Insider trading refers to buying or selling a public company’s stock while in possession of material information about the stock which has not been made public yet. It also includes tipping others when you have any material non public information.
Material information can be any information which would substantially impact the decision to buy or sell a certain stock. Non public information means ‘information not legally or officially released to the public yet’.
Understanding Insider Trading
Let’s understand this concept with an example. Suppose Mr. A is CEO of a company called ‘John Black Ltd’. He is aware of a merger deal involving ‘John Black Ltd’ which will be finalized tomorrow. This deal will boost revenues and future prospects of the company. He shares this information with his friend Mr. Z. Now, Mr. Z immediately buys 1,000 shares of ‘John Black Ltd’ at Rs 1,200 per share, before the merger news is made public.
When the news of the merger is made public the next day, the share price gallops to Rs 1,800. Mr. Z sells the 1,000 shares at Rs 1,800 and pockets a profit of Rs 600,000. In this example, Mr. Z bought and sold the stock based on ‘insider information’ before it was ‘released to the public’. This is called ‘Insider Trading’.
Why is Insider Trading illegal?
- Those having access to ‘material non public information’ have an unfair advantage over other investors and can make potentially huge profits or get rid of their investments to avoid major losses.
- Investors feel cheated and lose confidence in the trading process. It is unethical. All investors should have equal opportunities in the stock market.
Securities Exchange Board of India (SEBI) regulates the securities and commodity markets in India. Even after many insider trading regulations by (SEBI), there have been very few convictions till date in India.
Notorious Insider Trading Scandals
Below are some of the most famous insider trading convictions which have happened in the USA.
> Jeffrey Skilling-Enron Corporation
Jeffrey Skilling was the CFO of Enron Corporation. He kept hiding Enron’s losses and was aware of the company’s dire financial status. He sold $60 million of Enron shares before quitting the company, just a few months before it filed for bankruptcy.
> Martha Stewart-ImClone Systems
Based on a tip from her broker friend Peter Bacanovic, Martha Stewart sold shares she owned in a pharmaceutical company called ImClone Systems. Bacanovic had informed her that ImClone’s CEO and his daughter were dumping their shares in advance of bad news from FDA.
> Raj Rajaratnam-Galleon Group
Raj Rajaratnam founded Galleon Group which became one of the world’s largest hedge funds. He used a large network of Wallstreet insiders to gather material non public information and generate stunning returns for his investors. Rajat Gupta, a director of Goldman Sachs had called Raj Rajaratnam immediately after the board meeting in which Warren Buffett’s capital infusion into Goldman was announced. This information was material to the price of Goldman shares. Raj Rajaratnam immediately bought shares of Goldman Sachs and sold them after the news of infusion was made public the next day, and made a substantial profit.
