Fidelity Investments will compensate investors for potential damage incurred as a result of the lavish gifts, entertainment, and gratuities some Fidelity traders received from 2002 to 2004 from Jeffries and Co. Inc., a New York securities firm.

(Jeffries was fined $9.7 million by the Securities and Exchange Commission and NASD last month. Click here for more information on the Jeffries case and the NASD and SEC rulings).

The decision to pay $42 million to certain Fidelity mutual funds was announced last month in an open letter posted on Fidelity’s Web site by Edward C. Johnson, chairman of the board of trustees of Fidelity Mutual Funds. It followed the release of a report by the Independent Trustees of the Fidelity Funds that found the company had failed to adequately supervise its traders in the Jeffries case.

The Independent Trustees review of the gifts and entertainment case was conducted by Judge John S. Martin, who concluded that while it wasn’t possible to prove whether traders’ actions had resulted in excessive costs to the Fidelity funds and as a consequence harmed investors, it was clear that the traders had “misdirected order flow” among brokerage firms. The latter conclusion, combined with the fact that Jeffries’ brokerage business with Fidelity substantially increased in the years during which Fidelity traders received $2 million worth of gifts and entertainment from Jeffries, could suggest that the Fidelity traders in question steered business to Jeffries.

In a statement posted on the Fidelity Web site, the Independent Trustees said, “In spite of the absence of proof that the funds experienced diminished execution quality as a result of traders' receipt of improper [travel, entertainment, gifts, and gratuities], the conduct at issue was serious, is worthy of redress, and, as Judge Martin concluded, any uncertainty should be resolved in favor of the funds.” The statement also noted 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,” and concluded that it would be appropriate for Fidelity to pay the affected funds $42 million, plus interest and expenses.

Click here for the report and conclusion of the Independent Trustees.

“These are serious charges,” said Johnson in his statement. “On behalf of myself and Fidelity I extend an apology for this improper behavior.” Johnson also conceded that although there was no proof that the Fidelity funds were harmed by the traders’ actions, “there is no question that the Funds were put at a potential risk . . .”

Click here to read Johnson’s letter.

The SEC is still investigating the Boston-based mutual fund giant for its role in the gift and entertainment scandal.