Justice Department Joins Bear Stearns Probe

People familiar with the investigation said the former Bear Stearns employees allegedly helped hedge funds engage in market-timing of mutual fund shares. The sources also said that all the trades arranged by the fired employees were carried out with the knowledge and approval of their supervisors.

One lawyer familiar with the investigation said the fired employees "were being hung out to dry" by Bear Stearns. Other sources said the Wall Street firm didn't have a problem with the activities of the fired employees, until regulators and prosecutors began their inquiry.

Another person familiar with Bear Stearns' operation said a broker in the firm's Chicago office also may have been permitted to market-time mutual fund shares on behalf of some big customers.

Market-timing is an arbitrage strategy in which time differences between the closing of U.S. and foreign exchanges are exploited by savvy traders, who move quickly in and out of mutual fund shares. While market-timing is technically legal, most mutual funds say they prohibit it because this rapid trading by hedge funds and other investors generates added fees and costs and dilutes the value of a fund's holdings.

The people familiar with the investigation said there's no evidence that any of the fired Bear Stearns employees had helped hedge funds engage in late trading, a more serious offense. In the eyes of regulators, late trading is violation of federal securities laws because it permits favored customers to buy or cancel an order to buy shares of mutual funds after the close of the trading day. The late trades enable customers to take advantage of late-breaking, market-moving news, an opportunity denied to most other investors.

But sources said prosecutors and regulators believe others at Bear Stearns may have permitted hedge funds to engage in late trading. Bear Stearns has said its internal investigation is continuing.