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
Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material, nonpublic information about the security.
What is an example of insider trading? ›
Illegal Insider Trading
For example, suppose the CEO of a publicly traded firm inadvertently discloses their company's quarterly earnings while getting a haircut. If the hairdresser takes this information and trades on it, that is considered illegal insider trading, and the SEC may take action.
What is insider trading and why is it illegal? ›
Insider trading is the selling or purchase of stocks and other securities based on non-public, material insider information. People found guilty of Illegal insider trading can receive up to 20 years of jail time and a $5 million fine.
What are the three types of insider trading? ›
Classic Insider Trading: Buying or selling assets based on important non-public information. Tipper-Tippee Trading: An insider gives others access to confidential information so they can trade using it. Trading During Blackout Periods: Insider trading during times when particular people are barred from trading.
Why is insider trading so bad? ›
Insider trading, as opposed to other forms of informed trading, can harm the integrity of the markets and lead to serious legal implications for the individuals involved. It also victimizes everyday investors who don't have access to the same information as the insiders.
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.
Who are the most famous insider traders? ›
Four insider trading cases that received a lot of media coverage in the U.S. were those of Albert H. Wiggin, Ivan Boesky, R. Foster Winans, and Martha Stewart. Financial Markets Standards Board (FMSB).
How does the IRS catch 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.
How do companies detect insider trading? ›
Every day, FINRA's Insider Trading Detection Program uses sophisticated technology and analytics to monitor 100% of trading in stocks, options and bonds for potentially suspicious activity around material news events, resulting in hundreds of referrals to the SEC and law enforcement every year.
How long do you go to jail for insider trading? ›
As to the criminal penalties for insider trading, the maximum sentence for an insider trading violation is 20 years in federal prison. The maximum criminal fine for individuals is $5 million, and the maximum fine for a company is $25 million.
The individual charged with insider trading must have been aware that the information was material and nonpublic. For example, if you overhear a conversation on a train but have no knowledge that it is insider information, you cannot be convicted if you act on this information.
Who commits insider trading? ›
An insider is a director, senior officer, or any person or entity of a company that beneficially owns more than 10% of a company's voting shares. Insider information is a fact that can be of financial advantage if acted upon before it is generally known to shareholders.
Who qualifies as an insider? ›
The Company's officers, directors, certain employees, certain consultants and certain stockholders (and their family members) are considered “Insiders.” Insiders are subject to insider trading laws that affect the sale and purchase of the Company's stock.
Did Martha Stewart actually do insider trading? ›
Martha Stewart was accused of insider trading after she sold four thousand ImClone shares one day before that firm's stock price plummeted. Although the charges of securities fraud were thrown out, Ms. Stewart was found guilty of four counts of obstruction of justice and lying to investigators.
How often is insider trading caught? ›
The US Securities and Exchange Commission prosecutes approximately 50 insider trading cases per year, and there are harsh penalties of up to 20 years in prison.
How do you prove insider trading? ›
The government must prove that a defendant bought or sold one or more securities “on the basis of material nonpublic information about that security or issuer,” according to the SEC's Rule 10b5-1, 17 C.F.R.
Which of these examples best illustrates insider trading? ›
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.
What situation would be considered insider trading? ›
Insider trading is when non-published information from a company is used to make a trading decision by someone with an invested interest in that company.
What is counted as insider trading? ›
Insider trading happens when a director or employee trades their company's public stock or other security based on important or “material” information about that business.
Which of the following scenarios could be examples of insider trading? ›
Answer. The scenario where a company executive sells shares before the public release of negative financial results is the best example of insider trading, which is illegal and considered securities fraud.So, the correct option is 4) A company executive sells shares before negative financial results are made public.
