The Massachusetts state pension board announced last week that it will not invest any new money in Fidelity Investments, reprimanding the world's largest fund company for the manner in which it has responded to the board's questions regarding a federal investigation of its trading desk.

Evoking memories of its fallout with Putnam Investments over market-timing allegations, the Pension Reserves Investment Management Board (PRIM) withheld a $75 million high-yield investment from Fidelity, suggesting that the company has been less than forthcoming about a Securities and Exchange Commission investigation of whether its traders accepted lavish gifts from brokers as incentives to trade with them.

In October 2003, Putnam's portfolio managers were implicated in the trading scandal, and the problems ultimately rose all the way up to the top, forcing Larry Lasser to resign as chairman and sending the company into a tailspin. In that case, Putnam's investors, including PRIM, felt an impact on their account and decided to terminate the relationship.

Unlike the Putnam situation, Fidelity has yet to be charged with any wrongdoing by regulators. And overall performance has been good. State officials are withholding cash as a precaution while they seek more information about whether two investment accounts totaling nearly $700 million that Fidelity manages for Massachusetts have been tainted by traders' activities.

"With Putnam, we had real concerns about what the future of the firm was going to look like given the changes that were taking place at all levels of the firm," said Timothy Cahill, treasurer of the Commonwealth of Massachusetts. "That's not the case here. What we're looking for is proof that the actions of the traders in question did not adversely impact our account."

On Dec. 16, Fidelity disclosed that it had disciplined 14 traders and that two other stock traders had left the firm for violating its gift and entertainment policies. Among those disciplined for their behavior was high-profile head trader Scott De Sano, who remains at his post. The violations included foursomes at upscale golf resorts, Super Bowl tickets, junkets to Las Vegas and expensive wine and dinners. Fidelity did not disclose which positions those traders held.

Subsequently, in a letter to the board, Bob Reynolds, chief operating officer at Fidelity, assured that the company found "no instances" in which investors suffered financial losses as a result of traders' activities and that no trades were directed to anyone as a result of those gifts.

However, on Jan. 27, Fidelity confirmed that two high-yield traders were among the group of traders disciplined for their actions, prompting the board to freeze new investments in order to request further information. Up until that point, the board was under the impression that these folks were stock traders. The pension board wants to know why this information was not brought to light at a Jan. 6 board meeting with Fidelity. "It's broader than we thought," said Stanley Mavromates, Jr., the pension fund's chief investment officer. "Now it doesn't affect one account, it affects two accounts, two different asset classes." Fidelity manages $352 million in high-yield debt for the state and another $340 million in large-cap equities. To further confuse matters, it was recently reported that traders Marc Beran and Steve Falzone left the company in the third week of January. While it is not known whether they worked on the equity side or the fixed-income side, Mavromates confirmed that traders handling the Massachusetts pension account are still with the firm.

While Fidelity refused to comment on when the high-yield traders were disciplined for their conduct, state officials confirmed that the high-yield traders were, in fact, among the original 14 who were reprimanded. Fidelity only provided that information to the board at its most recent meeting, when the board requested the information. Fidelity maintains that it has kept an open and honest dialogue with the PRIM board.

"We want verification that what they're telling us is the truth," Cahill said. "They haven't given us the physical proof." Cahill could not specify what would constitute significant proof on account of it being handled at the staff level. He did say that the board has no plans to fire Fidelity at this time but expects the company to deliver more information expeditiously. "Our relationship isn't any worse off at this point," Cahill added.

In keeping with its policy, Fidelity declined comment on its relationships with clients. "We understand that the Commonwealth is performing the due diligence necessary of any plan sponsor," said Anne Crowley, a spokeswoman for Fidelity Investments. "We value our long relationship with them, and we have [provided] and will continue to provide information necessary for them to perform their due diligence."

Another point of contention with Massachusetts officials is the trading commissions Fidelity pays to brokers to execute trades. Mavromates said that the commissions "seem higher than average" compared to other equity fund managers employed by the state. In response to that claim, Fidelity reiterated that its trading costs are lower than 85% of the industry, according to recent data published by research firm Abel/Noser of New York.

The noise surrounding Fidelity was generated by last week's board meeting, during which officials were planning to divide up a $300 million account from fired money manager W.R. Huff Asset Management equally among the remaining firms that manage debt for the state, including Fidelity, Loomis Sayles, Shenkman and Seix. In light of the new information regarding the high-yield traders, the board deemed it prudent to exclude Fidelity from the Huff fire sale. Both parties maintain that this is a normal part of the due diligence process.

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