October 6, 2023

Stock market scams and how to avoid them – Front Running / Insider Trading

Vineet Rajani | Equity Investing

Picture this. You work at a large listed public company. This company will announce its latest quarterly results tomorrow. You already know the results because of your role in this company. You know the results will be received positively by the market. So you buy some shares of your company today to sell it after the results are announced. 

Is there anything wrong with this? You had information; you acted upon it. The problem is that you had access to material information that was not known to the public. You had an undue advantage over the general public.

Insider reading or front running is when you trade with the intention of profiting from material information that the general public is unaware of. Any trade based on information that can impact a stock price but is not yet known to the public is an insider trade.

Promoters, business partners, auditors, and employees of a business are likely to have access to non-public information. SEBI prohibits them from keeping such information non-public without any reason.

Information asymmetry always exists. Beyond promoters and employees of a business, other market participants might also resort to front-running in the greed of quick gains. Investment advisors or news presenters might buy stocks in their personal accounts right before advising their clients/giving tips on those stocks on a news channel. This is also an example of insider trading.

Let us try and understand what is and what isn’t front-running. A fund manager buying a stock in their personal account before buying it in the fund is front-running.

A new stock will be added to the index next month. An active fund buying this stock today and selling it when index funds start buying it next month is not front-running.

How?

The mutual fund’s intention to buy a stock is not public knowledge until it is actually bought. Hence, its fund manager acting on it in their private account is front-running.

However, here is something that looks like front-running but is not. If a stock is announced to be added to an index the next month, index funds will also have to buy that stock next month. When all index funds flock to buy together, it creates a buying pressure thereby pushing the stock price up. This is public knowledge. Active funds can take advantage of this by buying the stock now and selling when index funds flock in. Since the active fund is acting on public knowledge, it is not front-running. 

Professional organizations term insider trading as unethical. It is punishable under section 15G of the SEBI Act, 1992. If proven guilty, the offender may have to pay a penalty of at least ₹10 lakhs, going up to ₹25 Cr or more.

Retail investors are usually the victims of insider trading due to their limited access to information. Therefore, SEBI has been mandating extensive and more frequent disclosures from companies, promoters, mutual funds, other institutional investors, and market intermediaries.

SEBI restricts Registered Investment Advisors (RIAs) from entering into trades contrary to their advice for 15 days from the date of advice. Research Analysts cannot deal/trade in the securities they recommend within 30 days before and 5 days after they publish a research report.

As an investor, always verify the credibility of who you are following for stock tips/advice on TV, social media, or newspapers. You might want to invest in companies where promoter holding is high, as it is symbolic of a motivated management team. But do track their shareholding pattern over the years to verify their stability and reliability. If you can afford it, work with an advisor who can handhold you through your investing journey.


Post a comment