In an issue of first impression, the Ninth Circuit Court of Appeals recently held that a rogue corporate officer’s fraudulent intent can be imputed to a corporation even where the defrauding officer acted against the corporation’s interest, known as the “adverse interest exception.” In re ChinaCast Educ. Corp. Sec. Litig., — F.3d –, 2015 WL 6405680, at *5 (9th Cir. Oct. 23, 2015). In so holding, the Ninth Circuit created “an exception to the exception” – when an innocent third party relies on a defrauding officer’s apparent authority, the officer’s fraud can be imputed to the corporation even if that fraud was adverse to the corporation’s interest.
ChinaCast Education Corporation is a postsecondary education service provider in China with shares listed on the NASDAQ stock exchange. The CEO and CFO of ChinaCast committed what the Ninth Circuit called “textbook securities fraud.” Among other things, the CEO embezzled $120 million of corporate assets to outside accounts controlled by him and his allies, and approved the CFO transferring $56 million in company funds to the CFO’s son. All of the fraud was completed as the CEO assured investors that the corporation was financially healthy and stable. Despite a “clear warning” from auditors a year earlier that fraudulent practices may be taking place, the corporation discovered the CEO’s fraud in 2012 and removed him from his corporate office. Thereafter, a group of ChinaCast shareholders brought a federal securities lawsuit under the PSLRA against the corporation, among others, alleging violations of Rule 10b–5 of the Securities Exchange Act of 1934.
The district court dismissed the complaint with prejudice pursuant to Rule 12(b)(6). It determined that the shareholders had failed adequately to plead fraudulent intent, or “scienter,” on the part of the corporation, refusing to impute the officers’ scienter to the corporation based on the adverse interest exception. Thus, because the officers had acted in their own self-interest and to the detriment of ChinaCast, the trial court refused to follow the general rule of imputing an officer’s fraud to the corporation.
The Ninth Circuit reversed this finding, holding that the officers’ fraudulent intent could in fact be imputed to the corporation. Applying common law agency principles, it determined that the adverse interest exception does not always block imputation to corporations, specifically when an innocent third party relied on an officer’s apparent authority.
The Ninth Circuit bolstered its position by relying on a recent, factually-similar Third Circuit case, as well as Supreme Court precedent that applied this principle in the federal antitrust context. It further reinforced its decision by relying on the public policy goals of fair risk allocation and proper corporate oversight, noting that the corporation had ignored earlier warning signs of the potential fraud. It also recognized this holding essentially eliminated the adverse interest exception altogether in the initial stages of fraud-on-the-market suits because a bona fide plaintiff would always be an innocent third party. The Court’s commentary noted that as discovery and litigation proceed, the question of the plaintiff’s innocence and the presumption of reliance are rebuttable.
Other circuits already have imputed to corporations a defrauding officer’s scienter under the agency principle of apparent authority. These circuits have not, however, addressed the interplay between the adverse interest exception and apparent authority in the same vein as the Ninth Circuit. Most circuits do not address the adverse interest exception at all, finding simply that the scienter of an officer acting under apparent authority can be attributed to the corporation per agency principles. In re ChinaCast appears to be the first clear explanation of the relationship between the adverse interest exception and apparent authority when pleading corporate scienter under federal securities laws, and when one trumps the other.
Corporations can no longer rely on the “rogue employee” as a defense for claims of fraud by innocent investors. Because the employee’s fraudulent intent can be imputed to the corporation, it would not be surprising to see an increase in fraud-on-the-market suits upon the discovery of any corporate officer fraud. Moreover, any litigation likely will persist for longer periods of time given the Ninth Circuit’s recognition that the adverse interest exception is essentially eliminated in the pleading stage of those suits.