Misappropriation Theory: What it is, How it Works, Example

What Is Misappropriation Theory?

Misappropriation theory states that using insider information in securities trading is securities fraud against the source of the information. In the United States, someone found guilty under the misappropriation theory can be convicted of insider trading.

While not specifically prohibited by U.S. securities laws, insider trading is considered to be a form of deceptive trading practices and is therefore illegal when using undisclosed material information.

KEY TAKEAWAYS

• Misappropriation theory prohibits trading based on nonpublic information received and used by someone outside of the corporation.
• Misappropriation theory is the legal principle behind convicting those who engage in insider trading.
• Misappropriation theory aims to protect securities markets and ensure fairness and efficiency.

Understanding Misappropriation Theory

Misappropriation theory differs from the classical theory of insider trading, which focuses on a corporate insider’s breach of duty to shareholders they transact with. Insiders can be employees, directors, or officers of the company.

Conversely, misappropriation theory criminalizes trading by someone outside the corporation who obtains nonpublic information. Misappropriation occurs when an outsider receives classified or insider information about a company and uses it to trade. The outsider betrays the trust of the information source, typically a corporate insider.

Example of Misappropriation Theory

Misappropriation theory gained prominence in the conviction of James H. O’Hagan by the Supreme Court. O’Hagan, an attorney, acted on insider information regarding a takeover bid for the Pillsbury Corporation. This case, United States v. O’Hagan, was a pivotal moment for the theory.

Misappropriation theory also applied to the insider trading case of Carl Reiter, a real estate developer in the 1980s. While golfing with friends, Reiter received advice to buy stock in the drugstore chain Revco Drug Stores. His friend provided inside knowledge of an upcoming merger that would benefit investors. Reiter followed the advice, bought the stock, and made a profit of $2,625 by selling his shares when the tip proved correct.

Unaware that he had engaged in illegal insider trading, Reiter and his friends, all of whom used the nonpublic information, were charged with insider trading under the misappropriation theory two years later. They had received information from someone who disclosed nonpublic information. Reiter was required to return his profits from the illegal investment and was fined by the Securities and Exchange Commission (SEC).