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

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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.

Mr. Spitzer's recent allegations share a common theme with those he successfully leveled against conflicted Wall Street research analysts

earlier this year, as well as the SEC's case against the NASD in 1996, and the Treasury auction scandal in the early 1990s. All reflect a significant weakness in the SEC's enforcement philosophy. The SEC staff does not have a culture of actively seeking to identify and preempt broad categories of misconduct based on fundamental operational and economic problems in the securities industry.

A Deficient Enforcement Culture

Some, but not all, of Mr. Spitzer's allegations are a case in point. His late-trading allegations, for example, probably do not reflect a failure of the SEC enforcement staff. The late-trading allegations took industry insiders and SEC attorneys alike by surprise. There has been no evidence that late trading is an industrywide problem, and it reflects no failure by the SEC that this fraud was first uncovered by someone else.

The allegations of funds using stale prices are a different matter. This fraud, which I call arbitrage pricing, has been widespread and well-known for years. Over three years ago,

I published two articles in TheStreet.com explaining how arbitrageurs cheat fund shareholders by exploiting stale prices. Both articles were cited in Mr. Spitzer's complaint, and these articles were not the only ones that had identified the problem. A number of hedge fund managers were known to be making a good living engaging in fund arbitrage. Published academic studies showed that fund shareholders lose billions of dollars annually to arbitrage pricing.

The SEC itself studied the practice and found that "large numbers" of arbitrageurs had made risk-free profits at the expense of fund shareholders. The SEC has not made its findings public, but you can find an analysis based on the SEC's methodology in my

June 10, 2000 article.

Despite years of mounting evidence that fund arbitrage was widespread and pernicious, the SEC took no action. The SEC never brought an enforcement action against a fund for using stale prices, thereby sending the message that it did not consider inaccurate pricing to be a major concern. This message was reinforced when the SEC failed to take action against the fund manager or directors of two Heartland municipal bond funds that in October 2000 lost 44% and 70%, respectively, of their net asset value in a single day because the funds' shares had been mispriced. (Check out these stories:

SEC May Hold Independent Directors Responsible for Heartland Debacle;

Heartland Fiasco Shows Need for Conflict of Interest Rules, and

TheStreet Recommends

Two Muni Funds Pay the Price for Extreme Risk.) William Nasgovitz, who settled private claims for $14 million ($10 million of which was paid by his insurer), still runs the fund's managing entity, and three of the four independent directors are still in place. (The fourth resigned only late last year.)

Examples of the SEC's failure to recognize and address systemic problems in fund industry abound.

SEC Chairman Levitt frequently complained in the 1990s about misleading fund ads that overemphasized short-term performance. Yet

SEC rules that require funds to include one-year returns, a measure of performance that independent data providers such as Morningstar have generally eschewed.

Rules proposed by the SEC last year in response to advertising abuses don't address the underlying problem of touting short-term performance. For example, the rules will require that current short-term performance be available via toll-free numbers, the idea apparently being that the problem is not that investors are relying on short-term performance, but that the short-term performance on which investors are relying is not current enough. The SEC's proposal entirely misses the point.

Blatantly misleading fund ads continue to appear without any SEC response. For example, an ad for the Strong Ultra Short-Term Income Fund that has appeared for months in a number of financial magazines asks in large, bold typeface: "Has your money fund slowed to a trickle?" The suggestion that a bond fund should replace a virtually risk-free money market fund is inherently misleading, not to mention that the ad violates the express terms of the rule governing fund ads by prominently displaying the fund's 3.49% 30-day yield while burying its 0.83% one-year return in a footnote. This ad was specifically authorized by the National Association of Securities Dealers and has run repeatedly without public objection from the SEC.

The SEC's response to misleading fund ads sends the message that such conduct is acceptable. Fund executives hear and understand this message, and they will inevitably live down to the SEC's standards.

Even on the occasion when the SEC has taken action, its commitment to high standards has been underwhelming. For example, in 1999 the SEC sued the Van Kampen Growth Fund for advertising its one-year return, 61.99%, without disclosing that the fund's performance resulted from its having been

stuffed with hot IPOs.

Before the offending ads ran, an article had appeared in the TheStreet.com noting the fund's heavy reliance on hot IPOs, and the fund directors had been briefed on this issue. With red flags waving left and right, the directors did nothing, yet the SEC's message was that they would not be held accountable. Ironically, one of the directors was subsequently selected by the Mutual Fund Directors Council, an SEC-sponsored group, to appear on a conference panel addressing board oversight of fund performance.

In the 1990s, directors of funds managed by Louis Navellier and Donald Yacktman attempted to exercise their legal right to fire the manager. (Check out these stories:

Navellier Says He's Getting His Fund Back,

Yacktman, Let Us Direct Your Funds, Please!) and

What Now? Sizing up the Yactkman Fracas.)

Mr. Yacktman responded by

threatening the "independent" directors with financial ruin and reminding them that their insurance policy would not cover claims made against them by Mr. Yacktman. Mr. Navellier ultimately sued the independent directors personally. Other than authorizing the Mr. Yachtman directors to use fund assets to solicit proxies, the SEC chose to stand by the sidelines and treat these confrontations as internal corporate battles that did not implicate federal law or policy.

Again, the SEC's message was clear. Independent directors who stand up to fund managers do so at their own personal risk. The SEC's apathy regarding fund directors' responsibilities apparently extends to other boards, as the directors of

Enron, Worldcom, Tyco

and other companies, unlike these companies' executives, have thus far come away unscathed.

For over 30 years, federal law has authorized the SEC to sue a fund's managers and its directors for charging excessive advisory fees. The SEC also can sue a fund's directors if they fail to request and evaluate, and the fund's manager if it fails to provide, information necessary to evaluate the advisory fee. The SEC has never brought either claim, apparently believing that, in the last three decades, no fund has ever charged an excessive fee, and no fund board has ever failed to conduct a complete evaluation of the advisory contract. Of course, neither possibility is plausible. The SEC has simply decided not to exercise its authority.

The SEC Response

If the SEC's response to Mr. Spitzer's announcement is any indication, however, then there is no reason to expect improvement. SEC Chairman William Donaldson stated that Mr. Spitzer's action illustrated the "importance of the SEC's ongoing review of both hedge funds and mutual funds and the SEC's upcoming recommendations regarding improvements and increased disclosure requirements for both."

First, this is not a hedge fund scandal, but a mutual fund scandal, and what's needed is action, not more "ongoing reviews." Second, the action needed has nothing to do with fund disclosure requirements. Mr. Spitzer's action shows that investors need enforcement, not more disclosure.

Perhaps even more telling is Mr. Donaldson's comment that "there is too much money at stake for us to know as little as we do about

hedge funds, in particular, and how they operate." Mr. Donaldson's mistaken view that we should be worried about hedge funds shows that the SEC knows "little" about them. If mutual fund managers feel free to conspire with investors -- whether or not they are hedge funds -- to cheat the funds' shareholders, nothing new that the SEC learns about hedge funds will protect fund shareholders. There is nothing in the nature of hedge funds that was necessary to perpetrate the frauds alleged by Mr. Spitzer. Indeed, you need only read popular Internet bulletin boards on investing to find that arbitrage pricing is a game played by hedge funds and retail investors alike.

None of this suggests that the SEC will fail to follow-up on the fraud uncovered by Mr. Spitzer. The SEC enforcement staff will follow up, and with vigor and competence unmatched among federal enforcers.

But will it recognize and act on the warnings signs of the next scandal? The SEC's inaction with respect to the Strong fund ad described above suggests that it will not. The Strong ad is an extreme example of a number of ads that have touted bond funds' recent returns without adequately disclosing that, like the hot Internet funds of the late 1990s, these funds may be money losers going forward. The SEC enforcement staff is failing to anticipate the role that misleading ads will have played in shareholders' losses in bond funds resulting from a precipitous rise in interest rates.

Another potentially damaging, systemic issue is funds' increasing purchases of IPOs from fund affiliates. In 1997, the

SEC substantially increased the amount of IPOs that funds could buy from their underwriter affiliates -- the same underwriters who were charged in this year's Spitzer settlement with Wall Street. Did these underwriters use their funds to as a captive market during the Internet boom, thereby harming fund shareholders? The SEC can't answer this question because it hasn't tracked the effect of the rule. Perhaps the rule has had no adverse effect at all, but it would be no surprise to see an academic study released that showed that Wall Street underwriters used the rule to take advantage of their funds, thereby igniting another scandal and providing another opportunity for Mr. Spitzer to eat the SEC's lunch.

As the fund industry is no doubt realizing, the SEC enforcement staff's weaknesses pose as great a risk to the fund industry as to fund investors. Unlike much of the financial services industry, the fund industry has an honest reputation that can be destroyed by occurrences of widespread fraud, and that reputation has been the single greatest factor in the industry's growth. The mutual fund brand is now more at risk than ever before, and it cannot be saved without the restoration of an effective enforcement culture at the SEC.

Mercer Bullard, a former SEC Assistant Chief Counsel, is founder and president of Fund Democracy, a fund shareholder advocacy group, and a securities law professor at the University of Mississippi School of Law.