What is Insider Trading?

20 Jul 2021  Read 2297 Views

“If companies tell us more, insider trading will be worth less.”
This is one gem of insight from James Surowiecki. Indeed, market regulators like SEBI have been trying their best to make more and more information about companies available for market participants, all in a bid to prevent Insider Trading. But for the neophytes, what does it mean?

Insider trading, as the title implies, is the unlawful trading of a company's bonds, stocks, and securities, on the basis of information (or ‘a tip’) that is kept secret and masked from the general public. Well, this practice is unfair and obviously illegal, so it must be avoided at all costs.

Here’s everything you need to know about insider trading.

Inside - Insider Trading

Buying or selling securities in violation of fiduciary responsibility or other relationship of trust and confidence on the basis of substantial, nonpublic information about the security, is known as Insider Trading. Insider trading offences can also involve "tipping" such information, stock trading by the person "tipped," and stock trading by individuals who misappropriate such knowledge.

For instance, a corporate manager notifies his wife about an undisclosed business agreement, and she then informs her friends, who then purchase the company's stock (because they know once the news is out in public, the company’s share price will rise). The manager, his wife, and her acquaintances could then be charged with violating insider trading regulations.

Unwary individual investors, many of whom have spent time and effort picking companies for investment, may find themselves on the losing end of a trade. Investors lose faith in the stock market if they assume insider trading is common, whether they are typical retail investors or overseas investors. Insider trading must be dealt with harshly in order to increase retail stock market participation.

So, who are considered as insiders, you ask?

Who is an Insider?

Most of the insiders fall into either of the following categories:

 

(Source of data: IOSCO)

More specifically, the SEBI defines Insider to comprise of the following person or organization:

  • Immediate relatives of connected individuals or insiders

  • An associated company or holding firm directly linked with the other corporation

  • A high-level executive belonging to such a holding firm of the parent company

  • An official working at a clearing house or stock exchange

  • Asset management company board members or a trustee in mutual fund management companies

  • A board member or chairman of a public financial organization.

Thus, anyone who falls into one of these categories should avoid trading equities for the company for which they are an insider.

But what exactly is considered as insider information?

Insider Information

The following things are regarded as insider information:

  • Major changes in policies or operative plans for the company

  • Intended dividend declaration

  • Any upcoming takeovers and/or mergers 

  • Periodic financial reports

  • Buy-back or issuance of securities 

So, a trader who has pre-emptive access to such information may be subject to insider trading lawsuits.

However, contrary to popular notions, not all insider trading activities are illegal. And just to be on the safe side of the law, we need to get into all the details that separate legal and illegal insider trading activities.

SEBI’s Restrictions on Insider Trading

Insider trading damages investor trust in the fairness and integrity of the securities markets. Hence, SEBI has made detecting and prosecuting insider trading offences a top priority.

  1. The first insider trading restriction stipulates that no insider shall communicate to anyone, any unpublished price-sensitive information (UPSI) about a company. It does, however, have some exceptions; one of which states that such disclosure of information may be permitted if it is made for legitimate objectives, the performance of duties, or the fulfilment of legal requirements.

  2. The second prohibition against insider trading is that any person, whether insider or outsider, is prohibited from obtaining any UPSI relating to a company.

  3. The third and most significant is set forth in regulation, which forbids anyone in possession of a listed company's UPSI from dealing in its securities on the stock market. This, too, has a few exceptions though.

Penalties against Insider Trading

  • Insider trading is specifically prohibited by section 12A(d) of the SEBI Act 1992, and section 15G levies a penalty ranging from ten lakhs to twenty-five crore rupees, or a penalty equal to three times the profit made out of such a trade, whichever is higher.

  • Section 195 of the Companies Act, 2013 forbids insider trading in addition to describing what it is, and states that a defaulter may face a five-year prison sentence and/or a fine of up to Rs. twenty-five crores.

Real-life Examples of Insider Trading in India

Reliance Industries

RIL was barred from the derivatives business for a year and fined by the Securities and Exchange Board of India in 2017. The corporation was accused of trying to make money by circumventing limitations on its legally authorised trading limits and decreasing the price of its stock in the cash market, according to the exchange regulator.

Infosys

When the IT firm failed to make public an allegation of illicit trading made by a business insider, it was found in breach of SEBI insider trading rules. The original complaint was made on September 20, 2019, but it was only discovered when the whistleblower mailed a copy to the media a couple of months later, in October. Kiran Mazumdar Shaw, Infosys' lead independent director, settled the accusations in November by paying a fine of Rs. 3 lakh to SEBI.

Rakesh Jhunjhunwala

SEBI had summoned independent ace investor Rakesh Jhunjhunwala for alleged insider trading at Aptech Limited. According to reports, the regulatory authority was looking into the months of February and September of 2016. SEBI was also investigating Jhunjhunwala's family member's involvement in the case. Recently, it was settled with Rakesh Jhunjhunwala, his family & associates, who might have to shell out as high as Rs 37 Crore!

Final Thoughts

It is obvious from this article that the laws preventing insider trading have developed significantly since their inception. But, there is still scope for improvement in ensuring even more transparency and accountability in the markets.

One of the stock market's ethical precepts is that no trader should have an undue edge over others. Being a part of the inner circle is nice and snug, but it also comes with a lot of commitment.

Invest ethically!

About the Author: Utkarsha Kadam | 8 Post(s)

Utkarsha is a chartered accountant with a background in finance, auditing, and taxation. She enjoys simplifying complex financial concepts. She also cherishes sketching and playing badminton in her spare time.

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