Ninth Circuit Rejects Adverse-Interest Exception in Fraud-on-the Market Securities Class Actions
Last week, the Ninth Circuit issued a decision that could affect analyses of corporate scienter in securities class actions. The court reversed the dismissal of In re ChinaCast Education Corporation Securities Litigation and held that a malfeasant executive’s knowledge could be imputed to his or her company when the executive acted with apparent authority. The court also observed that, “as a practical matter,” the adverse-interest exception presumptively does not apply in fraud-on-the-market securities class actions.
The adverse-interest exception is a deviation from the general rule that a corporate executive’s knowledge may be imputed to the company for purposes of determining corporate scienter. Under the exception, an executive’s knowledge will not be imputed to the company if he or she acted contrary to the company’s interests. The exception is typically used in cases where a rogue executive embezzles money or otherwise acts for his or her own purposes, to the detriment of the company. However, various courts have held that this exception will not apply when an innocent third party relies on the malfeasant executive’s representations that are made with apparent authority on behalf of the company.
In the ChinaCast case, ChinaCast’s CEO and founder had allegedly embezzled more than $120 million from the company in 2011 and 2012 – conduct that had allegedly “brought ChinaCast to financial ruin.” The CEO had purportedly told investors throughout this period that the company was financially healthy and stable. ChinaCast did not discover its CEO’s alleged fraud until early 2012, at which time he was removed from the Board after he had attempted to interfere with the company’s audit. A securities class action against the company and certain of its directors and officers (but not the former CEO) followed.
The U.S. District Court for the Central District of California dismissed the suit on the grounds that the adverse-interest exception barred a finding of corporate scienter. The Ninth Circuit unanimously reversed this decision, noting that “the adverse interest rule doesn’t apply in every instance where there is a faithless fraudster within the corporate ranks.” Because the CEO had acted with apparent authority on behalf of ChinaCast in its SEC filings and investor communications, and because the third-party shareholder plaintiffs had “understandably relied” on his representations, the court held that the CEO’s knowledge could be imputed to the company.
In reaching this determination, the Ninth Circuit engaged in a somewhat lengthy analysis of agency-law principles. But the court noted at the close of its opinion that such an analysis might not be necessary, as a “bona fide plaintiff will always be an innocent third party” in fraud-on-the-market suits. To avoid the “gymnastic exercise of imposing a general rule of imputation followed by analyzing the applicability of the exception to the exception,” the court observed that “having a clean hands plaintiff eliminates the adverse interest exception” on the pleadings.
For now, the Third and Ninth Circuits (as well as various U.S. district courts) appear to be the only jurisdictions that have held that an exception to the adverse-interest exception exists. No other court has suggested that the adverse-interest exception is inappropriate for dismissal of a fraud-on-the-market securities class action. However, if other Circuits follow ChinaCast, companies that are already dealing with the fall-out of a rogue executive’s actions could also face uphill legal battles regarding corporate scienter.
The adverse-interest exception also recently appeared in In re Petrobras Securities Litigation. As we noted in our prior blog, the Southern District of New York rejected the argument that Petrobras had sustained unmitigated injury from its executives’ alleged participation in a bid-rigging and political-corruption scheme because the plaintiffs had “plausibly alleged” that Petrobras had received some benefits from the alleged scheme: the company had purportedly benefited from an inflated stock price; it had been able to attract investments; and it had “benefited from remaining in favor with its political patrons.”