Academic journal article Suffolk Transnational Law Review

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)

Academic journal article Suffolk Transnational Law Review

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)

Article excerpt

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. …

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