Insider Trading Meaning
Insider 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.
- Insider trading is defined as the process of using non-public material knowledge about a listed company by an insider like associates, employees, board membersBoard MembersBoard members comprise the individuals whom the shareholders elect as their representatives. They are responsible for taking crucial corporate decisions regarding the company's policies, dividend payouts, top-level managers' recruitment or layoff and executive compensation., etc. The information is used to execute buying or selling of company securities for personal benefits.
- In 1942, lawmakers adopted the Rule 10b-5 in the Securities Exchange Act 1934 to allow prosecution of this offence. In 2021, US lawmakers also passed the Insider Trading Prohibition Act, a bill to explicitly prohibit the offence.
- A company’s directors, officers or employees are prohibited from taking advantage of confidential corporate information to earn profits from the company’s stock. In addition, the SEC penalizes the perpetrators.
- Insider trading is legal when the company’s directors, employees, executives, or officers report such trading and comply with the SEC’s regulations.
How does Insider Trading Work?
Insider trading is an illegal activity in the stock marketStock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price.. Company insiders have access to the company’s non-public information, such as consecutive losses that could jolt its stock price. While large-scale shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares. remain unaware of this information until the public announcement, the offenders of illegal insider trading will act on it.
The offender will take crucial trading decisions related to the company’s stock for undue personal advantage at the expense of unaware shareholders. In 1942, lawmakers adopted the Rule 10b-5 in the Securities Exchange Act 1934 to allow prosecution of this offence. In 2021, the US lawyers also passed the Insider Trading Prohibition Act bill to have a law that explicitly prohibits it.
Law describes an “insider” as a company’s director, employee, external officials, family members, etc., who can gain “non-public material information” about the company due to their position. The “non-public material information” can affect large-scale shareholders’ investment in the company, so they must be informed of it.
Any trading decisions before the shareholders’ knowledge will be unfair and could bring them losses. Therefore, it is illegal to circulate and act on non-public material information gained during employment or by a third source. The insiders should either reveal it to everyone or abstain from disclosing it until it becomes public.
Insider Trading Punishments with an Example
In the US, the SEC has imposed strict restrictions on illegal insider trading to protect the interests of the investors. In the legal kind, there are no punishments for it is conducted as per the rules. However, laws specify that an offender of the illegal insider trading may end up paying a penalty of up to $ 5 million. In addition, the accused could also be penalized with a maximum prison sentence of 20 years if found guilty of a criminal offence. Let us look at an example to understand this better.
George is a board member of a firm, Zinc. He learnt that some corrupt officials of Zinc were involved in a multi-million scam. Zinc was now almost bankrupt. The managing board came up with a crisis management plan as they knew that the company’s share price would crash when the news becomes public.
The board decided to inform Zinc’s shareholders in an official statement. George was holding many of Zinc’s share. Before the news became public, he secretly sold them off at the current price to avoid incurring losses after the news release. During enquiries, the authorities unearthed his crime too. George was barred from stock trading as a penalty and was heavily fined.
Real-World Insider Trading Cases
One of the earliest insider trading cases was Texas Gulf Sulphur Company, where certain officials traded its stock ahead of an important public announcement. The historical ruling suggested abstaining from disclosing such things before the public announcement or revealing it to everyone concerned while disseminating.
Another infamous historical case was of the Wall Street Journal columnist, R.Foster Winans. He was accused of leaking confidential corporate stock information to two stockbrokers. As a result, he was paid $31,000 from the gains of about $690,000 made out of illegal disclosures. Winans was found guilty and imprisoned for 18 months.
In fact, the financial history is colored in many notorious insider trading cases and examples that threatened the sanctity of stock markets. Arbitrageur Ivan Boesky, Martha Stewart, former Enron president Jeffrey Skilling are some such infamous offenders.
Legal vs Illegal Insider Trading
Many studies suggest that both these cases are common before a public announcement that could affect the share price.
In the illegal kind, one uses the non-public corporate information for trading securities against the rules of the law. As a result, it causes material losses to the affected parties and erodes their trust in the system. The regulatory bodies penalize the offenders to discourage these crimes. Therefore, company officials should ensure that the inside information is not circulated.
In contrast, it is considered legal insider trading when a company’s insiders engage in buying or selling securities of their corporation but regularly report it to the SEC. Also, doing so publicly discloses the organization’s information. An example of the legal kind is employee stock options, which many insiders undertake regularly.
Insider trading is termed illegal when one uses a company’s confidential stock price information for personal gains. By doing so, a person acts in violation of their duties and breaches the trust of the affected parties. In 1942, lawmakers adopted the Rule 10b-5 in the Securities Exchange Act 1934 to allow its prosecution.
The two types are legal and illegal. In the illegal kind, one breaches the company’s trust by trading based on the inside information while others remain ignorant.
In legal cases, an insider engages in buying or selling securities of their corporation based on the inside information too. However, the person reports the same to the regulatory authorities like the SEC.
No, illegal insider trading is a criminal offence in India. Therefore, like the SEC, the Securities Exchange Board of India (SEBI) is the regulatory body that works towards its avoidance and investor protection.
The Securities and Exchange Commission detects the offence in the following three ways:
• Tips provided and complaints reported by the sources such as the company’s investors, option writers, enraged traders, etc.
• Conducting market surveillance by going through the company’s growth and earnings reports.
• Various other sources provide leads and clues of such trading practices, including media, self-regulatory firms and other SEC divisions.
This article has been a guide to what is Insider trading, its meaning along with practical examples. Here we also discuss the differences between Legal vs. Illegal Insider Trading. You may also have a look at the following articles to learn more about trading –