(MONEY Magazine) – The store was jammed with shoppers elbowing one another for turkey, squash and pumpkin pie, when an 80-year-old woman screamed out, "Eliot Spitzer is our hero! He's the only one we can trust!" It was the night before Thanksgiving 2002 at Fairway, a bustling Manhattan supermarket. Joseph Baker was surprised by his acquaintance's outburst--which he'd provoked by telling her that he worked with Spitzer at the New York State attorney general's office--but even more by the reaction around him: heads nodding, people giving the thumbs-up. "It was like a little pep rally," recalls Baker. "Everyone was like, 'Go Eliot, go! You go, boy!'"

Since Spitzer, 44, began his investigation into conflicts of interest on Wall Street two years ago, he has emerged as a populist figure, right out of Frank Capra and Mr. Smith Goes to Washington. It was Spitzer who first targeted Merrill Lynch for issuing suspect stock reports and made public internal e-mail in which analysts openly derided the very stocks that they were recommending. His investigations reinvigorated regulatory activism on the part of the New York Stock Exchange, the National Association of Securities Dealers and the Securities and Exchange Commission. In April he, along with other state attorneys general, the SEC, the NYSE and the NASD secured a $1.4 billion settlement with 10 investment banks.

You don't have to share the Fairway shoppers' adoration of Spitzer to credit him with being the first to expose just how fragile the marriage between Main Street and Wall Street became during the bull market of the late 1990s. But he has also emerged as a lightning rod for critics on both sides: Is regulation of Wall Street too soft? (For all of Spitzer's efforts--and headlines--no one on Wall Street has gone to jail.) Or too harsh? What's the right balance between protecting investors and supporting a free-market environment?

I first met Spitzer in the early 1990s, when I was a reporter at The American Lawyer magazine and he was an ambitious young prosecutor in the Manhattan district attorney's office pursuing a case against the Gambino family. Recently we've had several interviews about those days and these, and what became clear was how similar his pursuits of Wall Street and the Mafia were. While he'd be the last to say that Wall Street and the Mafia were doing the same thing, he's the first to say that they needed the same medicine.

WALTZING WITH THE WISE GUYS

At first blush, Spitzer seems an odd candidate for savior of the little guy. He grew up a child of wealth and privilege, attending Princeton University and Harvard Law School. But he never shied away from a fight. William Taylor, the founding editor of Fast Company magazine and Spitzer's roommate at Princeton, recalls his friend's determination to become the president of the student government as a sophomore: "He campaigned morning, noon and night." Taylor laughs. "I remember waking up in the middle of the night to hear Eliot screaming at the provost over the phone about a food-service workers strike. He was fearless even then."

After graduating from law school, Spitzer clerked for a federal judge and worked in private practice, then headed to the D.A.'s office. As the 32-year-old chief of the labor-racketeering unit, he spearheaded an investigation designed to end the Gambino crime family's stranglehold on the trucking business in New York City's garment industry. His tactic: He set up his own sting operation, manufacturing sweaters, shirts and pants, to gather evidence against the Gambinos.

"Tommy Gambino had tens of millions of dollars in liquid assets," explains Michael Cherkasky, then chief of the investigations division at the D.A.'s office (and today CEO of Kroll, a security consulting firm). "If we just put Tommy in jail, someone would have replaced him in a snap of the fingers....We knew Tommy Gambino was going to be prosecuted in the federal courts and probably would be going to jail anyway, but our focus was to change the industry."

In the end, Spitzer and his crew did just that: Thomas and brother Joseph Gambino pleaded guilty to antitrust charges, paid $12 million in fines and--equally important in Spitzer's eyes--agreed to stay out of the trucking business in the garment industry for good. At the time, Spitzer was criticized for being too soft on the Gambinos, just as he was charged last year with having been too easy on Merrill Lynch when he accepted a $100 million settlement.

"There are always those who second-guess," Spitzer acknowledges. But he remains convinced that "the way to remedy the market failure was to change the rules by which business was being conducted."

"A VERY SOPHISTICATED PLAYER"

That, it turns out, is exactly what Spitzer's been trying to do with Wall Street too. A case against an individual "will disappear into the ether if somebody steps right into the shoes of the defendant and begins doing the same thing," Eliot told me. "If you want to really have an impact and prevent crime...you have to address the structure rather than just the individual who happens to be the pawn of the given moment. You try to change the whole marketplace." He adds that individual Wall Streeters may yet face shareholder suits based on information in the settlement.

This spring's Wall Street settlement is his victory marker. It includes several reforms that could herald a new era: It mandates a clear separation between research and investment banking divisions; analysts will no longer be allowed to solicit business or identify investment banking prospects; and investment bankers will no longer have input into analysts' evaluations and compensation. In addition, the settlement establishes a new mechanism for providing investors with free independent research for five years, as well as objective data on the accuracy of the analysts' performance.

The settlement also bans "spinning," the practice whereby investment firms routinely offered preferential access to valuable IPO shares to officers or directors of public companies from which they sought or obtained investment banking business. "I insisted that spinning be prohibited," Spitzer says. "It will be gone. No director of a publicly traded company will be able to get an allocation of hot stocks. Boom. The whole issue is gone."

But has Spitzer's campaign really succeeded in changing Wall Street for the better? Brad Hintz, who covers the securities industry for Sanford Bernstein, acknowledges that things have changed for analysts. "The idea that equity research analysts can also be investment bankers is over and is never going to come back," he says. "Spitzer has made it clear to the individual investor what the conflicts were. And he did it without causing catastrophic harm to the brokerage industry....This was a very sophisticated player who knew exactly what buttons to push to get things done on the Street."

Other Wall Streeters (none of whom were willing to speak publicly) insist that Spitzer destroyed a workable business model. "What you're going to do now is turn analysts into a relatively low-paying job on Wall Street," says one lawyer who worked at an investment bank for many years. "Who is going to pay for research for retail investors after the five years that the settlement calls for? The failure to manage the conflicts of interest doesn't mean that the system was terrible.... At the end of the day the average retail investor will get much worse research than he or she would have gotten if the system had simply been put back on track."

Not surprisingly, Barbara Roper, director of the Consumer Federation of America's division of investor protection, welcomes the settlement. But she believes much more should be done. "I think the investment bankers and researchers were doing exactly what the CEOs of these firms wanted them to do," she says. "If [the higher-ups] are held personally accountable, then that is going to have a deterrent effect that the structural reforms themselves might not be able to accomplish on their own." Several U.S. senators at a Banking Committee hearing in early May made essentially the same argument.

Neither Spitzer nor Stephen Cutler, director of the SEC's enforcement division and a key figure in the Wall Street settlement, claim that the fines and agreements announced in April make the financial markets entirely safe for individual investors. "There's always risk in the market," admits Cutler. Spitzer echoes that view, urging investors not to let down their guard: "It's your money." Joel Seligman, the dean of the Washington University School of Law, who has just completed a history of the SEC, has an appropriately nuanced assessment of the settlement's impact: "For the foreseeable future you're going to see much more rigor in the recommendation process from analysts," he says. "But it is unrealistic to assume that anything on Wall Street is ever permanently fixed. It just doesn't work that way."

THE FEDS VS. ARTHUR ANDERSEN: "IT WAS A MISTAKE"

Spitzer's preference for structural change over punitive action sets him apart from many prosecutors. Asked about the Department of Justice's handling of Arthur Andersen in the wake of the Enron scandal, he told me, "I think it was a mistake. Destroying a company with 60,000 employees because of the misbehavior of 10 or 15 of them...was an improper prosecutorial decision. The net result was reduced competition in the marketplace for accounting services. It went from the Big Five to the Big Four. I'm not sure who gained by that."

Spitzer's own prosecutorial focus is shifting: He now expects the SEC to take the lead with Wall Street ("I've always said the SEC is the primary regulator"), even as his office continues investigations into specific bankers, hedge funds and fairness opinions (determinations by advisers that the financial terms of a corporate transaction are fair to, say, shareholders of the company being acquired). Increasingly his target for structural change is the pharmaceutical industry. "We're taking an aggressive stance," says Joe Baker, who heads Spitzer's health-care bureau, "not to interfere with a free market but to make sure that the market is really functioning in a way that is fair to consumers."

The difference here, of course, is that Spitzer is hardly the first to the task. ("There's a much greater sharing of the creativity and the litigation" than there was in the initial Wall Street actions, Spitzer says, noting that other states and the Federal Trade Commission have been working this ground.) What made his move against Merrill so momentous--for those on both sides--was his timing and his success in getting the maximum exposure for the infamous e-mail messages.

"All these controversies--the e-mails and so forth--have gotten such wide publicity," comments Henry Hu, a professor of securities law at the University of Texas in Austin. "Even if you're living in a cave you know--even Osama bin Laden knows--the true meaning of 'buy' and 'strong buy.'"

Spitzer may not be everyone's idea of a hero. But his campaign against flawed research has undoubtedly disrupted an unhealthy dynamic on Wall Street. And that's something all investors can cheer.