What Is Insider Trading and When Is It Legal?

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What is Insider Trading?

Insider Trading is an essential concept in economics and law. In countries like the US and India, it is punishable mainly because it is considered an illegal practice. The US was the first country that made laws against insider trading. Later, the UK also followed. However, in some cases, it is also said to benefit society. Sometimes, the rules for and against insider trading arise from the duties traders owe to shareholders. It is based on the principles of honesty, integrity, and ethics. There have also been many insider trading cases in India and other countries. This makes one want to explore the essentials of insider trading and the grounds on which it can be accepted. What Is Insider Trading and When Is It Legal?

Let us understand what is insider trading?

Insider Trading is a practice where employees of a company take advantage of confidential information they have about their company to trade in the company's securities. This confidential information is otherwise withheld from the public because it can impact the securities' pricing and the profits a company makes. This information can be very crucial for making decisions related to investment. Thus, insider trading can be termed a white-collar financial crime. Insider Trading examples include a Director of a company trading in his company's securities secretly after getting to know of secret business developments. Another example where this may be done indirectly is when the CEO of a publicly traded firm, without realizing it, discloses his company's quarterly earnings to a hairdresser while getting a haircut. If this hairdresser trades on the company's securities based on this information, it will be considered illegal.

When Is It Illegal?

As mentioned earlier, insider trading is not illegal on the face of it. It is due to specific reasons that it is considered illegal.

These include-

  • It is done to make profits. Based on profits earned, the penalty is also increased in some countries. In severe cases, the offender can also be imprisoned.
  • The information is not shared just for business purposes.
  • It harms investors and reduces their confidence in the securities markets.
  • It harms the one who issues these securities.
  • The insider is stealing the company's property and committing theft which must be prohibited even if there is no harm.

Features Of Insider Trading

The features of insider trading are as follows-

  • The information provided or utilized should be significant. This means that this information should be capable of changing the price of a company. Since this company can be small or big, the answer to this question is subjective.
  • The shareholders of the company suffer harm as a result of insider trading. Insider trading does not qualify as a crime if such trading is not leading to any negative effect.
  • The insider makes money or avoids losses by using confidential information to his advantage. The trader's intention to earn profit from this form of trading is essential in this regard.
  • People who do not have such information suffer as a result of the use of the information. This is in furtherance of the first point.

Purpose Of Insider Trading

There can be many reasons why insider trading happens. The purpose of insider trading are as follows-

  • It helps make the market more efficient.
  • It helps others estimate the pricing trends of securities in the market. When investors and traders look at the fluctuations in price, they gain insights. It also helps in market correction because the market reacts to these trades and slowly moves toward the correct price. This is a slow but effective process.
  • It motivates managers or directors of a company to take risks that can add to the company's value in the future. The increase in the price of the security as a result of public disclosure is a flawed but rather accurate estimate of the importance of the innovation to the firm.
  • It increases the awareness of investors by letting them know which securities they should invest in.

Insider Trading In India

One must be guessing what is insider trading in India. In India, the financial market has developed rapidly in recent years. As a result, it was important to restrict any bad practices that might happen in the financial sector. This was done to avoid any major crisis. Apart from this, regulations have also been put in place to protect the interests of investors. The Securities and Exchange Board of India discourages the practices of insider trading. It is not only unethical but also illegal in some cases. Insider Trading is punishable with a monetary penalty. In India, there are many laws and regulations that regulate insider trading. These majorly include the Securities and Exchange Board of India Act of 1992, the Companies Act of 2013, and the SEBI (Prohibition of Insider Trading) Regulations, 1992. Under the SEBI Act, those found guilty of insider trading shall be punished with a fine of not less than ten lakh rupees extending to twenty-five crore rupees. Alternatively, they can be punished with three times the amount of profits they have made from trading, whichever is greater in amount.

Insider Trading Under SEBI (Prohibition of Insider Trading) Regulations, 1992.

This discussion also brings us to the question of what is Insider Trading in SEBI. Insider Trading has not been defined explicitly under any SEBI regulation. However, per the above-mentioned regulations enacted in 1992, we can break down the term into two further terms- "insider" and "trading" to understand it collectively. An insider is a person who is part of a company or is deemed to be so and is expected to have access to information (known as price-sensitive information) that, if let out in public or published in the general sense, is likely to fundamentally affect the price of securities of that company. These insiders are prohibited from trading in securities of the company they are associated with while possessing such price-sensitive information. He is also prohibited from communicating or securing any such information directly or indirectly to a person. This person must be such who, if gets his hands on such information, should not be dealing in securities. Besides this, SEBI has the power to investigate Insider Trading under the National Stock Exchange and matters related to it. SEBI exercises this power in two aspects-

  • Examine complaints made by brokers, investors, or other parties regarding alleged violations of insider trading.
  • To safeguard the interests of investors in securities against the breach of SEBI (Prohibition of Insider Trading) Regulations, SEBI may conduct investigations based on knowledge or information in its possession.

Relation of Insider Trading with Business Ethics

We have already delved into the question of what is insider trading, it is important to focus on what is insider trading in business ethics. Certain points prove that insider trading is within business ethics. Firstly, information related to the company is owned by those who run the company. In this case, such people should have the right to decide how and when such information can be revealed to the public. Secondly, it is not possible to keep certain information completely confidential. Brokers or printers can also get to know about some information beforehand when a new stock has to be issued. Thirdly, individuals who trade on the information are only taking a chance. This means they are trading on what is probable since they will be trading before taking action based on that information. Fourthly, one of the major arguments in favor of insider trading is that it is not the real reason behind the harm caused to investors. The reason behind this is the information asymmetry between investors and insiders. This means that there is certain information that companies are not required to disclose, even if it is material to investor decision-making. In many cases, laws of different countries have not dealt with this gap, because of which investors are bound to get losses in one way. This is because whether or not insider trading is allowed, the securities market investors can't access the same information as those insiders. Therefore, one cannot say that the shareholder will suffer loss or injury if his shares are purchased by an insider but not when an outsider purchases the same shares without access to sensitive information. He may be at risk in both ways. When we talk about shareholders or investors, we should instead say that potential losses concerning him are more a reason for legal rules that do not allow revealing certain corporate information instead of insider trading. Thus, due to these reasons, insider trading follows business ethics.  

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