SEC launches inquiry into Pax World Funds

Portsmouth-based Pax World Funds — the nation’s largest and oldest socially responsible mutual fund is facing a Securities and Exchange Commission inquiry about “internal control issues” so serious that they may affect the company’s ability to continue to manage its High Yield Fund, according to a Sept. 8 SEC filing.

The inquiry is primarily related to market-timing issues that are several years old, said Joe Keefe, chief executive officer of Pax World Management Corp., investment manager for Pax World Funds. But it also may touch on other matters.

Keefe, a former chair of the New Hampshire Democratic Committee who took over the top job at Pax in May, said, “It is a non-public inquiry, and I’m not in a position to characterize it or offer any other commentary.”

The SEC also is inquiring about the dual role of Pax chairman Laurence Shadek, whose family both owns Pax World Management Corp. and partly owns HG Wellington, the company that distributes the funds. Such relationships have been spelled out in SEC documents in the past.

“We were very careful to disclose that, because it was fraught with conflict,” Shadek said, who added that the family will “disentangle” some of its holdings because the fund has grown larger and because of the greater SEC scrutiny on corporate governance.

Shadek said that because of such general scrutiny — but not because of any specific question — Pax on Sept. 8 removed Lee D. Unterman as its chief compliance officer and attorney for the three mutual funds Pax World manages.

Unterman will remain as attorney for the company’s management company, but Ropes and Gray, a Boston corporate law firm, will handle the fund’s legal work.

Unterman’s multiple roles also have been made clear in earlier SEC filings.

The SEC would not comment about the inquiry. Neither would the state Bureau of Securities Regulation.

“Our office is aware that the SEC is in contact with Pax World Funds, and we are working with the SEC,” said Mark Connolly, the bureau’s director, adding that he had “no further comment at this time.”

Market timing charges

Pax World Funds, known for advocating corporate transparency, revealed the SEC probe in footnote F in its certified shareholder report:

“The High Yield Fund and the Adviser [the PAX WORLD MANAGEMENT CORP] have contacted the Securities and Exchange Commission (the “SEC”) regarding an internal control issue at the Adviser relating to certain corporate records of the Fund. As of August 4, 2005, it is uncertain what impact, if any, the resolution of this issue may have on the High Yield Fund, including on the Adviser’s ability to manage the Fund.”

Keefe, however, said he thought the disclosure was adequate, especially since the inquiry may amount to nothing that would affect the fund.

Keefe also noted that Pax revealed in Shadek’s letter to shareholders on Dec. 15, 2004, that the SEC had issued a deficiency letter to the company because the High Yield Fund had been hit by market timing charges in 2003.

Market timing, though not technically illegal, occurs when investors buy or sell based on their prediction of a short-term trend in the market, or by a certain fund or company. The SEC becomes involved when such decisions are made as a result of inside information or when manipulating orders by using late trades to sell or buy based on the closing times of different markets.

Pax agreed that that there appears to have been trading based on market timing and launched an internal investigation. The fund said that market timers took advantage of policies to allow long-term shareholders to switch investments among its funds, which helped the timers escape redemption fees that would have made such timing too expensive.

But unlike other mutual fund scandals, the Pax letter said that the market timing did not involve late trading or trading by a Pax employee, and did not cause shareholders to suffer any material loss.

Much of the alleged manipulation involving Pax occurred in the high-yield, or junk, bond market.

At the time, chairman Laurence A. Shadek told, “We got blindsided by this — we were victims. We’re substantial holders of the funds ourselves.”

Shadek said he still stands by the letter, though he added that “perhaps we were partly to blame because we didn’t stop it as we should have.”

It was difficult to stop because market timers’ funds were often commingled with “bona fide orders” and it was hard to sort all of it out. But he noted that since safeguards have been put into place, the market timing has stopped.

Corporate governance

Pax World Funds was founded in 1971 to provide an alternative mutual fund for those looking to invest in socially responsible companies. The company screens out companies with undesirable holdings, products or services, such as defense- or weapons-related companies or those that manufacture tobacco, liquor or gambling products. In February, for instance, Pax dumped its holdings in Starbucks because it started marketing coffee with liquor in it.

The fund has grown into a small powerhouse. The company’s Balanced Fund alone has more than $1.5 billion in assets under management, and performed nearly twice as well as the Lipper Balanced Fund Index during 2004. Indeed, Lipper rated Pax among the top 2 percent performing funds in that year.

Pax’s other two funds — Growth and High Yield — also have performed well. Pax’s Growth Fund, which posted a total return of 22 percent, was in the top 1 percent. And all three funds earned a four-star rating from Morningstar.

In addition to its investment mission, the company has been an advocate of more openness in the mutual fund industry. It has lobbied hard, for instance, for mutual funds to disclose how they vote on key proxy resolutions of the companies they invest in, not only on such issues as the environment and workers’ rights, but also corporate governance issues, such as CEO compensation.

In another example, in a Feb. 4, 2004, letter to the SEC, the company urged several reforms to curtail improper market timing, including having the compliance officer report directly to an independent board of directors, time-stamping of all trades in a manner that cannot be altered, and an attachment of an identifying control number.

“For 32 years Pax World has advocated for better governance and greater disclosure in corporate management,” wrote Thomas W. Grant, president of Pax, in a letter congratulating the SEC about some recent reforms for more independent directors and pushing for greater reforms on CEO compensation.

But Pax’s own filings have long contained information raising possible questions on its own corporate governance.

According to SEC filings, Shadak’s family owns substantially all of the capital stock in Pax World Management Corp. known as the “advisor” in securities law. Pax World Management Corp. receives commissions from each of the three funds it manages — all of them chaired by Lawrence Shadak. James M. Shadek, Lawrence’s brother, is treasurer of two of the funds. The advisor assumed about a half-million dollars of their expenses, an amount that the board deemed in line with other social investment funds.

In addition, the Shadak family owns 25 percent of HG Wellington, the funds’ distributor, which received nearly $800,000 in commissions during the last three years, with a commission percentage reaching as high as 50 percent.

President Thomas Grant and Christopher H. Brown, vice president at Pax World Funds and portfolio manager of its Balanced Fund, hold executive positions in both companies.

Then there is the role of Unterman, the board’s secretary and former chief compliance officer of all three funds. Unterman is a partner in the New York law firm of Kurzman Karelsen & Frank, which took in more than $200,000 in legal fees from the three funds during one six-month period. The firm also serves as legal counsel for HG Wellington.

The final question may be the role Diane Keefe (not related to Joe Keefe), portfolio manager of the High Yield Fund currently under inquiry.

Diane Keefe owns more than $1 million in equity securities in the fund that she manages. She also has $170,000 in assets in other accounts.

The SEC filing notes that “an inherent conflict of interest exists when a portfolio manager is responsible for the management of more than one account because the potential exists for the portfolio manager to favor one account over another account.”

Joe Keefe and Laurence Shadak said that the fact that Diane Keefe is so heavily invested in the fund she manages is a good sign.

Joe Keefe was not aware of her other accounts, but said that portfolio managers often manage other funds, and that the “inherent conflict of interest” language was common.

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