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Insider Trading: Definition, Consequences, Types and Laws          

Insider Trading: Definition, Consequences, Types and Laws

Insider Trading: Definition, Consequences, Types and Laws
By Arjun Arjun Remesh | Reviewed by Shivam Shivam Gaba | Updated on February 26, 2024

Insider trading means company insiders like managers, directors, and employees buy or sell stock using non-public important information about the company. Insider trading is done legally or illegally, depending on when and how they use the information to trade. Illegal insider trading has consequences that are very severe. This can lead to huge fines and time in jail. It reduces trust in fair and equal stock markets. Those found guilty face punishment from criminal and civil laws. For companies, it damages their reputation and loses investor trust in them.

There are two types of insider trading. Legal insider trading happens when insiders like managers buy or sell company stock following company rules and insider trading laws. Illegal insider trading happens when insiders buy or sell stocks using important non-public information in the wrong way. Different places have different rules on insider trading. For example, in the United States, the Securities and Exchange Commission (SEC) enforces insider trading rules under the 1934 Exchange Act. In many other countries, similar organizations enforce insider trading laws. These laws aim to keep markets fair and transparent and prevent manipulation.

Insider trading is a term that often causes big arguments in the investment community about fairness, ethics, and the need for rules. Understanding exactly what insider trading means, the possible results, the types, and the laws that govern it are important for any investor working in financial markets.

What Is Insider Trading?

Insider trading is buying or selling a public company’s stock by someone who has non-public, material information about that stock. It’s a term that so often gets tied to illegal activity, but it’s key to understand that it refers to both legal and illegal conduct.

Why Is Insider Trading Considered Illegal in The Financial Markets?

Insider trading is complicated legally. The considerations that are involved include fairness, making sure the market is working properly, protecting regular investors, stopping bad business acts, and following the rules. The big consideration is fairness. The whole idea of the market is that everybody has an equal shot at making money on an investment. When insiders use information that has not been made public to make money for themselves, that’s not fair.

And it’s true that when you’ve created an unfair playing field that tips in the direction of one group or another, you’re undermining the confidence that regular investors have in that market. This imbalance is fundamentally unjust, and that is why insider trading is deemed illegal. Illegal insider trading damages market integrity. Markets work best when prices fully reflect all public information available. However, when insiders trade using non-public information, stock prices move away from their true values. This manipulation destabilizes the market and hinders its growth. 

What Are the Potential Consequences of Insider Trading?

The consequences of insider trading are severe, including hefty fines, imprisonment, and reputational damage. Insider trading also undermines confidence in the financial markets and distorts the allocation of capital. Those found guilty of insider trading face both civil and criminal penalties. Civil sanctions may include the disgorgement of profits, the return of profits earned from illegal trading activities, and substantial fines. The fines are up to three times the profit gained or loss avoided as a result of insider trading.

Criminal penalties are even more severe. Criminal insider trading can result in up to 20 years in prison and up to $5 million in criminal fines for individuals under the United States Securities Exchange Act of 1934. For non-natural persons, such as corporations, the fines are far steeper, hitting $25 million. India has similarly stringent regulations.

How Does Insider Trading Affect Market Integrity?

Insider trading poses a significant threat to market integrity. It distorts market prices, reduces investor confidence, and increases regulatory scrutiny and compliance costs. The integrity of the markets depends on a fair and level playing field where all investors have access to relevant information. They need to be confident that the market is operating fairly and transparently at all times. Insider trading fundamentally undermines all of this.

Leaking non-public information to trade typically results in the stock market price being distorted. This is because a company’s stock price is supposed to reflect our collective assessment of a company’s value over time. Non-public information has a nasty habit of creating an un-level playing field. When non-public information is used in trading, the stock price then no longer reflects the real-time consensus belief of the public, and as such, the stock price becomes artificially inflated or deflated. Not only does this distort the real value of the company for its owners and investors, but it also results in inefficient capital allocation across the real economy and lost jobs.

What Are the Different Types of Insider Trading?   

There are two main types of insider trading and one sub-category. The two main types are legal and illegal. The subcategory is called tipping.

Legal Insider Trading

Legal insider trading occurs when corporate insiders‚ÄĒofficers, directors, and employees‚ÄĒbuy and sell stock in their own company. This might seem contradictory, but it is perfectly legal, provided that the trades are reported to the Securities and Exchange Commission (SEC) and are done in compliance with company policy. This type of insider trading is often based on the insider‚Äôs long-term belief in the company‚Äôs prospects.

The SEC requires that these transactions be reported within two business days and that the information be made available to the public. This information is useful to investors as it provides insight into how insiders view the company’s prospects.

Legal insider trading has potential benefits. It signals the insider’s confidence in the company and its financial health to other investors. It also aligns the interests of company insiders with those of the company’s shareholders.

Illegal Insider Trading

Illegal insider trading refers to the illicit buying or selling of stock based on non-public, material information. This type of insider trading is illegal because it is seen as an unfair advantage over other investors who do not have access to this privileged information.

Illegal insider trading involves company insiders, as well as outsiders such as friends, family, or business associates who might be privy to non-public information. For instance, An insider shares confidential information about an upcoming merger with a friend, and the friend uses that information to buy stock in the company before the merger is announced, which would be considered illegal insider trading.

Illegal insider trading is taken seriously by regulatory bodies like the SEC. Penalties include hefty fines, disgorgement of profits, imprisonment, and damage to one’s professional reputation.

Tipping and Insider Trading

A subcategory of insider trading is ‚Äútipping.‚ÄĚ Tipping involves passing on non-public, material information to someone else who then trades on that information. The tipper, as well as the person who trades on the tip, can both be held legally responsible.

The implications of tipping are severe. Not only do the tippers face criminal charges and penalties, but they also irreparably damage their reputation and career.

All forms of insider trading carry significant implications and must be approached with caution and a clear understanding of the rules and regulations. Companies and individuals alike have a responsibility to uphold market integrity, ensuring that all actions are within the bounds of the law.

How Can Regulators Distinguish Insider Trading? 

Regulators employ a combination of quantitative and qualitative methods, including unusual trading activity analysis, market surveillance systems, and whistleblower programs.

An important means by which regulators detect insider trading is through the use of unusual trading activity (UTA) alerts in the stock market. UTA alerts identify individual trades that deviate substantially from their stock’s usual trading behavior. For example, if a stock normally has a very low trading volume, and then there is a large burst of trading activity right before the company releases major news that moves the stock, this may prompt an insider trading investigation. Advanced statistical models and algorithms are used to generate UTA. These models consider many variables, including trading volume, price changes, and the timing of the trades in generating UTA. By examining this information, regulators are able to identify activities that are suspicious and warrant further scrutiny.

Market surveillance systems are another crucial tool used by regulators to distinguish insider trading. These systems employ sophisticated technology to monitor and analyze real-time market data, enabling regulators to identify potential instances of insider trading quickly. 

Whistleblower programs are another essential means through which regulators distinguish insider trading. These programs encourage individuals who are knowledgeable about illegal activities, such as insider trading, to report the misconduct to the authorities. In return, whistleblowers may receive financial rewards and protection from retaliation.

Is There a Legal Insider Trading?  

Yes, there is a legal form of insider trading. Legal insider trading refers to when company insiders‚ÄĒsuch as directors, officers, or employees‚ÄĒbuy or sell shares in their own companies in a way that complies with securities laws and regulations. These insiders must report their trades to the Securities and Exchange Commission (SEC) and are not allowed to trade based on material non-public information.

This type of insider trading is deemed legal as it follows stringent disclosure regulations and is done in a transparent manner. This transparency allows investors to gain insight into insiders’ views of the company’s prospects, which is sometimes a useful indicator of the organization’s health. However, it is essential that this trading is done in strict adherence to the rules to maintain market integrity and investor confidence.

What Are the Laws and Regulations Governing Insider Trading in Various Jurisdictions?    

Most jurisdictions have stringent laws and regulations against illegal insider trading. These laws aim to ensure fair and transparent markets, maintain investor confidence, and prevent market manipulation.

United States

The Securities and Exchange Commission (SEC) oversees and regulates insider trading. The SEC enforces the Securities Exchange Act of 1934, which is the primary law that governs insider trading. According to this law, any person who has access to non-public, material information about the security must not trade on this information. Furthermore, insiders must report their transactions to the SEC. Violation of these laws leads to severe penalties, including hefty fines and imprisonment.

India

insider trading is regulated by the Securities and Exchange Board of India (SEBI). SEBI has instituted strict regulations to control insider trading, and these are outlined in the SEBI (Prohibition of Insider Trading) Regulations, 2015. These regulations prohibit individuals who have access to unpublished price-sensitive information from trading in securities. They also require prompt disclosure of such trades. The rules apply to all company insiders, including directors, employees, and even family members. Violations lead to hefty fines and imprisonment. However, similar to other jurisdictions, legal insider trading is allowed with proper disclosure and compliance with the regulations.

European Union

The Market Abuse Regulation (MAR) governs insider trading in the European Union. The MAR prohibits unlawful disclosure of inside information and manipulative market practices. The regulation applies to all financial instruments traded on the regulated market or for which a request for admission to trading on such a market has been made. The European Securities and Markets Authority (ESMA) oversees the enforcement of these regulations and imposes sanctions for non-compliance.

United Kingdom

In the United Kingdom, the Financial Conduct Authority (FCA) enforces the laws and regulations against insider trading. These regulations are in line with the EU’s Market Abuse Regulation (MAR), despite Brexit. The FCA imposes hefty fines, sanctions, or criminal charges against those who breach these regulations.

Canada

The Ontario Securities Commission (OSC) regulates insider trading in Canada. The Securities Act of Ontario prohibits trading based on material, non-public information and requires insiders to report trades. The OSC imposes penalties, including fines and imprisonment, for violations.

Australia

The Australian Securities and Investments Commission (ASIC) regulates insider trading under the Corporations Act 2001. This law prohibits anyone possessing inside information from trading, tipping, or procuring. Violations result in heavy fines or imprisonment.

Japan

The Financial Services Agency enforces the Financial Instruments and Exchange Act, which governs insider trading. The law prohibits anyone with material, non-public information from trading securities or providing the information to others. It carries strict penalties for violations, including fines and imprisonment.

How Does Insider Trading Impact the Transparency of The Stock Market?

Insider trading creates an environment of information asymmetry, undermining the principle of equal information access that is integral to market transparency. This lack of transparency erodes investor confidence, distorts market prices, and ultimately harms the integrity of the market. 

Insider trading fundamentally erodes the transparency of the stock market. Transparency is a crucial element in any financial market, as it ensures that all market participants have equal access to relevant information. This level playing field is key to maintaining trust and confidence among investors. Insiders create an information asymmetry. This means that some traders have access to important information that others do not, which gives them an unfair advantage. This directly undermines the principle of transparency, as the market is no longer operating on the basis of equal access to information.

How Can Investors Secure Their Investments Against Insider Trading?

One of the most effective ways to protect your investments is through diversification. By spreading your investments across various sectors, companies, and types of securities, you reduce the risk associated with any single investment. If insider trading significantly impacts one company’s stock, it’s less likely to ruin your overall portfolio if your investments are adequately diversified. Before investing, conduct thorough and diligent research into the company. This includes reviewing financial statements, understanding the company’s business model, and being aware of any significant upcoming events that could impact the company’s performance. A well-informed investor is less likely to be caught off guard by the impact of insider trading.

Ensure you use regulated trading platforms that are overseen by financial authorities. These platforms are required to have measures in place to detect and prevent insider trading. They are also mandated to report suspicious trading activity to the appropriate authorities.

What Are Some Known Real-Life Cases of Insider Trading?

One of the most high-profile insider trading cases involved Martha Stewart, a businesswoman and television personality, in 2001. Martha Stewart was charged with securities fraud, obstruction of justice, and conspiracy for selling her shares in ImClone Systems based on non-public, material information. This information indicated that the Food and Drug Administration (FDA) was about to reject ImClone’s new cancer drug, Erbitux.

Before the FDA’s decision became public, Stewart sold all her 3,928 shares of ImClone, avoiding a loss of $45,673. The transaction was triggered by an illegal tip she received from her broker, Peter Bacanovic, who was privy to the forthcoming FDA decision. The case drew significant media attention, putting a spotlight on insider trading. In 2004, Stewart was convicted and sentenced to five months in prison, five months of house arrest, two years of probation, and a $30,000 fine. Her broker, Bacanovic, was also convicted and received a similar sentence. This case serves as a stark reminder of the legal repercussions of insider trading and the importance of maintaining integrity in financial markets.

How Is Insider Trading Related to Corporate Governance and Fiduciary Duty?   

Insider trading, corporate governance, and fiduciary duty are interconnected concepts in the world of finance and business. They each play a crucial role in shaping the trust and confidence of shareholders, which ultimately affect a company’s valuation, reputation, and overall success. Corporate governance is the system of rules, practices, and processes by which a company is directed and controlled. It involves balancing the interests of a company’s many stakeholders, such as shareholders, management, customers, suppliers, financiers, government, and the community. Good governance is about ensuring that a company is run in a transparent, accountable, and fair manner. It is meant to prevent any form of misconduct, including insider trading, by implementing stringent policies and procedures.

What Are the Ethical Considerations Surrounding Insider Trading?

The first ethical consideration related to insider trading is the unfair advantage it gives to insiders. Stock markets operate on the principle of fairness ‚Äď that all participants have equal access to information. Insiders, due to their position, have access to information that others do not. If they act on this information, they gain an unfair advantage over other investors. This fundamentally goes against the principles of fairness and equality.

Insider trading also leads to market manipulation. Insiders with knowledge of significant upcoming events influence the market by making large trades based on this information. This manipulation distorts the market, leading to inaccurate pricing of securities and harming other investors.

What Are the Challenges in Prosecuting and Preventing Insider Trading?

Insider trading represents a profound challenge to the fairness and integrity of financial markets worldwide. It‚Äôs the illegal practice of trading on the stock exchange to one‚Äôs own advantage through having access to confidential information. Laws exist to regulate and prevent insider trading, and the enforcement and prosecution of such activities present a unique set of difficulties. 

Detection Hurdles

Detecting insider trading is complicated, as the act itself is often covert and disguised within regular trading activities. Traders with inside information may use complex strategies or proxies to avoid suspicion, making detection incredibly difficult.

Legal Ambiguity

The definition of what constitutes ‚Äėmaterial, non-public information‚Äô can sometimes be unclear, leading to legal ambiguities. This vagueness makes it challenging to prove that insider trading has occurred and to bring charges against the alleged perpetrator.

International Jurisdiction Issues

Insider trading spans multiple jurisdictions, complicating the prosecution process. Different countries have different regulations, and coordinating between various enforcement agencies is a daunting task.

The journey towards completely eliminating insider trading may be long and arduous, but each step taken contributes to a more transparent and equitable financial market.

How Does Insider Trading Impact the Overall Functioning of The Global Financial System?

A vital aspect of the global financial system is the principle of fairness and transparency. Insider trading directly undermines this principle by creating an uneven playing field. This disruption leads to a decline in investor confidence and reduces the willingness of investors to participate in the market, which consequently lowers the liquidity and efficiency of the financial system. Market integrity and investor confidence are crucial for the smooth functioning of the global financial system.

However, rampant insider trading erodes these two key components, thereby undermining the overall health of the system. Insider trading sends a message to the average investor that they are at a disadvantage, which leads to a loss of faith in the fairness of the market. This loss of confidence deters individual and institutional investors from investing, thereby reducing market liquidity and potentially stagnating economic growth.

Is leaking Non-Public Information to Investors to Make a Buying or Selling Decision Called Insider Trading? 

Yes, leaking non-public information to investors for the purpose of influencing their buying or selling decisions is a form of insider trading, which is generally considered illegal and unethical. Insider trading is a term broadly used to describe the buying or selling of a company’s shares or other securities by individuals with access to non-public, material information about the company. This conduct impedes the fairness and integrity of financial markets, as it gives certain individuals an unfair advantage over others.

Is Insider Trading a Criminal Offense?

Yes, In India, insider trading is prohibited under the Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 2015. These regulations were enacted to prevent insider trading and protect the interests of investors in securities. Insider trading is considered a criminal offense in many jurisdictions. In the U.S., insider trading is prohibited under federal securities laws. 

Is the SEC Responsible for Pursuing Illegal Insider Trading?

Yes, the SEC (Securities and Exchange Commission) is the primary regulator responsible for pursuing insider trading violations in the U.S. securities markets.

Arjun
Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam
Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.

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