Critics of hedge funds might well have had their worst doubts about the industry confirmed last week when the Financial Services Authority’s Market Watch publication highlighted widespread and systemic failures by funds to have in place proper systems to combat market abuse – and notably insider dealing.

To read the article in full was akin to your worst school report. The word “disappointing” cropped up regularly – sometimes it even extended to “particularly disappointing”. In days gone by this would have led to one of those “This is going to hurt me more than it will hurt you” moments.

However, at the turn of the decade there was a switch away from criminal prosecutions to civil actions to net more offenders. It has not worked. In the past seven years there have been fewer than 30 cases brought. This is not a drop in the ocean – it is a dropette.

So lawyers who work in this field are scarcely surprised by the Market Watch findings. “Although I personally don’t think this is uniquely a hedge fund problem, the Financial Services Authority (FSA) is getting a lot of evidence that insider dealing is taking place,” says Robert Falkner, of Morgan Lewis. “However, it is much more difficult to get evidence to prove a particular case.”

No wonder then that the more cavalier hedge funders can sleep easily in their gold-inlaid beds. “The fact that there have been so few actions against market abuse means that it has not been a high priority for many hedge funds,” Jonathan Herbst, of Norton Rose, says. “It also has to be remembered that the culture of hedge funds is highly entrepreneurial and has largely grown out of ‘front office’ organisations. The people who run them don’t have much experience of managing compliance issues. And if their careers started with larger organisations they are used to leaving it to others to deal with.” But alongside these issues of complacency and negligence there are genuine problems over grey areas in the law. “The complexity of many of today’s financial instruments makes it very complicated as to whether or not they are actually covered by the rules against use of inside information,” Herbst says.

Falkner agrees. The evermore opaque packaging of deals means that the exact status of some of them in relation to the FSA rules is not clear. “This is certainly the area that I have found most troubling and the one that gives concern to clients,” he says.

As a last resort the advice can be sought from the FSA but most clients will consult their lawyers first. A firm such as Simmons & Simmons (which is widely regarded a leader in the hedge-fund business) reckons that it gets a call a day from a clients worried about these issues. As the FSA points out, using inside information is a big problem for hedge funds. But it can also give rise to philosophical and psychological debates about its impact on decision-making. For example, what is the difference between rumour and gossip? What is the status of information sharing by shareholder action groups? And just how big an influence emotionally might a particular piece of data have on a decision maker?

At the heart of the debate about inside information is the conundrum that while analysts apply themselves assiduously to building up detailed and accurate pictures about what is happening to a stock, as soon as they strike gold – reliable inside information – they are precluded from acting on it.

In most cases, though, it is not clear-cut. The image used by Sarah Bowles, who heads the financial services group at Simmons & Simmons, is of a “mosaic” consisting of hundreds of tiny pieces of information acquired by analysts. Amid these tiles there may be some “inside” nuggets but they do not fundamentally shape the picture that the hedge fund has of the stock. However, she says, if your puzzle is more like an infant’s jigsaw with just five or six pieces – and one of them is price-sensitive “inside information” – then you could fall foul of the rules.

Meanwhile, Robert Turner, a financial litigation partner at Simmons & Simmons, thinks that he detects a change of mood at the FSA. “I believe there is a desire at the FSA that the market should start taking its responsibilities towards market abuse seriously in the same way that it does towards money laundering.

“Rather than seeing insider dealing as purely a problem for the regulators, hedge funds should see that they have to deal with it themselves.”

And if they do not? Well, Herbst reckons that the FSA’s patience may soon be exhausted. “There is a view that it will only be when ‘someone gets done’ that the market will sit up and take notice.” And to make the point forcibly it may not be one or two cases but a whole batch of them, Herbst says.

So while we’re not quite in the Last Chance Saloon, that may be the name of the next bar down the road.

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