From time to time, D&O Developments will take a closer look at an important issue decided in an appellate opinion. In this post, I analyze In re ChinaCast Education Corp. Securities Litigation, 809 F.3d 471 (9th Cir. 2015), in which the Ninth Circuit reversed the dismissal of a securities class action against ChinaCast Education Corporation, a for-profit e-learning provider in China. ChinaCast’s founder and CEO, Ron Chan, had bilked the company out of millions and, due to his failure to disclose the underlying fraud, made false and misleading statements in conference calls, press releases, and SEC filings. Even though Chan’s conduct was contrary to ChinaCast’s interests, the court ruled that his fraudulent intent could be imputed to the company because he acted with apparent authority on the company’s behalf.
At first blush, the Ninth Circuit’s holding seems fair: why shouldn’t the company be liable for the false statements of its CEO? Yet the holding reads the scienter element out of Section 10(b), and thus expands the scope of liability under that section, contrary to the Supreme Court’s direction that its implied right of action be narrowly construed. The Ninth Circuit compounded its legal error with an incomplete analysis of public policy considerations. Holding a defrauded corporation liable for the fraud committed against it by its officers simply re-victimizes the corporation, and rewards class-period purchasers of stock at the expense of current shareholders.
Factual and Procedural Background
At least on appeal, the parties didn’t dispute the details of the fraud. ChinaCast was a successful, promising business. But its March 2011 10-K filing disclosed that the company’s outside auditor, a Deloitte affiliate, had identified “serious internal control weaknesses” with respect to ChinaCast’s financial oversight. Within a few months of that report, Chan began the process of sending some $120 million in company money to outside accounts that he or close associates controlled. He also used millions of dollars of ChinaCast money to secure loans that had nothing to do with the business, and engaged in other unauthorized and illegal transfers of company assets to third parties.
All the while, Chan made statements about the company’s success and financial security in press releases and on investor calls, and signed SEC disclosures that didn’t mention his looting. Though the board of directors uncovered Chan’s actions in spring 2012, removed him as CEO, and publicly disclosed that he and other senior officers had engaged in illegal conduct, the damage was done. Chan’s actions ruined the company financially.
Purchasers of ChinaCast stock sued Chan, ChinaCast, its Chief Financial Officer, and the company’s independent directors in the Central District of California in September 2012. The district court dismissed the complaint with prejudice as to ChinaCast and the independent directors, holding that the complaint had not adequately alleged scienter. Specifically, the district court reasoned that Chan’s rogue conduct could not be held against the company or its directors because he acted only in his own self-interest and there was nothing to suggest the company benefitted from his actions—what the law of agency calls the “adverse interest exception” to the general principle of holding companies responsible for their agents’ actions. Id. at 474. (Chan and the CFO had not been served and were not the subject of the motion to dismiss ruling.)
The Ninth Circuit’s Ruling
The Ninth Circuit reversed, holding that common law agency principles permitted ChinaCast to be held accountable for Chan’s fraud. The panel explained that ordinarily, actions within the scope of an officer’s apparent authority are imputed to the company. While there is an adverse interest exception to this principle, the exception itself has an exception, which the district court failed to recognize: an agent’s rogue conduct is imputed to the principal (the company) to protect innocent third parties who dealt with the principal in good faith. When ChinaCast permitted Chan to speak on investor calls and through the press, the company gave him its stamp of approval. Innocent shareholders understandably relied on those statements, and protecting their interests requires that Chan’s conduct be imputed to the company. In this case, the company and board did nothing to beef up their oversight processes despite Deloitte’s warning about serious internal risks, and failed to adequately monitor Chan, who, as CEO, should have been subject to careful scrutiny.
The panel relied on a 2013 decision of the Third Circuit, which had rejected a corporate defendant’s adverse interest argument, and allowed a complaint to go forward where the company’s Ponzi-scheming employee acted within the scope of his apparent authority. Id. at 477 (citing Belmont v. MB Inv. Partners, Inc., 708 F.3d 470, 496 (3d Cir. 2013)).
The opinion closed by acknowledging the consequences of its reasoning:
Assuming a well-pled complaint, we recognize 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.
Id. at 479. But the panel further concluded that this result is consistent with the securities laws’ purposes of protecting investors and promoting confidence in securities markets. Id.
The ChinaCast Holding Is Inconsistent with Section 10(b)
Resort to agency law for guidance on federal securities law questions can be appropriate, if it doesn’t conflict with the underlying securities law. But the Ninth Circuit’s agency-law analysis, even if correct, reads the scienter element out of Section 10(b). Under the types of facts present in ChinaCast, the company can only disclose the underlying fraud through those who know about it. But when the looter himself is the only one who knows about the fraud, the company is incapable of disclosing it—the looter has essentially gagged the company. In such a situation, to say that the company “knew,” by imputing the looter’s state of mind to the company, is a dangerous fiction: a company can’t defraud purchasers of its stock by omitting information of which it had no knowledge or ability to disclose other than through the looter. Moreover, the company doesn’t benefit from being defrauded. To the contrary, it is not only directly harmed by the theft, but may also develop legal liabilities due to the looting, and its interest is in preventing further looting and pursuing remedies against the wrongdoer to address those legal liabilities.
In making this error, the Ninth Circuit relied on “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,” as a basis for refusing to apply the adverse interest exception. ChinaCast, 809 F.3d at 478-79. But expanding Section 10(b) liability on such grounds is not allowed. The Supreme Court has consistently warned against expanding the scope of Section 10(b)’s implied private right of action without a clear statement from Congress. See, e.g., Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296, 2301-02 (2011); Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, 552 U.S. 148, 165 (2008). This principle is especially relevant in the context of corporate scienter. Under Section 10(b), liability is foreclosed absent scienter, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976), and of course, scienter is required as to each defendant, including the company.
In contrast to Section 10(b), Congress has explicitly lowered the burden for plaintiffs in other provisions of the securities laws. For example, Section 11 claims impose strict liability on issuers for misstatements in a registration statement. See Ernst & Ernst, 425 U.S. at 200 (contrasting Section 10(b) to other liability provisions in the securities laws, including Section 11). Congress designed Section 11’s lower burden “to assure compliance with the disclosure provisions of the Act by imposing a stringent standard of liability on the parties who play a direct role in a registered offering.” Herman & MacLean v. Huddleston, 459 U.S. 375, 381-82 (1983). Thus, where Congress intends to allocate risk among market participants, it does so explicitly, and there has been no similar allocation in the Section 10(b) context.
Moreover, the Ninth Circuit incorrectly calibrated its fairness analysis. If an executive loots the company in secret and then prevents it from fulfilling its obligations under the securities laws to make accurate public disclosures, imposing liability on the company would further harm and thus re-victimize the company and its shareholders. Indeed, holding the company liable rewards only class-period purchasers of stock, who may or may not be current shareholders, at the expense of the company and its current shareholders.
It is important for courts to remain faithful to the structure of the securities laws in cases that present facts similar to ChinaCast. Although such cases are thankfully rare, they are cases in which there are many victims of the fraud—including the corporation itself, as well as innocent officers and directors.