Academic journal article Harvard Law Review

Securities Law - Rule 10b-5 - Ninth Circuit Effectively Eliminates Adverse Interest Exception as a Defense to 'Fraud on the Market' Claims

Academic journal article Harvard Law Review

Securities Law - Rule 10b-5 - Ninth Circuit Effectively Eliminates Adverse Interest Exception as a Defense to 'Fraud on the Market' Claims

Article excerpt

SECURITIES LAW--RULE 10B-5--NINTH CIRCUIT EFFECTIVELY ELIMINATES ADVERSE-INTEREST EXCEPTION AS A DEFENSE TO FRAUD-ON-THE-MARKET CLAIMS.--In re ChinaCast Education Corp. Securities Litigation, 809 F.3d 471 (9th Cir. 2015).

Because corporations cannot act or think on their own, courts apply common law agency principles (1) to impute employees' knowing conduct to their corporate employers when the employees act within the scope of their employment. However, under the adverse-interest exception, courts do not impute agents' knowledge to their principals when agents act adversely to their principals' interests. Recently, in In re ChinaCast Education Corp. Securities Litigation, (2) the Ninth Circuit held that a CEO's scienter to commit securities fraud can be imputed to his corporate employer even when the CEO's underlying conduct--looting the company coffers and concealing his theft from the board and shareholders--was adverse to the corporation's interests. (3) The Ninth Circuit refused to apply the adverse-interest exception because it found that the plaintiff shareholders were innocent third parties who relied on the CEO's apparent authority. (4) By doing so, the court effectively removed the adverse-interest exception as a defense to fraud-on-the-market claims--claims regarding the disclosure of misleading information that impacts the market price of a security (5)--at the pleading stage. (6) The court's formulaic application of traditional agency principles to attribute liability to corporations looted by their managers conflicts with the restrained approach of both Congress and the Supreme Court to liability arising from suits filed by private investors. (7) Furthermore, the court ignored important nuances associated with fraud-on-the-market securities claims that undercut the traditional policy justifications for the common law's innocent-third-party exception. Ultimately, the court's decision might be detrimental to the very class it was seeking to protect--innocent shareholders.

ChinaCast Education Corporation (ChinaCast), formerly listed on NASDAQ, (8) provides college-level education--in both physical and online formats--to students in China. (9) In March 2011, ChinaCast disclosed in its annual report filed with the Securities and Exchange Commission (SEC) that its outside auditor, Deloitte, had "identified 'serious internal control weaknesses' with respect to [the company's] financial oversight." (10) ChinaCast and its board allegedly "turned a blind eye" to Deloitte's warning. (11) Shortly after the disclosure, ChinaCast's founder and CEO, Ron Chan Tze Ngon (Chan), committed massive misappropriations--including siphoning $120 million in company funds into outside accounts--that brought the company "to financial ruin." (12) At the same time, Chan and Antonio Sena, the company's CFO, concealed the fraud from investors; Chan even emphasized ChinaCast's "financial health and stability" in conference calls and other communications to investors. (13)

After learning that Chan had attempted to interfere with an annual audit, ChinaCast's board dismissed him as CEO and chairman in March 2012. (14) Sena stepped down the following day. (15) Soon thereafter, ChinaCast announced that it had discovered illegal behavior by its senior executives. (16) In September 2012, shareholders who had purchased ChinaCast stock between February 2011 and April 2012 sued Chan, Sena, ChinaCast, and ChinaCast's independent directors in district court for violating Rule 10b-5 under section 10(b) of the Securities Exchange Act of 193417 (1934 Act). (18)

The district court dismissed the shareholders' complaint for failure to state a claim, holding that the shareholders failed to plead that ChinaCast acted with scienter as required under Rule 10b-5. (19) Applying the adverse-interest exception, the court reasoned that Chan's fraudulent intent could not be imputed to ChinaCast because his looting was adverse to the corporation's interests. …

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