Investors Deserve an Intolerant SEC

During the 63 years that mutual funds have been federally regulated, the industry has earned a reputation as a scandal-free refuge from the predictable bouts of fraud in America's financial-services industry. In one day last week, New York Attorney General Eliot Spitzer obliterated the "scandal-free" claim.

Whether the fund industry's image descends to the level of its incorrigible cousins in the brokerage, insurance, banking and hedge fund businesses will depend largely on how the Securities and Exchange Commission responds to this first-ever mutual fund scandal.

SEC staff is very effective at focused policing and responding to specific fraud uncovered by the press or academics. But it has failed to anticipate or even respond to signs of certain systemic problems that require a more global perspective.

Last Wednesday, Mr. Spitzer's office filed charges against Canary Capital Partners, a hedge fund, alleging illegal fund arbitrage, late trading and other frauds. The charges would have been unexceptional had they not included allegations that Bank of America (BAC Quote) (NationsFunds), Janus (JNS Quote), Bank One (ONE Quote) and Strong fund executives conspired with Canary to cheat their own funds' shareholders. Most critics are blaming the fund industry for this crisis, but the industry is not solely -- or even primarily -- responsible, I would argue.

The context in which business executives operate is like any other social system that will produce the results it is designed to produce. Thus, the lax rules governing the conduct of brokers and investment bankers predictably yield frequent scandals. In contrast, the fund industry is regulated under a particularly stringent set of rules that establish a higher standard of conduct. To date, fund executives generally have lived up to the standard expected and required of them.

Of course, mutual fund executives and directors will live up the law's expectations only to the extent that the law is enforced. When the SEC fails to enforce the law, fund executives and directors will live down to the SEC's lowered expectations. Mr. Spitzer's allegations illustrate that the SEC's expectations have become inexcusably low.