It was announced recently that a Federal Bankruptcy court judge ordered Bear Stearns, one of America’s top tier trading firms to pay $160 million to investors who lost money with a hedge fund that cleared through Bear Stearns. While doing stock research on publicly traded brokerage corporations, we came across the settlement. This spurred us on to thinking, what does this mean for the everyday investor, and what does it mean for stock research in general. Here’s the real story.Hedge Fund’s Asset Base SKYROCKETSHedge funds have become a significant force in the investment world. At the beginning of the 1990’s, hedge funds controlled less than $40 billion in assets, less than Warren Buffett’s personal investment portfolio. Today there are more than 9000 hedge funds controlling in excess of $1.1 trillion dollars of assets.Hedge funds also use leverage, averaging some six times their asset base. This means the industry today controls investments of about $7 trillion dollars. These investments are on both the long and short side. The mutual fund industry can only go long, and never on margin, which means no leverage.Now leverage is a two-edge sword. When things are going your way, it creates excessive returns or alpha. When trades go against you however, it can wipe out your investment in lightning like fashion. The hedge fund borrows money on its asset base from prime brokers, and other lending institutions. The lender always charges a fee, and the fees are big. For the brokerage firms involved, these fees may make up the vast bulk of their bottom line depending upon the firm involved.Hedge funds must clear through clearing firms that are referred to as prime brokers. The prime broker sees every trade the hedge fund does, unless the hedge fund employs multiple prime brokers. Now lets say, the hedge fund lays on a massive trade using margin borrowed from the prime broker, and the trade goes against you, meaning paper losses are sustained. What happens next?The hedge fund has to make a decision as to whether to close out the trade or not. Some funds believing that the momentum will turn, will double down, or increase the investment. The success of this transaction lies in whether or not the momentum is in fact changing at the time of the double down. If not, than the second investment will be under water as well.Now a prime broker will never allow a hedge fund’s trades in total to be under water. This would mean that the hedge fund has gone negative equity, and the prime broker would be at risk. The prime broker never wants to be at risk, nor will it allow itself to be.Enter the Manhattan Investment FundWhat happened with the fraud we mentioned in the title of this article is that a hedge fund called the Manhattan Investment Fund clearing through Bear Stearns lost nearly $400 million of their assets. These assets belonged to rich investors, and the fund’s managers made the wrong bets on Internet stocks in the late 1990’s. Apparently Manhattan Investment Fund sought to cover up or delay the inevitable consequences of its trading activities by issuing FALSE reports to its investors.