American domestic guru and TV tycoon Martha Stewart went to jail for five months. When she was allowed out on probation, she wore an electronic ankle bracelet so that the police would know if she has stepped out of her house.

Her crime? She was told by her friend, Sam Waksal, that his company Imclone's cancer drug has been rejected by the food and drug administration. Before this information was made public, Stewart told her broker to sell her 4,000 shares in the company and escaped unhurt when the stock got hammered. The day after she sold the stock, it dropped 16 per cent to $46 and Stewart saved $45,673.

From the above example, it is evident that those trading on the basis of insider information have an opportunity to enter and exit at the correct time. Finally, when the news goes public, the stock goes back to its realistic price level. Result: an ordinary investor, with little information, is stuck with the stock at a price, which could be too high or too low, while those who have inside knowledge manage to make a packet and a safe exit.

Who is an insider?

The Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992, say, "insider" is any person who, is or was connected with the company, and who is reasonably expected to have access to unpublished price-sensitive information about the stock of that particular company, or who has access to such unpublished price sensitive information.

Information that could be price sensitive includes periodical financial results of a company, intended declaration of dividend, issue or buyback of securities, any major expansion plans or execution of new projects, amalgamation, merger, takeovers, disposal of the whole or substantial part of the undertaking and any other significant changes in policies, plans or operations of the company.

However, insider trading isn't always illegal. Trading by a company insider in its shares is not violation per se and is legal. What is illegal is the trading by an insider on the basis of unpublished price-sensitive information.

Insider trading violations may also include 'tipping' such information and the person using it.

How does insider trading work?

An insider buys the stock (he might also already own it). He then releases price-sensitive information to a small group of people close to him, who buy the stock based on it, and spread the information further. This results in an increase in volumes and prices of the stock. The inside information has now become known to a larger group of people which further pushes up volumes and prices of the stock.

After a certain price has been reached, which the insider knows about, he exits, as do the ones close to him, and the stock's price falls. Those who had inside information are safe while the ordinary retail investor is stuck holding a white elephant as, in many cases, the 'tip' reaches him only when the stock is already on a boil.

The regular investor gets on the bandwagon rather late in the day as he is away from the buzz with no direct connection to the 'real' source. He buys the overvalued stock due to imbalance in the information flow.

Difficult to prove

While it's common knowledge that insider trading takes place, it is very difficult to prove. Insiders may not trade on their own account. Flow of information is another important factor, but difficult to track. Regulations are in place to prevent this, but the stock price of a company invariably tends to move up or down at least a couple of weeks ahead of any price-sensitive announcement.

Take the case of IFCI. The stock has been on fire since early January 2007. It gained almost 53 per cent in eight trading sessions from Rs 13.45 before the announcement of its 7-per cent stake sale in NSE was made in January 2007.

The stock also gained 30 per cent in 12 sessions before the announcement to appoint Ernst & Young for advising the company on induction of a strategic investor in the company was made in March 2007. From this level, the run up in the stock has been over 210 per cent.

While it is not possible to say that insider trading took place in this case, little else explains the share price movement.

The expected strategic sale was called off in December 2007, and the stock shed almost 23 per cent in one session. Investors who got on the bandwagon at around Rs 70-74 in early September 2007 and did not sell by this time, would have lost all their gains.

Innocent till proven guilty. Considering the sensitivity of the subject and the evidence required to allege and prove it, the instances of insider trading that get reported are far and few. Says Bhavesh Shah, vice-president (research), Asit C Mehta Investment Intermediates: "Majority of the cases that have been reported and acted upon by the exchange and the Sebi have been too few and the action too late. A study of the reported cases on insider trading in Securities Appellate Tribunal (SAT) very clearly reflects a complex web of transactions of unusual nature put through for extraordinary gains by few interested parties. However, in almost all cases the Sebi has not managed to bring the culprit to book for one or the other reason."

Samir Arora, the erstwhile fund manager of Alliance Capital Mutual Fund, was probed for professional misconduct, fraudulent and unfair trade practices and insider trading. SAT dismissed the charges against Arora on the premise that there was no violation and for want of evidence. Recently, the Sebi has initiated an investigation into sale of 4.01 per cent in Reliance Petroleum [Get Quote] by Reliance Industries [Get Quote].

The key is in detecting and preventing

"Although many factors can lead to spikes in trading, deviations of the kind observed by measured markets (an entity which carries out early warning services for stocks) are among the data used by regulators in the US to spot insider trading," says a broking industry source. In the US, of the 90 big mergers that took place in 2007, shares of 37 target companies exhibited abnormal trading in the days and weeks before the deals were disclosed.

One way to reduce insider trading is to make it more costly and difficult, which calls for strict surveillance measure and penalties. "Exchanges and the Sebi require professionals from the market on their payroll for carrying out this function. Good surveillance software would keep continuously pointing out to unusual trading pattern on a real-time basis," says Shah.

Market regulator Sebi has put in place a comprehensive Integrated Market Surveil-lance System to track trading data from all the market participants�stock exchanges, depository participants, custodians as well as data of clearing houses. This system is expected to help it detect potential and accomplished insider trading and manipulation or fraud violations across financial instruments and markets. How effective will this system be, is yet to be known.

Market plague

The impact of insider trading on the small investor is negative both from the point of view of their financial interest and also their confidence in the markets. It is extremely detrimental to the growth of a healthy capital market where all participants, big and small, can step in with confidence of a fair play. In an efficient market, even one share traded on insider trading violates the integrity of the markets.

The efficient market hypothesis asserts that financial markets are "informationally efficient". This means that the share price already reflects all known information and is unbiased. It reflects the collective beliefs of all investors about future prospects.

In reality, however, there are those who are in the know, and those who get the news too late.

How to safeguard yourself

So, is it that those who are not in the know will always be left high and dry? Investors can exercise certain precautions so that they don't get caught in this whirlpool of the information game. Keen observation is needed to remain safe.

You need to be on the alert for strong price movement in the stocks you monitor, increasing volume but no news flow about those stocks or without any apparent improvement in the reported numbers. This could be difficult for those who believe in momentum, and while there is a good chance that they might lose out on some potential gains, the primary aim, however, should be to protect capital and not get stuck at a higher price with limited scope for capital appreciation.

If you do buy a scrip based on a tip, try and book early profits. Do not wait to catch the top as the downfall, when it comes, will be swift and sudden. If it's a company that you have never heard about, or it's of an industry that you have no idea about, it is best to forego the possibility of a quick profit and ignore the tip altogether.

Points to ponder

Despite the fact that Sebi regulations on insider trading penalise the person who gives out company information, that is the 'tipper', stock prices have seen unwarranted movements ahead of price-sensitive announcements. The market regulator has recently come out with a consultative paper on amendments to Sebi (Prohibition of Insider Trading) Regulations 1992. Some of the points it makes are:

Pinning the guilty
The Sebi consultation paper suggests that there should be specific penalty even for the tipped, who is the beneficiary of the tip-off. While currently there is a vague prohibition against procurement of information, it does not clearly prohibit a 'tipped' from trading based on the information received.

Smaller Spread
It also proposes to remove bonus shares and rights shares from the purview of insider trading. However, industry body Ficci has said that Sebi should retain such announcements within the ambit of its insider trading policy as stock prices are sensitive to such news.

Expensive Process
Sebi feels that the costs of criminal sanction on lack of proper processes and corporate governance are excessive and disproportionate. It has proposed that criminal penalties on corporate governance measures be removed and powers of monetary penalties and directions retained.

In the open
It has been suggested that companies should make a standardised disclosure in their annual report as to what regulations they are not complying with. This will let the market decide whether to levy monetary penalties on the companies that don't have these safeguards in place, or not.

In the back alleys

As a representative of a large multinational company, I come into contact with a lot of small- and medium-sized listed software companies. Our relations are built at the top and often our discussions spill over to other deals and potential orders of the company.

The directors and others in the know blatantly tell us what deals are expected and when. In one such company, I got the tip-off when the stock was at Rs 470. I bought as many shares as I could. In less than six months, the stock shot up Rs 1,000. The drop, when it came, was sudden. The stock is now languishing around Rs 500.

In fact, when the news finally broke in the media, it was exactly as it was predicted to me months before. A large client deal was signed. They told me a global organisation would be funding them, which is exactly what happened. I was also quite surprised that a broking firm, which has a large number of retail investors, even put out a buy tip on the stock just before the news broke. They, in fact, also sent their subscribers an SMS to buy this stock.

In my case, profits and losses from insider trading have evened out. While I did make exceptional profits on some tips, there have been others where I did not sell at the right time and ended up clutching worthless paper once the news played out and the more influential insiders exited.

In many industries it is common practice to offer shares of the company to customers as way of an incentive for getting the order. When the deal is announced, both the vendor and the customer benefit. This not only ensures business growth, but also that everybody is richer for it.

A first person account of an insider about what happens behind the curtains, as told to Veena Venugopal.