Insider trading occurs when people buy or sell a company's stocks or bonds based on important information that isn't available to the public. This practice raises significant concerns because it can create unfair advantages for some investors. It undermines trust in the financial markets, as those with insider knowledge can profit while others remain unaware of the situation. Many people believe this unfairness damages the overall integrity of investing.
What is insider trading?
Insider trading refers to the illegal act of buying or selling financial instruments, such as shares or bonds, based on material information that is not yet publicly disclosed. This typically involves individuals in positions of trust—such as company directors, managers, or employees—who have access to confidential corporate data. Regulations surrounding insider trading aim to uphold fairness in the financial markets by ensuring all investors operate on a level playing field, thereby maintaining market integrity and trust.
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’s 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- Making the decision: Using this unpublished data, the insider makes informed choices about whether to purchase or sell company securities.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.
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.
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.
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.
