A small group of frontline employees in Bear Stearns' ( BSC) stock-clearing operation has emerged as a focal point in the government's ongoing investigation of how clients of the Wall Street firm were able to engage in abusive mutual fund trading.

The group, informally dubbed the "timing desk" inside the brokerage, wasn't high-ranking executives, but operations specialists who processed mutual fund trades submitted to the firm's giant clearing operation. The group was occasionally targeted by mutual fund companies complaining about market-timing by Bear Stearns clients.

In August 2002, for instance, a Boston-based mutual fund company sent an email to the Bear Stearns group threatening to block future trades if Bear Stearns didn't take action against customers who were making abusive trades. A source described the email to TheStreet.com on condition that the fund company not be identified.

The scrutiny of the timing desk comes as federal prosecutors in New York and regulators at the Securities and Exchange Commission step up their investigation of Bear Stearns' clearing operation, which is the biggest on Wall Street. The Wall Street Journal last week reported that Bear Stearns dismissed at least three clearing employees -- two of them managing directors -- for failing to follow the firm's policies on mutual fund trading.

People familiar with the inquiry say prosecutors and regulators are trying to determine whether Bear Stearns may have aided and abetted the abusive trading by failing to stop it. Investigators also looking into allegations that Bear Stearns permitted brokerage customers and some hedge funds to engage in illegal late-trading.

Market-timing is the term for a shady strategy in which mutual fund shares are bought and sold frequently in order to profit from price differences in different markets. It's harmful for the vast majority of mutual fund investors because it can dilute the value of a fund by driving up trading and administrative costs.

Late trading is a more serious offense. It involves permitting a favored customer to buy shares of a mutual fund after their 4 p.m. closing price in order to take advantage of late-breaking market-moving news.

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

But people familiar with Bear's position say the firm believes it has a number of defenses to allegations that it didn't do enough to stop abusive trading on its clearing platform.

These people note that market-timing is legal and that the main obligation for blocking abusive trading rests with the mutual fund companies and the small brokerages that actually place the trades for their hedge fund customers. These people also point out that Bear Stearns did take steps to stop abusive trading when it was brought to its attention.

As for allegations of late trading, people familiar with Bear Stearns say the firm's attorneys advised it that some after-hours trading might be permissible. The lawyers reportedly advised Bear Stearns that it technically could accept trades up until 5:30 p.m. -- the time at which most mutual fund companies calculates that day's net asset value.

But from interviews with a number of people familiar with the investigation, it appears Bear Stearns often practiced selective deterrence when it came to abusive mutual fund trading.

Prior to 2001, people say Bear Stearns' clearing platform had an open door policy for small brokers with market-timing customers. One person who did not want to be identified says that in the late 1990s, "Bear was known as the place to clear for market-timers."

New Jersey state regulators, in an enforcement action filed in February against Pimco mutual funds, said the Bear Stearns clearing platform was particularly "advantageous for market-timers" because trades could clear within a day rather than the industry's three-day norm. A shorter clearing time made it easier for market-timers to move in and out of a trading position with alacrity.

Some time in 2001, sources say, Bear Stearns began to crack down on some market-timing, following a storm of complaints from mutual fund companies. The Wall Street firm took the action after several mutual fund companies threatened to stop doing business with its brokerage division, and one fund company demanded the right to do an audit of the firm's mutual fund clearing operation.

"They were getting a lot of pressure from mutual fund families to stop timing," one person said.

Sources say a number of small brokerages that had cleared market-timing trades through Bear Stearns suddenly found the door shut. People say one brokerage that Bear Stearns moved to block was Empire Financial ( EFH), a Florida-based brokerage that aggressively promoted itself to investors looking to market-time mutual fund shares.

Officials at Empire could not be reached for comment. But the firm is one of several small brokerages that cleared trades through Bear that have been implicated in the investigation. In November, Empire disclosed that the SEC had served a subpoena on the company and four of its employees in connection with the mutual fund trading investigation.

The doors at Bear Stearns remained open to others, however, including Canary Capital Partners, the New Jersey hedge fund led by Edward Stern that paid a $40 million fine last year over its role in the trading scandal.

"My understanding was that you could keep on doing it but within parameters," said James Nesfield, a former consultant to Canary and Stern. "(Bear) threw out anyone they didn't like, but kept a few like Stern. They went from being an open door for everyone to a more exclusive open door."

In the Pimco action, New Jersey regulators allege that brokers at Brean Murray, a small New York brokerage firm, used the Bear Stearns platform to place numerous market-timing trades for Canary and other clients in 2002.

So far, investors haven't paid much attention to the investigation of Bear Stearns. Shares of the Wall Street firm are up 19% since the TheStreet.com first reported in November that federal prosecutors and regulators were investigating Bear Stearns.

Investors appear to believe that Bear Stearns, which reported blowout first-quarter earnings two weeks ago, can weather any fine that regulators and prosecutors may impose on the firm. But investors should be mindful that it's not just fines Bear Stearns must fear.

In a reaching a settlement with Bank of America ( BAC) over its role in the trading scandal, regulators required the bank to exit the clearing business by year's end. While no one is suggesting regulators want Bear Stearns to divest itself of its clearing business, a possible enforcement action against the firm could extend beyond a financial penalty.

Any new restrictions regulators might impose on Bear Stearns' clearing operation could limit the profitability of a division that accounted for $784 million, or 13%, of the firm's $6 billion in net revenues in 2003.

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