Agent’s Scienter Imputed to Corporate Defendant Even Where Agent’s Fraud Was Adverse to the Company’s Interests: Ninth Circuit | Practical Law

Agent’s Scienter Imputed to Corporate Defendant Even Where Agent’s Fraud Was Adverse to the Company’s Interests: Ninth Circuit | Practical Law

In In re ChinaCast Education Corp. Securities Litigation, the US Court of Appeals for the Ninth Circuit reversed the dismissal of a complaint against a corporation, holding that a corporate officer's scienter, or intent to defraud, could be imputed to the corporation even where the defrauding officer acted adversely to the corporation's interests. Where an innocent third-party relies on the officer's misrepresentations, the corporation could not take advantage of the "adverse interest" exception to common law agency rules to defeat liability.

Agent’s Scienter Imputed to Corporate Defendant Even Where Agent’s Fraud Was Adverse to the Company’s Interests: Ninth Circuit

by Practical Law Litigation
Published on 27 Oct 2015 • USA (National/Federal)
In In re ChinaCast Education Corp. Securities Litigation, the US Court of Appeals for the Ninth Circuit reversed the dismissal of a complaint against a corporation, holding that a corporate officer's scienter, or intent to defraud, could be imputed to the corporation even where the defrauding officer acted adversely to the corporation's interests. Where an innocent third-party relies on the officer's misrepresentations, the corporation could not take advantage of the "adverse interest" exception to common law agency rules to defeat liability.
On October 23, 2015, in In re ChinaCast Education Corp. Securities Litigation, the US Court of Appeals for the Ninth Circuit reversed the dismissal of a complaint against a corporation, holding that a corporate officer's scienter could be imputed to the corporation even where the defrauding officer acted adversely to the corporation's interests. Where an innocent third-party relies on the officer's misrepresentations, the corporation could not take advantage of the "adverse interest" exception to common law agency rules to defeat liability (No. 12-57232, (9th Cir. Oct. 23, 2015)).

Case Background

The defendant ChinaCast is a for-profit post-secondary education and e-learning services provider founded by co-defendant and former CEO Ron Chan (Chan). In March 2011, ChinaCast revealed in a Securities and Exchange Commission (SEC) filing that its outside accounting firm identified serious weaknesses in the company's financial oversight. The complaint alleges that, shortly after this clear warning from its accountants, Chan embezzled approximately $120 million of company funds through various means, ultimately bringing ChinaCast to ruin.
While this fraud was ongoing, Chan also participated in ChinaCast earnings calls with investors, where he emphasized the company's financial health and stability even as he was embezzling funds. He further reassured investors that no questions or concerns had ever been raised by company auditors about the company's cash balances.
In March 2012, after discovering that Chan tried to interfere with an annual audit, ChinaCast's board removed Chan as chairman and CEO. In April 2012, the company disclosed to the SEC that it had discovered illegal conduct by several officers, including Chan. A group of ChinaCast shareholders sued ChinaCast and Chan, among others, in September 2012, alleging violations of Rule 10b-5 of the Securities Exchange Act of 1934.
The district court dismissed the complaint against ChinaCast under FRCP 12(b)(6). The court found that the shareholders failed to adequately plead scienter, or intent to defraud, one of the key requirements of a 10b-5 claim under the Private Securities Litigation Reform Act of 1995 (PSLRA). The court held imputation did not apply in this case under the "adverse interest" exception to the common law rules of agency. This exception holds that an officer's fraudulent actions cannot be imputed to the corporation where the officer acted adversely to the corporation's interests, as Chan did. The shareholders appealed. The parties did not dispute that that Chan had in fact acted within the scope of his apparent authority and that Chan's actions had harmed the company.

The Ninth Circuit's Ruling

In a case of first impression, the Ninth Circuit reversed the dismissal and held that Chan's fraudulent actions as CEO, while adverse to ChinaCast's business and interests, could be imputed to ChinaCast because Chan acted with apparent authority on behalf of the company.
Based on the common law rules of agency and principals, the court determined that an agent's actions are imputed to the principle where the agent is acting within the scope of his apparent authority. This applies in the context of Rule 10b-5 to hold a corporation responsible for fraud committed by its officers. The court rejected ChinaCast's argument that the rule of imputation did not apply in this case due to the adverse interest exception, since Chan had robbed the company itself.
The court focused on a critical caveat to the adverse interest exception: adverse interest does not apply when an innocent third party relies on the agent or officer's apparent authority. Chan's scienter could be imputed to the corporation because third-party shareholders relied on Chan's representations as CEO, which were made with the imprimatur of the corporation who selected Chan to speak on its behalf.
In addition to common law rules, the court found further support for its conclusion from:
  • Case law from other courts, including:
    • a ruling from the Third Circuit holding that, when a corporate officer commits wrongdoing, the principal who has placed the agent in a position of trust and confidence should suffer, rather than an innocent stranger; and
    • the Supreme Court's endorsement of the identical principle of imputation in the antitrust context, in reasoning not limited to that context.
  • Public policy considerations, such as fair risk allocation and ensuring close and careful oversight of high-level corporate officials to deter securities fraud.
Practitioners in the Ninth Circuit should be aware that a corporate defendant cannot avail itself of the adverse interest exception in Rule 10b-5 lawsuits where the plaintiff is an innocent third party who relies on the apparent authority of a rogue agent. However, as discovery and litigation proceed, the questions of a plaintiff's innocence and reliance are rebuttable.