Silvery - 3:21 pm on Mar 22, 2010 (gmt 0)
As an agency SEO, I would strongly recommend against hiring on a firm that has a conflict of interest. First, they should have disclosed the conflict upfront, without necessarily specifying who they may be working for, or what sites they might own. Second, how would you ever know for sure they weren't giving their best work to their own sites? Third, when contract ends, it'd probably be easy for them to undo some amount of the work, at least where external links are concerned.
Firms I work for would not take on a conflict of interest, or would disclose if they had a competitor client operating in the same or closely overlapping market.
One very strong advantage of going with someone *not* operating in the same market is that they could bring a variety of other techniques into play, while still examining your competitor's techniques and immitating the effective ones. This could give you the best of both worlds, as opposed to using overly incestuous tactics.
Just in terms of link-building, having a wide variation of link sources is desirable -- it's even possible that the firm you're considering who work in your space already may be employing unethical link-building methods that could get you both banned, simultaneously. Just because they rank well today does not mean they will tomorrow.
ken_b, the idea that firms ought to disclose all clients is somewhat naive. A great many of my clients insist upon non-disclosure agreements so that their competitors will not know who they are working with. micklearn is also correct - disclosing client lists also can alert your competitors to study techniques you may be employing, and it gives Google more information than they need.
I think most top firms get permission or offer contractual discounts in order to disclose a select few clients for publicity purposes. It's rare and undesirable for an agency to disclose everyone they work with.