Insider Trading: Definition, Main Cause, Regulations, Punishments, Examples

Insider Trading

Insider trading is pervasive and becoming more common each year. Insider trading is the activity of trading (buying and selling directly or indirectly) in a company’s stocks while using confidential data (unpublished price-sensitive information) about the company. The problem of insider trading is as old as the equities market trading itself. It is regarded as the biggest transgression of business ethics and a possible destroyer of investor confidence in the stock market. Unpublished price-sensitive information also known as non-public information is data that is not legally in the public domain and is only held by a small number of people who are directly related to it. The information is referred regarded as “price-sensitive” since it has the potential to affect the market price of a company’s securities.

 An insider can be a company executive or an employee of the government who has access to economic reports before they are made available to the general public. The Securities and Exchange Board of India strongly discourages insider trading, which is the use of such information to make an unjustified profit or loss in the order to encourage fair trading in the market for the benefit of the average investor. Insider trading is unfair conduct in which the absence of crucial insider non-public information puts the other stockholders at a significant disadvantage. For example, if the CEO of a corporation tells a friend who holds a significant share in the company crucial information regarding the acquisition of his business before the information is made public and the friend takes action on the information and sells all of his shares is illegal insider trading.

Depending on when an insider makes a trade, insider trading may be either legal or illegal. Insider trading is legal as long as it complies with the guidelines established by the Securities and Exchange Board of India(SEBI). Insiders are permitted to purchase and sell shares of their company’s stock. In fact, thousands of reports of insider trading are filed every day. No laws are broken as long as the insider is trading using information that is commonly available to the public. However, When the crucial information is still undisclosed, insider trading is believed to be unlawful and is subject to severe penalties, including possible fines and jail time.

The phrase “insider trading” is not explicitly defined under the Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations 1992. However, it defines the terms “Insider,” “Connected Person,” and “Price Sensitive Information.”

  1. Insider: As defined by the Regulations, an “Insider” is any individual who is, was, or is believed to have been associated with a company and who would reasonably be anticipated to have access to confidential information about that company that could affect its stock price.
  2. Connected Person: According to the Regulation, a “connected person” is someone who is a director of a company, as defined in clause (13) of section 2 of the Companies Act, 1956, or is regarded as such under sub-clause (10) of section 307 of the Act or holds a position involving a professional or business relationship between himself and the company, whether it be temporary or permanent, or holds a position in which he is an officer, employee, or occupies some other position, and who may reasonably be expected to have access to unpublished price-sensitive information about that company.
  • Price Sensitive Information: This term refers to any information that directly or indirectly pertains to a company and that, if published, has the potential to significantly alter the price of the firm’s stocks. The instances of price-sensitive information are as follows:
    • The company’s financial outcomes
    • Intended dividend declaration
    • Issue of shares via public rights, bonuses, etc
    • Any major initiatives for growth or the start of new projects
    • Merge, acquisition, and amalgamation
    • Disposal of the undertaking in whole or in part

Why regulate Insider Trading

  1. To safeguard shareholders: Insider trading usually results in significant losses for businesses, which in turn causes either loss for investors or substantial profits for insiders at the expense of all other investors. It takes away from an investor the opportunity to earn a profit.
  2. To safeguard the company’s interests and reputation: When a company faces insider trading issues, investors often lose faith in that company and stop making investments there, and sell all of the company’s stock.
  3. Maintaining investor trust in stock market operations-Since SEBI regulates all trading, if any insider manages to violate the rules, it would diminish investors’ faith in the stock exchange operations as a whole.

Major Steps Taken

Over time, various committees and regulations are formed to address the Insider Trading issue. The Thomas Committee was formed in 1948 as the first actual effort to control insider trading. The Securities Exchange Act of 1934 was able to regulate insider trading to some extent. Sections 307 and 308 were added to the Companies Act of 1956.

The Sachar Committee acknowledged in 1979 that the Companies Act of 1956 needed to be amended because employees may abuse corporate information and manipulate stock prices. The Patel committee in 1986 recommended that the Securities Contracts (Regulations) Act, 1956 should be changed to allow exchanges to reduce insider trading. The Abid Hussain Committee set up in 1989 recommended that insider trading activities should be subject to both civil and criminal proceedings and also suggested to SEBI to create the rules and regulating codes necessary to avoid unfair business practices. After that, Insider trading was outlawed in India in 1992 by “The Security and Exchange Board of India (Insider Trading) Regulations Act, 1992 and if a  person is found guilty of insider trading, in this case, he faces penalties under Sections 24 and 15G of the SEBI Act, 1992. Later, The Regulations underwent significant changes in 2002 and were renamed “SEBI Regulations, 1992.

Punishment under the SEBI Act of 1992

The SEBI Act of 1992 governs insider trading in India. A fine of up to Rs. 25 crores or three times the profit made from it, whichever is bigger, may be imposed by SEBI. SEBI has the authority to file charges in criminal cases, declare transactions in shares to be based on price-sensitive information that has not been publicized, or order an insider not to trade in the company’s securities. Moreover, Section 11(2)E of the Companies Act of 1956 forbids insider trading. Directors or other key management personnel of a corporation are prohibited from engaging in insider trading under Section 195 of the Act.

Examples in the Real World

  1. Amazon– Brett Kennedy, a former financial analyst for Inc. (AMZN), was accused of insider trading in September 2017. Authorities assert that before the public disclosure, Kennedy provided fellow University of Washington alumnus Maziar Rezakhani with information on Amazon’s first-quarter 2015 financial results. Rezakhani paid Kennedy $10,000 in exchange for the information. According to the U.S. Securities and Exchange Commission, Rezakhani profited $115,997 trading Amazon shares after receiving a tip from Kennedy in a related case.
  2. Martha Stewart– When news broke that the FDA had rejected ImClone’s new cancer treatment, the company’s shares fell dramatically. The family of CEO Samuel Waskal appeared unaffected even after such a sharp decline in the share price. Martha Stewart had advance notification of the rejection, and she sold her holdings When the company’s stock was trading at $50, and the price later dropped below $10 in the subsequent months. Waskal was given a sentence of more than seven years in prison and a fine of $4.3 million in 2003, forcing her to quit as the CEO of her business.
  3. Joseph Nacchio– While serving as the CEO of Qwest Communications at a time when he was aware of the serious issues the company was facing, Joseph Nacchio gained $50 million by selling off his stock on the market and providing positive financial projections to stockholders. He was found guilty in 2007.

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