A regulatory inquiry into allegations of "front-running" at

Knight Trading

(NITE)

, the big Nasdaq market maker, is heating up.

In a corporate filing Tuesday, Knight reported that the

Securities and Exchange Commission

has filed "a formal order of investigation'' into the matter. Knight previously reported that the SEC and the regulatory arm of the NASD were "gathering information concerning the allegation."

Front-running is a form of improper trading. It usually occurs when a trader has advance knowledge that an investor intends to move a big block of shares and seeks to capitalize on that information advantage by making his own trades.

Sources in the regulatory community said an SEC order of investigation is usually filed when it decides it needs to either subpoena documents or testimony in an investigation. The filing does not necessarily mean charges will be filed against a firm.

The SEC investigation stems from an arbitration case filed more than a year ago by a former Knight employee. The employee contends he was forced out of his job in July 2001 because he complained about an "elaborate front-running scheme'' that he'd discovered on Knight's institutional trading desk, according to a copy of the arbitration complaint.

The arbitration and the front-running allegation was first reported last summer by

The Wall Street Journal

. At the time, Knight denied the allegations, and confirmed that it had been cooperating with the securities regulators looking into the matter.

The former Knight employee, Robert Stellato, in the arbitration complaint contends he discussed his concerns about front-running at the trading firm with Kenneth Pasternak, Knight's former chairman and chief executive. Pasternak, along with Knight, is a named defendant in the arbitration.

Stellato's complaint identifies two former Knight traders as being at the center of the alleged front-running scheme. They are brothers, and according to the complaint left Knight in November 2000 -- a few months after he took his concerns to Knight management. One of the brothers now works on the trading desk of another brokerage firm.

The complaint alleges that Stellato found evidence of front-running on at least three occasions in August 2000. It accuses Knight management's "engaged in a cover-up to ensure" that no one found out about the alleged front-running.

Knight's general counsel, John Bluher, said the firm did nothing wrong and has no intention of settling the arbitration case. He said dispute with the former Knight employee is set for an arbitration hearing early next year.

The news that SEC is stepping up its investigation, however, did little damage to Knight's shares. In mid-afternoon trading, the stock was down just 9 cents to $4.69.

Some of the muted reaction is no doubt due to the fact that most of the allegations have been known on the Street for some time. But Knight also is a beaten down company and much of the air was long ago taken out of its sails.

Back in the heyday of the bull market, Knight was one of Wall Street's high-flyers. Trading revenues rolled into the Jersey City, N.J., firm from the explosive popularity of Nasdaq stocks. Knight is the biggest market-maker on the Nasdaq Stock Market.

But the collapse of the Nasdaq has taken a big bite out of Knight's profits. In the most recent quarter, the firm posted a $3.4 million loss.

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