Mutual fund data provider Morningstar appears to have made a relatively minor, correctable error regarding data from hedge fund Rock Canyon Top Flight (FUND:TOPFX). However, the company still received a Wells Notice that the Securities and Exchange Commission is investigating its publication of the incorrect total return data. Add to this the backdrop of a possible Morningstar IPO, and you've got the makings of a good drama.

The $19 million Top Flight fund describes itself as a "hedge fund in a mutual fund wrapper." It moves in and out of stocks quickly, and in 2003 it had a turnover rate of 2,686%! While hedge funds have gained in popularity and often have high turnover rates, Dayana Yochim recommends looking for funds with turnover rates of less than 50% -- preferably much lower than that. By comparison, the average index fund has a turnover rate of around 5%.

Top Flight paid a short-term capital gain to investors in December, leading some financial sites to incorrectly report the payout as a decline in the fund's total value. Morningstar, however, correctly recorded the data.

The problem for Morningstar began when an employee of Top Flight sent information providers a chart of the fund's actual and adjusted daily averages. Morningstar changed its data based on the chart and incorrectly showed a 25% increase in value as of the date of the capital gains distribution, putting it at the top of the company's list of funds. (Funds rated with four or five stars by Morningstar tend to attract the most new money.)

Upon seeing the new numbers, Top Flight sent Morningstar a letter saying the information was incorrect, but it sent the same chart as before. Morningstar did not change its data because it was the same as what was in the chart. Two weeks later, the SEC sent Morningstar a letter stating the information was incorrect, and the company then changed the information. Two months later, the SEC sent out the Wells Notice, which the regulatory body uses when it plans to bring a civil action against a company.

Whether or not the SEC actually does bring a civil action depends greatly upon whether investors have been harmed by the actions of the company. Yet, according to Top Flight, not one investor purchased the fund during the time in question, and it believes Morningstar acted with "integrity." So one might assume "no harm, no foul."

But add in that Morningstar filed for an IPO a little more than a month after this, and the water becomes a little muddy. In a Financial-Planning.com article, IPO analyst and Fool contributor Tom Taulli was quoted as questioning whether the Wells Notice has had an effect on the IPO. "I haven't seen any traction on that IPO," he said. "It's just hanging out there." Perhaps the company was waiting for the matter to be settled before continuing with its proposed $100 million offering.

Certainly the IPO market has been improving this year. The 277 potential IPOs filed with the SEC are the most since 674 were filed in 2000. But 45 companies have either postponed or withdrawn their filings so far, up from 42 last year, which was considered the worst year for IPOs since the 1970s.

Or maybe the IPO was more of a "For Sale" sign than one of actual interest in going public. Morningstar is the premier data provider for information on more than 16,000 mutual funds for some 3 million subscribers. Last year, it had revenues of $139.5 million, an annual increase of 27%, but it has been unprofitable for four of the past five years. Much as Lipper Analytical Services was bought by Reuters (NASDAQ:RTRSY) back in the late 1990s, perhaps Morningstar seeks a buyer as well.

Holding Morningstar's feet to the fire over this issue is seen as unique by some observers, who note that the SEC doesn't have explicit jurisdiction over the data provider, even though some of its services are registered as investment advisors. Others welcome the closer scrutiny as it continues the SEC's push on keeping a tight rein on mutual fund practices.

Fool contributor Rich Duprey does not own any of the stocks mentioned in this article.