Insider trading

Definition

Insider trading in business refers to the illegal practice of buying or selling a company’s securities (such as stocks, bonds, or options) based on material, non-public information about the company.

What is insider trading?

This act involves individuals within the company, known as insiders, who have access to confidential information that, if disclosed, could significantly impact the company’s stock value. Insider trading undermines fair market practices, as it gives certain individuals an unfair advantage over other investors who do not have access to the same information.

Types of insider trading:

1. Traditional insider trading: Buying or selling a company’s securities based on material nonpublic information.
2. Tipper-tippee trading: An insider (the tipper) provides material information to someone else (the tippee), who then trades on that information.
3. Front-running: A broker trades on advance knowledge of future orders from their clients.
4. Misappropriation: Outsiders gain access to confidential information and use it for securities trading.

Individuals found guilty of insider trading face severe legal consequences, including fines, imprisonment, disgorgement of profits, and civil lawsuits. Companies may also face legal action if they are found to have facilitated or failed to prevent insider trading within their organisation.

Companies often implement strict corporate governance measures and codes of conduct to prevent insider trading within their organisations. This includes blackout periods during which insiders are restricted from trading to avoid potential conflicts.

When is insider trading illegal?

Insider trading is illegal when individuals buy or sell securities based on material, non-public information in violation of a duty of trust or confidence. This typically involves corporate officers, directors, employees, or anyone who has access to confidential information about the company. The illegality arises when this information is used for personal gain or to avoid losses, thereby giving an unfair advantage over other investors who do not have access to such information.

When is insider trading legal?

Insider trading is legal when corporate insiders—such as executives, directors, and employees—buy or sell stock in their own companies without using material, non-public information. These transactions must be reported to regulatory authorities to ensure transparency. Legal insider trading often occurs under predetermined trading plans which allow insiders to buy or sell shares at set times to avoid accusations of improper conduct. Compliance with disclosure requirements and trading regulations ensures that these activities remain lawful and transparent.

Example of insider trading

XYZ Corporation is a publicly traded company, and John, an executive within the company, has access to confidential information about an upcoming positive earnings announcement, and he learns that XYZ Corporation is about to report significantly higher-than-expected earnings for the quarter due to a major contract win that is not yet disclosed to the public.

Instead of keeping this information confidential, John decides to capitalise on it for personal gain. He purchases a substantial number of XYZ Corporation’s shares before the positive earnings announcement. John’s trade is considered insider trading because he used material, nonpublic information to make a stock trade, giving him an unfair advantage over other investors who did not have access to that information.

This example highlights the illegal and unethical nature of insider trading, where an individual exploits confidential information for personal financial gain.