How does insider trading work?
Insider trading functions through a sequence of unethical practices where privileged access to sensitive information is exploited for personal gain. Here is how the process typically unfolds:
- Information access: Individuals like senior executives or employees may obtain confidential insights—such as impending mergers, financial disclosures, or regulatory approvals—that are not yet available to the public.
- Making the decision: Using this unpublished data, the insider makes informed choices about whether to purchase or sell company securities.
- Executing trades: Transactions are carried out, sometimes via intermediaries like relatives or offshore accounts, to disguise the insider’s connection and avoid suspicion.
- Profit realisation: Once the information becomes public and the market reacts, the insider benefits from price movements—either by securing profits or avoiding losses.
Types of Insider Trading
Insider trading broadly refers to dealing in securities while in possession of unpublished, price-sensitive information. It can take different forms depending on who trades, how the information is used, and whether the activity violates regulations.
Legal insider trading
This occurs when company insiders trade shares of their own company while fully complying with disclosure norms and regulatory requirements. Such trades are reported to stock exchanges and do not involve unpublished price-sensitive information.
Illegal insider trading
This involves trading securities based on confidential, non-public information that can influence share prices. It gives insiders an unfair advantage and is prohibited under securities laws.
Tipper insider trading
In this case, an insider shares unpublished price-sensitive information with another person, known as the tippee, who then trades based on that information.
Tippee insider trading
A tippee engages in trading after receiving confidential information from an insider, knowing that the information is non-public and price-sensitive.
Accidental insider trading
This may occur when someone unknowingly trades while in possession of sensitive information, though intent and circumstances are closely examined by regulators.
What are the effects of insider trading?
Insider trading can have severe consequences for financial markets and investor confidence. The key impacts include:
- Providing certain individuals with an unfair advantage, undermining equitable trading conditions.
- Eroding trust in the transparency and reliability of the markets.
- Distorting stock prices and exposing unsuspecting investors to potential financial harm.
- Reducing market efficiency and hampering free flow of accurate information.
How does SEBI regulate insider trading?
The Securities and Exchange Board of India (SEBI) identifies several categories of individuals and entities whose trading activity may be considered insider trading. These include:
- Close family members of corporate insiders.
- Subsidiaries or holding companies associated with the listed entity.
- Senior executives of parent organisations.
- Officials from clearing houses or stock exchanges.
- Members of boards or trustees in asset management and mutual fund firms.
- Chairpersons or directors of public financial institutions.
SEBI prohibits such individuals from accessing or sharing Unpublished Price Sensitive Information (UPSI), unless mandated by law or judicial requirement.
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SEBI regulations against insider trading
As per Section 11(2)(E) of the Companies Act, 1956, insider trading is restricted to:
- Promote equal market access for all participants.
- Preserve fairness and integrity in trading activities.
- Prevent asymmetrical access to corporate information.
Information considered sensitive, and thereby subject to insider trading scrutiny, includes:
- Announcements of dividends
- Financial performance reports
- Security issuances or buy-back schemes
- Strategic policy changes
- Planned mergers, acquisitions, or takeovers
Hypothetical examples of insider trading
To better illustrate insider trading, consider the following fictional examples:
- A company director learns that quarterly results will exceed expectations. They purchase a large number of shares beforehand and later sell them at a profit after the results are announced and the share price surges.
- A medical researcher working on a breakthrough drug finds the trial data promising. Before public release, they buy shares in the pharmaceutical firm, benefiting financially once the market responds positively to the news.
These examples illustrate various scenarios where individuals with access to non-public information exploit that information for personal financial gain, thereby violating securities laws against insider trading.
Real-life examples of insider trading
- Martha Stewart: Stewart sold her shares in ImClone Systems based on confidential knowledge that the stock would drop, avoiding losses. She was later convicted of securities fraud and served a prison sentence.
- Reliance Industries: SEBI penalised RIL and barred it from derivatives trading for manipulating stock prices to bypass legal trading limits.
- Joseph Nacchio: The former Qwest Communications CEO sold shares using insider knowledge of the company’s poor financial health, later receiving a prison sentence.
- Yoshiaki Murakami: This Japanese investor was found guilty of trading NBS shares based on undisclosed tender offer information, receiving a suspended sentence and fines.
- Raj Rajaratnam: Founder of the Galleon Group hedge fund, he used insider information from tech company executives to gain illicit profits. His conviction resulted in an 11-year prison sentence.
- Amazon: Brett Kennedy, an ex-Amazon analyst, shared confidential earnings data with a former classmate in exchange for payment, resulting in significant illegal profits and SEC action.
Penalties for insider trading
Consequences for insider trading can vary but typically include:
- Fines: Substantial monetary penalties based on the amount of illegal profit earned.
- Imprisonment: Serious breaches may result in custodial sentences.
- Restitution: Courts may order the return of unlawfully gained earnings.
- Civil sanctions: Regulatory bodies may impose bans on trading, revoke licences, or enforce other professional restrictions.
When is Insider Trading illegal?
Insider trading is illegal when a person trades securities while in possession of unpublished, price-sensitive information that is not available to the public. It is also unlawful when such information is shared with others who then trade based on it. These actions create an unfair advantage, harm market integrity, and violate securities regulations enforced by market regulators.
When is insider trading legal?
Insider trading is considered legal when company insiders trade shares while fully complying with regulatory requirements. This includes trading without access to unpublished price-sensitive information and making timely disclosures to stock exchanges and regulators. Such transactions are transparent, pre-approved where required, and reported publicly, ensuring fairness and equal access to information for all market participants.
Conclusion
Insider trading poses a threat to the integrity and working of the Indian financial market. Ultimately, combating insider trading is essential for fostering a fair and trustworthy market environment. This benefits all participants, from individual investors to businesses seeking capital, ensuring an even playing field and promoting healthy economic growth.
