Charles A. Jaffe: Spitzer's legacy lies in the scandals he uncovered

Eliot Spitzer's fall from grace last week brought with it a chance for critics to kick him in the butt on the way out the door. As critics debated his legacy, the consensus seemed to be that he'll be more remembered as "Client No. 9" - his purported designation as a customer of a high-priced escort service - than as the "sheriff of Wall Street," the guy who took on the big investment houses and beat them into submission.

What you are hearing about Spitzer - aside from the tawdry details of his costly trysts - is that he was a bully who stopped at nothing to make his point, but often got nothing out of his most famous cases.

During his time as attorney general, the soon-to-be-resigned governor of New York was able to reach multiple settlements with big investment firms, but he almost never got to the individuals behind the bad research, bid-rigging, and other bad actions that he was desperate to quash.

He was largely responsible for shining a light on the mutual fund rapid-trading scandals in 2003, which critics now say were a lot of noise about almost nothing, since few investors were directly hurt by the actions of the bad guys. Industry insiders cast him as a bully, and the Securities and Exchange Commission said he overstepped his jurisdiction and actually hurt their actions, and those critics are now crowing about his downfall.

The truth, however, is that Spitzer's biggest, most lasting impact came in the fund industry, and in a lot of ways that ordinary investors do not think about and fail to appreciate. Moreover, by uncovering the fund scandals when he did, he saved Wall Street from a much larger problem that, in hindsight, would appear to have been an inevitable consequence of the bad behavior that was happening in the fund world.

To see why, let's revisit some Spitzer history and the lasting outcomes.

In 2003, Spitzer started pursuing a case in which some mutual fund management companies were allowing hedge funds to rapidly trade in and out. If a big day in the United States appeared ready to give foreign markets a power boost, the rapid traders would jump into an international fund moments before the domestic market closed; they would capture the one-day pop and be out again.

The problem is that the funds had rules against quick turnarounds, and that ordinary investors were paying the freight - the trading costs - for every load-in and load-out.

Spitzer incorrectly characterized the bad acts as market timing - there is nothing illegal about market timing, the problem was in giving some investors special trading privileges - but correctly moved to root it out and to get any executive who had a hand in bestowing favors on certain customers.

The Spitzer-inspired actions, and subsequent step-up by an embarrassed SEC, stopped the covert trading cold. That is crucial because 2003 was the last year of a protracted bear market and near the beginning of a huge run in international and emerging-markets stocks.

Investment firms are notorious copycats; if they see one firm making money on a certain strategy, they want to follow suit. With the Street reeling from the bear market, firms would have been anxious to line up the deals, and the impact would have mushroomed. Billions would have been lost as the bad practices continued for several more years.

Spitzer had some wild ideas too. At one point, he suggested that fund boards should have to put management contracts out for bids every year - a patently silly notion, because no firm would ever start a new fund again - but the biggest changes stemmed from issues he brought to light and that other regulators and politicians then pushed along.

Most notably, today's shareholders benefit from stepped-up compliance requirements and disclosure rules. Investors may not recognize that fund directors must now justify why they renewed a manager's contract, but directors realize that the decisions they make - and the reasons for those choices - will be scrutinized by shareholders and, more important, the plaintiffs' bar, looking to make a case. Requiring a majority of a fund's trustees to be independent also came from the fallout of the scandals.

"It's not the numbers in the settlement that matters," said Geoff Bobroff, a consultant, fund director and industry observer whose firm is based in East Greenwich, R.I. "Don't look at the shops that had great compliance to begin with - firms like Vanguard or T. Rowe Price - but look at the small firms that didn't care much. . . . Investors are safer in funds today, and there's no denying that Spitzer had a hand in that."