What Is the 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 will likely 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 non-public information.

Key Takeaways

  • Misappropriation theory describes someone who commits securities fraud against the source of information and uses it for insider trading.
  • 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 the Misappropriation Theory

Misappropriation theory differs from the classical theory of insider trading. Under the classical theory, a person who is not an insider but who learns of material non-public information and uses that to trade is not guilty of insider trading.

The classical theory requires the person accused of insider trading to be an actual insider—an officer or employee of the company whose securities they are buying or selling. Under this theory, only the corporate insider owes a fiduciary duty to the corporation and its shareholders not to engage in buying or selling the corporation's securities using material non-public information. The outsider who happens across some material non-public information does not owe that fiduciary duty and cannot be guilty of insider trading.

Under misappropriation theory, however, the outsider who happens across some material non-public information of a corporation may not use that information to trade because they owe a fiduciary duty to the source of the information. Misappropriation theory is intended to protect securities markets from outsiders who have access to confidential corporate information but who do not owe a fiduciary duty to the corporation or its shareholders.

Example of Misappropriation Theory

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

A typical example of how misappropriation theory applies to insider trading is the case of Carl Reiter, a real estate developer in the 1980s. Reiter was playing golf with friends when one of those friends advised him to buy some stock in the drug store chain, Revco Drug Stores. The friend suggested that he had inside knowledge of an upcoming merger that would be profitable for investors. Reiter followed his friend’s advice, buying a few thousand dollars’ worth of the stock, and cashing out two months later (having made a profit of $2,625 when the friend’s tip turned out to be correct).

As a real estate developer with no personal involvement in the Revco company, Reiter went on with his life, not realizing that he had participated in illegal insider trading. However, Reiter wasn’t the only person on the golf course that day and wasn’t the only one who followed the tip. Two years later, Reiter and his friends were charged with insider trading under the misappropriation theory. They hadn’t been insiders themselves, but they had received information from someone who was and used it inappropriately. Ultimately, Reiter was asked to discharge his profits from the illegal investment and pay a fine to the Securities and Exchange Commission (SEC).