For purposes of determining the scienter of a corporate entity defendant under the federal securities laws, a company’s executives’ knowledge generally is imputed to company. There is an exception to these general principles – the “adverse interest exception” – which provides that an executive’s knowledge will not be imputed to the company if the executive acted for his or her own purposes and contrary to the interests of the company. There is also an exception to the exception, which provides further that a rogue executive’s knowledge will nevertheless be imputed to the company when an innocent third-party has relied on the executive’s representations made with apparent authority.
In an October 23, 2015 opinion (here), the Ninth Circuit applied these principles to reverse the district court’s dismissal of the ChinaCast Education Corp. securities class action lawsuit, holding that the knowledge of the company’s CEO, who had embezzled funds and mislead investors through omissions and false statements, could be imputed to the company for purposes of innocent third-party investors’ claims.
ChinaCast is a postsecondary education and e-learning services provider in China. Its shares were listed on the NASDAQ exchange. Between January 2011 and April 2012, the company’s founder and CEO, Ron Chan, transferred $120 million from the company (including proceeds from the company’s U.S. share offerings) to accounts controlled by him and his allies. Chan also permitted or participated in other transactions that removed assets from the company. These actions, according to the Ninth Circuit, “brought ChinaCast to financial ruin.” While this fraudulent activity was taking place, Chan participated in a series of earnings calls and other communications with investors in which he emphasized the company’s financial health and stability. He never disclosed the $120 million in transfers or other fraudulent activity.
In early 2012, the company’s board removed Chan as the company’s Chair and CEO after he attempted to interfere with the company’s audit. The company subsequently discovered and disclosed Chan’s fraudulent activity.
As discussed here, in September 2012, a group of the company’s shareholders filed a securities class action lawsuit against the company and certain of its directors and officers. The defendants moved to dismiss the lawsuit, arguing in reliance on the adverse interest doctrine that Chan’s knowledge of his fraudulent misconduct could not be imputed to the company. In a December 7, 2012 ruling (here), Central District of California Judge John F. Walter granted the motion to dismiss, holding that because Chan had acted contrary to ChinaCast’s interests, Chan’s scienter could not be imputed to the corporation. The plaintiffs appealed Judge Walter’s ruling as to ChinaCast.
The October 23, 2015 Decision
In an October 23, 2015 opinion written by Judge M. Margaret McKeown for a unanimous three judge panel, the Ninth Circuit reversed the district court’s dismissal of the lawsuit, holding that Chan’s knowledge could be imputed to the company because he had “acted with apparent authority on behalf of the company,” which had “placed him in a position of trust and confidence and controlled the level of oversight of his handling of the business.”
ChinaCast had urged the appellate court to affirm the district court’s ruling, arguing in reliance on the adverse interest doctrine that because Chan had acted out of his own interests and contrary to the interests of the company, his knowledge could not be imputed to the company.
The appellate court acknowledged these arguments, but noted further that “the adverse interest rule doesn’t apply in every instance where there is a faithless fraudster” – there is, the court noted, an “exception to the exception.” The adverse interest rule “collapses in the face of an innocent third party who relies on the agent’s apparent authority.”
Taking all of these principles into account, the Ninth Circuit said, “compels the conclusion that Chan’s scienter can be imputed to the corporation in these circumstances.” The appellate court noted further that the complaint alleges that “third-party shareholders understandably relied on Chan’s representations, which were made with the imprimatur of the corporation that selected him to speak on its behalf and sign SEC filings.”
In the interests of avoiding the contortions required to make determinations based on exceptions to exceptions, the appellate court stated 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.” Under this practical rule, which the court characterized as an “appropriately narrow view of the adverse interest exception,” the “gymnastic exercise of imposing a general rule of imputation followed by analyzing the applicability of the exception to the exception becomes unnecessary.”
The adverse interest exception often is invoked by defendant companies in securities class action lawsuits involving bad actor executives. The classic example in the securities litigation archives is the securities suit filed in the era of corporate scandals against Tyco, which arose after rogue CEO Dennis Kozlowski looted the company. (In that case, the district court held, as the Ninth Circuit held here, that the adverse interest doctrine did not operate to preclude imputation of the bad actor’s knowledge to the company).
More recently, Petrobras tried to rely on the adverse interest doctrine in arguing that its corrupt senior executives’ knowledge could not be imputed to the company. As discussed here, Southern District of New York Judge Jed Rakoff rejected the company’s argument, stating that the allegations “do not conclusively establish that the company received no benefit from the corrupt executives’ actions.” (In other words, he never got to the “exception to the exception” stage of the analysis, because he concluded that the company had failed to show that the exception itself applied.)
In recognition of the confusing pileup of agency law principles involved in the “exception to the exception” analysis, the Ninth Circuit here adopted a pragmatic rule holding that the adverse interest exception simply doesn’t apply in fraud on the market cases, because a shareholder plaintiff who simply relied on the market will always be an innocent third party. This pragmatic principle would not apply if in subsequent proceedings in the case the defendants were to show that plaintiffs were not innocent third parties.
This case will now go back to the district court for further proceedings. While the outcome in the Ninth Circuit represents a substantial victory for the plaintiffs, there are suggestions in the appellate court’s opinion that the plaintiffs’ win could be hollow. Among other things, the appellate court noted in its opinion that the company’s financial reverses were so ruinous that the company “cannot even afford its legal bills.” Its lawyers explained the “bare-bones brief” they had filed on appeal by stating that “ChinaCast now unfortunately lacks the funds necessary to mount with full vigor the defense of this appeal.” The prospects for a substantial recovery from the company appear slim. (Because the plaintiffs have been unable to effect service of process on Chan and the company’s former CFO, the prospects for a recovery from these two individuals are nil.)
Readers of this blog may wonder about the company’s D&O insurance. There is nothing in the appellate opinion one way or the other about the company’s insurance, but the fact that the company lacked the wherewithal to mount anything but a barebones effort on appeal suggests that whatever insurance the company might have had is either unavailable or depleted. While I have no knowledge at all about ChinaCast’s D&O insurance program (or if it even had D&O insurance), I do know from having represented a number of U.S.-listed Chinese companies at that time that many of these companies purchased only very limited amounts of D&O insurance. If ChinaCast purchased the same kind of lower limits of liability for its insurance program as did many other U.S.-listed Chinese companies at that time, it could well have exhausted or substantially depleted its insurance just getting through the motion to dismiss and trying to respond to the appeal. If, on the other hand, the company, like some other U.S.-listed Chinese companies at the time, simply balked at buying the insurance, it could have no alternative but to try to fund its continuing involvement in these proceedings out of its own assets.
Special thanks to a loyal reader for sending me a copy of the Ninth’s Circuit’s opinion.
A Classic Song: The song “Maggie May” by raspy-voiced rock singer Rod Stewart has a very special place in my heart. Every time I hear the song, I am transported back to a sunny afternoon in May 1974, when my high school buddy Dave Morris and I played hooky and drove into Washington where we sat at a sidewalk café for hours before driving home along the G.W. Parkway in Dave’s Chevy Vega with the windows open and the song “Maggie May” playing on the radio.
All of these memories came flooding back to me anew as I read the October 22, 2015 Wall Street Journal interview of Stewart (here) in which he explained how he came to write and record the song. It turns out that the song itself is a vestige of an experience from Stewart’s own youth. Here’s a great 1971 video of Stewart performing the song. I can’t explain why he is kicking the soccer ball around with the other band members at the end of the video. (Sorry about the advertisement at the beginning of the video.)