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Who Is Insider
Who Is Insider
The concept of 'Insider' is very important one, and on this concept only, the whole play of
insider trading rests. Broadly, there are two types of insiders—Primary Insiders and
Secondary Insiders, A primary insider is a person who has access to inside information by
virtue of his relationship to an issuer of securities. While a secondary insider is person who
acquires inside information from a primary insider.
The characterizations of an insider as any person who possesses inside format ion
because he has access to it by virtue of the exercise of his employment, profession or duties,
brings out two types of insiders. One is internal insider who obtains inside information in the
exercise of his duties as officer or employee of the company. The other one is external
insider who obtains information because his connection with the company on account of his
employment and profession.
Above explanations of an insider, bring a concluding definition of the insider and that is
what explained by Greek law, "a person becomes an insider if he acquires confidential
information as a result of offering services under any capacity on a permanent or temporary
basis to an issuer or for an issuer". The Securities Exchange Board of India has given a very
wide definition, which merely defines an insider as:
The term "insider" is defined in clause (e) of regulation 2 as: "insider means any person who, is
or was connected with the company or is deemed to have been connected with the company, and
who is reasonably expected to have access, by virtue of such connection, to unpublished price
sensitive information in respect of securities of the company, or who has received or had access
to such unpublished price sensitive information."
The definition has two limbs. The two limbs form the two essential ingredients of the definition,
both of which may be split and presented as follows:
In order to brand a person an insider any one of the two tests stipulated in the first limb, and one
of the three tests stipulated in the second limb, of the definition must be established.
Clause (c) of regulation 2 defines the expression "connected person" and the following persons
will be treated as connected persons:
a director or shadow director of a company,
an officer or employee of the company,
A person having professional or business relationship with a company, if he may
reasonably be expected to have access to unpublished price-sensitive information in relation
to that company.
Clause (h) of regulation (2) defines the phrase "deemed to have been connected", these secondary
insiders are connected persons, but they are not directly connected with the companies. Person
is deemed to be a connected person if such person —
(i) is a company under the same management or group or any subsidiary company thereof
within the meaning of section (1B) of section 370, or subsection (11) of section 372, of (he
Companies Act, 1956 (1 of 1956) or sub-clause (g) of section 2 of the Monopolies and
Restrictive Trade Practices Act, 1969 (54 of 1969) as the case may be: or
(ii) Is an intermediary as specified in section 12 of the Act. Investment Company, Trustee
Company, Asset Management Company or an employee or director thereof or an official of a
stock exchange or of clearing house or Corporation;
Or
(iii) is a merchant banker, share transfer agent, registrar to an issue, debenture trustee, broker,
portfolio manager, Investment Advisor, sub- broker, Investment Company or an employee
thereof, or is a member of the Board of Directors of the Asset Management Company of a
mutual fund or is an employee thereof who have a fiduciary relationship with the company;
(iv) is a member of the Board of Directors, or an employee, or a public financial institution
as defined in Section 4A of the Companies Act, 1956; or
(v) is an official or an employee of a self regulatory organization recognized or authorized by
the Board of a regulatory body; or
(vi) is a relative of any of the aforementioned persons;
(vii) is a banker of the company;
(viii) relatives of the connected person;
(ix) is a concern, firm, trust, Hindu Undivided Family, company or Association of Persons
wherein any of the connected persons mentioned in clause 3(1)above this regulation or any of
the person mentioned in sub-clause (5) ,(6),(7) here in above has have more than 10% of the
holding or interest.
Relatives of connected person shall be relative of another, if and only if,
(A) They are members of Hindu Undivided Family; or
(B) They are husband and wife; or
(C) The one is related to the other in the manner indicated below:
MALE FEMALE
Father Mother (Incl. step mother)
Son (including step-Son) Sons' Wife
Father's Father Daughter (Incl. step-daughter)
Mother's Father Father's Mother
Son's Son Mother's Mother
Son's Daughter husband Sons' Son's wife
Daughter's Son Son's Daughter
Daughter's Son Daughter's Sons' wife
Daughter's Daughter's husband Daughters 's Daughter
Brother (Incl.-step-Brother) Brother's wife
Sister's husband Sister (Incl. step-sister)
Motivated reports strategically published in newspapers and magazines are also one form of
insider trading. Several investors act on the motivated reports and suffer their own fate, by
the time they realise their mistake the insider has got away with the benefits.
Insider trading also takes the form of manipulation. Under the listing agreements
entered into by the companies with the stock exchange concerned, the publication of half
yearly working results are mandatory. Now the normal practice of dressing the half yearly
results in such a manner so as to show a result contrary to the general trend is very common
feature of companies. Suppose, A Ltd. is expected to do reasonably well at the year end, the
management of A Ltd. shows almost a break picture for the half year. The individuals close
to the management will unload all their holdings a few days before the publication of the
results. The common investor of A Ltd. will be watching the share prices coming down.
Then the poor half yearly results will be published which will further bring down the prices.
After a few months, the insiders will slowly buy back the holdings and spread the news that
the company has started doing well and the prospects of (he company are bright.
Yet another form of insider trading takes the form of market support provided by the
management by resorting to very heavy purchases of its company's shares through various
intermediaries. Such practice is particularly used when the company is coming out with a big
right issue and the management cannot afford the price to fall below a specified minimum.
Generally, after the issue is over subscribed the price comes down and the investor who has
subscribed for the new issue realize that the issue was not worth the price paid by him. This
aspect of insider trading has almost become a permanent feature of the share market
operations of today's corporate world.
Such unfair practices are more common and frequent during or near the time of
declaration of annual or half yearly profits, bonus or rights issue or issue of convertible
debentures, new profits schemes of amalgamations or takeovers etc. Sometimes, insider
trading is resorted to by connected persons through speculators or brokers under the benami
transactions. Whatever form insider trading may assume, it is obvious that the common
investors are the ones who always lose.
For understanding the effects of insider trading, it is helpful to categorize the agents involved
or affected into several groups. Economic analysis of insider trading typically considers the
following parties: insiders, market professionals, liquidity traders, and
Investors, who are defined as follows. Insiders, as defined earlier, are the officers, directors,
and other key employees of a firm who, by the nature of their employment, obtain or possess
confidential information regarding the firm’s prospects. An example of an insider is the chief
executive officer or the chief engineer of the firm. Market professionals are informed non-
insiders, including securities analysts, brokers, or arbitrageurs, who have acquired private
information regarding the firm’s prospects by spending their own resources and who do not
have any fiduciary relationship with the firm. For example, a security analyst may have
called the firm’s major customers and learned that they are not interested in buying its new
product line. Liquidity traders, sometimes referred to as “noise” traders, are short-term stock
market participants who have some, usually negligible, holdings of the firm’s shares and
trade in order to hedge risk or balance their portfolios without consideration of a firm’s
prospects. An example of a liquidity trader is a large pension fund that buys and sells the
firm’s shares from time to time in order to meet the investment and redemption needs of its
clients. Investors may be small or large shareholders who have a long-term investment
objective such that they “buy and hold.” While not privy to management’s private
information, investors have a significant beneficial interest in the firm’s actual performance.
For instance, the heir to a substantial holding of the firm’s stock who does not take an active
role in its daily management is an investor. Insider trading involves and affects each of the
above classes of agents. If insiders were allowed to trade on their privileged information,
they would of course reap trading profits. At the same time, insiders who are professional
managers may receive reduced compensation from investors to reflect the profits managers
can earn from trading. Insider trading also affects liquidity traders, who face the prospects of
incurring losses when trading with agents possessing superior information.
On the other hand, if they avoid trading, they will lose the diversification/hedging benefits
that prompt them to trade in the first place. In addition, insider trading implies that informed
non insiders or market professionals face informed competitors in the financial marketplace.
The rivalry between informed insiders and informed non insiders.
may drive the latter out of the market, making prices less informative, or, by furthering
competition, increase the speed with which information is released to uninformed traders.
Insider trading has an impact on investors through its effects on both investors’ trading
profits (when they buy and sell holdings for liquidity reasons) and managerial incentives to
create value. If insider trading were not prohibited by law, investors, especially large
shareholders, would need to decide their firm’s policy toward insider trading. The legal and
economic literature on insider trading attempts to weigh the trade-offs discussed above to
formulate optimal policies. Different authors focus on different classes of actors and
different types of effects. Given the number of classes of actors involved in and affected by
insider trading and the multiplicity of effects, differences in focus have led to rather
discordant assessments of insider trading and conflicting policy recommendations.
Certain types of transaction can alert securities regulators that the investor who initiated them must
have been acting based upon inside knowledge -- in other words, knowing some significant piece of
news before the general public. A transaction will be considered suspicious based upon a
combination of criteria:
The timing is just a little too good. Anyone can make an investment at any time, but
someone who buys soon-to-be profitable put options or sells a stock short in the few trading days
immediately before a major decline in the stock's price will seem to have been more than ordinarily
lucky. This criterion is suggestive when present, but is not mandatory. For example, a short sale
could have been made quite some time before it would turn out to be profitable. But the longer in
advance a short sale or put-option purchase is made, the more uncertainty there will be as to whether
events will play out according to plan; so generally the inside trader doesn't make illicit trades very
long in advance.
The transaction itself is too specific. For example, if someone bought puts on United
Airlines and American Airlines but not on Delta Airlines, investigators will be sure that the trader
knew in advance that these two airlines were targets of the attack. (On the other hand, this works
both ways: If there were similar trades in a third airline but not in others, investigators can conclude
that one or more flights of that airline were supposed to have been hijacked as well.)
The transaction is too large. One of the most reliable indicators of illegal insider trading is
that the perpetrator has traded at an abnormally high level. In other words, someone who normally
makes trades of a few thousand dollars now and then, but suddenly begins to make much bigger
plays, may well be doing so because s/he has some form of inside knowledge. If inside-traders kept
their trades to reasonable levels, they would seldom, if ever, be caught -- since their trades would not
seem especially abnormal and they could be explained as part of their regular investment strategy.
However, people typically get caught up by their own greed: when they know for certain that
something significant is going to happen to the price of a stock, they cannot resist the temptation to
make as much money as possible on their knowledge.
Transactions deviate from normal trading levels. In the options markets, there is normally a
reasonably even balance between call and put options on any given stock; and there is normally a
reasonably predictable level of activity in options on any particular stock. When the balance
between puts and calls is grossly disrupted and the level of volume in options trading is far beyond
normal, investigators can be pretty sure that something is up.
The transaction is too speculative. In other words, the transaction is one that would be
unreasonably risky -- if not out-and-out stupid -- were it not that the perpetrator was trading based
upon inside knowledge. For example, a large purchase of stock options that were both significantly
"out of the money" and relatively close to their expiration date, but suddenly turned out to be
valuable based upon some news affecting the underlying stock, would seem to represent an
unreasonable degree of prescience.