“The mutual-fund scandal is spreading, as it becomes clear that players throughout the $7 trillion industry could face scrutiny for improper practices that are turning out to be surprisingly common,” writes Tom Lauricella in today’s Wall Street Journal.

“On Thursday, Massachusetts securities regulators signaled that they are investigating whether employees at three big mutual-fund companies — Fidelity Investments, Morgan Stanley and Franklin Resources Inc. — helped brokers get around prohibitions on short-term trading in their funds. The same day, state prosecutors in New York who have spearheaded a growing criminal investigation of the fund business, notched their first conviction of a mutual-fund executive: a former senior official with Fred Alger Management Inc., who pleaded guilty to obstructing the probe.”

“New York Attorney General Eliot Spitzer, having earlier forced changes in the way analysts at brokerage firms operate, now says he intends to use the mutual-fund investigation to clean up another part of the financial world that has favored large clients at the expense of smaller ones, including millions of workers and retirees. The Securities and Exchange Commission, scrambling to keep up with him, as it did during the investigation of Wall Street analysts, is now filing civil suits of its own and is considering possible new rules aimed at preventing misbehavior in mutual-fund trading.”

“Industry heads have begun to roll. Top mutual-fund executives at Bank of America Corp. and Bank One Corp. have lost their jobs because of allegations of questionable rapid trading at those firms. Alliance Capital Management Holdings LP suspended a veteran portfolio manager who ran one of the country’s largest technology-stock funds.”

“The widening debacle — which could shake investor confidence and lead to significant changes in mutual-fund rules — is rooted in a paradox that has dogged the industry since its birth nearly 80 years ago. The central attraction of mutual funds is that they offer the opportunity to buy shares in a single investment that reflects the composite value of dozens, or even hundreds, of individual securities.”

“The chance for rapid speculative profits arises from the common mutual-fund practice of assigning a value to fund shares only once a day, usually at 4 p.m. Eastern time. But the value of the securities those fund shares represent changes continuously. That means that fund-share prices often are out-of-sync with the underlying assets — a discrepancy that big, sophisticated investors can exploit. Technological advances and the globalization of markets have opened many more such opportunities.”

“The big investors’ quick profits from these games ultimately come out of the pockets of longer-term shareholders. Regulators and class-action lawyers are expected to try to recover these shareholder losses in legal actions that could cost fund companies hundreds of millions of dollars.”

“The mutual-fund industry has wrestled with the pricing paradox for generations. In the 1930s, many mutual funds effectively had two prices: one that was public and another, more-up-to-date one that was made known hours before it was published to certain big investors. Those in the know could make quick profits because they knew where fund prices were headed. The Investment Company Act of 1940 eliminated this blatant unfairness by requiring funds to stick to a single public price, among other rules that created the modern mutual-fund industry.”