Securities Law--Ninth Circuit Uses Exception to Adverse Exception and Imputes CEO's Scienter to Corporation Under Rule 10b-5--In re ChinaCast Educ. Corp. Sec. Litig., 809 F.3d 471 (9th Cir. 2015).

• Author: Koutrobis, Christos

The United States, through the Securities Exchange Act of 1934 (the Exchange Act), created protections for investors from conduct such as misrepresentation, deceit, and fraud in connection with the purchase or sale of securities. (1) From the authority given in the Exchange Act, the Securities and Exchange Commission (the SEC) created 17 C.F.R. 240.10b-5 (Rule 10b-5) to combat fraud. (2) Scienter is an essential element in Rule 10b-5 and courts often apply it to determine whether a corporation is liable for the actions of its chief executive officer (CEO). (3) The United States Court of Appeals for the Ninth Circuit, in In re ChinaCast Education Corp. Securities Litigation, (4) was faced with the question of whether or not the scienter of a corporation's CEO could be imputed to the corporation. (5) The Ninth Circuit ultimately held that regardless of the conflicting interests of the corporation and its CEO, the corporation was liable for the actions of its CEO when he or she acts with apparent authority. (6)

Ron Chan Tze Ngon (Chan) founded ChinaCast Education Corporation (ChinaCast), a postsecondary and e-learning for-profit corporation in the People's Republic of China, in 1999. (7) Prior to its ultimate downfall, ChinaCast was listed on the NASDAQ Global Select Market and valued at over USD200 million. (8) In March 2011, ChinaCast disclosed in its Form 10-K filing with the SEC that its outside accounting-consulting firm Deloitte Tohamatasu CPA Ltd. (Deloitte) indicated in its audit that there were "serious internal control weaknesses" regarding financial oversight. (9) As ChinaCast's CEO, Chan transferred USD120 million from ChinaCast to accounts that he and his associates controlled during June 2011 to April 2012. (10) In addition, Chan unlawfully transferred the company's control over two private colleges outside ChinaCast, used USD37 million in assets as collateral to secure loans unrelated to ChinaCast's business, and permitted a vice president to move USD5.6 million from the company to his son. (11)

Chan and the chief financial officer, Antonio Sena (Sena), were involved in numerous communications including conference calls with investors. (12) During these communications, Chan and Sena stressed confidence in the financial stability of China-Cast and never disclosed the fraud to the investors. (13) After Deloitte voiced its concerns about ChinaCast's financial status in conference calls and press releases, Chan stated that no auditor or committee expressed concerns about the corporation's cash balances. (14) Prior and subsequent to Deloitte's audit of ChinaCast, Chan had signed multiple SEC filings; none of which disclosed any of the fraudulent statements or unlawful transfers of corporate funds. (15) Early in 2012, the board at China-Cast discovered Chan attempted to interfere with the annual audit and disclosed to the SEC that it '"uncovered questionable activities' and illegal conduct on the part of its senior officers," after which the board removed Chan and Sena resigned thereafter. (16)

Shortly after the board reported to the SEC, Alejandro Puente filed a shareholder class action lawsuit against ChinaCast and many corporate officers on behalf of individuals who purchased shares of ChinaCast between February 2011 and April 2012. (17) The class action lawsuit alleged claims for relief for violation of Section 10(b) of the Exchange Act, Rule 1 Ob-5, and Section 20(a) of the Exchange Act. (18) ChinaCast filed a motion to dismiss based on the plaintiffs' failure to plead the element of scienter adequately as required under the Private Securities Litigation Reform Act (the PSLRA) and the Federal Rules of Civil Procedure. (19) The United States District Court for the Central District of California granted ChinaCast's motion to dismiss based on an exception to the general rule of imputation where the conduct of agents do not transfer to their principals when the agent acts adversely to the principal. (20) The plaintiffs appealed the district court's grant of the motion to dismiss to the Ninth Circuit on the grounds that scienter can be imputed from an agent to its principal where the agent acts with actual or apparent authority and an innocent third party relies on the agent's authority, regardless if the conduct is adverse to the principal. (21) The Ninth Circuit reversed the decision of the district court and held the scienter of Chan could be imputed to ChinaCast because he acted with apparent authority as the CEO and that the plaintiffs were presumed to be innocent third parties. (22)

Following the Great Depression and the crash of the stock market in 1929, the United States Congress and President Franklin Roosevelt enacted the Securities Act of 1933 (the Securities Act) and the Exchange Act. (23) The SEC was created in the Exchange Act and its purpose as an administrative agency is to regulate the securities industry and protect investors. (24) The SEC promulgated Rule 10b-5, pursuant to its authority in Section 10(b) of the Exchange Act, to prohibit corporations from making false misrepresentations, omitting material facts, or engaging in fraudulent conduct. (25) To succeed on a Rule 10b-5 claim, a plaintiff must prove: (1) a material misrepresentation (or omission); (2) scienter; (3) a connection with the purchase or sale of a security; (4) reliance; (5) economic loss; and (6) loss causation. (26) Congress enacted the PSLRA to prevent frivolous lawsuits, over the veto of President Bill Clinton. (27) Congress designed the PSLRA to limit frivolous securities lawsuits by heightening the standard for pleading scienter, the Rule 10b-5 culpability element. (28)

To satisfy the element of scienter in a Rule 10b-5 claim, a plaintiff must prove that an individual or corporation acted more than negligently when making the material misrepresentation or omission. (29) As it can be difficult to prove knowledge of a nonhuman corporation, generally, the scienter can be imputed from the corporations' officers like the CEO. (30) A CEO is the highest-ranking officer in a company and thus, investors put much of their confidence in the statements and conduct of the CEO as a representative of the corporation. (31) As an agent of the corporation, the CEO acts on its behalf and the investors rely on what the CEO says regarding corporate matters, such as the financial stability and overall well-being of the company. (32)

An exception to the rule of imputation is a common law agency exception where the CEO acts adversely to the interests of the corporation. (33) When an agent acts adversely to the principal, the principal is excused from normal imputation of liability because of the nature of the agent's actions. (34) There is also an exception to the adverse interest exception where the agent acts with apparent or actual authority of the principal, and an innocent third party detrimentally relies on the agent. (35) Under this exception, when an agent acts adversely to the corporation but does so with apparent or actual authority and an innocent third party relies on that authority, the statements made will be imputed to the corporation. (36) This exception was carved out in common law to protect the interests of the innocent third parties relying on the authority or appearance of authority the agent was acting with, which the principal had given. (37)

In In re ChinaCast Education Corp. Securities Litigation, the Ninth Circuit maneuvered through the intertwining securities laws and agency principles. (38) Initially, the Ninth Circuit acknowledged a corporation can act only through its employees and agents and thus, can only have the requisite scienter through those acting on its behalf. (39) Next, the Court expressed how agency principles governed the relationship between the corporation and its agents because federal securities laws failed to provide explicit guidelines. (40) Using common law agency principles, the Court determined that as the CEO, Chan was acting with the apparent authority of ChinaCast and general imputation rules applied. (41) The Ninth Circuit agreed that Chan may have acted adversely to ChinaCast but did not go so far as to say it relieved the corporation of liability for his actions. (42) Instead, the Court discussed the agency principle that the lower court missed that holds a corporation liable for its agent where the agent acts adversely to the corporation but does so with apparent authority and innocent third parties rely on that authority. (43)

The Court noted that investors purchased and kept shares of ChinaCast while Chan omitted material information about his fraudulent conduct and maintained the corporation was in great financial shape. (44) The Court reversed the lower court's decision based on the reliance of the third party investors on the CEO's apparent authority. (45) The Ninth Circuit referenced a Supreme Court of the United States antitrust decision that cited other Rule 10b-5 cases that imputed scienter to the principal from the agent where the agent acted adversely to the principal, but third parties relied on it. (46) Additionally, the Court stated that as a matter of public policy, it is logical to have strict imputation rules so the high-ranking officers of the company are closely supervised and scrutinized. (47) Lastly, the Court further noted that ChinaCast's auditors mentioned there were serious internal control issues and ChinaCast failed to take action and '"turned a blind eye.'" (48) Based on the findings that Chan's conduct could be imputed to ChinaCast because innocent third parties relied on his conduct, the Ninth Circuit determined the plaintiffs satisfied the pleading requirement for scienter under the PSLRA and reversed the district court's decision. (49)

First, the Ninth Circuit's correct application of agency principles helped the investors overcome obstacles that the legislature and the judiciary created. (50) Initially, the lower court decided...