Misappropriation Theory

What Is Misappropriation Theory?

Misappropriation theory postulates that a person who uses insider information in trading securities has committed securities fraud against the information source. In the United States, a person who is guilty according to the misappropriation theory may be convicted of insider trading.

Though not expressly forbidden by U.S. securities laws, insider trading is considered to fall under the prohibition against deceptive trading practices and is thus illegal when committed using material nonpublic information.

KEY TAKEAWAYS

  • Misappropriation theory outlaws trading based on nonpublic information received and used by a corporate outsider.
  • Misappropriation theory is the legal principle behind convicting those guilty of insider trading.
  • Misappropriation theory is intended to protect securities markets to keep them fair and efficient.

Understanding Misappropriation Theory

Misappropriation theory differs from the classical theory of insider trading. The classical theory targets a corporate insider's breach of duty to shareholders with whom the insider transacts. The insider may be an employee, director, or officer of the company.

On the other hand, misappropriation theory outlaws trading by a corporate outsider who receives nonpublic information. When an outsider receives classified or insider information about a company and uses the information to trade, misappropriation has occurred. The outsider has betrayed the trust of the source, most likely a corporate insider. 

Example of Misappropriation Theory

Misappropriation theory gained prominence in the Supreme Court's conviction of James H. O'Hagan. An attorney, O'Hagan acted on insider information regarding a takeover bid for the Pillsbury Corporation. The United States versus O'Hagan was a watershed case for the theory.

Misappropriation theory applied to the insider trading case of Carl Reiter, a real estate developer in the 1980s. While golfing with friends, Reiter was advised to buy stock in the drug store chain, Revco Drug Stores. The friend provided inside knowledge of an upcoming merger that would be profitable for investors. Reiter followed his friend’s advice, bought the stock, and garnered a profit of $2,625 by selling his shares when the friend’s tip proved correct.

Without further involvement in the Revco company, Reiter was unaware that he had participated in illegal insider trading. Two years later, Reiter and his fellow friends, all of who used the nonpublic information, were charged with insider trading under the misappropriation theory. They had received information from someone who disclosed nonpublic information. Reiter was required to discharge his profits from the illegal investment and was fined by the Securities and Exchange Commission (SEC).

Article Sources
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  1. Library of Congress. "U.S. Reports: United States v. O'Hagan."

  2. U.S. Securities and Exchange Commission. "SEC Docket, Volume 43, No. 10."

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