On a Saturday morning four weeks ago, New York State attorney general Eliot Spitzer walked onto a tennis court in Washington for a match with his niece and chanced upon Matthew Fink, president of the Investment Company Institute, the mutual fund industry's trade group. Howya doing? Spitzer asked. Fine, Fink answered. He then mentioned that his industry seemed to be under unusual scrutiny, adding, "At least you aren't giving us a hard time." Spitzer's response left Fink weak in the knees. "Just wait," he said with a smile.
Fink didn't have to wait long. On Sept. 3, the crusading A.G., fresh from lashing the brokerage industry into a $1.4 billion settlement over fraudulent stock research, revealed his latest target: the mutual fund business. This time Spitzer asserts that the industry we have trusted to put us on equal footing with the big hitters was favoring them at our expense--through short-term trading schemes that dilute the gains of long-term holders.
His investigation issued its first criminal charge last week and began to shift to a second set of mutual fund trades--those by Millennium Partners, a $4 billion hedge fund run by storied Wall Street investor Israel Englander. And Spitzer wasn't the only cop on the Wall Street beat. The NASD, a securities-industry regulator, had settled a separate case with Morgan Stanley, which it charged with offering brokers improper incentives to push in-house funds that might not be best for its clients.
The fallout from Spitzer's assault has been swift. Fund-research firm Morningstar--the 800-lb. gorilla of independent fund analysis--took the unprecedented step of warning investors to avoid the four fund families at the eye of Spitzer's storm--Strong, Bank of America's Nations Funds, Bank One's One Group, and most Janus offerings (except for its Mid Cap Value, Small Cap Value and Risk-Managed Stock funds, which are run by outside managers). "The firms put their own profitability ahead of shareholders'," says Kunal Kapoor, Morningstar's associate director of fund research. "Until we see changes, we don't think they deserve to be trusted with people's money." A riled-up Janus shot back that Morningstar was acting with "recklessness and irresponsibility." The company said it has pledged to cooperate with Spitzer and even put back money after it determines which funds were hurt and by how much.
The fund industry, its trust breached, is now making all the right noises. Fink called the alleged abuses "outrageous" and urged all his group's members to review their internal procedures. Spitzer's investigation is far from over, though, and it may touch broadly an industry entrusted with $7 trillion of our retirement and other savings--a gargantuan sum that politicians will be eager to make a show of protecting.