Securities regulators probing
role in the mutual fund trading scandal are increasingly interested in a back-office manager at the firm's clearing business in determining whether Bear should be the first major Wall Street brokerage to face enforcement action in the investigation.
Regulators are interested in James Delvecchio, the head of operations in Bear's mutual fund clearing unit, because of his intimate view into the trading activity of the hundreds of small brokerages that submitted and cleared their mutual fund trades through Bear, people familiar with the investigation say.
While Delvecchio himself isn't a target of the probe, investigators believe he may have information that could help them decide whether Bear was a bystander to -- or an enabler of -- clients trying to game the fund-pricing system.
Bear Stearns' stock-clearing and trade-processing operation -- one of the largest on Wall Street -- is drawing intense scrutiny from federal securities regulators and federal prosecutors because it was the conduit between scores of mutual fund families and dozens of small brokerages and hedge funds that have been implicated in the far-reaching trading scandal. Investigators are trying to determine whether Bear may have aided and abetted this abusive trading either by turning a blind eye to the activity, or actively assisting the rogue traders.
Over the past several months, lawyers from the
Securities and Exchange Commission
have interviewed a number of former and current Bear Stearns employees and continue to do so. Sources say that while Delvecchio is clearly a possible star witness for the SEC investigation, they would not detail how the SEC came to believe he has information that is valuable or the extent to which he has spoken to regulators. Delvecchio, an operations man with a high-powered New York lawyer representing him, did not answer repeated phone calls from
The investigation is unfolding at a time the SEC has made a preliminary determination to file civil charges against the much smaller trade-processing arm of
over its role in the mutual fund scandal. Sources say the SEC is getting close to making a decision on whether to pursue civil action against Bear Stearns. If the agency does, it would mark a major new salvo in the mutual fund probe, adding a first-tier Wall Street brokerage to the long list of mutual fund managers and hedge funds that have paid a total of $2 billion in settlements so far.
To date, brokerages have largely been ignored in the mutual fund investigation. Bear Stearns has become a target of investigators because of its enormous role in clearing, an arcane but crucial service on Wall Street in which a firm acts as a middleman for parties doing stock and bond transactions. The clearing divisions of big Wall Street firms like Bear are crucial to the hundreds of smaller brokerages -- known as "correspondents" -- that lack the financial resources and back-office muscle to make sure big sales of securities go off smoothly.
Regulators are looking for patterns that would show that however passive Bear's role might have been in clearing trades, its permissiveness -- particularly with big clients -- amounted to an invitation to game the system. Indeed, that allegation was the basis for a class-action lawsuit filed against the firm in November by mutual fund investors who said Bear actually marketed its platform to big-time market timers.
Delvecchio is in a better position than most to know what the firm did or didn't do about abusive trading, because all the mutual fund trading tickets submitted to the firm's clearing desk passed through his office and his team of order clerks.
"Delvecchio and his group are a natural place for investigators to look," says one person familiar with the inquiry who requested anonymity. "They are clearly in the middle and may have lots of information."
James Nesfield, a former consultant to the now infamous Canary Capital Partners hedge fund, which paid a $40 million fine last year over its role in the trading scandal, says: "My understanding of Bear was all things passed by Delvecchio's desk."
Several people familiar with the investigation characterized the role of Delvecchio and his group as that of toll collectors, saying that even if there were systemic violations at Bear Stearns, his team was just carrying out policies put into motion by others. Still, a determination that Bear Stearns should have known its clearing platform was being abused could draw it into a scandal that until now has focused almost exclusively on sophisticated brokerage clients and the mutual fund families they traded.
Delvecchio did not return telephone calls to his office at Bear Stearns. His attorney, Howard Wilson, a former top federal prosecutor in New York and a partner with Proskauer Rose, declined to comment.
People familiar with Bear Stearns say the firm had policies in place to stamp out abusive mutual trading such as market timing and illegal late-trading. In recent months, the firm has dismissed a number of brokers and clearing executives for violating those polices. People familiar with the firm suggest these are isolated incidents and Bear Stearns is not aware of any widespread improper behavior.
Bear Stearns' attorney, Lewis Liman, a former federal prosecutor and a partner with Cleary Gottlieb Steen & Hamilton, didn't return a telephone call.
Market timing, or frequent trading of mutual fund shares, is technically a legal trading strategy. But it is prohibited under most mutual fund prospectuses because it can dilute the value of a portfolio's holdings. Late-trading, meanwhile, is an illegal practice in which someone buys shares of a mutual fund after their 4 p.m. closing price in order to take advantage of late-breaking, market-moving news.
A potential problem for Bear Stearns in its battle with regulators and prosecutors is that its policies for deterring market timing may have been selectively enforced, and that the firm's rules against late-trading were susceptible to abuse, say people familiar with the inquiry.
previously reported that prior to 2001, Bear Stearns' clearing platform was known on Wall Street as
an open door for small brokers with market-timing customers. Bear Stearns began to kick out those customers only after Delvecchio's group received a flood of angry emails from mutual fund companies in which some threatened to stop doing business with Bear Stearns' brokerage division.
This belated crackdown on market timers, however, wasn't comprehensive. Sources say the doors at Bear Stearns allegedly remained open to some big players, including Canary Capital, the New Jersey hedge fund led by Edward Stern that has been a central player in just about every aspect of the investigation into the $7.6 trillion mutual fund industry.
Bear Stearns' enforcement of rules against late-trading weren't much better.
An executive with one small brokerage that does business with Bear says all a trader had to do to get a late order processed at the 4 p.m. price was to vouch to Delvecchio's staff that an investor had placed the trade before 4 p.m. While that customer was never involved in any improper late-trading, he said, the procedures at Bear were ripe for abuse.
After the mutual fund scandal broke last September, Bear Stearns quickly moved to revise its policies on late trades. The firm's clearing desk told its customers that all trades had to be submitted by 4 p.m. in order to be processed at that day's closing prices. Any trades submitted after 4 p.m. would be treated as next-day trades, even if the trade was authorized before 4 p.m.
People familiar with Bear Stearns' thinking don't deny that the old rule to deter late-trading could be violated. They say it wasn't the job of Delvecchio's crew to make sure its clearing customers were telling the truth about the time a trade was placed. It was the responsibility of the firm's clearing customers to guard against any illegal activity. Bear's defenders point to its standard clearing agreement, which requires small brokerages and their customers to abide by all applicable rules, law and regulations.
But people familiar with the inquiry say regulators and prosecutors are skeptical of this see-no-evil, hear-no-evil line of defense. Investigators are trying to determine whether officials at Bear Stearns knew there were rogue traders and brokers who were skirting the rules on late-trading and did nothing to stop it, or worse, aided and abetted the illegal activity.
One allegation being looked at by the SEC and federal prosecutors in New York is whether Bear Stearns officials helped Canary engage in late-trading.
Some critics suggest Bear Stearns' policy on late-trading looks questionable in light of advances in trading technology.
In a 2001 letter obtained by the
, Patrick Maloney, a Bear Stearns managing director and an in-house attorney, suggested the primary reason Bear Stearns allowed clearing customers to submit trades after the 4 p.m. deadline was because of a large "volume of faxes being received at the end of the day."
Maloney explained the deluge of faxes meant that some order tickets were not received by Bear Stearns until after 4 p.m. In light of that technological glitch, he wrote, it was OK for Bear Stearns to process those trades, as long as its brokerage customers had received authorization for those trades prior to the 4 p.m. deadline.
That legal analysis may have been justified in early 2001, when the primary way for brokers to submit orders to Delvecchio's trade-processing group was by sending a fax. But within months of Maloney's letter, Bear Stearns already was moving toward a system by which its brokerage customers could submit orders electronically -- a far faster and more efficient method of communication.
Yet even with that electronic system in place, sources say, Bear Stearns continued to permit brokerages to submit late orders to buy and sell mutual fund shares. In fact, orders often were accepted up until 5:45 p.m. and processed at the 4 p.m. prices, as long as the broker submitting the order said the trade had been authorized before 4 p.m.
A class-action lawsuit filed in November against Bear Stearns charges the firm openly marketed its electronic platform to abusive mutual fund traders and the firm "generated substantial revenues and profits from participating in the illegal conduct." The lawsuit also alleges that some rogue traders were allowed to submit orders to buy or sell mutual shares before 4 p.m. and cancel them after the bell. Bear Stearns, in regulatory filings, has denied the allegations in the lawsuit.
Bear Stearns' repeated denials on late-trading don't sit well with Fred Dietrich, a former brokerage executive who was the recipient of that January 2001 letter from Maloney, and who provided a copy of the letter to
Dietrich's former firm,
, recently won a $25,000 arbitration award against Bear Stearns in a dispute that involved allegations of late-trading.
"It just don't wash," says Dietrich, who charged that Bear Stearns had improperly processed several late mutual funds trades submitted by a former Pentad broker in March 2000. "If they were having such trouble handling all the order flow, they shouldn't have accepted the trades."
In the course of that proceeding, which dates back to a time that most mutual fund trades still were submitted by fax, Bear Stearns was ordered to produce copies of tickets for dozens of mutual fund trades it received and processed after 4 p.m. Dietrich, who lives in Lakeland, Fla., says the tickets revealed that scores of brokerages had been submitting mutual fund trades after the bell.
Time stamps on the tickets, some of which were reviewed by
, showed that some trades were being processed as late as 5 p.m.
Many of the late tickets bore notations such as "Attention Charlie," or, "Talked to Charlie before 4 p.m." Arbitration documents submitted by Bear Stearns reveal that Charlie is a former clerk who was part of Delvecchio's group.