What is Insider Trading in the Share Market?

You often hear the term 'insider trading' in the stock market. Have you ever wondered what it means? And who are the people doing it? For starters, you should know that insider trading is an illegal and unfair practice. Let us look at it in more detail.

What is Insider Trading?

Insider trading in the stock market refers to the buying or selling of shares by individuals who have access to non-public, material information about a company. As you know, some information can significantly affect the company’s stock price once it becomes public. But if you have access to this information before it becomes public and use it to your advantage, it is called insider trading. Because insider trading gives an unfair advantage to those with privileged information, it is illegal in most countries, including India.

Types of Insider Trading

We can divide insider trading into two main categories:

1. Illegal Insider Trading: This occurs when a person in the company trades based on confidential or "inside" information that is unavailable to the general public. For instance, a company's senior executive knows about an upcoming merger, a significant profit/loss report, or a major business decision that could impact the stock price. If this executive buys or sells the company’s stock before this information is made public, it is considered illegal.
2. Legal Insider Trading: Not all insider trading is illegal. Company executives, employees, or directors often buy or sell shares in their own companies. This is legal as long as they comply with disclosure regulations, report their trades, and avoid trading based on non-public material information.

Participants of Insider Trading

Here are the key participants of insider trading:

1. Insiders: They are individuals who have access to unpublished price-sensitive information about a company due to their position or association with the company. These participants often hold confidential knowledge about the company’s financial health, business plans, or upcoming announcements that could impact the stock price.

2. Connected Persons: These are individuals or entities who are not necessarily direct employees or executives but still have access to unpublished price-sensitive information due to their professional association with the company. SEBI regulations define "connected persons" broadly to prevent any loopholes. These participants may not be directly employed by the company but have access to insider information by their relationship. These could be lawyers, auditors, legal advisors, etc.

3. Tippees: A tippee is a person who receives insider information indirectly from an insider or a connected person.

4. Intermediaries and Market Participants: Certain financial intermediaries and market participants who work closely with companies may inadvertently or intentionally become involved in insider trading. They are subject to strict regulations and compliance checks to prevent misuse of non-public information.

How Does Insider Trading Work?

We can divide insider trading into three steps:

• Access to Non-Public Information: Individuals who work for a company, such as executives, directors, or employees with access to sensitive information, may have inside knowledge about the company's performance or upcoming events.
• Trading Based on Information: Using this non-public information, these individuals may buy or sell securities in anticipation of a price change. For example, if they know about an upcoming merger or acquisition that is expected to boost the company's stock price, they may buy shares before the news is publicly announced.
• Profiting from Information: By trading on non-public information, insiders can profit from price movements that would not have been possible without their insider knowledge.

Let us take an example of the above. A high-ranking executive at a tech company, let us call her Mrs Arya, discovers that the company is about to announce a groundbreaking new product that is expected to boost the company's stock price significantly.

Knowing this confidential information, Mrs Arya, before the news is publicly announced, buys a large number of shares in the company. Arya does not disclose her knowledge of the upcoming announcement to anyone else. Once the news is made public and the stock price rises, Mrs Arya sells her shares, making a substantial profit.

Let us assume that the company's stock price trades at Rs 100 per share. Mrs Arya knows that the product announcement that will likely drive the stock price up to Rs 200 per share. She buys 10,000 shares at Rs 100 per share, investing a total of Rs 10,00,000. After the announcement, the stock price rises to Rs 200 per share. Mrs Arya sells her 10,000 shares at Rs 200 per share, making a profit of Rs 10,00,000.

Example of Insider Trading

India, over the years, has had many cases of insider trading. Let us look at some of the popular ones:

The Ranbaxy Case (2016): Promoters and executives of Ranbaxy Laboratories were accused of insider trading related to the company's merger with Sun Pharmaceutical Industries. The accused were alleged to have traded in Ranbaxy shares based on non-public information about the merger negotiations.

The Infosys Case (2018): Former Infosys CEO Vishal Sikka and other company executives were accused of insider trading. The accused were alleged to have traded in Infosys shares based on non-public information about the company's financial performance and internal matters. The case is still under investigation, with SEBI continuing to gather evidence.

Pros and Cons of Insider Trading

The pros of insider trading are only associated with legal insider trading (we discussed this earlier).

Here are the top three pros of legal insider trading:

• Transparency through Legal Disclosure: When company executives, directors, or major shareholders buy or sell shares legally and disclose these trades to the public, it provides transparency to investors. Investors can see how insiders are managing their holdings, giving them insights into the company's health.
• Confidence in Company Leadership: When insiders invest in their own companies legally, it can boost shareholder confidence. It’s often seen as a positive signal when top management uses personal funds to buy company stock, as it suggests belief in the company’s long-term growth.
• Market Efficiency (Legal Context): Some argue that insider trading can contribute to market efficiency by ensuring that all available information—whether public or insider knowledge—gets reflected in the stock price as quickly as possible.

Here are some of the cons associated with insider trading:

• Unfair Advantage: Illegal insider trading creates an unfair playing field where those with access to privileged, non-public information can profit or avoid losses, leaving ordinary investors at a disadvantage.
• Market Manipulation and Loss of Integrity: Illegal insider trading can lead to market manipulation and reduce investor confidence in the fairness of financial markets.
• Harm to Ordinary Investors: Retail investors, or everyday people who invest in stocks, are often the biggest losers in cases of illegal insider trading.
• Damage to Company Reputation: When executives or insiders are involved in illegal insider trading, it can damage the company's reputation.

Before you go

Insider trading is a serious offense that undermines market integrity and investor trust. SEBI has established a robust framework to prevent and detect insider trading through stringent regulations, advanced monitoring tools, and severe penalties for violators. For investors, understanding the rules around insider trading and staying informed can help avoid legal complications and ensure a level playing field in the financial markets.