Bear Stearns ( BSC) is emerging as a critical player in the fast-expanding mutual fund trading investigation, according to sources and court documents.

The big investment bank, which previously reported receiving subpoenas from investigators, is drawing scrutiny from regulators because it processed and cleared trades for a number of small broker-dealers that may have permitted hedge funds to engage in improper trading of mutual funds.

Two brokerages under regulatory scrutiny that used Bear Stearns to process and clear some of their customers' mutual fund trades are Kaplan Securities and Empire Financial Holding ( EFH), both of Florida.

But beyond clearing and processing trades for mutual fund traders, Bear Stearns might have given traders the tools to carry out those potentially improper transactions, a lawsuit alleges.

A recent lawsuit alleges that Bear created and marketed an "electronic routing system" that made it easier for hedge funds and small brokerages to trade shares of mutual funds. The lawsuit alleges that Bear's trading platform was used to permit hedge funds and brokerages to engage in both market-timing and late trading, the two main offenses regulators are investigating.

The mutual fund trading platform apparently was a lucrative venture for Bear Stearns. The lawsuit contends Bear Stearns "generated substantial revenues and profits from participating in the illegal conduct" of the traders by collecting a commission on each trade executed.

The class-action lawsuit filed in Manhattan federal court specifically alleges that Bear was at the center of much of the improper trading activity that investigators have uncovered in mutual funds sold by Janus ( JNS) and Putnam Investments, a division of Marsh & McClennan ( MMC).

"We think this is one of the most egregious cases of market-timing and late trading, and documents an incestuous relationships among these players," said Andrew Friedman, an attorney with Bonnett Fairbourn Friedman & Balint in Phoenix. "There is a shocking level of mutual benefits that were reaped by all the defendants to the detriment of the plaintiffs' class."

Market-timing is an arbitrage strategy in which time differences between the closing of U.S. and foreign exchanges are exploited. While market-timing is technically legal, most mutual funds say they prohibit it because the rapid in-and-out trading by hedge funds and other investors can dilute the value of a fund's holdings and hurt other investors. That's one reason regulators are cracking down on funds that permitted some investors to engage in market-timing.

Late-trading is an even more serious offense, because it's an activity in which a mutual fund company permits a favored customer to buy shares that were priced prior to the release of market-moving news, giving the investors an unfair advantage.

It appears market-timing and late trading became popular activities on Wall Street the past few years, as fast-money investors such as hedge funds tried to take advantage of the fact that mutual fund shares are priced just once a day, after the market's close.

A Bear Stearns spokesman declined to comment. The company's attorney, Lewis Liman, a partner at Cleary Gottlieb Steen & Hamilton and a former federal prosecutor, could not be reached for comment.

A spokesman for New York Attorney General Eliot Spitzer, whose office served a subpoena on Bear Stearns, also wouldn't comment. Also mum was the Securities and Exchange Commission, which has asked Bear Stearns to voluntarily turn over information about its involvement in mutual fund trading.

Bear Stearns, meanwhile, may not be the only Wall Street firm with a trade-clearing operation that may be coming under scrutiny.

On Wednesday, Bank of New York ( BK), which has a major clearing business, said "various governmental and self-regulatory agencies have sought information from it" with regard to the mutual fund investigations. Bank of New York had been the clearing firm for D.C. Capital, a small Long Island, N.Y., brokerage that recently received a subpoena from Spitzer's office. Bear Stearns recently became the brokerage's clearing firm, according to a person familiar with the investigation.

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) 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.

The lawsuit also contends Empire Financial used the Bear Stearns trading platform to transmit its customers' mutual fund trades. Empire officials didn't return several telephone calls.

Empire Financial, which operates a small online brokerage business, said last week that the SEC served a subpoena on the company and on four employees in connection with the mutual fund trading investigation. Empire previously has said that Canary Capital was one of its mutual fund customers but that all of the hedge fund's trades were proper.

A person familiar with the investigation said Millennium also was a customer of Empire Financial. Another person familiar with Empire Financial said it had similar mutual fund trading arrangements with a number of hedge funds and that those deals were a profitable business for the firm.

Besides Bear Stearns, the lawsuit also names Canary, Millennium, Empire Financial, Janus and Putnam as defendants. The lawsuit was filed by lawyers on behalf of Michael Pflugrath, an investor in several Janus and Putnam funds.

The lawsuit alleges that Bear Stearns' trading platform made it particularly easy for hedge funds and brokers to engage in late trading in shares of mutual funds. In some instances, customers were able to enter orders to buy stocks up until 8 p.m. ET, well after the 4 p.m. close of trading. The trading platform was also used to cancel buy orders, so customers could wait to assess the impact of some late-breaking news on the market.

Late trading has emerged as one of the most serious offenses prosecutors and regulators are examining in the quickly expanding investigation into the $7 trillion mutual fund industry. But it's possible Bear Stearns and its brokerage customers could have a valid defense to some of the allegations in the lawsuit.

That's because the issue of what constitutes late trading is not as clear-cut as it's been made out to be. In fact, has previously reported that a number of high-powered lawyers have written legal opinions for their brokerage clients saying the regulation that's supposed to bar late trading may actually permit some trades to take place up until 5:30 p.m. -- 90 minutes after the markets have closed.

The legal opinions, meanwhile, are said to focus on what some see as a potential loophole in the securities regulation that's supposed to prohibit late trading -- the "price forward rule." These opinions point out that the regulation never states that all orders to buy or sell mutual fund shares must be submitted to the fund company by the 4 p.m. close of the trading day.

This omission in the price forward rule may leave the door open for late trading through a broker intermediary, as long as it takes place before a mutual fund company calculates that day's net asset value, or NAV, for the shares of a particular fund. Many mutual funds don't actually calculate the NAVs for their funds until 5:30 p.m.

An attorney familiar with this legal thinking said that because few mutual funds are actually priced at 4 p.m., it's debatable whether that's the true deadline for submitting all orders to buy and sell. Indeed, the mutual fund industry itself has acknowledged implicitly that the price forward rule prohibition on late trading may not be as airtight as prosecutors contend.

In fact, an agreement the Canary hedge fund had with Kaplan Securities appears to have tried to take advantage of this 90-minute late-trading window. Under the agreement, Canary had to submit a list of mutual fund trades to Kaplan by 2:30 p.m. each day, but Canary had until 4:30 p.m. to either confirm or cancel those trades.

Presumably, Canary was able to use the half-hour after the market's close to determine whether any late-breaking news would have an impact on the shares of the funds it wanted to purchase.

Bear Stearns, according to a copy of the agreement, was the clearing firm for all those trades. The agreement states: "Kaplan & Co. will function as the broker in regards to arranging, on a best-efforts basis, market-timing agreements with Bear Stearns and/or mutual fund companies."

An official for Kaplan said the company believes all its activities did not violate any securities regulations.

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