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 (BAC:NYSE - commentary - research) Nation's Funds, Bank One (ONE:NYSE - commentary - research), Janus (JNS:NYSE - commentary - research) and Strong.

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.