Legal Threat to Us Mutuals

The $7 trillion US mutual fund industry was put under further pressure yesterday as the justice department began its own investigation into improper trading, raising the threat of a federal criminal prosecution.

The fresh inquiry emerged as Bank of America, one of the firms implicated in a lawsuit against the hedge fund Canary Capital Partners last week, moved swiftly to restore confidence in the firm by offering restitution to customers harmed by questionable trading techniques.

James Comey, the justice department's US attorney in Manhattan, has told other regulators he intends to join the investigations into the industry.

The latest scandal to dent the investing public's trust in Wall Street was uncovered by the New York state attorney general, Eliot Spitzer, who alleged that mutual funds were taking kickbacks in exchange for bending the rules to favour Canary over long-term shareholders. Canary agreed to pay $40m to settle the charges but admitted no wrongdoing.

The suit named four funds run by Bank of America, Janus, Bank One and Strong Capital Management. None was charged with wrongdoing.

The investigation will focus on two areas: late trading and market timing. Late trading allows orders after the fund's share price has been set at the close of the New York markets at 4pm.

Market timing allows rapid-fire buying and selling to exploit inefficiencies in the pricing of mutual fund shares, usually only once a day.

Mr Spitzer's office has sent a second wave of subpoenas to other mutual fund firms while the securities and exchange commission, the US markets regulator, has also sent requests for information from dozens of firms.

Bank of America said it would offer "appropriate restitution" to shareholders in its Nations Funds' mutual funds unit.

The bank will hire an outside firm to determine whether shareholders lost money and it said the funds would be reimbursed for all transaction fees from a market-timing agreement with Canary. It is continuing to cooperate with investigations.

Market timing, unlike late trading, is legal but frowned upon and often contrary to mutual funds' prospectuses, which routinely state that they attempt to discourage the activity.