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Posted on  June 20, 2024 under  by Ayush Maurya

What is Insider Trading: Meaning, Example & is it Illegal?

Insider trading refers to the practice of buying or selling a publicly traded company's shares based on material, non-public information about the company. This information can give an unfair advantage to an investor in the stock market, leading to significant profits or avoiding losses. Understanding what is insider trading is crucial because it can have a great impact on the fairness and integrity of financial markets. Although some forms of trading are legally compliant with regulations, illegal trading is a serious crime that can result in heavy penalties, including fines and imprisonment.

Key Takeaways

1. Insider trading involves trading based on non-public, material information, leading to severe penalties in India.
2. Legal insider trading requires strict adherence to disclosure norms and approved trading plans.
3. SEBI enforces insider trading laws with fines up to ₹25 crore, imprisonment up to 10 years, and other regulatory actions.
4. The SEBI (Prohibition of Insider Trading) Regulations, 2015, and the Companies Act, 2013 ensure market fairness and transparency.

Who is an Insider?

An insider is someone who has access to important, non-public information about a company. This can include executives, directors, employees, and sometimes even external parties like lawyers, accountants, and consultants who work closely with the company. Insiders are aware of the information that may influence a company's share price, such as financial reports, major deals, mergers, demergers, or any other significant decision related to the company. 

For example, let's consider the CEO of a tech company. The CEO knows that the company is about to launch a revolutionary new product. This information is not yet available to the public. If the CEO buys more company shares before the product launch, anticipating that the stock price will rise, they are using their insider knowledge for personal gain.

What is Insider Trading?

Insider trading occurs when an investor has some non-public and confidential information about a company. Based on that information which can significantly impact the company's stock price, he decides to buy or sell the shares. Because the information is not available to the general public, using it for trading gives an unfair advantage and is considered unethical and illegal.

It can be done legally if done in compliance with regulations set by the stock market regulator. For instance, company executives are allowed to buy and sell stock, but they must report their transactions to the relevant authorities, such as the stock exchange, to ensure transparency. However, it becomes illegal when insiders use non-public information for personal gain without proper reporting.

How Does Insider Trading Work?

How Does Insider Trading Work?

The insider trading process follows a very specific pattern. The insider gets access to confidential information and then trades before the information is public. Insiders can profit or avoid a loss from the trade when the information goes public and the share price increases or decreases.

First, an insider gains access to material information that could affect the company's stock price. Material information is any information that an average investor considers important when buying or selling stock. This could include earnings reports, merger announcements, or new product launches.

Next, the insider acts on this information by buying or selling stock before the news is made public. For instance, if an insider knows that their company is about to announce a profitable quarter, they might buy shares in anticipation of the stock price rising. Conversely, if they know bad news is coming, they might sell their shares to avoid losses.

Let's look at a real-life example. In 2001, Martha Stewart sold her shares in a biotech company, ImClone Systems, after receiving non-public information from her broker that the company's cancer drug was about to be rejected by the FDA. When the news became public, ImClone's stock price plummeted, but Stewart avoided significant losses because she had sold her shares beforehand. This action led to insider trading charges against her, and she was sentenced to prison.

Types of Insider Trading

There are several types of insider trading, each with distinct characteristics. Understanding these types is crucial for maintaining fair and transparent financial markets.

Legal insider trading occurs when the executives, employees, and directors of the company buy or sell the shares of their company but follow the necessary guidelines to do so. The transactions should be reported properly to the relevant authorities of the country.
Example: If a company CEO purchases shares of their company and reports this transaction to the SEBI, it is considered legal insider trading.

2. Illegal Insider Trading

Illegal insider trading happens when an insider uses material, non-public information to make a trade that gives them an unfair advantage. This type of trading is a serious offence and can lead to heavy fines and imprisonment.
Example: A financial analyst working on a merger deal buys stock in one of the companies involved before the merger is announced, using confidential information to profit from the expected increase in stock price. This is illegal trading.

3. Tipping

Tipping is a specific form of illegal insider trading where an insider provides non-public information to another person (the tippee), who then trades on that information. Both the tipper and the tippee can be held liable.
Example: An executive tells a friend about an upcoming product launch, and the friend buys stock in the company before the launch is made public. This is illegal insider trading through tipping.

4. Front Running

Front running involves a broker or any other entity executing orders on a company’s share when they receive orders on that share in large amounts from their clients.
Example: A broker receives a large order from a client to buy stock and buys the stock for themselves first, anticipating that the client's order will drive up the stock price. This is an illegal form of insider trading.

5. Temporary Insiders

Temporary insiders become insiders temporarily due to their professional relationship with the company. These can include lawyers, accountants, consultants, and other professionals who have access to confidential information during their service. If they trade on this information, it is considered insider trading.
Example: An accountant working on a company's financial audit learns about an undisclosed loss and sells their shares in the company before the information becomes public. This constitutes illegal trading by a temporary insider.

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Insider Trading Regulations - SEBI

In India, insider trading regulations are strictly enforced to maintain fairness and transparency in the financial markets. The regulatory authority that inspects and implements the regulations in India is the Securities Exchange Board of India (SEBI). Understanding these rules is essential for anyone involved in the Indian stock market.

SEBI Regulations

SEBI has established comprehensive guidelines to prevent and penalize insider. These regulations are known as the SEBI (Prohibition of Insider Trading) Regulations. They define what constitutes insider trading, who is considered an insider, and the penalties for violating the rules.

Key Points of SEBI Regulations:

  • Definition of Insider: SEBI defines an insider as anyone who has access to unpublished, price-sensitive information. An insider can be the company's director, its employees, auditors, or even the relatives of the people associated with the company.
  • Unpublished Price-Sensitive Information (UPSI): UPSI refers to material information that has not yet been publicised and can impact the company's share price. Examples include financial results, mergers, acquisitions, and new product launches.
  • Disclosure Requirements: Insiders are required to disclose their trades to the company and the stock exchanges. This ensures transparency and helps prevent illegal trading.

Example: If a director of an Indian company learns about a significant upcoming merger and buys shares before the public announcement, they must disclose this trade. Failure to do so can lead to severe penalties.

Penalties for Violations

SEBI imposes strict penalties on those found guilty of insider trading. These can include:

  • Monetary Fines: Financial penalties can be imposed on individuals and companies involved in insider trading.
  • Imprisonment: Severe cases can lead to imprisonment of up to 10 years.
  • Disgorgement: Insiders must return any profits made from illegal trades.
  • Bans: SEBI can also ban individuals from trading in the securities market for a specified period.

Example: In a notable case, SEBI imposed heavy fines on individuals involved in insider trading during the merger announcement of two major Indian companies. The guilty parties had to return their profits and were banned from trading for several years.

For Indian investors and market participants, understanding and following trading regulations is essential. It ensures a level playing field for all investors and helps maintain the credibility of the Indian financial markets.

Hypothetical Examples of Insider Trading

Understanding trading can be simplified by looking at hypothetical scenarios. Here are a few hypothetical examples of insider trading to illustrate how it can occur.

Example 1: The CEO's Secret

Imagine the CEO of a major tech company knows that their company is about to announce a groundbreaking new product. This information is not yet public. The CEO buys a large number of shares in the company, anticipating that the stock price will soar once the announcement is made. The CEO sells the shares for a significant profit after the product is revealed and the stock price increases. This is a clear case of illegal insider trading because the CEO used confidential information for personal gain.

Example 2: The Accountant's Advantage

An accountant working at a pharmaceutical company discovers through their work that the company's latest drug trial has failed. Knowing that this will likely cause the stock price to drop, the accountant sells their shares in the company before the news is made public. This action helps the accountant avoid losses, but insider trading is considered illegal because they acted on non-public, material information.

Example 3: The Consultant's Tip

A consultant hired by a retail company learns that the company is planning to acquire a popular competitor. This information is confidential and has not yet been disclosed to the public. The consultant tells a friend about the upcoming acquisition, and the friend buys shares in the retail company. When the acquisition is announced, and the stock price rises, the friend sells the shares for a profit. This scenario involves illegal insider trading through tipping, as the consultant shared non-public information that led to unfair trading advantages.

These hypothetical examples of insider trading demonstrate how insiders might misuse confidential information for personal benefit, highlighting the importance of adhering to legal and ethical trading practices.

Famous Example - Rajat Gupta Insider Trading Case

The Rajat Gupta insider trading case is one of the most famous examples of insider trading, showcasing how high-level corporate executives can misuse confidential information for personal gain.

Rajat Gupta, an esteemed Indian-American business executive, was once the managing director of McKinsey & Company and served on the boards of Goldman Sachs and Procter & Gamble. His downfall began in 2010 when he was implicated in an insider trading scheme involving Raj Rajaratnam, the founder of the Galleon Group hedge fund​.

The Insider Trading Scheme

The scheme primarily involved Gupta passing non-public information to Rajaratnam, who then used this information to make profitable trades. Here are key incidents from the case:

  • Goldman Sachs Investment Tip: On September 23, 2008, during a Goldman Sachs board meeting, Gupta learned about a $5 billion investment in Goldman by Warren Buffett’s Berkshire Hathaway. Within minutes of the meeting, Gupta called Rajaratnam and tipped him off. Rajaratnam then bought 215,000 shares of Goldman Sachs, resulting in profits of about $1.2 million when the stock price surged after the public announcement​.
  • Quarterly Earnings Information: Gupta also provided Rajaratnam with confidential information about Goldman Sachs' quarterly earnings in June 2008. Rajaratnam used this information to make trades that generated approximately $18.5 million in illicit profits​​.

In 2012, Gupta was convicted on charges of securities fraud and conspiracy. He was sentenced to two years in prison, one year of supervised release, and ordered to pay a $5 million fine. Despite appeals, his conviction was upheld​.

The Rajat Gupta insider trading case had far-reaching implications. It highlighted the need for stricter enforcement of trading laws and underscored the importance of ethical behaviour among corporate executives. The case also served as a cautionary tale, illustrating how even highly respected professionals can succumb to unethical practices.

Ethical Considerations

Gupta's actions breached the trust placed in him by his colleagues and the companies he served. His decisions were illegal and morally wrong, undermining the principles of integrity, fairness, and honesty. This case reinforces the critical need for robust ethical standards and regulations to ensure fairness in financial markets​​.

The Rajat Gupta insider trading case remains one of the most famous examples of insider trading, emphasizing the severe consequences of such unethical behavior.

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Penalties for Insider Trading in India

It is a serious offence in India, governed by strict regulations to ensure market fairness and transparency. Here’s an overview of the penalties associated with insider trading under Indian law, particularly relevant for our Indian readers.

Monetary Penalties

According to the Securities and Exchange Board of India (SEBI) Act, 1992, insider trading can attract substantial fines. The penalties include:

  • A minimum fine of ₹10 lakh.
  • A maximum fine of ₹25 crore or three times the profit made from trading, whichever is higher​​.

These hefty fines underscore the severity with which insider trading is treated in India, acting as a significant deterrent to potential offenders.

Imprisonment

In addition to monetary penalties, individuals convicted of insider trading can face imprisonment. The terms can range from three to ten years, depending on the severity of the offence​ (iPleaders)​​ (WealthDesk)​.

Regulatory Actions by SEBI

SEBI, the regulatory authority overseeing securities markets in India, has the power to impose additional penalties and take several actions, including:

  • Disgorgement of Profits: SEBI can require offenders to return any profits made from illegal trades.
  • Trading Bans: Individuals may be banned from trading in securities for a specified period.
  • Employment Restrictions: Offenders can be barred from holding positions within SEBI-regulated companies.

High-Profile Cases

Several high-profile cases illustrate the application of these penalties:

  • Rakesh Jhunjhunwala: In 2016, his relatives traded shares based on non-public information, resulting in SEBI imposing a fine of ₹18.5 crore, which included a disgorgement amount​​.
  • Infosys and Wipro Employees: In 2020, two employees engaged in insider trading, making profits of ₹2.6 crore. SEBI banned them from trading and seized their profits​​.

These cases highlight SEBI’s active role in enforcing insider trading laws and the serious consequences for those who violate them.

Conclusion

Understanding what is insider trading is crucial for anyone involved in the stock markets, particularly when trading on the NSE and BSE. It can have severe consequences, including hefty fines and imprisonment, enforced by SEBI under strict regulations to ensure market integrity. While legal trading requires full disclosure and adherence to compliance norms, illegal trading undermines market fairness and can significantly harm other investors.
By being aware of these regulations and the serious penalties involved, traders can contribute to a transparent and fair trading environment in India's financial markets.

Frequently Asked Questions

Q1. Why is Insider Trading Illegal?

Insider trading is illegal because it gives an unfair advantage to insiders with access to non-public information, undermining market fairness and harming other investors who do not have access to such information. It disrupts the level playing field that is essential for the integrity of financial markets​

Q2. Can Insider Trading Ever Be Legal?

Yes, insider trading can be legal when corporate insiders trade their company's stock and disclose these transactions to regulatory authorities. Legal trading requires adherence to disclosure norms and approved trading plans, ensuring transparency and fairness in the market.​

Q3. When is Insider Trading Illegal?

It is illegal when it involves trading based on material, non-public information that could affect a company's stock price. This includes any trading done by individuals with access to confidential information unavailable to the general public. Examples of illegal trading include an executive selling shares before a poor earnings report or an employee leaking information about a pending merger for personal gain​​.

Q4. When is Insider Trading Legal?

It is legal when corporate insiders—such as directors, officers, and employees—buy or sell stock in their own companies and report their trades to the regulatory authorities. This transparency ensures that the trades are made without unfair advantage. Legal trading requires adherence to disclosure norms and trading plans approved by a compliance officer​.

Q5. Can We Do Insider Trading in an Index?

No, insider trading in an index is not possible. Insider trading involves buying or selling a single company's stock based on confidential information. An index is a collection of multiple stocks from various companies, so the entire index has no specific insider information.

Q6. What are SEBI Regulations Against Insider Trading?

The Securities and Exchange Board of India (SEBI) has established stringent regulations to curb insider trading. The SEBI (Prohibition of Insider Trading) Regulations, 2015 define and prohibit trading, mandating severe penalties for violations. SEBI enforces these rules through fines, imprisonment, and trading bans to ensure market integrity and protect investors​.

Q7. What are the Penalties for Illegal Insider Trading?

Penalties for illegal insider trading in India include monetary fines ranging from ₹10 lakh to ₹25 crore, or three times the profit made, whichever is higher. Additionally, individuals can face imprisonment for up to 10 years, along with bans on trading and holding certain positions within companies.​

Q8. What is Regulation 3 of Insider Trading Regulations?

Regulation 3 of the SEBI (Prohibition of Insider Trading) Regulations, 2015, prohibits insiders from communicating, providing, or allowing access to unpublished price-sensitive information (UPSI) except for legitimate purposes, performance of duties, or discharge of legal obligations. It aims to prevent misuse of UPSI to ensure market fairness.​

Ayush Maurya

Written by Ayush Maurya

Ayush is a seasoned financial markets expert with over 3years of experience. He has a passion for breaking down complex financial concepts into simple, digestible terms. Through his 50+ articles, Ayush has helped countless individuals navigate the often intimidating world of finance.

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