// BY STEFAN LINSSEN

In the post-Enron era of heightened scrutiny on corporate governance and business ethics, public companies have borne the brunt of the attention. Not surprisingly, this has contributed to an increasing number of companies going private.

In this environment, it takes a lot more for a privately owned company to stand out enough from its peers to warrant public scrutiny. Through the following, one organization did just that:

That company is Fidelity Investments, the nation’s largest 401(k) administrator and manager of over $3 trillion in investment assets.

It’s inevitable to include the irony of Fidelity’s name in this story, so perhaps it’s best to just get it out of the way now. Fidelity, by a dictionary’s standards, is “the quality or state of being faithful or loyal.”

THE QUESTION IS – TO WHOM IS FIDELITY LOYAL?
The fundamental premise of the Ethisphere Institute is that ethical leadership is rewarded over the longer term through sustained competitive advantage and superior profits. But Fidelity, the former wunderkind investment manager of the 1980s, seems to have sacrificed longterm leadership- ethical, innovative and far-thinking- for short-term profits for the controlling Johnson family.

The preponderance of evidence that leaks out to the public- despite the company’s best efforts to suppress it- affirms that conclusion. Some suggest that major business media have been dissuaded from digging in themselves, for fear of losing millions of dollars of Fidelity advertising.

Enter Ethisphere.

When a company is the largest player in an industry, as is Fidelity, the public increasingly expects them to set a positive tone for others to follow. This piece is an opinion piece based upon meticulous research and scrutiny of publicly available information. In the ensuing pages, we raise some of the issues the company has faced in recent years and present a recommended “investment” strategy for Fidelity to get itself back on track.

EXECUTIVE EXODUS
In early August of this year, Ellyn McColgan, a top Fidelity executive, stepped down. There wasn’t much hoopla about it- no significant press releases or statements from her former employer. The official word was that she merely left “to pursue opportunities outside of the company.” For those familiar with Fidelity, this was an unexpected move: McColgan was thought to be a leading contender to succeed CEO Ned Johnson. So, why did she resign to seek “opportunities” elsewhere?

Maybe McColgan was just getting fed up, but whatever the reason, she’s not alone. Recently, an unprecedented number of high-level managers have been leaving Fidelity’s ranks, making it impossible to ignore. And with some of the incidents that have reached the press in recent years, perhaps it’s not all that surprising.

THE GLOBAL TERRORISM CONNECTION
This summer, David van Duyn, one of Fidelity’s former compliance officers in charge of ensuring Fidelity’s compliance with the anti-terrorism and anti-money laundering provisions of the U.S. Patriot Act, sued Fidelity as a whistleblower over willfully violating the Act’s antiterror measures.

Van Duyn accused Fidelity’s Anti- Money Laundering Chief, R. Stephen Ganis, of instructing him to ignore requirements to monitor and report financial transactions to government authorities and to falsify documents. These reports were designed to prevent money laundering by terrorist groups.

According to his lawyer, van Duyn was allegedly ordered to stop watching certain accounts for specific periods of time in order to avoid “embarrassment” for Fidelity and important clients.

While many cases of alleged Patriot Act noncompliance make national news, this one didn’t. Within hours, Fidelity countersued, and rushed to block public record of van Duyn’s claims.

OUTLAWED INVESTMENTS SOLD TO U.S. MILITARY PERSONNEL
That wasn’t the first time that Fidelity or its broker-dealers have come under scrutiny for violating industry regulations. Earlier this year, the National Association of Securities Dealers (NASD) raised a complaint against Fidelity for presenting U.S. military personnel with faulty sales material for two out-of-date Fidelity mutual funds.

The funds, known as Destiny I and II, used “contractual plans,” a type of investment that requires monthly contributions for 10 to 15 years, but charges half of the first year’s investment in fees. These systematic investment plans were banned by Congress in 2006. In fact, even before Congressional intervention brought these plans to a halt, many professionals in the mutual fund world were already aghast at these types of investments.

“Would I ever recommend that an investor buy contractual plans? No, I would not,” John C. Bogle, founder of the Vanguard Group, told The New York Times in 2004.

The sales material used to advertise these Destiny plans claims they outperformed the S&P 500 index over the past 10 to 15 years. In reality, the plans drastically underperformed.

“These failures were aggravated by the fact that the plans were sold primarily to military personnel, who often have limited time to study the marketing materials for investment products,” said James Shorris, NASD Executive Vice President. “And these particular products involve complex or unique features that may not be fully understood by the customers to whom they are offered or by the brokers who recommend them.”

Ultimately, the NASD fined two of Fidelity’s brokerage dealers $400,000 for the violations and required the two dealers, Fidelity Investments Institutional Services Company of Smithfield, Rhode Island, and Fidelity Distributors Corporation of Boston, to allow current Destiny account owners to increase investment in their plans without paying the initial 50 percent startup cost.

Although Fidelity declined to admit guilt, it agreed to pay the fine. The $400,000 went to NASD’s nonprofit Investor Education Foundation, a group that helps educate members of the U.S. military and their families on financial decisions.

FIDELITY’S PROXY VOTES SUPPORT MANAGEMENT
The issue that is perhaps the most complicated, and potentially the most dangerous to investors, is the tremendous conflict of interest that Fidelity brings upon itself through expanding its business services beyond mutual funds for the masses. Impressively, the company has leveraged its position to become the nation’s largest manager of corporate 401(k) employee retirement plans. Sometimes, their mutual fund and benefits sectors intersect.

Examples: Fidelity’s giant mutual fund Magellan owns 3 million shares of Rockwell Collins stock, a company that also pays Fidelity to manage its benefits. Additionally, Fidelity’s largest mutual fund, Contrafund, owns 622,000 shares of FMC Technologies, and Fidelity runs benefits for that firm as well.

What is the conflict? When Fidelity’s mutual funds own stock in the same businesses that pay Fidelity for other services, the question becomes, “Who is looking out for whom?”

Some have suggested that by virtue of having a company as a client, Fidelity will be less inclined to vote against the company or its management- even if the vote is in the interest of the broader shareholder base. Could the quest to maximize profit from all revenue streams cause Fidelity to turn a blind eye and unquestionably vote with management so as not to jeopardize its lucrative 401(k) management practice?

Consider Tyco International before the 2002 scandal when CEO Dennis Kozlowski and CFO Mark Schwartz were accused of stealing $600 million from the company. In 1998, Fidelity was the largest shareholder of Tyco at 14 percent. In addition, Fidelity managed Tyco’s employee benefits program, reportedly earning $1.8 million. When Tyco shareholders proposed an amendment to make directors financially independent from executives, Fidelity voted with management. Fifteen other investment firms sided with the shareholders. When the scandal broke in 2002, Tyco lost $80 billion in market value.

THE GOVERNMENT REGULATES
Until recently, investment firms were not required to disclose how they vote at shareholder meetings. The change occurred when the SEC realized the potential conflict of interest. Their first course of action was to get opinions on the matter from businesses, mutual fund advisers and various institutions.

Three thousand responses came back, some from outside the United States. One letter, sent on behalf of several major institutional shareholders in Europe, including British Airways Pension Investment Management and Shell Pensions Management Services, not only asked the SEC to mandate proxy voting disclosure, but to mandate that companies publicly disclose any potential conflicts of interest as well. Fidelity Investments, on the other hand, was one of the investment firms campaigning against the new measures.

Finally in 2003, after sorting through all the responses, the SEC ruled that mutual funds must disclose their proxy votes. The SEC hoped this would “encourage funds to become more engaged in corporate governance of issuers held in their portfolios,” which in turn would be in the best interest of all investors.

Although investment firms are legally required to use their proxy votes to protect the best interests of shareholders, there was no real way to enforce this standard prior to the SEC’s decision. While Fidelity had its proxy voting guidelines posted on the company website, whether or not they followed them is unknown, as no actual voting records were released to the public. In contrast, Calvert Group and PAX World Management both revealed their guidelines and actual voting history.

With proxy votes now in the open, one can consider the example of Rockwell Collins. Rockwell Collins’ leadership hired Fidelity to manage its 401(k) and retirement packages. At the same time, Fidelity’s Magellan fund manages $200 million worth of stock in Rockwell Collins, earning it significant voting power. When the time came to vote for management at a February 2007 Rockwell Collins shareholder meeting, how did Fidelity vote? They voted to reelect all managers. Fidelity also voted for all managers in a 2007 FMC shareholder meeting.

DOES THIS ACTUALLY MEAN ANYTHING?
Fidelity won’t argue that it usually votes with management. After all, Fidelity executives say if they didn’t like the management they wouldn’t have invested in the first place, or would sell the shares that they have.

“If we make a determination that a company is not being run well, we have the option to sell our shares and, in fact, we make such decisions to buy and sell shares daily in the market,” says Fidelity spokesperson Anne Crowley.

However, problems arise when Fidelity owns a large quantity of shares in a specific company, making it very difficult to divest. Mutual funds have discovered that it’s not easy to use the “Wall Street rule” of selling- just selling the stock instead of battling management- when a company performs badly. Many experts recommend instead that Fidelity capitalize on its large stakes in companies to monitor ethical corporate governance. The company has the ability and is in the position to be an ethical trendsetter.

HIDDEN 401(K) FEES
Conflicts of interest aside, additional complications arise with Fidelity’s 401(k) management.

According to a 2006 report by the Government Accountability Office (GAO), approximately half of all workers participate in some sort of employer-sponsored retirement or pension plan. The fastest growing and most widely used defined contribution plans are 401(k) accounts.

As part of owning a 401(k), participants pay managerial fees associated with operating the plans. These fees, although usually a small percentage, can add up significantly over time. For instance, a one percent increase can reduce savings by 17 percent over 20 years.

The danger comes from opaque companies administering 401(k) plans. Often, corporations and their fund administrators won’t reveal the fees associated with a plan or will force participants to sort through several different types of documents to get an accurate amount.

“The 401(k) world is various,” says Barbara Bovbjerg, Director of Education, Workforce, and Income Security Issues for the GAO. “Some participants probably are getting really good, direct, straightforward information on the fees they’re paying, but that’s not uniformly true.” Many participants have no idea of the fees associated with their retirement plans, and it’s because the information just isn’t out there.

“The law, the statute and the regulations don’t really require a certain format, they don’t require all fees to be disclosed, they don’t require it all to be in one place,” Bovbjerg says. Investors can pore over account statements, annual reports and other documents, and still not find an accurate representation of what they’re paying.

The Employee Retirement Income Security Act (ERISA) requires retirement plan fiduciaries to act in the best interests of plan holders. This includes keeping costs (amounts paid for management, daily operations and so on) as low as possible. However, many times these fees can devolve into unethical profit for several companies involved.

For this very reason, a group of employees from Deere & Co. sued Fidelity,along with Deere, in December 2006. At the heart of the case were accusations that Fidelity charged indirect, hidden and excessive fees to administer the employees’ 401(k) accounts. The workers claimed that Deere and Fidelity had an undisclosed profit-sharing system set up under which Fidelity shared some of the fees it charged participants with Deere.

The suit was eventually thrown out by the judge overseeing the case. While profit-sharing existed, the judge felt that Deere and Fidelity had no responsibility to disclose it to workers.

Why such a secret? Besides shedding light on behind-the-scenes deals, transparent fees also help lower costs by increasing competition. “The more people become aware of what fees should be charged and what amount they’re paying, it’s likely more competition will emerge,” explains Tamara Cross, assistant director at the GAO.

Unfortunately, since the largest corporations are failing to address this issue, it is left to the legislatures to address. Although Bovbjerg notes that Congress and Labor are proactively working on the problem, she believes disclosure is ultimately the key.

“I think that getting more information to participants would be a really valuable thing,” she says. “Sunshine is a crucial aspect in fees. If more sunshine can be let in I think it will be better for everybody.”

A ‘MOO’T POINT?
Inadequately disclosed fees may be one thing, but then there’s the small-scale skimping. As the Wall Street Journal originally reported, Fidelity’s Westlake, Texas, campus owns 24 cattle that graze on a portion of its property in order to save money through a state property tax law.

The law was originally designed to help farmers and ranchers save a little extra money by giving a tax break to those who raise livestock, grow crops or protect natural wildlife, but now is being exploited by big companies operating in the area, such as Fidelity.

Fidelity took this approach and, although its primary business is clearly investments, applied for the tax break for owning cattle. So what does the company save by raising the livestock? About $318,000 a year- Fidelity’s county-property tax on the portion of land that the cattle graze on dropped from $319,417 to $714.

Fidelity manages about $3 trillion and over 41,000 employees. Its revenue in 2006 was close to $13 billion, and its income about $1.2 billion. Fidelity’s 77-year-old CEO Edward “Ned” Johnson III and daughter Abigail are often found on Forbes Magazine’s “most wealthy” lists. Yet, the company uses a law designed to help protect farmers and plops 24 cattle on a customer service campus to save .0025 percent of its annual revenue.

OFFERING KICKBACKS TO CERTAIN TRADERS
As part of a long-running investigation, Fidelity came under further scrutiny in 2004 by the SEC, NACD and its own independent board of trustees. They were all looking at alleged kickbacks that Fidelity traders had received from third-party brokerage firms and the potential harm that this caused Fidelity funds.

Although Fidelity’s Board determined there was no proof of harm, they said the danger was real and agreed to pay $42 million plus interest to the at-risk Fidelity mutual funds.

According to Crowley, the NASD reached a settlement with four of Fidelity’s broker-dealers associated with the kickback scandal (Fidelity Brokerage Services, Fidelity Investments Institutional Services, National Financial Services and Fidelity Distributors Corporation) to pay $3.75 million. “Fidelity neither admitted nor denied the findings in connection with that settlement,” Crowley said.

The SEC investigation is still pending.

Fidelity has apologized on several occasions for this issue, including issuing what was considered a rare public apology by Ned Johnson.

DWARF-THROWING, WOMEN-FOR-HIRE AND OTHER SHENANIGANS
What is an example of a kickback that employees received? In 2005, Fidelity traders accepted over $75,000 to fi nance the bachelor party of one of their star employees, Thomas Bruderman, Jr., by brokerage houses Jefferies & Co, Lazard and SG Cowan.

According to media reports, the brokerages supplied a $65,000 private jet to take Bruderman and his guests from Boston to Miami and paid for the rooms at the high-end Delano Hotel. The lavish party included strippers, yachts and an activity known as “dwarf tossing.” Use your imagination to fi gure out how that works. Hint: It involves little people and Velcro walls. An internal investigation of the event discovered that at least 16 Fidelity traders had broken company rules. Guests of Bruderman included Scott Desano, former head of stock trading for Fidelity, and Dennis Kozlowski, the former head of Tyco.

A STRUGGLING BEHEMOTH
External troubles aren’t the only problems for Fidelity. As mentioned earlier, a recent exodus of high-level talent, such as Ellyn McColgan, has raised questions on internal morale as well.

Another notable executive that left the company is former COO Bob Reynolds, who stepped down in July, forcing CEO Ned Johnson to personally handle the company’s daily operations- which is probably not what the 77-year-old patriarch had in mind for his golden years.

What’s strange about all this is that during 2007, Fidelity funds have actually done quite well. This year, Fidelity diversified U.S. equity funds had some of the highest average returns compared to its four biggest competitors, according to research provided by Morningstar analysts. It’s not performance, therefore, that is causing some of these people to leave.

The problem isn’t constrained to just high-level executives, either. Many employees complain about the heavy politics involved in getting ahead within the company and the constant fear of having their jobs outsourced to another country. Now, managers who a few years ago would have been hard-pressed to leave have recently begun taking rivals’ offers.

As one disgruntled employee posts on a discussion board about Fidelity, “In its own hometown, Fidelity is a running joke. All companies have too much politics, of course, but at Fidelity, politics is your job. You will spend all day, every day, in meetings. Those who seek to do a good day’s work, challenge themselves, and grow, all know they have no place in this company.” This seems to sum up the views of most of the people participating in the discussion.

Whether the low morale is a result of the missteps Fidelity has taken or some other root cause, the one thing that is clear is that all of these issues underscore the company’s bottom-line tactics.

And, while Crowley does accurately point out that “the mere fi ling of a lawsuit does not in any way suggest a finding of fact,” it’s hard to ignore a pattern that suggests ill-advised or even potentially illegal behavior happening at a higher pace than would be expected.

Perhaps high-level Fidelity bosses aren’t aware of these occurrences, or believe them to be isolated incidents, but it all comes down to the same question of whether the company has adequate compliance controls. The legal troubles have come from a variety of divisions within the company, scattered around the country, but it seems as though the company merely responds on an issue-by-issue basis, caving in after enough pressure is applied, rather than proactively improving the overall ethical culture. If that’s the case, then it’s not only the investors and general public that get harmed, but the company suffers with a damaged reputation as well. In the end, this approach benefits no one.

RECOMMENDATIONS FOR A REMEDY
So what needs to be done? Here are five steps Fidelity can make to move toward transparent and honorable business conduct.

The future in asset management is going to be competitive.

Lower fees, greater investment disclosure, increased product competition,higher demands for transparency and a heightened focus on compliance are five trends that are expected to accelerate in the asset management industry. Given Fidelity’s dominance in the asset management industry, we would certainly like to see Fidelity improve and exercise ethical leadership.

Whether Fidelity chooses to be a leader or a laggard when it comes to addressing all five of these trends for the future, that remains to be seen. Judging by its actions up until now, we’d put our money on the latter.