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How Pax came to alter its investment rules: after an SEC probe, the socially responsible mutual fund has designed more flexible standards.

How could Pax World Funds, a family of socially responsible mutual funds whose very name means peace, end up investing tens of millions in contractors that do billions of dollars of business with the U.S. Defense Department?

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At the end of July, the Securities and Exchange Commission fined the Portsmouth-based Pax, the largest and oldest socially responsible fund, $500,000 for being lax in adhering to its own screening polities. Among the investments in question was one involving a defense contractor--Jacobs Engineering--that was involved in nuclear, biological and chemical weapons. All of the investments occurred between 2001 and 2005.

It was the SEC's first case against a socially responsible fund. The result has been shock among believers in moral investing, and sneers from skeptics who have pooh-poohed the idea that investors can remain pure while making a buck.

Pax CEO Joe Keefe (who was not with Pax at the time of the alleged violations) stressed that only 10, out of more than 600 investments, were involved, that most of the screening errors were relatively innocuous violations of procedures that have since been corrected, and were made by people no longer with the company. Keefe also said that the previously rigid standards have since been made more flexible and realistic.

Under those new standards, the Pax family of funds had investments of more than $110 million in companies that had $4.8 billion of contracts with the Defense Department, according to an NHBR analysis of Pax's latest SEC filing of its investments (May 2008) and Fedspending.org's listing of 2007 defense contracts.

Keefe defended these investments, noting that many of the companies involved--like PepsiCo and Johnson & Johnson--supply such things as food and medicine to the military. Besides, he argued, such companies are so large that a mere $200 million in military contracts between them doesn't nearly surpass Pax's old standard of less than 5 percent of revenue coming from the Department of Defense.

The new standard pertains to companies "significantly involved in the manufacture of weapons or weapons-related products...."

"Significantly involved" means 20 percent or more of a company's revenues, although the threshold can be lower depending on the nature of the product, according to Keefe.

Keefe noted the numerous potential investments in companies that Pax has rejected (without identifying them), ranging from firms that do combat-related training to those that manufactures military helicopters.

Yet does the $755 million worth of equipment and services provided by Dell Computer to the military and $402 million of military contracts with IBM have nothing to do with weapons and combat?

And how about Pax's $11 million investment in AECOM Technologies, with its $375 million worth of defense contracts to provide--according AECOM's SEC filings--"comprehensive services for the operation and maintenance of complex government installations, including military bases" (as well as the Department of Energy's nuclear test site in Nevada) and training at the H.S. Army's Center for Security Training?

"Anyone in the mutual fund business who constructs investment portfolios has to make judgment calls, which is why stocks are generally selected by analysts and portfolio managers rather than by computers," said Keefe.

Military contractors

The socially responsible investment community has been struggling with such questions ever since Pax started its balance fund back in the 1971. With more than $2.8 billion under management, Pax is one of the biggest financial institutions based in the state. It was only a matter of time before its size attracted the scrutiny of federal regulators.

In 2005, the SEC launched an investigation into Pax probing, among other things, market timing issues. Pax reported that at the time, but it didn't mention that the SEC was also looking into whether it was adhering to its own screening policies. That is, until the SEC announced the $500,000 settlement.

"People often choose socially responsible funds because they feel strongly about how they are investing their money. Therefore it's absolutely essential that the mutual fund company keeps its promises about its investments," David P. Bergers, regional director of the SEC's Boston office told NHBR.

From 2001 to 2005, two of the smaller Pax funds--the Pax World Growth and High Yield Funds--failed to consistently following screening practices, sometimes investing in funds that flunked the criteria, the SEC charged.

The two funds invested in 10 securities not only involving military spending, but also relating to gambling, alcohol, and environmental or labor standards. (See sidebar.)

The SEC did not disclose the name of the companies in which the investments were made, but Pax did.

In the middle of 2002, while the nation was preparing for the war in Iraq--Pax World Growth Fund had more than $1 million (its seventh-largest investment at the time) in Jacobs Engineering, a Tennessee company that does about half a billion dollars of business a year with the military.

Other companies flunked the 5 percent military test as well. Humana, in which Pax had $685,500 invested at the end of 2003, billed itself as "the most trusted name in military health," providing health services to 3.8 million active-duty and retired military and their families in the South. The company was the 16th-largest military contractor in 2002.

Sierra Health Services also provides health services to the military. Michael Foods, which mainly supplies eggs and poultry, boasted that it was doing its part in "feeding the troops in the Middle East," according to one conference call.

Being cited by the SEC for investments like these was the reason Pax changed its criteria, said Keefe.

"Compliance-related concerns were among the reasons we recommended to shareholders that the social screens be modified in 2006, but they were not the predominant factor," said Keefe. He later added, "Today, we only have a weapons screen and a company would not automatically fail, as Michael Foods, Humana and Sierra Health Services apparently did, for providing food or health care to members of the military."

But two other investments flunked the Pax military contract test.

Pax World Growth had invested $348,000 in Analog Devices at the end of 2002. Analog, which produces integrated circuits for the military as well as commercial use, was cited in 1998 in Military and Aerospace Electronics magazine for its digital signal processor, which "continue to dominate military and aerospace applications."

And then there was Jacobs Engineering. In 2001, in the company's annual filing with the SEC, under a section entitled "Defense and aerospace industry," the company said: "We have been a provider of technical services to the DOD for more than 50 years ... our support includes services such as aerodynamic testing of next-generation fighter aircraft; propulsion testing for space programs; launch support services for Titan, Atlas, and Delta rockets and payloads; and acquisition support to weapons systems such as air-to-air missile systems and precision guided, smart weapons used for various high-value targets. We also support the acquisition and development of Special Operation Forces ("SOF") systems and equipment, as well as nuclear, biological, chemical ("NBC") detection and protection systems."

When Keefe was asked how Pax could have invested in such a company, he attributed it to a simple error.

"The portfolio manager bought Jacobs Engineering thinking it had been screened and passed when in fact it hadn't," he said.

Praise for Keefe

Keefe emphasized that Pax's largest, oldest and most popular fund, the $1.9 billion Balanced Fund--representing approximately 92 percent to 97 percent of the fund's assets in 2005--was not charged with any violations. In 2005, the Growth Fund had only $100 million and the High Yield Fund approximately $70 million, which when combined was less than 10 percent the size of the Balanced Fund.

Keefe also pointed out that all the alleged violations took place before he joined the firm, and those responsible for the questionable investments are no longer with Pax. In addition, he said, the company has upgraded its screening practices.

"We regret and take full responsibility for what occurred during the 2001-2005 time period. We are also proud of the progress we have made and we are committed to meeting the highest standards going forward," Keefe said.

The SEC order said it took into account the fund's remedial efforts when determining a penalty against Pax.

"I would not characterize this as a systematic breakdown," said Mark Connolly, the director of the state Bureau of Securities Regulation, "but a problem with two of the smaller funds that lacked efficient controls."

Connolly said that Pax fully cooperated with the investigation, and praised Keefe specifically for "having done an exemplary job of handling the matter."

Bob Sanders can be reached at bsanders@nhbr.com.
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Title Annotation:SECURITIES; Securities and Exchange Commission; Pax World Funds
Author:Sanders, Bob
Publication:New Hampshire Business Review
Article Type:Case overview
Date:Aug 15, 2008
Words:1430
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