Securities and Exchange Commission Chairman William H. Donaldson criticized the actions of some lawyers in the mutual fund scandal and urged an audience of attorneys “to identify today's issues and prevent them from blossoming into tomorrow's scandals.”

Donaldson, speaking before the Practising Law Institute in Washington late last week, said that honest markets depend on the integrity of those who participate in it, according to Financial-Planning.com

“Some will pursue questionable activity right up to technical conformity with the letter of the law or accounting standards, and some will step over the red line, perhaps with the help of a lawyer or accountant. The success of our mission depends on those of you who do not succumb to those practices,” he said.

He went on, “Similarly, think how much anguish we could have avoided if a few more lawyers had pointed out to their hedge-fund clients that late trading of mutual fund shares is illegal, as are duplicitous market timing and quid pro quo 'sticky asset' arrangements.”

The mutual fund industry was rocked by scandal in late 2003 when it was revealed that some firms traded stocks after hours and knowingly pushed overvalued stocks, among other problems. The SEC has brought 61 cases related to mutual funds, ordering about $1.4 billion to be disgorged and $1 billion to be paid in penalties.

Donaldson said the new requirement that hedge fund advisers register with the SEC is an opportunity for attorneys to encourage their clients to act ethically.

“I hope you will not expend significant time, money, and energy devising structures aimed at evading requirements and trying to achieve an accounting or disclosure result that is 'better' only because it achieves technical compliance with a rule while artfully dodging the rule's purpose,” he said.

Donaldson also discussed rule-making actions the SEC has taken over the last year and a half to identify conflicts. He expressed satisfaction over the new process for selecting directors for mutual fund boards. The chairman and three-quarters of the board must be independent of a fund's management company.

He also said he was frustrated by rules on executive compensation. “One problem is that there has not been good enough disclosure under current rules,” he said. The SEC's Division of Corporation Finance is working on improving and simplifying disclosure, Donaldson reported.

You can read the complete text of Donaldson's speech.