An insider is someone who is “connected” to the company, who could have the unpublished price sensitive information or receive the information from somebody in the company. The following people can be treated as an insider:
- corporate officers, director and employees who traded the corporations securities after learning of significant, confidential corporate developments
- Friends, business associates, family members and other “tippees” of such officers, directors, and employees, who traded the securities after receiving such information;
- Employees of law, banking, brokerage and printing firms who were given such information to provide services to the corporation whose securities they tried;
- Government employees who learned of such information because of their employment by the government; and
- Other persons who misappropriated, and took advantage of, confidential information from their employers
The first “Insider trading” case was reported in the US way back in 1792.William Duer, the then assistant secretary in the US department of treasury used his official position to gather insider knowledge and involved in speculative trading in the newly issued debt of the US government. He was indicted and spent his days behind bars. In the early 1920s JP Morgan & Co. used its high influence with Republican Party to make huge profits from central bank of US which led to an unprecedented boom in NYSE and consequently the selloff started plunging the prices to new lows and triggering a panic among investors and banks. This chaotic economic scenario led into the decade long great depression. It was after the great depression that the public demanded for tough laws on insider trading done to manipulate profits. In 1964 the Securities Act Amendment laid down disciplinary controls over brokers and dealers.
“Insider trading” is a term that most investors have heard and usually associate with illegal conduct. But the term actually includes both legal and illegal conduct. The legal version is when corporate insiders—officers, directors, and employees—buy and sell stock in their own companies. When corporate insiders trade in their own securities, they must report their trades to the SEC.
Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information. Because insider trading undermines investor confidence in the fairness and integrity of the securities markets, the SEC has treated the detection and prosecution of insider trading violations as one of its enforcement priorities.
How to control insider trading
Criminal: One way of dealing with insider trading is by passing regulations prohibiting such trades, making them penal and enforcing criminal actions against violators. As any penal provision, this is supposed to deter others from violating the regulations. However experience has shown us that this method provides only a small amount of relief even in more heavily regulated countries. Thus the threat of a jail sentence for the offender under S.24 of the SEBI Act is more of a paper tiger. Though the jail sentence may look good on the statute, history bears out the difficulty in enforcing criminal prosecution against an economic offender. The burden of proof of proving a criminal charge is so onerous, the requirement of intent so strict, and the courts procedures so long and ‘due’ that conviction is an exceptional exception For instance the only case of insider trading prosecuted by Dutch authorities in ten years failed on lack of proof. The Securities and Exchange Commission of the United States brought 47 cases of insider trading in the year 20017 of which only 4 were referred to the Department of Justice for criminal action
Ivan Boesky paid $100 million to the Securities and Exchange Commission to settle insider-trading charges that he netted $50 million in illegal profits. Boesky pleaded guilty to a related charge and was sentenced to 3½ years in prison in 1987.
Civil and administrative penalties: Civil monetary penalties and issue of various administrative actions like bar from the industry without going to courts is a more effective remedy and with the enhanced powers granted to the regulator to impose penalties of 25 crores or three times the gain made, an economic harm can more easily be inflicted and deterrence more effectively administered
A recent US case is illustrative of a typical civil penalty charged by the Securities and Exchange Commission. In SEC v. Steve Madden, the Commission filed a settled injunctive action against shoe designer Steve Madden alleging that he engaged in insider trading. The complaint alleged that after Madden learned from the criminal authorities that he was the target of a criminal investigation and would be indicted or otherwise charged for securities fraud, he sold 100,000 shares of common stock in his company, Steven Madden Ltd. Madden sold this stock without disclosing to the public the information he had learned regarding the criminal investigation. After Madden was arrested, the company’s stock price sank and Madden avoided losses of $784,000. Madden consented to an order of permanent injunction and agreed to disgorge $784,000 of illegally avoided losses, plus prejudgment interest, and to pay $784,000 in civil penalties
Prophylactics: The third way of attacking the problem is by encouraging the companies to practice self regulation and taking prophylactic action. This is inherently connected to the field of corporate governance. It is a means by which the company signals to the market that effective self regulation is in place and that investors are safe to invest in their securities. In addition to prohibiting inappropriate actions (which might not necessarily be prohibited), self regulation is also considered an effective means of creating shareholder value. Companies can always regulate their directors/officers beyond what is prohibited by the law. Another way is to mandate all companies to release annual reports of the degree of compliance with the standards set forth.
In a case The Wall Street Journal columnist R. Foster Winans was convicted in 1985 of giving information to two stockbrokers about stocks he was planning to write about in the Heard on the Street column. They used the information to make about $690,000. Winans’ cut was $31,000. Winans was sentenced to 18 months in prison. Other players, including stockbroker Kenneth Felis and Winans’ roommate, David Carpenter, were also convicted. A second stockbroker, Peter Brant, pleaded guilty Similarly, former ImClone CEO Samuel Waksal was sentenced to 87 months in prison and fined $3 million after pleading guilty to six counts, including insider trading and fraud. Waksal sold ImClone stock after finding out regulators had rejected an application for the company’s new cancer drug, Erbitux. (The drug was later approved.) In 2004, style guru and media magnate Martha Stewart was convicted of obstruction of justice charges relating to her sale of ImClone stock. She was sentenced to 10 months, split between prison and home confinement, and fined $30,000. Her stock broker, Peter Bacanovic, was also convicted.In the biggest scandal, the Enron company, Jeffrey Skilling, the former Enron president, was convicted in 2006 on 19 counts, including insider trading. He was sentenced to 24 years and fined $45 million. Last year, a judge cut 10 years off Skilling’s sentence in a deal in which more than $40 million of Skilling’s fortune will be given to victims of Enron’s collapse.In another case, Raj Rajaratnam was the founder of the once-mighty hedge fund firm Galleon Group. The firm fell apart after Rajaratnam was arrested in 2009 on charges of conspiring to trade using insider information. The scheme could have brought in profits of some $20 million, according to the government. Rajaratnam was found guilty on 14 counts of conspiracy and securities fraud charges on May 11, 2011. The jury convicted him of nine counts of securities fraud and five counts of conspiracy for what prosecutors describe as the money manager’s central role in the most sweeping probe of insider trading at hedge funds on record. Former Goldman Sachs executive Rajat Gupta was also convicted for supplying Rajaratnam with many of the tips that eventually took the Galleon manager down.Similarly, Steven A. Cohen ran one of the most admired hedge funds in the world, garnering some of the highest returns (and highest fees) in the industry until its spectacular fall from grace. In 2010, federal agents raided the offices of two hedge funds founded by SAC Capital Advisors alumni, and later arrested several top traders at SAC, including Michael Steinberg and Matthew Martoma. Cohen was not charged, but SAC Capital itself pleaded guilty in November to fraud charges and agreed to pay $1.8 billion to settle charges that it allowed insider trading for more than a decade In an interesting case of Scott London, a senior partner at KPMG, had a habit of talking about work over dinner and golf with an old buddy. He later discovered his friend was making trades based on their banter, and began accepting cash gifts and Rolex watches in exchange for further tips. In total, London received about $70,000 in gifts before the SEC found them out. His friend Bryan Shaw pulled in roughly $1.3 million. London was sentenced in April to 14 months in prison and a $100,000 fine. Shaw pleaded guilty to insider trading charges as well