"I think you should investigate mutual funds," said a clearly nervous female voice.

The anonymous phone message, left with a staff lawyer for New York Attorney General Eliot L. Spitzer, touched off an intense investigation of the mutual fund industry in the summer of 2003. Spitzer, the ambitious prosecutor who had just nailed Wall Street investment banks for sending out biased stock research to investors, was looking for a new target. The $7 trillion mutual fund industry, which had been largely scandal-free for decades, was ripe for exploration, especially given the fees they charge investors for handling their money.

What follows is an inside look at how that investigation developed, based on interviews with Spitzer, his team and his adversaries.

* * *

"Doesn't this woman ever answer her phone?" Noreen Harrington thought to herself in early June 2003 as she tried once again to reach a live person at Spitzer's shop. This was positively the last time she was going to call. She had already left one cryptic message about mutual funds, and if the office couldn't follow it, that was Spitzer's problem. Harrington wanted to clear her conscience, but not enough to leave her number. Surely, five or six attempts to get through were enough.

Surprised when lawyer Lydie Pierre-Louis actually picked up the line, Harrington blurted out, "I'm that woman who was calling you about mutual funds."

"Oh, I'm so glad you called," Harrington remembered Pierre-Louis saying. "We really want to look into this, but we don't understand it. We want you to come in."

No way, Harrington thought. "I can explain it on the phone," she said and started talking in rapid-fire Wall Street fashion about "capacity," "market timing" and after-hours trading. Pierre-Louis was encouraging but sounded confused. Here Harrington was, reporting what she thought was a crime -- that small investors were being ripped off by hedge funds making improper mutual fund trades -- and the lawyer on the other end of the line didn't seem to get it. Eventually, Harrington was persuaded that she was going to have to do more, so she agreed to come into the office.

But when the day came, Harrington almost didn't make it through the lobby of 120 Broadway, the Lower Manhattan building that housed Spitzer's operations. So nervous that she hadn't even put the appointment in her datebook, she grew agitated when she was forced to stand in line to check in with security and almost walked out. Upstairs, Spitzer's lawyers were nearly as anxious. Could she be for real?

They peered down the hall at the elevators, waiting for the first glance of their tipster. When Harrington walked off the elevator, the excitement in the room was palpable. Trim, neatly dressed, with well-groomed graying hair, Harrington looked every inch the former Goldman Sachs trader that she said she was. "That doesn't look like a nut to me," deputy Investment Protection Bureau chief Roger Waldman said, half to himself.

It took the lawyers several interviews to understand and piece together Harrington's story. But in essence, here was what she had to say: She had been working for Edward J. Stern, the younger son of one of New York's richest and toughest business magnates, Leonard Stern, who had built a $3 billion fortune out of pet supplies and real estate. Since 2001, Harrington had helped the Stern family invest its money in a variety of outside hedge funds, largely unregulated investment pools aimed at wealthy people.

Her tip concerned another part of Eddie Stern's business, two internal hedge funds -- known collectively as Canary Capital Management -- that sought to make money by engaging in a practice known as market timing. In English, that meant they were trying to exploit the fact that stock prices changed all the time but mutual funds were priced just once a day. They would move millions of dollars into a particular mutual fund whenever they thought its prices were "stale" -- lagging behind the actual value of the underlying assets -- and then sell their shares as soon as the fund price caught up, usually within a few days.

Dozens of hedge funds were trying this strategy, and many mutual fund managers hated them because the sudden inflows and outflows increased costs and cut into profits for long-term investors. The Canary team stood out from the pack -- it earned a return of more than 25 percent in 2001, a year in which the standard stock indexes all declined.

One evening in 2002, when Harrington happened to be working late, she watched the Canary team begin to celebrate a big score. "We just picked off this fund," Harrington remembered a trader crowing as the group crowded around a computer terminal they referred to as "the box." The whole scene seemed odd to her. Same-day mutual fund trading was supposed to stop at 4 p.m. This was well into the evening. "Who are you trading with? Japan?" she asked. No one answered.

Now on the alert for odd behavior, Harrington noticed that the Canary traders routinely wrote order tickets in the hours between 4 p.m. and 8 p.m. She also began to wonder if the trading was connected to a call Stern had asked her to make to Goldman earlier that year. Eddie wanted to make frequent trades in and out of Goldman's mutual funds, but the honchos there had turned him down. Stern had hoped Harrington could find him another way in.

No dice. "Noreen, you can't do that; it's illegal," Harrington's pals at Goldman had said. "We can't have that kind of turnover in our funds."

She tried to sleuth discreetly. Fellow employee James Nesfield, a former trader now in North Carolina, told her his job was to find "capacity," funds where Stern's team could make their enormous investments and then pull out within days without having to pay a fee, usually known as a redemption charge.

That kind of cat-and-mouse game sounded wrong, so Harrington went directly to Eddie Stern. "Is this legal?" she asked. A lithe and smooth-talking Haverford graduate who could ooze charm when he wanted to, Eddie sidestepped the question. "If the regulators ever look at it, they'll want the mutual funds, not me," he assured Harrington.

By Labor Day 2002, Harrington had left the Stern family business, but she initially kept quiet. She believed Stern's trading was an isolated problem, and she wasn't inclined to jeopardize her own future on Wall Street by rocking the boat. But her next job, with a private investment boutique, brought her into contact with lots of hedge fund managers who openly engaged in market timing. When she asked them about after-hours trading, they tended to tiptoe around the subject rather than reject the idea outright.

She also began to focus on the harm Stern was doing. In April 2003, Harrington's sister, Mary Ellen Corrigan, was so appalled by the shrinking value of her 401(k) retirement account that she sent Noreen a copy of her statement, accompanied by a bitter joke: "I guess I'll have to work forever." On the statement, Harrington recognized the names of several fund companies that she knew had been granting Stern special trading privileges.

She realized with a start that she had been working for a reverse Robin Hood. "Money isn't created," she observed. "It's taken from one person to another. [Stern was making money off] people who had no money."

'A Man on a Mission'

By late May 2003, Harrington was convinced she had to do something. "I'm a senior person in the industry. We're supposed to police ourselves. I don't want people to think we're all crooks," she remembered thinking. But where should she go? For the past few months, the papers had been full of articles about Spitzer and his ambitious "global settlement" that had reformed Wall Street stock research. "He had a profile in the paper that was clear; he was a man on a mission," she said.

The more one of Spitzer's lawyers, David Brown, thought about Harrington's story, the odder it seemed. Why would fund companies allow Stern the privileges Harrington had described? Market timing increased expenses, cutting into returns for long-term investors. Harrington had a ready answer for the fund managers' duplicity: "For the fees, of course," she explained.

Fund companies made money by charging customers a management fee based on a percentage of the assets they invested, and as a fund company's funds grew, so did its income. Market timers, in exchange for permission to jump in and out of individual funds, would usually agree to park a certain amount of cash with the fund company overall, generating a steady stream of fees.

Brown set his law school interns to work, looking for information that would help bolster Harrington's story. One of them hit pay dirt, a mutual fund Internet chat room where investors trolled for "timing capacity" and promised to "pay top dollar." Among the many messages was a November 2002 exchange in which a Seth Fox at fundtiming@hotmail.com announced he was "Looking for timers who need Capacity" and received a Nov. 24 reply from an ejstern@canarycapital.com. "Run a very large timing pool. $2 Bn. Call me if this is for real. Don't waste my time if it isn't. ES." Both the phone number and the e-mail address traced back to the Stern family offices in Secaucus, N.J.

On June 30, 2003, Brown was ready to send out subpoenas. He called Nesfield's North Carolina home first and asked if he would accept a subpoena. Nesfield, who no longer worked for Stern, immediately called his former employer, partly to give him a heads-up and partly to find out if Stern would get him a lawyer.

Stern told Nesfield he was on his own. So the North Carolinian called Brown back and asked what the attorney general's office wanted. "I didn't do anything wrong," Nesfield reasoned. "So why am I going to act like I did? Spitzer has a reputation for doing the right thing." Nesfield then threw 16 boxes of documents and his laptop -- filled with trading records -- into the back of his Ford F-150 pickup and drove the nearly 500 miles to Manhattan.

The Trader Comes In

After getting Nesfield's story, Spitzer's lawyers turned to Andrew Goodwin, a former Canary portfolio manager, who came to their offices with his lawyer. A short and solidly built redhead, Goodwin had been Canary's whiz kid, setting up the computer programs that used statistical models to determine when Stern's team should put its money in or pull it out. He also had been forced out of Canary in December 2001 over a dispute about the way he had handled an e-mail containing salary information. Now the investigators had a former insider who could confirm Harrington's allegations.

Much of what Goodwin said also appeared in the documents that were rolling into the office from Bank of America, Janus Capital Management and the other fund families that Brown had subpoenaed. But it was the 11 hours of interviews with Goodwin that brought these operations to life.

"Absent him stepping up and saying, 'It is real,' I think we still would have had some doubts about the case at that time," Brown recalled. "I was absolutely astounded that the mutual funds would allow this."

As Brown reconstructed events, Canary traders had made hundreds of after-hours mutual fund trades through Bank of America, at first manual trades they phoned in to a broker named Theodore C. Sihpol III and then through Canary's own dedicated computer terminal, which allowed the hedge fund staff to enter trades directly into Bank of America's clearing system until 6:30 p.m. -- this was the "box" that Harrington had seen. To Spitzer's team, the manual trades sounded blatantly deceptive. Sometime before 4 p.m., Canary would call Sihpol with a list of proposed trades, and the broker would write them down on order tickets stamped before 4 p.m. Then, after the markets closed, a Canary employee would call back and tell Sihpol which trades the fund wanted put through, and the broker would put the other order tickets into the wastebasket. (Sihpol was later acquitted of criminal charges but settled with the Securities and Exchange Commission.)

Goodwin had been anxious about the legality of the late trades long before Spitzer's office called. But Stern brushed off his concerns, saying, "I have an expert SEC lawyer who has confirmed that the mutual funds don't like it but we can do it." Eventually, the young trader demanded and received a written guarantee that Canary would cover his legal costs if he were sued for his role in the hedge fund's mutual fund trades.

Even as they interviewed Stern's former employees, Spitzer's lawyers were also applying the screws to the fund companies and the brokers who had worked with Stern. Fresh from the stock analyst investigation, Spitzer felt that the office needed to keep up the pressure and not allow the investigation to lag.

Unlike the investment banks that had been the Spitzer team's last target, the Stern family took the attorney general's office seriously from the outset. Eddie hired Gary Naftalis, a top Manhattan criminal defense attorney who quickly realized the danger his client was in. Though late trading had never been prosecuted, New York's Martin Act of 1921 was so broad that it would probably allow Spitzer to bring criminal charges against Stern.

Within weeks, Naftalis made clear to Spitzer that Stern was interested in a deal. From Spitzer's point of view, Stern had much to offer. He had the goods on dozens of mutual fund firms and brokerages.

When Eddie Stern finally showed up in Spitzer's office on Aug. 5, he was a far cry from the confident son of privilege who had assured Harrington and Goodwin that they had nothing to fear from the regulators. Visibly nervous, Stern lingered in the doorway of the Investment Protection Bureau's 23rd-floor conference room, as if resisting his lawyer's plan for him come in and tell all. When asked questions, he mumbled, looked down and began to sweat.

Naftalis had negotiated a "queen for a day" arrangement, which meant that nothing Stern said to Spitzer's team could be used against him in court unless he lied. But that didn't stop Spitzer's staff from asking the key question.

"Did you do late trading?" they pressed him.

"Yes," Stern replied, his body hunched over, his arms crossed across his chest and his hands cupping his elbows.

The Tennis Deal

Negotiating the outlines of a settlement did not take long. The two sides agreed that Canary would make a total payment of $40 million -- $30 million in restitution to investors in the mutual funds in which Canary had made improper trades and a $10 million penalty -- and Spitzer would agree not to go after the investors who had profited from Canary's trades, including Stern's family and friends. Stern himself was banned from managing mutual fund investments for anyone other than members of his family.

But as Labor Day weekend approached, the deal started coming apart as disagreements arose over the details. Spitzer had been getting briefings from his team, who wanted to get the Stern settlement done, then move on to the mutual funds with the momentum of one deal under their belts and the credibility to press for structural reform.

Spitzer was in North Carolina watching the U.S. Open tennis tournament on television. He sent word to the Canary defense team that if they couldn't work out a deal by the time the match finished, all bets were off. Finally, between 10 and 11 p.m., he and Naftalis were able to cut through the clutter. The were ready to fax each other final language.

But the fax machine at Spitzer's beach house had broken down. He went down the street to a local deli.

"They wondered who I was," Spitzer recalled, but they let him use the fax machine anyway. As a result, the settlement papers that sparked one of the biggest scandals in the history of the mutual fund industry were all stamped "Tommy's Market."