When legitimate fact-finding becomes insider information

How do so many big-brained Wall St hedge fund managers beat the market so handsomely? We look set to get some clues.

FBI agents swarmed into the offices of three US funds last week, seizing boxes of documents and confiscating traders' BlackBerrys as part of a sudden crackdown on insider trading.

In images carefully orchestrated to alarm the financial community, burly men were photographed carrying carton after carton of printouts from the premises of Diamondback Capital Management, Level Global Investors and Loch Capital.

A day later, hedge fund titans SAC Capital and Citadel, which manage US$30 billion ($40.3 billion) in assets between them - were served with subpoenas demanding information about trades.

The criminal investigation, jointly conducted by the US Securities and Exchange Commission (SEC), New York prosecutors and the FBI, is the biggest assault on insider dealing for years and has rattled Wall St.

But the key target for the authorities are little-known intelligence firms far from Wall St that provide "expert network" information to fund managers.

Last Thursday, the Feds arrested Don Chu, an executive at Primary Global Research, which describes itself as a provider of "incremental information" giving institutional investors a "strategic advantage" in investment decisions.

Firms such as Chu's conduct deep due diligence on quoted companies: they talk to suppliers, clients and employees in an effort to find out what products are hot and which lines are going cold.

They've been known to count the cars in carparks to see how busy companies appear to be - all fodder to help fund managers decide whether to invest.

This poses a dilemma. In a perfect free-market model, all investors on the stock market are supposed to have access to the same information.

Deciding whether to buy shares in Apple, Google or Microsoft, investors can look at official reports providing balance sheets, sales numbers and earnings breakdowns to see how iPods, Android phones or Xboxes have been faring.

On top of that, there's nothing wrong with doing a little extra industry research. But when does legitimate fact-finding tip over into obtaining unlawful insider information?

Chu is charged with covertly obtaining upcoming earnings figures from employees at technology companies such as Broadcom and Sierra Wireless which, if proven, amount to insider information. But is it illegal to befriend corporate executives and chat about business trends?

An Ohio-based chain of discount household stores, Big Lots, has decided to test this: it is suing an "expert network" research company for snooping around its workforce and obtaining trade secrets by offering unspecified inducements to its employees.

Chu will be the first of many to be arrested. The FBI moved quickly on him because he was preparing to fly to Taiwan. New York's federal prosecutor, Preet Bharara, recently declared insider trading was rampant and that it was acting like a financial steroid.

A Wall Street Journal columnist compared the SEC to Stalin.

And a hitherto obscure analyst, John Kinnucan, has become a hero, lauded by CNBC's financial blowhards for blowing the cover of the entire investigation by firing an email off to his hedge fund clients warning them that the FBI had tried, unsuccessfully, to persuade him to wear a wiretap to incriminate the recipients of tips.

The problem is that on both sides of the Atlantic, insider information is extremely poorly drawn in law.

The broadest possible definition of "insider" information would make most financial journalism a crime for uncovering price-sensitive stories.

Beyond that, there's a sliding scale of nudges, winks and tip-offs. And the web has further blurred the line between rumour, private and public information.

But illegal or not, this probe is lifting the lid on how hedgies operate. It's not always instinct, bravado and market nous that yield huge bonuses - it's paying large wodges of money to lackeys who count cars in office carparks.

- Observer