##### Table of Contents





UNITED STATES SECURITIES AND
    EXCHANGE COMMISSIONWashington, D.C.
    20549
      Form 10-K
      (Mark One)þ

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended December 31, 2008ORo

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934For 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
  o þ
  o þ
  þ o
  Regulation S-K Form 10-K Form 10-K. þ
  Rule 12b-2
 o þ o o
  Rule 12b-2 o þ




---



##### 





HIGHLAND
    DISTRESSED OPPORTUNITIES, INC.
  TABLE OF
    CONTENTS
   
 PagePART IItem 1


Business


3Item 1A


Risk Factors


15Item 1B


Unresolved Staff Comments


32Item 2


Properties


32Item 3


Legal Proceedings


32Item 4


Submission of Matters to a Vote of Security
    Holders


32PART IIItem 5


Market for Registrants Common Equity and
    Related Stockholder Matters


32Item 6


Selected Financial Data


35Item 7


Managements Discussion and Analysis of
    Financial Condition and Results of Operations


35Item 7A


Quantitative and Qualitative Disclosures about
    Market Risk


43Item 8


Financial Statements and Supplementary Data


45Item 9


Changes in and Disagreements with Accountants on
    Accounting and Financial Disclosure


81Item 9A


Controls and Procedures


81Item 9B


Other Information


82PART IIIItem 10


Directors, Executive Officers and Corporate
    Governance


82Item 11


Executive Compensation


87Item 12


Security Ownership of Certain Beneficial Owners
    and Management


87Item 13


Certain Relationships and Related Transactions


88Item 14


Principal Accountant Fees and Services


89PART IVItem 15


Exhibits, Financial Statement Schedules


91Signatures


92EX-10.15EX-24.1EX-31.1EX-31.2EX-32.1   2




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##### Table of Contents



PART I  Item 1.
    Business  Forward-Looking
    Statements
    
    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.  Form 10-K, Form 10-Q Form 8-K. 1-800-SEC-0330. (http://www.sec.gov) http://www.HighlandHCD.com.
  Overview
   3




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Our
    Investment Adviser
      bottom-up
  Our
    Administrator
   4




---



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Our
    Executive Offices
  (877) 247-1888.
  Operating
    and Regulatory Structure
  Business Development Company.
  Regulated Investment Company.
          and/or
 5




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Investments
       Aerospace

   Financial

   Housing   Broadcasting

   Forest Products/Containers

   Service   Consumer Non-Durables

   Gaming/Leisure

   Transportation   Diversified Media

   Healthcare

   Wireless Communications  6




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Market
    Opportunity
  Growing Supply of Distressed Investment
    Opportunities.
          Inefficient Distressed Markets.
  
    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 7




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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
    Investment Expertise.
  Operating Expertise. Versatile Transaction Structuring.
  Longer investment horizon with attractive publicly-traded
    model.
 8




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Investment
    Policies and Portfolio Composition
      and/or
   9




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Portfolio
    Company Characteristics
    Liquidation Value of Assets.
  Strong Competitive Position in Industry.
  Exit Strategy. and/or
  Experienced Management.
  Value Orientation/Positive Cash Flow.
  The
    Investment Process
      Early-Mover Advantage.
 10




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First-Look Investment
    Opportunities.
  Network of Relationships.
  Due Diligence.
  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.
  Managerial
    Assistance
    Competition
   11




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Investment
    Advisory and Management Agreement
      payment-in-kind
  Catch-up
   12




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Staffing
    Leverage
    Sarbanes-Oxley
    Act of 2002
    
    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; 13




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
    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.    Certifications
  Form 10-K
  Privacy
    Policy
    Collection of Information.
  
    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.
  Confidentiality and Security of
    Information.
  Available
    Information
  http://www.highlandhcd.com. Form 10-K, Form 10-Q, Form 8-K,
 14




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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 operate in a highly competitive market for investment
    opportunities.
    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.
    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.
   15




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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.
    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.
    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 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. 16




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
    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.
      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.
   17




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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.
    The lack of liquidity in our investments may adversely affect
    our business.
    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 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.
   18




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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.
    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.
    
    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.    Economic recessions or downturns could impair our portfolio
    companies and harm our operating results.
   19




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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.
      
    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.     20




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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.
    Investments in obligations of distressed or bankrupt issuers
    present certain challenges inherent in the bankruptcy process or
    in participation on creditor committees.
  debtor-in-possession,
   21




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Investments in debt obligations pose certain risks in
    U.S. courts with respect to insolvency considerations.
   22




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Our portfolio companies may incur additional debt that ranks
    equally with, or senior to, our investments in such
    companies.
    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.
 23




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##### Table of Contents



and/or
      Second Lien Loans.
  Other Secured Loans.
  Unsecured Loans.
 24




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##### Table of Contents



The debt securities in which we invest are subject to
    prepayment risk.
    Inflation may cause the real value of our investments to
    decline.
    The Companys reinvestment of its cash flow subjects it
    to risks posed by fluctuating interest rates.
  interest-on-interest,
  Issuers rights to call all or part of
    certain securities subject the Company to timing risks.
    Common stock investments may be volatile and may fluctuate
    substantially.
  The Company has exposure to common
    stocks.
  Distributions on common stock investments are not guaranteed
    and are declared at the discretion of the issuers board of
    directors.
    Investments in small and mid-cap company securities pose
    risks due to their relatively smaller size, including low
    volatility and trading volumes.
   25




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Investments in preferred stocks present certain challenges,
    including deferred distributions, subordination to other debt
    instruments, lack of liquidity and limited voting rights.
    Deferral.
  Subordination.
  Liquidity.
  Limited Voting Rights.
  Lending of the Companys securities may lead to the risk
    of lost opportunities due to the securities
    unavailability.
  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.
    Risks Associated with Options.
   26




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Risks of Investing in Structured Finance
    Securities.
             27




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Asset-Backed Securities Risk.
  Mortgage-Backed Securities Risk.
      Derivative Risk.
       28




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Counterparty Risk.
  Synthetic Securities Risk.
  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.
    Investments in small, unseasoned companies may be risky.
  start-up
 29




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Our investments in foreign securities may involve significant
    risks in addition to the risks inherent in
    U.S. investments.
      Our investments in emerging markets may involve significant
    risks in addition to the risks inherent in developed markets.
  non-U.S. issuers
  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.
  four-day
  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.
   30




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Risks
    Related to an Investment in Our Common Stock
  We may experience fluctuations in our net asset value.
    We may be subject to U.S. federal income tax if we are
    unable to qualify as a regulated investment company.
    Our recognition of income before or without receiving cash
    representing such income may lead to difficulties in making
    distributions.
        Changes in the laws or regulations governing our portfolio
    companies could have a material adverse affect on our
    business.
   31




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Our certificate of incorporation and bylaws could deter
    takeover attempts and have an adverse impact on the price of our
    shares.,
    Item 1B.
    Unresolved
    Staff Comments    Item 2.
    Properties    Item 3.
    Legal
    Proceedings    Item 4.
    Submission
    of Matters to a Vote of Security Holders   PART II  Item 5.
    Market
    for Registrants Common Equity, Related Stockholder Matters
    and Issuer Purchases of Equity Securities  Price
    Range of Common Stock
    Sales PriceHigh


LowYear Ending December 31, 2008First Quarter

$
9.26


$
5.96Second Quarter

$
8.68


$
5.66Third Quarter

$
6.13


$
2.94Fourth Quarter

$
3.42


$
0.86Year Ending December 31, 2007First Quarter (period from January 18, 2007* to
    March 31, 2007)

$
15.25


$
14.06Second Quarter

$
15.05


$
13.84Third Quarter

$
14.48


$
9.75Fourth Quarter

$
13.20


$
8.38     *
    
    Commencement of operations 32




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Holders
    Distributions
      Date Declared

Record Date


Payment Date


AmountMarch 9, 2007


June 19, 2007



June 29, 2007


$
0.2625August 3, 2007


September 18, 2007



September 28, 2007


$
0.2625November 6, 2007


December 21, 2007



December 31, 2007


$
0.2625Total declared during 2007









$
0.7875March 7, 2008


March 20, 2008



March 31, 2008


$
0.2625June 6, 2008


June 20, 2008



June 30, 2008


$
0.2625September 5, 2008


September 19, 2008



September 30, 2008


$
0.1500December 4, 2008


December 19, 2008



December 31, 2008


$
0.0750Total declared during 2008









$
0.7500            33




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(877) 665-1287.
  Recent
    Sales of Unregistered Securities
    Issuer
    Purchases of Equity Securities
    Stock
    Performance Graph
  (1) (2)
  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:  34




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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 Ending02/26/07

12/31/07

03/31/08

06/30/08

09/30/08

12/31/08Highland Distressed Opportunities, Inc.


100.00



60.62



51.57



43.85



23.59



18.25BDC Peer Group


100.00



77.83



76.20



60.14



62.07



26.77S&P 500


100.00



102.92



93.20



90.66



83.07



64.84   Form 10-K
  Item 6.
    Selected
    Financial Data    Year Ended


Period EndedDecember 31,


December 31,2008


2007(a)Total investment income

$
21,978,674


$
31,329,721Net expenses

$
11,188,738


$
14,240,203Net investment income

$
10,789,936


$
17,089,518Net 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


$
346,923,924Borrowings outstanding

$
15,500,000


$
142,000,000Stockholders 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
   35




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36




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Critical
    Accounting Policies
    Valuation
    of Investments
    Market
    Quotations Available
    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 will then be documented and
    discussed with Highland Capital Management, L.P.s (the
    Investment Adviser) senior management. 37




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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.    Revenue
    Recognition
  and/or Payment-in-kind
  Net
    Realized Gains or Losses and Net Change in Unrealized
    Appreciation or Depreciation
      Portfolio
    and Investment Activity
    CorporateSenior Loans

Notes and Bonds

Claims

Equity InterestsDecember 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
%  38




---



##### Table of Contents



Argatroban
    Royalty Sub, LLC
    Azithromycin
    Royalty Sub, LLC
  ®
  Baker &
    Taylor, Inc.
    Celtic
    Pharma Phinco B.V.
   39




---



##### Table of Contents



Comcorp
    Broadcasting, Inc.
  No. 06-50410). 1-866-381-9100.
  Fontainebleau
    Florida Hotel, LLC
  22-acre
  Genesys
    Ventures IA, LP
    Kepler
    Holdings Limited
    LVI
    Services, Inc.
    Penhall
    Holding Company
   40




---



##### Table of Contents



Results
    of Operations
    Investment
    Income
    Operating
    Expenses
      Net
    Investment Income
    Net
    Unrealized Depreciation on Investments
    Net
    Realized Losses
    Net
    Decrease in Stockholders Equity (Net Assets) from
    Operations
   41




---



##### Table of Contents



Financial
    Condition, Liquidity and Capital Resources
          Contractual
    Obligations
    Payments Due By Year(dollars in millions)2010 andTotal

2009

thereafterRevolving 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. 42




---



##### Table of Contents



Off-Balance
    Sheet Arrangements
    Distributions
        Item 7A.
    Quantitative
    and Qualitative Disclosures about Market Risk     43




---



##### Table of Contents



(3-month
   44




---



##### 



Item 8.
    Financial
    Statements and Supplementary Data  Index
    to Financial Statements
   
 PageReport of Independent Registered Public
    Accounting Firm


46Schedule of Investments  As of
    December 31, 2008 and December 31, 2007


47Statement of Assets and Liabilities 
    As of December 31, 2008 and December 31, 2007


59Statement of Operations  For the year
    ended December 31, 2008 and for the period
    January 18, 2007* through December 31, 2007


60Statement 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


61Statement of Cash Flows  For the year
    ended December 31, 2008 and for the period
    January 18, 2007* through December 31, 2007


62Notes to Financial Statements


63      *
    
    Highland Distressed Opportunities,
    Inc. commenced operations on January 18, 2007. 45




---



##### Table of Contents



Report of
    Independent Registered Public Accounting Firm      Form 10-K.
           46




---



##### Table of Contents



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



843,134Term Loan, 7.75%, 04/03/13 (c)(d)


18,849,521



18,525,278



8,835,71320,351,231



9,678,847CONSUMER NON-DURABLES  1.7%Totes Isotoner Corp.Second Lien Term Loan, 9.88%, 01/31/14


3,377,228



3,400,514



1,013,169DIVERSIFIED MEDIA  0.7%Penton Media, Inc.Second Lien Term Loan, 8.42%, 02/01/14


2,000,000



2,035,654



425,000FINANCIAL  9.4%Emerson Reinsurance Ltd.Tranche C Term Loan, 7.25%, 12/15/11


1,500,000



1,495,043



1,297,500Flatiron Re Ltd.Closing Date Term Loan, 5.71%, 12/29/10


25,529



25,704



24,796Delayed Draw Term Loan, 5.71%, 12/29/10


12,366



12,451



12,011Kepler Holdings Ltd.Term Loan, 7.00%, 06/30/09


5,000,000



5,006,959



4,400,0006,540,157



5,734,307FOREST PRODUCTS/CONTAINERS  0.2%Tegrant Corp.Second Lien Term Loan, 6.96%, 03/08/15


1,000,000



1,000,000



103,340GAMING/LEISURE  12.4%Fontainebleu Florida Hotel, LLCTranche C Term Loan, 8.00%, 06/06/12


6,000,000



6,000,000



5,100,000Lake at Las Vegas Joint Venture/ LLV-1,LLCRevolving Loan Credit-Linked Deposit, 14.35%, 06/20/12 (e)


3,611,111



3,611,111



273,831Term Loan, 14.35%, 06/20/12 PIK (e)


33,756,283



28,269,771



2,143,69737,880,882



7,517,528HEALTHCARE  3.1%Life Technologies Corp.Term B Facility, 09/30/15 (f)


1,995,000



1,955,100



1,881,963HOUSING  2.0%MetroFlag BP, LLC / MetroFlag Cable, LLCSecond Lien Term Loan, 12.00%, 01/06/09


5,000,000



5,000,000



375,000  See accompanying Notes to Financial Statements.
 47




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##### Table of Contents



Schedule
    of Investments
  As
    of December 31, 2008 (continued)
    Highland Distressed Opportunities, Inc.  Principal ($)


Cost ($)


Value ($)Senior Loans (continued)HOUSING (continued)MPH Mezzanine II, LLCMezzanine 2B, 7.48%, 02/09/08 (d)(e)


10,000,000



10,000,000



MPH Mezzanine III, LLCMezzanine 3, 8.48%, 02/09/08 (d)(e)


4,000,000



4,000,000



Pacific Clarion, LLCTerm Loan, 15.00%, 01/23/09 (d)(e)(g)


4,950,573



4,945,680



841,05323,945,680



1,216,053SERVICE  11.1%LVI Services, Inc.Tranche B Term Loan, 6.49%, 11/16/11


9,377,348



9,317,890



4,102,590Penhall Holding Co.Term Loan, 12.29%, 04/01/12 PIK


5,821,220



5,762,042



2,619,54915,079,932



6,722,139TRANSPORTATION  AUTOMOTIVE  0.2%BST Safety Textiles Acquisition GmbHSecond Lien Facility, 14.60%, 06/30/09


673,957



674,415



117,943Total Senior Loans






112,863,565



34,410,289Corporate Notes and Bonds (h)  33.4%DIVERSIFIED MEDIA  5.8%Baker & Taylor, Inc.11.50%, 07/01/13


8,300,000



8,749,446



3,537,875HEALTHCARE  27.6%Argatroban Royalty Sub, LLC18.50%, 09/21/14


3,306,706



3,306,706



2,942,968Azithromycin Royalty Sub, LLC16.00%, 05/15/19


5,000,000



4,974,238



4,350,000Celtic Pharma Phinco B.V.17.00%, 06/15/12 PIK


10,561,138



10,132,572



7,815,242Cinacalcet Royalty Sub, LLC15.50%, 03/30/17 PIK


1,038,750



1,023,972



768,675  See accompanying Notes to Financial Statements.
 48




---



##### Table of Contents



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



822,08120,464,320



16,698,966Total Corporate Notes and Bonds






29,213,766



20,236,841Claims (j)  0.1%AEROSPACE  0.1%Northwest Airlines, Inc.ALPA Trade Claim, 08/21/13


3,000,000



431,377



5,640Bell Atlantic Trade Claim, 08/21/13


2,500,000



434,058



4,700EDC Trade Claims, 08/21/13


2,500,000



447,357



4,700Flight Attendant Claim, 08/21/13


5,326,500



739,501



10,014GE Trade Claim, 08/21/13


1,500,000



275,185



2,820IAM Trade Claim, 08/21/13


4,728,134



728,935



8,889Pinnacle Trade Claim, 08/21/13


8,433,116



1,529,071



15,854Retiree Claim, 08/21/13


3,512,250



487,621



6,603Total Claims






5,073,105



59,220SharesCommon Stock (j)  29.6%AEROSPACE  0.6%Delta Air Lines, Inc.


30,433



215,657



348,762BROADCASTING  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



17,412,000WIRELESS COMMUNICATIONS  0.3%ICO Global Communications


138,632



500,000



153,882Total Common Stocks






19,902,860



17,914,644Total Investments (k)  119.9%






167,053,296



72,620,994Other 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.
 49




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##### Table of Contents



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.
 50




---



##### Table of Contents



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



4,439,103BROADCASTING  10.9%Comcorp Broadcasting, Inc.Revolving Loan, 10.84%, 10/02/12 (b)(c)


1,036,724



1,036,724



1,036,724Term Loan, 10.44%, 04/02/13 (b)


18,849,521



18,453,200



18,849,52119,489,924



19,886,245CABLE  US CABLE  3.6%Bresnan Communications, LLCFirst Lien Additional Term Loan B, 06/30/13 (d)


1,000,000



960,000



958,120CellNet Group, Inc.Second Lien, 10.85%, 10/22/11


1,000,000



1,000,000



959,380WideOpen West Finance, LLCSecond Lien Term Loan, 11.61%, 06/29/15


5,000,000



4,906,201



4,550,0006,866,201



6,467,500DIVERSIFIED MEDIA  0.9%Penton Media, Inc.Second Lien Term Loan, 10.36%, 02/01/14


2,000,000



2,042,662



1,690,000ENERGY  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



4,950,000ENERGY  OTHER ENERGY  4.1%Resolute Aneth, LLCSecond Lien Term Loan, 9.51%, 06/26/13


7,500,000



7,500,000



7,443,750FINANCIAL  8.7%Emerson Reinsurance Ltd.Tranche C Term Loan, 10.95%, 12/15/11


1,500,000



1,493,372



1,492,500Flatiron Re Ltd.Closing Date Term Loan, 9.61%, 12/29/10


610,748



617,040



607,694Delayed Draw Term Loan, 9.61%, 12/29/10


295,831



298,879



294,352Kepler Holdings Ltd.Term Loan, 10.70%, 06/30/09


5,000,000



5,021,070



4,975,000Panther Re Holdings Ltd.Term B Loan, 10.08%, 12/01/10


500,000



505,080



497,500Penhall 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.
 51




---



##### Table of Contents



Schedule
    of Investments
  As
    of December 31, 2007 (continued)
    Highland Distressed Opportunities, Inc.  Principal ($)


Cost ($)


Value ($)Senior Loans (continued)15,744,884



15,825,036FOREST PRODUCTS  PACKAGING  0.5%Tegrant Corp.Second Lien Term Loan, 10.35%, 03/07/15


1,000,000



1,000,000



850,000GAMING/LEISURE  OTHER LEISURE  13.0%Fontainebleau Florida Hotel, LLCTranche C Term Loan, 11.11%, 06/06/12


10,000,000



10,000,000



9,375,000Lake at Las Vegas Joint Venture, LLCPIK Term Loan, 15.31%, 06/20/12 (e)


27,290,363



27,290,363



12,690,019Synthetic Revolver, 10.20%, 06/20/12 (e)


3,611,111



3,611,111



1,679,16740,901,474



23,744,186HEALTHCARE  ACUTE CARE  0.5%LifeCare Holdings, Inc.Term Loan, 8.20%, 08/11/12


989,873



966,641



876,652HEALTHCARE  MEDICAL PRODUCTS  4.1%Graceway Pharmaceuticals, LLCMezzanine Loan, 13.45%, 11/01/13


2,000,000



1,644,408



1,660,000Rotech Healthcare, Inc.PIK Term Loan, 11.36%, 09/26/11


6,413,395



6,362,958



5,707,9218,007,366



7,367,921HOUSING  REAL ESTATE DEVELOPMENT 
    10.2%Metroflag BP, LLC / Metroflag Cable, LLCSecond Lien Term Loan, 13.65%, 07/06/08


5,000,000



5,000,000



4,500,000MPH Mezzanine II, LLC Mezzanine 2B, 7.90%, 02/09/08 (b)


10,000,000



10,000,000



9,987,800MPH Mezzanine III, LLC Mezzanine 3, 9.34%, 02/09/08


4,000,000



4,000,000



3,990,00019,000,000



18,477,800INFORMATION TECHNOLOGY  0.3%Metrologic Instruments, Inc.Second Lien Term Loan, 11.45%, 12/21/13


500,000



507,866



481,875MANUFACTURING  0.9%Latham Manufacturing Corp.New Term Loan, 8.52%, 06/30/12


1,931,388



1,929,339



1,709,279RETAIL  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.
 52




---



##### Table of Contents



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



9,695,493SERVICE  OTHER SERVICES  1.0%NES Rentals Holdings, Inc.Permanent Term Loan, 12.13%, 07/20/13


2,000,000



2,033,978



1,880,000TRANSPORTATION  AUTO  4.4%BST Safety Textiles Acquisition GmbHSecond Lien Facility, 12.49%, 06/30/09


665,500



666,884



598,950Motor Coach Industries International, Inc.PIK Second Lien, 13.64%, 12/01/08


7,662,162



7,802,529



7,432,2988,469,413



8,031,248UTILITIES  4.3%Entegra Power Group, LLCPIK Third Lien Term Loan, 10.83%, 10/19/15


8,264,857



8,190,233



7,753,510WIRELESS COMMUNICATIONS  2.6%Clearwire Corp.Term Loan, 11.15%, 07/03/12


4,987,500



4,987,500



4,812,938Total Senior Loans






172,517,898



150,967,130Corporate Notes and Bonds 59.6%BROADCASTING  0.9%Young Broadcasting, Inc.10.00%, 03/01/11


2,000,000



1,991,871



1,572,500CONSUMER NON-DURABLES  4.0%Ames True Temper, Inc.10.00%, 07/15/12


2,000,000



1,951,876



1,110,000Solo Cup Co.8.50%, 02/15/14


7,000,000



6,118,435



6,055,0008,070,311



7,165,000DIVERSIFIED MEDIA  4.6%Baker & Taylor, Inc.11.50%, 07/01/13 (f)


8,300,000



8,758,751



8,258,500ENERGY  EXPLORATION &
    PRODUCTION  7.3%Energy XXI Gulf Coast10.00%, 06/15/13


6,200,000



6,064,317



5,719,500Helix 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.
 53




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##### Table of Contents



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



5,043,75013,564,317



13,319,500FOOD/TOBACCO  FOOD/TOBACCO PRODUCERS 
    3.1%Pinnacle Foods Group, Inc.10.63%, 04/01/17 (f)


6,500,000



6,561,250



5,622,500GAMING/LEISURE  OTHER LEISURE  5.2%Six Flags, Inc.4.50%, 05/15/15


2,267,000



2,551,335



1,646,409Tropicana Entertainment Resorts Holdings, L.P.9.63%, 12/15/14


12,199,000



10,255,479



7,807,36012,806,814



9,453,769HEALTHCARE  ACUTE CARE  4.0%Argatroban Royalty Sub, LLC18.50%, 09/21/14


4,389,424



4,389,424



4,411,371HCA, Inc.7.69%, 06/15/25


1,800,000



1,463,385



1,499,222Tenet Healthcare Corp.9.88%, 07/01/14


1,500,000



1,514,227



1,436,2507,367,036



7,346,843HEALTHCARE  MEDICAL PRODUCTS  3.4%Angiotech Pharmaceuticals, Inc.7.75%, 04/01/14


5,000,000



4,560,846



4,212,500Encysive Pharmaceuticals, Inc.2.50%, 03/15/12


4,000,000



2,674,520



1,995,0007,235,366



6,207,500HOUSING  BUILDING MATERIALS  0.4%Masonite Corp.11.00%, 04/06/15


1,000,000



1,000,000



785,000HOUSING  REAL ESTATE DEVELOPMENT 
    9.5%Realogy Corp.10.50%, 04/15/14 (f)


5,000,000



4,959,445



3,750,00012.38%, 04/15/15 (f)


21,500,000



16,871,858



13,598,75021,831,303



17,348,750  See accompanying Notes to Financial Statements.
 54




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##### Table of Contents



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



2,565,00010.13%, 12/15/16


7,000,000



7,000,000



5,810,0009,998,184



8,375,000RETAIL  3.0%Dollar General Corp.10.63%, 07/15/15 (f)


3,000,000



2,776,003



2,767,500Rite Aid Corp.9.38%, 12/15/15


1,250,000



1,232,689



1,043,7509.50%, 06/15/17


2,000,000



1,969,195



1,665,0005,977,887



5,476,250TELECOMMUNICATIONS  2.8%Intelsat Bermuda, Ltd.10.83%, 06/15/13 (g)


5,000,000



5,242,581



5,150,000TRANSPORTATION  AUTO  6.8%Delphi Corp.6.55%, 06/15/06 (e)


1,500,000



1,151,250



900,0006.50%, 05/01/09 (e)


2,500,000



1,850,000



1,512,5006.50%, 08/15/13 (e)


2,667,000



1,861,483



1,560,1957.13%, 05/01/29 (e)


3,500,000



2,565,250



2,152,500Motor Coach Industries International, Inc.11.25%, 05/01/09


12,000,000



10,508,610



6,300,00017,936,593



12,425,195Total Corporate Notes and Bonds






128,342,264



108,506,307Claims 0.9%AEROSPACE  AIRLINES  0.6%Northwest Airlines, Inc.ALPA Trade Claim, 08/21/13


3,000,000



659,420



108,750Bell Atlantic Trade Claim, 08/21/13


2,500,000



733,713



90,625EDC Trade Claims, 08/21/13


2,500,000



713,944



90,625Flight Attendant Claim, 08/21/13


5,326,500



1,144,392



193,086GE Trade Claim, 08/21/13


1,500,000



436,427



54,375IAM Trade Claim, 08/21/13


4,728,134



1,088,341



171,395Lambert Leasing Trade Claim, 08/21/13 (d)


3,433,116



896,468



124,450  See accompanying Notes to Financial Statements.
 55




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##### Table of Contents



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



181,250Retiree Claim, 08/21/13


3,512,250



754,603



127,3197,817,995



1,141,875CABLE  US CABLE  0.3%Adelphia Communications, 06/15/11


4,056,000



1,688,310



441,090Total Claims






9,506,305



1,582,965SharesCommon Stocks 28.0%AEROSPACE  AIRLINES  6.3%Northwest Airlines, Inc. (h)


787,799



15,346,369



11,430,959CABLE  US CABLE  0.8%Time Warner Cable, Inc. (h)


50,336



505,513



1,389,264DIVERSIFIED MEDIA  0.7%Gannett Co., Inc.


35,000



1,927,994



1,365,000  See accompanying Notes to Financial Statements.
 56




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##### Table of Contents



Schedule
    of Investments
  As
    of December 31, 2007 (continued)
    Highland Distressed Opportunities, Inc.  SharesCommon Stocks (continued)FINANCIAL  0.2%Guaranty Financial Group, Inc. (h)


17,500



498,906



280,000Jer Investors Trust, Inc., REIT


7,731



96,260



83,263595,166



363,263FOREST PRODUCTS  PAPER  0.6%Temple-Inland, Inc.


52,500



1,839,716



1,094,625GAMING/LEISURE  OTHER LEISURE  0.7%Starwood Hotels & Resorts Worldwide, Inc.


26,923



1,878,199



1,185,420HEALTHCARE  MEDICAL PRODUCTS  3.3%PDL BioPharma, Inc. (h)


221,600



5,651,605



3,882,432TLC Vision Corp. (h)


636,900



2,855,567



2,120,8778,507,172



6,003,309HOUSING  BUILDING MATERIALS  0.1%Owens Corning, Inc. (h)


13,125



308,341



265,388HOUSING  REAL ESTATE DEVELOPMENT 
    0.2%Forestar Real Estate Group, Inc. (h)


17,500



779,541



412,825METALS/MINERALS  OTHER METALS/MINERALS 
    6.5%Alcoa, Inc


208,439



8,240,259



7,618,446RTI International Metals, Inc. (h)


62,112



5,129,522



4,281,38013,369,781



11,899,826TELECOMMUNICATIONS  4.4%Communications Corp. of America (b)(h)


1,256,635



7,187,203



8,014,818TRANSPORTATION  AUTO  1.7%The Goodyear Tire & Rubber Co. (h)


107,852



3,071,002



3,043,583UTILITIES  2.5%Entegra TC, LLC (h)


136,750



6,343,550



4,461,469Total Common Stocks






61,659,547



50,929,749Total Investments (i)  171.4%






372,026,014



311,986,151Other 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.
 57




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##### Table of Contents



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.
 58




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##### Table of Contents



Statement
    of Assets and Liabilities
  Highland Distressed Opportunities, Inc.  As of


As ofDecember 31, 2008


December 31, 2007($)


($)Assets:Investments in:Unaffiliated issuers, at value (cost $127,514,862 and
    $345,348,887, respectively)


45,530,147



284,085,088Affiliated issuers, at value (cost $39,538,434 and $26,667,127,
    respectively)


27,090,847



27,901,063Total investments, at value (cost $167,053,296 and $372,026,014,
    respectively)


72,620,994



311,986,151Cash and cash equivalents






4,291,098Foreign currency (cost $10 and $0, respectively)


10



Receivable for:Investments sold


12,106,871



24,628,173Dividend and interest


2,337,202



5,951,790Other assets


96,923



66,712Total assets


87,162,000



346,923,924Liabilities:Due to Custodian


122,505



Notes payable (Note 4)


15,500,000



142,000,000Net discount and unrealized depreciation on unfunded transactions


31,756



16,228Payables for:Investments purchased


9,809,787



19,387,884Investment advisory fee (Note 3)


627,965



1,812,285Administration fee (Note 3)


109,894



317,150Incentive fee (Note 3)






383,951Interest expense (Note 4)


112,469



759,465Directors fees (Note 3)


5,100



592Accrued expenses and other liabilities


286,096



231,317Total liabilities


26,605,572



164,908,872Stockholders equity (net assets)


60,556,428



182,015,052Composition 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



17,717Paid-in capital


253,018,580



253,163,644Undistributed net investment income


1,067,487



3,420,147Accumulated 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



182,015,052Net Asset Value Per Share (Net Assets/Common Stock
    Outstanding)


3.42



10.27   See accompanying Notes to Financial Statements.
 59




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##### Table of Contents



Statement
    of Operations
  Highland Distressed Opportunities, Inc.  For The Year Ended


For The Period EndedDecember 31, 2008


December 31,
    2007(a)($)


($)Investment Income:Unaffiliated interest income


20,092,839



30,519,314Affiliated interest income (Note 7)


1,845,150



17,645Unaffiliated dividends (net of foreign taxes withheld)


40,685



792,762Total investment income


21,978,674



31,329,721Expenses:Investment advisory fees (Note 3)


4,194,605



6,306,869Incentive fees (Note 3)


1,680,346



2,475,541Administration fees (Note 3)


734,056



1,103,702Accounting service fees


154,590



123,913Transfer agent fees


29,890



24,500Legal fees


1,128,698



396,096Audit and Tax fees


152,500



127,500Directors fees


19,881



35,441Custody fees


28,827



50,956Registration fees


24,097



20,247Reports to stockholders


131,041



29,725Franchise tax expense


80,393



119,367Organization expense (Note 3)






170,383Rating agency fees


66,184



57,003Interest expense (Note 4)


3,173,667



7,407,511Merger expenses


21,227



Other expense


378,713



151,384Total operating expenses


11,998,715



18,600,138Fees and expenses waived or reimbursed by Investment Adviser
    (Note 3)


(809,977
)


(4,359,935
)Net expenses


11,188,738



14,240,203Net investment income


10,789,936



17,089,518Net 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






172,955Net realized gain/(loss) on foreign currency transactions


(82
)


33,337Net 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
)


1,096Net 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.
 60




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##### Table of Contents



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)
   TotalPaid-in


Undistributed


Undistributed


Net Unrealized


StockholdersCommon Stock


Capital in


Net Investment


Net Realized


Appreciation/


EquityShares


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















5,000,000Issuance of common stock


17,284,300



17,285



247,965,312















247,982,597Distributions reinvested


99,138



99



1,328,558















1,328,657Capital contribution, 02/20/07 (b)










87,596















87,596Distributions 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
)

$
182,015,052Distributions 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.
 61




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##### Table of Contents



Statement
    of Cash Flows
  Highland Distressed Opportunities, Inc.   For The Year Ended


For The Period EndedDecember 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



14,301,265Net change in unrealized (appreciation)/depreciation on
    investments, unfunded transactions and translation of assets and
    liabilities denominated in foreign currency


34,425,068



60,038,767Purchase 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



870,095,540Net amortization/(accretion) of premium/(discount)


(1,040,493
)


(1,260,290
)Net realized gain/(loss) on total return swaps






172,955Net 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
)


19,387,884Increase/(Decrease) in payables to related parties


(1,771,019
)


2,513,978Increase/(Decrease) in interest payable


(646,996
)


759,465Increase/(Decrease) in other liabilities


38,551



247,545Net 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






251,852,704Increase/(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
)


381,265,566Net Increase (Decrease) in Cash, Cash Equivalents and Foreign
    Currency


(4,291,088
)


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


4,291,098



End of the period


10



4,291,098Supplemental 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.
 62




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##### Table of Contents



Notes
    to Financial Statements
  Highland Distressed
    Opportunities, Inc.
  Note 1.
    Organization          Note 2.
    Significant
    Accounting Policies    Form 10-K Regulation S-X,
    (a)
    Investments
    in financial instruments      Market
    Quotations Available
   63




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##### Table of Contents



Notes
    to Financial Statements  (Continued)
  Highland Distressed
    Opportunities, Inc.
    Market
    Quotations Not Available
             64




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##### Table of Contents



Notes
    to Financial Statements  (Continued)
  Highland Distressed
    Opportunities, Inc.
  Adoption
    of Statement of Financial Accounting Standards No. 157
    Fair Value Measurement
    (FAS 157):
        
    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. 65




---



##### Table of Contents



Notes
    to Financial Statements  (Continued)
  Highland Distressed
    Opportunities, Inc.
             and/or and/or
     66




---



##### Table of Contents



Notes
    to Financial Statements  (Continued)
  Highland Distressed
    Opportunities, Inc.
        Enterprise
    Value (Multiples) Analysis
          Discounted
    Cash Flow Model
     67




---



##### Table of Contents



Notes
    to Financial Statements  (Continued)
  Highland Distressed
    Opportunities, Inc.
  Yield/Spread
    Model
          Assets at Fair Value

Total


Level 1


Level 2


Level 3Portfolio Investments

$
72,620,994


$
502,644


$
1,881,963


$
70,236,387Cash and foreign currency


10



10







Total

$
72,621,004


$
502,654


$
1,881,963


$
70,236,387       For the Year EndedDecember 31,2008Assets at Fair Value Using Unobservable Inputs (Level 3)

Portfolio InvestmentsBalance as of December 31, 2007

$
37,888,863Net transfers in/(out) of Level 3


78,579,945Net 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*


25,637,779Balance 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. 68




---



##### Table of Contents



Notes
    to Financial Statements  (Continued)
  Highland Distressed
    Opportunities, Inc.
       New
    Accounting Pronouncements
  No. 157-3  Determining the Fair Value of a Financial Asset When the
    Market for That Asset is Not Active (FSP 157-3) FSP 157-3 FSP 157-3 states FSP 157-3 FSP 157-3 FSP 157-3 FSP 157-3 FSP 157-3. FSP 157-3
  (b)
    Net asset
    value per share    (c)
    Securities
    transactions    (d)
    Interest
    income  and/or Payment-in-kind
 69




---



##### Table of Contents



Notes
    to Financial Statements  (Continued)
  Highland Distressed
    Opportunities, Inc.
  (e)
    Taxation 
    general      (f)
    Taxation
    of distributions    (g)
    Payment
    of distributions    (h)
    Foreign
    currency  and/or
  (i)
    Forward
    contracts    (j)
    Investment
    in swap agreements   70




---



##### Table of Contents



Notes
    to Financial Statements  (Continued)
  Highland Distressed
    Opportunities, Inc.
    (k)
    Cash and
    cash equivalents    (l)
    Registration
    expenses    (m)
    Incentive
    fee expense recognition    Note 3.
    Agreements         71




---



##### Table of Contents



Notes
    to Financial Statements  (Continued)
  Highland Distressed
    Opportunities, Inc.
    Catch-up
  Catch-Up
                 72




---



##### Table of Contents



Notes
    to Financial Statements  (Continued)
  Highland Distressed
    Opportunities, Inc.
        Note 4.
    Credit
    Facility  364-day
     73




---



##### Table of Contents



Notes
    to Financial Statements  (Continued)
  Highland Distressed
    Opportunities, Inc.
        Note 5.
    Net Asset
    Value Per Share    Note 6.
    Unfunded
    Loan Commitments    Unfunded Loan CommitmentDecember 31,

December 31,Borrower

2008

2007Comcorp Broadcasting, Inc.

$
58,999


$
848,228    74




---



##### Table of Contents



Notes
    to Financial Statements  (Continued)
  Highland Distressed
    Opportunities, Inc.
   Note 7.
    Transactions
    in Securities of Affiliated Issuers    December 31,
    2008
  Borrower

Shares


Principal


Market ValueComcorp Broadcasting, Inc.*Revolving Loan





$
1,825,953


$
843,134Term Loan






18,849,521



8,835,713Communications Corp. of America


1,256,635







Genesys Ltd.


12,000,000







17,412,000Total









$
27,090,847   December 31,
    2007
  Borrower

Shares


Principal


Market ValueComcorp Broadcasting, Inc.*Revolving Loan





$
1,036,724


$
1,036,724Term Loan






18,849,521



18,849,521Communications Corp. of America


1,256,635







8,014,818Total









$
27,901,063     *
    
    Company is a wholly owned
    subsidiary of Communications Corp. of America.  Note 8.
    Portfolio
    Information      Note 9.
    Affiliated
    Transactions    Note 10.
    Certain
    Transactions   75




---



##### Table of Contents



Notes
    to Financial Statements  (Continued)
  Highland Distressed
    Opportunities, Inc.
   76




---



##### Table of Contents



Notes
    to Financial Statements  (Continued)
  Highland Distressed
    Opportunities, Inc.
  Note 11.  Financial
    Highlights
    Year Ended


Period EndedDecember 31,


December 31,2008


2007(a)Net asset value, beginning of year

$
10.27


$
14.33
(b)Net investment income


0.61



0.97Net 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


$
10.27Market price per share, beginning of year

$
8.57


$
15.00Market price per share, end of year

$
2.15


$
8.57Total 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


$
182,015Ratios 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


$
142,000Asset 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. 77




---



##### Table of Contents



Notes
    to Financial Statements  (Continued)
  Highland Distressed
    Opportunities, Inc.
   Note 12.  Income
    Tax Information and Distributions to Stockholders
    Date Declared

Record Date

Payment Date

AmountMarch 9, 2007

June 19, 2007

June 29, 2007

$
0.2625August 3, 2007

September 18, 2007

September 28, 2007

$
0.2625November 6, 2007

December 21, 2007

December 31, 2007

$
0.2625Total declared during 2007*





$
0.7875March 7, 2008

March 20, 2008

March 31, 2008

$
0.2625June 6, 2008

June 20, 2008

June 30, 2008

$
0.2625September 5, 2008

September 19, 2008

September 30, 2008

$
0.1500December 4, 2008

December 19, 2008

December 31, 2008

$
0.0750Total declared during 2008





$
0.7500     *
    
    Highland Distressed Opportunities,
    Inc. commenced operations on January 18, 2007.      2008

2007Undistributed Net Investment Income

$
144,982


$
246,424Accumulated Net Realized Loss

$
82


$
(246,424
)Paid-In Capital

$
(145,064
)

$
     Distributions paid from:

2008

2007Ordinary income*

$
13,287,578


$
13,915,795Long-term capital gains

$



$
     *
    
    For tax purposes short-term capital
    gains distributions, if any, are considered ordinary income
    distributions    2008


2007Capital loss carryforward

$
(79,324,572
)*

$
(9,946,969
)**Undistributed ordinary income

$
1,165,348


$
3,525,488Post-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. 78




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##### Table of Contents



Notes
    to Financial Statements  (Continued)
  Highland Distressed
    Opportunities, Inc.
       2008


2007Unrealized appreciation

$
5,545,106


$
2,429,611Unrealized depreciation


(111,293,406
)


(62,469,474
)Net unrealized depreciation

$
(105,748,300
)

$
(60,039,863
)     Note 13.  SEC
    Filings and Certifications
  Form 10-K, Form 10-Q Form 8-K,
  Form 10-K
  Note 14.  Impact
    of New Accounting Standards
   79




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##### Table of Contents



Notes
    to Financial Statements  (Continued)
  Highland Distressed
    Opportunities, Inc.
  Note 15.  Selected
    Quarterly Financial Data (Unaudited) (in thousands, except per
    share amounts)
  2007Q1 *

Q2

Q3

Q4

TotalTotal investment income

$
1,653


$
9,577


$
9,521


$
10,578


$
31,330Total investment income per share

$
0.09


$
0.54


$
0.54


$
0.60


$
1.77Net investment income

$
1,290


$
6,173


$
4,266


$
5,361


$
17,090Net investment income per share

$
0.07


$
0.35


$
0.24


$
0.30


$
0.97Net 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.  2008Q1

Q2

Q3

Q4

TotalTotal investment income

$
7,893


$
6,479


$
4,086


$
3,520


$
21,979Total investment income per share

$
0.45


$
0.37


$
0.23


$
0.20


$
1.24Net investment income

$
3,481


$
4,050


$
1,972


$
1,286


$
10,790Net investment income per share

$
0.20


$
0.23


$
0.11


$
0.07


$
0.61Net 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
         80




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##### Table of Contents



Item 9.  Changes
    in and Disagreements with Accountants on Accounting and
    Financial Disclosure   Item 9A.  Controls
    and Procedures  Form 10-K Rule 13a-14
  (a)
    Evaluation
    of Disclosure Controls and Procedures  Form 10-K,
  Form 10-K. Form 10-Q Form 10-K.
    (b)
    Managements
    Report on Internal Control Over Financial Reporting  Rule 13a-15(f),
 81




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##### Table of Contents



(c)
    Attestation
    Report of the Independent Registered Public Accounting
    Firm    (d)
    Changes
    in Internal Controls Over Financial Reporting   Item 9B.  Other
    Information   PART III  Item 10.
    Directors,
    Executive Officers and Corporate Governance    Board
    of Directors
  Number ofPosition(s) Held



Portfolios inWith the Company,

Principal

Highland FundLength of Time

Occupation(s)

Complex

OtherServed and Term

During Past

Overseen

DirectorshipsName (Age) Address
    1

of Office

Five Years

by Director
    2

HeldDirector  Class I
    (Non-Interested
    Directors3)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). 82




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##### Table of Contents



Number ofPosition(s) Held



Portfolios inWith the Company,

Principal

Highland FundLength of Time

Occupation(s)

Complex

OtherServed and Term

During Past

Overseen

DirectorshipsName (Age) Address
    1

of Office

Five Years

by Director
    2

HeldBryan 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
    Directors3)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. 83




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##### Table of Contents



Number ofPosition(s) Held



Portfolios inWith the Company,

Principal

Highland FundLength of Time

Occupation(s)

Complex

OtherServed and Term

During Past

Overseen

DirectorshipsName (Age) Address
    1

of Office

Five Years

by Director
    2

HeldDirector  Class III
    (Interested
    Directors4)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 andPosition(s) Held

Length ofName (Age)
    1

With the Company

Time Served

Principal Occupation(s) During Past Five YearsJames 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). 84




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##### Table of Contents



Term of Office andPosition(s) Held

Length ofName (Age)
    1

With the Company

Time Served

Principal Occupation(s) During Past Five YearsM. 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
    Codes of
    Ethics
  Rule 17j-1 (http://www.sec.gov), e-mail 20549-0102.
  877-247-1888.
   85




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##### Table of Contents



Audit
    Committee
    Nominating/Corporate
    Governance/Compensation Committee
        Litigation
    Committee
   86




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##### Table of Contents



Qualified
    Legal Compliance Committee
    Item 11.
    Executive
    Compensation    Compensation
    Committee Interlocks and Insider Participation
  Regulation S-K
  Item 12.
    Security
    Ownership of Certain Beneficial Owners and
    Management    Amount and Nature





PercentTitle of Class

Name of Beneficial Owner

of Beneficial Ownership*


Value of Securities


of ClassCommon 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.
    Dondero1


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. 87




---



##### Table of Contents



Amount and Nature

PercentTitle of Class

Name of Beneficial Owner

of Beneficial Ownership*

of ClassCommon Stock

Highland Capital Management,
    L.P.(a)

996,489.17 shares

5.6%NexBank Tower13455 Noel Road, Suite 800Dallas, TX 75240Common Stock

Pentagram Partners,
    L.P.(b)

1,012,200 shares

5.7%630 Fifth Avenue, 20th FloorNew York, NY 10111Common Stock

RiverNorth Capital Management,
    Inc.(c)

1,257,903 shares

7.1%325 N. LaSalle, Suite 645Chicago, 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
  Rule 17e-1
      Director
    Independence
   88




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##### Table of Contents



Item 14.
    Principal
    Accountant Fees and Services  Independent
    Registered Public Accounting Firm Fees and
    Services
  Rule 2-01(c)(7)(ii) Regulation S-X,
  Fiscal Year Ended

2008


20071Audit Fees

$
200,000


$
150,337Audit-Related Fees

$
60,000
2

$
52,500
2Tax Fees

$
20,000
3

$
20,100
3All 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-Related Fees.
  Tax Fees.
  All Other Fees.
 89




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##### Table of Contents



Report of
    the Audit Committee
  Form 10-K
  The
    Auditors Communication With Those Charged With
    Governance Independence Discussions with Audit Committees,
    Form 10-K
    
 90




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##### Table of Contents



PART IV  Item 15.
    Exhibits
    and Financial Statement Schedules  (a)(1)
    Financial Statements.    (a)(2)
    Financial Statement Schedules      Exhibit No.

Description3
.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. 91




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##### Table of Contents



SIGNATURES    HIGHLAND
    DISTRESSED OPPORTUNITIES, INC. (Registrant)
  Dated: February 27, 2009

Signature:

/s/ James D. DonderoName:

James D. DonderoTitle:

President (Principal Executive Officer)     /s/ James D. DonderoJames
    D. Dondero
    President (Principal Executive Officer)/s/ M. Jason BlackburnM.
    Jason Blackburn
    Secretary and Treasurer (Principal Financial and Principal
    Accounting Officer)*Timothy K. HuiTimothy
    K. Hui
    Director*Scott F. KavanaughScott
    F. Kavanaugh
    Director*James F. LearyJames
    F. Leary
    Director*Bryan A. WardBryan
    A. Ward
    DirectorDated: February 27, 2009

*By:

/s/ M. Jason BlackburnM.
    Jason Blackburn
    Attorney-in-Fact  92