The gray art of not quite insider trading

  @FortuneMagazine August 15, 2013: 9:07 AM ET
INS02 franklin

"We used to be able to talk to investigators on drug trials," says Source A, a hedge fund portfolio manager. Like all the analysts, research directors, and portfolio managers who cooperated for this article, Source A requested anonymity. People don't want their names in a story about gray areas of equities research that border on insider trading.

Four or five years ago, Source A continues, he and other health care analysts still used to get in touch with doctors who were serving as investigators on Phase II or Phase III trials, studies required by the U.S. Food and Drug Administration before a pharmaceutical can be approved as safe and effective. He might have been able to reach as many as eight out of 10 investigators running a study, and sometimes he could reach the principal investigator, the overseer of the whole thing.

"Say each investigator has 11 patients," Source A continues. "You could almost go patient by patient," asking how they were doing.

The outcome of these drug trials would have an enormous impact on the stock price of the pharmaceutical firm developing the drug. For a small company, the stock might go down 90% or up 100%, depending on the result, and even the stock of a big company, like Pfizer, might move 5%.

The doctors on these studies were providing the analysts with nonpublic information. They may well have been violating confidentiality agreements they had signed with the pharmaceutical companies that commissioned the studies. Source A was paying the doctors for their information, in that he'd reach them through expert-network firms that his hedge fund had on retainer, and the networks paid the doctors for their time.

Isn't that insider trading? In fact, doesn't it sound a lot like the top charge currently being leveled in the marquee insider-trading case of our time: the indictment, filed in July, against Steven A. Cohen's hedge fund, SAC Capital Advisors, which the government alleges made $276 million in July 2008 by obtaining nonpublic information from a doctor overseeing a study of an Alzheimer's drug?

Yet Source A doesn't think his conversations with drug-study doctors in the past ever crossed the line from good, aggressive research into criminality. As we'll see, he's probably right.

This story is about the layers of gray that wash over the world in which hedge fund portfolio managers and stock analysts operate, a world of which the general public knows little. It's about what insider trading is, why it's so hard to define, why prosecutors and regulators like it that way, and why analysts don't.

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