Prashant from my team found this interesting issue.  I will blog it here until the KB comes out on this.

Problem
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WebService server responds back with a HTTP 400 error when using PreAuthenticate on the WebServiceProxy class.  This results in a System.Net.WebException: “The request failed with HTTP status 400: Bad Request”

Symptoms
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Consuming a WebService that uses Basic Authentication from a .Net 2.0 client through a Proxy using NTLM authentication the WebService server responds back with a HTTP 400 error message.  This happens only when using the PreAuthenticate property of the proxied WebService class.

Cause
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When the client uses the PreAuthenticate property, the client tries to re-negotiate the NTLM handshake with the Proxy. When the Proxy sees that the connection has already been authenticated, it simply ignores the re-negotiation and forwards a blank request - with Content-Length: 0 to the server. The server expects a valid Content-Length followed by a soap-envelope which it never receives and hence responds back with a HTTP 400: Bad Request response.

Resolution
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Do not set the HttpWebRequest.PreAuthenticate property (set it to false) when calling the Webservice with the above configuration.  By default, the PreAuthenticate is turned off and set to false.