Dec. 9–Canary Capital Management’s in-and-out trading of Invesco mutual funds was so disruptive that Timothy Miller, Invesco’s chief investment officer, insisted in an internal memo that the”bastards” ought to be cut off.

“These guys … are day-trading our funds, and in my case I know they are costing our legitimate shareholders significant performance,” Miller wrote to other Invesco executives in February.

Ten months later, Miller’s memo castigating Canary has taken on ironic proportions: It is being used to bolster a securities fraud case against Invesco. And Canary, a key player in what has become a widening mutual fund industry scandal, has settled allegations against it and is cooperating with regulators.

Profiting by hedge funds such as Canary at the expense of buy-and-hold investors is at the core of the securities fraud cases filed last week against Invesco by New York Attorney General Eliot Spitzer, the Securities and Exchange Commission and Colorado’s attorney general.

The SEC and Spitzer allege that Invesco and Raymond Cunningham, its chief executive officer, committed fraud by permitting favored investors to trade more often than fund rules would lead other shareholders to believe. The “secret” arrangements, as the SEC labeled them, were alleged to have been made to bring Invesco more management fees.

Invesco, whose parent is Atlanta-run Amvescap, has denied any wrongdoing and has noted that market timing, as in-and-out trading is known, is legal.

At the very least, however, company documents contained in the New York lawsuit show how troublesome market timing had become for Invesco as well as for long-term mutual fund investors.

In January, Invesco executive James Lummanick told Cunningham in a memo that the firm “has increased its business risk by granting frequent exceptions to its prospectus policy (effectively changing the policy) without notice to shareholders.”

Lummanick, the firm’s chief compliance officer, wrote in the same memo that while “this waiver benefits market timers, it may not be the same thing as acting ‘in the best interests of the fund and its shareholders.'”

In contrast, in anticipation of the complaints being filed, Amvescap said in late November that it continued “to believe that the actions taken by our funds have been consistent at all times with the best interests of fund shareholders.”

Last week, Amvescap responded to the charges by reiterating that it tried to control market timing by limiting it to certain funds and applying other restrictions.

But Canary apparently did not restrict easily. Cunningham, responding in February to apparent concerns about Canary’s activity, told Invesco executives, “I am certain that we have reach (sic) a point where either our communication with them has broken down or they have chosen to ignore the original parameters we discussed.”

In one fund alone, Canary traded so often that it turned over $10.4 billion in investments in two years, according to the New York complaint.

And Canary wasn’t the only market timer using Invesco funds. According to the SEC’s suit, more than 60 fund holders were allowed to trade more often than fund prospectuses said was permitted.

The Invesco case is the first to be filed related to market timing alone. Market timing, or frequent trading to take advantage of discrepancies between the value of a fund and the values of the stocks it holds, is not illegal. Late trading, or buying and selling funds after 4 p.m. but getting the 4 p.m. price, is illegal.

Other cases filed since Spitzer began an industry investigation this year have dealt with late trading or other abuses.

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