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The learning curve for new investors used to be purely financial. These days, you need a law degree to understand what's going on in your portfolio.

Amid the widening mutual fund investigation launched by New York State Attorney General Eliot Spitzer and the

Securities and Exchange Commission

, here's a crash course in the legal intricacies of when unethical behavior becomes downright illegal.

Spitzer's probe began with allegations of late trading, and has already resulted in two criminal convictions. Late trading is an expressly illegal practice in which favored clients are allowed to purchase mutual fund shares after the market's close, but pay the 4 p.m. ET close price. (Mutual fund shares are valued only once a day.) That allows the client to take advantage of after-market price swings, a practice most commonly used in international funds as foreign companies announce material news at odd hours. (Say


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announces some good news after the U.S. markets close. A late trader would purchase shares in a fund likely to benefit from that good news at the market's open.)

The more confusing issue for investors, though, is that of market-timing. Several funds and their executives are under investigation for this active-trading practice -- an unethical but technically legal practice that increases the churn in a fund, dilutes the fund's value and directly skims profits off the top and away from long-term investors. While market-timing is not illegal

per se

, in practice it can quickly cross the line from unethical to actual fraud.

Market-timing is an arbitrage strategy that allows traders to take advantage of the time differences between the closing of U.S. and foreign exchanges. The SEC has identified at least 40 mutual fund families that permitted outside investors to engage in market-timing. Most mutual funds say they prohibit market-timing -- and it's in the language of that claim that makes or breaks these charges.

If a fund states in its public documents -- such as its prospectus -- that it discourages market-timing and then is found to have actually permitted it (or even encouraged it, as in the alleged

case of

Strong Financial's

chairman Richard Strong), that's a breach of fiduciary duty, says John Coffee, a professor at Columbia University's law school.

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A heavier wallop -- which can be delivered civilly or criminally -- is the charge of insider trading. Generally levied on the likes of corporate moguls such as former Chief Executive Sam Waskal of



, fund executives aren't thought to have the material and nonpublic information used to profit from in insider-trading schemes, but it's certainly possible for them to run afoul of this law. "If you know through your position with a fund company nonpublic and material information that you profit from, that's insider trading," Coffee says. "Regardless of how uncommon it may be."

Spitzer is able to bring civil or criminal charges -- or both -- under New York State law. The SEC, as a regulatory body, can bring only civil charges. Federal criminal charges must be brought by the Justice Department.

Putnam Investments, a unit of

Marsh & McLennan

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, is the first mutual fund family to be

charged in the scandal. Other firms implicated in the market-timing and/or late trading scandal include

Janus Capital Management



Fred Alger Management


Alliance Capital

and brokers

Merrill Lynch




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Salomon Smith Barney.

Advantages to Civil Suits

There are advantages to bringing a civil suit rather than (or simply ahead of) a criminal trial, Coffee says. "These are complicated cases to bring before a jury," he says. "Criminal cases are easier won if you can go in there and say that the SEC has already deemed this behavior a breach of fiduciary duty or insider trading."

Also -- just like on

Law & Order

-- very often a civil suit can be used to procure needed information for a continuing investigation. That's likely why Spitzer settled with hedge fund Canary Investment Partners for $40 million and no admission of guilt, according to Carl Frischling, an attorney with Kramer, Levin, Naftalis & Frankel. "He wanted information and he got it," Frischling says. "It's no different from a criminal proceeding. If you cooperate, you'll get a reduced sentence."

Don't Count Your Reparations Before They're Sent

If the case is proved or settled successfully, any prosecutor can require the disgorgement of profits -- which simply means any money made via late trading gets returned to shareholders. Indeed, Strong and Janus have both already announced that they'll take such measures themselves. Additionally, a jury can award punitive damages in a civil trial, and the SEC can assess a fine, which is punitive in nature. But no matter how damning the case against these fund companies seems, investors shouldn't spend that money just yet -- it'll be a long time coming.

And how the returned funds will be disseminated is a matter of some debate. Investors who are part of a class-action suit will be able to make their claim on the returned funds, even if they no longer hold shares. The calculus gets a bit tricky, but essentially if you owned 1% of the fund, you're entitled to 1% of the damages, after legal fees and other expenses are subtracted.

The funds' boards will likely lobby to have any disgorged profits simply returned to the funds, which would mean only current shareholders would benefit. Since there's no precedent for this type of fund scandal, it remains unclear how returned funds will be handled.