DEFINITION:
Insider trading happens when someone buys or sells stocks or securities using information that the public doesn't know. It's a direct breaking of trust or a violation of duties.
Insider trading occurs when someone makes a trade using important information that's not known to the public. This significant information is anything that could impact a company's stock price. Legally, it refers to facts that, if known, would influence the decision to buy or sell.
Having access to these facts gives the investor an advantage in trading shares. This advantage is not shared by many others, creating an unfair benefit.
Usually, the trader must have a duty to another person or entity, like brokers who trade on behalf of clients. If you buy or sell shares based on exclusive information while having a duty to someone else, it can lead to trouble.
When someone is expected to act in the best interest of another person, it's called a fiduciary duty. People with fiduciary duties must be careful, loyal, act in good faith, keep things confidential, make prudent decisions, and disclose relevant information.
Insider trading happens when someone uses secret information to make money or avoid losses, which is an unfair use of their knowledge or power.
This is against the law because it creates an unfair advantage. Those who are "in the know" get a chance to make more money, while others without access to these secret tips miss out.
People who have been charged and found guilty of insider trading include corporate officers, employees, government officials, and even those who share insider information with someone else.
Insider trading can also occur without a fiduciary duty. In these cases, the crime may be uncovered because of another wrongdoing, such as corporate espionage. If people use illegal means to get private information, they could be charged with insider trading and other related crimes.
It's important to note that not all insider trading is automatically illegal. The Securities and Exchange Commission (SEC) considers various factors before bringing charges, and they must prove certain things for someone to be convicted of insider trading.
Penalties for insider trading typically include fines and prison sentences, and in many cases, both. The severity of the penalty depends on the seriousness of the case.
Additionally, there could be other consequences, such as financial or professional repercussions, and frequently a combination of both. The SEC has taken steps to prevent those involved in trading violations from serving on the boards of publicly traded companies.
Back in the early 20th century, insider trading wasn't considered illegal or frowned upon. It was even seen as a "perk" for executives, according to a Supreme Court ruling.
Things changed after the stock market crash in 1929 and the Great Depression. Court cases and laws started addressing insider trading, imposing severe penalties for those involved. In 1934, the SEC was created, and the Securities Exchange Act was passed, marking the first legal steps to regulate insider trading.
While the Act didn't outright forbid or clearly define insider trading, the SEC gradually criminalized specific actions through a series of rules. Fraud during stock sales became illegal, and this rule was later extended to cover stock purchases. However, these rules were somewhat fragmented and challenging to enforce.
Over time, the SEC has become more proactive. They've filed insider trading complaints against hundreds of individuals, including lawyers, corporate insiders, and hedge fund managers.
Several well-known cases have involved insider trading.
In 1996, Rakesh Agrawal, managing director of ABS Industries Ltd., signed a deal with Bayer AG, a German business, which agreed to purchase 51% of ABS Industries Ltd.’s shares. Following UPSI’s announcement of the acquisition, the accused sold a significant portion of his ABS Industries ownership, which he owned through his brother-in-law, Mr. I. P. Kedia. Considering Mr. Kedia to be a well-connected individual, SEBI held that Mr. Rakesh Agrawal was guilty of insider trading and directed him to deposit Rs. 34 lakhs with Investor Protection Funds of Stock Exchange, Mumbai and NSE (in equal proportion i.e. Rs.17 lakhs in each exchange) to pay any investor who may make a claim afterward
Hindustan Liver bought 8 lakh shares of Brook Bond Lipton India Ltd. (“BBLIL”) from Public Investment Institution, Unit Trust of India (“UTI”) two weeks prior to the public announcement of the merger of two companies, i.e., HLL and BBLIL. SEBI, suspecting insider trading, issued a Show Cause Notice (“SCN”) to the Chairman, all Executive Directors, the Company Secretary and the then Chairman of HLL.
The O'Hagan case went to the Supreme Court, and the 6-3 ruling reinstated the verdict. The Court determined that O'Hagan was guilty of using a deceptive scheme in connection with buying a security.
Insider trading grabbed headlines once more in 2003 during the Martha Stewart ImClone scandal. The stock price of the company plummeted in a single day. Suspicion fell on Stewart when it was revealed that she had sold thousands of ImClone shares just the day before. Although she was cleared of fraud charges in court, she was found guilty of obstruction of justice and lying to investigators, leading to her imprisonment.
In 2011, insider trading made headlines again when hedge fund manager Raj Rajaratnam received a record 11-year prison sentence. He had traded stocks based on confidential information.
To manage insider trading, various rules have been established, and some of them permit it, but only to a certain extent. According to Section 16 of the Securities and Exchange Act of 1934, if someone on the inside, like officers, directors, or those who own 10% or more of a company, buys and sells the company's stock within six months, any profits must be given back to the company. This rule aims to reduce the temptation for insiders to benefit from small changes in the stock price.
Moreover, people inside the company must inform others about any changes in their ownership of stocks, including when they buy or sell shares. This disclosure helps maintain transparency about their trading activities.
