Insider Trading: Meaning, Types and Examples

Imagine if you knew some big news about a company, like a major deal or a poor financial result, before everyone else. You could quickly buy or sell that company’s shares and make a profit. That might sound smart and easy, but it’s considered unfair and unethical.

Insider trading can shake investor confidence and disrupt the level playing field that financial markets are meant to provide. In this blog, we’ll explain what insider trading is, how it works, why it’s illegal, and how regulators work to prevent it, so that all investors have a fair shot.

What Is Insider Trading?

Insider trading refers to the buying or selling of a publicly traded company’s stock based on non-public, material information about the company. It provides an unfair advantage to those who have privileged access to confidential information. Insider trading can be both legal and illegal, depending on the circumstances in which it occurs.

Understanding insider trading is essential to recognising its impact on financial markets. Corporate insiders—such as executives, board members, and employees can legally trade the company's shares, but they are required to disclose these transactions to regulatory authorities. However, when individuals use undisclosed, price-sensitive information to trade and gain an unfair advantage either to earn profits or avoid losses, it is considered illegal insider trading.

Who is an Insider?

According to SEBI, an “insider” is:

• A connected person, such as directors, employees, or any person associated with the company in any capacity during the six months prior to the act of insider trading.

• Anyone in possession of or having access to Unpublished Price Sensitive Information (UPSI).

Types of Insider Trading

There are various types of insider trading, including:

1. Legal Insider Trading

Legal insider trading happens when company insiders such as executives, directors, or employees buy or sell shares of their own company while following all applicable regulations. These individuals often possess significant knowledge about the company’s performance and operations, but as long as their trades are:

• Not based on unpublished price-sensitive information (UPSI), and

• Properly disclosed to regulatory authorities like SEBI,

their actions are completely legal.

For example, a CEO buying shares of their own company and reporting the trade to the stock exchange under SEBI guidelines is engaging in legal insider trading.

2. Illegal Insider Trading

Illegal insider trading occurs when a person trades securities based on confidential, material information that is not yet available to the public. This could include knowledge of:

• Upcoming earnings results

• Major acquisitions or mergers

• Regulatory approvals or rejections

• Strategic decisions that can impact stock prices

If someone uses such unpublished price-sensitive information to make a profit or avoid a loss, they violate insider trading laws. This is considered unethical and illegal, as it creates an unfair advantage over other investors who do not have access to that information.

For example, if an employee learns that their company is about to announce a significant loss and sells their shares before the news becomes public, it qualifies as illegal insider trading.

Hypothetical Examples of Insider Trading

Hypothetical examples of insider trading include:

• CEO Stock Dumping: A company’s CEO learns that an upcoming earnings report will show massive losses. Before this information becomes public, the CEO sells his shares to avoid financial loss.

• Leaked Merger Information: A finance executive at a pharmaceutical company learns about an upcoming merger. He tells his friend, who then buys the company’s stock before the official announcement.

• Insider Tip at a Party: An employee overhears a senior manager discussing a lucrative government contract and buys company shares before the news goes public.

Real-life Insider Trading Examples

Summary of Notable Insider Trading Cases in India

Famous Insider Trading Cases Abroad

• Raj Rajaratnam  & Rajat Gupta Case: Founder of Galleon Group, Raj Rajaratnam, was convicted of insider trading in 2011. He received confidential stock tips from company insiders and used them to make millions in profits. Former Goldman Sachs director Rajat Gupta was convicted for sharing confidential boardroom discussions with hedge fund manager Raj Rajaratnam, leading to illegal trades.

• Martha Stewart Scandal: Martha Stewart was accused of insider trading after selling her shares in ImClone Systems based on non-public information from a broker. She was sentenced to prison and fined heavily.

How Does SEBI Regulate Insider Trading?

The Securities and Exchange Board of India (SEBI) strictly regulates insider trading to maintain fair market practices. SEBI has established the Prohibition of Insider Trading (PIT) Regulations, which prohibit the misuse of unpublished information. Key aspects of these insider trading regulations include:

• Disclosure Requirements: Corporate insiders must report their share transactions.

• Trading Windows: Companies set specific periods during which insiders are allowed to trade.

• Restricted List: Certain employees and executives are restricted from trading during sensitive periods.

• Penalties for Violations: SEBI imposes strict insider trading penalties, including fines, legal action, and imprisonment.

Penalties for Insider Trading

The penalties for insider trading vary depending on the severity of the violation and jurisdiction. Common consequences include:

• Monetary Fines: Regulatory bodies can impose hefty fines on individuals and companies.

• Imprisonment: In severe cases, offenders may face jail time.

• Reputation Damage: Being convicted of insider trading can severely damage one’s career and reputation.

• Trading Bans: Offenders may be prohibited from trading or holding executive positions in companies.

In India, SEBI can impose fines up to three times the profit gained or ₹25 crore, whichever is higher. In the U.S., the SEC can impose criminal and civil penalties, including imprisonment of up to 20 years.

Conclusion

Understanding insider trading and its implications is crucial for maintaining fair and transparent financial markets. While legal insider trading is permissible under strict regulatory frameworks, illegal insider trading carries severe consequences. SEBI has stringent insider trading regulations in place to detect and prevent unfair trading practices. Investors must be aware of insider trading penalties and avoid engaging in unlawful activities to maintain market integrity.