Faulting oversight of traders, Fidelity to pay funds $42m

Fidelity Investments will pay its mutual funds $42 million after an internal report found that it failed to adequately supervise traders who accepted gifts, travel, and other benefits from brokers in violation of company policies, the Boston mutual fund giant said yesterday.

The findings, based on a report commissioned by a group of trustees charged with looking out for the interest of Fidelity's mutual fund shareholders, prompted a rare public apology from Fidelity chairman Edward C. Johnson III.

" These are serious charges," Johnson wrote in a statement posted on Fidelity's website. "On behalf of myself and Fidelity, I extend an apology for this improper behavior."

Johnson and the company both noted there is no proof shareholders were harmed, and mentioned stricter oversight the company has put in place recently.

Industry specialists said the review was one of the harshest public critiques of management ever issued by a fund board. Such boards are often criticized for failing to stand up for shareholder interests.

Earlier this month, a New York brokerage used by Fidelity, Jefferies & Co., agreed to pay more than $10 million to settle regulators' claims it had violated gift limits meant to ensure brokerages compete for business fairly. Documents filed in connection with the settlement showed Jefferies spent about $2 million on some of Fidelity's top personnel from 2002 to 2004, showering them with private flights, sports tickets, and expensive bottles of wine.

Jefferies did not admit or deny wrongdoing, but filings show Fidelity substantially increased its business with Jefferies in the same period. Fidelity's commissions with Jefferies rose from $4 million in 2001 to $30 million in 2003 and $24.5 million in 2004. Fidelity has said its business with Jefferies also increased because Jefferies improved and expanded its services.

Fidelity's statements did not mention Jefferies by name, but described some of the same conduct. Fidelity has maintained that it was impossible to show that investors were harmed by the actions of its traders, and that it had disciplined those traders as a result of violations of company policies.

Regulators, including the US Securities and Exchange Commission and the NASD, formerly the National Association of Securities Dealers, have been investigating Fidelity's dealings with Jefferies for two years. In discussing the settlement with Jefferies, SEC officials said their investigation into Fidelity's conduct is continuing. SEC officials had no comment.

Meanwhile, the 10 independent trustees on Fidelity's 13-member funds board launched their own investigation into traders' acceptance of gifts. The independent trustees, previously led by Robert M. Gates, who became US secretary of defense this month, hired former federal judge John S. Martin Jr. to determine whether holders of Fidelity mutual funds were harmed. Martin, drawing on an economist's analysis of the trading activities in the funds, concluded it wasn't possible to prove or disprove statistically whether the traders' actions resulted in excessive costs to the funds and harmed shareholders. But, Martin concluded, "certain traders had misdirected order flow" among brokerage firms, raising the possibility that they steered business to those who offered gifts to the traders.

In spite of the absence of proof that the gifts harmed investors, the independent trustees wrote in their report yesterday, "the conduct at issue was serious, is worthy of redress and . . . any uncertainty should be resolved in favor of the funds." The trustees also wrote that "inadequate supervision and other shortcomings exposed the funds to the potential risks of adverse publicity, loss of credibility with their principal regulators, and loss of fund shareholders."

In his apology, Johnson said that although there is no proof shareholders were harmed , "there is no question that the funds were put at potential risk, as identified in the trustees' report. Therefore, I have agreed that Fidelity should pay a penalty set by the trustees for this misbehavior and the company's failure to stop it."

Johnson also wrote that he hoped the findings of the trustees would help to resolve the SEC's concerns as well. "We also appreciate the SEC's wisdom in permitting the independent trustees to complete their work in advance of the final resolution" with the SEC, Johnson wrote.

Independent trustees at mutual fund companies are paid handsomely to represent shareholders' interests in vehicles like Fidelity's Magellan fund. Gates, for example, was paid $362,250 by Fidelity in 2004, in addition to his compensation of $416,020 as president of Texas A&M University for the academic year starting in 2004. Gates, who resigned Dec. 6 after he was confirmed as defense secretary, was succeeded as chairman of the independent trustees by Ned C. Lautenbach, a partner in a New York private equity firm. In his letter Johnson noted the work of both Gates and Lautenbach, and of Marvin L. Mann, who was the chair of the independent trustees until a year ago.

Neither Johnson nor other executives would comment beyond his letter, Fidelity spokeswoman Anne Crowley said. Lautenbach and Mann have previously declined to discuss the matter and did not return messages yesterday. Gates has not responded to repeated questions about Fidelity this month, including inquiries to his spokesman yesterday.

Since 2003 other mutual fund companies have paid hundreds of millions of dollars to settle regulatory probes. But industry figures like Susan Wyderko, executive director of the Mutual Fund Directors Forum, which represents independent trustees, said they couldn't recall a payment nearly as large initiated by a trustee investigation. "The Fidelity trustees have set an important example to the entire fund industry," she said.

James Lowell, who edits a newsletter for Fidelity investors, said the trustees' sharp action was noteworthy because Johnson and Mann have been key opponents of proposed reforms that would remove insiders like Johnson himself from leading fund boards. While Lautenbach is head of the independent trustees on the board, Johnson serves as chairman of the entire board.

At the same time, Lowell said, the action by Fidelity and its trustees could effectively preempt a harsher settlement with the SEC. "Fidelity has probably orchestrated a way for themselves to not have to make the check out to the SEC but rather to their own shareholders," he said.

In a third posting on its website yesterday, Fidelity reiterated that "we deeply regret this behavior," but added that "it is important to note that this misconduct was an aberration and not at all indicative of Fidelity's record of commitment to the interests of fund shareholders and to other clients. Fidelity has a longstanding record of demonstrating our commitment to ethical conduct and compliance with the rules and regulations of our industry."

Fidelity has cooperated fully with the independent trustees' investigation, the company added. It said it had agreed to pay $42 million to the funds, plus interest, and reimburse them separately for the costs of the trustees' review.

Ross Kerber can be reached at kerber@globe.com.