Insider Information

Updated on March 26, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Insider Information Definition

Insider Information is a piece of fact, information, or an understanding (M&A, New Contracts, R&D breakthrough, new product launch, etc.) that could impact the prices of a listed entity or publicly-traded organizations once disclosed in the public domain. Trading based on such information is considered to be illegal.

Insider Information

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It is challenging to pronounce someone guilty only based on holding the insider information and trading in it. One of the most arduous tasks for the SEC is to prove that the person who gained benefits from insider tradingInsider TradingInsider trading is defined as the act of taking key trading decisions related to a company’s listed stock using critical non-public information. The US Securities and Exchange Commission (SEC) penalizes offenders of illegal insider trading as it causes material loss to the investors. It also shakes their faith in the stock market. read more is also responsible for some fiduciary duty in the organization whose shares have been used for unfair personal gain.

Insider Information Explained

Insider information refers to those details, knowledge an dstatistics that are known by only the persons working at specific levels of a business, not by the general public. Those information are not allowed to be given to outsiders before a specific point of time, because it may affect the operations, stock prices or market image which may be detrimental to the business.

If at all any insider information reaches the general people before it should, then there are many rules and regulations that may stop it from being misused for any personal gain. Such laws vary from country to country or us based on the jurisdiction, where the company is operating.

Every listed company has some stock insider information that comes into the public domain and would affect the price of equity in the market. For example, the announcement of dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more, new product launches, heavy losses, new contracts, etc., could make the security price volatile. This information is available only to the persons involved in the entity’s day-to-day operations or to those who have a deep connection in the organization, such as directors, senior officers, accountants, and so on.

Based on the undisclosed information, if somebody tries to make personal gains by trading in the entity’s securities, it is known as insider trading. These practices interfere with the free trade policies in the equities market and put other investors devoid of information at a disadvantage.

But, this could also be used for gains or averting losses when creating or manipulating various organizations or technical bugs to use or create a loophole in the system.

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Laws

A handful of people within the company commonly know any information which may directly affect the stock prices of daily operations of the business. They may be related to an acquisition, merger, fall in revenue, project failure, etc. There are many legal rules and regulations that are strictly followed to prevent this kind of information from being mis utilised, if in case they reach wrong hands.

People who know such information need to promise that they will maintain the confidentiality of such cases and if they fail to do so, strict legal action will be taken against them. They are not allowed to either use the knowledge regarding stock insider information for their own gain or pass it on to someone else who are not authorised to know it.

In United States, the Securities and Exchange Commission (SEC) is responsible for such regulation. If a director, employee or any other company executive uses the knowledge to trade, they will be subject to the regulations that are encoded within the Securities Exchange Act of 1934. Here, the main section is Rule 10b – 5, which mentions that using such information for trading is deceptive and a fraudulent activity.

Another rule known as Regulation FD(Fair Disclosure) states that any publicly traded enterprize should let the public know any material information immediately because selective disclosure leads to misuse and disturbs the balance of the financial market.

The SEC can bring action in the form of civil enforcement laws against the people or corporates who indulge into insider trading and punish them to prevent further violation of law.

Further, among the insider information laws, the Insider Trading Act of 1988 came into force, which raised the financial penalty of all people who get involve in trading illegally using information that is confidential for the business.

Examples

A few examples of insider trading are as follows:

Example#1

For instance, material information such as the finalization of a mergerMergerMerger refers to a strategic process whereby two or more companies mutually form a new single legal venture. For example, in 2015, ketchup maker H.J. Heinz Co and Kraft Foods Group Inc merged their business to become Kraft Heinz Company, a leading global food and beverage firm.read more deal with another organization would impact the company’s profitability in the future; thus, positive news for the stock market could be used to earn gains via stock purchase before the deal is announced in public.

Example#2

The launch of a new product that could boost the organization’s sales and would add substantially to the bottom lineBottom LineThe bottom line refers to the net earnings or profit a company generates from its business operations in a particular accounting period that appears at the end of the income statement. A company adopts strategies to reduce costs or raise income to improve its bottom line. read more could also be termed as a piece of insider information if the entity concerned is a public company.

From the above examples, it is clear that the management and people working within an organization should have proper knowledge of rules and insider information laws followed regarding such type of information. They should not use them for personal gain because it lead to lack of integrity within the market.

To curb insider trading based on undisclosed information, Sec 16 of the Securities and Exchange Act, 1934 requires all the insiders, including senior personnel like directors, officers, and substantial equity holders of the company, i.e., holding of 10% or more is subjected to various regulations.

Any gain or losses averted due to the insider information within the six months should be deposited with the company’s account. This move has made even small benefits from malpractices in insider trading less advantageous. Also, owners of substantive equity holding who also chair the management posts in the company need to report the transactions involving the purchase or sale of shares to the Security and Exchange Commission.

Insider Trading With Insider Information

  1. Insider trading denotes dealing in the entity’s share by persons (holding 10% or more of the corporation’s equity) in the equities market by surpassing the law of free trade and making profits or avoiding gains based on information not available to the general public. So, the high-level officers, directors, and owners with more than 10% holding come under the radar of insiders.
  2. Insiders could be charged for not just trading in security by using undisclosed information but also when such communication is being communicated to other persons who could benefit from that.
  3. It is permissible to do trading by the organization’s insiders, provided that the SEC is well-informed about their trades.
  4. Insider trading is a criminal offense in the U.S, and heavy penalties with imprisonment could be imposed. The SEC (Securities and Exchange Commission is responsible for persecuting the persons involved in unfair trades based on inside information.

How To Get Insider Information?

This kind of information can be used for legal trading and practices, provided it is acquired through legal methods. Let us study the process.

An investor can invest in good stocks if they can learn about the products and financial practices of such companies well in advance. For this purpose, the investors can refer to public databases which publish important information about the ongoing policies, practices and performances of the company over a certain period.

These databases offer financial information regarding buying and selling of stocks or any oter type of business activity by the company management which is essential for investors to know before making investment.

The Foreign Institutional Investors (FII) and Domestic Institutional Investors (DII) trading and activity is also an important way to get insider information.  They are well informed about the whereabouts of the company, better than the public in general.

By doing such tracking, investors can understand which way the stocks may move in future and take financial decision accordingly.

Insider information on itself is of no harm unless it is being used to manipulate the trading of a listed entity for undue gain and averting losses. Insider trading based on undisclosed information in the public sphere is tough to frame and prove the charges. Over the years, the law has become very stringent on such issues due to mass exploitation and public outcry, but it is still unable to stop such rampant incidents in the corporate world.

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