What is Insider Trading in Stock Markets

6 mins read
by Angel One

As the term implies, insider trading is trading conducted by insiders, persons with knowledge of a particular company’s stock and its trends. Individuals invest in stocks and other securities with the intent of accumulating wealth. For some investors, the sooner this objective is accomplished, the better. In trading, particularly for stocks and shares, traders look for strategies to maximise profit. Of doubt, the stock markets and exchanges have their fair share of misconduct while trading, and some traders will go to considerable lengths to profit.

Insider trading is defined as trading on an insider’s information.

In stock market jargon, ‘insider trading’ refers to trading stocks, such as bonds and shares, by specific corporate ‘insiders’ who have unique access to information. These insiders are aware of individual security before any information gets public. When insiders invest in stocks while the general public is unaware of the existence of the stock, this is referred to as insider trading. If regulatory authorities become aware of such trade, the ‘insider’ faces severe consequences.

When is it Illegal to engage in Insider Trading?

According to SEBI laws, the Securities and Exchange Board of India strongly opposed insider trading. The rationale for labelling the practice ‘illegal’ is that insider trading gives some investors an unfair edge in the stock market. Insider trading is often conducted by individuals who have exclusive access to specific strategic information about a company’s stocks due to their employment. Knowing a company’s private information can significantly impact whether you invest and earn a profit or not. For instance, insiders may know if a company’s quarterly earnings will reveal a significant profit, increasing stock prices. They can take advantage of this and invest a sizable sum in the above stock, virtually guaranteeing significant returns. Insider trading is deemed unlawful from this vantage point. However, when investors invest in stocks and all concerned investors are aware of specific information that affects their profit or loss in trading, insider trading is not prohibited.

Insider Information

In the trading world, material information regarding a stock or firm refers to any information that may significantly impact a trader’s or investor’s decision to trade (buy or sell) particular security. Insider trading is prohibited regardless of how the information was obtained or whether the company employs the ‘insider’. Non-public information is information that is not made publicly available. As a result, material knowledge that is not made public is what insiders utilise to gain an unfair advantage while trading. Consider the following scenario: a person obtains a friend’s insider information (non-public information). Following that, this information is shared with a family member. The family member trades the stock using this knowledge. All three parties involved could face prosecution or severe penalties in such a case.

Ethical Trading

While you should not be forced to trade through unethical methods, you may be wondering how to make trading successful. If you open a demat account with a reputable broker, such as Motilal Oswal, you can benefit from expert advice and learn from the best. This is the appropriate and proper technique to calculate your stock market investment return.

How is Insider Trading Executed?

Insider trading is a fraudulent action that occurs in the stock market. Company insiders have access to non-public information about the company, such as consecutive losses that could cause the stock price to plummet. While institutional investors

Stay oblivious of this information until it is made public. The perpetrators of illicit insider trading will take action.

The offender will make critical trading decisions involving the company’s stock for their gain at the expense of unwitting shareholders. To facilitate prosecution of this offence, lawmakers enacted Rule 10b-5 in the Securities Exchange Act 1934 in 1942. In 2021, US legislators also approved the Insider Trading Prohibition Act, which expressly forbids insider trading.

According to the law, an “insider” is defined as a company’s director, employee, external official, or family member who has access to “non-public material information about the business as a result of their employment.” Because “non-public material information” can potentially impact large-scale shareholders’ investment in the company, it must be disclosed to them.

Any trading decisions made without the shareholders’ awareness are unjust and may result in losses. As a result, it is unlawful to circulate and act on material non-public information obtained during work or from a third party. Insiders should either disclose it to the public or refrain from doing so until it becomes public.

Insider Trading Penalties with an Illustration

The Securities and Exchange Commission (SEC) has set firm limits on illicit insider trading to safeguard investors’ interests in the US. There are no penalties for the legal kind because it is conducted according to the rules. However, statutes indicate that an individual who engages in illegal insider trading may face a fine of up to $ 5 million. The accused may face a maximum prison sentence of 20 years if convicted of a criminal offence. Consider the following example to help you grasp this concept.

George serves on the board of directors of a company called Zinc. He discovered that several dishonest Zinc officials were engaging in a multimillion-dollar scheme. Zinc was now on the verge of bankruptcy. The managing board devised a crisis management strategy in anticipation of the company’s share price collapsing when the news became public.

Zinc’s board of directors decided to notify shareholders via an official announcement. George had a sizable portion of Zinc’s stock. He secretly sold them before the news became public to prevent incurring losses following the news announcement. George was forbidden from stock trading and fined severely due to his actions. Authorities also discovered his crime during their investigations.

Cases of Actual Insider Trading

Texas Gulf Sulphur Company was one of the early instances of insider trading, with certain officials trading the company’s stock ahead of a significant public announcement. The historical precedent indicated either not sharing such information before the public announcement or providing it to all parties involved during dissemination.

Another infamous historical example included R.Foster Winans, a Wall Street Journal columnist. He was charged with disclosing to two stockbrokers secret business stock information. As a result, he received $31,000 from the approximately $690,000 in gains derived through illegal disclosures. Winans was convicted and sentenced to 18 months in prison.

Indeed, financial history is replete with infamous insider trading cases and instances that jeopardise the legitimacy of stock markets. Ivan Boesky, Martha Stewart, and former Enron CEO Jeffrey Skilling are just a few of these infamous offenders.

Numerous studies indicate that these scenarios are prevalent before a public announcement that may affect the share price.

In the unlawful type, non-public company information is used for trading securities against the letter and spirit of the law. As a result, it results in material losses for impacted parties and undermines their confidence in the system. To deter these crimes, regulatory agencies penalise offenders. As a result, firm executives must ensure that confidential information is not disseminated.

By contrast, insider trading is deemed permissible when a company’s insiders buy or sell its securities but report it to the SEC regularly. Additionally, doing so publicly discloses information about the company. Employee stock options are examples of a legal type that many insiders use regularly.