Illegal Insider Trading: What is it and how does it happen?
When investors read news articles regarding unlawful insider trading behavior, they usually pay attention since it is an activity that has an impact on them, often in a bad manner. Despite the fact that there are legal types of insider trading, the more understanding you have of why unlawful insider trading is a crime, the better understanding you will have of how the market operates. In this section, we will explore what an unlawful insider is, how it jeopardizes the essential conditions of a capital market, and what constitutes a member of the insider class.
In what ways is insider trading harmful, and why is it harmful in the first place?
Insider trading happens when a trade is impacted by the fact that the trader has privileged access to corporate information that has not yet been made publicly available. In order to acquire an unfair advantage over the rest of the market, a person who uses insider information is attempting to obtain information that is not available to other investors.
Trading on the basis of nonpublic information is a violation of transparency, which is at the heart of a functioning financial markets. Transparent markets are characterised by the fact that information is transmitted in a way that ensures that all market players receive it at roughly the same time. Under these circumstances, the only way for one investor to gain an advantage over another is to become skilled at analyzing and interpreting the information that is accessible.
Individual merit and self-awareness are required for this skill. If one individual trades using nonpublic information, that person gains an unfair advantage that the rest of the public will not be able to compete with. The practice of insider trading is not only unjust, but it is also disruptive to a well functioning market. If insider trading were permitted, investors would lose confidence in their disadvantaged position (in comparison to insiders) and would cease to invest.
The Rule of Law
The Securities and Exchange Commission (SEC) adopted new rules involving insider trading in August 2000, effective immediately (made effective in October of the same year). Insider trading is defined by the Securities and Exchange Commission (SEC) as any securities transaction in which the person who initiated the trade is aware of nonpublic material information and is therefore in violation of their duty to maintain the secrecy of that information.
If the revelation of information has the potential to affect the stock price of a company, the information is considered material. A sample of material information includes the following items: the announcement that the company will receive a tender offer, the announcement of a merger, a positive earnings announcement, the release of the company’s discovery, such as a new drug, an upcoming dividend announcement, an unreleased buy recommendation by an analyst, and finally, an impending exclusive in a financial news column.
Another measure taken by the SEC to reduce the risk of insider trading is the Regulation Fair Disclosure (Reg FD), which was announced at the same time as Rule 10b5-1 and states that corporations will no longer be able to choose how they share information in the future. The result is that analysts or institutional clients will not be able to obtain information ahead of retail customers or members of the general public. Each individual who is not a corporate employee will receive information at the same time as the company employees.
Who Is Considered an Insider?
For the purposes of defining criminal insider trading, a corporate insider is defined as someone who has access to information that has not yet been made available to the rest of the public. Insiders are expected, as well as required by law, to maintain a fiduciary duty to the company and its shareholders, and they are bound to safeguard the confidentiality of any nonpublic material information that they may have in their possession. Individuals who engage in the course of their business based on insider information with the hope of making a profit are subject to criminal prosecution.
Insiders can be identified in a variety of ways, including the following: Material information is, of course, made available to CEOs, executives, and directors prior to its release to the general public. Some additional interactions, however, are automatically associated with confidentiality, according to the misappropriation hypothesis of insider trading accusations. In the second section of Rule 10b5-2, the SEC outlines three nonexclusive situations in which a duty of trust or confidentiality is required:
The expression of agreement to maintain confidentiality by an individual.
When the history, pattern, and/or practice of a relationship demonstrate that the connection is one of mutual confidentiality
When a person receives information from a spouse, parent, kid, or sibling, the material is considered confidential (unless it can be proven that such a relationship has not and does not give rise to confidentiality).
Co-conspirators in crime
A tipster and a tipee are two people who participate in insider trading that occurs as a result of information being leaked outside of the company’s internal communications system. The tipper is the person who has intentionally breached their fiduciary obligation by disclosing inside information without their consent. Tippers are those who intentionally exploit insider knowledge to earn a profit in the stock market (in turn also breaking confidentiality). Both sides often agree to this in exchange for a monetary gain shared by both parties. It is possible that the tipper is the spouse of a CEO who goes ahead and tells their neighbor the inside information as gossip. The neighbor, on the other hand, who intentionally makes use of this inside information in a securities transaction is guilty of insider trading in that transaction. Even if the tippee does not utilize the information to trade, the tipper may still be held liable for the information that was provided to him or her.
Proving that a person is a tipper may prove challenging for the Securities and Exchange Commission. It is difficult to trace the flow of insider knowledge and the impact it has on people’s stock trading decisions. Consider the case of a person who makes a trade because their broker has advised them to buy or sell shares in the company. If the broker’s recommendation was based on material non-public information, the person who made the trade may or may not have been aware of the broker’s knowledge prior to making the trade – and establishing what the person knew before making the trade may be difficult to establish.
People who have been accused of a crime frequently say that they simply overheard someone speaking. Consider the situation of a neighbor who overhears a chat between a CEO and their husband about private corporate information. It is illegal for a neighbor to engage in commercial activity based on overheard information, even if the information was “innocently” overheard: the neighbor is deemed an insider with a fiduciary duty and obligation to maintain the confidentiality of nonpublic material information the moment they come into possession of the nonpublic material information.
Because the CEO and their husband, on the other hand, did not attempt to benefit from their secret knowledge, they are not necessarily liable for insider trading. They may, however, be in violation of their secrecy as a result of their carelessness.
The bottom line is as follows:
Due to the fact that unlawful insider trading takes advantage of luck rather than expertise, it poses a danger to investor confidence in the capital market. I believe it is critical for you to understand the concept of unlawful insider trading because it has the potential to impact both yourself as an investor and the firm in which you are investing.