Focus in Fund Scandal Turns to Bear Stearns

Clearing is a largely administrative process in which firms serve as custodians for brokerage accounts and process and execute all trades. Small brokerages often rely on clearing firms to handle the back-office function of processing customer trades, because the operation is both costly and capital-intensive.

Bear Stearns and Bank of New York have two of the biggest clearing operations on Wall Street.

Back in 1999, Bear's clearing operation got in a heap of trouble over its role in the infamous A.R. Baron stock-fraud case that bilked investors out of $75 million. Baron, a now-defunct brokerage firm, used Bear's stock-clearing operation to process transactions in stocks that were manipulated by Baron brokers. Bear paid a $38.5 million fine to the Manhattan district attorney and the SEC to settle an investigation into its role in the fraud.

The scandal led to new rules that require clearing firms to inform regulators of any investor complaints lodged against one of their customers.

Meanwhile, the allegations in the lawsuit that Bear Stearns established a trading platform for hedge funds to engage in market-timing and late trading sounds similar to allegations leveled by investigators against Bank of America(BAC Quote) and Security Trust, a Phoenix-based trust bank. In its $40 million settlement with Canary Capital Management, Spitzer's office alleged that both Bank of America and Security Trust built trading platforms that made it easy for Canary to make illegal trades.

In fact, the lawsuit contends that Canary and Millennium Partners, another hedge fund implicated in the scandal, both used the Bear platform to make some of their trades.

A lawyer for Millennium couldn't be reached for comment. A source familiar with the investigation said Canary didn't actually make any trades on the Bear Stearns system. However, Canary did use Bear Stearns to clear and execute some of its trades.