In Re ChinaCast Educ. Corp. Litig.: Court Reverses Summary Judgment Ruling Dismissing Securities Fraud Claims

In In Re ChinaCast Educ. Corp. Litig., No. 12-57232, 2015 BL 349540, (9th Cir. Oct. 23, 2015), the United States Court of Appeals for the Ninth Circuit reversed the lower court’s dismissal of a securities fraud claim, holding the investors (collectively, “Plaintiffs”) of Defendant ChinaCast Education Corporation (“ChinaCast”) adequately met the pleading requirements of the Private Securities Litigation Reform Act (“PSLRA”). 

The Plaintiffs’ alleged that ChinaCast’s CEO, Ron Chan (“Chan”), moved hundreds of millions of dollars of corporate assets to outside accounts between June 2011 and April 2012, including one controlled by the son of a ChinaCast vice president, and pledged an additional $37 million in ChinaCast assets to secure loans unrelated to its business. The Plaintiffs further alleged Chan did not disclose any of the fraudulent activities taking place, but emphasized ChinaCast’s financial stability in a number of different communications with investors. The Plaintiffs contended that they relied on Chan’s misleading statements and representations prior to the financial collapse of ChinaCast.

The Plaintiffs filed suit alleging violation of Rule 10b-5 of the Securities Exchange Act of 1934. The complaint argued that Chan acted in his official capacity as an agent of ChinaCast during his commission of these fraudulent activities, and thus his scienter could properly be imputed to ChinaCast.

ChinaCast did not dispute Chan acted within the scope of his apparent authority when he made the alleged misleading statements and misrepresentations regarding the financial health of ChinaCast. In its defense, ChinaCast argued that because Chan’s actions were adverse to the interests of the corporation, imputation of Chan’s scienter to the corporation was improper under the common law adverse interest exception.

Under Section 10(b) of the Exchange Act and Rule 10b-5, a plaintiff must allege: (1) a material misrepresentation (or omission); (2) scienter; (3) a connection between the misrepresentation and the purchase or sale of a security; (4) reliance upon the misrepresentation; (5) economic loss; and (6) loss causation. The PSLRA requires plaintiffs “to state with particularity both the facts constituting the alleged violation, and the facts evidencing scienter.”

In the context of Rule 10b-5, a corporation can be held responsible for a corporate officer’s fraud committed within the scope of his or her employment. The adverse interest exception may prevent a court from imputing knowledge of wrongdoing to a principle when the agent has completely abandoned the interests of the employer, such as by stealing from, or defrauding, it. Knowledge of wrongdoing may be imputed, however, when it is necessary to protect the rights of an innocent third party who dealt with the principle in good faith and relied on the agent’s apparent authority.

The court held Chan’s individual scienter could be imputed to ChinaCast, finding the adverse interest exception failed in the face of the Plaintiffs’ reliance on Chan’s authority and alleged misrepresentations. The court also found imputation comported with the public policy goals of both securities and agency law by encouraging fair risk allocation and careful oversight of high-ranking corporate officials to deter securities fraud. The court explained that when a corporate officer commits wrongdoing, the principal that placed the agent in a position of trust and confidence should suffer, rather than an innocent third party.

Accordingly, the court held the Plaintiffs’ allegations of imputation were sufficient to survive PSLRA’s pleading requirements.

The primary materials for this case can be found on the DU Corporate Governance website.