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On October 23, 2015, the Ninth Circuit held that fraudulent misrepresentations made by Ron Chan, the founder and CEO of ChinaCast Education Corporation, could be imputed to ChinaCast even though Chan had acted adversely to ChinaCast’s interests by “embezzl[ing] millions” from the company. In re ChinaCast Educ. Corp. Sec. Litig., 2015 WL 6405680 (9th Cir. 2015) (McKeown, J.) (ChinaCast II). The Ninth Circuit determined that the adverse interest exception to the general rule imputing an executive’s scienter to the corporation did not apply because the complaint alleged that (1) “Chan [had] acted with apparent authority on behalf of the corporation” and (2) “third-party shareholders [had] understandably relied on Chan’s representations, which were made with the imprimatur of the corporation that selected him to speak on its behalf and sign SEC filings.”

Background

ChinaCast is “a for-profit postsecondary education and e-learning services provider” that at one point “boasted a market capitalization topping $200 million.” In March 2011, ChinaCast disclosed that its outside accounting firm (an affiliate of Deloitte & Touche LLP) “had identified ‘serious internal control weaknesses’ with respect to [the company’s] financial oversight.” Plaintiffs alleged that “despite this ‘clear warning from Deloitte’ . . . the company and its board ‘turned a blind eye’ to the problem.”

Between June 2011 and April 2012, “Chan [allegedly] ‘transferred’ $120 million of corporate assets to outside accounts that were controlled by him and his allies” and also engaged in a variety of other maneuvers that eventually “brought ChinaCast to financial ruin.” During this time, Chan allegedly “emphasized the company’s financial health and stability” in public statements to investors. In March 2012, after “ChinaCast’s board discovered that Chan had attempted to interfere with an annual audit,” the board removed Chan as chairman and CEO.

ChinaCast’s shareholders subsequently brought the instant securities fraud action. In December 2012, the Central District of California dismissed plaintiffs’ complaint with prejudice for failure to allege scienter. In re ChinaCast Educ. Corp. Sec. Litig., 2012 WL 6136746 (C.D. Cal. Dec. 7, 2012) (Walter, J.). The court held that Chan’s scienter could not be imputed to ChinaCast based on the adverse interest exception, pursuant to which courts “refus[e] to impute scienter from the fraud of a rogue agent.” The court found that here, there was “no allegation that Chan or his accomplices [had] acted out of anything other than their own self-interest, or that their conduct [had] in any way benefitted ChinaCast.” Plaintiffs appealed.

Ninth Circuit Reverses, Finding That Chan’s Scienter May Be Imputed to ChinaCast Because the Company’s Shareholders Relied on Misrepresentations Made by Chan within the Scope of His Apparent Authority

On appeal, the Ninth Circuit explained that it has “adopted the general rule of imputation” pursuant to which “a corporation is responsible for a corporate officer’s fraud committed ‘within the scope of his employment’ or ‘for a misleading statement made by an employee or other agent who has actual or apparent authority’” ChinaCast II, 2015 WL 6405680 (quoting Hollinger v. Titan Capital Corp., 914 F.2d 1564 (9th Cir. 1990)). The Ninth Circuit noted that a number of courts in other circuits have “follow[ed] the same principles, even after the advent of” the Private Securities Litigation Reform Act (“PSLRA”) “and its strict focus on scienter.”

Here, defendants did “not dispute that Chan [had] acted within the scope of his apparent authority,” but claimed that “the ordinary rule of imputation [was] inapposite because of the common law’s so-called ‘adverse interest exception.’” The Ninth Circuit acknowledged that Chan had “lined his own pockets at the expense of ChinaCast’s interests,” but determined that “the adverse interest rule doesn’t apply in every instance where there is a faithless fraudster within the corporate ranks.”

The Ninth Circuit found that “the adverse interest exception itself has an exception: the principal is charged with even the faithless agent’s knowledge when an innocent third-party relies on representations made with apparent authority.” Because plaintiffs alleged that ChinaCast’s shareholders had “relied on Chan’s representations,” the Ninth Circuit held that “Chan’s scienter [could] be imputed to ChinaCast” at the pleading stage “for those material misrepresentations or omissions made within the scope of [his] apparent authority.”

The Ninth Circuit held that it was appropriate to impute Chan’s scienter to ChinaCast given the “public policy goals of both securities and agency law –  namely, fair risk allocation and ensuring close and careful oversight of high-ranking corporate officials to deter securities fraud.” The court found that plaintiffs had “pled sufficient allegations to support imputation and survive the pleading requirements of the PSLRA.” The court noted that even though the ChinaCast board had received an audit report indicating significant internal control weaknesses, the board had “failed to take significant action or heighten oversight.” The court emphasized that “Chan was hardly a random corporate bureaucrat or mid-level manager.” As the company’s CEO, Chan was “the one person on whom the board undoubtedly should have kept close tabs.”

Ninth Circuit Discusses Whether Defendants Can Obtain Dismissal of Securities Fraud Complaints at the Pleading Stage Based on the Adverse Interest Exception  

The Ninth Circuit observed that “at the pleading stage, a key inquiry in § 10(b) and Rule 10b-5 cases is whether the complaint sufficiently alleges scienter attributable to the corporation.” The court stated that in cases where defendants assert the adverse interest exception, “[a] threshold question is whether the pleadings support application of the adverse interest rule at all.” The Ninth Circuit found that “as a practical matter, having a clean hands plaintiff eliminates the adverse interest exception in fraud on the market suits because a bona fide plaintiff will always be an innocent third party.”

However, the Ninth Circuit noted that the adverse interest exception may provide a basis for dismissal on the merits at a later stage if defendants can either show that the plaintiff was not an innocent party or rebut the presumption of reliance.