(FORTUNE Magazine) – IN THE FALL OF 2003, AS THE MUTUAL fund world reeled from a series of widening scandals, Morningstar decided to assert its moral authority. As the self-appointed guardian of the average investor, the Chicago investment research firm used its popular website to rail against the fund companies implicated in the misdeeds and urged shareholders immediately to sell their stakes in the enterprises. Best known for rating the performance of mutual funds, Morningstar launched new fiduciary ratings to grade funds on the efficacy of their corporate governance. Essentially the 20-year-old company began to sell itself, at least in part, as a judge of integrity.

Now Morningstar's own reputation for integrity is on the line. The company is the subject of two government investigations--one by the Securities and Exchange Commission and the other by New York attorney general Eliot Spitzer. According to Morningstar, the SEC inquiry, which began in the spring of 2004, deals with erroneous fund-performance data that the company posted on its website and failed to correct for nearly two weeks after being alerted to the problem. Morningstar says Spitzer's subpoena, which it received in mid-December, concerns retirement-plan services it provides on behalf of large institutions. But FORTUNE has uncovered new details that suggest both investigations may be broader than previously reported.

For Morningstar, the scrutiny could not come at a worse time. Surprisingly small, with just 830 employees and $139 million in revenue, the firm has lost nearly $80 million over the past five years. In May, Morningstar filed for an initial public offering, which it hopes will raise at least $100 million to fund new initiatives. Now, with the specter of civil and criminal charges looming, the IPO appears to be in jeopardy.

Although distinct, the two government investigations both touch on a potentially troubling aspect of Morningstar's business: the company's burgeoning financial relationships with the same mutual funds it rates. Morningstar wields tremendous influence over America's $7.4 trillion mutual fund industry. Academic studies have demonstrated a direct correlation between the company's easy-to-grasp star ratings and mutual fund flows. In 2003, for example, funds that received Morningstar's coveted four- and five-star grades (those with the best medium- and long-term performance records) attracted $215 billion in new investment, while funds that received three stars or fewer saw $50 billion go out the door.

Morningstar, meanwhile, has become increasingly reliant on the income it gets for selling its data, research, and expertise to large institutions, including mutual funds. In 2003 institutional sales accounted for 43% of the company's revenues, compared with just 25% from consumer ratings and research.

Morningstar declined all interviews with FORTUNE for this article except to specifically address the government investigations, citing quiet-period restrictions that precede an IPO. But dozens of conversations with former employees, industry experts, and mutual fund executives reveal a picture of a firm that has never fully made the jump from great idea to great company, and has struggled to find a way to capitalize on its valuable brand. The firm's leadership, particularly founder and chief executive Joe Mansueto, has clung to the same make-it-up-as-we-go-along spirit that fostered creativity when the company was a scrappy startup. And that lack of definition and discipline in its business plan has contributed to its current troubles.

In 1984, Mansueto launched Morningstar with a revolutionary idea: to provide small investors research and analysis about the neglected area of mutual funds. The 27-year-old entrepreneur's goal was to cover funds the way newspapers did sports, with statistics, rankings, and interviews with the participants--in this case the fund managers. It was a winning formula, and the timing couldn't have been better. In 1984 there was just $371 billion invested in roughly 1,200 U.S. mutual funds. By 2000 that amount had swelled to nearly $7 trillion in more than 8,100 funds.

Mansueto surrounded himself with bright young employees who shared his passion. Most were liberal arts graduates from the University of Chicago, who Mansueto believed were better equipped than business school grads to pursue Morningstar's journalistic approach to investment research. "People really thought they were adding value to society," says a former Morningstar fund analyst. "It wasn't just a bunch of greedy Wall Street people." One of his first hires was Don Phillips, who had been working on a Ph.D. in English. Articulate and charismatic, Phillips became one of the most frequently quoted figures in the business press (including FORTUNE).

Morningstar quickly outpaced more established competitors, such as Lipper Analytical Services and Value Line, for the affections of the investing public, and its star ratings became the benchmark for both investors and fund managers. "They came out of nowhere in an industry where the research had been very shabby, and created a new standard," says a prominent fund manager, who spoke on condition of anonymity. "All the other companies were forced get better."

Citing fatigue, Mansueto stepped down as CEO in 1996 and chose Phillips as his replacement. At the time, the Internet was raising the small firm's profile to a much higher level. The very creation of a website, of course, made its analysis easily available to a wide audience. And spurred by the fear that a high-tech upstart or an established Internet player like AOL could extinguish its business overnight, Morningstar began to transform its operations radically. The firm invested millions in a spate of new initiatives, many aimed at large institutions such as mutual fund companies, brokerage firms, and insurers. Morningstar sold subscriptions to its databases and launched institutional consulting and retirement-planning businesses. It also introduced Advisor Workstation, an advanced, web-based version of Principia, the successful software package of stock and fund data it had sold to financial planners since 1991. The new product was geared toward advisors at large brokerage houses. From October 1999 to October 2000, the staff grew from 520 to 830.

One seemingly obvious move Morningstar did not make was to cash in by going public in the booming IPO market. Mansueto has said he preferred to avoid the distractions, particularly in such an overheated environment. Whatever the reason, in 1999 Morningstar instead accepted a $91 million investment from Japanese venture capital firm Softbank, which already knew Morningstar from a joint venture with its Japanese subsidiary. (Softbank received a 20% stake in the firm, and Mansueto kept the rest, except for a small portion dedicated to employee stock options.)

To manage the rapid growth, Phillips broke with the firm's long-held practice of hiring from within and brought in a team of experienced managers, many from the fund industry, such as Tim Armour of Stein Roe and Jim Wironen from Fidelity. The new executives quickly observed what the company's income statement had shown for some time: Morningstar's prospects rested on its ability to develop large institutional customers, not the small investors that had defined its original mission. Wironen, in particular, worked on developing new products for big fund companies and investment banks.

But the new team didn't get the chance to carry out its vision. Former executives say a power struggle developed between the new management and the old guard--longtime executives such as retail head Catherine Odelbo and CTO Tao Huang--who were unaccustomed to taking orders from outsiders. "It became the old Morningstar vs. the new," says one former executive, "and the organism rejected the implants."

In October 2000, Mansueto demoted Phillips and Armour, fired the rest of the executive team, and reinstalled himself as CEO. At the time, the explanation was that Morningstar's spending had grown out of control, a rationale that certainly had some truth to it. In the 14 months before Mansueto's return, Morningstar burned through $40 million of the Softbank investment, much of it on technology upgrades and consumer marketing for the website. But several former executives wonder if Mansueto simply blanched at the pace with which his creation was changing.

In Phillips's place, Mansueto promoted Huang, who assumed the title of COO. A classic American immigrant success story, Huang arrived in New York from China in 1987 at the age of 25 and began his career as a bicycle delivery man for a Chinese restaurant. After getting a master's in computer science, Huang went to work for Morningstar in the late 1980s.

Several former employees describe Huang as a run-and-gun programmer, someone who didn't stop to document his work because it slowed down the process. "There was a fear that the thing was a real Krakatua," says one former executive, referring to the company's database. "The database had been bad for a long time," says another former executive, who left Morningstar in 2001. "Parts of it were antiquated, overloaded. It's inexplicable that a company whose whole revenue stream depended on the quality of its data wasn't more rigorous." The executive questions whether Huang's control over technology contributed to Morningstar's current data problems. Morningstar would not make Huang available for comment.

The incident the SEC is investigating surfaced in February, when Jonathan Ferrell, the portfolio manager of the Rock Canyon Top Growth Fund, noticed that Morningstar had mistakenly recorded the 25% dividend he paid out to shareholders as a loss. But when his transfer agent reported the problem to Morningstar, the company misunderstood the problem and exacerbated it, adding 25% to Rock Canyon's annual return and pushing it to the top of its category. Despite several attempts to persuade Morningstar to correct the problem, the erroneous data remained on the site for 12 days.

Although the Rock Canyon error appears to be inadvertent, it is not isolated. Within the industry, the company has a history of data problems. Since July 2003, the Wall Street Journal and the New York Times have printed three corrections they attributed to mistakes in Morningstar data. And an article published last summer in the Journal of Portfolio Manage-ment reported significant problems with Morningstar's historical data--"The moral is: Do not attempt a study of this sort without data that is better than Morningstar's." Since it publicized the SEC inquiry in September, Morningstar has taken steps to shore up its data. The company now has a corrections page on its website, which averages about one or two entries a day.

But there are indications that the SEC may be investigating more than data errors. A Morningstar spokesperson acknowledged to FORTUNE that the agency is conducting a "routine examination" of two of the company's business units--Morningstar Associates, which recommends funds for 401(k) plans and advises investors on how to allocate their assets, and Morningstar Investment Services, a registered broker. The SEC didn't respond to requests for comment, but sources tell FORTUNE the examination is part of a larger investigation of the role of middlemen in the retirement and annuities business.

According to sources with knowledge of Spitzer's subpoena, the attorney general's interest in Morningstar arose as a result of an inquiry into a retirement product sold by two large insurance companies, which are clients of Morningstar Associates. Spitzer is looking into Morningstar Associates' role in what a source calls an "unsavory product," including whether fund companies may have paid Morningstar to recommend their funds over those of other firms. The investigation is still in its early stages, but a source says, "This is the kind of problematic structure we've seen issues with in the past."

Mansueto is adamant that his firm is above reproach. "Our only fee comes from the plan provider," he says. "We are not getting anything from the funds we include in our [recommended] lineups." Morningstar has been criticized for potential conflicts of interest before--in 2002 it accepted an undisclosed fee from Fidelity to provide research to the fund giant's customers. But even former executives critical of Morningstar doubt the firm would jeopardize its reputation--and its entire business--with the sort of behavior being investigated by Spitzer's office. "The kind of people working there would never do such a thing," says Lillian Goldthwaite, a mutual fund consultant employed by the firm until 2002. "But when you set out to be a white knight, you're asking for people to inspect your whiteness."

Ironically, Morningstar's latest growth plan, a push into stock research, was created after an earlier investigation by the New York attorney general. In the "Spitzer settlement" of 2003, ten of the world's largest investment banks agreed to pay $432.5 million over five years to fund independent equity research to settle a lawsuit charging them with improperly shaping their analysis to favor their investment-banking clients. Morningstar was selected to provide research to five of the banks, including Merrill Lynch and Goldman Sachs. The firm has invested heavily in the effort and now employs nearly three times as many stock researchers as fund analysts. But industry experts don't expect the contract to be more than marginally profitable and say it won't solve the company's long-term problems.

Morningstar's future almost certainly depends on expanding its institutional services business. And if it can manage to pull off an IPO, the cash infusion may give the company the flexibility to get there. But without an overhaul of its basic model, Morningstar will have to continue straddling the line between its original mission of serving individual investors and serving its own self-interest. In the past when times got tough, the company always had one thing to fall back on: its unimpeachable reputation. In the days ahead, that may not be so easy.