
process and are Year 2000 compliant. Over 73% of the systems have completed
certification testing. The Year 2000 project at SSBH remains on schedule.
The systems and components supporting the General Partner's
business that require remediation have been identified and modifications have
been made to bring them into Year 2000 compliance. Testing of these systems was
20
completed in the fourth quarter of 1998. Final testing and certification are
expected to be completed by the end of the first quarter of 1999.
This expenditure and the General Partner's resources dedicated
to the preparation for Year 2000 do not and will not have a material impact on
the operation or results of the Partnership.
The General Partner has requested and received statements from
the Advisors that each has undertaken its own evaluation and remediation plans
to identify any of its computer systems that are Year 2000 vulnerable. Each
Advisor has confirmed it is taking immediate actions to remedy those systems as
necessary. The General Partner will continue to inquire into and to confirm each
Advisor's readiness for Year 2000.
The most likely and most significant risk to the Partnership
associated with the lack of Year 2000 readiness is the failure of outside
organizations, including the commodities exchanges, clearing organizations, or
regulators with which the Partnership interacts to resolve their Year 2000
issues in a timely manner. This risk could involve the inability to determine
the value of the Partnership at some point in time and would make effecting
purchases or redemptions of Units in the Partnership infeasible until such
valuation was determinable.
SSB has successfully participated in industry-wide testing
including: The Streetwide Beta Testing organized by the Securities Industry
Association (SIA), a government securities clearing test with the Federal
Reserve Bank of New York, The Depository Trust Company, and The Bank of new
York, and Futures Industry Association participants test. The firm is also
21
participating in the streetwide testing which commenced in March 1999.
It is possible that problems may occur that would require some
time to repair. Moreover, it is possible that problems will occur outside SSBH
for which SSBH could experience a secondary effect. Consequently, SSBH is
preparing comprehensive, written contingency plans so that alternative
procedures and a framework for critical decisions are defined before any
potential crisis occurs.
The goal of Year 2000 contingency planning is a set of
alternate procedures to be used in the event of a critical system failure or a
failure by a supplier or counterparty. Planning work was completed in December
1998, and testing of alternative procedures will be conducted in the first half
of 1999.
European Economic and Monetary Union
European Economic and Monetary Union ("EMU") is an historic event in
Europe involving the unification of currency in eleven major countries. The new
unified currency, called the Euro, is expected to compete on a global scale with
the U.S. Dollar and the Japanese Yen. Introduction of the Euro began on January
1, 1999, when the European Central Bank assumed control of the monetary policy
for participating nations. Exchange rates between the participating countries
were fixed and the Euro is available for electronic payments. Also on January 1,
1999, various issuers re-denominated their securities and harmonized bond
payment conventions. A three-year transition period began on January 1, 1999,
after which Euro notes and coins will be issued by the European Central Bank and
national currencies will be phased out. 22
The Company completed a successful conversion to the Euro and
has commenced trading and settlement in the new currency with no major
exceptions.
As the preceding risks are largely interrelated, so are the
Company's actions to mitigate and manage them. The Company's Chief
Administrative Officer is responsible for, among other things, oversight of
global operations and technology. An essential element in mitigating the risks
noted above is the optimization of information technology and the ability to
manage and implement change. To be an effective competitor in an
information-driven business of a global nature requires the development of
global systems and databases that ensure increased and more timely access to
reliable data.
(e) New Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board issued SFAS 133,
Accounting for Derivative Instruments and Hedging Activities ("SFAS 133"). SFAS
133 requires that an entity recognize all derivatives in the statement of
financial condition and measure those instruments at fair value. SFAS 133 is
effective for fiscal year beginning after June 15, 1999 SFAS 133 is expected to
have no material impact on the financial statements of the Partnership as all
commodity interests are recorded at fair value, with changes therein reported in
the statement of income and expenses.
23
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Introduction
The Partnership is a speculative commodity pool. The market sensitive
instruments held by it are acquired for speculative trading purposes, and all or
substantially all of the Partnership's assets are subject to the risk of trading
loss. Unlike an operating company, the risk of market sensitive instruments is
integral, not incidental, to the Partnership's main line of business.
Market movements result in frequent changes in the fair market value of
the Partnership's open positions and, consequently, in its earnings and cash
flow. The Partnership's market risk is influenced by a wide variety of factors,
including the level and volatility of interest rates, exchange rates, equity
price levels, the market value of financial instruments and contracts, the
diversification effects among the Partnership's open positions and the liquidity
of the markets in which it trades.
The Partnership rapidly acquires and liquidates both long and short
positions in a wide range of different markets. Consequently, it is not possible
to predict how a particular future market scenario will affect performance, and
the Partnership's past performance is not necessarily indicative of its future
results.
Value at Risk is a measure of the maximum amount which the Partnership
could reasonably be expected to lose in a given market sector. However, the
24
inherent uncertainty of the Partnership's speculative trading and the recurrence
in the markets traded by the Partnership of market movements far exceeding
expectations could result in actual trading or non-trading losses far beyond the
indicated Value at Risk or the Partnership's experience to date (i.e., "risk of
ruin"). In light of the foregoing as well as the risks and uncertainties
intrinsic to all future projections, the inclusion of the quantification
included in this section should not be considered to constitute any assurance or
representation that the Partnership's losses in any market sector will be
limited to Value at Risk or by the Partnership's attempts to manage its market
risk.
Quantifying the Partnership's Trading Value at Risk
The following quantitative disclosures regarding the Partnership's
market risk exposures contain "forward-looking statements" within the meaning of
the safe harbor from civil liability provided for such statements by the Private
Securities Litigation Reform Act of 1995 (set forth in Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934).
All quantitative disclosures in this section are deemed to be forward-looking
statements for purposes of the safe harbor except for statements of historical
fact (such as the terms of particular contracts and the number of market risk
sensitive instruments held during or at the end of the reporting period).
The Partnership's risk exposure in the various market sectors traded by
the Advisors is quantified below in terms of Value at Risk. Due to the
25
Partnership's mark-to-market accounting, any loss in the fair value of the
Partnership's open positions is directly reflected in the Partnership's earnings
(realized or unrealized). Exchange maintenance margin requirements have been
used by the Partnership as the measure of its Value at Risk. Maintenance margin
requirements are set by exchanges to equal or exceed the maximum losses
reasonably expected to be incurred in the fair value of any given contract in
95%-99% of any one-day intervals. The maintenance margin levels are established
by dealers and exchanges using historical price studies as well as an assessment
of current market volatility (including the implied volatility of the options on
a given futures contract) and economic fundamentals to provide a probabilistic
estimate of the maximum expected near-term one-day price fluctuation.
Maintenance margin has been used rather than the more generally available
initial margin, because initial margin includes a credit risk component which is
not relevant to Value at Risk.
In the case of market sensitive instruments which are not exchange
traded (almost exclusively currencies in the case of the Partnership), the
margin requirements for the equivalent futures positions have been used as Value
at Risk. In those rare cases in which a futures-equivalent margin is not
available, dealers' margins have been used.
The fair value of the Partnership's futures and forward positions does
not have any optionality component. However, certain of the Advisors trade
commodity options. The Value at Risk associated with options is reflected in the
26
following table as the margin requirement attributable to the instrument
underlying each option. Where this instrument is a futures contract, the futures
margin, and where this instrument is a physical commodity, the
futures-equivalent maintenance margin has been used. This calculation is
conservative in that it assumes that the fair value of an option will decline by
the same amount as the fair value of the underlying instrument, whereas, in
fact, the fair values of the options traded by the Partnership in almost all
cases fluctuate to a lesser extent than those of the underlying instruments.
In quantifying the Partnership's Value at Risk, 100% positive
correlation in the different positions held in each market risk category has
been assumed. Consequently, the margin requirements applicable to the open
contracts have simply been added to determine each trading category's aggregate
Value at Risk. The diversification effects resulting from the fact that the
Partnership's positions are rarely, if ever, 100% positively correlated have not
been reflected. The Partnership's Trading Value at Risk in Different Market
Sectors
The following table indicates the trading Value at Risk associated with
the Partnership's open positions by market category as of December 31, 1998. All
open position trading risk exposures of the Partnership have been included in
calculating the figures set forth below. As of December 31, 1998, the
Partnership's total capitalization was $151,797,782.
27
December 31, 1998
% of Total
Market Sector Value at Risk Capitalization
Currencies
- - OTC Contracts $ 3,585,707 2.36%
- - Exchange Traded Contracts 407,950 0.27%
Energy 1,783,000 1.17%
Grains 434,400 0.29%
Interest rate U.S. 1,261,900 0.83%
Interest rates Non-U.S 4,400,489 2.90%
Livestock 169,300 0.11%
Metal 1,666,300 1.10%
Softs 1,260,507 0.83%
Stock Indices 1,999,807 1.32%
----------- ------
Total $16,969,360 11.18%
=========== =====
Material Limitations on Value at Risk as an Assessment of Market Risk
The face value of the market sector instruments held by the Partnership
is typically many times the applicable margin requirement (margin requirements
generally range between 2% and 15% of contract face value) as well as the
capitalization of the Partnership. The magnitude of the Partnership's open
positions creates a "risk of ruin" not typically found in most other investment
vehicles. Because of the size of its positions, certain market conditions --
unusual, but historically recurring from time to time -- could cause the
Partnership to incur severe losses over a short period of time. The foregoing
Value at Risk table -- as well as the past performance of the Partnership --
give no indication of this "risk of ruin."
28
Non-Trading Risk
The Partnership has non-trading market risk on its foreign cash
balances not needed for margin. However, these balances (as well as any market
risk they represent) are immaterial.
Materiality as used in this section, "Qualitative and Quantitative
Disclosures About Market Risk," is based on an assessment of reasonably possible
market movements and the potential losses caused by such movements, taking into
account the leverage, optionality and multiplier features of the Partnership's
market sensitive instruments. Qualitative Disclosures Regarding Primary Trading
Risk Exposures
The following qualitative disclosures regarding the Partnership's
market risk exposures - except for (i) those disclosures that are statements of
historical fact and (ii) the descriptions of how the Partnership manages its
primary market risk exposures - constitute forward-looking statements within the
meaning of Section 27A of the Securities Act and Section 21E of the Securities
Exchange Act. The Partnership's primary market risk exposures as well as the
strategies used and to be used by the General Partner and the Advisors for
managing such exposures are subject to numerous uncertainties, contingencies and
risks, any one of which could cause the actual results of the Partnership's risk
controls to differ materially from the objectives of such strategies. Government
interventions, defaults and expropriations, illiquid markets, the emergence of
dominant fundamental factors, political upheavals, changes in historical price
29
relationships, an influx of new market participants, increased regulation and
many other factors could result in material losses as well as in material
changes to the risk exposures and the management strategies of the Partnership.
There can be no assurance that the Partnership's current market exposure and/or
risk management strategies will not change materially or that any such
strategies will be effective in either the short- or long- term. Investors must
be prepared to lose all or substantially all of their investment in the
Partnership
The following were the primary trading risk exposures of the
Partnership as of December 31, 1998, by market sector.
Interest Rates. Interest rate risk is the principal market exposure of
the Partnership. Interest rate movements directly affect the price of the
futures positions held by the Partnership and indirectly the value of its stock
index and currency positions. Interest rate movements in one country as well as
relative interest rate movements between countries materially impact the
Partnership's profitability. The Partnership's primary interest rate exposure is
to interest rate fluctuations in the United States and the other G-7 countries.
However, the Partnership also takes futures positions on the government debt of
smaller nations -- e.g., Australia. The General Partner anticipates that G-7
interest rates will remain the primary market exposure of the Partnership for
the foreseeable future. The changes in interest rates which have the most effect
on the Partnership are changes in long-term, as opposed to short-term, rates.
30
Consequently, even a material change in short-term rates would have little
effect on the Partnership were the medium- to long-term rates to remain steady.
Currencies. The Partnership's currency exposure is to exchange rate
fluctuations, primarily fluctuations which disrupt the historical pricing
relationships between different currencies and currency pairs. These
fluctuations are influenced by interest rate changes as well as political and
general economic conditions. The General Partner does not anticipate that the
risk profile of the Partnership's currency sector will change significantly in
the future, although it is difficult at this point to predict the effect of the
introduction of the Euro on the Advisors' currency trading strategies. The
currency trading Value at Risk figure includes foreign margin amounts converted
into U.S. dollars with an incremental adjustment to reflect the exchange rate
risk inherent to the dollar-based Partnership in expressing Value at Risk in a
functional currency other than dollars.
Stock Indices. The Partnership's primary equity exposure is to equity
price risk in the G-7 countries. The stock index futures traded by the
Partnership are by law limited to futures on broadly based indices. As of
December 31, 1998, the Partnership's primary exposures were in the S&P 500,
Financial Times (England), Nikkei (Japan) and Hang Seng (Hong Kong) stock
indices. The General Partner anticipates little, if any, trading in non-G-7
stock indices. The Partnership is primarily exposed to the risk of adverse price
trends or static markets in the major U.S., European and Japanese indices.
(Static markets would not cause major market changes but would make it difficult
31
for the Partnership to avoid being "whipsawed" into numerous small losses.)
Metals. The Partnership's primary metal market exposure is to fluctuations in
the price of gold and silver. Although certain of the Advisors will from time to
time trade base metals such as aluminum and copper, the principal market
exposures of the Partnership have consistently been in the precious metals, gold
and silver. The Advisors' gold trading has been increasingly limited due to the
long-lasting and mainly non-volatile decline in the price of gold over the last
10-15 years. However, silver prices have remained volatile over this period, and
the Advisors have from time to time taken substantial positions as they have
perceived market opportunities to develop. The General Partner anticipates that
gold and silver will remain the primary metals market exposure for the
Partnership.
Commodities. The Partnership's primary commodities exposure is to
agricultural price movements which are often directly affected by severe or
unexpected weather conditions. Coffee, cocoa, cotton and sugar accounted for the
substantial bulk of the Partnership's commodity exposure as of December 31,
1998.
Energy. The Partnership's primary energy market exposure is to gas and oil
price movements, often resulting from political developments in the Middle East.
Oil prices are currently depressed, but they can be volatile and substantial
profits and losses have been and are expected to continue to be experienced in
this market.
32
Qualitative Disclosures Regarding Non-Trading Risk Exposure
The following were the only non-trading risk exposures of the Partnership
as of December 31, 1998.
Foreign Currency Balances. The Partnership's primary foreign currency
balances are in Japanese yen, German marks, British pounds and French francs.
The Advisor regularly converts foreign currency balances to dollars in an
attempt to control the Partnership's non-trading risk.
Qualitative Disclosures Regarding Means of Managing Risk Exposure.
The General Partner monitors the Partnership's performance and the
concentration of its open positions, and consults with the Advisors concerning
the Partnership's overall risk profile. If the General Partner felt it necessary
to do so, the General Partner could require certain of the Advisors to close out
individual positions as well as enter programs traded on behalf of the
Partnership. However, any such intervention would be a highly unusual event. The
General Partner primarily relies on the Advisors' own risk control policies
while maintaining a general supervisory overview of the Partnership's market
risk exposures.
Each Advisor applies its own risk management policies to its trading. The
Advisors often follow diversification guidelines, margin limits and stop loss
points to exit a position. The Advisors' research of risk management often
suggests on going modifications to their trading programs. As part of the
General Partner's risk management, the General Partner periodically meets with
the Advisors to discuss their risk management and to look for any material
changes to the Advisors'portfolio balance and trading techniques.The Advisors
are required to notify the General Partner of any material changes to their
programs.
33
Item 8. Financial Statements and Supplementary Data.
SMITH BARNEY DIVERSIFIED FUTURES FUND L.P. II
INDEX TO FINANCIAL STATEMENTS
Page
Number
Oath or Affirmation F-2
Report of Independent Accountants. F-3
Financial Statements:
Statement of Financial Condition at
December 31, 1998 and 1997. F-4
Statement of Income and Expenses for the years ended
December 31, 1998 and 1997 and for the period from
January 17, 1996 (commencement of trading operations)
to December 31, 1996. F-5
Statement of Partners' Capital for
the years ended December 31, 1998, 1997
and 1996. F-6
Notes to Financial Statements. F-7 - F-11
F-1
Continued
To The Limited Partners of
Smith Barney Diversified Futures Fund L.P. II
To the best of the knowledge and belief of the undersigned, the information
contained herein is accurate and complete.
By: Daniel A. Dantuono, Chief Financial Officer
Smith Barney Futures Management Inc.
General Partner, Smith Barney Diversified
Futures Fund L.P. II
Smith Barney Futures Management Inc.
390 Greenwich Street
1st Floor
New York, N.Y. 10013
212-723-5424
F-2
Report of Independent Accountants
To the Partners of
Smith Barney Diversified Futures Fund L.P. II:
In our opinion, the accompanying statement of financial condition and the
related statements of income and expenses and of partners' capital present
fairly, in all material respects, the financial position of Smith Barney
Diversified Futures Fund L.P. II at December 31, 1998 and 1997, and the results
of its operations for each of the three years in the period ended December 31,
1998, in conformity with generally accepted accounting principles. These
financial statements are the responsibility of the management of the General
Partner; our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits of these financial
statements in accordance with generally accepted auditing standards which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by the management of the General Partner,
and evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.
PricewaterhouseCoopers LLP
New York, New York
February 26, 1999
F-3
Smith Barney Diversified Futures Fund L.P. II
Statement of Financial Condition
December 31, 1998 and 1997
1998 1997
Assets:
Equity in commodity futures trading
account:
Cash (Note 3c) $146,338,218 $104,013,967
Net unrealized appreciation on open
futures contracts 7,931,171 8,931,038
Commodity options owned, at fair
value cost($144,827 in 1997) -- 219,299
------------ ------------
154,269,389 113,164,304
Interest receivable 423,262 383,130
------------ ------------
$154,692,651 $113,547,434
------------ ------------
Liabilities and Partners' Capital:
Liabilities:
Accrued expenses:
Commissions $ 788,297 $ 578,625
Management fees 344,022 263,105
Incentive fees 236,839 18,146
Other 59,980 67,467
Redemptions payable (Note 5) 1,465,731 1,040,399
------------ ------------
2,894,869 1,967,742
------------ ------------
Partners' capital (Notes 1 and 7):
General Partner, 1,287.3915 and
1,003.8833 Unit equivalents
outstanding
in 1998 and 1997, respectively 1,569,575 1,128,124
Limited Partners, 123,220.1454 and
98,287.8866 Units of Limited
Partnership Interest outstanding in
1998 and 1997, respectively 150,228,207 110,451,568
------------ ------------
151,797,782 111,579,692
------------ ------------
$154,692,651 $113,547,434
============ ============
See notes to financial statements.
F-4
Smith Barney Diversified Futures Fund L.P. II
Statement of Income and Expenses
for the year ended 1998 and 1997 and for the period from
January 17, 1996 (commencement of trading operations) to
December 31, 1996
1998 1997 1996
Income:
Net gains (losses) on
trading of commodity
interests:
Realized gains (losses)
on closed positions $ 24,030,158 $ (1,202,278) $ 9,032,056
Change in unrealized
gains on open positions (1,074,339) 6,998,480 2,007,030
------------ ------------ ------------
22,955,819 5,796,202 11,039,086
Less, Brokerage
commissions including
clearing fees
of $201,707, $164,059
and $67,406,
respectively (Note 3c) (8,891,659) (6,257,856) (2,169,468)
------------ ------------ ------------
Net realized and
unrealized gains(losses) 14,064,160 (461,654) 8,869,618
Interest income
(Notes 3c and 6) 4,818,279 3,634,245 1,190,687
------------ ------------ ------------
18,882,439 3,172,591 10,060,305
------------ ------------ ------------
Expenses:
Management fees (Note 3b) 3,553,437 2,545,702 866,887
Incentive fees (Note 3b) 1,998,362 314,930 1,199,948
Other expenses 351,104 625,783 119,553
Organization expense
(Note 6) -- -- 291,264
------------ ------------ ------------
5,902,903 3,486,415 2,477,652
------------ ------------ ------------
Net income (loss) $ 12,979,536 $ (313,824) $ 7,582,653
============ ============ ============
Net income (loss) per Unit
of Limited Partnership
Interest and General
Partner Unit equivalent
(Notes 1 and 7) $ 95.43 $ (1.30) 185.99
============ ============ ============
See notes to financial statements.
F-5
Smith Barney Diversified
Futures Fund L.P. II
Statement of Partners' Capital
for the years ended
December 31, 1998, 1997 and 1996
Limited Genearal
Partners Partner Total
Partners' capital at
December 31, 1995 $ 1,000 $ 1,000 $ 2,000
Proceeds from offering of
8,529 Units of Limited
Partnership Interest
and General Partner's
contribution
representing 86 Unit
equivalents (Note 1) 8,529,000 86,000 8,615,000
Offering and organization
costs (Note 6) (519,700) (5,300) (525,000)
------------- ------------- -------------
Opening Partnership
capital for operations 8,010,300 81,700 8,092,000
Net income 7,506,058 76,595 7,582,653
Sale of 42,034.2002 Units
of Limited Partnership
Interest and General
Partner's contribution
representing 411.0108
Unit equivalents 41,190,000 402,000 41,592,000
Redemption of 1,911.1385
Units of Limited
Partnership Interest (1,968,649) -- (1,968,649)
------------- ------------- -------------
Partners' capital at
December 31, 1996 54,737,709 560,295 55,298,004
Net loss (310,653) (3,171) (313,824)
Sale of 61,154.0723 Units
of Limited Partnership
Interest and General
Partner's contribution
representing 505.8725
Unit equivalents 68,708,600 571,000 69,279,600
Redemption of 11,519.2474
Units of Limited
Partnership Interest (12,684,088) -- (12,684,088)
------------- ------------- -------------
Partners' capital at
December 31, 1997 110,451,568 1,128,124 111,579,692
Net income 12,849,085 130,451 12,979,536
Sale of 38,309.9229 Units
of Limited Partnership
Interest and General
Partner's contribution
representing 283.5082
Unit equivalents 42,074,000 311,000 42,385,000
Redemption of 13,377.6641
Units of Limited
Partnership Interest (15,146,446) -- (15,146,446)
------------- ------------- -------------
Partners' capital at
December 31, 1998 $ 150,228,207 $ 1,569,575 $ 151,797,782
============= ============= =============
See notes to financial statements.
F-6
Smith Barney Diversified
Futures Fund L.P. II
Notes to Financial Statements
1. Partnership Organization:
Smith Barney Diversified Futures Fund L.P. II (the "Partnership") is a
limited partnership which was organized on May 10, 1994 under the
partnership laws of the State of New York to engage in the speculative
trading of a diversified portfolio of commodity interests including futures
contracts, options and forward contracts. The commodity interests that are
traded by the Partnership are volatile and involve a high degree of market
risk. Between August 21, 1995 (commencement of the offering period) and
January 16, 1996, 8,529 Units of Limited Partnership Interest ("Units") were
sold at $1,000 per Unit. The proceeds of the initial offering were held in
an escrow account until January 17, 1996, at which time they were turned
over to the Partnership for trading. The Partnership continues to offer
Units during the continuous offering period. The Partnership is authorized
to sell 100,000 Units during the public offering period of the Partnership.
Smith Barney Futures Management Inc. acts as the general partner (the
"General Partner") of the Partnership. On September 1, 1998, the
Partnership's commodity broker, Smith Barney Inc., merged with Salomon
Brothers Inc and changed its name to Salomon Smith Barney Inc. ("SSB"). SSB
is an affiliate of the General Partner. The General Partner is wholly owned
by Salomon Smith Barney Holdings, Inc. ("SSBH"), which is the sole owner of
SSB. On October 8, 1998, Travelers Group Inc. merged with Citicorp Inc. and
changed its name to Citigroup Inc. SSBH is a wholly owned subsidiary of
Citigroup Inc. The General Partner and each limited partner share in the
profits and losses of the Partnership in proportion to the amount of
partnership interest owned by each except that no limited partner shall be
liable for obligations of the Partnership in excess of his initial capital
contribution and profits, if any, net of distributions. The Partnership will
be liquidated upon the first to occur of the following: December 31, 2014;
the net asset value of a Unit decreases to less than $400 as of a close of
any business day; or under certain other circumstances as defined in the
Limited Partnership Agreement.
2. Accounting Policies:
a. All commodity interests (including derivative financial instruments and
derivative commodity instruments) are used for trading purposes. The
commodity interests are recorded on trade date and open contracts are
recorded in the statement of financial condition at fair value on the
last business day of the year, which represents market value for those
commodity interests for which market quotations are readily available.
Investments in commodity interests denominated in foreign currencies are
translated into U.S. dollars at the exchange rates prevailing on the last
business day of the year. Realized gains (losses) and changes in
unrealized values on commodity interests are recognized in the period in
which the contract is closed or the changes occur and are included in net
gains (losses) on trading of commodity interests.
b. Income taxes have not been provided as each partner is individually
liable for the taxes, if any, on his share of the Partnership's income
and expenses.
c. The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities at
the date of the financial statements and the reported amounts of revenues
and expenses during the reporting period. Actual results could differ
from these estimates.
F-7
3. Agreements:
a. Limited Partnership Agreement:
The General Partner administers the business and affairs of the
Partnership including selecting one or more advisors to make trading
decisions for the Partnership.
b. Management Agreements:
The General Partner, on behalf of the Partnership, has entered into
Management Agreements with John W. Henry & Company, Inc. ("JWH"),
Millburn Ridgefield Corporation, Campbell & Co., Inc., Willowbridge
Associates Inc. and ARA Portfolio Management Company, L.L.C.,
(collectively, the "Advisors"), registered commodity trading advisors.
The Advisors are not affiliated with one another and none is affiliated
with the General Partner or SSB and are not responsible for the
organization or operation of the Partnership. The Parnership will pay
each Advisor a monthly management fee equal to 1/6 of 1% (2% per year) of
month-end Net Assets allocated to the Advisor (except JWH, which will
receive a monthly management fee equal to 1/3 of 1% (4% per year) of
month-end Net Assets). In addition, the Partnership is obligated to pay
each Advisor an incentive fee payable quarterly equal to 20% of the New
Trading Profits, as defined, earned by each Advisor for the Partnership
(except JWH, which will receive an incentive fee of 15% of New Trading
Profits).
c. Customer Agreement:
The Partnership has entered into a Customer Agreement which provides that
the Partnership will pay SSB a monthly brokerage fee equal to 1/2 of 1%
(6% per year) of month-end Net Assets, as defined, in lieu of brokerage
commissions on a per trade basis. SSB will pay a portion of brokerage
fees to its financial consultants who have sold Units in this
Partnership. Brokerage fees will be paid for the life of the Partnership,
although the rate at which such fees are paid may be changed. The
Partnership will pay for National Futures Association ("NFA") fees,
exchange, clearing, user, give-up and floor brokerage fees. All of the
Partnership's assets are deposited in the Partnership's account at SSB.
The Partnership's cash is deposited by SSB in segregated bank accounts to
the extent required by Commodity Futures Trading Commission regulations.
At December 31, 1998 and 1997, the amount of cash held for margin
requirements was $18,983,738 and $20,242,392, respectively. SSB has
agreed to pay the Partnership interest on 80% of the average daily equity
maintained in cash in its account during each month at a 30-day U.S.
Treasury bill rate determined weekly by SSB based on the average
noncompetitive yield on 3-month U.S. Treasury bills maturing in 30 days
from the date on which such weekly rate is determined. The Customer
Agreement between the Partnership and SSB gives the Partnership the legal
right to net unrealized gains and losses. The Customer Agreement may be
terminated upon notice by either party.
4. Trading Activities:
The Partnership was formed for the purpose of trading contracts in a variety
of commodity interests, including derivative financial instruments and
derivative commodity interests. The results of the Partnership's trading
activity are shown in the statement of income and expenses. All of the
commodity interests, owned by the Partnership, are held for trading
purposes. The fair value of these commodity interests, including options
thereon, if applicable, at December 31, 1998 and 1997 was $7,931,171 and
$9,150,337, respectively, and the average fair value during the year then
ended, based on a monthly calculation, was $8,531,763 and $5,938,920,
respectively.
F-8
5. Distributions and Redemptions:
Distributions of profits, if any, will be made at the sole discretion of the
General Partner; however, beginning with the quarter ended June 30, 1996, a
limited partner may require the Partnership to redeem his Units at their Net
Asset Value as of the last day of any month on 10 days' notice to the
General Partner provided that no redemption may result in the limited
partner holding fewer than 3 Units after redemption is effected. There is no
fee charged to limited partners in connection with redemptions.
6. Organization and Offering Costs:
Expenses related to the continuous offering of Units in 1998 and 1997
totaled $248,844 and $501,620, respectively, and are included in other
expenses. Offering and organization expenses of approximately $525,000
relating to the issuance and marketing of Units during the initial offering
period were initially paid by SSB and were charged against the initial
capital of the Partnership. In addition, expenses of $291,264 related to the
continuous offering of Units were incurred through December 31, 1996. As of
December 31, 1996, the Partnership had reimbursed SSB for all such expenses
incurred during the initial offering and continuous offering period (in
addition to interest at the prime rate quoted by the Chase Manhattan Bank
totaling approximately $20,929) from interest earned on funds held in its
account.
7. Net Asset Value Per Unit:
Changes in the net asset value per Unit of Partnership interest for the
years ended December 31, 1998 and 1997 and for the period from January 17,
1996 (commencement of trading operations) to December 31, 1996 were as
follows:
1998 1997 1996
Net realized and unrealized
gains (losses) $ 103.15 $ (0.92) $ 177.40
Interest income 41.25 43.48 36.09
Expenses (48.97) (43.86) (67.51)
Other -- -- 40.01
--------- --------- ---------
Increase (decrease) for period 95.43 (1.30) 185.99
Net asset value per Unit,
beginning of period 1,123.76 1,125.06 939.07
--------- --------- ---------
Net asset value per Unit,
end of period $1,219.19 $ 1,123.76 $ 1,125.06
========== ========= =========
8. Financial Instrument Risks:
The Partnership is party to financial instruments with off-balance sheet
risk, including derivative financial instruments and derivative commodity
instruments, in the normal course of its business. These financial
instruments may include forwards, futures and options, whose value is based
upon an underlying asset, index, or reference rate, and generally represent
future commitments to exchange currencies or cash flows, or to purchase or
sell other financial instruments at specific terms at specified future
dates, or, in the case of derivative commodity instruments, to have a
reasonable possibility to be settled in cash or with another financial
instrument. These instruments may be traded on an exchange or
over-the-counter ("OTC"). Exchange traded instruments are standardized and
include futures and certain option contracts. OTC contracts are negotiated
between contracting parties and include forwards and certain options. Each
of these instruments is subject to various risks similar to those related to
the underlying financial instruments including market and credit risk. In
general, the risks associated with OTC contracts are greater than those
associated with exchange traded instruments because of the greater risk of
default by the counterparty to an OTC contract. Market risk is the potential
F-9
for changes in the value of the financial instruments traded by the
Partnership due to market changes, including interest and foreign exchange
rate movements and fluctuations in commodity or security prices. Market risk
is directly impacted by the volatility and liquidity in the markets in which
the related underlying assets are traded. Credit risk is the possibility
that a loss may occur due to the failure of a counterparty to perform
according to the terms of a contract. Credit risk with respect to exchange
traded instruments is reduced to the extent that an exchange or clearing
organization acts as a counterparty to the transactions. The Partnership's
risk of loss in the event of counterparty default is typically limited to
the amounts recognized in the statement of financial condition and not
represented by the contract or notional amounts of the instruments. The
Partnership has concentration risk because the sole counterparty or broker
with respect to the Partnership's assets is SSB. The General Partner
monitors and controls the Partnership's risk exposure on a daily basis
through financial, credit and risk management monitoring systems, and
accordingly believes that it has effective procedures for evaluating and
limiting the credit and market risks to which the Partnership is subject.
These monitoring systems allow the General Partner to statistically analyze
actual trading results with risk adjusted performance indicators and
correlation statistics. In addition, on-line monitoring systems provide
account analysis of futures, forwards and options positions by sector,
margin requirements, gain and loss transactions and collateral positions.
The notional or contractual amounts of these instruments, while
appropriately not recorded in the financial statements, reflect the extent
of the Partnership's involvement in these instruments. At December 31, 1998,
the Partnership's commitment to purchase and sell these instruments was
$627,878,574 and $849,849,754, respectively, as detailed below. All of these
instruments mature within one year of December 31, 1998. However, due to the
nature of the Partnership's business, these instruments may not be held to
maturity. At December 31, 1998, the fair value of the Partnership's
derivatives, including options thereon, if applicable, was $7,931,171, as
detailed below.
December 31, 1998
Notional or Contractual
Amount of Commitments
To Purchase To Sell Fair Value
Currencies:
-Exchange Traded Contracts $ 23,119,700 $ 1,535,710 $ (260,990)
-OTC Contracts 206,074,644 166,497,199 (1,219,718)
Energy -- 16,794,100 316,796
Grains 301,800 15,364,740 446,680
Interest Rate U.S. 70,685,806 226,439,506 (588,909)
Interest Rate Non-U.S 281,828,669 352,070,813 7,311,953
Livestock -- 4,570,380 214,540
Metals 15,054,941 42,312,165 790,656
Softs 14,099,125 15,753,068 853,554
Indices 16,713,889 8,512,073 66,609
------------ ------------ ------------
Total $627,878,574 $849,849,754 $ 7,931,171
============ ============ ============
F-10
At December 31, 1997, the notional or contractual amounts of the Partnership's
commitment to purchase and sell these instruments was $529,827,193 and
$562,544,334, respectively, and the fair value of the Partnership's derivatives,
including options thereon, if applicable, was $9,150,337, as detailed below.
December 31, 1997
Notional or Contractual
Amount of Commitments
To Purchase To Sell Fair Value
Currencies:
-Exchange Traded Contracts $ 16,384,721 $107,228,370 $ 480,324
-OTC Contracts 51,178,514 103,210,400 451,488
Energy -- 35,726,058 1,910,464
Grains 7,962,725 10,551,808 79,029
Interest Rate U.S. 140,875,215 11,765,610 717,418
Interest Rate Non-U.S 262,803,653 198,052,010 1,149,142
Livestock -- 7,732,038 262,598
Metals 21,841,650 52,955,116 2,665,247
Softs 26,105,281 19,193,510 888,328
Indices 2,675,434 16,129,414 546,299
------------ ------------ ------------
Total $529,827,193 $562,544,334 $ 9,150,337
============ ============ ============
9. Subsequent Events:
Millburn Ridgefield Corporation and ARA Portfolio Management Company,
L.L.C. were terminated as Advisors to the Partnership on January 31, 1999.
Beacon Management Corporation and Roy G. Niederhoffer Co., Inc. were
added as Advisors on February 1, 1999.
10. New Accounting Pronouncements:
In June 1998, the Financial Accounting Standards Board issued SFAS 133,
Accounting for Derivative Instruments and Hedging Activities ("SFAS 133").
SFAS 133 requires that an entity recognize all derivatives in the statement
of financial condition and measure those instruments at fair value. SFAS
133 is effective for fiscal years beginning after June 15, 1999. SFAS 133
is expected to have no material impact on the financial statements of the
Partnership as all commodity interests are recorded at fair value, with
changes therein reported in the statement of income and expenses.
F-11
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
During the last two fiscal years and any subsequent interim
period, no independent accountant who was engaged as the principal accountant to
audit the Partnership's financial statements has resigned or was dismissed.
PART III
Item 10. Directors and Executive Officers of the Registrant.
The Partnership has no officers or directors and its affairs are
managed by its General Partner, Smith Barney Futures Management Inc. As of
December 31, 1998, investment decisions were being made by John W. Henry
& Company, Inc., Campbell and Company Inc., Millburn Ridgefield Corporation,
Willowbridge Associates Inc. and
ARA Portfolio Management Company, L.L.C. (collectively, the "Advisors").
Item 11. Executive Compensation.
The Partnership has no directors or officers. Its affairs are
managed by Smith Barney Futures Management Inc., its General Partner. SSB, an
affiliate of the General Partner, is the commodity broker for the Partnership
and receives brokerage commissions for such services, as described under "Item
1. Business." Brokerage commissions and clearing fees of $8,891,659 were paid
for the year ended December 31, 1998. Management fees and incentive fees of
$3,553,437 and $1,998,362, respectively, were paid to the Advisors for the year
ended December 31, 1998.
35
Item 12. Security Ownership of Certain Beneficial Owners and Management.
(a). Security ownership of certain beneficial owners. As of March 1,
1999, the Partnership knows of no person who beneficially owns more than 5%
of the Units outstanding.
(b). Security ownership of management. Under the terms of the Limited
Partnership Agreement, the Partnership's affairs are managed by the General
Partner. The General Partner owns Units of general partnership interest
equivalent to 1,287.3915 Units (1.0%) of Limited Partnership Interest as of
December 31, 1998.
(c). Changes in control. None.
Item 13. Certain Relationship and Related Transactions.
Salomon Smith Barney Inc. and Smith Barney Futures Management Inc.
would be considered promoters for purposes of item 404 (d) of Regulation S-K.
The nature and the amounts of compensation each promoter will receive from
the Partnership are set forth under "Item 1. Business" and "Item 11. Executive
Compensation."
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
(a) (1)Financial Statements:
Statement of Financial Condition at December 31, 1998 and 1997.
Statement of Income and Expenses for the years ended December31,
1998 and 1997 and for the period from January 17, 1996
(commencement of trading operations) to December 31, 1996.
Statement of Partners' Capital for the years ended December 31,
1998, 1997 and 1996.
(2)Financial Statement Schedules: Financial Data Schedule for the
year ended December 31, 1998.
36
(3) Exhibits:
3.1 - Limited Partnership Agreement (filed as Exhibit 3.1 to the
Registration Statement on Form S-1 (File No. 33-79244 and
incorporated herein by reference).
3.2 - Certificate of Limited Partnership of the Partnership as
filed in the office of the County Clerk of New York County
(filed as Exhibit 3.2 to the Registration Statement
on Form S-1 (Filed No. 33-79244) and incorporated
herein by reference).
10.1- Customer Agreement between the Partnership and Smith Barney
(filed as Exhibit 10.1 to the Registration Statement
on Form S-1 (File No. 33-79244) and incorporated herein
by reference).
10.2- Subscription Agreement (filed as Exhibit 10.2 to the
Registration Statement on Form S-1 (File No. 33-29144) and
incorporated herein by reference).
10.3- Escrow Instructions relating to escrow of subscription funds
(filed as Exhibit 10.3 to the Registration Statement on
Form S-1 (File No. 33-79244) and incorporated herein
by reference).
37
10.4- Management Agreement among the Partnership, the General
Partner and Chesapeake Capital Corporation (filed as Exhibit
10.5 to the Registration Statement on Form S-1 (File No.
33-79244) and incorporated herein by reference).
10.5- Management Agreement among the Partnership, the General
Partner and John W. Henry & Co. Inc.(filed as Exhibit 10.6
to the Registration Statement on Form S-1 (File No.33-79244)
and incorporated herein by reference).
10.6- Management Agreement among the Partnership, the General
Partner and Millburn Ridgefield Corporation (filed as
Exhibit 10.7 to the Registration Statement on Form S-1
(File No. 33-79244) and incorporated herein by reference).
10.7- Management Agreement among the Partnership, the General
Partner and Willowbridge Associates Inc. (filed as Exhibit
10.7 to the Form 10-K for the year ended December 31, 1997).
10.8- Management Agreement among the Partnership, the General
Partner and ARA Portfolio Management Company, L.L.C. (filed
as Exhibit 10.8 to the Form 10-K for the year ended December
31, 1997).
10.9- Letter from General Partner terminating Management Agreement
with Chesapeake Capital Corporation (filed as Exhibit 10.9
to the Form 10-K for the year ended December 31, 1997).
38
10.10- Management Agreement among the Partnership, the General
Partner and Campbell & Co., Inc. (filed as Exhibit 10.10 to
the Form 10-K for the year ended December 31, 1997).
10.11- Letters extending Management Agreements with John W. Henry
& Company Inc., Chesapeake Capital Corporation and Millburn
Ridgefield Corporation for 1996 and 1997 (filed as Exhibit
10.11 to the Form 10-K for the year ended December 31,
1997).
10.12- Letters from General Partner terminating Management
Agreement with Millburn Ridgefield Corporation (filed
herein).
10.13- Letter from General Partner terminating Management
Agreement with ARA Portfolio Management (filed herein).
10.14- Management Agreement among the Partnership, the General
Partner and Beacon Management Corporation (filed herein).
10.15- Management Agreement among the Partnership, the General
Partner and Roy G. Neiderhoffer Co., Inc. (filed herein).
10.16- Letters extending Management Agreements with John W. Henry
& Company Inc., Campbell & and Company, Inc. and
Willowbridge Associates Inc.(filed herein). (b) Reports on
8-K: None Filed.
39
Supplemental Information To Be Furnished With Reports Filed Pursuant To
Section 15(d) Of The Act by Registrants Which Have Not Registered Securities
Pursuant To Section 12 Of the Act.
Annual Report to Limited Partners
40
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Registration Statement
to be signed on its behalf by the undersigned, thereunto duly authorized, in the
City of New York and State of New York on the 24th day of March 1999.
SMITH BARNEY DIVERSIFIED FUTURES FUND L.P. II
By: Smith Barney Futures Management Inc.
(General Partner)
By /s/ David J. Vogel
David J. Vogel, President & Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Registration Statement has been signed below by the following persons in the
capacities and on the date indicated.
/s/ David J. Vogel /s/ Jack H. Lehman III
David J. Vogel, Jack H. Lehman III
Director, Principal Executive Chairman and Director
Officer and President
/s/ Michael R. Schaefer /s/ Daniel A. Dantuono
Michael R. Schaefer Daniel A. Dantuono
Director Treasurer, Chief Financial
Officer and Director
/s/ Daniel R. McAuliffe, Jr. /s/ Steve J. Keltz
Daniel R. McAuliffe, Jr. Steve J. Keltz
Director Secretary and Director
/s/ Shelley Ullman
Shelley Ullman
Director
41