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Justice Department Joins Bear Stearns Probe

U.S. Attorney James Comey is investigating mutual fund trading.

Federal prosecutors in New York are taking an active role in an investigation into allegations of improper mutual fund trades handled by

Bear Stearns


, according to sources and securities regulatory filings.

People familiar with the investigation said U.S. Attorney James Comey has assigned a senior prosecutor in the securities fraud division to oversee the inquiry, which appears to be in its early stages.


Securities and Exchange Commission

and the

New York Stock Exchange

also are investigating Bear Stearns. New York Attorney General Eliot Spitzer, whose office served a subpoena on Bear Stearns several months ago, is taking a back seat in the inquiry and deferring to the federal prosecutors, sources said.

A Bear Stearns spokesman declined to comment on the investigation. A Comey spokesman also declined to comment.

The focus of the inquiry by federal prosecutors is not entirely clear, but Bear Stearns processed and executed trades for many of the hedge funds and small brokerage firms in the middle of the fast-expanding trading scandal. Two brokerages that used Bear Stearns to process and clear some of their customers' questionable mutual fund trades are

Kaplan Securities


Empire Financial Holding


, both of Florida.

Last week, Bear Stearns fired six employees from its private client group who allegedly helped some of the firm's hedge fund customers trade shares of mutual funds.

Also, a

TheStreet Recommends

recently filed lawsuit in Manhattan federal court alleges that Bear Stearns played a pivotal role in the trading scandal by making it easier for hedge funds and brokerages to engage in improper trading of mutual funds sold by




Putnam Investments

, a division of

Marsh & McLennan

(MMC) - Get Marsh & McLennan Companies, Inc. (MMC) Report

. The lawsuit contends Bear Stearns created and marketed an "electronic routing system" that made it easier for hedge funds and small brokerages to trade shares of mutual funds.

Bear Stearns disclosed the Justice Department's involvement in the mutual fund inquiry on the securities registration forms for four of the brokers it fired last week. The Wall Street firm said it fired the brokers, along with two sales assistants, because of the outside investigations and the findings of its own "internal review into the trading in shares of mutual funds."

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 closeof 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.

Meanwhile, in a separate development in the mutual fund investigation, Spitzer's office is close to filing civil charges against Gary Pilgrim and Harold Baxter, the founding partners of

Pilgrim Baxter & Associates

. Last week, both men resigned from the 21-year-old mutual fund company after it was revealed that Pilgrim was an investor in a hedge fund that market-timed shares of several Pilgrim mutual funds. Sources familiar with the investigation said Spitzer could file charges in a matter of days.