Insider trading
This article written by Akshit Gupta (ESSEC Business School, Master in Management, 2022) presents the concept of Insider Trading.
Definition
Inside information refers to non-public information about a listed company, that can significantly affect its stock price if made available in the public domain. Insider trading refers to “buying or selling a security, in breach of a fiduciary duty (the mutual relationship of trust, confidence and reliance that exists between the different parties) or other relationship of trust and confidence, on the basis of material, non-public information about the security” as defined by the Securities and Exchange Commission (SEC) in the United States of America. Insider trading can be legal or illegal depending on the time the information is used to execute the trades (or passed on to third party to execute trades). Illegal insider trading has severe repercussions for the person/group using or supplying such confidential information and carries penalties or imprisonments if found guilty. Different countries have several provisions in place to stop such acts from taking place that undermine the rights of honest investors by destroying market integrity.
The following are the examples of infamous acts of insider trading which gained a lot of traction from international public and media:
- Ivan Frederick Boesky (1987)
- Martha Stewart & ImClone (2001)
- Robert Foster Winans (1984)
- Raj Rajaratnam (2009)
Economic/moral effects of insider trading
From an economic point of view, in the short term, illegal insider trading improves the market efficiency in their strong form. In the strong form, stock prices reflect all the public and private information about the company. The use of inside information (a part of private information) by some investors leads to more efficient prices, which are important for all investors for their asset allocation.
From a moral point of view, insider trading is considered as unethical and unfair as it creates illicit profits for some investors who use their access to privileged information, and it deprives honest investors with the basic rights of fair participation and access to information that has the potential to significantly affect the stock prices for a publicly listed company. The people in possession of insider information make unfair gains or avoid losses by trading on such news. These trades break the flow of financial markets and may render honest investors unwilling to participate in further trades.
Rules to respect for the top management team
As per the rules defined under the Insider Trading Policy of 2013 by the SEC, no person on directorial, managerial or employee level should carry out any transaction on the basis of material non-public information that can significantly impact the stock prices for the listed company.
More specifically, according to the SEC guidelines, “Investment by the Company’s directors, officers or employees in Company securities is encouraged, so long as such persons do not purchase or sell such securities in violation of this Insider Trading Policy. In furtherance of the goals underlying the Company’s Insider Trading Policy, the Company’s directors, officers (those required to make filings under Section 16 of the Securities Exchange Act of 1934) and all employees at the Vice President level and above, as well as all employees in the accounting group are prohibited from buying or selling Company securities at all times, except during the period extending from the third (3rd) through the thirteenth (13th) business day following the release of the Company’s earnings for the immediately preceding fiscal period to the public (the “Trading Window Period”). The grant or exercise of stock options to purchase the Company’s stock is permitted outside Trading Window Periods.”
Trading in the securities of other entities is also prohibited for any director, manager or employee of a company, who’s future course of actions, information about which is still not available in the public domain, have the capability of affecting the value of the underlying entity. For example, this is the case before a merger or acquisition takes place.
Laws / Regulations for different Countries
Illegal Insider Trading comes with severe repercussions and the penalties/fines for such acts have been significantly increased globally over the course of time.
USA
In USA, illegal insider trading can be a civil and a criminal offense charging and individual or an entity depending on numerous factors involving the scale for the offense, intentional violation of the law etc.
As per the Securities Exchange Act of 1934, a person/entity can face criminal sanctions wherein, “The maximum prison sentence for an insider trading violation is now 20 years. The maximum criminal fine for individuals is now $5,000,000, and the maximum fine for non-natural persons (such as an entity whose securities are publicly traded) is now $25,000,000” and/or civil sanctions which involves, “Persons who violate insider trading laws may become subject to an injunction and may be forced to disgorge any profits gained or losses avoided. The civil penalty for a violator may be an amount up to three times the profit gained or loss avoided as a result of the insider trading violation” and “The Company faces a civil penalty not to exceed the greater of $1,000,000 or three times the profit gained or loss avoided as a result of the violation if the Company knew or recklessly disregarded the fact that the controlled person was likely to engage in the acts constituting the insider trading violation and failed to take appropriate steps to prevent the acts before they occurred.”
European Union (FRANCE)
European Union has issued several guidelines commonly known as directives for curbing illegal insider trading from distorting the smooth functioning of the global financial markets. The rules and regulations for insider trading are adapted by each country and requires a law to be passed by respective Parliament at their own discretion.
Insider trading regulations are mostly uniform throughout Europe and the rules have been transposed from the European Union’s Market Abuse Directive of 2003. In France, the laws against insider trading were first implement by means of an Ordinance passed by the French Government on 28th September 1967 making disclosure of insider trading compulsory for every listed company. However, the law was later scrapped off since it was limited in terms of its scope and companies still practiced illegal insider trading.
The French Monetary and Financial Code was passed in 2000 defining insider trading and regulations were made to state the penalties for such activities. The sanctions under the law are imposed by the Autorité des Marchés Financiers (AMF) which oversees the French financial markets. The law imposes a maximum imprisonment of 2 years and a fine amounting to €1,500,000, which could be increased to up to ten times the amount of profit. The French Laws has been progressing and several amendments have been implemented thereafter making the regulations even more stringent.
Movies related to insider trading
The movie shows the use of insider information by a famous investor named Gordon Gekko, related to BlueStar Airlines and how he capitalized on the private information to earn huge profits.
The movie shows the use of insider information related to ‘orange crop report’, given by United States Department of Agriculture, by Duke Brothers to capitalise on the gains in the commodities market.
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Examples of Insider Trading
Article written by Akshit GUPTA (ESSEC Business School, Master in Management, 2022)