Malfeasance by a corporate insider against his company has the potential to leave a gaping wound. Facing a securities lawsuit due to that malfeasance is like salt in that wound. Corporations targeted with such lawsuits have turned to the adverse interest exception to try to protect themselves from further liability stemming from the rogue executive’s wrongdoing. But on October 23, the U.S. Court of Appeals for the Ninth Circuit issued a precedent-setting decision rendering that salve unavailable. In In re ChinaCast Education Corp. Securities Litigation, the court held that under the federal securities laws, an executive’s scienter is imputed to the corporation where he “acted with apparent authority on behalf of the corporation, which placed him in a position of trust and confidence and controlled the level of oversight of his handling of the business.” Slip op. at 4.

ChinaCast arose out of an alleged massive embezzlement committed by Ron Chan Tze Ngon (“Chan”). Chan was the founder and CEO of ChinaCast, a Chinese for-profit educational company listed on the NASDAQ Global Select Market. Plaintiffs allege that in 2011 and 2012, Chan “‘transferred’ $120 million of corporate assets to outside accounts that were controlled by him and his allies.” Slip op. at 5. While he was “looting . . . the corporate coffers,” id. at 3, Chan made false and misleading statements about the company’s financial health in earnings calls and other investor communications. The SEC sued Chan civilly in the Southern District of New York in 2013, and judgment was entered against him in early 2015 for disgorgement of more than $40 million.

Unable to serve Chan in China, the plaintiffs focused their attention on the company, accusing it of Rule 10b-5 allegations and alleging that Chan’s fraudulent intent could be imputed to the company. The district court (Judge John F. Walter of the Central District of California) rejected this argument, relying upon the “adverse interest exception” to agency law. Because Chan was acting against ChinaCast’s interests in embezzling and in making false statements to cover it up, Judge Walter held that Chan’s knowledge could not be imputed to ChinaCast under an agency theory. As a result, the district court dismissed the plaintiffs’ 10b-5 claims against ChinaCast for failure to adequately plead scienter.

The Ninth Circuit reversed and allowed the claims against ChinaCast to proceed. The court explained that under agency law, the “adverse interest exception” does not apply where an innocent third party relies upon the apparent authority of the agent. As between the innocent investors and the innocent corporation, the court held that it should be the corporation who is responsible for the misconduct of its executives. In the court’s view, the corporation is better positioned than the investors to identify and deter such misdeeds. In this vein, the court highlighted an audit report from 2011 that identified material weaknesses in internal controls, inferring that the corporation and its outside directors could and should have acted upon that report and prevented the looting that was to come.

The facts of the ChinaCast case are unusual in (i) the apparent severity of Chan’s misconduct, (ii) the corporation’s concession of Chan’s alleged wrongdoing, and (iii) the “red flags” raised by auditors that should have prompted more careful attention to the actions of Chan and other executives. The decision is nonetheless likely to foreclose use of the “adverse interest exception” in similar actions in the Ninth Circuit, and thereby expose corporations that suffer from internal wrongdoing to the added burden of federal securities lawsuits.