7 effective ways to prevent insider trading

Apr 05, 2024

Insider trading has been around for a long time now. In order to prevent day-to-day losses while trading in the stock market, traders use this information to adjust their buying and selling prices. 

The securities board of every country has laid down strict laws discouraging insider trading.

It is a criminal activity in which a handful of traders and investors have access to sensitive information capable of manipulating the prices of a share.

With acts of unethical activities, ordinary people disregard investing and trading in the stock market fearing loss of wealth and falling prey to the hands of prominent market players. 

What is insider trading?

Insider trading is an illegal activity conducted by the employees or directors of a company, wherein they supply critical information related to their stocks to third parties.

The data is shared with them before surfacing in the public realm, as this gives them an edge to increase their profits or lower their losses.

With beforehand knowledge of the stock price, these people can take counter-action before the news goes out in the crowd. 

The illegal information supplied to a particular category of people is called material non-public information.

This information can be circulated within the company to guide the employee's actions in a specific direction, but it becomes an insider tip when this news goes out before an official announcement.

Sharing words like these that are capable of influencing stock prices is a punishable offense in the eyes of the law. 

Under material non-public information, it does not matter where the information was received from or who communicated the information.

All the parties who utilized, shared, and took advantage of the news will be held accountable and need to pass the court's trial. 

Suppose an employee of the company overheard non-public news and communicated it to another employee, who took advantage of this news and bought/sold shares.

According to the law, both the employees can be prosecuted under the insider trading policy for taking undue advantage of the information. 

Examples of material non-public information:

• Prior knowledge of the company's acquisitions, mergers, or new ventures.

• Buy-back of stocks and share splits.

• An undisclosed or special dividend.

• Leaking of a company's financial statements or sensitive financial information.

What are the legal implications of insider trading?

Insider trading is a punishable crime, whether conducted by an employee or by the company's director.

The profit from insider trading is regarded as illegal revenue; hence, the person found guilty will be either imprisoned or fined, or both. 

In the US, the imprisonment term for violating the insider trading policy is up to 20 years and can attract a fine of five million dollars.

Whereas, in India, according to the Securities Exchange Board of India (SEBI), a penalty of 250 million will be imposed on the guilty party or three times the profit earned through the illegal tip.

When is insider trading legal?

Insider trading can be legal as well as illegal. It is considered illegal when the material non-public information is not yet unveiled to the public to know.

However, under legal insider trading, the business owners or directors declare the transactions legally to the securities body. 

Legal insider trading happens every day on the stock exchange, where the company directors, employees, and significant shareholders buy or sell their shares as per the market sentiment.

Every sale and purchase activity is wholly verified, legalized, and conducted according to the stock market's direction.

Under such circumstances, their activities are considered usual and not suspicious. 

On the contrary, if a major buy-back or selling of shares occurs right before a breakout, the securities body may intervene to examine the reason for such actions.

What are the effective ways to prevent insider trading in your company?

Preventing insider trading from being practiced in your company is the responsibility of the top-level management.

With an increasing number of defaulter cases within the company, the administration must take strict measures to ensure insider trading compliance. 

Mentioned below are the ways how companies can prevent insider trading in their companies:

1. Do not overshare sensitive information

The management should be mindful while communicating information and data to their employees.

Not everything is meant to be shared with them - there are specific matters that are highly sensitive to a company's position and brand value and should be restricted to a handful of employees. 

If the employee accidentally spills a piece of confidential information to a third party, the possibility of insider trading rises.

Hence, keeping the news restricted to a few employees is critical to preventing any fraudulent activity.

2. Educational programs

Employees can unknowingly get looped in the insider trading process.

Hence, it becomes crucial for the management to educate them on what lies within the legal means and what does not. 

Under the educational programs, employees should be informed on what information is non-public or not yet to be disclosed to the shareholders.

They need to be encouraged to avoid participation in an unlawful disclosure of the news and immediately report the parties who approach them for such help.

3. Blackout periods and trading window

One of the most effective measures to prevent insider trading is blackout periods.

Under the insider trading policy, a blackout period is when the corporation's employees and directors are barred from buying and selling their holdings in the company's shares or making changes to their investment structure.

The most common time of the blackout period is around the company's earnings announcement. 

The trading window is the opposite of the blackout period. In the trading window, the companies encourage the employees to buy the company shares in the time specified by them.

4. Conduct due diligence

The prevention measures drive back to your hiring process.

Before hiring an applicant in your company, businesses must do a thorough background check of his past experiences and financial conduct.

While collecting reports of the applicants, if the HR team finds any red flags related to corporate misconduct and wrongdoing, the applicant should be immediately rejected.

5. Review and timely update restricted lists

The insider information list needs to be regularly reviewed and updated according to the market's direction and time of announcement. 

For example, In the first-quarter earnings report, a company announces its merger with another company.

After the announcement, the company can remove this information from the list and update any latest news.

6. Review and revise the company's insider trading policies

The employees get habitual of the same insider trading policy as they know how it works and monitors their activities.

The year-on-year continuation of the same insider trading policy builds a stagnant and ignorant management image in the employees' eyes. 

Timely revision and upgradation of the policy show the management's seriousness in preventing illegal tipping.

7. Watch out for irregular trading patterns

By monitoring the trading activity of the company's shares, the management understands the usual trading pattern of the traders.

If there's a sudden increase or decrease in the sale-purchase activity of the company shares without any external factor, the management should prioritize looking into the cause behind this movement.