The fund industry has finally met its match: Federal trial judges. They can't be bought off by special-interest lobbyists. In the coming year they will preside over trials guaranteed to reform the fund industry.

FundDirections (search), a magazine for trustees, directors and other insiders, recently reported that a "new, aggressive and savvy plaintiffs' bar, including attorneys who participated in huge settlements won against the tobacco industry, are now methodically working on a nationwide scale" to challenge the fund industry.

So, as University of South Carolina Law School Prof. John Freeman (search), a former SEC attorney, succinctly put it: "Fund insiders are now running scared. Their special-interest lobby can control Congress, the SEC and the White House, but they can't buy the judges." And the judges don't like what they see.

The background of this incredible turn of events is fascinating: For many decades fund managers have had powerful lobbyists who won special protections from Congress, the SEC and the White House. In fact, since the passage of the Investment Company Act (search) of 1940, fund-industry insiders have taken it for granted that they can run $8 trillion fund industry with impunity, putting their own personal interests ahead of the fiduciary duties of America's 95 million small investors.

So after the Senate killed the Mutual Fund Reform Act in early 2004 I felt that the fund industry's lobby was so powerful, so bullet-proof, that nothing could penetrate and reform it. So when I reviewed two new books by highly respected critics exposing corruption in the industry, it wasn't with any hope they would trigger change.

Fund industry is a 'colossal failure'

One book was "The Battle for the Soul of Capitalism," by Vanguard's founder Jack Bogle (search). His arguments were familiar, after years of reading his speeches and books.

The second was "Unconventional Success" by David Swensen (search), the amazingly successful manager of the Yale University endowment fund (16.1% average annual returns since 1982!). Swensen originally set out to share his experience with average investor. However, he finally concluded that investors would never be able to use his strategies.

Worse yet, Swensen concluded that fund industry conflicts of interest "lead to behaviors that line the pockets of mutual fund managers at the expense of the individual investor;" that the "colossal failure of the fund industry carries serious implications for society, particularly regarding retirement security for America's workers;" and that the industry is "seriously impairing the level of resources available to support future generations." A brutal indictment.

Two powerful attacks by highly respected experts. Unfortunately, these two books merely repeated criticisms we've heard many times before from big guns like former SEC chairman Arthur Levitt in "Take on the Street," and other high-profile critics.

We heard the same indictments, to no avail, during the 2003-04 congressional hearings from Sen. Peter Fitzgerald, author of the Fund Reform Act of 2004, and other critics: Fitzgerald said "the fund industry is the world's largest skimming operation, a $7 trillion trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the nation's household, college and retirement savings."

But that didn't matter! The industry dodged the bullet anyway. Fitzgerald was trumped by the fund industry's special interest "conspiracy," as Bogle called it. After months of hearings, Sen. Richard Shelby, chairman of the Senate Banking Committee, dismissed the reform legislation: "We must be sensitive to the current political environment, in which I believe it will be very difficult to pass a bill."

SEC run by little Chihuahuas

When the Senate killed the reform bill, it handed the responsibility back to the SEC. But since the SEC, like Congress, is also controlled by special interests, that was like throwing the fox back into the henhouse: SEC "professionals are dedicated to protecting the industry's managers, and the industry's managers have an agenda that does not place the fund shareholders first," says Freeman. "The SEC has failed mutual fund investors. [They are] a Chihuahua watchdog, not the Doberman that shareholders need."

So my initial reaction was: So what. Unfortunately, even two great books by Bogle and Swensen will have little effect. The industry lobby is so powerful, protected by a conspiracy of friends in high places in Congress, the SEC and the White House, these books will be old news in a week.

But then I learned the fund-reform movement had shifted to the federal courts, and suddenly, massive changes are almost certain! The industry is in for huge reforms. So fund insiders are running scared because they can't buy off trial judges as they can Congress and the SEC. They are facing a full-court press rivaling the attack on the tobacco industry.

According to Freeman, in the next year you can expect to see more than two dozen cases going to trial in federal courts all over America, against Fidelity, Federated, Franklin-Templeton, MFS, AIM and others. This is significant because they're based on a totally new legal strategy: For two decades excessive-fee cases never got to trial. Industry lawyers routinely got them dismissed based on the Gartenberg vs. Merrill Lynch ruling that essentially said if a fund's expenses were in line with the expenses of similar funds, the fees could not be excessive (no matter how high!).

But now federal judges are letting these new cases go to trial based on a new theory: Plaintiffs argue that the fund industry's explosive growth has generated economies of scale that fund managers are not sharing with all investors. Instead, the benefits are shared primarily with larger investors, or favored institutional clients, or simply pocketed by insiders, all of which is a violation of the fiduciary duties imposed by the 1940 act.

Ironically, when the Senate avoided responsibility by passing the ball back to the harmless Chihuahuas at the SEC, it didn't realize it was also turning loose a couple dozen Dobermans in the plaintiff bar. And the Dobermans started attacking.

Bottom line: The Federal judiciary is now going to do what Congress, the SEC and the White House have long refused to do: Reform a corrupt mutual fund industry.