- Annual Report (10-K)

Share Name	Share Symbol	Market	Type
Highland Distressed Opportunities, Inc.	NYSE:HCD	NYSE	Ordinary Share

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-K


(Mark One)
þ		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		For the fiscal year ended December 31, 2008
OR
o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		For the transition period to

Commission file number: 814-00729

Highland Distressed Opportunities, Inc.

(Exact Name of Registrant as Specified in Charter)


Delaware		205423854
(State or Jurisdiction of Incorporation or Organization)		(IRS Employer Identification No.)

NexBank Tower

13455 Noel Road, Suite 800

Dallas, Texas 75240

(Address of Principal Executive Offices)

(877) 247-1888

(Registrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act:


Common Stock, par value $.001 per share		New York Stock Exchange
(Title of class)		(Name of exchange on which registered)

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes o No þ

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 periods as the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

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. þ

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer o Accelerated Filer þ Non-Accelerated Filer o Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

The aggregate market value of the voting stock held by non-affiliates of the Registrant on June 30, 2008, based on the closing price on that date of $5.74 on The New York Stock Exchange, was $95,979,642. As of February 6, 2009 there were 17,716,771 shares of the Registrant’s common stock outstanding.

HIGHLAND DISTRESSED OPPORTUNITIES, INC.

TABLE OF CONTENTS


			Page

PART I
	Item 1	Business		3
	Item 1A	Risk Factors		15
	Item 1B	Unresolved Staff Comments		32
	Item 2	Properties		32
	Item 3	Legal Proceedings		32
	Item 4	Submission of Matters to a Vote of Security Holders		32

PART II
	Item 5	Market for Registrant’s Common Equity and Related Stockholder Matters		32
	Item 6	Selected Financial Data		35
	Item 7	Management’s Discussion and Analysis of Financial Condition and Results of Operations		35
	Item 7A	Quantitative and Qualitative Disclosures about Market Risk		43
	Item 8	Financial Statements and Supplementary Data		45
	Item 9	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		81
	Item 9A	Controls and Procedures		81
	Item 9B	Other Information		82

PART III
	Item 10	Directors, Executive Officers and Corporate Governance		82
	Item 11	Executive Compensation		87
	Item 12	Security Ownership of Certain Beneficial Owners and Management		87
	Item 13	Certain Relationships and Related Transactions		88
	Item 14	Principal Accountant Fees and Services		89

PART IV
	Item 15	Exhibits, Financial Statement Schedules		91
		Signatures		92
EX-10.15
EX-24.1
EX-31.1
EX-31.2
EX-32.1

PART I


Item 1.	*Business*

Forward-Looking Statements

Some of the statements in this report constitute forward-looking statements, which relate to future events or the future performance or financial condition of Highland Distressed Opportunities, Inc. (the “Company,” “we,” “us” and “our”). The forward-looking statements contained in this report involve risks and uncertainties, including statements as to:


	•	our future operating results;

	•	the benefits of the proposed reorganization of the Company into Highland Credit Strategies Fund, announced on December 19, 2008;

	•	our business prospects and the prospects of our portfolio companies;

	•	the impact of investments that we expect to make;

	•	our contractual arrangements and relationships with third parties;

	•	the dependence of our future success on the general economy and its impact on the industries in which we invest;

	•	our expected financings and investments;

	•	the adequacy of our cash resources and working capital, including our ability to obtain continued financing on favorable terms;

	•	the timing of cash flows, if any from the operations of our portfolio companies; and

	•	the ability of our investment adviser to locate suitable investments for us and to monitor and administer our investments.

We have generally identified such statements by using words such as “anticipates,” “believes,” “expects,” “intends,” “will,” “should,” “may” and similar expressions to identify forward-looking statements. Our actual results could differ materially from those projected in the forward-looking statements for any reason. We have based the forward-looking statements included in this report on information available to us on the date of this report, and we assume no obligation to update any such forward-looking statements. Although we undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise, you are advised to consult any additional disclosures that we may make directly to you or through reports and other information that we in the future may file with the Securities and Exchange Commission (“SEC”), including proxy statements, annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. The public may read and copy any materials filed by the Company with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site (http://www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically. Information about the Company is also available at http://www.HighlandHCD.com.

Overview

Highland Distressed Opportunities, Inc. is a non-diversified closed-end company incorporated under the laws of Delaware to invest primarily in financially-troubled or distressed companies that are either middle-market companies or unlisted companies. We were incorporated on August 22, 2006 and commenced material operations on February 27, 2007. We have elected to be treated as a business development company (“BDC”) under the Investment Company Act of 1940 (the “1940 Act”). Additionally, we have elected to be treated for U.S. federal income tax purposes as a regulated investment company, or RIC, under Subchapter M of the Internal Revenue Code of 1986 (the “Code”).

Our investment objective is total return generated by both capital appreciation and current income. We seek to achieve this objective by investing in senior secured debt, mezzanine debt and unsecured debt, each of which may include an equity component, and in equity investments. Generally, distressed companies are those that (i) are facing financial or other difficulties and (ii) are or have been operating under the provisions of the U.S. Bankruptcy Code or other similar laws or, in the near future, may become subject to such provisions or otherwise be involved in a restructuring of their capital structure. We use the term “middle-market” to refer to companies with annual revenues between $50 million and $1 billion. We use the term “unlisted” to refer to companies not listed on a national securities exchange (for example, companies whose securities are quoted on the over-the-counter bulletin board or through Pink Sheets LLC would not be “listed” on a national securities exchange, although they may be considered “public” companies).

On December 19, 2008, the Board of Directors of the Company approved an agreement and plan of merger and liquidation (“Agreement”). The Agreement provides for the merger of the Company with and into HCF Acquisition LLC (“Merger Sub”), a Delaware limited liability company to be organized as a wholly owned subsidiary of Highland Credit Strategies Fund (“HCF”), a non-diversified, closed-end management investment company also managed by Highland Capital Management, L.P. (the “Merger”), with Merger Sub being the surviving entity and pursuant to which common stockholders of the Company will receive shares of beneficial interest of HCF (and cash in lieu of any fractional shares). Immediately after the Merger, Merger Sub will distribute its assets to HCF, and HCF will assume the liabilities of Merger Sub, in complete liquidation and dissolution of Merger Sub (collectively with the Merger, the “Reorganization”). As a result of the Reorganization, each common stockholder of the Company will become a common shareholder of HCF. The conversion will be done on the basis of the relative net asset values of the Company and HCF.

The closing of the Reorganization is subject to several conditions, including the approval of the Company’s stockholders. If stockholders of the Company do not approve the reorganization or, if such other conditions are not satisfied or waived, the Company will continue its current operations. There is no assurance that the requisite stockholder approval will be obtained for the Reorganization or such other conditions will be satisfied. For additional information, please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Overview.”

Our Investment Adviser

We have no employees and our operations are conducted by our external manager, Highland Capital Management, L.P. (the “Investment Adviser”), pursuant to an investment advisory agreement between us, under which the Investment Adviser, subject to the overall supervision of the Company’s Board of Directors (the “Board”), manages the day-to-day operations of, and provides investment advisory services to the Company.

Highland Capital Management, L.P., founded in 1993, is an investment adviser registered under the Investment Advisers Act of 1940 (the “Advisers Act”) that specializes in credit and alternative investment strategies. The Investment Adviser, together with its affiliate Highland Capital Management Europe, Ltd., had over $28 billion in assets under management, as of December 31, 2008.

The Investment Adviser employs a fundamental, bottom-up investment approach that is enhanced by its industry-focused structure. This approach enables its professionals to focus on individual issues. This approach is further improved by a fund-specific, top-down analysis performed at the senior portfolio management level. Our investment process is driven by a team-management approach, utilizing industry specialization across multiple industries.

Our Administrator

In addition to furnishing us with office facilities, equipment, clerical, bookkeeping and recordkeeping services, our Investment Adviser performs, or oversees the performance, of our required administrative services, which include, among other things, being responsible for the financial records that we are required to maintain, monitoring portfolio and regulatory compliance matters and preparing reports to our stockholders and reports filed with the SEC. Our Investment Adviser assists in determining, and arranging for the publishing of, our net asset value, overseeing the preparation and filing of tax returns and the printing and disseminating of reports to

stockholders, and generally overseeing the payment of expenses and the performance of administrative and professional services rendered to us by others. Under a separate sub-administration agreement, the Investment Adviser has delegated certain administrative functions to PNC Global Investment Servicing (U.S.) Inc. (“PNC”) (formerly PFPC Inc.). PNC’s sub-administration services fees are payable by the Investment Adviser, not the Company.

Our Executive Offices

Our principal executive office is located at NexBank Tower, 13455 Noel Road, Suite 800, Dallas, Texas 75240, and our telephone number is (877) 247-1888.

Operating and Regulatory Structure

Business Development Company. As a BDC, we are required to comply with certain regulatory requirements. For instance, we are generally prohibited from acquiring assets other than “qualifying assets” unless, after giving effect to the acquisition, at least 70% of our total assets are qualifying assets. Qualifying assets generally include securities of “eligible portfolio companies” (as defined in the 1940 Act), cash, cash equivalents, U.S. government securities and high-quality debt instruments maturing in one year or less from the time of investment.

Regulated Investment Company. We have elected and intend to continue to qualify annually to be treated as a regulated investment company under Subchapter M of the Code. Accordingly, we must, among other things, meet the following requirements regarding the source of our income and the diversification of our assets:

(i) We must derive in each taxable year at least 90% of our gross income from the following sources: (a) dividends, interest (including tax-exempt interest), payments with respect to certain securities loans, and gains from the sale or other disposition of stock, securities or foreign currencies, or other income (including but not limited to gains from options, futures and forward contracts) derived with respect to our business of investing in such stock, securities or foreign currencies; and (b) interests in “qualified publicly-traded partnerships” (as defined in the Code).

(ii) We must diversify our holdings so that, at the end of each quarter of each taxable year: (a) at least 50% of the value of our total assets are represented by cash and cash items, U.S. government securities, the securities of other regulated investment companies and other securities, with such other securities limited, in respect of any one issuer, to an amount not greater than 5% of the value of our total assets and not more than 10% of the outstanding voting securities of such issuer and (b) not more than 25% of the value of our total assets is invested in the securities (other than U.S. government securities and the securities of other regulated investment companies) of: (I) any one issuer, (II) any two or more issuers that we control (by owning 20% or more of their voting power) and that are determined to be engaged in the same business or similar or related trades or businesses or (III) any one or more “qualified publicly-traded partnerships” (as defined in the Code).

As a regulated investment company, we generally will not be subject to U.S. federal income tax on income and gains that we distribute to our stockholders, provided that we distribute each taxable year at least the sum of: (i) 90% of our investment company taxable income (which includes, among other items, dividends, interest and the excess of any net short-term capital gain over net long-term capital loss and other taxable income, other than any net long-term capital gain, reduced by deductible expenses) and (ii) 90% of our net tax-exempt interest (the excess of our gross tax-exempt interest over certain disallowed deductions). The Company intends to distribute substantially all of such income each year. The Company will be subject to income tax at regular corporation rates on any taxable income or gains that it does not distribute to its stockholders.

Although we do not presently expect to do so, we are authorized to borrow funds and to sell assets in order to satisfy distribution requirements. However, under the 1940 Act and the instrument under which we issue debt, we may be prohibited from declaring distributions to our stockholders while our debt obligations and other senior securities are outstanding unless certain “asset coverage” tests are met.

Moreover, our ability to dispose of assets to meet our distribution requirements may be limited by (i) the illiquid nature of our portfolio and/or (ii) other requirements relating to our status as a regulated investment

company, including the diversification requirements. If we dispose of assets in order to meet the distribution requirements or to avoid the excise tax, discussed below, we may make such dispositions at times that, from an investment standpoint, are not advantageous.

The Code imposes a 4% nondeductible excise tax on the Company to the extent the Company does not distribute by the end of any calendar year at least the sum of: (i) 98% of its ordinary income (not taking into account any capital gain or loss) for the calendar year and (ii) 98% of its capital gain in excess of its capital loss (adjusted for certain ordinary losses) for a one-year period generally ending on October 31 of the calendar year (unless an election is made to use the Company’s fiscal year). In addition, the minimum amounts that must be distributed in any year to avoid the excise tax will be increased or decreased to reflect any under-distribution or over-distribution, as the case may be, from the previous year. There can be no assurance that sufficient amounts of the Company’s taxable income and capital gain will be distributed to avoid entirely the imposition of the excise tax. In that event, the Company will be liable for the excise tax only on the amount by which it does not meet the foregoing distribution requirement. The Company may elect to retain taxable income and determine to pay the excise tax on such amounts.

A distribution will be treated as paid during the calendar year if it is paid during the calendar year or declared by us in October, November or December of the year, payable to stockholders of record on a date during such a month and paid by us during January of the following year. Any such distributions paid during January of the following year will be deemed to be received on December 31 of the year the distributions are declared, rather than when the distributions are received. For purposes of determining (i) whether the distribution requirement is satisfied for any year and (ii) the amount of capital gain dividends paid for that year, we may, under certain circumstances, elect to treat a distribution that is paid during the following taxable year as if it had been paid during the taxable year in question. If we make such an election, the U.S. stockholder will still be treated as receiving the distribution in the taxable year in which the distribution is made.

If, for any taxable year, we do not qualify as a regulated investment company, all of our taxable income (including our net capital gain) will be subject to tax at regular corporate rates without any deduction for distributions to stockholders, and such distributions will be taxable to the stockholders as ordinary dividends to the extent of our current or accumulated earnings and profits. Provided that stockholders satisfy certain holding period and other requirements with respect to their shares, such distributions generally would be eligible (i) to be treated as qualified dividend income in the case of stockholders taxed as individuals and (ii) for the dividends-received deduction in the case of stockholders taxed as corporations. Further, we could be required to recognize unrealized gains, pay taxes and make distributions (which could be subject to interest charges) before requalifying for taxation as a regulated investment company. If we fail to qualify as a regulated investment company in any year, we must pay out our earnings and profits accumulated in that year in order to qualify again as a regulated investment company. If we fail to qualify as a regulated investment company for a period greater than two taxable years, we may be required to recognize and pay tax on any net built-in gains with respect to certain of our assets (i.e., the excess of the aggregate gains, including items of income, over aggregate losses that would have been realized with respect to such assets if we had been liquidated) or, alternatively, to elect to be subject to taxation on such built-in gain recognized for a period of ten years, in order to qualify as a regulated investment company in a subsequent year.

Investments

The following is a representative list of the industries in which the Company is currently invested:


• Aerospace	• Financial	• Housing
• Broadcasting	• Forest Products/Containers	• Service
• Consumer Non-Durables	• Gaming/Leisure	• Transportation
• Diversified Media	• Healthcare	• Wireless Communications

Market Opportunity

Growing Supply of Distressed Investment Opportunities. The Investment Adviser believes that current market conditions present abundant opportunities to invest in distressed markets and expects that the breadth of opportunities will continue to expand due to the recent trading levels of leveraged loans in the secondary markets and increasing default and amendment rates.

As a consequence of increased market volatility that began in July 2007, credit markets experienced a significant technical dislocation in 2008, pushing approximately 81% of senior secured loans (also called bank loans, leveraged loans, or floating rate loans) into distressed territory, according to S&P/LSTA Leveraged Loan Index (“S&P/LSTA”). This situation provides the potential for capital appreciation with higher quality loans than normally would be the case with distressed investing. Additionally, the need to work through bankruptcy or amendment issues is potentially minimized if the Investment Adviser is able to identify the strongest loans trading at artificially depressed prices due to technical factors.

Additionally, with defaults of loans anticipated to increase during 2009, the opportunities for traditional distressed investing are likely to increase. The lagging twelve month default rate, as a percentage of outstanding principal, increased from approximately 0.2% on December 31, 2007, to approximately 3.8% on December 31, 2008 (Source: S&P/LSTA). The lagging twelve month default rate, by number of issuers, increased from approximately 0.3% to approximately 4.4% during the same time period (Source: S&P/LSTA). The fact that the number of issuers defaulted is a higher percentage than the percentage of dollar amount defaulted indicates that smaller issuers defaulted in 2008. Given the contagion in the economy and the general lack of credit available to businesses, the Investment Adviser believes the default rate will continue to increase into 2009. Not only will the default rate increase, but companies experiencing significant cash flow issues will increase. Therefore, it is expected that the distressed debt market will be robust for years to come.

As tracked by the S&P/LSTA, the average bid price of loans, which as of December 31, 2008 represent approximately 47.4% of the Company’s portfolio, has decreased significantly since December 31, 2007 from approximately 94.4% of par to approximately 61.7% of par as of December 31, 2008. Similarly, the average price of high-yield bonds has dropped significantly from an average price of approximately 94.1% of par as of December 31, 2007 to approximately 61.7% of par as of December 31, 2008 (Source: Credit Suisse High Yield Index). As of December 31, 2008, corporate notes and bonds (also called high-yield bonds) represented approximately 27.8% of the Company’s portfolio. These price movements are a result of the massive technical dislocation that ravished the debt markets in 2008. This was caused by banks and credit providers pulling leverage out of the market as they scrambled to shore up their balance sheets. What began as a crisis in subprime mortgages spread to the entire credit market and finally to the global financial system.

As a result, the average interest rate spreads of leveraged and high-yield bonds have experienced sharp increases during this period. During 2008, the discounted spread on loans had increased from approximately 453 basis points (“bps”) over the London Interbank Offered Rate (“LIBOR”) to approximately 2,373 bps over LIBOR (Source: S&P/LSTA). Similarly, the spread over comparable maturity U.S. government treasury securities on high-yield bonds had increased from approximately 166 bps to approximately 1,185 bps (Source: Credit Suisse High Yield Index). The Investment Adviser believes that this massive deleveraging and broad sentiment shift has created irrational value dislocations, which the Company will seek to identify and capture as markets begin to normalize.

Inefficient Distressed Markets. The Investment Adviser believes the distressed markets are relatively inefficient due to a number of factors, including:


	•	Forced Selling. Many investors are unwilling or unable to purchase or hold distressed debt, leading to forced selling and artificially low pricing. Additionally, regulatory or capital restrictions at many institutions prevent the holding, leveraging or actively managing of defaulted securities and often force the divestment of such positions.

	•	Complexity of Analysis. The analysis of distressed investment opportunities is significantly more complex and challenging than that of traditional par investments. Investors often overestimate the long-term impact of


		a given company’s distress on fundamental value or become intimidated by the complexities of the restructuring process, leading to significant selling pressure and resulting in inefficient pricing.


	•	Lack of Middle-Market and Unlisted Demand. Middle-market and unlisted investment opportunities are often overlooked by distressed debt analysts because of lower trading volume and the lack of third party research coverage of such securities. As a result, middle-market and unlisted investments are generally characterized by less competition than larger, more-liquid, listed opportunities and typically offer more attractive valuations.

	•	Barriers to Entry. Successful distressed investing requires a specialized skill set that includes: (i) the capacity to accurately value a company’s assets and analyze its capital structure; (ii) a sophisticated knowledge of the complex legal environment in which such investing occurs, particularly bankruptcy, securities, corporate and indenture law; (iii) the experience necessary to determine accurately the financial interests and legal rights of the debtor and each of its creditor constituencies; and (iv) refined negotiating skills.

Competitive Advantages

We believe that we possess the following competitive advantages over many other capital providers to middle-market and unlisted companies.

Investment Expertise. The Investment Adviser’s continuous monitoring of the market in general and specific existing positions by these investment professionals often leads to a meaningful advantage in the timeliness and quality of information that the Investment Adviser can obtain on prospective investments in the earlier stages of impairment. This information and positioning advantage allows the Investment Adviser to evaluate management and performance over a protracted time horizon and assess historical trading data. Additionally, the Investment Adviser’s presence in both the primary and secondary leveraged loan markets has allowed the Investment Adviser to build strong relationships with regional, national and global financial institutions. This network of broker/dealer relationships is much broader than the typical networks possessed by most other distressed funds and has proved to be a great advantage when identifying investments and new financing opportunities, especially middle-market loans held by smaller regional institutions and unlisted company loans.

Operating Expertise. Successful distressed investing is a complex, resource-intensive process demanding significant experience, specialized skills and an extensive infrastructure. As a result of the Investment Adviser’s extensive operating experience, the Investment Adviser and its partners have developed a strong reputation in the capital markets. We believe that this experience affords us a competitive advantage in identifying and investing in middle-market and unlisted companies with the potential to generate returns. Versatile Transaction Structuring. We expect to be flexible in structuring investments, the types of securities in which we invest and the terms associated with such investments. The principals of the Investment Adviser have extensive experience in a wide variety of securities for leveraged companies with a diverse set of terms and conditions. This approach and experience should enable the Investment Adviser to identify attractive investment opportunities throughout the economic cycle and across a company’s capital structure so that we can make investments consistent with our stated objective.

Longer investment horizon with attractive publicly-traded model. Unlike private equity and venture capital funds, we are not subject to standard periodic capital return requirements. Such requirements typically stipulate that these funds, together with any capital gains on such invested funds, can only be invested once and must be returned to investors after the expiration of a pre-agreed time period. These provisions often force private equity and venture capital funds to seek returns on their investments more quickly than they otherwise might through mergers, public equity offerings or other liquidity events, potentially resulting in both a lower overall return to investors and an adverse impact on their portfolio companies. We believe that our flexibility to make investments with a long-term view and without the capital return requirements of traditional private investment vehicles provides us with the opportunity to generate returns on invested capital and enable us to be a better long-term partner for our portfolio companies. This is especially important for distressed investing, which requires a longer hold period than par investing.

Investment Policies and Portfolio Composition

Our investment objective is total return generated by both capital appreciation and current income. We intend to invest primarily in financially-troubled or distressed companies that are either middle-market companies or unlisted companies by investing in senior secured debt, mezzanine debt and unsecured debt, each of which may include an equity component, and in equity investments. We use the term “middle-market” to refer to companies with annual revenues between $50 million and $1 billion. We use the term “unlisted” to refer to companies not listed on a national securities exchange (for example, companies whose securities are quoted on the over-the-counter bulletin board or through Pink Sheets LLC would not be “listed” on a national securities exchange, although they may be considered “public” companies). Generally, distressed companies are those that (i) are facing financial or other difficulties and (ii) are or have been operating under the provisions of the U.S. Bankruptcy Code or other similar laws or, in the near future, may become subject to such provisions or otherwise be involved in a restructuring of their capital structure. Distressed debt obligations may be performing or non-performing and typically trade at a discount to par, or at prices substantially lower than lower grade securities of companies in similar industries.

There is no limit on the maturity or duration of any security in our portfolio, but it is anticipated that our senior secured loans and our mezzanine loans typically will have maturities of three to seven years and five to ten years, respectively. A significant portion of the debt that we invest in will likely be rated by a rating agency as below investment grade (rated lower than “Baa3” by Moody’s or lower than “BBB-” by either S&P or Fitch). The Investment Adviser estimates that for those investments that are not rated, they will be of comparable, below investment grade quality. In addition, we may invest without limit in debt of any rating, including debt that has not been rated by any nationally recognized statistical rating organization.

While our primary focus is to generate capital appreciation and current income through investments in senior secured debt, mezzanine debt, unsecured debt and equity investments, we may invest up to 30% of the portfolio in opportunistic investments that the research platform of the Investment Adviser identifies during the investment process in order to seek to enhance returns to stockholders. Such investments may, for example, include investments in the senior secured debt, mezzanine debt, unsecured debt, equity investments, other debt obligations, options, structured products and other derivatives of middle-market or unlisted companies operating in the financial sector or foreign and/or larger, listed companies. We expect that these companies generally will have debt securities that are non-investment grade.

The Company invests in high-yield debt securities (also commonly referred to as “junk” securities), the generic name for debt securities rated below BBB- and Baa3 by Moody’s or S&P. High-yield debt securities are frequently issued by corporations in the growth stage of their development, but also may be issued by established companies. These bonds are regarded by the rating organizations, on balance, as predominantly speculative with respect to capacity to pay interest and repay principal in accordance with the terms of the obligation. Such securities also are generally considered to be subject to greater risk than securities with higher ratings. Securities that are rated Ba by Moody’s or BB by S&P have speculative characteristics with respect to the capacity to pay interest and repay principal. Securities that are rated B by Moody’s or S&P reflect the rating organizations’ view that such securities generally lack characteristics of a desirable investment and assurance of interest and principal payments over any long period of time may be small. Securities that are rated Caa by Moody’s or CCC by S&P or below are of poor standing. Those issues may be in default (such as those rated D by S&P) or present elements of danger with respect to principal or interest. The Company is not limited in its holdings of such securities and from time to time may invest in such securities, or securities held by the Company may become subject to payment default subsequent to purchase. High-yield securities held by the Company may include securities received as a result of a corporate reorganization or issued as part of a corporate takeover. Securities issued to finance corporate restructurings may have special credit risks because of the highly-leveraged conditions of the issuers, and such securities usually are subordinate to securities subsequently issued by the issuer. In addition, such issuers may lose experienced management as a result of the restructurings. Finally, the market price of such securities may be more volatile to the extent that expected benefits from restructuring do not materialize.

Portfolio Company Characteristics

The Investment Adviser has identified several criteria that it believes are important in identifying and investing in prospective portfolio companies. These criteria provide general guidelines for our investment decisions; however, each prospective portfolio company may fail to meet one or more of these criteria. Generally, the Investment Adviser seeks to utilize its access to information generated by the investment professionals of the Investment Adviser and its affiliates to identify investment candidates and to structure investments quickly and effectively.

Liquidation Value of Assets. The prospective liquidation value of the assets, if any, collateralizing loans in which the Company invests is an important factor in the Investment Adviser’s credit analysis. The Investment Adviser emphasizes both tangible assets, such as accounts receivable, inventory, equipment and real estate, and intangible assets, such as intellectual property, customer lists, networks and databases.

Strong Competitive Position in Industry. The Investment Adviser seeks to invest in companies that have developed good market positions within their respective markets and are well positioned to capitalize on growth opportunities. The Investment Adviser seeks companies that demonstrate significant competitive advantages, which should help to protect their market position and profitability, as compared to their competitors.

Exit Strategy. The Investment Adviser seeks to invest in companies that it believes will provide a steady stream of cash flow to repay loans and/or build equity value. With respect to their loans and debt securities, the Investment Adviser expects that such internally-generated cash flow, leading to the payment of interest on, and the repayment of the principal of, the debt is a key means by which we exit these investments over time. In addition, the Investment Adviser also seeks to invest in companies whose business models and expected future cash flows offer attractive exit possibilities. These companies include candidates for strategic acquisition by other industry participants and companies that may repay our investments through an initial public offering of common stock or another capital market transaction. With respect to our equity investments, the Investment Adviser looks to repurchases by the portfolio company, public offerings and acquisitions.

Experienced Management. The Investment Adviser generally requires that our portfolio companies have an experienced management team. The Investment Adviser also generally requires the portfolio companies to have in place proper incentives to induce management to succeed and to act in concert with our interests as investors, which may include management’s having significant equity interests in the portfolio company.

Value Orientation/Positive Cash Flow. The Investment Adviser’s investment philosophy places a premium on fundamental analysis from an investor’s perspective and has a distinct value orientation. The Investment Adviser focuses on companies in which the Company can invest at relatively low multiples of operating cash flow and that are profitable at the time of investment on an operating cash flow basis.

The Investment Process

The Investment Adviser manages our portfolio through a team of portfolio managers and investment professionals. Our portfolio managers are senior members from the Investment Adviser. The portfolio managers are supported by and have access to a team of investment professionals and the analytical capabilities and support personnel of the Investment Adviser. The investment professionals from the Investment Adviser identify and evaluate investment opportunities. An investment committee comprised of senior investment professionals of the Investment Adviser review prospective investments identified by the Investment Adviser’s investment team and give final approval to all significant investment decisions.

The Investment Adviser utilizes the same value-oriented philosophy used by the investment professionals of the Investment Adviser in managing their private investment funds and commits its resources to managing downside exposure.

Early-Mover Advantage. Continuous monitoring of a large universe of issuers should enable us to identify potential investments at the earliest stages of their impairment. This timely identification of opportunities often will give us an early-mover advantage from a due diligence standpoint as well as in tactically sourcing our distressed investments. This is a competitive advantage that many other distressed investment firms do not have, as they

typically do not play an active role in the broader leveraged loan market and therefore tend to engage their resources only once a company has reached a critical point of deterioration or in reaction to a catalytic event (e.g., a missed coupon payment). This early-mover advantage is especially important within the middle market and among unlisted companies, where companies typically provide detailed operating statistics to only their existing senior lenders.

First-Look Investment Opportunities. The Investment Adviser’s position within the primary and secondary leveraged loan market and its reputation as a distressed investor also provide major Wall Street banks, regional financial institutions, and large asset-based lenders incentive to give the Investment Adviser first-look investment opportunities on divestments of troubled credit portfolios or other unique distressed opportunities. These firms have an incentive to work with the Investment Adviser due to demand for investors capable of: (i) evaluating risk quickly, efficiently and accurately; (ii) sourcing a significant amount of capital; and (iii) executing large trades expeditiously.

Network of Relationships. Additionally, the Investment Adviser has established a network of relationships with financial sponsors, corporate managers, legal professionals, accountants and investment bankers that also actively bring opportunities to its attention. These constituents, in their efforts to build relationships and to facilitate their solicitation of business from distressed situations, can point the Investment Adviser’s professionals toward developing opportunities. Most of the investments sourced through these means represent first-look, non-auction opportunities.

Due Diligence. The Investment Adviser may conduct due diligence on prospective portfolio companies in a manner consistent with the approach utilized by the Investment Adviser in the past.

Key Procedures. Due diligence typically includes the following key procedures:


	•	review of historical and prospective financial information;

	•	review of public information;

	•	interviews with management, employees, customers and vendors of the potential portfolio company;

	•	review of financing documents and other material contracts; and

	•	research relating to the company’s management, industry, markets, products, services and competitors.

Timing Considerations. Once a financial analysis has been completed and the Investment Adviser has a good understanding of the likely enterprise value of a target company under various performance assumptions and preferred exit strategies, the Investment Adviser estimates the time that it will most likely take to realize the monetization of the investment. Because total returns are a function of both value and time, the various intervening events surrounding a distressed investment, such as intercreditor negotiations, litigation or extensions, can have a meaningful impact on the success of an investment.

Managerial Assistance

As a BDC, we offer, and must provide upon request, managerial assistance to our portfolio companies. This assistance could involve, among other things, participating in board and management meetings, consulting with and advising officers of portfolio companies and providing other organizational and financial guidance or exercising strategic or managerial influence over such companies. The Investment Adviser will provide managerial assistance on our behalf to those portfolio companies that request this assistance. We and any third-parties engaged by such portfolio companies, such as Barrier Advisors, Inc. (an affiliate of the Investment Adviser), may receive fees for providing these services. However, the Investment Adviser will not receive any compensation from the portfolio companies for providing managerial assistance.

Competition

We believe that there are currently numerous opportunities to provide financing for financially-troubled or distressed companies that are middle-market companies and unlisted companies. Initially, we believed our primary competitors in this market include other BDCs, public funds, private funds, including private equity and hedge funds, commercial and investment banks, and commercial financing companies. Although these competitors

regularly provided finance products to financially-troubled or distressed companies in the past, many of them lack the necessary capital to provide financing in the current troubled environment. We also face competition from other firms that do not specialize in financially-troubled or distressed companies that are middle-market companies and unlisted companies, but that are substantially larger and have considerably greater financial and marketing resources than we do. Some of our competitors have a lower cost of funds and access to funding sources that are not available to us. In addition, some of our competitors have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments. Furthermore, many of our competitors are not subject to the regulatory restrictions that the 1940 Act imposes on us as a BDC; nor are they subject to the requirements imposed on RICs by the Code. We use the industry information of the Investment Adviser’s investment professionals to which we have access to assess investment risks and determine appropriate pricing for our investments in portfolio companies. In addition, we believe that the relationships of the members of Highland Capital Management, L.P. and of the senior principals of the Investment Adviser, enable us to learn about, and compete effectively for, financing opportunities with attractive middle market companies in the industries in which we seek to invest.

Investment Advisory and Management Agreement

The Company has entered into an Investment Advisory and Management Agreement with the Investment Adviser, under which the Investment Adviser, subject to the overall supervision of the Company’s Board, manages the day-to-day operations of, and provides investment advisory services to, the Company. For providing these services, the Investment Adviser receives a base management fee and an incentive fee from the Company.

The base management fee is payable quarterly in arrears at a rate equal to 2.00% per annum of the Company’s Managed Assets. Managed Assets are the value of total assets of the Company less all accrued liabilities of the Company (other than the aggregate amount of any outstanding borrowings, preferred stock issuances, or other instruments or obligations constituting financial leverage).

The incentive fee consists of two components: (1) the Pre-Incentive Fee Net Investment Income and (2) the Capital Gains Fee. Pre-Incentive Fee Net Investment Income is calculated and payable quarterly in arrears. For this purpose, Pre-Incentive Fee Net Investment Income means interest income, dividend income and any other income (including any other fees (other than fees for providing managerial assistance), such as commitment, origination, structuring, diligence and consulting fees or other fees that we receive from portfolio companies) accrued during the calendar quarter, minus the Company’s operating expenses for the quarter (including the base management fee, any expenses payable under the administration agreement, and any interest expense and dividends paid on any issued and outstanding preferred stock, but excluding the incentive fee). Pre-Incentive Fee Net Investment Income includes, in the case of investments with a deferred interest feature (such as market discount, debt instruments with payment-in-kind (“PIK”) interest, preferred stock with PIK dividends and zero coupon securities), accrued income that we have not yet received in cash. The Investment Adviser is not under any obligation to reimburse the Company for any part of the Incentive Fee it received that was based on accrued income that we never received as a result of a default by an entity on an obligation that resulted in the accrual of such income. Pre-Incentive Fee Net Investment Income does not include any realized capital gains, realized and unrealized capital losses or unrealized capital appreciation or depreciation.

Pre-Incentive Fee Net Investment Income, expressed as a rate of return on the value of the Company’s net assets at the end of the immediately preceding calendar quarter, is compared to the “hurdle rate” of 1.75% per quarter (7.00% annualized) (the “Hurdle Rate”). The Company will pay the Investment Adviser an Incentive Fee with respect to the Company’s Pre-Incentive Fee Net Investment Income in each calendar quarter as follows: (1) no incentive fee in any calendar quarter in which Pre-Incentive Fee Net Investment Income does not exceed the Hurdle Rate; (2) 100% of Pre-Incentive Fee Net Investment Income with respect to that portion of such Pre-Incentive Fee Net Investment Income, if any, that exceeds the Hurdle Rate but is less than 2.1875% in any calendar quarter (8.75% annualized) (the “Catch-up Provision”); and (3) 20% of the amount of Pre-Incentive Fee Net Investment Income, if any, that exceeds 2.1875% in any calendar quarter (8.75% annualized).

These calculations are appropriately prorated for any period of less than three months and adjusted for any share issuances or repurchases during the relevant quarter.

The second part of the Incentive Fee (the “Capital Gains Fee”) is determined and payable in arrears as of the end of each calendar year (or upon termination of the Investment Advisory and Management Agreement), beginning on December 31, 2007, and is calculated at the end of each applicable year by subtracting (A) the sum of the Company’s cumulative aggregate realized capital losses and aggregate unrealized capital depreciation from (B) the Company’s cumulative aggregate realized capital gains, in each case calculated from the date of the IPO of the Company’s shares. If such amount is positive at the end of such year, then the Capital Gains Fee for such year is equal to 20% of such amount, less the aggregate amount of Capital Gains Fees paid in all prior years. If such amount is negative, then there is no Capital Gains Fee paid for such year.

The Investment Advisory and Management Agreement provides that in the absence of willful misfeasance, bad faith, gross negligence or reckless disregard of its obligations thereunder, the Investment Adviser is not liable to the Company or any of the Company’s stockholders for any act or omission by it or its employees in the supervision or management of its investment activities or for any loss sustained by the Company or the Company’s stockholders, and provides for indemnification by the Company of its members, directors, officers, employees, agents and control persons for liabilities incurred by them in connection with their services to the Company, subject to certain limitations and conditions.

Staffing

We do not currently have any employees and do not expect to have any employees. Services necessary for our business are provided by individuals who are employees of the Investment Adviser, pursuant to the terms of the Investment Advisory and Management Agreement and the Administration Agreement. James D. Dondero, our President; Mark Okada, our Executive Vice President; R. Joseph Dougherty, our Senior Vice President; M. Jason Blackburn, our Treasurer and Secretary; and Michael Colvin, our Chief Compliance Officer; comprise our senior management. Certain of these individuals are also partners of our Investment Adviser. Our day-to-day investment operations are managed by the Investment Adviser. The Investment Adviser, not the Company, will be responsible for the Company’s allocable portion of overhead, including rent and the allocable portion of the employment costs of the Company’s executive officers and their respective staffs and other employees of the Investment Adviser who devote substantial attention to the administration of the Company, except that the Company will be responsible for all costs relating to maintenance of a toll-free stockholder information telephone line, including the reimbursement of the Company’s allocable share of routine overhead expenses of any third-party service provider furnishing this telephone line. Each of the Company’s portfolio companies will pay all of its own expenses.

Leverage

We seek to enhance our total returns through the use of leverage, which may include the issuance of shares of preferred stock, commercial paper or notes and other borrowings. There is no assurance that our use of leverage will be successful in enhancing the level of our total return. The net asset value of our shares may be reduced by the issuance costs of any leverage. Depending on market conditions and restrictions imposed by our credit facility, we may use leverage in an aggregate amount up to 50% of our total assets (including the proceeds from the leverage), the maximum amount allowable under the 1940 Act. Our credit agreement currently imposes stricter limitations than the 1940 Act, requiring generally that asset coverage be at least 350% after a borrowing. The use of leverage involves significant risks.

Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 imposes a wide variety of regulatory requirements on publicly-held companies and their insiders. Many of these requirements affect us. For example:


	•	Pursuant to Rule 13a-14 under the Securities Exchange Act of 1934 (the “1934 Act”), our Principal Executive Officer and Principal Financial Officer must certify the accuracy of the financial statements contained in our periodic reports;

	•	Pursuant to Item 307 of Regulation S-K, our periodic reports must disclose our conclusions about the effectiveness of our disclosure controls and procedures;


	•	Pursuant to Rule 13a-15 of the 1934 Act, our management must prepare a report regarding its assessment of our internal control over financial reporting, which must be audited by our independent registered public accounting firm; and

	•	Pursuant to Item 308 of Regulation S-K and Rule 13a-15 under the 1934 Act, our periodic reports must disclose whether there were significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

We have adopted procedures to comply with the Sarbanes-Oxley Act and the regulations promulgated thereunder. The Sarbanes-Oxley Act requires us to review our current policies and procedures to determine whether we comply with the Sarbanes-Oxley Act and the regulations promulgated thereunder. We will continue to monitor our compliance with all regulations that are adopted under the Sarbanes-Oxley Act and will take actions necessary to ensure that we are in compliance therewith.

Certifications

In April 2008, the Company submitted to the New York Stock Exchange pursuant to Section 303A.12(a) of its Listed Company Manual, an unqualified certification of the Company’s Chief Executive Officer. In addition, certifications by the Company’s Chief Executive Officer and Principal Financial Officer have been filed as exhibits to this annual report on Form 10-K as required by the Securities Exchange Act of 1934, as amended, and the Sarbanes-Oxley Act of 2002.

Privacy Policy

We recognize and respect your privacy expectations, whether you are a visitor to our website, a potential stockholder, a current stockholder or even a former stockholder.

Collection of Information. We may collect nonpublic personal information about you from the following sources:


	•	Account applications and other forms , which may include your name, address and social security number, written and electronic correspondence and telephone contacts;

	•	Website information , including any information captured through our use of “cookies”; and

	•	Account history , including information about the transactions and balances in your accounts with us or our affiliates.

Disclosure of Information. We may share the information we collect (described below) with our affiliates. We may also disclose this information as otherwise permitted by law. We do not sell your personal information to third parties for their independent use.

Confidentiality and Security of Information. We restrict access to nonpublic personal information about you to our employees and agents who need to know such information to provide products or services to you. We maintain physical, electronic and procedural safeguards that comply with federal standards to guard your nonpublic personal information, although you should be aware that data protection cannot be guaranteed.

Available Information

Our corporate website is http://www.highlandhcd.com. We make available free of charge on our website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. Our website address is included in this document as an inactive textual reference only. Information contained on our website is not incorporated by reference into this annual report and you should not consider information contained on our website to be part of this annual report.


Item 1A.	*Risk Factors*

Before you invest in shares of our common stock, you should be aware of various risks, including those described below. You should carefully consider these risks, together with all of the other information included in this annual report on Form 10-K, including our consolidated financial statements and the related notes thereto, before you decide whether to make an investment in shares of our common stock. The risks set out below are not the only risks we face. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results. If any of the following events occur, our business, financial condition and results of operations could be materially adversely affected. In such case, our net asset value and the trading price of our common stock could decline, and you may lose all or part of your investment.

Risks Related to Our Business and Structure

We are a relatively new company with limited operating history.

We were incorporated on August 22, 2006, commenced material operations on February 27, 2007 and have conducted limited operations to date. We are subject to all of the business risks and uncertainties associated with any new business, including the risk that we may not achieve our investment objective and that the value of your investment could decline substantially.

We operate in a highly competitive market for investment opportunities.

Many entities, including public and private funds, commercial and investment banks, commercial financing companies, BDCs and insurance companies will compete with us to make the types of investments that we plan to make in middle-market and unlisted companies. Many of these competitors are substantially larger, have considerably greater financial, technical and marketing resources than we do and offer a wider array of financial services. For example, some competitors may have a lower cost of funds and access to funding sources that are not available to us. In addition, some competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments and establish more relationships. Many competitors are not subject to the regulatory restrictions that the 1940 Act imposes on us as a BDC or the restrictions that the Code imposes on us as a regulated investment company. Some competitors may make loans with interest rates that are lower than the rates the Company wishes to offer. The Company cannot assure you that the competitive pressures it faces will not have a material adverse effect on its business, financial condition and results of operations. Also, as a result of this competition, the Company may not be able to take advantage of attractive investment opportunities from time to time, and can offer no assurance that it will be able to identify and make investments that are consistent with its investment objective.

The Investment Adviser’s key personnel have limited experience managing a BDC and we cannot assure you that their past experience will be sufficient to manage our Company as a BDC.

The 1940 Act imposes numerous complex constraints on the operations of BDCs. In order to maintain our status as a BDC, the 1940 Act prohibits us from acquiring any assets other than “qualifying assets” unless, after giving effect to the acquisition, at least 70% of our total assets are qualifying assets. Qualifying assets generally may include securities of certain unlisted U.S. companies, cash, cash equivalents, U.S. government securities and high-quality debt instruments maturing one year or less from the time of investment. The failure to comply with these provisions in a timely manner could prevent us from qualifying as a BDC or could force us to pay unexpected taxes and penalties, which could be material. The lack of experience of the Investment Adviser’s senior professionals in managing a portfolio of assets under such regulatory constraints may hinder their ability to take advantage of attractive investment opportunities and, as a result, achieve our investment objective.

Key personnel of the Investment Adviser provide services to other clients, which could reduce the amount of time and effort they devote to us and thus negatively impact our performance.

Our ability to achieve our investment objective will depend on our ability to manage our business, which will depend, in turn, on the ability of the Investment Adviser to identify, invest in and monitor companies that meet our investment criteria. Accomplishing this result largely will be a function of the investment process and ability of the

Investment Adviser, in its capacity as our Investment Adviser and administrator, to provide competent, attentive and efficient services to us. The Company’s portfolio managers have substantial responsibilities to other clients of the Investment Adviser and its affiliates in addition to its activities on behalf of the Company. The portfolio managers and the investment professionals dedicated to our business may also be required to provide managerial assistance to our portfolio companies. These demands on their time may distract them or slow our rate of investment. Any failure to manage our business effectively could have a material adverse effect on our business, financial condition and result of operations.

Key personnel of the Investment Adviser provide advisory services to other investment vehicles that may have common investment objectives with ours and may face conflicts of interest in allocating investments.

The Investment Adviser or its officers and employees serve or may serve as officers, trustees, directors or principals of entities that operate in the same or a related line of business or of investment funds managed by the Investment Adviser or its affiliates. Accordingly, these individuals may have obligations to investors in those entities or funds, the fulfillment of which might not be in the best interests of the Company or its stockholders. As a result, the Investment Adviser will face conflicts in the allocation of investment opportunities to the Company and other entities or funds. In order to fulfill its fiduciary duties to each of its clients, the Investment Adviser will endeavor to allocate investment opportunities over time in a fair and equitable manner that may, subject to applicable regulatory constraints, involve pro rata co-investment by the Company and such other clients or may involve a rotation of opportunities among the Company and such other clients. In addition, the Investment Adviser may invest on behalf of other funds and accounts in different levels of an issuer’s capital structure, which may result in potential conflicts of interest.

Our success is dependent upon the members of the Investment Adviser’s senior professionals, and the loss of any of them could severely and detrimentally affect our operations.

The Company’s ability to identify and invest in attractive opportunities is dependent upon the Investment Adviser. If one or more key individuals leaves the Investment Adviser, the Investment Adviser may not be able to hire qualified replacements or may require an extended time to do so. This situation could prevent the Company from achieving its investment objective.

Because we use leverage, you will be exposed to additional risks, including the risk that our use of leverage can magnify the effect of any losses we incur.

We seek to enhance our total returns through the use of leverage, which may include the issuance of shares of preferred stock, commercial paper or notes and other borrowings. At December 31, 2008, we had borrowings outstanding of $15.5 million under a credit facility. Although our use of leverage may create an opportunity for increased returns for our common shares, it also results in additional risks and can magnify the effect of any losses and thus could negatively impact our business and results of operation. If we do incur leverage, a decrease in the value of our investments would have a greater negative impact on the value of our shares than if we did not use leverage. If the income and gains from the investments purchased with leverage, net of increased expenses associated with such leverage, do not cover the cost of such leverage, the return to holders of our shares will be less than if leverage had not been used. There is no assurance that our use of leverage, if any, will be successful. Leverage involves other risks and special considerations for common stockholders including, but not limited to, the following:


	•	We would not be permitted to pay distributions on the shares if dividends on the preferred stock and/or interest on borrowings have not been paid or set aside for payment.

	•	Under the provisions of the 1940 Act, we are permitted, as a BDC, to issue debt or preferred stock or other senior securities only in amounts such that our asset coverage, as defined in the 1940 Act, equals at least 200% after each issuance of senior securities. If the value of our assets declines below that level we may be prohibited from paying distributions on the shares. If that happens, in order to maintain our tax qualification we may be required to sell a portion of our investments and repay a portion of our leverage at a time when such sales and/or repayments may be disadvantageous from an investment perspective.


	•	It is likely that any debt we incur will be governed by an indenture or other instrument containing covenants that may restrict our operating flexibility or our ability to pay distributions on shares in certain instances.

	•	Any debt that we issue or incur may be secured by a lien on our assets, which, in the event of a default under the instrument governing the debt, would subject such collateral to liquidation by the lenders at a time when such sales may be disadvantageous.

	•	We and, indirectly, our stockholders will bear the cost of issuing and servicing our leverage.

	•	Any leverage instruments that we issue in the future will have rights, preferences and privileges over our income and against our assets in liquidation that are more favorable than those of our shares.

	•	There will likely be greater volatility of net asset value and market price of our shares than for a comparable company that does not use leverage.

	•	When we use leverage, the base management fee payable to our Investment Adviser will be higher than if we did not use leverage because it is calculated using managed assets, not net assets.

	•	We may be subject to certain restrictions on investments imposed by guidelines of one or more rating agencies, which may issue ratings for the leverage instruments issued by us.

	•	The 1940 Act provides certain rights and protections for preferred stockholders which may adversely affect the interests of our common stockholders, including rights that could delay or prevent a transaction or a change in control to the detriment of the holders of our shares.

Regulations governing our operation as a BDC affect the investments we may make and our ability to, and the way in which we, raise additional capital.

Our business may benefit from raising additional capital from time to time. We may acquire additional capital through the use of leverage and issuance of additional shares. We may use leverage up to the maximum amount permitted by the 1940 Act. We generally will not be able to issue and sell our shares at a price below net asset value per share. We may, however, sell our shares, or warrants, options or rights to acquire our shares, at prices below the current net asset value of the shares if our Board determines that such sale is in the best interests of the Company and its stockholders, and our stockholders approve such sale. At our 2008 Annual Meeting of Stockholders on June 6, 2008, stockholders approved a proposal to authorize the Company, subject to the approval of the Board, to sell shares of its common stock at a price below net asset value per share, or warrants, options and rights to acquire its Common Stock at a price below the then current net asset value per share. This authorization expires on the earlier of the one-year anniversary of the approval and the date of our 2009 Annual Meeting of Stockholders. In any such case, except in connection with rights offerings or with stockholder approval, the price at which our securities are to be issued and sold may not be less than a price that, in the determination of our Board, closely approximates the market value of such securities (less any underwriting commission or discount).

We may also make rights offerings to our stockholders at prices per share less than the net asset value per share, subject to applicable requirements of the 1940 Act. If we raise additional funds by issuing more shares or issuing leverage instruments convertible into, or exchangeable for, our shares, the percentage ownership of our stockholders at that time would decrease and such stockholders may experience dilution. Moreover, we can offer no assurance that we will be able to issue and sell additional equity securities in the future, on favorable terms or at all.

If certain of our investments are deemed not to be qualifying assets, we could be precluded from investing in the manner described in our prospectus, or deemed to be in violation of the 1940 Act, in which case we may not qualify to be treated as a BDC.

In order to maintain our status as a BDC, we must not acquire any assets other than “qualifying assets” unless, at the time of and after giving effect to such acquisition, at least 70% of our total assets are qualifying assets. There is a risk that certain investments that we intend to make would not be deemed to be qualifying assets. For example, qualifying assets include securities of a listed or unlisted U.S. issuer that is not an investment company or a financial company (that is, a company that would be an investment company except for one or more of the exclusions from the definition of investment company in Section 3(c) of the 1940 Act) if the issuer is in bankruptcy and subject to reorganization or if the issuer, immediately prior to the Company’s purchase, were unable to meet its obligations as

they came due without material assistance other than conventional lending or financing arrangements and if the purchase is made in transactions not involving a public offering from the issuer, someone who has been an affiliated person of the issuer within the prior 13 months or from any person in transactions incident thereto. If certain of our investments are deemed to not be qualifying assets under such definition we could be precluded from investing in the manner described in this annual report or deemed to be in violation of the 1940 Act.

Certain of our portfolio investments are recorded at fair value as determined in good faith pursuant to policies and procedures approved by our Board and, as a result, there will be uncertainty as to the value of our portfolio investments.

A large percentage of the Company’s portfolio investments may be in the form of securities that are not publicly-traded. The fair value of securities and other investments that are not publicly-traded may not be readily determinable. The Company values these securities at least quarterly at fair value as determined in good faith pursuant to the policies and procedures approved by the Board. However, because fair valuations, and particularly fair valuations of private securities and private companies, are inherently uncertain, may fluctuate over short periods of time and are often based to a large extent on estimates, comparisons and qualitative evaluations of private information, our determinations of fair value may differ materially from the values that would have been used if a ready market for these securities existed. These factors could make it more difficult for investors to value accurately the Company’s securities and could lead to under-valuation or over-valuation of the shares.

The lack of liquidity in our investments may adversely affect our business.

We make investments in unlisted companies. Substantially all of these securities are subject to legal and other restrictions on resale or are otherwise less liquid than listed securities. The illiquidity of these investments may make it difficult for us to sell such investments if the need arises. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we have previously recorded such investments. In addition, we may face other restrictions on our ability to liquidate an investment in a portfolio company to the extent that the Investment Adviser has material non-public information regarding such portfolio company. Under certain market conditions, including those experienced recently, this risk may be particularly pronounced for the Company.

We pay the Investment Adviser a base management fee based on our Managed Assets, which may create an incentive for the Investment Adviser to cause us to incur more leverage than is prudent in order to maximize its compensation.

We pay the Investment Adviser a quarterly base management fee based on the value of our Managed Assets. Accordingly, the Investment Adviser will have an economic incentive to increase our leverage. If our leverage is increased, we will be exposed to increased risk of loss, bear the increased cost of issuing and servicing such senior indebtedness, and will be subject to any additional covenant restrictions imposed on us in an indenture or other instrument or by the applicable lender. See “Risks Related to Our Business and Structure — Because we use leverage, you will be exposed to additional risks, including the risk that our use of leverage can magnify the effect of any losses that we incur.” We pay the Investment Adviser incentive compensation based on our net investment income and realized capital gains, which may create an incentive for the Investment Adviser to cause us to incur more leverage than is prudent in order to maximize its compensation.

We pay the Investment Adviser incentive compensation based on our net investment income and realized capital gains, which may create an incentive for the Investment Adviser to cause us to incur more leverage than is prudent in order to maximize its compensation.

The incentive fee payable to the Investment Adviser may create an incentive for the Investment Adviser to make investments that are riskier or more speculative than would be the case in the absence of such compensation arrangement. The way in which the incentive fee payable to the Investment Adviser is determined, which is calculated as a percentage of the return on net assets, may encourage the Investment Adviser to use leverage to increase the return on the Company’s investments. If the Investment Adviser acquires poorly-performing assets with such leverage, the loss to holders of the shares could be substantial. Moreover, if our leverage is increased, we will be exposed to increased risk of loss, bear the increased cost of issuing and servicing such senior indebtedness or preferred stock, and will be subject to any additional covenant restrictions imposed on us in an indenture or other

instrument or by the applicable lender. See “Risks Related to Our Business and Structure — Because we use leverage, you will be exposed to additional risks, including the risk that our use of leverage can magnify the effect of any losses that we incur.” We pay the Investment Adviser a base management fee based on our Managed Assets, which may create an incentive for the Investment Adviser to cause us to incur more leverage than is prudent in order to maximize its compensation.

Our proposed Reorganization into Highland Credit Strategies Fund may affect the market price of our common stock, and if the Reorganization does not occur, the market price of our shares may be adversely affected.

The proposed Reorganization into HCF is expected to be considered at a stockholder meeting during the 2nd quarter of 2009. If the Reorganization is delayed or not completed (because, for example, shareholder approval is not obtained or other conditions of the Merger are not satisfied), the price of our common stock may decline to the extent that the current market price of that stock reflects a market assumption that the Reorganization will be completed and that the related benefits will be realized. Because the number of shares of HCF to be received in exchange for each share of the Company would be determined based on the relative net asset value per share of each entity on the valuation date, changes in the net asset value of HCF’s portfolio, or changes in market outlook for the asset classes in which that fund invests, may affect the market price of the Company’s common stock. If the Reorganization is not completed, the Company will have incurred substantial expenses without achieving the expected benefits.

Risks Related to Our Investments

Investments in middle-market and unlisted companies present certain challenges, including the lack of available information about such companies, a dependence on the talents and efforts of only a few key portfolio company personnel and a greater vulnerability to economic downturns.

Investments in middle-market and unlisted companies involve a number of significant risks, including the following:


	•	Such companies may have limited financial resources and may be unable to meet their obligations under their debt securities that we hold, which may be accompanied by a deterioration in the value of any collateral.

	•	Such companies typically have shorter operating histories, narrower product lines and smaller market shares than larger or listed businesses, which tend to render them more vulnerable to competitors’ actions and market conditions, as well as general economic downturns.

	•	Such companies are more likely to depend on the management talents and efforts of a small group of persons; therefore, the death, disability, resignation or termination of one or more of these persons could have a material adverse impact on the portfolio company and, in turn, on us.

	•	Such companies generally have less predictable operating results, may from time to time be parties to litigation, may be engaged in rapidly changing businesses with products subject to a substantial risk of obsolescence, and may require substantial additional capital to support their operations, finance expansion or maintain their competitive position.

	•	Such companies may cease to be treated as unlisted companies for purposes of the regulatory restrictions applicable to us, in which case we might not be able to invest additional amounts in them.

Little public information exists about these companies. The greater difficulty in making a fully-informed investment decision raises the risk of misjudging the credit quality of the company and we may lose money on our investments.

Economic recessions or downturns could impair our portfolio companies and harm our operating results.

Many of our portfolio companies may be susceptible to economic slowdowns or recessions and may be unable to repay loans during these periods. Therefore, our non-performing assets are likely to increase and the value of our portfolio is likely to decrease during these periods. Adverse economic conditions also may decrease the value of collateral securing some of our loans and the value of our equity investments. Economic slowdowns or recessions could lead to financial losses in our portfolio and a decrease in revenues, net income and assets. Unfavorable

economic conditions also could increase funding costs, limit access to the capital markets or result in a decision by lenders not to extend credit to us. These events could prevent us from increasing investments and harm our operating results.

A portfolio company’s failure to satisfy financial or operating covenants could lead to defaults and, potentially, termination of its loans and foreclosure on its secured assets, which could trigger cross-defaults under other agreements and jeopardize our portfolio company’s ability to meet its obligations under the debt securities that we hold. We may need to incur additional expenses to seek recovery upon default or to negotiate new terms with a defaulting portfolio company. In addition, if one of our portfolio companies were to go bankrupt, even though we may have structured its interest as senior debt, depending on the facts and circumstances, including the extent to which we actually provided significant managerial assistance to that portfolio company, a bankruptcy court might recharacterize our debt holding and subordinate all or a portion of its claim to that of other creditors.

Investments in lower credit quality obligations present certain challenges, including higher risks of default, increased adverse effects caused by economic downturns and lack of liquidity.

Most of the Company’s debt investments are likely to be in lower grade obligations. The lower grade investments in which the Company invests may be rated below investment grade by one or more nationally-recognized statistical rating agencies at the time of investment or may be unrated but determined by the Investment Adviser to be of comparable quality. Debt securities rated below investment grade are commonly referred to as “junk bonds” and are considered speculative with respect to the issuer’s capacity to pay interest and repay principal.

Investment in lower grade investments involves substantial risk of loss. Lower grade securities or comparable unrated securities are considered predominantly speculative with respect to the issuer’s ability to pay interest and principal and are susceptible to default or decline in market value due to adverse economic and business developments. The market values for lower grade debt tend to be very volatile, and are less liquid than investment grade securities. For these reasons, your investment in the Company is subject to the following specific risks:


	•	increased price sensitivity to a deteriorating economic environment;

	•	greater risk of loss due to default or declining credit quality;

	•	adverse company specific events are more likely to render the issuer unable to make interest and/or principal payments; and

	•	if a negative perception of the lower grade debt market develops, the price and liquidity of lower grade securities may be depressed. This negative perception could last for a significant period of time.

Adverse changes in economic conditions are more likely to lead to a weakened capacity of a lower grade issuer to make principal payments and interest payments than an investment grade issuer. The principal amount of lower grade securities outstanding has proliferated in the past decade as an increasing number of issuers have used lower grade securities for corporate financing. An economic downturn could severely affect the ability of highly leveraged issuers to service their debt obligations or to repay their obligations upon maturity. Similarly, downturns in profitability in specific industries could adversely affect the ability of lower grade issuers in that industry to meet their obligations. The market values of lower grade debt tend to reflect individual developments of the issuer to a greater extent than do higher quality investments, which react primarily to fluctuations in the general level of interest rates. Factors having an adverse impact on the market value of lower grade debt may have an adverse effect on the Company’s net asset value and the market value of the shares. In addition, the Company may incur additional expenses to the extent it is required to seek recovery upon a default in payment of principal of or interest on its portfolio holdings. In certain circumstances, the Company may be required to foreclose on an issuer’s assets and take possession of its property or operations. In such circumstances, the Company would incur additional costs in disposing of such assets and potential liabilities from operating any business acquired.

Under certain market conditions, the secondary market for lower grade debt may not be as liquid as the secondary market for more highly rated debt, a factor that may have an adverse effect on the Company’s ability to dispose of a particular instrument. The prices quoted by different dealers may vary significantly and the spread between the bid and asked price is generally much larger than higher quality instruments. Under adverse market or economic conditions, the secondary market for lower grade debt could contract further, independent of any specific

adverse changes in the condition of a particular issuer, and these instruments may become highly illiquid. As a result, the Company could find it more difficult to sell these instruments or may be able to sell the securities only at prices lower than if such instruments were widely traded. Prices realized upon the sale of such lower rated or unrated securities, under these circumstances, may be less than the prices used in calculating the Company’s net asset value.

Since investors generally perceive that there are greater risks associated with lower-grade debt of the type in which the Company invests a significant portion of its assets, the yields and prices of such debt may tend to fluctuate more than those for higher rated instruments. In the lower quality segments of the fixed income markets, changes in perceptions of issuers’ creditworthiness tend to occur more frequently and in a more pronounced manner than do changes in higher quality segments of the income securities market, resulting in greater yield and price volatility.

Our investments in debt securities of distressed or bankrupt companies may subject us to certain risks, including lack of income, extraordinary expenses, uncertainty with respect to satisfaction of debt, lower-than-expected investment values or income potentials and resale restrictions.

At times, distressed debt obligations may not produce income and may require the Company to bear certain extraordinary expenses (including legal, accounting, valuation and transaction expenses) in order to protect and recover its investment. Therefore, to the extent the Company invests in distressed debt, the Company’s ability to achieve current income for its stockholders may be diminished. The Company also will be subject to significant uncertainty as to when and in what manner and for what value the distressed debt the Company invests in will eventually be satisfied (e.g., through a liquidation of the obligor’s assets, an exchange offer or plan of reorganization involving the distressed debt securities or a payment of some amount in satisfaction of the obligation). In addition, even if an exchange offer is made or plan of reorganization is adopted with respect to distressed debt held by the Company, there can be no assurance that the securities or other assets received by the Company in connection with such exchange offer or plan of reorganization will not have a lower value or income potential than may have been anticipated when the investment was made. Moreover, any securities received by the Company upon completion of an exchange offer or plan of reorganization may be restricted as to resale. As a result of the Company’s participation in negotiations with respect to any exchange offer or plan of reorganization with respect to an issuer of distressed debt, the Company may be restricted from disposing of such securities.

Investments in obligations of distressed or bankrupt issuers present certain challenges inherent in the bankruptcy process or in participation on creditor committees.

The Company is authorized to invest in the securities and other obligations of distressed and bankrupt issuers, including debt obligations that are in covenant or payment default and including by providing debtor-in-possession, or DIP, financing. There is no limit on the amount of the Company’s portfolio that can be invested in distressed or bankrupt issuers, and the Company may invest for purposes of control (either by itself or together with other funds managed by our Investment Adviser). Such investments generally trade significantly below par and are considered speculative. The repayment of defaulted obligations is subject to significant uncertainties. Defaulted obligations might be repaid only after lengthy workout or bankruptcy proceedings, during which the issuer might not make any interest or other payments. Typically such workout or bankruptcy proceedings result in only partial recovery of cash payments or an exchange of the defaulted obligation for other debt or equity securities of the issuer or its affiliates, which may in turn be illiquid or speculative.

There are a number of significant risks inherent in the bankruptcy process. First, many events in a bankruptcy are the product of contested matters and adversary proceedings and are beyond the control of the creditors. While creditors are generally given an opportunity to object to significant actions, there can be no assurance that a bankruptcy court in the exercise of its broad powers would not approve actions that would be contrary to the interests of the Company. Second, the effect of a bankruptcy filing on an issuer may adversely and permanently affect the issuer. The issuer may lose its market position and key employees and otherwise become incapable of restoring itself as a viable entity. If for this or any other reason the proceeding is converted to a liquidation, the value of the issuer may not equal the liquidation value that was believed to exist at the time of the investment. Third, the duration of a bankruptcy proceeding is difficult to predict. A creditor’s return on investment can be adversely affected by delays while the plan of reorganization is being negotiated, approved by the creditors and confirmed by the bankruptcy court and until it ultimately becomes effective. Fourth, the administrative costs in connection with a bankruptcy proceeding are frequently high and would be paid out of the debtor’s estate prior to any return to

creditors. For example, if a proceeding involves protracted or difficult litigation, or turns into a liquidation, substantial assets may be devoted to administrative costs. Fifth, bankruptcy law permits the classification of “substantially similar” claims in determining the classification of claims in a reorganization. Because the standard for classification is vague, there exists the risk that the Company’s influence with respect to the class of securities or other obligations it owns can be lost by increases in the number and amount of claims in that class or by different classification and treatment. Sixth, in the early stages of the bankruptcy process it is often difficult to estimate the extent of, or even to identify, any contingent claims that might be made. Seventh, especially in the case of investments made prior to the commencement of bankruptcy proceedings, creditors can lose their ranking and priority if they exercise “domination and control” over a debtor and other creditors can demonstrate that they have been harmed by such actions. Eighth, certain claims that have priority by law (for example, claims for taxes) may be substantial. In any investment involving distressed debt obligations, there exists the risk that the transaction involving such debt obligations will be unsuccessful, take considerable time or will result in a distribution of cash or a new security or obligation in exchange for the distressed debt obligations, the value of which may be less than the Company’s purchase price of such debt obligations. Furthermore, if an anticipated transaction does not occur, the Company may be required to sell its investment at a loss. Given the substantial uncertainties concerning transactions involving distressed debt obligations in which the Company invests, there is a potential risk of loss by the Company of its entire investment in any particular investment.

Investments in companies operating in workout modes or under Chapter 11 of the Bankruptcy Code are also, in certain circumstances, subject to certain additional liabilities that may exceed the value of our original investment in a company. For example, under certain circumstances, creditors who have inappropriately exercised control over the management and policies of a debtor may have their claims subordinated or disallowed or may be found liable for damages suffered by parties as a result of such actions. The Investment Adviser’s active management style may present a greater risk in this area than would a more passive approach. In addition, under certain circumstances, payments to us and distributions by us or payments on the debt may be reclaimed if any such payment is later determined to have been a fraudulent conveyance or a preferential payment.

The Investment Adviser on our behalf may participate on committees formed by creditors to negotiate with the management of financially-troubled companies that may or may not be in bankruptcy or may negotiate directly with debtors with respect to restructuring issues. If we do choose to join a committee, we would likely be only one of many participants, all of whom would be interested in obtaining an outcome that is in their individual best interests. There can be no assurance that we would be successful in obtaining results most favorable to it in such proceedings, although we may incur significant legal and other expenses in attempting to do so. As a result of participation by us on such committees, we may be deemed to have duties to other creditors represented by the committees, which might thereby expose us to liability to such other creditors who disagree with our actions. Participation by us on such committees may cause us to be subject to certain restrictions on our ability to trade in a particular investment and may also make us an “insider” or an “underwriter” for purposes of federal securities laws. Either circumstance will restrict our ability to trade in or acquire additional positions in a particular investment when we might otherwise desire to do so.

Investments in debt obligations pose certain risks in U.S. courts with respect to insolvency considerations.

Various laws enacted for the protection of creditors may apply to the debt obligations held by the Company. The information in this paragraph is applicable with respect to U.S. issuers subject to U.S. bankruptcy laws. Insolvency considerations may differ with respect to other issuers. If a court in a lawsuit brought by an unpaid creditor or representative of creditors of an issuer of a debt obligation, such as a trustee in bankruptcy, were to find that the issuer did not receive fair consideration or reasonably equivalent value for incurring the indebtedness constituting the debt obligation and, after giving effect to such indebtedness, the issuer (i) was insolvent, (ii) was engaged in a business for which the remaining assets of such issuer constituted unreasonably small capital or (iii) intended to incur, or believed that it would incur, debts beyond its ability to pay such debts as they mature, such court could determine to invalidate, in whole or in part, such indebtedness as a fraudulent conveyance, to subordinate such indebtedness to existing or future creditors of such issuer, or to recover amounts previously paid by such issuer in satisfaction of such indebtedness. The measure of insolvency for purposes of the foregoing will vary. Generally, an issuer would be considered insolvent at a particular time if the sum of its debts were then greater than all of its property at a fair valuation, or if the present fair saleable value of its assets was then less than

the amount that would be required to pay its probable liabilities on its existing debts as they became absolute and matured. There can be no assurance as to what standard a court would apply in order to determine whether the issuer was “insolvent” after giving effect to the incurrence of the indebtedness constituting the debt obligation or that, regardless of the method of valuation, a court would not determine that the issuer was “insolvent” upon giving effect to such incurrence. In addition, in the event of the insolvency of an issuer of a debt obligation, payments made on such debt obligation could be subject to avoidance as a “preference” if made within a certain period of time (which may be as long as one year) before insolvency. Similarly, a court might apply the doctrine of equitable subordination to subordinate the claim of a lending institution against an issuer, to claims of other creditors of the borrower, when the lending institution, another investor, or any of their transferees, is found to have engaged in unfair, inequitable, or fraudulent conduct. In general, if payments on a debt obligation are avoidable, whether as fraudulent conveyances or preferences, such payments can be recaptured either from the initial recipient (such as the Company) or from subsequent transferees of such payments (such as the investors in the Company). To the extent that any such payments are recaptured from the Company, the resulting loss will be borne by the investors. However, a court in a bankruptcy or insolvency proceeding would be able to direct the recapture of any such payment from such a recipient or transferee only to the extent that such court has jurisdiction over such recipient or transferee or its assets. Moreover, it is likely that avoidable payments could not be recaptured directly from any such recipient or transferee that has given value in exchange for its investment, in good faith and without knowledge that the payments were avoidable. Although the Investment Adviser will seek to avoid conduct that would form the basis for a successful cause of action based upon fraudulent conveyance, preference or equitable subordination, these determinations are made in hindsight, and in any event, there can be no assurance as to whether any lending institution or other investor from which the Company acquired the debt obligations engaged in any such conduct (or any other conduct that would subject the debt obligations and the issuer to insolvency laws) and, if it did, as to whether such creditor claims could be asserted in a U.S. court (or in the courts of any other country) against the Company.

Our portfolio companies may incur additional debt that ranks equally with, or senior to, our investments in such companies.

Our portfolio companies usually will have, or may be permitted to incur, other debt that ranks equally with, or senior to, debt securities in which we will often invest. By their terms, such debt instruments may provide that the holders are entitled to receive payment of interest or principal on or before the dates on which we are entitled to receive payments. Also, in the event of insolvency, liquidation, dissolution, reorganization or bankruptcy of a portfolio company, holders of debt instruments ranking senior to our investment in that portfolio company would typically be entitled to receive payment in full before we receive any distribution in respect of our investment. After repaying such senior creditors, the portfolio company may not have any remaining assets to use for repaying its obligations to us. In the case of debt ranking equally with debt securities in which we invest, we would have to share on an equal basis any distributions with other creditors holding such debt in the event of an insolvency, liquidation, dissolution, reorganization or bankruptcy of the relevant portfolio company. In addition, we may not be in a position to control any portfolio company by investing in its debt securities. As a result, we are subject to the risk that a portfolio company in which we invest may make business decisions with which we disagree and the management of such company, as representatives of the holders of their common equity, may take risks or otherwise act in ways that do not serve our interests as debt investors.

Investments in senior loans, second lien loans, other secured loans and unsecured loans present certain challenges, such as restrictive covenants, low trading volume and risks related to rank.

Senior Loans. Bank loans are typically at the most senior level of the capital structure, and are sometimes secured by specific collateral, including, but not limited to, trademarks, patents, accounts receivable, inventory, equipment, buildings, real estate, franchises and common and preferred stock of the obligor or its affiliates. A portion of the Company’s investments may consist of loans and participations therein originated by banks and other financial institutions, typically referred to as “bank loans.” The Company’s investments may include loans of a type generally incurred by borrowers in connection with highly leveraged transactions, often to finance internal growth, acquisitions, mergers or stock purchases, or for other reasons. As a result of the additional debt incurred by the borrower in the course of the transaction, the borrower’s creditworthiness is often judged by the rating agencies to be below investment grade. Such loans are typically private corporate loans which are negotiated by one or more commercial banks or financial institutions and syndicated among a group of commercial banks and financial

institutions. In order to induce the lenders to extend credit and to offer a favorable interest rate, the borrower often provides the lenders with extensive information about its business which is not generally available to the public.

Bank loans often contain restrictive covenants designed to limit the activities of the borrower in an effort to protect the right of lenders to receive timely payments of principal and interest. Such covenants may include restrictions on distribution payments, specific mandatory minimum financial ratios, limits on total debt and other financial tests. Bank loans usually have shorter terms than subordinated obligations and may require mandatory prepayments from excess cash flow, asset dispositions and offerings of debt and/or equity securities. The bank loans and other debt obligations to be acquired by the Company are likely to be below investment grade.

The Company may acquire interests in bank loans and other debt obligations either directly (by way of sale or assignment) or indirectly (by way of participation). The Company may purchase bank loans and other debt obligations directly from the issuers as well as in the secondary transactions. The purchaser of an assignment typically succeeds to all the rights and obligations of the assigning institution and becomes a lender under the credit agreement with respect to the debt obligation; however, its rights can be more restricted than those of the assigning institution, and in any event, the Company may not be able unilaterally to enforce all rights and remedies under the loan and any associated collateral. A participation interest in a portion of a debt obligation typically results in a contractual relationship only with the institution participating out the interest, not with the borrower. In purchasing participations, the Company generally will have no right to enforce compliance by the borrower with the terms of the loan agreement or any rights of setoff against the borrower, and the Company may not directly benefit from the collateral supporting the debt obligation in which it has purchased the participation. As a result, the Company will be exposed to the credit risk of both the borrower and the institution selling the participation.

Purchasers of bank loans are predominantly commercial banks, investment funds and investment banks. As secondary market trading volumes increase, new bank loans frequently adopt standardized documentation to facilitate loan trading which should improve market liquidity. There can be no assurance, however, that future levels of supply and demand in bank loan trading will provide an adequate degree of liquidity or that the current level of liquidity will continue. Because of the provision to holders of such loans of confidential information relating to the borrower, the unique and customized nature of the loan agreement, the limited universe of eligible purchasers and the private syndication of the loan, bank loans are not as easily purchased or sold as a publicly-traded security, and historically the trading volume in the bank loan market has been small relative to the high-yield debt market.

Second Lien Loans. Second lien loans are subject to the same risks associated with investment in senior loans and non-investment grade securities. However, second lien loans are second in right of payment to senior loans and therefore are subject to additional risk that the cash flow of the borrower and any property securing the loan may be insufficient to meet scheduled payments after giving effect to the senior secured obligations of the borrower. Second lien loans are expected to have greater price volatility than senior loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in second lien loans, which would create greater credit risk exposure.

Other Secured Loans. Secured loans other than senior loans and second lien loans are subject to the same risks associated with investment in senior loans, second lien loans and non-investment grade securities. However, such loans may rank lower in right of payment than any outstanding senior loans and second lien loans of the borrower and therefore are subject to additional risk that the cash flow of the borrower and any property securing the loan may be insufficient to meet scheduled payments after giving effect to the higher-ranking secured obligations of the borrower. Lower-ranking secured loans are expected to have greater price volatility than senior loans and second lien loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in lower-ranking secured loans, which would create greater credit risk exposure.

Unsecured Loans. Unsecured loans are subject to the same risks associated with investment in senior loans, second lien loans, other secured loans and non-investment grade securities. However, because unsecured loans have lower priority in right of payment to any higher ranking obligations of the borrower and are not backed by a security interest in any specific collateral, they are subject to additional risk that the cash flow of the borrower and available assets may be insufficient to meet scheduled payments after giving effect to any higher ranking obligations of the borrower. Unsecured loans are expected to have greater price volatility than senior loans, second lien loans and

other secured loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in unsecured loans, which would create greater credit risk exposure.

The debt securities in which we invest are subject to prepayment risk.

If interest rates fall, the principal on debt held by the Company may be able to be paid earlier than expected. If this happens, the proceeds from a prepaid security may be reinvested by the Company in securities bearing lower interest rates, resulting in a possible decline in the Company’s income and distributions to stockholders. The improved financial performance of an issuer can lead an issuer to prepay securities.

Inflation may cause the real value of our investments to decline.

Inflation risk results from the variation in the value of cash flows from a security due to inflation, as measured in terms of purchasing power. For example, if the Company purchases a bond in which it can realize a coupon rate of 5%, but the rate of inflation increases from 2% to 6%, then the purchasing power of the cash flow has declined. For all but adjustable bonds or floating rate bonds, the Company is exposed to inflation risk because the interest rate the issuer promises to make is fixed for the life of the security. To the extent that interest rates reflect the expected inflation rate, floating rate bonds have a lower level of inflation risk.

The Company’s reinvestment of its cash flow subjects it to risks posed by fluctuating interest rates.

The Company generally reinvests the cash flows received from a security. The additional income from such reinvestment, sometimes called interest-on-interest, is reliant on the prevailing interest rate levels at the time of reinvestment. There is a risk that the interest rate at which interim cash flows can be reinvested will fall. Reinvestment risk is greater for longer holding periods and for securities with large, early cash flows such as high-coupon bonds. Reinvestment risk also applies generally to the reinvestment of the proceeds the Company receives upon the maturity or sale of a portfolio security.

Issuers’ rights to “call” all or part of certain securities subject the Company to timing risks.

Many agency, corporate and municipal bonds, and most mortgage-backed securities, contain a provision that allows the issuer to “call” all or part of the issue before the bond’s maturity date, often after 5 or 10 years. The issuer usually retains the right to refinance the bond in the future if market interest rates decline below the coupon rate. There are three disadvantages to the call provision. First, the cash flow pattern of a callable bond is not known with certainty. Second, because an issuer is more likely to call the bonds when interest rates have dropped, the Company is exposed to reinvestment rate risk, i.e., the Company may have to reinvest at lower interest rates the proceeds received when the bond is called. Finally, the capital appreciation potential of a bond will be reduced because the price of a callable bond may not rise much above the price at which the issuer may call the bond. The improved financial performance of an issuer can lead an issuer to “call” securities.

Common stock investments may be volatile and may fluctuate substantially.

The Company has exposure to common stocks. Although common stocks have historically generated higher average total returns than fixed-income securities over the long term, common stocks also have experienced significantly more volatility in those returns. The equity securities acquired by the Company may fail to appreciate and may decline in value or become worthless.

Distributions on common stock investments are not guaranteed and are declared at the discretion of the issuer’s board of directors.

Distributions on common stock are not fixed, but are declared at the discretion of an issuer’s board of directors. There is no guarantee that the issuers of the common stocks in which the Company invests will declare distributions in the future or that, if declared, they will remain at current levels or increase over time.

Investments in small and mid-cap company securities pose risks due to their relatively smaller size, including low volatility and trading volumes.

We invest in companies with small or medium capitalizations. Securities issued by smaller and medium companies can be more volatile than, and perform differently from, larger company securities. There may be less trading in a smaller or medium company’s securities, which means that buy and sell transactions in those securities

could have a larger impact on the security’s price than is the case with larger company securities. Smaller and medium companies may have fewer business lines; changes in any one line of business, therefore, may have a greater impact on a smaller or medium company’s security price than is the case for a larger company. In addition, smaller or medium company securities may not be well known to the investing public.

Investments in preferred stocks present certain challenges, including deferred distributions, subordination to other debt instruments, lack of liquidity and limited voting rights.

To the extent the Company invests in preferred securities, there are special risks associated with investing in preferred securities, including:

Deferral. Preferred securities may include provisions that permit the issuer, at its discretion, to defer distributions for a stated period without any adverse consequences to the issuer. If the Company owns a preferred security that is deferring its distributions, the Company may be required to report income for tax purposes although it has not yet received such income.

Subordination. Preferred securities are subordinated to bonds and other debt instruments in a company’s capital structure in terms of priority to corporate income and liquidation payments, and therefore will be subject to greater credit risk than more senior debt instruments.

Liquidity. Preferred securities may be substantially less liquid than many other securities, such as common stocks or U.S. government securities.

Limited Voting Rights. Generally, preferred security holders (such as the Company) have no voting rights with respect to the issuing company unless preferred dividends have been in arrears for a specified number of periods, at which time the preferred security holders may elect a number of directors to the issuer’s board. Generally, once all the arrearages have been paid, the preferred security holders no longer have voting rights.

Lending of the Company’s securities may lead to the risk of lost opportunities due to the securities’ unavailability.

The Company may lend its portfolio securities to banks or dealers that meet the creditworthiness standards established by the Board. Securities lending is subject to the risk that loaned securities may not be available to the Company on a timely basis and the Company may, therefore, lose the opportunity to sell the securities at a desirable price. Any loss in the market price of securities loaned by the Company that occurs during the term of the loan would be borne by the Company and would adversely affect the Company’s performance. Also, there may be delays in recovery, or no recovery, of securities loaned or even a loss of rights in the collateral should the borrower of the securities fail financially while the loan is outstanding. These risks may be greater for non-U.S. securities.

Our use of certain instruments, such as options, structured finance securities and derivatives, may result in losses greater than if they had not been used.

We may invest in various derivative securities which, to the extent they are not qualifying assets, will be limited to the 30% of our assets that we may use for opportunistic investments.

Risks Associated with Options. There are several risks associated with transactions in options on securities, such as, exchange-listed, over-the-counter and index options. For example, there are significant differences between the securities and options markets that could result in an imperfect correlation between these markets, causing a given transaction not to achieve its objectives. A decision as to whether, when and how to use options involves the exercise of skill and judgment, and even a well-conceived transaction may be unsuccessful to some degree because of market behavior or unexpected events.

As the writer of a covered call option, the Company foregoes, during the option’s life, the opportunity to profit from increases in the market value of the security covering the call option above the sum of the premium and the strike price of the call, but has retained the risk of loss should the price of the underlying security decline. As the Company writes covered calls over more of its portfolio, its ability to benefit from capital appreciation becomes more limited. The writer of an option has no control over the time when it may be required to fulfill its obligation as a writer of the option. Once an option writer has received an exercise notice, it cannot effect a closing purchase

transaction in order to terminate its obligation under the option and must deliver the underlying security at the exercise price.

When the Company writes covered put options, it bears the risk of loss if the value of the underlying stock declines below the exercise price minus the put premium. If the option is exercised, the Company could incur a loss if it is required to purchase the stock underlying the put option at a price greater than the market price of the stock at the time of exercise plus the put premium the Company received when it wrote the option. While the Company’s potential gain in writing a covered put option is limited to distributions earned on the liquid assets securing the put option plus the premium received from the purchaser of the put option, the Company risks a loss equal to the entire exercise price of the option minus the put premium.

Risks of Investing in Structured Finance Securities. A portion of the Company’s investments may consist of collateralized mortgage obligations, collateralized bond obligations, collateralized loan obligations or similar instruments. Structured finance securities may present risks similar to those of the other types of debt obligations in which the Company may invest and, in fact, such risks may be of greater significance in the case of structured finance securities. Moreover, investing in structured finance securities may entail a variety of unique risks. Among other risks, structured finance securities may be subject to prepayment risk. In addition, the performance of a structured finance security will be affected by a variety of factors, including its priority in the capital structure of the issuer thereof, and the availability of any credit enhancement, the level and timing of payments and recoveries on and the characteristics of the underlying receivables, loans or other assets that are being securitized, remoteness of those assets from the originator or transferor, the adequacy of and ability to realize upon any related collateral and the capability of the servicer of the securitized assets.

The Company invests in a special type of structured finance security called Royalty Securities. Royalty Securities are securities related to pharmaceutical royalty streams, which means that they are debt and equity securities secured by or related to royalties derived from licenses of intellectual property related to pharmaceutical products.

Companies holding rights to intellectual property may create bankruptcy remote special purpose entities whose underlying assets are royalty license agreements and intellectual property rights related to a product. Royalty Securities may include bonds, loans and equity issued by the special purpose entity.

In a typical structure in the pharmaceutical industry, a small pharmaceutical company that develops a compound may license the commercial opportunity to a large-cap pharmaceutical company in exchange for payments upon completion of certain milestones (for example, FDA approval) and a percentage of future product sales. Upon securing the right to receive royalties on product sales, the small pharmaceutical company finances a loan or bond secured by the royalty stream, which is typically non-recourse to either of the pharmaceutical companies.

In addition, a company, the sponsor, may create a wholly owned subsidiary, the issuer, that issues the Royalty Securities. The sponsor sells, assigns and contributes to the issuer rights under one or more license agreements, including the right to receive royalties and certain other payments from sales of the pharmaceutical or other products. The sponsor also pledges the equity ownership interests in the issuer to the trustee under the indenture related to the notes. In return, the sponsor receives the proceeds of the securities from the issuer. The issuer of the securities grants a security interest in its assets to the trustee and is responsible for the debt service on the notes. An interest reserve account may be established to provide a source for payments should there be a cash flow shortfall for one or more periods.

If the issuer of the loan or bond defaults, any recourse will be limited to the issuer (which is formed for the limited purpose of purchasing and holding the license agreement or related intellectual property) and the collateral. The pharmaceutical or other company sponsoring the special purpose entity will generally not have the obligation to contribute additional equity to the issuer.

Risk factors of Royalty Securities, in addition to the risks of structured finance securities generally, include risks relating to the products associated with the royalty stream (such as challenges to the intellectual property rights, product recalls and product liability claims, and approval by the FDA of the drug), risks relating to the license

agreement, risks relating to the structure of the financing and risks relating to bankruptcy or reorganization proceedings.

Asset-Backed Securities Risk. Payment of interest and repayment of principal on asset-backed securities may be largely dependent upon the cash flows generated by the assets backing the securities and, in certain cases, supported by letters of credit, surety bonds or other credit enhancements. Asset-backed security values may also be affected by the creditworthiness of the servicing agent for the pool, the originator of the loans or receivables or the entities providing the credit enhancement. In addition, the underlying assets are subject to prepayments that shorten the securities’ weighted average maturity and may lower their return.

Mortgage-Backed Securities Risk. A mortgage-backed security, which represents an interest in a pool of assets such as mortgage loans, will mature when all the mortgages in the pool mature or are prepaid. Therefore, mortgage-backed securities do not have a fixed maturity, and their expected maturities may vary when interest rates rise or fall.

When interest rates fall, homeowners are more likely to prepay their mortgage loans. An increased rate of prepayments on the Company’s mortgage-backed securities will result in an unforeseen loss of interest income to the Company as the Company may be required to reinvest assets at a lower interest rate. Because prepayments increase when interest rates fall, the price of mortgage-backed securities does not increase as much as other fixed income securities when interest rates fall.

When interest rates rise, homeowners are less likely to prepay their mortgage loans. A decreased rate of prepayments lengthens the expected maturity of a mortgage-backed security. Therefore, the prices of mortgage-backed securities may decrease more than prices of other fixed income securities when interest rates rise.

Derivative Risk. Derivative transactions in which the Company may engage for hedging and speculative purposes or to enhance total return, including engaging in transactions such as options, futures, swaps, foreign currency transactions, forward foreign currency contracts, currency swaps or options on currency futures and other derivatives transactions (collectively, “Derivative Transactions”), also involve certain risks and special considerations. Derivative Transactions have risks, including the imperfect correlation between the value of such instruments and the underlying assets, the possible default of the other party to the transaction or illiquidity of the derivative instruments. Furthermore, the ability to successfully use Derivative Transactions depends on the Investment Adviser’s ability to predict pertinent market movements, which cannot be assured. Thus, the use of Derivative Transactions may result in losses greater than if they had not been used, may require the Company to sell or purchase portfolio securities at inopportune times or for prices other than current market values, may limit the amount of appreciation the Company can realize on an investment or may cause the Company to hold a security that it might otherwise sell. The use of foreign currency transactions can result in the Company’s incurring losses as a result of the imposition of exchange controls, suspension of settlements or the inability of the Company to deliver or receive a specified currency. Additionally, amounts paid by the Company as premiums and cash or other assets held in margin accounts with respect to Derivative Transactions are not otherwise available to the Company for investment purposes.

Unless and until the Company is fully qualified to utilize the regulated derivatives markets, the use of Derivative Transactions will generally be confined to private transactions with legally-authorized counterparties.

To the extent that the Company purchases options pursuant to a hedging strategy, the Company will be subject to the following additional risks. If a put or call option purchased by the Company is not sold when it has remaining value, and if the market price of the underlying security remains equal to or greater than the exercise price (in the case of a put), or remains less than or equal to the exercise price (in the case of a call), the Company will lose its entire investment in the option.

Also, where a put or call option on a particular security is purchased to hedge against price movements in a related security, the price of the put or call option may move more or less than the price of the related security. If restrictions on exercise were imposed, the Company might be unable to exercise an option it had purchased. If the Company were unable to close out an option that it had purchased on a security, it would have to exercise the option in order to realize any profit or the option may expire worthless.

Counterparty Risk. We will be subject to credit risk with respect to the counterparties to the derivative contracts purchased or sold by us. If a counterparty becomes bankrupt, or otherwise fails to perform its obligations under a derivative contract due to financial difficulties, we may experience significant delays in obtaining any recovery under the derivative contract in a bankruptcy or other reorganization proceeding. We may obtain only a limited recovery or may obtain no recovery in such circumstances.

Synthetic Securities Risk. In addition to credit risks associated with holding non-investment grade loans and high-yield debt securities, with respect to synthetic securities the Company will usually have a contractual relationship only with the counterparty of such synthetic securities, and not the Reference Obligor (as defined below) on the Reference Obligation (as defined below). The Company generally will have no right to enforce directly compliance by the Reference Obligor with the terms of the Reference Obligation nor any rights of set-off against the Reference Obligor, nor have any voting rights with respect to the Reference Obligation. The Company will not benefit directly from any collateral supporting the Reference Obligation or have the benefit of the remedies on default that would normally be available to a holder of such Reference Obligation. In addition, in the event of insolvency of its counterparty, the Company will be treated as a general creditor of such counterparty and will not have any claim with respect to the credit risk of the counterparty as well as that of the Reference Obligor. As a result, an overabundance of synthetic securities with any one counterparty subjects the notes to an additional degree of risk with respect to defaults by such counterparty as well as by the Reference Obligor. The Investment Adviser may not perform independent credit analyses of the counterparties, any such counterparty, or an entity guaranteeing such counterparty, individually or in the aggregate. A “Reference Obligation” is the debt security or other obligation upon which the synthetic security is based. A “Reference Obligor” is the obligor on a Reference Obligation. There is no maximum amount of the Company’s assets that may be invested in these securities.

Non-diversification of the Company’s assets or the use of other focused strategies may present more risks than if the Company were diversified or used broad strategies.

While the Investment Adviser will invest in a number of fixed-income and equity instruments issued by different issuers and plans to employ multiple investment strategies with respect to our portfolio, it is possible that a significant amount of our investments could be invested in the instruments of only a few companies or other issuers or that at any particular point in time one investment strategy could be more heavily weighted than the others. As of December 31, 2008, approximately 85.3% of our portfolio consisted of investments in 10 issuers, which represents a greater portion of the portfolio in a relatively small number of issuers than as of the end of prior periods. The focus of our portfolio in any one issuer would subject us to a greater degree of risk with respect to defaults by such issuer or other adverse events affecting that issuer, and the focus of the portfolio in any one industry or group of industries would subject us to a greater degree of risk with respect to economic downturns relating to such industry. The focus of our portfolio in any one investment strategy would subject us to a greater degree of risk than if our portfolio were varied in its investments with respect to several investment strategies. The Company is not subject to concentration restrictions applicable to investment companies. As of December 31, 2008, over 41.3% of our total assets were invested in the healthcare industry.

Investments in small, unseasoned companies may be risky.

We may invest in the securities of smaller, less seasoned companies. These investments may present greater opportunities for growth, but also involve greater risks than customarily are associated with investments in securities of more established companies. Some of the companies in which we may invest will be start-up companies, which may have insubstantial operational or earnings history or may have limited products, markets, financial resources or management depth. Some may also be emerging companies at the research and development stage with no products or technologies to market or approved for marketing. Securities of emerging companies may lack an active secondary market and may be subject to more abrupt or erratic price movements than securities of larger, more established companies or stock market averages in general. Competitors of certain companies may have substantially greater financial resources than many of the companies in which we may invest.

Our investments in foreign securities may involve significant risks in addition to the risks inherent in U.S. investments.

We may invest up to (but may invest more than) 20% of our total assets in foreign securities, which may include securities denominated in U.S. dollars or in foreign currencies or multinational currency units. Investing in foreign securities involves certain risks not involved in domestic investments, including, but not limited to: (1) future foreign economic, financial, political and social developments; (2) different legal systems; (3) the possible imposition of exchange controls or other foreign governmental laws or restrictions; (4) lower trading volume; (5) much greater price volatility and illiquidity of certain foreign securities markets; (6) different trading and settlement practices; (7) less governmental supervision; (8) changes in currency exchange rates; (9) high and volatile rates of inflation; (10) fluctuating interest rates; (11) less publicly available information; (12) different accounting, auditing and financial recordkeeping standards and requirements; and (13) expropriation, confiscatory taxation and nationalization.

We may employ hedging techniques to minimize currency exchange rate risks or interest rate risks, but we can offer no assurance that such strategies will be effective. If we engage in hedging transactions, we may expose ourselves to risks associated with such transactions. Hedging against a decline in the values of our portfolio positions does not eliminate the possibility of fluctuations in the values of such positions or prevent losses if the values of such positions decline. Moreover, it may not be possible to hedge against an exchange rate or interest rate fluctuation that is so generally anticipated that we are not able to enter into a hedging transaction at an acceptable price.

Our investments in emerging markets may involve significant risks in addition to the risks inherent in developed markets.

Some of the securities of foreign issuers in which the Company may invest include securities of emerging market issuers. Emerging market countries generally include every nation in the world except the U.S., Canada, Japan, Australia, New Zealand and most countries located in Western Europe. Investing in securities of issuers based in underdeveloped emerging markets entails all of the risks of investing in securities of non-U.S. issuers to a heightened degree. These heightened risks include: (i) greater risks of expropriation, confiscatory taxation and nationalization and less social, political and economic stability; (ii) the smaller size of the markets for such securities and a lower volume of trading, resulting in lack of liquidity and in price volatility; and (iii) certain national policies that may restrict the Company’s investment opportunities, including restrictions on investing in issuers or industries deemed sensitive to relevant national interests.

Terrorist attacks and acts of war may affect any market for our shares, impact the businesses in which we invest and harm our business, operating results and financial condition.

The war with Iraq, its aftermath and the continuing U.S. presence in Iraq and Afghanistan are likely to have a substantial impact on the U.S. and world economies and securities markets. The nature, scope and duration of the war and occupations cannot be predicted with any certainty. Terrorist attacks on the World Trade Center and the Pentagon on September 11, 2001 closed some of the U.S. securities markets for a four-day period and similar events in the future cannot be ruled out. The war, the U.S. presence in Iraq, terrorism and related geopolitical risks have led to, and may in the future lead to, increased short-term market volatility and may have adverse long-term effects on U.S. and world economies and markets generally. Those events could also have an acute effect on individual issuers or related groups of issuers. These risks could also adversely affect individual issuers and securities markets, inflation and other factors relating to the shares.

There can be no assurance that the Investment Adviser will be able to predict accurately the future course of the price movements of securities and other investments and the movements of interest rates.

The profitability of a significant portion of the Company’s investment program depends to a great extent upon the Investment Adviser’s correctly assessing the future course of the price movements of securities and other investments and the movements of interest rates. There can be no assurance that the Investment Adviser will be able to predict accurately these price and interest rate movements. With respect to the investment strategies the Company may utilize, there will be a high degree of market risk.

Risks Related to an Investment in Our Common Stock

We may experience fluctuations in our net asset value.

Because a substantial portion of the assets of the Company consist of loans and debt securities, the net asset value of the shares will fluctuate with changes in interest rates, as well as with changes in the prices of the securities owned by the Company caused by other factors. These fluctuations are likely to be greater when the Company is using financial leverage.

We may be subject to U.S. federal income tax if we are unable to qualify as a regulated investment company.

To maintain our qualification as a regulated investment company under the Code, we must meet certain source-of-income, asset diversification and annual distribution requirements. Satisfying these requirements may require the Company to take actions that it would not otherwise take, such as selling investments at unattractive prices to satisfy such source-of-income, diversification or distribution requirements. In addition, while the Company is authorized to borrow funds in order to make distributions, under the 1940 Act it is not permitted to make distributions to stockholders while its debt obligations, if any, and other senior securities are outstanding unless certain “asset coverage” tests are met. If we fail to qualify as a regulated investment company for any reason and become or remain subject to U.S. federal corporate income tax, the resulting corporate taxes could substantially reduce our net assets, the amount of income available for distribution and the amount of our distributions. Such a failure would have a material adverse effect on the Company and its stockholders.

Our recognition of income before or without receiving cash representing such income may lead to difficulties in making distributions.

For U.S. federal income tax purposes, we will include in income certain amounts that we have not yet received in cash, such as original issue discount, which may arise if we invest in zero coupon securities, deferred interest securities or certain other securities, or if we receive warrants in connection with the making of a loan or possibly in other circumstances. Such original issue discount generally will be included in income before we receive any corresponding cash payments. We also may be required to include in income certain other amounts that we will not receive in cash.

That part of the incentive fee payable by us that relates to our net investment income will be computed and paid on income that may include interest that has been accrued but not yet received in cash. If a portfolio company defaults on a loan that is structured to provide accrued interest, it is possible that accrued interest previously used in the calculation of the incentive fee will become uncollectible. In such case, the Investment Adviser is not obligated to reimburse the Company for any incentive fees received even if the Company subsequently recognizes losses or never receives cash with respect to income that was previously accrued.

Since in certain cases we may recognize income before or without receiving cash representing such income, we may have difficulty making distributions in the amounts necessary to satisfy the requirements for maintaining regulated investment company status and for avoiding U.S. federal income and excise taxes. Accordingly, to meet these distribution requirements we may have to sell some of our investments at times we would not consider advantageous, or we may have to raise additional debt or equity capital or reduce new investment originations. If we are not able to obtain cash from other sources, we may fail to qualify as a regulated investment company and become subject to corporate-level U.S. federal income tax.

Changes in the laws or regulations governing our portfolio companies could have a material adverse affect on our business.

Our portfolio companies will be subject to regulation by laws at the local, state and federal level. These laws and regulations, as well as their interpretation, may be changed from time to time. Any change in these laws or regulations, or any failure to comply with them by our portfolio companies, could have a material adverse affect on our business.

Our certificate of incorporation and bylaws could deter takeover attempts and have an adverse impact on the price of our shares.,

Our certificate of incorporation and bylaws include provisions that could limit the ability of other entities or persons to acquire control of us or convert us to an investment company. These provisions could deprive the holders of shares of opportunities to sell their shares at a premium over the then current market price of the shares or at net asset value.


Item 1B.	*Unresolved Staff Comments*

None.


Item 2.	*Properties*

As of December 31, 2008, we do not own any real estate or other physical properties materially important to our operation. Our principal executive office is located at NexBank Tower, 13455 Noel Road, Suite 800, Dallas, Texas 75240. We believe that our office facilities are suitable and adequate for our business as it is contemplated to be conducted.


Item 3.	*Legal Proceedings*

We are not a defendant in any material pending legal proceeding, and no such material proceedings are known to be contemplated.


Item 4.	*Submission of Matters to a Vote of Security Holders*

No matters were submitted to a vote of stockholders through the solicitation of proxies or otherwise during the fourth quarter of the fiscal year ending December 31, 2008.

PART II


Item 5.	*Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities*

Price Range of Common Stock

Our common stock began trading on the New York Stock Exchange (“NYSE”) on February 22, 2007, under the symbol “HCD.” On February 6, 2009, there were approximately 5,325 record holders and beneficial owners (held in street name) of our common stock. The following table sets forth the range of high and low sales prices of our common stock as reported on the NYSE from our IPO through December 31, 2008.


	Sales Price
	High		Low

Year Ending December 31, 2008
First Quarter	$	9.26	$	5.96
Second Quarter	$	8.68	$	5.66
Third Quarter	$	6.13	$	2.94
Fourth Quarter	$	3.42	$	0.86
Year Ending December 31, 2007
First Quarter (period from January 18, 2007* to March 31, 2007)	$	15.25	$	14.06
Second Quarter	$	15.05	$	13.84
Third Quarter	$	14.48	$	9.75
Fourth Quarter	$	13.20	$	8.38


*		Commencement of operations

Holders

As of February 6, 2009, we had approximately 10 stockholders of record.

Distributions

We currently intend to make quarterly distributions to our stockholders. Our quarterly distributions, if any, will be determined by our Board.

The following table summarizes the distributions declared by us for each quarter following the completion of our IPO:

Date Declared

Record Date

Payment Date

Amount

March 9, 2007

June 19, 2007

June 29, 2007

0.2625

August 3, 2007

September 18, 2007

September 28, 2007

0.2625

November 6, 2007

December 21, 2007

December 31, 2007

0.2625

Total declared during 2007

0.7875

March 7, 2008

March 20, 2008

March 31, 2008

0.2625

June 6, 2008

June 20, 2008

June 30, 2008

0.2625

September 5, 2008

September 19, 2008

September 30, 2008

0.1500

December 4, 2008

December 19, 2008

December 31, 2008

0.0750

Total declared during 2008

0.7500

As a BDC, we have elected to be treated as a regulated investment company under Subchapter M of the Code. To qualify as a regulated investment company and maintain our regulated investment company status, we must distribute at least 90% of our “investment company taxable income” (which, generally, consists of ordinary income and realized net short-term capital gains in excess of realized net long-term capital losses, if any) and net tax-exempt interest. We intend to distribute each quarter to stockholders substantially all of our net investment income and net short-term capital gains that legally are available for distribution in order to meet this distribution requirement.

In order to avoid certain excise taxes imposed on regulated investment companies, we generally must distribute during each calendar year an amount at least equal to the sum of (i) 98% of our ordinary income for the calendar year, (ii) 98% of our capital gains in excess of our capital losses for the one-year period ending on October 31 of each calendar year, and (iii) any ordinary income and net capital gains for preceding years that were not distributed during such years. There can be no assurance, however, that sufficient amounts of our taxable income and capital gain will be distributed to avoid entirely the imposition of the excise tax. In that event, we will be liable for the excise tax only on the amount by which we do not meet this 98% distribution requirement.

A portion of the cash distributions we receive from our investments may be treated as a return of capital and, therefore, generally would not be treated as investment company taxable income. While we anticipate that we will distribute some or all of such return of capital to stockholders, we are not required to do so in order to maintain our regulated investment company status.

Although we currently intend to distribute realized net capital gains (i.e., net long-term capital gains in excess of short-term capital losses), if any, at least annually, out of the assets legally available for such distributions, we may in the future decide to retain such capital gains for investment and designate such retained amount as a deemed distribution.

Unless the registered owner of your shares elects to receive cash by contacting PNC Global Investment Servicing (U.S.) Inc. (formerly PFPC Inc.) (the “Plan Agent”), the agent for stockholders that is administering our Dividend Reinvestment Plan (the “Plan”), all distributions declared for your shares will be automatically reinvested by the Plan Agent in additional shares. If the registered owner of your shares elects not to participate in the Plan, you will receive all distributions in cash paid by check mailed directly to you (or, if the shares are held in street or other nominee name, then to such nominee) by the Plan Agent, as the dividend disbursing agent. You may elect not to participate in the Plan and to receive all distributions in cash by sending written instructions or by contacting the Plan Agent, as the dividend disbursing agent, at the address set forth below. Participation in the Plan is completely voluntary and may be terminated or resumed at any time without penalty by contacting the Plan Agent before the distribution record date;

otherwise, such termination or resumption will be effective with respect to any subsequently-declared distribution. Some brokers may automatically elect to receive cash on your behalf and may reinvest such cash in additional shares for you. Stockholders that receive distributions in the form of shares will be subject to the same federal, state and local tax consequences as stockholders who elect to receive their distributions in cash. If you wish for all distributions declared on your shares to be automatically reinvested pursuant to the Plan, please contact your broker.

All correspondence concerning the Plan should be directed to the Plan Agent at PNC Global Investment Servicing (U.S.) Inc., 301 Bellevue Parkway, Wilmington, Delaware 19809; telephone (877) 665-1287.

Recent Sales of Unregistered Securities

During the year ended December 31, 2008, we did not sell any securities that were not registered under the Securities Act of 1933.

Issuer Purchases of Equity Securities

We did not repurchase any shares of our common stock during any month within the year ended December 31, 2008.

Stock Performance Graph

The following graph compares the total cumulative return on our common stock with that of the Standard & Poor’s 500 Stock Index (the “S&P 500 Index”) ⁽¹⁾ and the BDC Peer Group ⁽²⁾ , for the period February 26, 2007 (the date of the Company’s IPO) through December 31, 2008 (the “Performance Graph”). The Performance Graph assumes that, on February 26, 2007, a person invested $100 in our common stock, the equity securities of the companies included in the S&P 500 Index, and the equity securities of the companies included in the BDC Peer Group. The Performance Graph measures total stockholder return, which takes into account changes in stock price and assumes that all distributions are reinvested in additional shares on the ex-date without commissions. This Performance Graph and the related textual information are based on historical data and are not necessarily indicative of future performance.

COMPARISON OF CUMULATIVE TOTAL RETURN AMONG HIGHLAND DISTRESSED
OPPORTUNITIES, INC., S&P 500, AND BDC PEER GROUP



Source: SNL Financial LC		^© 2009


⁽¹⁾		The S&P 500 Index is an unmanaged, capitalization-weighted index generally representative of the U.S. market for large capitalization stocks. This information shows how our performance compares with the returns of one of the most widely used U.S. equity indexes. The S&P 500 Index cannot be invested in directly.

⁽²⁾		The BDC Peer Group consists of the following closed-end companies that have elected to be regulated as business development companies under the 1940 Act:


Allied Capital Corporation American Capital Strategies, Ltd. Apollo Investment Corporation Ares Capital Corporation Capital Southwest Corporation Equus Total Return, Inc. Fifth Street Finance Corporation		Gladstone Capital Corporation Gladstone Investment Corporation. GSC Investment Corporation Harris & Harris Group, Inc. Hercules Technology Growth Capital, Inc. Kayne Anderson Energy Development Co.		Kohlberg Capital Corporation MCG Capital Corporation Medallion Financial Corporation MVC Capital, Inc. NGP Capital Resources Company Patriot Capital Funding, Inc.		Pennantpark Investment Corp. Prospect Capital Corporation TICC Capital Corporation Tortoise Capital Resources Corp. Triangle Capital Corporation Utek Corporation


	Period Ending
	02/26/07		12/31/07		03/31/08		06/30/08		09/30/08		12/31/08
Highland Distressed Opportunities, Inc.		100.00		60.62		51.57		43.85		23.59		18.25

BDC Peer Group		100.00		77.83		76.20		60.14		62.07		26.77

S&P 500		100.00		102.92		93.20		90.66		83.07		64.84

The graph and other information furnished under this Part II Item 5(a) of this Form 10-K shall not be deemed to be “soliciting material” or to be “filed” with the SEC or subject to Regulation 14A or 14C, or to the liabilities of Section 18 of the 1934 Act.


Item 6.	*Selected Financial Data*

The following table sets forth our selected historical financial and operating data, as of and for the dates and period indicated. The selected historical financial data are derived from our financial statements which have been audited by PricewaterhouseCoopers LLP, our independent registered public accounting firm. This selected financial data should be read in conjunction with our financial statements and related notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this report.


	Year Ended			Period Ended
	December 31,			December 31,
	2008			2007 ^(a)

Total investment income	$	21,978,674		$	31,329,721
Net expenses	$	11,188,738		$	14,240,203
Net investment income	$	10,789,936		$	17,089,518
Net realized and unrealized gain/(loss) on investments	$	(118,960,982	)	$	(74,340,032	)
Net increase/(decrease) in stockholders’ equity (net assets) resulting from operations	$	(108,171,046	)	$	(57,250,514	)
Balance Sheet Data:
Total assets	$	87,162,000		$	346,923,924
Borrowings outstanding	$	15,500,000		$	142,000,000
Stockholders’ equity (net assets)	$	60,556,428		$	182,015,052


^(a)		Highland Distressed Opportunities, Inc. commenced operations on January 18, 2007.


Item 7.	*Management’s Discussion and Analysis of Financial Condition and Results of Operations*

The information contained in this section should be read in conjunction with the Selected Financial and Other Data and our financial statements and notes thereto appearing elsewhere in this Annual Report.

Overview

We were incorporated in Delaware on August 22, 2006 and initially funded on January 18, 2007. We commenced material operations on February 27, 2007. Our investment objective is total return generated by both capital appreciation and current income. We will seek to achieve this objective by investing in financially-troubled

or distressed companies that are either middle-market companies or unlisted companies by investing in senior secured debt, mezzanine debt and unsecured debt, each of which may include an equity component, and in equity investments.

Generally, distressed companies are those that (i) are facing financial or other difficulties and (ii) are or have been operating under the provisions of the U.S. Bankruptcy Code or other similar laws or, in the near future, may become subject to such provisions or otherwise be involved in a restructuring of their capital structure. We use the term “middle-market” to refer to companies with annual revenues between $50 million and $1 billion. We use the term “unlisted” to refer to companies not listed on a national securities exchange (for example, companies whose securities are quoted on the over-the-counter bulletin board or through Pink Sheets LLC would not be “listed” on a national securities exchange, although they may be considered “public” companies).

We have elected to be treated as a business development company (a “BDC”) under the Investment Company Act of 1940 (the “1940 Act”). As a BDC, we are required to comply with certain regulatory requirements. For instance, we are generally prohibited from acquiring assets other than “qualifying assets” unless, after giving effect to the acquisition, at least 70% of our total assets are qualifying assets. Qualifying assets generally include securities of “eligible portfolio companies” (as defined in the 1940 Act), cash, cash equivalents, U.S. government securities and high-quality debt instruments maturing in one year or less from the time of investment. Additionally, we have elected to be treated as a regulated investment company under Subchapter M of the Internal Revenue Code of 1986 (the “Code”).

On February 26, 2007, the Company closed its initial public offering (“IPO” or the “Offering”) and sold 17,000,000 shares of its common stock at a price of $15.00 per share, less an underwriting discount and commissions totaling $0.675 per share. We commenced material operations on February 27, 2007 as we received $243,525,000 in total net proceeds from the IPO. On March 23, 2007 the Company issued 284,300 shares of common stock to cover the underwriters’ partial exercise of the over-allotment option on the Offering and received approximately $4,072,698 in net proceeds after deducting underwriting discounts and commissions.

On December 19, 2008, the Board of Directors of the Company approved an agreement and plan of merger and liquidation (“Agreement”). The Agreement provides for the merger of the Company with and into HCF Acquisition LLC (“Merger Sub”), a Delaware limited liability company to be organized as a wholly owned subsidiary of Highland Credit Strategies Fund (“HCF”), a non-diversified, closed-end management investment company also managed by the Highland Capital Management, L.P. (the “Merger”), with Merger Sub being the surviving entity and pursuant to which common stockholders of the Company will receive shares of beneficial interest of HCF (and cash in lieu of any fractional shares). Immediately after the Merger, Merger Sub will distribute its assets to HCF, and HCF will assume the liabilities of Merger Sub, in complete liquidation and dissolution of Merger Sub (collectively with the Merger, the “Reorganization”). As a result of the Reorganization, each common stockholder of the Company will become a common shareholder of HCF.

On December 24, 2008, HCF filed with the Securities and Exchange Commission a proxy statement/prospectus with respect to the Reorganization. The Company expects to mail the proxy statement/prospectus to its stockholders and to solicit approval of the reorganization in March 2009. The Company and HCF will bear the costs of the reorganization. It is currently expected that the Reorganization will qualify as a tax-free reorganization for federal income tax purposes. The number of shares of HCF (and cash for fractional shares) that stockholders of the Company will receive in the Reorganization will be based on the relative net asset values of the Company and HCF as of the close of business on the valuation date for the Reorganization. Subject to stockholder approval and the satisfaction or waiver of certain conditions, the Reorganization is currently expected to occur in the 2nd quarter of 2009.

Until the date of the stockholder meeting to consider the Reorganization and, if approved, during the period between the stockholder meeting and the closing of the Reorganization, the Company may determine to use funds

received from interest payments or the sale of investments to pay down the Company’s credit facility and may maintain a larger cash position than under normal circumstances pending the Reorganization.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Changes in the economic environment, financial markets and any other parameters used in determining such estimates could cause actual results to differ materially. In addition to the discussion below, our significant accounting policies are further described in the notes to the financial statements.

Valuation of Investments

We use the following valuation methods to determine either current market value for investments for which market quotations are available, or if not available, then fair value, as determined in good faith pursuant to policies and procedures approved by the Company’s Board:

Market Quotations Available

The market value of each security listed or traded on any recognized securities exchange or automated quotation system will be the last reported sale price at the relevant valuation date on the composite tape or on the principal exchange on which such security is traded. If no sale is reported on that date, the Company utilizes, when available, pricing quotations from principal market makers. Such quotations may be obtained from third-party pricing services or directly from investment brokers and dealers in the secondary market. Generally, the Company’s loan and bond positions are not traded on exchanges and consequently are valued based on market prices received from third-party pricing services or broker-dealer sources. The Company obtains multiple broker-dealer quotes when available, but places greater reliance on quotes from broker-dealers that serve as underwriters for the issuer. In order to validate market quotations, the Company evaluates information, as available and as applicable, to determine if the quotations are representative of fair value, including, but not limited to, the source and nature of the quotations, qualitative analysis of the issuer and internally developed expectations and models. The valuation of certain securities for which there is little to no market activity may take into account appraisal reports obtained by management from independent valuation firms. Short-term debt securities having a remaining maturity of 60 days or less when purchased and debt securities originally purchased with maturities in excess of 60 days but which currently have maturities of 60 days or less may be valued at cost adjusted for amortization of premiums and accretion of discounts.

Market Quotations Not Available

Securities for which market quotations are not readily available, or for which the Company has determined the price received from a pricing service or broker-dealer is “stale” or otherwise does not represent fair value, are valued by the Company at fair value, taking into account factors reasonably determined to be relevant, including: (i) the fundamental analytical data relating to the investment; (ii) the nature and duration of restrictions on disposition of the securities; and (iii) an evaluation of the forces that influence the market in which these securities are purchased and sold. The Company takes the following steps each time it determines its net asset value in order to determine the value of its securities for which market quotations are not readily available, as determined in good faith pursuant to policies and procedures approved by the Board:


	1.	The valuation process begins with each portfolio company or investment being initially valued by the investment professionals responsible for the portfolio investment.

	2.	Preliminary valuation conclusions will then be documented and discussed with Highland Capital Management, L.P.’s (the “Investment Adviser”) senior management.


	3.	The Company’s valuation committee, comprised of the Investment Adviser’s investment professionals and other senior management, will then review these preliminary valuations. An independent valuation firm engaged by the Company’s Board reviews all of these preliminary valuations each quarter.

	4.	Finally, the Board discusses valuations and reviews the fair value of each investment in the Company’s portfolio in good faith, pursuant to policies and procedures approved by the Board, based on the input of the valuation committee and an independent valuation firm.

As part of the valuation process, management takes into account the following types of factors, if relevant, in determining the fair value of our investments: the enterprise value of a portfolio company (an estimate of the total fair value of the portfolio company’s debt and equity), the nature and realizable value of any collateral, the portfolio company’s ability to make payments and its earnings and discounted cash flow, the markets in which the portfolio company does business, comparison to publicly traded securities, changes in the interest rate environment and the credit markets generally that may affect the price at which similar investments may be made in the future and other relevant factors. When an external event such as a purchase transaction, public offering or subsequent equity sale occurs, we use the pricing indicated by the external event to corroborate our valuation.

Revenue Recognition

We record interest income, adjusted for amortization of premium and accretion of discount, on an accrual basis. Origination, closing and/or commitment fees associated with investments in portfolio companies are accreted into interest income over the respective terms of the applicable loans. Upon the prepayment of a loan or debt security, any prepayment penalties and unamortized loan origination, closing and commitment fees are recorded as interest income. Payment-in-kind (“PIK”) interest, computed at the contractual rate specified in each loan agreement, is added to the principal balance of the loan and recorded as interest income. To maintain the Company’s status as a RIC, this non-cash source of income must be paid out to stockholders in the form of distributions, even though the company has not yet collected cash. We do not accrue as a receivable interest on loans and debt securities if we have reason to doubt our ability to collect such interest.

Net Realized Gains or Losses and Net Change in Unrealized Appreciation or Depreciation

We measure realized gains or losses by the difference between the net proceeds from the repayment or sale and the amortized cost basis of the investment, without regard to unrealized appreciation or depreciation previously recognized, but considering unamortized upfront fees. Net change in unrealized appreciation or depreciation reflects the change in portfolio investment values during the reporting period, including the reversal of previously recorded unrealized appreciation or depreciation, when gains or losses are realized.

Within the context of these critical accounting policies, we are not currently aware of any reasonably likely events or circumstances that would result in materially different amounts being reported.

Portfolio and Investment Activity

The following table summarizes the historical composition of our investment portfolio, exclusive of cash and cash equivalents, as a percentage of total investments.


				Corporate
	Senior Loans			Notes and Bonds			Claims			Equity Interests

December 31, 2008		47.4	%		27.8	%		0.1	%		24.7	%
September 30, 2008		60.5	%		24.9	%		0.7	%		13.9	%
June 30, 2008		68.1	%		27.0	%		0.2	%		4.7	%
March 31, 2008		49.7	%		40.4	%		0.5	%		9.4	%
December 31, 2007		48.4	%		34.8	%		0.5	%		16.3	%
September 30, 2007		50.3	%		34.4	%		1.2	%		14.1	%
June 30, 2007		45.9	%		35.4	%		0.8	%		17.9	%
March 31, 2007		76.7	%		21.1	%		0.8	%		1.4	%

Our equity investments increased as a percentage of total investments during the fourth quarter. This was caused primarily by a decline in our loan and bond investments while the equity investments maintained their value in large part. However, during the fourth quarter we did not increase our equity holdings through additional investments.

Bank debt typically accrues interest at variable rates determined by reference to a base lending rate, such as LIBOR or prime rate, and typically will have maturities of 3 to 5 years. Corporate notes and bonds will typically accrue interest at fixed rates and have stated maturities at origination that range from 5 to 10 years. At December 31, 2008, the weighted average yield of our portfolio investments, exclusive of cash and cash equivalents, was approximately 5.7%. At December 31, 2008, the weighted average yield of our investments in senior loans and corporate notes and bonds was approximately 6.0%. Yields are computed assuming a fully settled portfolio; using interest rates as of the report date and include amortization of senior loan discount points, original issue discount and market premium or discount; weighted by their respective costs when averaged.

As of December 31, 2008, approximately 85.3% of our portfolio consisted of investments in 10 issuers. This is a material increase from prior quarters as we have sought to consolidate our holdings into fewer core positions. We accomplished this consolidation by liquidating smaller, non-core positions and using the proceeds to pay down the credit facility. Additional information regarding these specific investments has been outlined below. This additional information is limited to publicly available information, and does not address the creditworthiness or financial viability of the issuer, or the future plans of the Company as it relates to a specific investment. Furthermore, while the objective of the Company is to invest primarily in financially-troubled or distressed companies, the Company can and does invest in issuers that are not financially-troubled or distressed at the time of investment. The Company may have sold some, or all, of the positions outlined below subsequent to December 31, 2008.

Argatroban Royalty Sub, LLC

Argatroban Royalty Sub, LLC, a wholly-owned subsidiary of Encysive Pharmaceuticals, was established to issue senior secured bonds backed by the royalty cash stream from the sales of Argatroban, a branded pharmaceutical marketed by GlaxoSmithKline plc. Argatroban is a synthetic direct thrombin inhibitor indicated as an anticoagulant for prophylaxis or treatment of thrombosis in patients with heparin-induced thrombocytopenia, or HIT, which is a profound allergic reaction to anticoagulation therapy with heparin. More information can be found at www.argatroban.com.

Azithromycin Royalty Sub, LLC

Azithromycin Royalty Sub, LLC, a wholly-owned subsidiary of InSite Vision Inc., was established to issue senior secured bonds backed by the royalty cash stream from the sales of azithromycin ophthalmic solution, a branded pharmaceutical sold under the brand name AzaSite ^® and marketed by Inspire Pharmaceuticals, Inc. The solution is used to treat conjunctivitis. More information can be found at www.azasite.com.

Baker & Taylor, Inc.

Baker & Taylor, Inc. (“B&T”) is engaged in the distribution of books, music, video and game products. In addition, unique information services built around the B&T’s proprietary databases as well as specialized consulting and outsourcing services are provided to customers. Customers include retailers (including Internet retailers), public, academic and school libraries and various departments of federal and local governments. B&T distributes its products throughout the United States and worldwide.

Celtic Pharma Phinco B.V.

Celtic Pharmaceuticals Phinco B.V. (“Celtic Pharma”) is a private investment fund with a mandate to purchase a diversified portfolio of novel pharmaceutical products in the later stages of development that have already demonstrated initial proof of principle efficacy in human clinical trials. Celtic Pharma has $250 million of equity commitments in addition to raising $156 million of high-yield bonds. Celtic Pharma has invested in nine drug programs since its 2004 inception. More information can be found at www.celticpharma.com.

Comcorp Broadcasting, Inc.

Comcorp Broadcasting, Inc. (“ComCorp”) is a privately-held regional broadcasting company based in Lafayette, LA. ComCorp operates 23 TV stations in 10 markets in Texas, Louisiana, and Indiana. ComCorp filed for bankruptcy in June 2006 after it was unable to meet its ongoing debt obligations. ComCorp, and its direct and indirect subsidiaries, exited bankruptcy with an effective date of October 4, 2007 under reorganization plans filed (“Plans”) with the United States Bankruptcy Court in the Western District of Louisiana (Case No. 06-50410). Copies of the Plans and the Confirmation Orders may be downloaded, without cost, at www.kccllc.net/cca, or be requested free of charge by calling Kurtzman Carson Consultants LLC at 1-866-381-9100.

Fontainebleau Florida Hotel, LLC

Fontainebleau Florida Hotel, LLC is the owner of the Fontainebleau Miami Beach, an 825 room luxury hotel redevelopment in Miami Beach, Florida. The parent company of Fontainebleau Florida Hotel, LLC and developer of the resort is Fontainebleau Resorts, LLC (“Fontainebleau”). Fontainebleau is led by Chairman Jeffrey Soffer, who also serves as Chief Executive Officer of Turnberry, Ltd., a creator of luxury condominium and condominium-hotel developments, and President and Chief Financial Officer Glenn Schaeffer, a former Chief Executive Officer of Mandalay Resort Group. The Fontainebleau Miami was renovated and expanded into a 22-acre destination resort, which opened in the fall of 2008. More information can be found at www.bleaumiamibeach.com.

Genesys Ventures IA, LP

Genesys Ventures IA, LP, a limited partnership with Genesys Capital Partners of Toronto, Ontario, was established to hold the preferred equity of three late-stage venture healthcare companies.

Kepler Holdings Limited

Kepler Holdings Limited is a Bermuda-based special purpose vehicle with a portfolio comprised of pre-defined segments of Hannover Re’s natural catastrophe property reinsurance business.

LVI Services, Inc.

LVI Services, Inc. (“LVI”) is a remediation and facility services firm serving commercial, industrial, retail, government, healthcare and education end markets. From a nationwide branch network, LVI provides asbestos abatement, soft and structural demolition, mold remediation, emergency response, fireproofing, decontamination and decommissioning, lead-based paint abatement and infection control. More information can be found at www.lviservices.com.

Penhall Holding Company

Penhall Holding Company is the parent company of Penhall International Corporation (“Penhall”), one of the largest providers of concrete cutting, breaking and highway grinding services in the United States. Penhall’s business model is centered on utilizing a nationwide network of approximately 800 skilled operators and an extensive fleet of specialized construction equipment to perform primarily non-residential and infrastructure-related construction work. The company operates 41 locations in the United States and Canada, and has a customer base that includes construction contractors, industrial companies, manufacturers, government agencies and municipalities.

Results of Operations

Results comparisons are for the year ended December 31, 2008 (“Fiscal 2008”) and the period from January 18, 2007 (commencement of operations) through December 31, 2007 (“Fiscal 2007”). These comparisons between current and prior periods may not necessarily be meaningful as we were incorporated in Delaware on August 22, 2006, initially funded on January 18, 2007, and commenced material operations on February 27, 2007.

Investment Income

We primarily generate revenue in the form of interest income on the debt securities that we own, dividend income on any common or preferred stock that we own, and capital gains or losses on any debt or equity securities that we acquire and subsequently sell. We also may acquire investments, which may pay cash or in-kind dividends on a recurring or otherwise negotiated basis. Investment income for Fiscal 2008 and Fiscal 2007 was approximately $22.0 million and $31.3 million, respectively, of which approximately $0.1 million and $0.8 million, respectively, was attributable to invested cash and cash equivalents and approximately $21.9 million and $30.5 million, respectively, was attributable to portfolio investments. For Fiscal 2008 and Fiscal 2007, of the approximately $21.9 million and $30.5 million, respectively, in investment income from investments other than cash and cash equivalents, approximately $3.5 million and $2.6 million, respectively, of PIK interest income was recorded. In Fiscal 2008, investment income decreased as compared to Fiscal 2007 for three primary reasons: 1) LIBOR was significantly lower for the majority of 2008 versus 2007, 2) defaults in the portfolio increased in 2008 and 3) we reduced our leverage by over 50% during 2008, decreasing the total amount of revenue generating assets.

Operating Expenses

Operating expenses for Fiscal 2008 and Fiscal 2007 were approximately $11.2 million and $14.2 million, respectively. These amounts consisted of advisory fees of approximately $4.2 million and $6.3 million, incentive fees of approximately $1.7 million and $2.5 million, and administrative fees, accounting fees, professional fees, directors’ fees, taxes and other expenses of approximately $3.0 million and $2.4 million, respectively, for Fiscal 2008 and Fiscal 2007.

Additionally, for the quarter ended June 30, 2008, the Investment Adviser voluntarily waived incentive fees of approximately $0.8 million. Pursuant to an agreement with the Investment Adviser, advisory fees of approximately $2.7 million were waived during Fiscal 2007. Additionally, for Fiscal 2007 the Investment Adviser voluntarily waived incentive fees of approximately $1.7 million.

Net Investment Income

The Company’s net investment income totaled approximately $10.8 million and $17.1 million, respectively, for Fiscal 2008 and for Fiscal 2007. Net investment income was lower in Fiscal 2008 primarily due to lower LIBOR rates, a smaller asset base, and higher defaults.

Net Unrealized Depreciation on Investments

For Fiscal 2008 and Fiscal 2007, the Company’s investments had net unrealized depreciation of approximately $34.4 million and $60.0 million, respectively.

Net Realized Losses

For Fiscal 2008 and Fiscal 2007, the Company had net realized losses on investments of approximately $84.5 million and $14.3 million, respectively.

Net Decrease in Stockholders’ Equity (Net Assets) from Operations

For Fiscal 2008 and Fiscal 2007, the Company had a net decrease in stockholders’ equity (net assets) resulting from operations of approximately $108.2 million ($6.11 per share) and $57.3 million ($3.23 per share), respectively. For Fiscal 2008 and Fiscal 2007, the decrease in stockholders’ equity (net assets) resulting from operations

was primarily attributable to net realized and net unrealized depreciation on investments, respectively, as discussed above.

Financial Condition, Liquidity and Capital Resources

In light of the broader unprecedented market dislocation that began in 2007, continued into 2008 and accelerated in the fourth quarter, we reduced our leverage from approximately 43.8% at December 31, 2007, to approximately 20.4% at December 31, 2008. On November 25, 2008, we amended our existing credit agreement with the credit facility provider, extending the maturity date from December 1, 2008 to May 29, 2009. Additionally, on December 19, 2008, the Board approved an agreement and plan of merger and liquidation (“Agreement”). The Agreement provides for the merger of the Company with and into HCF Acquisition LLC (“Merger Sub”), a Delaware limited liability company to be organized as a wholly owned subsidiary of Highland Credit Strategies Fund (“HCF”), a non-diversified, closed-end management investment company also managed by the Investment Adviser (the “Merger”), with Merger Sub being the surviving entity and pursuant to which common stockholders of the Company will receive shares of beneficial interest of HCF (and cash in lieu of any fractional shares). Immediately after the Merger, Merger Sub will distribute its assets to HCF, and HCF will assume the liabilities of Merger Sub, in complete liquidation and dissolution of Merger Sub (collectively with the Merger, the “Reorganization”). As a result of the Reorganization, if consummated, each common stockholder of the Company will become a common shareholder of HCF.

During Fiscal 2008, liquidity and capital resources were generated primarily from cash flows from operations, including investment sales and prepayments and income earned from investments and cash equivalents. The liquidity generated from these sources was used to reduce the amount outstanding on the credit facility and to pay shareholder distributions. At year end, the Company had no cash on hand but had approximately $14.4 million in receivables for investments sold and interest due from investments. This was partially offset by approximately $11.1 million in payables, mainly for investments purchased but not yet settled.

Although the Company has $44.5 million available on its credit facility, certain restrictions within the agreement significantly limit the amount we can effectively borrow. Regardless, we do not anticipate drawing down on the facility in the first quarter of 2009, and we are likely to fund our operations through additional sales of investments, if warranted, and interest from investments. At December 31, 2008, the Company had $15.5 million in borrowings outstanding. During the first quarter, we intend to use excess funds to primarily repay borrowings under our credit facility, make strategic investments to meet our investment objectives, to make cash distributions to holders of our common stock and to fund our operating expenses. If the Reorganization into HCF described above is not approved by stockholders or is otherwise not consummated prior to the expiration of our credit facility on May 29, 2009, there can be no assurance that we will be able to renew or extend the facility on favorable terms. If we are unable to do so, we may need to sell investments and may not be able to use leverage as a part of our investment strategy.

During Fiscal 2008, the Company generated approximately $135.4 million in cash flows from operations, of which $126.5 million was used to repay borrowings under its credit facilities and approximately $13.3 million was used to make cash distributions to holders of our common stock.

Contractual Obligations

The following table shows our significant contractual obligations for the repayment of outstanding borrowings under our revolving credit facility as of December 31, 2008.


	Payments Due By Year
	(dollars in millions)
					2010 and
	Total		2009		thereafter

Revolving Credit Facility(1)	$	15.5	$	15.5	$	—


(1)		At December 31, 2008, approximately $44.5 million remained unused under our revolving credit facility. Our current credit facility, as amended, terminates on May 29, 2009.

In addition, we have certain obligations with respect to the investment advisory and administration services we receive. See “— Our Investment Adviser” and “— Our Administrator.” We incurred approximately $4.2 million for investment advisory services and approximately $0.7 million for administrative services for the year ended December 31, 2008. As of December 31, 2008, we had unfunded commitments to fund senior loans to Comcorp Broadcasting, Inc. ($58,999).

Off-Balance Sheet Arrangements

At December 31, 2008, we did not have any off-balance sheet liabilities or other contractual obligations that are reasonably likely to have a current or future material effect on our financial condition, other than the investment advisory and management agreement and the administration agreement described above.

Distributions

We have elected to be taxed as a regulated investment company under Subchapter M of the Internal Revenue Code of 1986. In order to maintain our status as a regulated investment company, we are required to meet specified source-of-income and asset diversification requirements and must distribute annually at least 90% of our investment company taxable income. Additionally, we must distribute at least 98% of our income (both ordinary income and net capital gains) to avoid an excise tax. We intend to make distributions to our stockholders on a quarterly basis of substantially all of our net operating income. We also intend to make distributions of net realized capital gains, if any, at least annually.

We may not be able to achieve operating results that will allow us to make distributions at a specific level or to increase the amount of these distributions from time to time. In addition, we may be limited in our ability to make distributions due to the asset coverage test for borrowings when applicable to us as a business development company under the Investment Company Act of 1940 and due to provisions in our credit facilities. If we do not distribute a certain percentage of our income annually, we will suffer adverse tax consequences, including possible loss of our status as a regulated investment company. We cannot assure stockholders that they will receive any distributions or distributions at a particular level.

On December 4, 2008, the Company’s Board declared a fourth quarter distribution of $0.075 per share ($1,328,758), which was paid on December 31, 2008 to common stockholders of record on December 19, 2008. The Company has established an “opt out” Dividend Reinvestment Plan (the “Plan”) for its common stockholders. As a result, if the Company declares a cash distribution in future periods, a stockholder’s cash distribution will be automatically reinvested in additional shares of the Company’s common stock unless the stockholder specifically “opts out” of the Plan and elects to receive cash distributions. For the fourth quarter distribution, holders of 1,829,815 shares participated in the Plan. As a result, of the $1,328,758 total amount distributed, $137,236 was used by the Plan agent to purchase shares in the open market, including fractions, on behalf of the Plan participants. On September 5, 2008, the Company’s Board declared a third quarter distribution of $0.15 per share ($2,657,516), which was paid on September 30, 2008 to common stockholders of record on September 19, 2008. On June 6, 2008, the Company’s Board declared a second quarter distribution of $0.2625 per share ($4,650,652), which was paid on June 30, 2008 to common stockholders of record on June 20, 2008. On March 7, 2008, the Company’s Board declared a first quarter distribution of $0.2625 per share ($4,650,652), which was paid on March 31, 2008 to common stockholders of record on March 20, 2008.


Item 7A.	*Quantitative and Qualitative Disclosures about Market Risk*

We are subject to financial market risks, including changes in interest rates and the valuations of our investment portfolio.

As of December 31, 2008, approximately 75.3% of our portfolio, exclusive of cash and cash equivalents, was invested in debt securities. This exposes the Company to a great degree of default risk with respect to the issuers in our portfolio. Although defaults were at historic lows during 2007, they have increased in 2008 and are likely to increase in the future. New derivative products are available to hedge against default risk; however, the Company did not hedge its exposure during the year ended December 31, 2008 as these hedges may be imperfect, unavailable

or too costly. As of December 31, 2008, the total percentage of the Company’s investments in default, measured by market value, was 4.6%.

As of December 31, 2008, approximately 47.4% and 27.9% of our portfolio, exclusive of cash and cash equivalents, was invested in securities that paid floating and fixed rates of interest, respectively. Increases or decreases in market interest rates may potentially affect the Company’s net asset value. When interest rates decline, the value of fixed rate securities in the Company’s portfolio may be expected to rise. Conversely, when interest rates rise, the value of fixed rate portfolio securities may decline. The sensitivity of the Company’s net asset value to changes in interest rates will increase to the extent that it holds a higher percentage of its portfolio in fixed rate investments. However, the technical dislocation in the debt markets in the past year and the contagion in the greater economy has changed this dynamic. Although interest rates declined from the beginning of the year to the end of the year, the leveraged loan and high yield debt markets had their worst years on record, as measured by the Standard & Poor’s/Loan Syndication Trading Association and Credit Suisse High Yield Indexes, respectively.

Increases or decreases in market interest rates may also affect the Company’s distributions. While the Company does not disclose whether it will be able to maintain historic distribution levels in the future, it is clear that for a portfolio holding a large percentage of floating rate investments, a decrease in market interest rates may have a negative impact on yield. There tends to be a lag in the effect that a decline in market interest rates has on the yield of floating rate investments. This is due to the resetting of the base rate underlying the individual investment, which typically happens every sixty to ninety days depending on the terms. As of December 31, 2008, the weighted average days for the underlying senior loans in the Company’s portfolio base rate to reset was approximately 66.6 days.

Additionally, beginning in August 2008, the market rate of interest that serves as the referenced base rate for many of the Company’s individual investments (3-month London Interbank Offered Rate, or LIBOR) began to experience significant volatility. As of December 31, 2008, this rate dropped to approximately 1.43% from a high of 4.82% on October 10, 2008. This may potentially have a negative impact on the Company’s future distribution levels.

As of December 31, 2008, approximately 46.1% of our portfolio was invested in securities for which market quotations are not readily available, and whose fair value was determined by the Board, in good faith, pursuant to the policies and procedures approved by the Board. Determination of the fair value is uncertain because it involves subjective judgments and estimates not easily substantiated by auditing procedures. Further, there can be no assurance that fair value pricing will reflect actual market value and it is possible that the fair value determined for a security will be materially different from the value that actually could be or is realized upon the sale of that asset.


Item 8.	*Financial Statements and Supplementary Data*

Index to Financial Statements


	Page

Report of Independent Registered Public Accounting Firm		46
Schedule of Investments — As of December 31, 2008 and December 31, 2007		47
Statement of Assets and Liabilities — As of December 31, 2008 and December 31, 2007		59
Statement of Operations — For the year ended December 31, 2008 and for the period January 18, 2007* through December 31, 2007		60
Statement of Changes in Stockholders’ Equity (Net Assets) — For the year ended December 31, 2008 and for the period January 18, 2007* through December 31, 2007		61
Statement of Cash Flows — For the year ended December 31, 2008 and for the period January 18, 2007* through December 31, 2007		62
Notes to Financial Statements		63


*		Highland Distressed Opportunities, Inc. commenced operations on January 18, 2007.

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of Highland Distressed Opportunities, Inc.:

In our opinion, the accompanying statement of assets and liabilities, including the schedule of investments, and the related statements of operations and of changes in stockholders’ equity (net assets) and of cash flows and the financial highlights present fairly, in all material respects, the financial position of Highland Distressed Opportunities, Inc. (the “Company”) at December 31, 2008 and December 31, 2007, and the results of its operations, its changes in stockholders’ equity (net assets) and its cash flows and the financial highlights for the year ended December 31, 2008 and for the period January 18, 2007 (commencement of operations) through December 31, 2007, in conformity with accounting principles generally accepted in the United States of America.

Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A on page 88 of the annual report on Form 10-K. Our responsibility is to express opinions on these financial statements and on the Company’s internal control over financial reporting based on our integrated audits (which was an integrated audit in 2008). We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

As discussed in Notes 1 and 16 to the financial statements, the Company’s Board of Directors has approved a reorganization of the Company into Highland Credit Strategies Fund, subject to several conditions, including the approval of the Company’s stockholders.

/s/ PricewaterhouseCoopers LLP

Dallas, Texas

February 26, 2009

Schedule of Investments


As of December 31, 2008	Highland Distressed Opportunities, Inc.


	Principal ($)		Cost ($)		Value ($)
Senior Loans (a) — 56.8%

BROADCASTING — 16.0%
Comcorp Broadcasting, Inc.
Revolving Loan, 7.52%, 04/03/13 (b)(c)(d)		1,825,953		1,825,953		843,134
Term Loan, 7.75%, 04/03/13 (c)(d)		18,849,521		18,525,278		8,835,713

				20,351,231		9,678,847

CONSUMER NON-DURABLES — 1.7%
Totes Isotoner Corp.
Second Lien Term Loan, 9.88%, 01/31/14		3,377,228		3,400,514		1,013,169

DIVERSIFIED MEDIA — 0.7%
Penton Media, Inc.
Second Lien Term Loan, 8.42%, 02/01/14		2,000,000		2,035,654		425,000

FINANCIAL — 9.4%
Emerson Reinsurance Ltd.
Tranche C Term Loan, 7.25%, 12/15/11		1,500,000		1,495,043		1,297,500
Flatiron Re Ltd.
Closing Date Term Loan, 5.71%, 12/29/10		25,529		25,704		24,796
Delayed Draw Term Loan, 5.71%, 12/29/10		12,366		12,451		12,011
Kepler Holdings Ltd.
Term Loan, 7.00%, 06/30/09		5,000,000		5,006,959		4,400,000

				6,540,157		5,734,307

FOREST PRODUCTS/CONTAINERS — 0.2%
Tegrant Corp.
Second Lien Term Loan, 6.96%, 03/08/15		1,000,000		1,000,000		103,340

GAMING/LEISURE — 12.4%
Fontainebleu Florida Hotel, LLC
Tranche C Term Loan, 8.00%, 06/06/12		6,000,000		6,000,000		5,100,000
Lake at Las Vegas Joint Venture/ LLV-1,LLC
Revolving Loan Credit-Linked Deposit, 14.35%, 06/20/12 (e)		3,611,111		3,611,111		273,831
Term Loan, 14.35%, 06/20/12 PIK (e)		33,756,283		28,269,771		2,143,697

				37,880,882		7,517,528

HEALTHCARE — 3.1%
Life Technologies Corp.
Term B Facility, 09/30/15 (f)		1,995,000		1,955,100		1,881,963
HOUSING — 2.0%
MetroFlag BP, LLC / MetroFlag Cable, LLC
Second Lien Term Loan, 12.00%, 01/06/09		5,000,000		5,000,000		375,000

See accompanying Notes to Financial Statements.

Schedule of Investments


As of December 31, 2008 (continued)	Highland Distressed Opportunities, Inc.


	Principal ($)		Cost ($)		Value ($)

Senior Loans (continued)
HOUSING (continued)
MPH Mezzanine II, LLC
Mezzanine 2B, 7.48%, 02/09/08 (d)(e)		10,000,000		10,000,000		—
MPH Mezzanine III, LLC
Mezzanine 3, 8.48%, 02/09/08 (d)(e)		4,000,000		4,000,000		—
Pacific Clarion, LLC
Term Loan, 15.00%, 01/23/09 (d)(e)(g)		4,950,573		4,945,680		841,053

				23,945,680		1,216,053

SERVICE — 11.1%
LVI Services, Inc.
Tranche B Term Loan, 6.49%, 11/16/11		9,377,348		9,317,890		4,102,590
Penhall Holding Co.
Term Loan, 12.29%, 04/01/12 PIK		5,821,220		5,762,042		2,619,549

				15,079,932		6,722,139

TRANSPORTATION — AUTOMOTIVE — 0.2%
BST Safety Textiles Acquisition GmbH
Second Lien Facility, 14.60%, 06/30/09		673,957		674,415		117,943

Total Senior Loans				112,863,565		34,410,289

Corporate Notes and Bonds (h) — 33.4%

DIVERSIFIED MEDIA — 5.8%
Baker & Taylor, Inc.
11.50%, 07/01/13		8,300,000		8,749,446		3,537,875
HEALTHCARE — 27.6%
Argatroban Royalty Sub, LLC
18.50%, 09/21/14		3,306,706		3,306,706		2,942,968
Azithromycin Royalty Sub, LLC
16.00%, 05/15/19		5,000,000		4,974,238		4,350,000
Celtic Pharma Phinco B.V.
17.00%, 06/15/12 PIK		10,561,138		10,132,572		7,815,242
Cinacalcet Royalty Sub, LLC
15.50%, 03/30/17 PIK		1,038,750		1,023,972		768,675

See accompanying Notes to Financial Statements.

Schedule of Investments


As of December 31, 2008 (continued)	Highland Distressed Opportunities, Inc.


	Principal ($)		Cost ($)		Value ($)

Corporate Notes and Bonds (continued)
HEALTHCARE (continued)
Molecular Insight Pharmaceuticals, Inc.
10.80%, 11/01/12 (i)		1,027,602		1,026,832		822,081

				20,464,320		16,698,966

Total Corporate Notes and Bonds				29,213,766		20,236,841
Claims (j) — 0.1%

AEROSPACE — 0.1%
Northwest Airlines, Inc.
ALPA Trade Claim, 08/21/13		3,000,000		431,377		5,640
Bell Atlantic Trade Claim, 08/21/13		2,500,000		434,058		4,700
EDC Trade Claims, 08/21/13		2,500,000		447,357		4,700
Flight Attendant Claim, 08/21/13		5,326,500		739,501		10,014
GE Trade Claim, 08/21/13		1,500,000		275,185		2,820
IAM Trade Claim, 08/21/13		4,728,134		728,935		8,889
Pinnacle Trade Claim, 08/21/13		8,433,116		1,529,071		15,854
Retiree Claim, 08/21/13		3,512,250		487,621		6,603

Total Claims				5,073,105		59,220



	Shares


Common Stock (j) — 29.6%
AEROSPACE — 0.6%
Delta Air Lines, Inc.		30,433		215,657		348,762

BROADCASTING — 0.0%
Communications Corp. of America (c)(d)		1,256,635		7,187,203		—

HEALTHCARE — 28.7%
Genesys Ltd. (c)(d)		12,000,000		12,000,000		17,412,000

WIRELESS COMMUNICATIONS — 0.3%
ICO Global Communications		138,632		500,000		153,882

Total Common Stocks				19,902,860		17,914,644

Total Investments (k) — 119.9%				167,053,296		72,620,994

Other Assets & Liabilities, Net — (19.9)%						(12,064,566	)

Net Assets — 100.0%						60,556,428


(a)		Senior loans in which Highland Distressed Opportunities, Inc. (the “Company”) invests generally pay interest at rates which are periodically determined by reference to a base lending rate plus a premium (unless otherwise identified by footnote (g), all senior loans carry a variable rate interest). These base lending rates are generally (i) the Prime Rate offered by one or more major United States banks, (ii) the lending rate offered by one or more European banks such as the London Interbank Offered Rate (“LIBOR”) or (iii) the Certificate of Deposit rate. Rate shown represents the weighted average rate at December 31, 2008. Senior loans, while exempt from registration under the Securities Act of 1933 (the “1933 Act”), contain certain restrictions on resale and cannot be sold publicly. Senior secured floating rate loans often require

See accompanying Notes to Financial Statements.

Schedule of Investments


As of December 31, 2008 (continued)	Highland Distressed Opportunities, Inc.


		prepayments from excess cash flow or permit the borrower to repay at its election. The degree to which borrowers repay, whether as a contractual requirement or at their election, cannot be predicted with accuracy. As a result, the actual remaining maturity may be substantially less than the stated maturity shown.

(b)		Senior loan asset has additional unfunded loan commitments. See Note 6.

(c)		Affiliated issuer. See Note 7.

(d)		Represents fair value as determined, in good faith, pursuant to the policies and procedures approved by the Company’s Board of Directors (the “Board’). Securities with a total aggregate market value of $27,931,900 or 46.1% of net assets, were fair valued as of December 31, 2008.

(e)		The issuer is in default of certain debt covenants. Income is not being accrued.

(f)		All or a portion of this position has not settled. Contract rates do not take effect until settlement date.

(g)		Fixed rate senior loan.

(h)		Securities exempt from registration under Rule 144A of the 1933 Act. These securities may only be resold, in transactions exempt from registration, to qualified institutional buyers. At December 31, 2008, these securities amounted to $20,236,841 or 33.4% of net assets.

(i)		Floating rate asset. The interest rate shown reflects the rate in effect at December 31, 3008.

(j)		Non-income producing security.

(k)		Cost basis for U.S. federal income tax purposes is $178,369,294.


PIK		Payment-in-Kind. All or a portion of the stated interest rate may be PIK interest.

See accompanying Notes to Financial Statements.

Schedule of Investments


As of December 31, 2007	Highland Distressed Opportunities, Inc.


	Principal ($)		Cost ($)		Value ($)
Senior Loans (a) 82.9%

AEROSPACE — AEROSPACE/DEFENSE — 2.4%
IAP Worldwide Services, Inc.
First Lien Term Loan, 11.50%, 12/30/12		4,949,495		4,961,019		4,439,103

BROADCASTING — 10.9%
Comcorp Broadcasting, Inc.
Revolving Loan, 10.84%, 10/02/12 (b)(c)		1,036,724		1,036,724		1,036,724
Term Loan, 10.44%, 04/02/13 (b)		18,849,521		18,453,200		18,849,521

				19,489,924		19,886,245

CABLE — US CABLE — 3.6%
Bresnan Communications, LLC
First Lien Additional Term Loan B, 06/30/13 (d)		1,000,000		960,000		958,120
CellNet Group, Inc.
Second Lien, 10.85%, 10/22/11		1,000,000		1,000,000		959,380
WideOpen West Finance, LLC
Second Lien Term Loan, 11.61%, 06/29/15		5,000,000		4,906,201		4,550,000

				6,866,201		6,467,500

DIVERSIFIED MEDIA — 0.9%
Penton Media, Inc.
Second Lien Term Loan, 10.36%, 02/01/14		2,000,000		2,042,662		1,690,000

ENERGY — EXPLORATION & PRODUCTION — 2.7%
TARH E&P Holdings, L.P.
First Lien Term Loan, 9.88%, 06/29/12		5,000,000		5,000,000		4,950,000

ENERGY — OTHER ENERGY — 4.1%
Resolute Aneth, LLC
Second Lien Term Loan, 9.51%, 06/26/13		7,500,000		7,500,000		7,443,750

FINANCIAL — 8.7%
Emerson Reinsurance Ltd.
Tranche C Term Loan, 10.95%, 12/15/11		1,500,000		1,493,372		1,492,500
Flatiron Re Ltd.
Closing Date Term Loan, 9.61%, 12/29/10		610,748		617,040		607,694
Delayed Draw Term Loan, 9.61%, 12/29/10		295,831		298,879		294,352
Kepler Holdings Ltd.
Term Loan, 10.70%, 06/30/09		5,000,000		5,021,070		4,975,000
Panther Re Holdings Ltd.
Term B Loan, 10.08%, 12/01/10		500,000		505,080		497,500
Penhall International Corp.
Senior Unsecured PIK Toggle Term Loan, 12.82%, 04/01/12		7,938,145		7,809,443		7,957,990

See accompanying Notes to Financial Statements.

Schedule of Investments


As of December 31, 2007 (continued)	Highland Distressed Opportunities, Inc.


	Principal ($)		Cost ($)		Value ($)

Senior Loans (continued)

				15,744,884		15,825,036

FOREST PRODUCTS — PACKAGING — 0.5%
Tegrant Corp.
Second Lien Term Loan, 10.35%, 03/07/15		1,000,000		1,000,000		850,000

GAMING/LEISURE — OTHER LEISURE — 13.0%
Fontainebleau Florida Hotel, LLC
Tranche C Term Loan, 11.11%, 06/06/12		10,000,000		10,000,000		9,375,000
Lake at Las Vegas Joint Venture, LLC
PIK Term Loan, 15.31%, 06/20/12 (e)		27,290,363		27,290,363		12,690,019
Synthetic Revolver, 10.20%, 06/20/12 (e)		3,611,111		3,611,111		1,679,167

				40,901,474		23,744,186

HEALTHCARE — ACUTE CARE — 0.5%
LifeCare Holdings, Inc.
Term Loan, 8.20%, 08/11/12		989,873		966,641		876,652

HEALTHCARE — MEDICAL PRODUCTS — 4.1%
Graceway Pharmaceuticals, LLC
Mezzanine Loan, 13.45%, 11/01/13		2,000,000		1,644,408		1,660,000
Rotech Healthcare, Inc.
PIK Term Loan, 11.36%, 09/26/11		6,413,395		6,362,958		5,707,921

				8,007,366		7,367,921

HOUSING — REAL ESTATE DEVELOPMENT — 10.2%
Metroflag BP, LLC / Metroflag Cable, LLC
Second Lien Term Loan, 13.65%, 07/06/08		5,000,000		5,000,000		4,500,000
MPH Mezzanine II, LLC Mezzanine 2B, 7.90%, 02/09/08 (b)		10,000,000		10,000,000		9,987,800
MPH Mezzanine III, LLC Mezzanine 3, 9.34%, 02/09/08		4,000,000		4,000,000		3,990,000

				19,000,000		18,477,800

INFORMATION TECHNOLOGY — 0.3%
Metrologic Instruments, Inc.
Second Lien Term Loan, 11.45%, 12/21/13		500,000		507,866		481,875

MANUFACTURING — 0.9%
Latham Manufacturing Corp.
New Term Loan, 8.52%, 06/30/12		1,931,388		1,929,339		1,709,279

RETAIL — 2.5%
Totes Isotoner Corp.
Second Lien Term Loan, 10.83%, 01/31/14		4,877,228		4,920,600		4,584,594

See accompanying Notes to Financial Statements.

Schedule of Investments


As of December 31, 2007 (continued)	Highland Distressed Opportunities, Inc.


	Principal ($)		Cost ($)		Value ($)

Senior Loans (continued)
SERVICE — ENVIRONMENTAL SERVICES — 5.3%
LVI Services, Inc.
Tranche B Term Loan, 9.91%, 11/16/11		10,086,339		9,998,798		9,695,493

SERVICE — OTHER SERVICES — 1.0%
NES Rentals Holdings, Inc.
Permanent Term Loan, 12.13%, 07/20/13		2,000,000		2,033,978		1,880,000

TRANSPORTATION — AUTO — 4.4%
BST Safety Textiles Acquisition GmbH
Second Lien Facility, 12.49%, 06/30/09		665,500		666,884		598,950
Motor Coach Industries International, Inc.
PIK Second Lien, 13.64%, 12/01/08		7,662,162		7,802,529		7,432,298

				8,469,413		8,031,248

UTILITIES — 4.3%
Entegra Power Group, LLC
PIK Third Lien Term Loan, 10.83%, 10/19/15		8,264,857		8,190,233		7,753,510

WIRELESS COMMUNICATIONS — 2.6%
Clearwire Corp.
Term Loan, 11.15%, 07/03/12		4,987,500		4,987,500		4,812,938

Total Senior Loans				172,517,898		150,967,130

Corporate Notes and Bonds 59.6%

BROADCASTING — 0.9%
Young Broadcasting, Inc.
10.00%, 03/01/11		2,000,000		1,991,871		1,572,500

CONSUMER NON-DURABLES — 4.0%
Ames True Temper, Inc.
10.00%, 07/15/12		2,000,000		1,951,876		1,110,000
Solo Cup Co.
8.50%, 02/15/14		7,000,000		6,118,435		6,055,000

				8,070,311		7,165,000

DIVERSIFIED MEDIA — 4.6%
Baker & Taylor, Inc.
11.50%, 07/01/13 (f)		8,300,000		8,758,751		8,258,500

ENERGY — EXPLORATION & PRODUCTION — 7.3%
Energy XXI Gulf Coast
10.00%, 06/15/13		6,200,000		6,064,317		5,719,500
Helix Energy Solutions Group, Inc.
9.50%, 01/15/16 (f)		2,500,000		2,500,000		2,556,250

See accompanying Notes to Financial Statements.

Schedule of Investments


As of December 31, 2007 (continued)	Highland Distressed Opportunities, Inc.


	Principal ($)		Cost ($)		Value ($)

Corporate Notes and Bonds (continued)
ENERGY — EXPLORATION & PRODUCTION (continued)
McMoran Exploration Co.
11.88%, 11/15/14		5,000,000		5,000,000		5,043,750

				13,564,317		13,319,500
FOOD/TOBACCO — FOOD/TOBACCO PRODUCERS — 3.1%
Pinnacle Foods Group, Inc.
10.63%, 04/01/17 (f)		6,500,000		6,561,250		5,622,500

GAMING/LEISURE — OTHER LEISURE — 5.2%
Six Flags, Inc.
4.50%, 05/15/15		2,267,000		2,551,335		1,646,409
Tropicana Entertainment Resorts Holdings, L.P.
9.63%, 12/15/14		12,199,000		10,255,479		7,807,360

				12,806,814		9,453,769

HEALTHCARE — ACUTE CARE — 4.0%
Argatroban Royalty Sub, LLC
18.50%, 09/21/14		4,389,424		4,389,424		4,411,371
HCA, Inc.
7.69%, 06/15/25		1,800,000		1,463,385		1,499,222
Tenet Healthcare Corp.
9.88%, 07/01/14		1,500,000		1,514,227		1,436,250

				7,367,036		7,346,843

HEALTHCARE — MEDICAL PRODUCTS — 3.4%
Angiotech Pharmaceuticals, Inc.
7.75%, 04/01/14		5,000,000		4,560,846		4,212,500
Encysive Pharmaceuticals, Inc.
2.50%, 03/15/12		4,000,000		2,674,520		1,995,000

				7,235,366		6,207,500

HOUSING — BUILDING MATERIALS — 0.4%
Masonite Corp.
11.00%, 04/06/15		1,000,000		1,000,000		785,000

HOUSING — REAL ESTATE DEVELOPMENT — 9.5%
Realogy Corp.
10.50%, 04/15/14 (f)		5,000,000		4,959,445		3,750,000
12.38%, 04/15/15 (f)		21,500,000		16,871,858		13,598,750

				21,831,303		17,348,750

See accompanying Notes to Financial Statements.

Schedule of Investments


As of December 31, 2007 (continued)	Highland Distressed Opportunities, Inc.


	Principal ($)		Cost ($)		Value ($)

Corporate Notes and Bonds (continued)

INFORMATION TECHNOLOGY — 4.6%
Freescale Semiconductor, Inc.
9.13%, 12/15/14 (f)		3,000,000		2,998,184		2,565,000
10.13%, 12/15/16		7,000,000		7,000,000		5,810,000

				9,998,184		8,375,000


RETAIL — 3.0%
Dollar General Corp.
10.63%, 07/15/15 (f)		3,000,000		2,776,003		2,767,500
Rite Aid Corp.
9.38%, 12/15/15		1,250,000		1,232,689		1,043,750
9.50%, 06/15/17		2,000,000		1,969,195		1,665,000

				5,977,887		5,476,250

TELECOMMUNICATIONS — 2.8%
Intelsat Bermuda, Ltd.
10.83%, 06/15/13 (g)		5,000,000		5,242,581		5,150,000

TRANSPORTATION — AUTO — 6.8%
Delphi Corp.
6.55%, 06/15/06 (e)		1,500,000		1,151,250		900,000
6.50%, 05/01/09 (e)		2,500,000		1,850,000		1,512,500
6.50%, 08/15/13 (e)		2,667,000		1,861,483		1,560,195
7.13%, 05/01/29 (e)		3,500,000		2,565,250		2,152,500
Motor Coach Industries International, Inc.
11.25%, 05/01/09		12,000,000		10,508,610		6,300,000

				17,936,593		12,425,195

Total Corporate Notes and Bonds				128,342,264		108,506,307

Claims 0.9%

AEROSPACE — AIRLINES — 0.6%
Northwest Airlines, Inc.
ALPA Trade Claim, 08/21/13		3,000,000		659,420		108,750
Bell Atlantic Trade Claim, 08/21/13		2,500,000		733,713		90,625
EDC Trade Claims, 08/21/13		2,500,000		713,944		90,625
Flight Attendant Claim, 08/21/13		5,326,500		1,144,392		193,086
GE Trade Claim, 08/21/13		1,500,000		436,427		54,375
IAM Trade Claim, 08/21/13		4,728,134		1,088,341		171,395
Lambert Leasing Trade Claim, 08/21/13 (d)		3,433,116		896,468		124,450

See accompanying Notes to Financial Statements.

Schedule of Investments


As of December 31, 2007 (continued)	Highland Distressed Opportunities, Inc.


	Principal ($)		Cost ($)		Value ($)

Claims (continued)

Pinnacle Trade Claim, 08/21/13		5,000,000		1,390,687		181,250
Retiree Claim, 08/21/13		3,512,250		754,603		127,319

				7,817,995		1,141,875


CABLE — US CABLE — 0.3%
Adelphia Communications, 06/15/11		4,056,000		1,688,310		441,090

Total Claims				9,506,305		1,582,965



	Shares
Common Stocks 28.0%

AEROSPACE — AIRLINES — 6.3%
Northwest Airlines, Inc. (h)		787,799		15,346,369		11,430,959

CABLE — US CABLE — 0.8%
Time Warner Cable, Inc. (h)		50,336		505,513		1,389,264

DIVERSIFIED MEDIA — 0.7%
Gannett Co., Inc.		35,000		1,927,994		1,365,000

See accompanying Notes to Financial Statements.

Schedule of Investments


As of December 31, 2007 (continued)	Highland Distressed Opportunities, Inc.


	Shares

Common Stocks (continued)
FINANCIAL — 0.2%
Guaranty Financial Group, Inc. (h)		17,500	498,906	280,000
Jer Investors Trust, Inc., REIT		7,731	96,260	83,263

			595,166	363,263

FOREST PRODUCTS — PAPER — 0.6%
Temple-Inland, Inc.		52,500	1,839,716	1,094,625

GAMING/LEISURE — OTHER LEISURE — 0.7%
Starwood Hotels & Resorts Worldwide, Inc.		26,923	1,878,199	1,185,420

HEALTHCARE — MEDICAL PRODUCTS — 3.3%
PDL BioPharma, Inc. (h)		221,600	5,651,605	3,882,432
TLC Vision Corp. (h)		636,900	2,855,567	2,120,877

			8,507,172	6,003,309

HOUSING — BUILDING MATERIALS — 0.1%
Owens Corning, Inc. (h)		13,125	308,341	265,388

HOUSING — REAL ESTATE DEVELOPMENT — 0.2%
Forestar Real Estate Group, Inc. (h)		17,500	779,541	412,825

METALS/MINERALS — OTHER METALS/MINERALS — 6.5%
Alcoa, Inc		208,439	8,240,259	7,618,446
RTI International Metals, Inc. (h)		62,112	5,129,522	4,281,380

			13,369,781	11,899,826

TELECOMMUNICATIONS — 4.4%
Communications Corp. of America (b)(h)		1,256,635	7,187,203	8,014,818

TRANSPORTATION — AUTO — 1.7%
The Goodyear Tire & Rubber Co. (h)		107,852	3,071,002	3,043,583

UTILITIES — 2.5%
Entegra TC, LLC (h)		136,750	6,343,550	4,461,469

Total Common Stocks			61,659,547	50,929,749

Total Investments (i) — 171.4%			372,026,014	311,986,151

Other Assets & Liabilities, Net — (71.4)%				(129,971,099	)

Net Assets — 100.0%				182,015,052


(a)		Senior loans in which Highland Distressed Opportunities, Inc. (the “Company”) invests generally pay interest at rates which are periodically determined by reference to a base lending rate plus a premium. (Unless otherwise identified, all senior loans carry a variable rate interest.) These base lending rates are generally (i) the Prime Rate offered by one or more major United States banks, (ii) the lending rate offered by one or more European banks such as the London Interbank Offered Rate (“LIBOR”) or (iii) the Certificate of Deposit rate. Rate shown represents the weighted average rate at December 31, 2007. Senior loans, while exempt from registration under the Securities Act of 1933 (the “1933 Act”), contain certain restrictions on resale and cannot be sold publicly. Senior secured floating rate loans often require prepayments from excess cash flow or permit the borrower to repay at its election. The degree to which borrowers repay, whether as a

See accompanying Notes to Financial Statements.

Schedule of Investments


As of December 31, 2007 (continued)	Highland Distressed Opportunities, Inc.


		contractual requirement or at their election, cannot be predicted with accuracy. As a result, the actual remaining maturity may be substantially less than the stated maturity shown.

(b)		Represents fair value as determined, in good faith, pursuant to the policies and procedures approved by the Company’s Board of Directors. Securities with a total aggregate market value of $37,888,863, or 20.8% of net assets, were valued under fair value by the Investment Adviser as of December 31, 2007.

(c)		Senior Loan has additional unfunded loan commitment. See Note 6.

(d)		All or a portion of this position has not settled. Contract rates do not take effect until settlement date.

(e)		The issuer is in default of certain debt covenants. Income is not being accrued.

(f)		Securities exempt from registration under Rule 144A of the 1933 Act. These securities may only be resold, in transactions exempt from registration, to qualified institutional buyers. At December 31, 2007, these securities amounted to $39,118,500 or 21.5% of net assets. These securities have been determined by the Company’s investment adviser to be liquid securities.

(g)		Floating rate note. The interest rate shown reflects the rate in effect at December 31, 2007.

(h)		Non-income producing security.

(i)		Cost for U.S. federal income tax purposes is $372,026,014.


PIK		Payment-in-Kind. All or a portion of the stated interest rate may be PIK interest.

REIT		Real Estate Investment Trust

See accompanying Notes to Financial Statements.

Statement of Assets and Liabilities


	Highland Distressed Opportunities, Inc.


	As of			As of
	December 31, 2008			December 31, 2007
	($)			($)

Assets:
Investments in:
Unaffiliated issuers, at value (cost $127,514,862 and $345,348,887, respectively)		45,530,147			284,085,088
Affiliated issuers, at value (cost $39,538,434 and $26,667,127, respectively)		27,090,847			27,901,063

Total investments, at value (cost $167,053,296 and $372,026,014, respectively)		72,620,994			311,986,151
Cash and cash equivalents		—			4,291,098
Foreign currency (cost $10 and $0, respectively)		10			—
Receivable for:
Investments sold		12,106,871			24,628,173
Dividend and interest		2,337,202			5,951,790
Other assets		96,923			66,712

Total assets		87,162,000			346,923,924

Liabilities:
Due to Custodian		122,505			—
Notes payable (Note 4)		15,500,000			142,000,000
Net discount and unrealized depreciation on unfunded transactions		31,756			16,228
Payables for:
Investments purchased		9,809,787			19,387,884
Investment advisory fee (Note 3)		627,965			1,812,285
Administration fee (Note 3)		109,894			317,150
Incentive fee (Note 3)		—			383,951
Interest expense (Note 4)		112,469			759,465
Directors’ fees (Note 3)		5,100			592
Accrued expenses and other liabilities		286,096			231,317

Total liabilities		26,605,572			164,908,872

Stockholders’ equity (net assets)		60,556,428			182,015,052

Composition of stockholders’ equity (net assets):
Common Stock, par value $.001 per share: 550,000,000 common stock authorized, 17,716,771 common stock outstanding		17,717			17,717
Paid-in capital		253,018,580			253,163,644
Undistributed net investment income		1,067,487			3,420,147
Accumulated net realized gain/(loss) on investments, total return swaps and foreign currency transactions		(99,083,521	)		(14,547,689	)
Net unrealized appreciation/(depreciation) on investments, unfunded transactions and translation of assets and liabilities denominated in foreign currency		(94,463,835	)		(60,038,767	)

Stockholders’ equity (net assets)		60,556,428			182,015,052

Net Asset Value Per Share (Net Assets/Common Stock Outstanding)		3.42			10.27

See accompanying Notes to Financial Statements.

Statement of Operations


	Highland Distressed Opportunities, Inc.


	For The Year Ended			For The Period Ended
	December 31, 2008			December 31, 2007 ^(a)
	($)			($)
Investment Income:
Unaffiliated interest income		20,092,839			30,519,314
Affiliated interest income (Note 7)		1,845,150			17,645
Unaffiliated dividends (net of foreign taxes withheld)		40,685			792,762

Total investment income		21,978,674			31,329,721

Expenses:
Investment advisory fees (Note 3)		4,194,605			6,306,869
Incentive fees (Note 3)		1,680,346			2,475,541
Administration fees (Note 3)		734,056			1,103,702
Accounting service fees		154,590			123,913
Transfer agent fees		29,890			24,500
Legal fees		1,128,698			396,096
Audit and Tax fees		152,500			127,500
Directors’ fees		19,881			35,441
Custody fees		28,827			50,956
Registration fees		24,097			20,247
Reports to stockholders		131,041			29,725
Franchise tax expense		80,393			119,367
Organization expense (Note 3)		—			170,383
Rating agency fees		66,184			57,003
Interest expense (Note 4)		3,173,667			7,407,511
Merger expenses		21,227			—
Other expense		378,713			151,384

Total operating expenses		11,998,715			18,600,138

Fees and expenses waived or reimbursed by Investment Adviser (Note 3)		(809,977	)		(4,359,935	)

Net expenses		11,188,738			14,240,203

Net investment income		10,789,936			17,089,518

Net Realized and Unrealized Gain/(Loss) on Investments:
Net realized gain/(loss) on investments		(84,535,832	)		(14,507,557	)
Net realized gain/(loss) on total return swaps		—			172,955
Net realized gain/(loss) on foreign currency transactions		(82	)		33,337
Net change in unrealized appreciation/(depreciation) on investments		(34,392,439	)		(60,039,863	)
Net change in unrealized appreciation/(depreciation) on unfunded transactions		(31,756	)		—
Net change in unrealized appreciation/(depreciation) on translation of assets and liabilities denominated in foreign currency		(873	)		1,096

Net realized and unrealized gain/(loss) on investments		(118,960,982	)		(74,340,032	)

Net decrease in stockholders’ equity (net assets) resulting from operations		(108,171,046	)		(57,250,514	)


(a)		Highland Distressed Opportunities, Inc. commenced operations on January 18, 2007.

See accompanying Notes to Financial Statements.

Statement of Changes in Stockholders’ Equity (Net Assets)


For the Year Ended December 31, 2008 and for the	Highland Distressed Opportunities, Inc.

Period Ended December 31, 2007 ^(a)


																	Total
					Paid-in			Undistributed			Undistributed			Net Unrealized			Stockholders’
	Common Stock				Capital in			Net Investment			Net Realized			Appreciation/			Equity
	Shares		Amount		Excess of Par			Income			Gain/(Loss)			(Depreciation)			(Net Assets)

Balance at January 18, 2007		—	$	—	$	—		$	—		$	—		$	—		$	—
Issuance of common stock, 01/18/07		333,333		333		4,999,667			—			—			—			5,000,000
Issuance of common stock		17,284,300		17,285		247,965,312			—			—			—			247,982,597
Distributions reinvested		99,138		99		1,328,558			—			—			—			1,328,657
Capital contribution, 02/20/07 (b)		—		—		87,596			—			—			—			87,596
Distributions declared		—		—		—			(13,915,795	)		—			—			(13,915,795	)
Offering cost		—		—		(1,217,489	)		—			—			—			(1,217,489	)
Net increase/(decrease) in stockholders’ equity (net assets) resulting from operations		—		—		—			17,335,942			(14,547,689	)		(60,038,767	)		(57,250,514	)

Balance at December 31, 2007		17,716,771	$	17,717	$	253,163,644		$	3,420,147		$	(14,547,689	)	$	(60,038,767	)	$	182,015,052

Distributions declared		—		—		—			(13,287,578	)		—			—			(13,287,578	)
Net increase/(decrease) in stockholders’ equity (net assets) resulting from operations		—		—		(145,064	)		10,934,918			(84,535,832	)		(34,425,068	)		(108,171,046	)

Balance at December 31, 2008		17,716,771	$	17,717	$	253,018,580		$	1,067,487		$	(99,083,521	)	$	(94,463,835	)	$	60,556,428


(a)		Highland Distressed Opportunities, Inc. commenced operations on January 18, 2007.

(b)		On February 20, 2007, the Company’s investment adviser contributed an additional $87,596 in capital to the Company prior to the offering. No additional shares were issued in conjunction with this transaction.

See accompanying Notes to Financial Statements.

Statement of Cash Flows


	Highland Distressed Opportunities, Inc.


	For The Year Ended			For The Period Ended
	December 31, 2008			December 31, 2007 ^(a)
	($)			($)

Cash Flow Provided by (Used in) Operating Activities:
Net increase/(decrease) in stockholders’ equity (net assets) resulting from operations		(108,171,046	)		(57,250,514	)
Adjustments to reconcile net increase/(decrease) in stockholders’ equity (net assets) resulting from operations to net cash and foreign currency:
Net realized (gain)/loss on investments, total return swaps and foreign currency transactions		84,535,914			14,301,265
Net change in unrealized (appreciation)/depreciation on investments, unfunded transactions and translation of assets and liabilities denominated in foreign currency		34,425,068			60,038,767
Purchase of investments securities		(98,191,348	)		(1,255,368,821	)
Proceeds from disposition of investment securities, total return swaps and foreign currency transactions		219,668,727			870,095,540
Net amortization/(accretion) of premium/(discount)		(1,040,493	)		(1,260,290	)
Net realized gain/(loss) on total return swaps		—			172,955
Net realized and change in unrealized gain/(loss) on foreign currency		(955	)		34,433
(Increase)/Decrease in dividends, interest and fees receivable		3,614,589			(5,951,790	)
(Increase)/Decrease in receivable for investments sold		12,521,301			(24,628,173	)
(Increase)/Decrease in other assets		(30,211	)		(66,712	)
Increase/(Decrease) in payable for investments purchased		(9,578,097	)		19,387,884
Increase/(Decrease) in payables to related parties		(1,771,019	)		2,513,978
Increase/(Decrease) in interest payable		(646,996	)		759,465
Increase/(Decrease) in other liabilities		38,551			247,545

Net Cash Flow Provided by (Used in) Operating Activities		135,373,985			(376,974,468	)

Cash Flows Provided by (Used in) Financing Activities:
Net proceeds from issuance of common stock		—			251,852,704
Increase/(Decrease) in notes payable		(126,500,000	)		142,000,000	(b)
Increase in due to custodian		122,505			—
Distributions paid in cash		(13,287,578	)		(12,587,138	)

Net Cash Flow Provided by (Used in) Financing Activities		(139,665,073	)		381,265,566

Net Increase (Decrease) in Cash, Cash Equivalents and Foreign Currency		(4,291,088	)		4,291,098

Cash, Cash Equivalents and Foreign Currency:
Beginning of the period		4,291,098			—
End of the period		10			4,291,098

Supplemental Information:
Interest paid during the year		3,820,663			6,648,046


(a)		Highland Distressed Opportunities, Inc. commenced operations on January 18, 2007.

(b)		During the period, $4 million was borrowed from an affiliate and repaid. See Note 9 for details.

See accompanying Notes to Financial Statements.

Notes to Financial Statements

Highland Distressed Opportunities, Inc.


Note 1.	Organization

Highland Distressed Opportunities, Inc. (the “Company”), is a closed-end company that has filed an election to be treated as a business development company (“BDC”) under the Investment Company Act of 1940 (the “1940 Act”). The Company was incorporated under the laws of Delaware on August 22, 2006. In addition, for tax purposes, the Company has elected to be treated as a regulated investment company, or RIC, under the Internal Revenue Code of 1986 (the “Code”). The Company’s investment objective is total return generated by both capital appreciation and current income. The Company intends to invest primarily in financially-troubled or distressed companies that are either middle-market companies or unlisted companies by investing in senior secured debt, mezzanine debt and unsecured debt, each of which may include an equity component, and in equity investments.

The Company commenced operations on January 18, 2007. On February 27, 2007, the Company closed its initial public offering (“IPO” or the “Offering”) and sold 17,000,000 shares of its common stock at a price of $15.00 per share, less an underwriting discount and commissions totaling $0.675 per share. The Company received $243,525,000 in total net proceeds from the Offering, before expenses.

On March 23, 2007, the Company issued 284,300 shares of common stock to cover the underwriters’ partial exercise of the over-allotment option on the Offering and received approximately $4,072,698 in net proceeds after deducting underwriting discounts and commissions.

As discussed in Note 16 to the financial statements, on December 19, 2008, the Company’s Board of Directors (the “Board”) approved a reorganization of the Company into Highland Credit Strategies Fund.


Note 2.	Significant Accounting Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Changes in the economic environment, financial markets and any other parameters used in determining these estimates could cause actual results to differ materially.

The Company’s financial statements are prepared in accordance with GAAP and pursuant to the requirements for reporting on Form 10-K and Regulation S-X, as appropriate. In the opinion of management, all adjustments, consisting solely of normal recurring accruals, considered necessary for the fair presentation of financial statements have been included.

The following are significant accounting policies consistently followed by the Company in preparation of its financial statements:


(a)	Investments in financial instruments

Investment transactions are recorded on the trade date.

The Company will use the following valuation methods to determine either current market value for investments for which market quotations are available, or if not available, then fair value, as determined in good faith pursuant to policies and procedures approved by the Board:

Market Quotations Available

Notes to Financial Statements — (Continued)

Highland Distressed Opportunities, Inc.

from third-party pricing services or directly from investment brokers and dealers in the secondary market. Generally, the Company’s loan and bond positions are not traded on exchanges and consequently are valued based on market prices received from third-party pricing services or broker-dealer sources. The Company obtains multiple broker-dealer quotes when available, but places greater reliance on quotes from broker-dealers that serve as underwriters for the issuer. In order to validate market quotations, the Company evaluates information, as available and as applicable, to determine if the quotations are representative of fair value, including, but not limited to, the source and nature of the quotations, qualitative analysis of the issuer and internally developed expectations and models. The valuation of certain securities for which there is little to no market activity may take into account appraisal reports obtained by management from independent valuation firms. Short-term debt securities having a remaining maturity of 60 days or less when purchased and debt securities originally purchased with maturities in excess of 60 days but which currently have maturities of 60 days or less may be valued at cost adjusted for amortization of premiums and accretion of discounts.

Market Quotations Not Available

1. The valuation process begins with each portfolio company or investment being initially valued by the investment professionals responsible for the portfolio investment.

2. Preliminary valuation conclusions are then documented and discussed with Highland Capital Management, L.P.’s (the “Investment Adviser”) senior management.

3. The Company’s valuation committee, comprised of the Investment Adviser’s investment professionals and other senior management, will then review these preliminary valuations. An independent valuation firm engaged by the Company’s Board reviews all of these preliminary valuations each quarter.

4. Finally, the Board discusses valuations and reviews the fair value of each investment in the Company’s portfolio in good faith, pursuant to policies and procedures approved by the Board, based on the input of the valuation committee and an independent valuation firm.

Notes to Financial Statements — (Continued)

Highland Distressed Opportunities, Inc.

Adoption of Statement of Financial Accounting Standards No. 157 “Fair Value Measurement” (“FAS 157”):

In September 2006, the Financial Accounting Standards Board (“FASB”) issued FAS 157, “Fair Value Measurement,” which is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. FAS 157 defines how fair value should be determined for financial reporting purposes, establishes a framework for measuring fair value under GAAP, and requires additional disclosures about the use of fair value measurements in interim and annual periods subsequent to initial recognition. FAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. Adoption FAS 157 requires the Company to assume that the portfolio investment is sold in a principal market to a market participant, or in the absence of a principal market, the most advantageous market, which may be a hypothetical market. Market participants are defined as buyers and sellers in the principal or most advantageous market that are independent, knowledgeable, and willing and able to transact. The principal market is the market in which the reporting entity would sell or transfer the asset with the greatest volume and level of activity for the asset. In determining the principal market for an asset or liability under FAS 157, it is assumed that the reporting entity has access to the market as of the measurement date. If no market for the asset exists or if the reporting entity does not have access to the principal market, the reporting entity should use a hypothetical market.

The Company has adopted FAS 157 as of January 1, 2008. In accordance with FAS 157 the Company has considered its principal market as the market in which the Company exits its portfolio investments with the greatest volume and level of activity or a hypothetical secondary market as of the measurement date. However, to the extent that an active market exists, the Company considers that as its principal market. The Company has performed an analysis of all existing investments and derivative instruments to determine the significance and character of all inputs to their fair value determination. Based on this assessment, the adoption of FAS 157 did not have any material effect on the Company’s net asset value. However, the adoption of FAS 157 does require the Company to provide additional disclosures about the inputs used to develop the measurements and the effect of certain measurements on changes in net assets for the reportable periods as contained in the Company’s periodic filings.

The levels of fair value inputs used to measure the Company’s investments are characterized in accordance with the fair value hierarchy established by FAS 157. Where inputs for an asset or liability fall into more than one level in the fair value hierarchy, the investment is classified in its entirety based on the lowest level input that is significant to that investment’s fair value measurement. The Company employs judgment and considers factors specific to the investment in determining the significance of an input to a fair value measurement. The three levels of the fair value hierarchy established under FAS 157 are described below:


	•	Level 1 — Quoted unadjusted prices for identical instruments in active markets to which the Company has access at the date of measurement;

	•	Level 2 — Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active, but are valued based on executed trades; broker quotations that constitute an executable price; and alternative pricing sources supported by observable inputs are classified within Level 2. Level 2 inputs are either directly or indirectly observable for the asset in connection with market data at the measurement date; and

	•	Level 3 — Model derived valuations in which one or more significant inputs or significant value drivers are unobservable. Unobservable inputs are those inputs that reflect the Company’s own assumptions that market participants would use to price the asset or liability based on the best available information.

Notes to Financial Statements — (Continued)

Highland Distressed Opportunities, Inc.

The determination of what constitutes “observable” requires significant judgment by management. Management considers observable data to be that market data which is readily available, regularly distributed or updated, reliable and verifiable, not proprietary, and provided by independent sources that are actively involved in the relevant market. Categorization within the hierarchy is based upon the pricing transparency of the investment and does not necessarily correspond to the Company’s perceived risk of that investment.

Consistent with the valuation policies and procedures, management evaluates the source of inputs, including any markets in which its investments are trading (or any markets in which securities with similar attributes are trading), in determining fair value. The Company’s valuation policy considers the fact that a readily available market value may not exist for a portion of the investments in its portfolio and that fair value for those investments will typically be determined using unobservable inputs.

Investments whose values are based on quoted market prices in active markets, and are therefore classified within Level 1, generally include active listed equities, certain U.S. government and sovereign obligations, and certain money market securities. The quoted price for such instruments are not adjusted, even in situations where the Company holds a large position and a sale could reasonably impact the quoted price.

Investments that trade in markets that are not considered to be active, but are valued based on executed trades, broker quotations that constitute an executable price, or alternative pricing sources supported by observable inputs are classified within Level 2. These may include investment-grade corporate bonds, certain bank loans and bridge loans, less liquid listed equities and certain loan commitments.

Investments classified within Level 3 have significant unobservable inputs, as they trade infrequently or not at all. Level 3 instruments may include private equity and real estate investments, certain bank loans and bridge loans, and less liquid corporate debt securities (including distressed debt instruments). In certain cases, investments classified within Level 3 may include securities for which the Company has obtained indicative quotes from broker-dealers that do not necessarily represent prices the broker may be willing to trade on, as such quotes can be subject to material management judgment. When observable prices are not available for these securities, management may employ one or more valuation techniques for which sufficient and reliable data is available.

The inputs used in estimating the value of Level 3 investments may include the original transaction price, comparable transactions in the same or similar instruments, completed or pending third-party transactions in the underlying investment or comparable issuers, subsequent rounds of financing, recapitalizations and other transactions across the capital structure, offerings in the equity or debt capital markets, and estimates of and changes in financial ratios or cash flows. Level 3 investments may also be adjusted as appropriate for liquidity, credit, market and/or other risk factors to reflect illiquidity and/or non-transferability, with the amount of such discount estimated based on the availability of sufficient and reliable data in the absence of market information. The fair value measurement of Level 3 investments does not include transaction costs that may have been capitalized as part of the security’s cost basis. Assumptions utilized due to the lack of observable inputs may significantly impact the resulting fair value and therefore the Company’s results of operations.

There is no single approach or methodology for determining fair value in good faith and, in fact, for any one portfolio investment, an estimate of fair value may be best expressed as a range of fair values. However, management must derive a single estimate of fair value. As a result, determining fair value requires that judgment be applied to the specific facts and circumstances of each portfolio investment while employing a rational/credible valuation process for the types of investments we the Company makes.

Because of the type of investments that the Company makes and the nature of its business, the Company’s valuation process requires an analysis of various factors. The Company’s fair value methodology includes the examination of, among other things, the underlying investment performance, financial condition, and market changing events that impact valuation.

Notes to Financial Statements — (Continued)

Highland Distressed Opportunities, Inc.

The Company seeks to invest primarily in issuers that are either middle-market companies or unlisted companies for which there is generally no publicly available information. Because of the private nature of these businesses, there is a need to maintain the confidentiality of the financial and other information of such companies. As disclosure of such information could put these companies at an economic or competitive disadvantage, the Company does not disclose financial or other information about its portfolio companies, unless required.

To determine the fair value of a given investment, management analyzes its historical and projected financial results. Such financial and other information may be obtained from the portfolio company, and may represent unaudited, projected or pro forma financial information.

The Company may use Level 3 inputs for measuring the fair value of certain investments by employing one or more of the following valuation methodologies:

Enterprise Value (Multiples) Analysis

Under the enterprise value or residual value valuation methodology (“EV”), the Company estimates the portfolio company’s total EV then will waterfall that value over the portfolio company’s securities in order of their legal priority relative to one another. EV means the entire value of the company to a market participant, including the sum of the values of debt and equity securities used to capitalize the enterprise at a point in time.

This methodology may be employed in valuing loan and debt securities as well as equity securities or other similar securities, subject to any applicable discounts when the Company has a minority ownership position, restrictions on resale, specific concerns about the receptivity of the capital markets to a specific company at a certain time, or other factors, which the Company believes would lead a market participant to discount such securities.

To estimate the EV of the portfolio company, the Company prepares an analysis consisting of traditional valuation methodologies including market, income and cost approaches, and weighs the use of such methods based on the individual circumstances of the portfolio company in order to conclude on its estimate of the EV.

In determining a reasonable multiple to use for valuation purposes, conventional considerations include not only the fact that a portfolio company may be a private company relative to a peer group of public comparables, but also consider potential “size-of-issue” (e.g. liquidity) and “size-of-company-based” (middle-market company) discounts as well as its specific strengths and weaknesses. If a portfolio company is distressed or has a predetermined life (e.g. patents) a liquidation or exit analysis may provide the best indication of value.

Discounted Cash Flow Model

When relevant observable market data does not exist, an alternative technique of valuing investments is based on discounted cash flow, or DCF. For the purposes of using DCF to provide fair value estimates, the Company considers multiple inputs such as a risk-adjusted discount rate that incorporates adjustments that market participants would make both for nonperformance and liquidity risks.

Akin to the enterprise value methodology of valuation, a multiple is applied to the selected financial measure (e.g. EBITDA), and based on the portfolio company’s presumed horizon and the selected discount rate, the Company arrives at the present value of the portfolio company’s terminal value, which is added to the DCF estimate to determine the portfolio company’s total value.

Notes to Financial Statements — (Continued)

Highland Distressed Opportunities, Inc.

Yield/Spread Model

The Company may also value its investments in loans and other debt securities by performing spread and yield analyses. To determine a hypothetical current sale of the investment, the analysis requires the Company to estimate the fair value based on such factors as third-party broker quotes and to make assumptions a market participant would use regarding the investments, including, but not limited to, estimated remaining life, current market yield and interest rate spreads of similar securities as of the measurement date. The Company weighs the use of third-party broker quotes in determining fair value based on its understanding of the level of actual transactions used by the broker to develop the quote and whether the quote was an indicative price or binding offer. The assumptions used to estimate the fair value in a hypothetical secondary market incorporate a significant amount of Level 3 inputs.

Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value of the Company’s investments may fluctuate from period to period. Additionally, the fair value of investments may differ significantly from the values that would have been used had a ready market existed for such investments and may differ materially from the values the Company may ultimately realize. Further, such investments may be subject to legal and other restrictions on resale or otherwise less liquid than publicly traded securities.

In addition, changes in the market environment and other events that may occur over the life of the investments may cause the gains or losses ultimately realized on these investments to be different than the valuations currently assigned.

The inputs or methodology used for valuing securities are not necessarily an indication of the risk associated with investing in those securities. A summary of the inputs used to value the Company’s assets as of December 31, 2008 as follows:


Assets at Fair Value	Total		Level 1		Level 2		Level 3

Portfolio Investments	$	72,620,994	$	502,644	$	1,881,963	$	70,236,387
Cash and foreign currency		10		10		—		—

Total	$	72,621,004	$	502,654	$	1,881,963	$	70,236,387

At December 31, 2008, portfolio investments recorded at fair value using level 3 inputs (as defined under FAS 157) represented approximately 96.7% of the Company’s portfolio, exclusive of cash and cash equivalents. The Company did not have any liabilities that were measured at fair value on a recurring basis at December 31, 2008.

The table below sets forth a summary of changes in the Company’s assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2008.


	For the Year Ended
	December 31,
	2008
Assets at Fair Value Using Unobservable Inputs (Level 3)	Portfolio Investments

Balance as of December 31, 2007	$	37,888,863
Net transfers in/(out) of Level 3		78,579,945
Net amortization/(accretion) of premium/(discount)		(14,828	)
Net realized gains/(losses)		(1,445,503	)
Net unrealized gains/(losses)		(70,409,869	)
Net purchases and sales*		25,637,779

Balance as of December 31, 2008	$	70,236,387


*		Includes any applicable borrowings and/or paydowns made on revolving credit facilities held in the Company’s investment portfolio.

Notes to Financial Statements — (Continued)

Highland Distressed Opportunities, Inc.

The net unrealized losses presented in the tables above relate to investments that are still held at December 31, 2008, and the Company presents these unrealized losses on the Statement of Operations as net change in unrealized appreciation/(depreciation) on investments.

Investments designated as Level 3 may include assets valued using quotes or indications furnished by brokers which are based on models or estimates and may not be executable prices. In light of the developing market conditions, the Investment Adviser continues to search for observable data points and evaluate broker quotes and indications received for portfolio investments. As a result, for the year ended December 31, 2008, approximately $78,579,945 of the Company’s portfolio investments were transferred from Level 2 to Level 3.

New Accounting Pronouncements

In October 2008, FASB Staff Position No. 157-3 — Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active (“FSP 157-3”) was issued. FSP 157-3 clarifies the application of FAS 157 in a market that is not active. More specifically, FSP 157-3 states that significant judgment should be applied to determine if observable data in a dislocated market represents forced liquidations or distressed sales and are not representative of fair value in an orderly transaction. FSP 157-3 also provides further guidance that the use of a reporting entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not available. In addition, FSP 157-3 provides guidance on the level of reliance of broker quotes or pricing services when measuring fair value in a non active market stating that less reliance should be placed on a quote that does not reflect actual market transactions and a quote that is not a binding offer. The guidance in FSP 157-3 is effective upon issuance for all financial statements that have not been issued and any changes in valuation techniques as a result of applying FSP 157-3 are accounted for as a change in accounting estimate. Since adopting FAS 157 in January 2008, our process for determining the fair value of our investments has been, and continues to be, consistent with the guidance set forth in FSP 157-3. As a result, the adoption of FSP 157-3 did not affect our process for determining the fair value of our investments and does not have a material effect on our financial position or results of operations.


(b)	Net asset value per share

The net asset value per share disclosed on the Statement of Assets and Liabilities is calculated by dividing the net assets attributable to the shares of the Company’s common stock by the number of such shares outstanding at period-end.


(c)	Securities transactions

All securities transactions are accounted for on a trade-date basis. Gains or losses on the sale of investments are calculated by using the specific identification method.


(d)	Interest income

Interest income, adjusted for amortization of premium and accretion of discount, is recorded on an accrual basis. Origination, closing and/or commitment fees associated with investments in portfolio companies are accreted into interest income over the respective terms of the applicable loans. Upon the prepayment of a loan or debt security, any prepayment penalties and unamortized loan origination, closing and commitment fees are recorded as interest income. Payment-in-kind (“PIK”) interest, computed at the contractual rate specified in each loan agreement, is added to the principal balance of the loan and recorded as interest income. To maintain the Company’s status as a RIC, this non-cash source of income must be paid out to stockholders in the form of distributions, even though the Company has not yet collected cash. For the year ended December 31, 2008, approximately $1.0 million of PIK interest income was recorded. For the period ended December 31, 2007, approximately $2.6 million of PIK interest income was recorded.

Notes to Financial Statements — (Continued)

Highland Distressed Opportunities, Inc.


(e)	Taxation — general

The Company intends to comply with the applicable provisions of the Code pertaining to regulated investment companies to make distributions of taxable income sufficient to relieve it from substantially all Federal income. However, depending on the level of taxable income earned in a year, the Company may choose to carry forward taxable income in excess of distributions and pay the 4% excise tax on the difference. Additionally, the Company is subject to franchise taxes in the states of Texas and Delaware.

In July 2006, the Financial Accounting Standards Board (“FASB”) released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (“FIN 48”). FIN 48 provides guidance on how uncertain tax positions should be recognized, measured, presented, and disclosed in the financial statements. FIN 48 requires the evaluation of tax positions taken or expected to be taken in the course of preparing the Company’s tax returns to determine whether the tax positions are “more-likely-than-not” of being sustained by the applicable tax authorities. Tax positions not deemed to satisfy the “more-likely-than-not” threshold would be recorded as a tax benefit or expense in the current year. FASB required adoption of FIN 48 for fiscal years beginning after December 15, 2006, and FIN 48 is to be applied to all open tax years as of the effective date. However, on December 22, 2006, the Securities and Exchange Commission (“SEC”) delayed the required implementation date of FIN 48 for business development companies until March 31, 2007. As of December 31, 2008 and December 31, 2007, the Company has evaluated the implications of FIN 48 and determined that there is no material impact on the financial statements.


(f)	Taxation of distributions

Book and tax basis differences relating to stockholder distributions and other permanent book and tax differences are reclassified to paid-in capital. In addition, the character of income and gains to be distributed is determined in accordance with income tax regulations that may differ from GAAP.


(g)	Payment of distributions

Distributions to common stockholders are recorded as of the date of declaration. The amount to be paid out as a distribution is determined by the Board each quarter and is generally based upon the earnings estimated by management. Net realized capital gains, if any, are distributed at least annually.


(h)	Foreign currency

The accounting records of the Company are maintained in U.S. dollars. All assets and liabilities denominated in foreign currencies are translated into U.S. dollars based on the rate of exchange of such currencies against U.S. dollars on the date of valuation. The Company’s investments in foreign securities may involve certain risks such as foreign exchange restrictions, expropriation, taxation or other political, social or economic risks, all of which could affect the market and/or credit risk of the investment. In addition, changes in the relationship of foreign currencies to the U.S. dollar can significantly affect the value of these investments and therefore the earnings of the Company.


(i)	Forward contracts

The Company may enter into forward exchange contracts in order to hedge against foreign currency risk. These contracts are marked-to-market by recognizing the difference between the contract exchange rate and the current market rate as unrealized appreciation or depreciation. Realized gains or losses are recognized when contracts are settled.


(j)	Investment in swap agreements

Swap agreements are recorded at fair value as estimated by management in good faith. The net unrealized gain or loss on swap agreement is recorded as an asset or liability on the Statement of Assets and Liabilities.

Notes to Financial Statements — (Continued)

Highland Distressed Opportunities, Inc.

The change in unrealized gain or loss is recorded in the Statement of Operations. Cash paid or received on net settlements is recorded as realized gain or loss in the Statement of Operations.


(k)	Cash and cash equivalents

Cash and cash equivalents consist of demand deposits and highly liquid investments with original maturities of three months or less when purchased. Cash and cash equivalents are carried at cost which approximates fair value.


(l)	Registration expenses

The Company records registration expenses related to shelf filings as prepaid assets. These expenses are charged as a reduction of capital upon utilization, in accordance with Section 8.24 of the AICPA Audit and Accounting Guide for Investment Companies.


(m)	Incentive fee expense recognition

The realized capital gain component of the incentive fee (the “Capital Gains Fee”), is payable in arrears as of the end of each calendar year (or upon termination of the investment advisory agreement, as of the termination date.) The Capital Gains Fee is estimated as of the end of the each calendar quarter based on the Company’s realized capital gains, if any, net of all realized capital losses, unrealized capital depreciation and fees paid on such net capital gains, computed on a cumulative basis. To the extent that Capital Gains Fees are earned by the Investment Adviser, an accrual is made in the amount of the estimated Capital Gains Fee. Because unrealized losses may fluctuate from quarter to quarter, the accrual, if any, may fluctuate as well. There were no Capital Gains Fees paid or accrued for the year ended December 31, 2008, and the period ended December 31, 2007. (See Note 3 for additional information.)


Note 3.	Agreements

The base management fee is equal to 2.00% per annum of the Company’s Managed Assets. Managed Assets are the value of total assets of the Company less all accrued liabilities of the Company (other than the aggregate amount of any outstanding borrowings, preferred stock issuances, or other instruments or obligations constituting financial leverage). The base management fee is payable quarterly in arrears.

The Investment Adviser contractually agreed to waive or reimburse the Company for all base management fees during the first three months of the Company’s operations and half of all the base management fees during the next three months of the Company’s operations. This contractual waiver expired on August 31, 2007.

The incentive fee consists of two components: (1) the Pre-Incentive Fee Net Investment Income and (2) the Capital Gains Fee. Pre-Incentive Fee Net Investment Income is calculated and payable quarterly in arrears. For this purpose, Pre-Incentive Fee Net Investment Income means interest income, dividend income and any other income (including any other fees (other than fees for providing managerial assistance), such as commitment, origination, structuring, diligence and consulting fees or other fees that we receive from portfolio companies) accrued during the calendar quarter, minus the Company’s operating expenses for the quarter (including the base management fee, any expenses payable under the administration agreement, and any interest expense and dividends paid on any issued and outstanding preferred stock, but excluding the incentive fee). Pre-Incentive Fee Net Investment Income includes, in the case of investments with a deferred interest feature (such as market discount, debt instruments with PIK interest, preferred stock with PIK dividends and zero coupon securities), and accrued income that we have not yet received in cash. The Investment Adviser is not under any obligation to reimburse the Company for any part of the Incentive Fee it

Notes to Financial Statements — (Continued)

Highland Distressed Opportunities, Inc.

received that was based on accrued income that we never received as a result of a default by an entity on an obligation that resulted in the accrual of such income. Pre-Incentive Fee Net Investment Income does not include any realized capital gains, realized and unrealized capital losses or unrealized capital appreciation or depreciation.

With respect to the Company’s Pre-Incentive Fee Net Investment Income from the Company’s commencement of operations until December 31, 2007, the Investment Adviser voluntarily has agreed to waive or reimburse the “Catch-Up” Provision, provided, however, that for such period the Company will pay the Investment Adviser 20% of Pre-Incentive Fee Net Investment Income with respect to that portion of such Pre-Incentive Fee Net Investment Income, if any, that exceeds the Hurdle Rate, but is less than 2.1875% in any calendar quarter (8.75% annualized).

The Investment Adviser agreed to waive the net investment income based incentive fees earned for the three-month period ended June 30, 2008. This voluntary waiver applied only to the second quarter ended June 30, 2008.

These calculations are appropriately prorated for any period of less than three months and adjusted for any share issuances or repurchases during the relevant quarter.

For the year ended December 31, 2008, the Investment Adviser earned $4.2 million in base management fees, $1.7 million in incentive fees related to pre-incentive fee net investment income and $0 in incentive management fees related to capital gains.

For the period ended December 31, 2007, the Investment Adviser earned $6.3 million in base management fees, $2.5 million in incentive fees related to pre-incentive fee net investment income and $0 in incentive management fees related to capital gains.

For the year ended December 31, 2008, the Investment Adviser agreed to waive $0 in base management fees, and $0.8 million in incentive fees related to pre-incentive fee net investment income.

For the period ended December 31, 2007, the Investment Adviser agreed to waive $2.7 million in base management fees, $1.7 million in incentive fees related to pre-incentive fee net investment income.

Pursuant to a separate administration agreement, the Investment Adviser furnishes the Company with office facilities, equipment, clerical, bookkeeping and recordkeeping services at such facilities. Under the administration agreement, the Investment Adviser also will perform, or oversee the performance of, the Company’s required administrative services, which include, among other things, being responsible for the financial records that the Company is required to maintain, monitoring portfolio and regulatory compliance matters and preparing reports to

Notes to Financial Statements — (Continued)

Highland Distressed Opportunities, Inc.

the Company’s stockholders and reports filed with the SEC. In addition, the Investment Adviser will assist the Company in determining, and arranging for the publishing of, the Company’s net asset value, overseeing the preparation and filing of tax returns and the printing and disseminating of reports to stockholders, and generally overseeing the payment of expenses and the performance of administrative and professional services rendered to the Company by others. For providing these services, the Investment Adviser will receive an annual administration fee, payable quarterly in arrears at an annual rate of 0.35% of the Company’s Managed Assets. Under a separate sub-administration agreement, the Investment Adviser has delegated certain administrative functions to PNC Global Investment Servicing (U.S.) Inc. (formerly PFPC Inc.) The administration agreement may be terminated by either party without penalty upon 60 days’ written notice to the other party.

For the year ended December 31, 2008 and period ended December 31, 2007, the Investment Adviser earned administration fees of approximately $0.7 million and $1.1 million, respectively.

The Investment Adviser paid to the underwriters an additional sales load of $0.15 per share, for a total sales load of $0.825 per share. The Company had agreed to pay this amount to the Investment Adviser, together with an interest factor, pursuant to an Agreement Regarding Payment of Sales Load (i) if during either the period commencing with the date of the IPO through the end of the Company’s first fiscal year or during the period of the Company’s second fiscal year (each a “Measuring Period”), the sum of (a) the Company’s aggregate distributions to its stockholders plus (b) the change in the Company’s net assets, equaled or exceeded 7.00% of the net assets of the Company at the beginning of such Measuring Period (but after adjusting, if necessary, the net assets of the Company at the end of such Measuring Period as follows: by subtracting the net proceeds of any of the Company’s stock issuances, and by adding the amount of any of the Company’s stock repurchases, that occurred during such Measuring Period) and without taking into account any accrual for the total payment amount; or (ii) upon the Company’s liquidation. Inasmuch as neither (i) nor (ii) above has occurred by the conclusion of the second Measuring Period, the Agreement Regarding Payment of Sales Load terminated on December 31, 2008, without the Company having any payment obligation to the Investment Adviser. As of December 31, 2008 and December 31, 2007, the Company was under no obligation to make a payment to the Investment Adviser under this agreement.


Note 4.	Credit Facility

In accordance with the 1940 Act, with certain limited exceptions, the Company is only allowed to borrow amounts such that its asset coverage, as defined in the 1940 Act, is at least 200% after such borrowing. On April 25, 2007, the Company entered into a $265 million Revolving Credit Agreement (the “Prior Credit Agreement”), with Barton Capital LLC, the lender party thereto and Société Générale, as agent. The Credit Agreement was a 364-day revolving credit facility with a stated maturity date of April 25, 2012 and was secured by substantially all of the assets in the Company’s portfolio, including cash and cash equivalents. Pricing was set at 0.325% over LIBOR. Additionally, there was a commitment fee of 0.17% on the unused portion of the Prior Credit Agreement. Borrowings under the Prior Credit Agreement were subject to compliance with a borrowing base that applies different advance rates to different types of assets in the Company’s portfolio. As of December 31, 2007, the Company was in compliance with all of the limitations and requirements of the Prior Credit Facility. On June 27, 2008, the Company repaid in full, and terminated the Prior Credit Agreement.

On June 27, 2008, the Company entered into a Revolving Credit and Security Agreement (the “New Credit Agreement”) with Liberty Street Funding LLC, as conduit lender, and The Bank of Nova Scotia, acting through its New York agency, as secondary lender and agent (the “Agent”). Under the New Credit Agreement, the Company had the right to borrow on a revolving basis up to $100 million, subject to the satisfaction of certain conditions including compliance with borrowing base tests and asset coverage limits. The New Credit Agreement had an original expiration date in December 2008.

On November 25, 2008, the Company executed Amendment No. 1 (the “Amendment”) to the Revolving Credit and Security Agreement (as amended, the “Amended New Credit Agreement”) with Liberty Street Funding LLC, as conduit lender, and The Bank of Nova Scotia, acting through its New York agency, as secondary lender and agent.

Notes to Financial Statements — (Continued)

Highland Distressed Opportunities, Inc.

Under the Amended New Credit Agreement, the Company may borrow on a revolving basis up to $60 million, subject to the satisfaction of certain conditions including compliance with borrowing base tests and asset coverage limits. The Amended New Credit Agreement imposes stricter limitations than the 1940 Act, requiring generally that asset coverage be at least 350% after a borrowing. The Amended New Credit Agreement expires on May 29, 2009 and borrowings thereunder are secured by substantially all of the assets in the Company’s portfolio, including cash and cash equivalents. The interest rate charged is based on prevailing commercial paper rates if the conduit lender makes the advance, other than through participations, plus commitment and utilization fees. However, if the conduit lender does not make the advance, other than through participations, the interest rate is based on the prevailing Eurodollar rate, Federal Funds rate or the agent’s reference rate, in each case plus an applicable spread and commitment and utilization fees. The Company pays a commitment fee at the annual rate of 1.25% on the total commitment amount, and a utilization fee at the annual rate of 0.75% on outstanding borrowings. The Amended New Credit Agreement contains customary events of default (with grace periods where customary) including, among other things, failure to pay interest or principal when due and failure to comply with certain asset coverage and borrowing base tests.

At December 31, 2008, the Company had borrowings outstanding under the Amended New Credit Agreement of $15.5 million. The interest rate charged on this loan as of December 31, 2008 was approximately 2.61%. The average daily loan balance during the three months ended December 31, 2008 on the facility was approximately $28.9 million at a weighted average interest rate of approximately 3.13%. Interest expense incurred for the year ended December 31, 2008 was approximately $3.2 million.

At December 31, 2007, the Company had borrowings outstanding on the Prior Credit Agreement of $142.0 million. The interest rate charged on this loan as of December 31, 2007 was approximately 5.41%. The average daily loan balance was approximately $178.5 million at a weighted average interest rate of approximately 5.35%. Interest expense incurred during the period ended December 31, 2007 was approximately $7.4 million.


Note 5.	Net Asset Value Per Share

At December 31, 2008, and December 31, 2007, the Company’s total net assets and net asset value per share were $60,556,428, and $182,015,052, and $3.42 and $10.27, respectively.


Note 6.	Unfunded Loan Commitments

As of December 31, 2008 and December 31, 2007, the Company’s portfolio had unfunded loan commitments of approximately $0.1 million, and $0.8 million, respectively. Unfunded loan commitments are marked to fair value along with the funded portion of the respective loans, in accordance with the Company’s valuation policy discussed in Note 2(a).


	Unfunded Loan Commitment
	December 31,		December 31,
Borrower	2008		2007

Comcorp Broadcasting, Inc.	$	58,999	$	848,228

Unfunded loan commitments are marked to market on the relevant day of valuation in accordance with the Company’s valuation policies. Any applicable unrealized gain/(loss) and unrealized appreciation/(depreciation) on unfunded loan commitments are recorded on the Statement of Assets and Liabilities and the Statement of Operations, respectively. As of December 31, 2008 and December 31, 2007, the Company recognized net unrealized depreciation on unfunded transactions of approximately $0.03 million and $0, respectively. The net change in unrealized depreciation on unfunded transactions for the year ending December 31, 2008 was approximately $0.03 million and is recorded in the Statement of Operations.

Notes to Financial Statements — (Continued)

Highland Distressed Opportunities, Inc.


Note 7.	Transactions in Securities of Affiliated Issuers

Under Section 2(a) (3) of the Investment Company Act of 1940, a portfolio company is defined as “affiliated” if a company owns five percent or more of its voting securities. Set forth in the tables below are the issuers in which the Company held at least five percent of the outstanding voting securities as of December 31, 2008 and December 31, 2007:

December 31, 2008


Borrower	Shares		Principal		Market Value

Comcorp Broadcasting, Inc.*
Revolving Loan			$	1,825,953	$	843,134
Term Loan				18,849,521		8,835,713
Communications Corp. of America		1,256,635				—
Genesys Ltd.		12,000,000				17,412,000

Total					$	27,090,847

December 31, 2007


Borrower	Shares		Principal		Market Value

Comcorp Broadcasting, Inc.*
Revolving Loan			$	1,036,724	$	1,036,724
Term Loan				18,849,521		18,849,521
Communications Corp. of America		1,256,635				8,014,818

Total					$	27,901,063


*		Company is a wholly owned subsidiary of Communications Corp. of America.


Note 8.	Portfolio Information

For the year ended December 31, 2008, the cost of purchases and proceeds from sales of securities, excluding short-term obligations, were approximately $98,191,348 and $219,668,727, respectively.

For the period ended December 31, 2007, the cost of purchases and proceeds from sales of securities, excluding short-term obligations, were approximately $1,255,368,821 and $870,095,540, respectively.


Note 9.	Affiliated Transactions

On January 18, 2007, the Company issued a promissory note payable to the Investment Adviser in the amount of $4 million with interest at 4.87% per annum, compounded semi-annually. The promissory note was fully redeemed on March 8, 2007. The average daily balance on the promissory note for the time it was held was $4 million at a weighted average interest rate of 5.00%.


Note 10.	Certain Transactions

On January 19, 2007, the Company entered into a warehouse arrangement in the form of a total return swap with the Bank of Nova Scotia, (“Scotia”). As of February 15, 2007, the notional value of the portfolio was approximately $124 million. The Company had the option, exercisable by the Company not later than March 15, 2007, to acquire the underlying assets in the total return swap at their value at the time of exercise. Upon entering into the warehouse arrangement the Company posted $9 million in collateral in a segregated account at the

Notes to Financial Statements — (Continued)

Highland Distressed Opportunities, Inc.

Company’s custodian. Prior to the termination of the warehouse arrangement, Scotia recorded the positive total return, if any, on such assets net of the warehouse arrangement’s financing cost in a collection account. To the extent there was a negative total return and the collection account had a negative balance, collateral was transferred from the collateral account to the collection account. The Company had no obligation to post additional collateral. If at any time the value of the collateral and collection account, as a percentage of the book value of the bank loans and other assets, was less than 5.00%, or 3.50% under certain circumstances, and the Company did not choose to post additional collateral by the next business day, Scotia would have had the right to terminate the warehouse arrangement, dispose of all of the assets and charge the Company for any cumulative negative total return up to the remaining amount of the posted collateral. On February 26, 2007, the Company exercised the option to acquire the underlying assets. Purchases from the entire underlying portfolio were settled on June 21, 2007. The net realized gain on the warehouse arrangement was approximately $172,955, and is recorded on the Statement of Operations as net realized gain/(loss) on total return swaps. As of December 31, 2008 and December 31, 2007, the Company did not have any investments in total return swaps.

Notes to Financial Statements — (Continued)

Highland Distressed Opportunities, Inc.

Note 11. Financial Highlights

The following is a schedule of financial highlights for the year ended December 31, 2008 and the period ended December 31, 2007:


	Year Ended			Period Ended
	December 31,			December 31,
	2008			2007(a)

Net asset value, beginning of year	$	10.27		$	14.33	^(b)

Net investment income		0.61			0.97
Net realized and unrealized loss on investments		(6.71	)		(4.43	)

Total from investment operations		(6.10	)		(3.46	)
Common Stock Offering Cost		—			(0.07	)
Capital Contribution		—			0.26	^(c)
Distributions Paid		(0.75	)		(0.79	)

Net asset value, end of year	$	3.42		$	10.27

Market price per share, beginning of year	$	8.57		$	15.00
Market price per share, end of year	$	2.15		$	8.57
Total investment return(d)
Based on net asset value per share		(61.24	)%		(23.30	)% ^(e)
Based on market price per share		(70.80	)%		(38.85	)% ^(e)
Net assets, end of year(f)	$	60,556		$	182,015
Ratios to Average Net Assets/Supplemental Data:
Total operating expense including interest expense		9.18	%		9.54	% ^(g)
Total operating expenses excluding interest expense		6.75	%		5.74	% ^(g)
Interest expense		2.43	%		3.80	% ^(g)
Waiver/reimbursement		0.62	%		2.24	% ^(g)
Net expense(h)		8.56	%		7.30	% ^(g)
Net investment income		8.25	%		8.77	% ^(g)
Portfolio turnover rate		49	%		224	% ^(e)
Debt:
Total loan outstanding, end of year(f)	$	15,500		$	142,000
Asset Coverage per $1000 indebtedness, end of year(i)	$	4,907		$	2,282


(a)		The Company commenced operations on January 18, 2007.
(b)		Net asset value at the beginning of the period reflects the deduction of the one-time initial sales load in connection with the offering.
(c)		On February 20, 2007, the Investment Adviser contributed an additional $87,596 in capital to the Company prior to the Offering. No additional shares were issued in the transaction. The contribution per share is based on the pre-offering share amount of 333,333.33
(d)		Total investment return based on market value may result in substantially different returns than investment return based on net asset value, because market value can be significantly greater or less than the net asset value. Investment return assumes reinvestment of distributions.
(e)		Not annualized.
(f)		Dollars in thousands.
(g)		Ratios to average net assets are calculated using the net assets for the period starting from the Offering on February 27, 2007 through December 31, 2007.
(h)		Net expense ratio has been calculated after applying any waiver/reimbursement.
(i)		Calculated by subtracting the Company’s total liabilities (not including any bank loans and senior securities) from the Company’s total assets, and dividing such amounts by the principal amount of the debt outstanding.

Notes to Financial Statements — (Continued)

Highland Distressed Opportunities, Inc.

Note 12. Income Tax Information and Distributions to Stockholders

For the year end December 31, 2008, and the period ended December 31, 2007, the Company’s Board declared the following distributions:


Date Declared	Record Date	Payment Date	Amount

March 9, 2007	June 19, 2007	June 29, 2007	$	0.2625
August 3, 2007	September 18, 2007	September 28, 2007	$	0.2625
November 6, 2007	December 21, 2007	December 31, 2007	$	0.2625

Total declared during 2007*			$	0.7875

March 7, 2008	March 20, 2008	March 31, 2008	$	0.2625
June 6, 2008	June 20, 2008	June 30, 2008	$	0.2625
September 5, 2008	September 19, 2008	September 30, 2008	$	0.1500
December 4, 2008	December 19, 2008	December 31, 2008	$	0.0750

Total declared during 2008			$	0.7500


*		Highland Distressed Opportunities, Inc. commenced operations on January 18, 2007.

Reclassifications are made to the Company’s capital accounts for permanent tax differences to reflect income and gains available for distribution (or available capital loss carryforwards) under income tax regulations.

For the year ended December 31, 2008 and period ended December 31, 2007, permanent differences resulting primarily from Section 988 gain/(loss) and nondeductible excise tax were identified and reclassified among the components of the Company’s net assets as follows:


	2008			2007

Undistributed Net Investment Income	$	144,982		$	246,424
Accumulated Net Realized Loss	$	82		$	(246,424	)
Paid-In Capital	$	(145,064	)	$	—

The tax character of distributions paid during the year ended December 31, 2008 and the period ended December 31, 2007 were as follows:


Distributions paid from:	2008		2007

Ordinary income*	$	13,287,578	$	13,915,795
Long-term capital gains	$	—	$	—


*		For tax purposes short-term capital gains distributions, if any, are considered ordinary income distributions

As of December 31, 2008 and December 31, 2007, the components of distributable earnings on a tax basis were as follows:


	2008			2007

Capital loss carryforward	$	(79,324,572	)*	$	(9,946,969	)**
Undistributed ordinary income	$	1,165,348		$	3,525,488
Post-October Losses	$	(8,442,951	)	$	(4,600,720	)
Net unrealized appreciation/(depreciation)	$	(105,779,833	)	$	(60,038,767	)


*		Accumulated losses of $9,946,969 and $69,377,603 to offset future capital gains, if any, expire on December 31, 2015 and December 31, 2016, respectively.

**		Accumulated losses of $9,946,969 to offset future capital gains, if any, expire on December 31, 2015.

Notes to Financial Statements — (Continued)

Highland Distressed Opportunities, Inc.

For the year ended December 31, 2008, and the period ended December 31, 2007, the Company elected to defer capital losses of $8,442,951 and $4,600,720, respectively attributable to post-October losses.

Unrealized appreciation and depreciation at December 31, 2008, and December 31, 2007, based on cost of investments for U.S. federal income tax purposes and excluding any unrealized appreciation and depreciation from changes in the value of other assets and liabilities resulting from changes in exchange rates was:


	2008			2007

Unrealized appreciation	$	5,545,106		$	2,429,611
Unrealized depreciation		(111,293,406	)		(62,469,474	)

Net unrealized depreciation	$	(105,748,300	)	$	(60,039,863	)

For the year ended December 31, 2008, and period ended December 31, 2007, the percentage of the income distributions qualifying for the dividends-received deduction available to corporations is 1.73%, and 5.48%, respectively.

Note 13. SEC Filings and Certifications

Copies of the Company’s annual reports on Form 10-K, proxy statements, quarterly reports on Form 10-Q and current reports on Form 8-K, and any amendments to those filings are available free of charge on its website, www.HighlandHCD.com, under “SEC Filings,” as soon as reasonably practicable after they are filed electronically with the SEC.

In April 2008, the Company submitted to the New York Stock Exchange (“NYSE”) pursuant to Section 303A.12(a) of its Listed Company Manual, an unqualified certification regarding its compliance with the corporate governance listing standards of the NYSE of the Company’s Chief Executive Officer. In addition, certifications by the Company’s Chief Executive Officer and Principal Financial Officer have been filed as exhibits to this annual report on Form 10-K as required by the Securities Exchange Act of 1934, as amended, and the Sarbanes-Oxley Act of 2002.

Note 14. Impact of New Accounting Standards

In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“FAS 161”). FAS 161 is effective for fiscal years and interim periods beginning after November 15, 2008. FAS 161 requires enhanced disclosures about the Company’s derivative and hedging activities, but is not expected to result in any changes to such activities. At this time, the Company is evaluating the implications of FAS 161 to determine the impact, if any, on the Company’s financial statements.

Notes to Financial Statements — (Continued)

Highland Distressed Opportunities, Inc.

Note 15. Selected Quarterly Financial Data (Unaudited) (in thousands, except per share amounts)


	2007
	Q1 *			Q2			Q3			Q4			Total

Total investment income	$	1,653		$	9,577		$	9,521		$	10,578		$	31,330
Total investment income per share	$	0.09		$	0.54		$	0.54		$	0.60		$	1.77
Net investment income	$	1,290		$	6,173		$	4,266		$	5,361		$	17,090
Net investment income per share	$	0.07		$	0.35		$	0.24		$	0.30		$	0.97
Net realized and unrealized gain/(loss)	$	(934	)	$	(5,729	)	$	(30,386	)	$	(37,291	)	$	(74,340	)
Net realized and unrealized gain/(loss) per share	$	(0.05	)	$	(0.32	)	$	(1.72	)	$	(2.10	)	$	(4.20	)
Net increase/(decrease) in stockholders’ equity (net assets) resulting from operations	$	356		$	443		$	(26,120	)	$	(31,929	)	$	(57,251	)
Net increase/(decrease) in stockholders’ equity (net assets) resulting from operations per share	$	0.02		$	0.03		$	(1.47	)	$	(1.80	)	$	(3.23	)


*		Highland Distressed Opportunities, Inc. commenced operations on January 18, 2007.


	2008
	Q1			Q2			Q3			Q4			Total

Total investment income	$	7,893		$	6,479		$	4,086		$	3,520		$	21,979
Total investment income per share	$	0.45		$	0.37		$	0.23		$	0.20		$	1.24
Net investment income	$	3,481		$	4,050		$	1,972		$	1,286		$	10,790
Net investment income per share	$	0.20		$	0.23		$	0.11		$	0.07		$	0.61
Net realized and unrealized gain/(loss)	$	(34,511	)	$	(17,433	)	$	(9,076	)	$	(57,971	)	$	(118,961	)
Net realized and unrealized gain/(loss) per share	$	(1.95	)	$	(0.98	)	$	(0.51	)	$	(3.27	)	$	(6.71	)
Net increase/(decrease) in stockholders’ equity (net assets) resulting from operations	$	(31,030	)	$	(13,383	)	$	(7,103	)	$	(56,655	)	$	(108,171	)
Net increase/(decrease) in stockholders’ equity (net assets) resulting from operations per share	$	(1.75	)	$	(0.76	)	$	(0.40	)	$	(3.20	)	$	(6.11	)

Note 16. Reorganization

On December 19, 2008 the Board approved a reorganization of the Company into Highland Credit Strategies Fund (“HCF”), a non-diversified closed-end management investment company also managed by the Investment Adviser.

The closing of the reorganization is subject to several conditions, including the approval of the Company’s stockholders. If stockholders of the Company do not approve the reorganization or, if such other conditions are not satisfied or waived, the Company will continue its current operations. There is no assurance that the requisite stockholder approval will be obtained for the reorganization or that such other conditions will be satisfied.

On December 24, 2008, HCF filed with the Securities and Exchange Commission a proxy statement/prospectus with respect to the Reorganization, and the Company expects to mail the proxy statement/prospectus to its stockholders and to solicit approval of the Reorganization in March 2009. The Company and HCF will bear the costs of the reorganization. It is currently expected that the Reorganization will qualify as a tax-free reorganization for federal income tax purposes. The number of shares of HCF (and cash for fractional shares) that stockholders of the Company will receive in the Reorganization will be based on the relative net asset values of the Company and HCF as of the close of business on the valuation day for the Reorganization.

Subject to stockholder approval and the satisfaction or waiver of certain conditions, the Reorganization is currently expected to occur in the 2nd quarter of 2009.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 9A. Controls and Procedures

Attached as exhibits to this Form 10-K are certifications by the Company’s Chief Executive Officer and Principal Financial Officer, which are required in accordance with Rule 13a-14 of the Securities Exchange Act of 1934. This section includes information concerning the controls and controls evaluation referred to in those certifications and should be read in conjunction with the certifications for a more complete understanding of the topics presented.


(a)	Evaluation of Disclosure Controls and Procedures

The Company conducted an evaluation of the effectiveness of the design and operation of its disclosure controls and procedures (Disclosure Controls) as of December 31, 2008. The controls evaluation was conducted under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Principal Financial Officer. Disclosure Controls are controls and procedures designed to reasonably assure that information required to be disclosed in the Company’s reports filed under the Exchange Act, such as this Form 10-K, is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms. Disclosure Controls are also designed to reasonably assure that such information is accumulated and communicated to the Company’s management, including the Company’s Chief Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. The Company’s quarterly evaluation of Disclosure Controls includes an evaluation of some components of its internal control over financial reporting, and internal control over financial reporting is also separately evaluated on an annual basis for purposes of providing the management report which is set forth below.

The evaluation of the Company’s Disclosure Controls included a review of the controls’ objectives and design, the Company’s implementation of the controls and the effect of the controls on the information generated for use in this Form 10-K. In the course of the controls evaluation, the Company reviewed any identified data errors, control problems or acts of fraud and sought to confirm that appropriate corrective actions, including process improvements, were being undertaken. This type of evaluation is performed on a quarterly basis so that the conclusions of management, including the Company’s Chief Executive Officer and Principal Financial Officer, concerning the effectiveness of the Disclosure Controls can be reported in the Company’s periodic reports on Form 10-Q and Form 10-K. The components of the Company’s Disclosure Controls are also evaluated on an ongoing basis by a third-party consultant. The overall goals of these various evaluation activities are to monitor the Company’s Disclosure Controls, and to modify them as necessary. The Company’s intent is to maintain the Disclosure Controls as dynamic systems that change as conditions warrant.

Based upon the controls evaluation, the Company’s Chief Executive Officer and Principal Financial Officer have concluded that, subject to the limitations noted in this Part II, Item 9A, as of December 31, 2008, the Company’s Disclosure Controls were effective to provide reasonable assurance that information required to be disclosed in its periodic reports, as promulgated under the Securities Exchange Act of 1934, is recorded, processed, summarized and reported within the time periods specified by the SEC, and that material information relating to the Company is made known to management, including the Company’s Chief Executive Officer and Principal Financial Officer, particularly during the period when its periodic reports are being prepared.


(b)	Management’s Report on Internal Control Over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f), and for performing an assessment of the effectiveness of internal control over financial reporting as of December 31, 2008. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Company’s internal control over financial reporting includes those policies and procedures that (i) pertain to assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation

of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.

Management performed an assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2008 based upon criteria in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).

Based on the Company’s evaluation under the framework in Internal Control — Integrated Framework issued by COSO, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2008. PricewaterhouseCoopers LLP, our independent registered public accounting firm, has issued an attestation report on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2008, as stated in its report which is included herein.


(c)	Attestation Report of the Independent Registered Public Accounting Firm

Our independent registered public accounting firm, PricewaterhouseCoopers LLP, has issued an attestation report on management’s assessment of the Company’s internal control over financial reporting, which is set forth above under the heading “Report of Independent Registered Public Accounting Firm” in Item 8.


(d)	Changes in Internal Controls Over Financial Reporting

Management has not identified any change in the Company’s internal control over financing reporting that occurred during the fourth fiscal quarter of 2008 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Item 9B. Other Information

None.

PART III


Item 10.	*Directors, Executive Officers and Corporate Governance*

The following tables set forth the name, age and other information regarding our directors and executive officers as of December 31, 2008.

Board of Directors


			Number of
	Position(s) Held		Portfolios in
	With the Company,	Principal	Highland Fund
	Length of Time	Occupation(s)	Complex		Other
	Served and Term	During Past	Overseen		Directorships
Name (Age) Address ¹	of Office	Five Years	by Director ²		Held


Director — Class I (Non-Interested Directors ³ )
James F. Leary (Age 78)	Director of the Company since December 2006 (with a term expiring at the 2011 annual meeting).	Managing Director, Benefit Capital Southwest, Inc. (a financial consulting firm) since January 1999.		9	Board Member of Capstone Group of Funds (7 portfolios).


			Number of
	Position(s) Held		Portfolios in
	With the Company,	Principal	Highland Fund
	Length of Time	Occupation(s)	Complex		Other
	Served and Term	During Past	Overseen		Directorships
Name (Age) Address ¹	of Office	Five Years	by Director ²		Held

Bryan A. Ward (Age 53)	Director of the Company since December 2006 (with a term expiring at the 2011 annual meeting).	Senior Manager, Accenture, LLP (a consulting firm) since January 2002.		9	None.

Director — Class II (Non-Interested Directors ³ )
Timothy Hui (Age 60)	Director of the Company since December 2006 (with a term expiring at the 2009 annual meeting).	Vice President since February 2008, Dean of Educational Resources from July 2006 to January 2008, Assistant Provost for Graduate Education from July 2004 to June 2006, and Assistant Provost for Educational Resources, July 2001 to June 2004 at Philadelphia Biblical University.		9	None.
Scott Kavanaugh (Age 48)	Director of the Company since December 2006 (with a term expiring at the 2009 annual meeting).	Vice-Chairman, President and Chief Operating Officer at Keller Financial Group since September 2007; Chairman and Chief Executive Officer at First Foundation Bank since September 2007; Private investor since February 2004; Sales Representative at Round Hill Securities from March 2003 to January 2004; Executive at Provident Funding Mortgage Corporation from February 2003 to July 2003; Executive Vice President, Director and Treasurer at Commercial Capital Bank from January 2000 to February 2003; Managing Principal and Chief Operating Officer at Financial Institutional Partners Mortgage Company and Managing Principal and President of Financial Institutional Partners, LLC (an investment banking firm) from April 1998 to February 2003.		9	None.


			Number of
	Position(s) Held		Portfolios in
	With the Company,	Principal	Highland Fund
	Length of Time	Occupation(s)	Complex		Other
	Served and Term	During Past	Overseen		Directorships
Name (Age) Address ¹	of Office	Five Years	by Director ²		Held

Director — Class III (Interested Directors ⁴ )
R. Joseph Dougherty (Age 38)	Director and Chairman of the Board of the Company since December 2006 (with a term expiring at the 2010 annual meeting).	Team Leader of Investment Adviser since 2000, Director/Trustee of the funds in the Highland Fund Complex since 2004 and President and Chief Executive Officer of the funds in the Highland Fund Complex since December 2008; Senior Vice President of the Company since inception; Senior Vice President of the funds in the Highland Fund Complex from 2004 to December 2008.		9	None.


1		The address of each Director is NexBank Tower, 13455 Noel Road, Suite 800, Dallas, Texas 75240.

2		The “Highland Fund Complex” consists of all of the registered investment companies that are advised by the Investment Adviser as of the date of this report and the Company.

3		“Non-Interested” Directors are those who are not “interested persons” of the Company as described under Section 2(a)(19) of the 1940 Act.

4		Mr. Dougherty is deemed to be an “interested person” of the Company under the 1940 Act because of his position with the Adviser. Each Director other than Mr. Dougherty is a “Non-Interested” Director.

Officers


		Term of Office and
	Position(s) Held	Length of
Name (Age) ¹	With the Company	Time Served	Principal Occupation(s) During Past Five Years

James D. Dondero (Age 46)	President and Chief Executive Officer	Indefinite Term and Officer since September 2006.	President and Director of Strand Advisors, Inc. (“Strand”), the General Partner of the Adviser. Chairman of the Board of Directors of Highland Financial Partners, L.P. and President of the funds in the Highland Fund Complex (2004 through December 2008).
Mark Okada (Age 46)	Executive Vice President	Indefinite Term and Officer since September 2006.	Executive Vice President of Strand; Chief Investment Officer of the Adviser and Executive Vice President of the funds in the Highland Fund Complex (2004 through December 2008).


		Term of Office and
	Position(s) Held	Length of
Name (Age) ¹	With the Company	Time Served	Principal Occupation(s) During Past Five Years

M. Jason Blackburn (Age 32)	Secretary and Treasurer (Principal Financial and Accounting Officer)	Indefinite Term and Officer since September 2006.	Assistant Controller of the Investment Adviser since November 2001; Treasurer and Secretary of the funds in the Highland Fund Complex.
Michael Colvin (Age 39)	Chief Compliance Officer	Indefinite Term and Officer since July 2007.	General Counsel and Chief Compliance Officer of the Adviser since June 2007 and Chief Compliance Officer of the funds in the Highland Fund Complex since July 2007; Shareholder in the Corporate and Securities Group at Greenberg Traurig, LLP from January 2007 to June 2007; Partner in the Private Equity Practice Group at Weil, Gotshal & Manges, LLP from January 2003 to January 2007.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the 1934 Act and Section 30(h) of the 1940 Act, and the rules thereunder, require that the Company’s Directors and officers, the Investment Adviser, certain persons affiliated with the Investment Adviser, and persons who own beneficially, directly or indirectly, more than 10% of the Company’s Common Stock, file reports of ownership and changes of ownership with the Securities and Exchange Commission (“SEC”) and the NYSE. Directors, officers, the Investment Adviser, certain affiliates of the Investment Adviser and greater than 10% beneficial owners are required by SEC regulations to furnish to the Company copies of all Section 16(a) forms they file with respect to shares of the Company. Based solely upon the Company’s reviews of the copies of such forms they receive and written representations from such persons, the Company believes that during the fiscal year ended December 31, 2008, these persons complied with all such applicable filing requirements.

Codes of Ethics

The Company and the Investment Adviser have adopted codes of ethics under Rule 17j-1 of the 1940 Act. These codes permit personnel subject to the codes to invest in securities, including securities that may be purchased or held by the Company. These codes can be reviewed and copied at the SEC’s Public Reference Room in Washington, D.C. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-202-551-8090. The codes of ethics are available on the EDGAR Database on the SEC’s web site (http://www.sec.gov), and copies of these codes may be obtained, after paying a duplicating fee, by electronic request at the following e-mail address: publicinfo@sec.gov, or by writing the SEC’s Public Reference Section, Washington, D.C. 20549-0102.

The Company has also adopted a Code of Ethics for Principal Executive and Senior Financial Officers. A copy of this code of ethics is available upon request, without charge, by call 877-247-1888.

During the fiscal year ended December 31, 2008, the Board of Directors of the Company convened 17 times. During the fiscal year ended December 31, 2008, each Director attended at least 75% of the meetings of the Board and Committees on which he serves held during the period he was a Director.

Directors are invited and encouraged to attend the Company’s Annual Meeting of Stockholders. A Director who is unable to attend the Annual Meeting is expected to notify the Chairman of the Board of Directors. Four of the five directors attended the 2008 Annual Meeting of Stockholders.

The Board of the Company has four committees; the Audit Committee, the Nominating/Corporate Governance/Compensation Committee, the Litigation Committee and the Qualified Legal Compliance Committee, each of which is currently comprised of all of the Non-Interested Directors, each of whom is “Independent” as defined by the New York Stock Exchange (the “NYSE”).

Audit Committee

Pursuant to the Audit Committee Charter adopted by the Board, the role of the Audit Committee is to (1) oversee the Company’s accounting and financial reporting processes and the audits of the Company’s financial statements and (2) assist in Board oversight of the integrity of the Company’s financial statements, the Company’s compliance with legal and regulatory requirements, and the independent auditors’ qualifications, independence and performance. The function of the Audit Committee is oversight; it is management’s responsibility to maintain appropriate systems for accounting and internal control over financial reporting. The Audit Committee met five times in fiscal year 2008. The members of the Audit Committee are Messrs. Hui, Kavanaugh, Leary, and Ward. The Board has determined that Mr. Leary is an “audit committee financial expert,” for purposes of the federal securities laws. Mr. Leary is “Independent” as defined by the NYSE. The Chairman of the Audit Committee presides at executive sessions of the non-management Directors held without management.

Nominating/Corporate Governance/Compensation Committee

The Company’s Nominating/Corporate Governance/Compensation Committee is responsible for selecting the Non-Interested Director nominees and recommending to the Board candidates for all other Director nominees for election by stockholders or appointment by the Board. In addition, the Nominating/Corporate Governance/ Compensation Committee is responsible for advising the Board with respect to Board composition, procedures and committees, developing and recommending to the Board a set of corporate governance principles applicable to the Company, overseeing the evaluation of the Board and the Company’s management, reviewing and approving the Company’s objectives relevant to compensation of Non-Interested Directors and making recommendations to the Board with respect to the compensation of Non-Interested Directors. A copy of the Company’s Nominating/Corporate Governance/Compensation Committee Charter is available at www.highlandhcd.com.

The Nominating/Corporate Governance/Compensation Committee will consider recommendations for nominees from stockholders submitted to the Secretary of the Company, Two Galleria Tower, Suite 800, 13455 Noel Road, Dallas, Texas 75240. Such stockholder recommendations must include information regarding the recommended nominee as specified in the Nominating/Corporate Governance/Compensation Committee Charter.

The Nominating/Corporate Governance/Compensation Committee Charter describes the factors considered by the Nominating/Corporate Governance/Compensation Committee in selecting nominees. In evaluating potential nominees, including any nominees recommended by stockholders, the Nominating/Corporate Governance/Compensation Committee takes into consideration factors listed in the Nominating/Corporate Governance/Compensation Committee Charter, including character and integrity, business and professional experience, whether the Nominating/Corporate Governance/Compensation Committee believes the person has time availability in light of other commitments and the existence of any other relationships that might give rise to a conflict of interest. The Nominating/Corporate Governance/Compensation Committee met two times during fiscal year 2008.

Litigation Committee

The Company has established a Litigation Committee to seek to address any potential conflicts of interest between the Company and the Adviser in connection with any potential or existing litigation or other legal proceeding relating to securities held by both the Company and the Adviser or another client of the Adviser. The Litigation Committee met four times in fiscal year 2008.

Qualified Legal Compliance Committee

The members of the Audit Committee of the Company shall serve as the Qualified Legal Compliance Committee (the “QLCC”) for the Company for the purpose of establishing alternative procedures for counsel to report potential material violations of federal or state securities laws by the Company or its officers, and to address related matters. The QLCC of the Company did not meet in fiscal year 2008.


Item 11.	*Executive Compensation*

The executive officers of the Company and Directors who are “interested persons” (as defined in the 1940 Act) receive no direct remuneration from the Company. Currently, Non-Interested Directors of the Company receive an annual fee of $150,000 payable in quarterly installments in arrears and allocated among each portfolio in the Highland Fund Complex based on relative net assets. The “Highland Fund Complex” consists of all of the registered investment companies that are advised by the Investment Adviser as of the date of this report and the Company. Prior to January 1, 2008, the Non-Interested Directors of the Company were compensated at the rate of $10,000 annually for serving as a Director of the Company, and also received compensation from the other portfolios in the Highland Fund Complex. Non-Interested Directors are also reimbursed for actual out-of-pocket expenses relating to attendance at meetings. The Directors do not have any pension or retirement plan.

Compensation Committee Interlocks and Insider Participation

All members of the Nominating/Corporate Governance/Compensation Committee are independent directors and none of the members are present or past employees of the Company. No member of the Compensation Committee: (i) has had any relationship with the Company requiring disclosure under Item 404 of Regulation S-K under the Exchange Act; or (ii) is an executive officer of another entity, at which one of our executive officers serves on the Board.


Item 12.	*Security Ownership of Certain Beneficial Owners and Management*

Set forth in the table below is the security ownership in the Company of each Director and executive officer.

Amount and Nature

Percent

Title of Class

Name of Beneficial Owner

of Beneficial Ownership*

Value of Securities

of Class

Common Stock

R. Joseph Dougherty

None

—

Common Stock

Timothy K. Hui

None

—

Common Stock

Scott F. Kavanaugh

None

—

Common Stock

James F. Leary

None

—

Common Stock

Bryan A. Ward

None

—

Common Stock

James D. Dondero ¹

695,549.44 shares

1,495,431

3.93

Common Stock

Mark Okada

None

—

Common Stock

M. Jason Blackburn

None

—

Common Stock

Michael Colvin

None

—


*		Valued as of December 31, 2008. Except as otherwise indicated, each person has sole voting and investment power.

1		Mr. Dondero’s ownership of these shares is based on his indirect ownership of the Adviser. Mr. Dondero disclaims beneficial ownership of shares held by the Adviser, except to the extent of his pecuniary interest therein.

To the knowledge of management of the Company and the Board, the following stockholders or “groups”, as the term is defined in Section 13(d) of the 1934 Act, beneficially owned, or were owners of record of, more than 5% of the Company’s outstanding shares as of February 6, 2009:


		Amount and Nature	Percent
Title of Class	Name of Beneficial Owner	of Beneficial Ownership*	of Class

Common Stock	Highland Capital Management, L.P. ^(a)	996,489.17 shares	5.6%
	NexBank Tower
	13455 Noel Road, Suite 800
	Dallas, TX 75240
Common Stock	Pentagram Partners, L.P. ^(b)	1,012,200 shares	5.7%
	630 Fifth Avenue, 20th Floor
	New York, NY 10111
Common Stock	RiverNorth Capital Management, Inc. ^(c)	1,257,903 shares	7.1%
	325 N. LaSalle, Suite 645
	Chicago, IL 60654-7030


(a)		Based on information contained in a Schedule 13D filed jointly by Highland Capital Management, L.P., Strand Advisors, Inc. and James D. Dondero on April 14, 2008. Reflects sole voting power and sole dispositive power with respect to all shares.

(b)		Based on information contained in a Schedule 13G filed jointly by Pentagram Partners, L.P., RJ II, Inc. and Richard Jacinto, II on January 9, 2009. Reflects sole voting power and sole dispositive power with respect to all shares.

(c)		Based on information contained in a Schedule 13G filed by RiverNorth Capital Management, Inc. on January 23, 2009. Reflects sole voting power and sole dispositive power with respect to all shares.


Item 13.	*Certain Relationships and Related Transactions, and Director Independence*

Transactions with Related Persons

Affiliated Brokers; Regular Broker-Dealers

The Investment Adviser is currently affiliated with NexBank Securities, Inc. (“NexBank”), a FINRA member broker-dealer that is indirectly controlled by the principals of the Investment Adviser. Absent an exemption from the SEC or other regulatory relief, the Company is generally precluded from effecting certain principal transactions with affiliated brokers. The Company may utilize affiliated brokers for agency transactions subject to compliance with policies and procedures adopted pursuant to Rule 17e-1 under the Investment Company Act. These policies and procedures are designed to provide that commissions, fees or other remuneration received by any affiliated broker or its affiliates for agency transactions are reasonable and fair compared to the remuneration received by other brokers in comparable transactions.

During the fiscal year ended December 31, 2008, the Company paid brokerage commissions of $66,487, of which $10,425 was paid to NexBank.

As partners of the Adviser, Messrs. Dondero, Okada and Dougherty, officers of the Company, may be deemed to have an indirect material interest in the investment advisory and management agreement and the administration services agreement of the Company. Under the investment advisory and management agreement, the Investment Adviser, subject to the overall supervision of the Registrant’s Board, manages the day-to-day operations of, and provides investment advisory services to, the Registrant. Under the administration services agreement, the Investment Adviser furnishes the Registrant with office facilities, equipment and clerical, bookkeeping and recordkeeping services at such facilities. See “Business — Our Investment Adviser,” “Business — Our Administrator,” “Business — Investment Advisory and Management Agreement” and Note 3 to the Financial Statements for additional information.

Director Independence

As described more fully under Item 10, Messrs. Hui, Kavanaugh, Leary and Ward are each “Independent” as defined by the New York Stock Exchange.


Item 14.	*Principal Accountant Fees and Services*

Independent Registered Public Accounting Firm Fees and Services

The following chart reflects fees paid to PricewaterhouseCoopers LLP (“PwC”), in the 2008 fiscal year and 2007 fiscal period. One hundred percent (100%) of all services provided by PwC to the Company in each year were pre-approved. The audit services are approved by the Audit Committee pursuant to an audit engagement letter, and, in accordance with the Company’s pre-approval policies and procedures, the Audit Committee of the Company must pre-approve all non-audit services provided by PwC, and all non-audit services provided by PwC to the Investment Adviser, or any entity controlling, controlled by, or under common control with the Adviser that provides ongoing services to the Company that are related to the operations and financial reporting of the Company. In some circumstances, the pre-approval requirement may be waived if the aggregate amount of the fees for such non-audit services constitutes less than five percent of the total amount of revenues paid to PwC by the Company during the fiscal year in which the non-audit services are provided. PwC provided non-audit services during the Company’s last two fiscal years to the Adviser, but these services did not relate directly to the operations and financial reporting of the Company. PwC did not provide any non-audit services to any entity controlling, controlled by or under common control with the Adviser that provides ongoing services to the Company. The aggregate fees billed for these non-audit services to the Adviser was $1,377,420, and $74,000 for the fiscal years ended 2008 and 2007, respectively. The non-audit services provided to the Adviser were not subject to pre-approval pursuant to Rule 2-01(c)(7)(ii) of Regulation S-X, and the audit committee has determined that the provision of such services is compatible with maintaining PwC’s independence.


Fiscal Year Ended	2008			2007 ¹

Audit Fees	$	200,000		$	150,337
Audit-Related Fees	$	60,000	²	$	52,500	²
Tax Fees	$	20,000	³	$	20,100	³
All Other Fees	$	—		$	—
Aggregate Non-Audit Fees	$	—		$	—


1		For the period ended December 31, 2007. The Company commenced investment operations on January 18, 2007.

2		Services to the Company consisted of a review of quarterly regulatory filings.

3		Services to the Company consisted of (i) review or preparation of U.S. federal, state, local and excise tax returns and (ii) U.S. federal, state and local tax planning, advice and assistance regarding statutory, regulatory or administrative developments.

Audit Fees. Audit fees consist of fees billed for professional services rendered for the audit of the Company’s year-end financial statements and reviews of the interim financial statements included in quarterly reports and services that are normally provided by PwC in connection with statutory and regulatory filings. These services also include the required audits of the Company’s internal controls over financial reporting.

Audit-Related Fees. Audit-related fees consist of fees billed for assurance and related services that are reasonably related to the performance of the audit or review of the Company’s consolidated financial statements and are not reported under “Audit Fees.” These services include attestation services that are not required by statute or regulation, consultations concerning financial accounting and reporting standards, and fees related to requests for documentation and information from regulatory and other government agencies.

Tax Fees. Tax fees consist of fees billed for professional services for tax compliance. These services include assistance regarding federal, state, and local tax compliance.

All Other Fees. All other fees would include fees for products and services other than the services reported above.

Report of the Audit Committee

The Audit Committee of the Company oversees the Company’s accounting and financial reporting processes and the audits of the Company’s financial statements. Management is responsible for the preparation, presentation and integrity of the Company’s financial statements, the Company’s accounting and financial and reporting principles and internal controls and procedures designed to assure compliance with accounting standards and applicable laws and regulations. In fulfilling its oversight responsibilities, the Committee reviewed the audited financial statements in the Company’s annual report on Form 10-K dated December 31, 2008 with management, including a discussion of the quality, not just the acceptability, of the accounting principles, the reasonableness of significant judgments, and the clarity of disclosures in the financial statements.

In the performance of its oversight function, the Committee has considered and discussed the above described December 31, 2008 audited financial statements with management and with PwC, the Company’s independent registered public accounting firm. The Committee has also discussed with PwC the matters required to be discussed by the Public Company Accounting Oversight Board (“PCAOB”) Rule AU 380, The Auditor’s Communication With Those Charged With Governance . The Committee reviewed with PwC, who is responsible for expressing an opinion on the conformity of those audited financial statements with generally accepted accounting principles, their judgment as to the quality, not just the acceptability, of the Company’s accounting principles and such other matters as are required to be discussed with the Committee under generally accepted auditing standards. Finally, the Committee reviewed the written disclosures and the letter from PwC required by Independence Standards Board Standard No. 1, Independence Discussions with Audit Committees, as currently in effect, has considered whether the provision of other non-audit services by PwC to the Company is compatible with maintaining PwC’s independence, and has discussed with PwC the independence of the independent registered public accounting firm.

The Committee discussed with PwC the overall scope and plans for the audit. The Committee met with PwC, with and without management present, to discuss the results of its audit, its evaluation of the Company’s internal controls, and the overall quality of the Company’s financial reporting.

Based upon the reports and discussions described in this report, and subject to the limitations on the role and responsibilities of the Committee referred to above and in the Committee Charter, the Committee recommended to the Board of Directors (and the Board has approved) that the audited financial statements be included in the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2008 and as filed with the SEC.

Stockholders are reminded, however, that the members of the Committee are not professionally engaged in the practice of auditing or accounting. Members of the Committee rely without independent verification on the information provided to them and on the representations made by management and PwC. Accordingly, the Committee’s oversight does not provide an independent basis to determine that management has maintained appropriate accounting and financial reporting principles or appropriate internal controls and procedures designed to assure compliance with accounting standards and applicable laws and regulations. Furthermore, the Committee’s considerations and discussions referred to above do not assure that the audit of the Company’s financial statements has been carried out in accordance the standards of the PCAOB, that the financial statements are presented in conformity with accounting principles generally accepted in the United States of America or that the Company’s independent registered public accounting firm is, in fact, “independent.”

Scott F. Kavanaugh, Audit Committee Chair
Timothy K. Hui, Audit Committee Member
James F. Leary, Audit Committee Member
Bryan A. Ward, Audit Committee Member

PART IV


Item 15.	*Exhibits and Financial Statement Schedules*


(a)(1)	Financial Statements.

Refer to Item 8 above.


(a)(2)	Financial Statement Schedules

None.

(a)(3) Exhibits


Exhibit No.			Description

	3	.1	Amended and Restated Articles of Incorporation of the Company.(2)
	3	.2	Bylaws of the Company.(1)
	4	.1	Form of Specimen Certificate.(2)
	10	.1	Form of Investment Advisory and Management Agreement between Company and Highland Capital Management, L.P.(1)
	10	.2	Form of Custodian Services Agreement between Company and PFPC Inc.(1)
	10	.3	Form of Administration Services Agreement between Company and Highland Capital Management, L.P.(2)
	10	.4	Form of Sub-Administration Services Agreement between Highland Capital Management, L.P. and PFPC Inc.(1)
	10	.5	Form of Transfer Agency Services Agreement between Company and PFPC Inc.(1)
	10	.6	Form of Accounting Services Agreement.(1)
	10	.7	Form of Structuring Fee Agreement between the Investment Adviser and Citigroup Global Markets Inc.(2)
	10	.8	Form of Structuring Fee Agreement between the Investment Adviser and Merrill Lynch & Co.(2)
	10	.9	Form of Structuring Fee Agreement between the Investment Adviser and Wachovia Capital Markets, LLC.(2)
	10	.10	Form of Agreement Regarding Payment of Sales Load.(2)
	10	.11	Form of Fee Waiver Agreement.(2)
	10	.12	Confirmation Agreement between the Company and the Bank Nova Scotia.(2)
	10	.13	Amendment No. 1 to the Administration Services Agreement dated as of June 6, 2008.(3)
	10	.14	Revolving Credit and Security Agreement among the Company, Liberty Street Funding LLC and The Bank of Nova Scotia dated as of June 27, 2008.(3)
	10	.15	Amendment No. 1 to the Revolving Credit and Security Agreement dated as of November 25, 2008.(4)
	24	.1	Power of Attorney.(4)
	31	.1	Certification of Chief Executive Officer of Periodic Report Pursuant to Rule 13a — 14(a) and Rule 15d — 14(a)(3).(4)
	31	.2	Certification of Chief Financial Officer of Periodic Report Pursuant to Rule 13a — 14(a) and Rule 15d — 14(a)(3).(4)
	32	.1	Certification of CEO and CFO Pursuant to 18 U.S.C. Section 1350.(4)


(1)		Previously filed in Pre-Effective Amendment No. 1 to the Company’s Initial Registration Statement on Form N-2, File No. 333-137435, filed on January 18, 2007.

(2)		Previously filed in Pre-Effective Amendment No. 3 to the Company’s Initial Registration Statement on Form N-2, File No. 333-137435, filed on February 16, 2007.

(3)		Previously filed in the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2008, File No. 814-00729, filed on August 8, 2008.

(4)		Filed herewith.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunder duly authorized.

HIGHLAND DISTRESSED OPPORTUNITIES, INC.
(Registrant)


Dated: February 27, 2009	Signature:	/s/ James D. Dondero

	Name:	James D. Dondero
	Title:	President (Principal Executive Officer)

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.



		/s/ James D. Dondero James D. Dondero President (Principal Executive Officer)

		/s/ M. Jason Blackburn M. Jason Blackburn Secretary and Treasurer (Principal Financial and Principal Accounting Officer)

		*Timothy K. Hui Timothy K. Hui Director

		*Scott F. Kavanaugh Scott F. Kavanaugh Director

		*James F. Leary James F. Leary Director

		*Bryan A. Ward Bryan A. Ward Director

Dated: February 27, 2009	*By:	/s/ M. Jason Blackburn M. Jason Blackburn Attorney-in-Fact

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- Annual Report (10-K)

27/02/2009 1:37pm

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