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 is the trading of a company's securities by individuals with access to confidential or material non-public information about the company.
What is an 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.
What 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? ›
Insider Trader
Insiders can be categorized into three groups: (1) the traditional insider, (2) the quasi-insider, and (3) the intermediary insider (Doffou 2003). The traditional insiders are defined as people who are a part of management, can access nonpublic information, and trade that information for their sake.
Is insider trading risky? ›
Insider trading has been associated with unethical trading behavior by people who have information about a company that could affect the market prices of its issued securities.
How do people get caught 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.
How can you tell if someone is insider trading? ›
Dirks Test is a standard used by the SEC to determine if someone who receives and acts on insider information is guilty of illegal insider trading. Tipping is the act of providing material non-public information about a publicly traded company to a person who is not authorized to have the information.
Am I allowed to buy stock in the company I work for? ›
Insiders can (and do) buy and sell stock in their own company legally all of the time; their trading is restricted and deemed illegal only at certain times and under certain conditions. A common misconception is that only directors and upper management can be convicted of insider trading.
What is the 10 am rule in stock trading? ›
Some traders follow something called the "10 a.m. rule." The stock market opens for trading at 9:30 a.m., and the time between 9:30 a.m. and 10 a.m. often has significant trading volume. Traders that follow the 10 a.m. rule think a stock's price trajectory is relatively set for the day by the end of that half-hour.
How long do people go to jail for insider trading? ›
If you're found guilty of insider trading, you could get up to 20 years in federal prison. This is why it's so important to hire a lawyer, so you can improve your chance at winning the case or keeping your insider trading jail time to a minimum.
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.
Why is insider trading so hard to prove? ›
Insider trading is a type of market abuse when an advantageous trade is made based on material nonpublic information. The issue is there's not a specific law defining what insider trading is, which makes it difficult to prosecute cases as they arise.
Why do people do insider trading? ›
Insider trading refers to using non-public information to make investment decisions. This means that people with access to important information that the general public doesn't have are using it to make a profit.
What happens if you accidentally insider trade? ›
Illegal insider trading can land you with hefty fines and even jail time. If you are using nonpublic information to make money in the stock market, you have to be very careful with how you go about it.
Are family members considered insiders? ›
Types of Insiders
If they share the information with a friend, family member, or business associate and the person who receives the tip exchanges stock in the company, they are also an insider.
What is a tipper insider trading? ›
A tipper is someone who has access to material, non-public information (MNPI) regarding a security, company, or industry. This information can be obtained through various sources, such as private conversations, insider knowledge, or having a privileged position within an organization.
What are the two types of insider trading? ›
There are two types of insider trading, legal and illegal.
In the illegal kind, one breaches the company's trust by trading based on the inside information while others remain ignorant. In legal cases, an insider buys or sells securities of their corporation based on the inside information.
What is a insider explain and give example? ›
a person who is a member of a group, organization, society, etc. a person belonging to a limited circle of persons who understand the actual facts in a situation or share private knowledge: Insiders knew that the president would veto the bill.
What celebrities have been caught insider trading? ›
Cases of insider trading often capture the attention of the media, particularly if the accused party is a public figure. Four cases that captured a significant amount of media coverage in the U.S. are the cases of Albert H. Wiggin, Ivan Boesky, R. Foster Winans, and Martha Stewart.
What is insider information with examples? ›
Insider Information is a piece of fact, information, or an understanding (M&A, New Contracts, R&D breakthrough, new product launch, etc.) that could impact the prices of a listed entity or publicly-traded organizations once disclosed in the public domain.
