Scandal Sullies Mutual Funds

By Thor Valdmanis and John Waggoner, USA TODAY

NEW YORK — The nation's $6.8 trillion mutual fund industry is at the center of an illegal trading scandal that threatens to further alienate small investors and stall a nascent stock market recovery.

The trouble came Wednesday when New York Attorney General Eliot Spitzer charged that major mutual fund companies pump up profits using illegal trading schemes that cost small investors "billions of dollars" annually.

"The full extent of this complicated fraud is not yet known," Spitzer said. "But one thing is clear: The mutual fund industry operates on a double standard. Certain companies and individuals have been given the opportunity to manipulate the system."

The charges are likely to send shock waves through the industry, prompt louder calls for reform, trigger a flood of lawsuits from investors and raise questions about why the Securities and Exchange Commission was again upstaged by an ambitious state prosecutor.

"The mutual fund industry is the only place that has not been tarnished by all the recent scandals," says former SEC assistant chief trial attorney Frank Razzano, partner at Washington law firm Dickstein Shapiro Morin & Oshinsky. "If investors lose faith in this industry, it will be devastating."

Spitzer is expected to build his case on a $40 million settlement announced Wednesday with Canary Capital Partners, a little-known hedge fund, or loosely regulated investment pool for wealthy investors. Spitzer says Canary gave four mutual fund companies banking business in exchange for the ability to engage in illegal after-hours trading and market exploitation.

"This is another example of the little guy being told to play by the rules, while the big player gets the breaks," says Jim Cramer, a former hedge fund manager "I never thought mutual funds would jeopardize their business by compromising individual investors. I guess I was naive."

The companies, run by Bank One, Bank of America, Janus Capital Group and Strong Capital, said they were cooperating with Spitzer's investigation, which could trigger criminal as well as civil charges. Canary also is helping in the probe.

"This is a stark reminder to investors that the mutual fund industry is working for the mutual fund industry," says Gary Gensler, undersecretary of the Treasury in the Clinton administration and author of The Great Mutual Fund Trap.

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