We occasionally delve on this Blog into topics relating to social responsibility. Much of our analysis involves the relationship between social responsibility and profit maximization.
The importance of social responsibility can be seen with particular clarity in the mutual fund area. Socially responsible funds (SRIs) attract investors by promising to engage in socially responsible investing (with the phrase individually defined by each fund). The usual notion is that investors agree to accept a reduced return but are promised an investment portfolio that meets certain socially responsible criteria. And, in fact, as a group, the SRIs underpeform other mutual funds. See Consumer Reports, Principles v. Performance, May 2008 ("And our analysis bore this out: In the past five years, SRI funds returned 11.1 percent annually, while all domestic equity funds returned 14.5 percent . . . . And only 15 percent of SRI funds with a five-year track record returned more than that."), and typically have a higher expense ratio. While there are exceptions, therefore, investors as a group essentially pay for the costs of socially responsible investing.
As a result, a fund that promises to engage in socially responsible investing but reneges on the promise is doing more than merely violating a policy. This issue came up in connection with the SEC's recent action against Pax World Management. In Pax World Management, Investment Company Act No. 38344 (admin proc July 30, 2008), the Commission issued a cease and desist order (and imposed a civil penalty of $500,000) against a fund that violated its socially responsible criteria. As the Commission found:
- At all relevant times, investment adviser Pax World represented to investors and to the boards of the mutual funds it advised (the "Pax World Funds" or the "Funds") that it complied with various "socially responsible investing" ("SRI") restrictions, including, among other things, that it would not purchase for the Funds securities issued by companies that derived revenue from the manufacture of weapons, alcohol, tobacco or gambling products. Pax World acted contrary to these representations and violated the Funds' SRI restrictions from 2001 through 2005 when it purchased for the Pax World Growth and High Yield Funds ten securities that these Funds' SRI restrictions prohibited them from buying, including securities of companies that: (1) derived revenue from the manufacture of alcohol and/or gambling products; (2) derived more than 5% of their revenue from contracts with the U.S. Department of Defense; and (3) failed to satisfy the Funds' environmental or labor standards. During this period, Pax World also failed to consistently follow its own SRI-related policies and procedures with respect to these two funds that required that all securities be screened by Pax World's Social Research Department prior to purchase to ensure compliance with the SRI disclosures. In addition, during this period, Pax World did not consistently adhere to other SRI-related policies and procedures, including continuously monitoring fund holdings. As a result of conduct during the period from 2001 through 2005, the Pax World Funds held at least one prohibited security at all times from 2001 through early 2006.
Several things ought to be noted. First, the Commission brought an administrative proceeding, not an injunctive proceeding. The difference is significant both in appearance (a court order is perceived to be a more severe sanction) and in practice (court orders are enforceable through contempt, administrative proceedings are not). Second, the Commission issued a cease and desist order for violations of Section 206 of the Advisers Act. There is no private right of action for a violation of the section. See Frank Russell Co. v. Wellington Mgmt. Co., 154 F.3d 97 (3rd Cir. 1998). At the same time, the Commission did not bring an action for violating Rule 10b-5 even though the language of the two sections is largely identical.
It's not quite right to call this action a slap on the wrist. For any reputable adviser (and Pax World is), an enforcement proceeding of any kind by the Commission is damaging, particularly to reputation. And, as the Commission noted, Pax World engaged in significant remedial acts. Pax World replaced management, developed new procedures and implemented a new computer softward for SRI compliance. Nonetheless, the severity of this offense was not recognized in the proceeding. For the relevant time periods, the particular funds were, in fact, not socially responsible funds. During the relevant time period, investors accepted the risk of a lower return without the promised consideration, that is that the funds would invest consistently with the stated socially responsible policies. It sends a terrible message and, in the context of decisions like shareholder access, suggest a low level of importance placed on shareholder rights.