Long before securities regulators began looking into improper trading in the mutual fund industry, Bear Stearns' ( BSC) legal department was addressing the issue of late trading.

A Bear Stearns attorney, in a January 2001 letter to a brokerage customer, acknowledged that "every day" the Wall Street firm's stock-clearing desk received orders to buy and sell shares of mutual funds a few minutes after the 4 p.m. trading deadline, and many of the trades were processed as if they had come in prior to the close of the trading day.

In the letter, a copy of which was obtained by TheStreet.com, the Bear Stearns attorney disputed that the Wall Street firm was doing anything improper in processing these trades for its many small brokerage customers.

"Provided that the order was received by the correspondent from its customer before 4 p.m., Bear Stearns can accept tickets minutes after 4 p.m.," wrote Patrick Maloney, a Bear Stearns in-house attorney and a managing director. ("Correspondent" refers to a brokerage customer of Bear.) He went on to say, "Events such as these happen almost daily."

The letter to Fred Dietrich of Pentad Securities, a former Bear Stearns clearing customer, is by no means a smoking gun for the regulators and federal prosecutors investigating Bear Stearns' role in the mutual fund trading scandal. Maloney sent the letter after Dietrich accused the firm of allowing a former Pentad broker to make several unauthorized late trades shortly after the 4 p.m. deadline.

Indeed, the two-page letter could be seen as the basis for a defense strategy for Bear Stearns. Maloney stresses that Bear Stearns' policy requires clearing customers to submit all mutual fund trades before 4 p.m. The policy, however, often falls short because the clearing operation's mutual fund order desk is frequently inundated with a "volume of faxes being received at the end of the day."

"The letter clearly states that all trades needed to be ordered by the customer and received by the correspondent firm by the market close deadline," says Bear Stearns spokeswoman Elizabeth Ventura.

But the letter, which regulators at the Securities and Exchange Commission are aware of, is significant because it reveals top officials at Bear Stearns knew as far back as three years ago that the firm's clearing arm sometimes received and processed orders to trade mutual funds after 4 p.m. Bear Stearns' stock-clearing desk has emerged as a focal point in the investigation because the firm handled trades for many small brokerages and hedge funds that have been implicated in the late-trading and market-timing scandal.

Late trading is considered a particularly bad offense because it enables 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. Mutual fund companies price their shares once a day based on the 4 p.m. closing prices of the stocks in their portfolios. Any orders received after 4 p.m. are supposed to be valued at the next day's prices to avoid a late trader getting an unfair advantage.

People familiar with the inquiry say regulators and prosecutors aren't particularly interested in questionable trades submitted a few minutes after the 4 p.m. deadline, like those Dietrich was complaining about. Investigators are more focused on trying to determine whether Bear Stearns' clearing desk, despite the stated 4 p.m. policy, allowed some brokerages and customers to submit and cancel trades several hours after the trading deadline.

But Dietrich has been persistent in pursuing his claim that Bear Stearns did something wrong on March 28, 2000, when it executed four mutual fund trades for a former Pentad broker after the 4 p.m. deadline. A stickler for detail, Dietrich fired the broker in May 2000 after learning of the trades and refused to pay the commissions on them.

The broker subsequently filed an arbitration claim against Pentad and Bear Stearns, seeking to collect his commissions and severance for wrongful termination. Bear Stearns ultimately was dismissed from the arbitration but not before it took roughly $50,000 out of Pentad's clearing account to cover its legal costs in the proceeding.

During the arbitration, Dietrich tried to introduce evidence that the broker had made illegal late trades. But the panel gave short shrift to those allegations, most likely because few people in the securities business had heard of late trading before Spitzer announced his settlement with Canary last September. The arbitrators found against Pentad and ordered Dietrich to pay his broker the commissions.

Not satisfied, Dietrich pursued a legal action against Bear Stearns. He filed an arbitration claim against Bear Stearns in March 2003 seeking $2 million in damages. In the complaint, Dietrich, who represented the firm himself, claimed Bear Stearns had no right to take money out of the firm's account to cover its legal costs. He once again argued that Bear Stearns had permitted the former broker to engage in illegal late trading. He accused Bear Stearns' of using heavy-handed tactics that led to the demise of Pentad, a small, family-owned Phoenix brokerage that shut its doors in December 2001.

In January, a New York Stock Exchange arbitration panel, without issuing a written opinion, ordered Bear Stearns to pay $25,000 to Dietrich and Pentad. Just like the first arbitration panel, this second group of arbitrators offered no verdict on Dietrich's late-trading allegations. Still, the 66-year-old Dietrich sees the arbitrators' ruling as a vindication for his firm.

"A win is a win," says Dietrich, commenting on the paltry award. "The clearing houses were supposed to cut trading off at 4 p.m. They were the ones that controlled this. Any trades they received after 4 o'clock should have gone over to be priced at the end of the next business day."

Bear Stearns disputes Dietrich's characterization of the arbitration. Ventura says, "We believe the money awarded by the panel was in relation to the dispute over legal fees."

Dietrich says the arbitration was an eye-opener. He says evidence gathered in preparation for the proceeding revealed that scores of brokerages had been submitting mutual fund trades after the 4 p.m. deadline. Time stamps on trade order forms that Bear Stearns gave him showed that some trades were being processed as late as 5:30 p.m.

Several order forms reviewed by TheStreet.com were time-stamped 4:30 p.m. and 4:22 p.m.

Sources say the trading records from other brokerage firms were mistakenly given to Dietrich.

In recent weeks, as regulators and prosecutors have stepped up their inquiry of the firm's clearing desk, Bear Stearns has dismissed a number of employees for violating its policies on mutual fund trading.

People familiar with Bear Stearns say the firm believes it has a number of defenses to allegations it aided and abetted abusive trading -- even trading as late as 5:30 p.m. These people say the firm's attorneys advised Bear Stearns that it technically could accept and process trades up until 5:30 p.m. -- the time at which most mutual fund companies calculate that day's net asset value.

Bear Stearns also is taking the position with investigators that it mainly was the obligation of the firm's brokerage customers to stamp out any illegal trading. The firm has said its clearing agreements clearly require brokerages to make sure that their customers have decided which mutual funds to buy and sell before 4 p.m.

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