What is Insider Trading?

Most of us enter the stock markets and invest in securities with an end objective to create wealth. Different types of investors find different ways to gain from the markets across different time periods. In the process, some like to achieve their goals much faster than others and, therefore, find ways of investing or trading that can maximise their gains. Many times the route taken by investors and traders to make quick gains involve malpractices. Insider trading is one such malpractice that occurs frequently in stock markets across the globe. 

Here, we will talk about insider trading, and its legal consequences and also highlight some of the top insider trading cases in India.

What is insider trading?

Insider trading is a stock market malpractice that involves buying or selling securities like a company’s equity or bonds by the company insiders. Insiders could be individuals who are employees of the organisation, the company directors, promoters or other executives associated with the company.

Insider trading involves securities transactions of listed companies and is based on unpublished price-sensitive information (UPSI). Such practices can impact the company’s stock price and thereby impact market participants.

Read more : What should you consider before buying stocks for long term?

Prevention of insider trading practices

Insider trading is one of the most serious malpractices that impact the interest of common investors and other market participants. Therefore, to prevent insider trading and ensure that fair trading prevails in the markets, the stock market regulator SEBI (the Securities and Exchange Board of India) prohibits companies from purchasing their own shares through the secondary market. 

When is it considered illegal?

SEBI has categorised insider trading practices as illegal and introduced various regulations to curb these. Insider trading is termed as ‘illegal’ since it allows few investors to gain monetary benefits from unfair trading practices in the share market. 

Insider trading is typically carried out by individuals who, due to their engagement with the company, may have access to publicly undisclosed strategic information about the company. Since they are aware of certain private information of the company, they may take investment decisions to earn profits based on the same. 

Let us understand this with an example:

An employee working in the finance department of a company may know about the company’s huge profits from its quarterly results that have not yet been published. Once the results are declared, the stock prices are likely to rise. In such a situation, the employee who is privy to the information may take advantage of early access and invest huge sums in the company’s stock. This way, he/she can make substantial returns within a short time. This act can be considered insider trading and is illegal. However, if the employee invests in stocks after the information on company results is made public, it is not considered insider trading nor is it illegal.

Some real-life insider trading cases

Here are some insider trading cases that are well known among stock market circles:

1. Reliance industries

In 2007, SEBI banned RIL for a year from participating in the derivatives segment and also levied a fine after finding that the company had indulged in insider trading. As per the SEBI investigation, the company carried out transactions with the intention of profiting by ignoring certain regulations on trading limits. The company was also found guilty of lowering its stock prices in the cash market.

2. Capital One and Tesora

SEBI also found these entities guilty of insider trading. These companies had traded in the futures and options (F&O) segment before their financial results were made public in 2020. As soon as the results were declared publicly, the companies offloaded their stock positions. 

SEBI observed that the transactions carried out by the companies were not possible without having access to or considering the unpublished price-sensitive information (UPSI). The companies made gains worth Rs. 2.79 crores and Rs. 26.82 lakhs respectively. 

How insider trading impacts common investors?

Common investors and other regular market participants are negatively impacted by insider trading practices in the market. Here’s how:

1. Unfair practices:

Stock market pricing is based on price discovery and buying/selling of securities is as per the demand and supply of the same. With insider trading, only a few can gain from price movements which results in an unfair trading scenario. Since only those who have access to sensitive information can benefit from such trading, it is unfair to other market participants.

2. Unethical:

Insider trading is considered unethical since it does not allow all investors a fair chance at making equal profits from the same set of investments.

3. Dampens investor confidence:

If insider trading is not curbed, investors may lose confidence in market functionalities and trading processes in general. It’s like playing a game that is rigged. If the market regulator does not penalise such practices, the markets will see less participation.

What is the penalty for insider trading?

In India, insider trading practices can result in a prison sentence, or fine, and also both of these may be applied in some cases. As per SEBI regulations, an insider trading conviction can invite a penalty of Rs. 250 crores or thrice the profit earned from such a deal, whichever is higher.

Conclusion

Although there are various rules and regulations surrounding stock market practices, insider trading continues to creep in from time to time. For a common investor, however, the punishments and penalties imposed on insider trading activities act as a ray of hope towards fair trading. 

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