Using insider information for financial benefit on the stock market
What is Insider Trading?
Insider trading refers to the practice of purchasing or selling a publicly-traded company’s securities while in possession of material information that is not yet public information. Material information refers to any and all information that may result in a substantial impact on the decision of an investor regarding whether to buy or sell the security.
By non-public information, we mean that the information is not legally out in the public domain and that only a handful of people directly related to the information possessed. An example of an insider may be a corporate executive or someone in government who has access to an economic report before it is publicly released.
Detailed rules regarding insider trading are complicated and generally, vary from country to country. The definition of an “insider” can differ significantly under different jurisdictions. Some may follow a narrow definition and only consider people within the company with direct access to the information as an “insider.” On the other hand, some may also consider people related to company officials as “insiders.”
Hypothetical Examples of Insider Trading
- The CEO of a company divulges important information about the acquisition of his company to a friend who owns a substantial shareholding in the company. The friend acts upon the information and sells all his shares before the information is made public.
- A government employee acts upon his knowledge about a new regulation to be passed which will benefit a sugar-exporting firm and buys its shares before the regulation becomes public knowledge.
- A high-level employee overhears some conversation about a merger and understands its market impact and consequently buys the shares of the company in his father’s account.
Real-life Examples of Insider Trading
1. Martha Stewart
Shares of ImClone took a sharp dive when it was found out that the FDA rejected its new cancer drug. Even after such a fall in the share price, the family of CEO Samuel Waskal seemed to be unaffected. After receiving advance notice of the rejection, Martha Stewart sold her holdings in the company’s stock when the shares were trading in the $50 range, and the stock subsequently fell to $10 in the following months. She was forced to resign as CEO of her company and Waskal was sentenced to more than seven years in prison and fined $4.3 million in 2003.
2. Reliance Industries
The Securities and Exchange Board of India banned RIL from the derivatives sector for a year and levied a fine on the company. The exchange regulator charged the company with the intention of making profits by skirting regulations on its legally permissible trading limits and lowering the price of its stock in the cash market.
3. Joseph Nacchio
Joseph Nacchio made $50 million by dumping his stock on the market while giving positive financial projections to shareholders as chief of Qwest Communications at a time when he knew of severe problems facing the company. He was convicted in 2007.
4. Yoshiaki Murakami
In 2006, Yoshiaki Murakami made $25.5 million by using non-public material information about Livedoor, a financial services company that was planning to acquire a 5% stake in Nippon Broadcasting. His fund acted upon this information and bought two million shares.
5. Raj Rajaratnam
Raj Rajaratnam made about $60 million as a billionaire hedge fund manager by swapping tips with other traders, hedge fund managers, and key employees of IBM, Intel Corp, and McKinsey & Co. He was found guilty of 14 counts of conspiracy and fraud in 2009 and fined $92.8 million.
Penalties for Insider Trading
If someone is caught in the act of insider trading, he can either be sent to prison, charged a fine, or both. According to the SEC in the US, a conviction for insider trading may lead to a maximum fine of $5 million and up to 20 years of imprisonment. According to the SEBI, an insider trading conviction can result in a penalty of INR 250,000,000 or three times the profit made out of the deal, whichever is higher.
Related Readings
Thank you for reading CFI’s guide on Insider Trading. To keep learning and advancing your career, the following resources will be helpful:
FAQs
Insider trading tells everybody at precisely the wrong time that everything is rigged, and only people who have a billion dollars and have access to and are best friends with people who are on boards of directors of major companies - they're the only ones who can make a true buck.
How to solve insider trading? ›
3. How to prevent insider trading
- 3.1 Define inside information. ...
- 3.2 Create insider lists. ...
- 3.3 Watch out for irregular trading patterns. ...
- 3.4 Implement a whistleblowing platform. ...
- 3.5 Impose pre-clearance procedures. ...
- 3.6 Educate employees on insider trading.
Direct evidence of insider trading is rare. There are no smoking guns or physical evidence that can be scientifically linked to a perpetrator. Unless the insider trader confesses his knowledge in some admissible form, evidence is almost entirely circ*mstantial.
Does insider trading hurt anyone yes or no? ›
Insider trading causes regular people to have a pessimistic view of the market due because of the unfair advantage insider trading have by using non-public material information. As a result, ordinary people are less likely to participate in the market, which decreases overall market liquidity and efficiency.
What was Warren Buffett's quote on trading? ›
“Price is what you pay, value is what you get.” “The most important quality for an investor is temperament, not intellect.” “Remember that the stock market is a manic depressive.” “The most important investment you can make is in yourself.”
What is really unethical about insider trading? ›
The main argument against insider trading is that it is unfair and discourages ordinary people from participating in markets, making it more difficult for companies to raise capital. Insider trading based on material nonpublic information is illegal.
What is the burden of proof for insider trading? ›
Burden of Proof in Insider Trading Cases
Prosecutors must prove that the defendant actually received information, that the information was both “material” and “nonpublic,” and that the information directly influenced the defendant's trade.
What percent of insider trading is caught? ›
Data drawn from all prosecuted insider trading cases
“Therefore, what we see in prosecutions is the tip of the iceberg. We further estimate that the probability of detection/prosecution of insider trading in both M&A and earnings announcements is approximately 15 per cent,” the authors note.
How can you tell if someone is insider trading? ›
Market surveillance activities: This is one of the most important ways of identifying insider trading. The SEC uses sophisticated tools to detect illegal insider trading, especially around the time of important events such as earnings reports and key corporate developments.
Has anyone gone to jail for insider trading? ›
A former Goldman Sachs and Blackstone analyst was sentenced to 28 months in prison Wednesday for insider trading, after admitting that his conduct was “catastrophically stupid.”
Insider transactions are legal if the insider makes a trade and reports it to the Securities and Exchange Commission, but insider trading is illegal when the material information is still non-public.
How do people get caught for insider trading? ›
The Securities and Exchange Commission plays a pivotal role in detecting and prosecuting insider trading. The agency monitors trading activities and investigates unusual spikes in trading volume or price changes that precede significant corporate events, such as mergers or earnings reports.
What best describes insider trading? ›
Insider trading is buying or selling a publicly traded company's stock by someone with non-public, material information about that company. Non-public, material information is any information that could substantially impact an investor's decision to buy or sell a security that has not been made available to the public.
What is the famous line from trading places? ›
Louis Winthorpe III: [approaching the New York Commodities Exchange] Think big, think positive, never show any sign of weakness. Always go for the throat. Buy low, sell high.
What is the inside market quote? ›
The inside market is the spread between the highest bid price and the lowest offer (ask) price in a quoted financial product. Historically, the inside market consisted of prices provided by market makers, but in the electronic trading age, it may be created by other participants as well.
What is the best example of insider trading? ›
A lawyer who represents the CEO of a company learns in confidence that the company will experience a substantial revenue decline. The lawyer reacts by selling off his stock the next day, because he knows the stock price will go down when the company releases its quarterly earnings.
