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Updated from 3:11 p.m. EDT

The mutual fund industry, already under fire for failing to disclose hidden fees on investors, is embroiled in a new scandal after a hedge fund settled charges it racked up tens of millions of dollars by illegally trading in mutual fund shares.

Prosecutors indicated the investigation is far from over and sources told

TheStreet.com

late Wednesday that a large number of mutual fund companies have been told by Spitzer's office they must preserve documents that could be pertinent to the probe.

At a noon press conference Wednesday, New York Attorney General Eliot Spitzer announced a $40 million settlement with a New Jersey hedge fund over allegations that it engaged in illegal trading in mutual fund shares sold by a number of Wall Street firms and banks.

The settlement coincides with the filing of a civil complaint in a New York state court that outlines an elaborate scheme between a hedge fund and group of big mutual funds to game the system at the expense of ordinary mutual fund investors.

Coal Mines

The hedge fund settling with Spitzer's office is Canary Capital Partners, managed by Edward Stern, whose family used to own the Hartz Mountain pet supply company. Canary will pay $30 million in restitution -- representing its illegal trading profits -- plus a $10 million fine.

Spitzer left little doubt that Wednesday's charges against Canary are just "step one" in his investigation, and further charges against mutual fund companies will likely follow.

"This is a continuing investigation," Spitzer said. "Mutual funds are in deep trouble."

Spitzer added that other hedge funds also might be snared in the investigation, and held out the possibility that some individual could be criminally charged. In pursuing the mutual fund industry, Spitzer appears to be gearing up for an inquiry that could rival his earlier inquiry into Wall Street's tainted stock research that culminated with a landmark $1.4 billion settlement.

Spitzer's office identified the Wall Street firms that allegedly sold the mutual fund shares to Canary as

Bank of America's

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Nation's Funds,

Bank One

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Janus

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A source familiar with the investigation said that Spitzer's office was still looking into the activities of several other mutual funds that reportedly did business with Canary. And this week Spitzer's office served subpoenas on a wide swath of mutual fund companies, asking them to preserve documents that could be sought at a later date.

But the complaint and supporting documents and emails filed by Spitzer's office with the court make it clear that Bank of America is the main Wall Street villain in the Canary case.

The complaint cites a number of articles, including a June 10, 2000, article written by mutual fund expert Mercer Bullard for

TheStreet.com

, to bolster its argument that Canary engaged in improper trading activities. (To see the Bullard stories, click

here and

here.)

Special Consideration

The investigation found that Canary, which once claimed $1 billion in assets, boosted its returns by engaging in a pattern of "late trading" and "market timing" in mutual fund shares, all with the active cooperation of the mutual fund companies.

Late trading is a particularly egregious offense that enables a trader to purchase shares in a mutual fund after the close of the trading, but at their 4 p.m. price. Market timing, meanwhile, is an arbitrage strategy that allows savvy traders to take advantage of the time differences between the closing of the U.S. markets and foreign exchanges.

To understand why late trading is so pernicious you have to understand how mutual funds value their assets.

While traders can buy shares in a mutual fund throughout the day, the shares' value is recalculated each day after the 4 p.m. close. Any change in the price of a fund's components that occurs after 4 p.m. should theoretically be reflected in the next day's calculation. So if a trader is able to buy mutual fund shares at the 4 p.m. price while knowing about price movements that took place after 4 p.m., he is effectively able to lock in a price that he knows is going to change.

What BofA and other mutual funds apparently did for Canary was allow the hedge fund to buy and sell mutual fund shares after 4 p.m. based on that day's closing value. In other words, Canary knew the value of those shares before it placed its order -- something that gave it a built-in advantage.

Spitzer compared the late trading by Canary to "betting on a horse race after the horses have crossed the finish line." And, Spitzer said, his investigation found that this kind of illegal trading between hedge funds and mutual funds is more common than anyone thought.

By contrast, it's not necessarily illegal for a hedge fund to "market time" in mutual fund shares. Spitzer said the mutual fund firms, by allowing Canary to actively time its trades in foreign mutual funds, violated a fiduciary duty it has to customers to limit such behavior.

Can't Say No

The documents gathered by investigators are particularly damning and in some respects more revealing about the motives of mutual fund companies than the emails released by investigators during the tainted research scandal. The emails from this latest investigation reveal that the funds were quick to accommodate Canary because of the high fees and commissions it paid.

Documents show that Bank of America broker Ted Sihpol and others at the nation's third-largest bank went to great lengths to flout the mutual fund industry's rule in order to gain Canary's trust and business. One memorandum prepared by Sihpol speculates on just how valuable Canary's business could be to the bank, noting that the Stern family has a net worth of $3 billion and is the 11th richest in the New York City area.

BofA even went so far as to install a computer system at Canary's office that helped them with their late-day trading.

A BofA spokeswoman said the Charlotte, N.C.-based bank is cooperating with the investigation. She declined to comment on Sihpol's involvement in the scheme.

Stern, who is cooperating with Spitzer's office in its investigation, released a statement in which he said he has "voluntarily" agreed to trade in mutual fund shares or manage any public investments for the next 10 years.

An attorney who represents a number of hedge funds in New York, however, disputed Spitzer's contention that the kind of trading abuses uncovered by Spitzer in the Canary case are widespread. Ron Geffner, an attorney with Sadis & Goldberg, said there is "nothing to suggest this kind of behavior is widespread. The facts seem to involve specific parties in a specific strategy.''

Numerous Probes

This, meanwhile, is not Spitzer's first investigation involving the mutual fund business.

Earlier this summer, Spitzer joined with Massachusetts Secretary of the Commonwealth William Galvin in an investigation of allegations that

Morgan Stanley

(MWD)

pressured brokers to sell the firm's in-house mutual fund products at the expense of other funds.

The

Securities and Exchange Commission

and

NASD

also have set their sights on Wall Street and the mutual fund industry. Both regulatory agencies have been investigating hidden fees charged by mutual funds and allegations that some Wall Street firms push their customers to buy shares in more expensive mutual fund offerings.

The SEC, for instance, is trying to determine whether Morgan Stanley brokers pushed customers to buy shares in its in-house mutual funds. The SEC investigation focuses specifically on whether Morgan customers were urged to buy so-called Class B shares in those in-house mutual funds. In recent years, Class B shares increasingly have drawn scrutiny from regulators at the SEC and the NASD because they tend to be the most costly mutual fund products.

On the surface, Class B shares often look like a good investment because investors generally don't pay any upfront sales charge, or "load." But investors in Class B shares often pay higher annual fees than on shares with upfront sales charges, fees that often exceed any initial savings an investor might reap. Additionally, brokers often waive or reduce the upfront fees on so-called Class A "load" shares for large investors.

The NASD, meanwhile, has been waging its own investigation into the sale of Class B shares and issued an investors advisory warning to mutual fund customers to avoid most Class B offerings pushed by Wall Street firms.

Spitzer declined to comment on how the investigation into Canary began. But he said it is unrelated to another investigation his office launched earlier this year into the $500 billion hedge fund business.

During the past year, hedge funds also have come under scrutiny in the aftermath of several big failures and allegations of fund managers manipulating the value of their assets in order to deceive investors.