Costa Brava Partnership III LP v. Chinacast Education Corp.

FOR PUBLICATION
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
IN RE CHINACAST EDUCATION No. 12-57232
CORPORATION SECURITIES
LITIGATION, D.C. No.
2:12-cv-04621-
JFW-PLA
COSTA BRAVA PARTNERSHIP III LP,
individually and on behalf of all
other persons similarly situated, OPINION
Plaintiff-Appellant,
v.
CHINACAST EDUCATION
CORPORATION; NED SHERWOOD;
STEPHEN MARKSCHEID; DEREK
FENG; DANIEL TSEUNG,
Defendants-Appellees.
Appeal from the United States District Court
for the Central District of California
John F. Walter, District Judge, Presiding
Argued and Submitted
April 7, 2015—Pasadena, California
Filed October 23, 2015
2 IN RE CHINACAST EDUC. CORP. SEC. LITIG.
Before: Stephen Reinhardt, M. Margaret McKeown,
and Milan D. Smith, Jr., Circuit Judges.
Opinion by Judge McKeown
SUMMARY*
Securities Fraud
Reversing the dismissal of a securities fraud claim, the
panel held that a CEO’s fraud could be imputed to his
corporate employer, even though his alleged embezzlement
and misleading of investors through omissions and false
statements were adverse to the company’s interests.
Taking the allegations in the complaint as true, the panel
agreed with the Third Circuit and concluded that the CEO’s
fraudulent misrepresentations¯and, more specifically, his
scienter or intent to defraud¯could be imputed to the
company because the CEO acted with apparent authority on
behalf of the company, which placed him in a position of trust
and confidence and controlled the level of oversight of his
handling of the business.
*
This summary constitutes no part of the opinion of the court. It has
been prepared by court staff for the convenience of the reader.
IN RE CHINACAST EDUC. CORP. SEC. LITIG. 3
COUNSEL
Jeremy A. Lieberman (argued), Marc I Gross, and Emma
Gilmore, Pomerantz Grossman Hufford Dahlstrom & Gross,
LLP, New York, New York; Patrick V. Dahlstrom,
Pomerantz Grossman Hufford Dahlstrom & Gross, LLP,
Chicago, Illinois; Laurence M. Rosen, The Rosen Law Firm,
P.A., Los Angeles, California; Philip Kim, The Rosen Law
Firm, P.A., New York, New York, for Plaintiff-Appellant.
William G. McGuinness (argued), Israel David, and Adam M.
Harris, Fried, Frank, Harris, Shriver & Jacobson LLP, New
York, New York, for Defendants-Appellees.
OPINION
McKEOWN, Circuit Judge:
Under Rule 10b-5 of the Securities Exchange Act of
1934, “it is unlawful for ‘any person, directly or indirectly,
. . . [t]o make any untrue statement of a material fact’ in
connection with the purchase or sale of securities.” Janus
Capital Grp., Inc. v. First Derivative Traders, 131 S. Ct.
2296, 2301 (2011) (alteration in original) (quoting 17 CFR
§ 240.10b-5(b)). Both parties agree such deception occurred
in this case: ChinaCast founder and CEO Ron Chan
embezzled millions from his corporation and misled investors
through omissions and false statements—textbook securities
fraud. The sole question on appeal is a purely legal one and
an issue of first impression in this circuit: Can Chan’s fraud
be imputed to ChinaCast, his corporate employer, even
though Chan’s looting of the corporate coffers was adverse to
ChinaCast’s interests? Taking the allegations in the
4 IN RE CHINACAST EDUC. CORP. SEC. LITIG.
complaint as true, we conclude that Chan’s fraudulent
misrepresentations—and, more specifically, his scienter or
intent to defraud—can be imputed to ChinaCast.
Significantly, imputation is proper because Chan acted with
apparent authority on behalf of the corporation, which placed
him in a position of trust and confidence and controlled the
level of oversight of his handling of the business. We reverse
the district court order dismissing the complaint under
Federal Rule of Civil Procedure 12(b)(6).
BACKGROUND
The facts are drawn from Costa Brava’s complaint, which
we accept as true for purposes of the Rule 12(b)(6) motion to
dismiss. Daniels-Hall v. Nat’l Educ. Ass’n, 629 F.3d 992,
998 (9th Cir. 2010). ChinaCast, founded in 1999, is a for-
profit postsecondary education and e-learning services
provider that sells distance learning and “multimedia
education content” over the Internet and from three campuses
in China. Before its abrupt downfall, ChinaCast boasted a
market capitalization topping $200 million and was listed on
the NASDAQ Global Select Market. ChinaCast’s stock
offerings in the United States in 2008 and 2009 generated $48
million in net proceeds.
In its March 2011 Form 10-K filing with the Securities
and Exchange Commission (“SEC”), ChinaCast disclosed
that its outside accounting firm Deloitte Tohmatsu CPA Ltd.
(an affiliate of Deloitte & Touche LLP) (“Deloitte”) had
identified “serious internal control weaknesses” with respect
to its financial oversight. The complaint alleged that, despite
this “clear warning from Deloitte” regarding its lax financial
oversight, the company and its board “turned a blind eye” to
the problem.
IN RE CHINACAST EDUC. CORP. SEC. LITIG. 5
Soon after, the complaint alleges, ChinaCast’s founder
and CEO, Ron Chan Tze Ngon (“Chan”), looted the
company’s coffers, including proceeds from the U.S. stock
offerings. From June 2011 through April 2012, Chan
“transferred” $120 million of corporate assets to outside
accounts that were controlled by him and his allies. In
addition, Chan permitted a company vice president to move
$5.6 million in company funds to his son; “unlawfully
transferred control” of two of ChinaCast’s private colleges
outside the company; and pledged $37 million in company
assets to secure third-party loans unrelated to ChinaCast’s
business. These actions brought ChinaCast to financial ruin.
The company cannot even afford its legal bills, according to
its lawyers, who submitted a bare-bones brief on appeal and
stated that “ChinaCast now unfortunately lacks the funds
necessary to mount with full vigor the defense of this appeal.”
In the midst of this fraud on multiple fronts, Chan and
ChinaCast Chief Financial Officer Antonio Sena participated
in a series of earnings calls and other communication with
investors. During these calls, neither official disclosed the
fraudulent activities taking place; instead, Chan emphasized
the company’s financial health and stability. For example, in
a press release and conference call in fall 2011, Chan
reassured investors that “no questions or concern[s] have ever
been raised by the company’s auditors or audit committee
about our cash balances.” Throughout 2011, Chan signed
SEC filings on behalf of ChinaCast and never disclosed the
$120 million in transfers and other fraudulent activities afoot.
In early 2012, ChinaCast’s board discovered that Chan
had attempted to interfere with an annual audit. The board
removed him as chairman and CEO on March 26, 2012, and
Sena resigned the next day. Beginning in April 2012,
6 IN RE CHINACAST EDUC. CORP. SEC. LITIG.
ChinaCast disclosed in a series of SEC forms that it had
“uncovered questionable activities” and illegal conduct on the
part of its senior officers.
In September 2012, a group of ChinaCast shareholders
who bought stock between February 2011 and April 2012
(“the shareholders”) brought this federal securities lawsuit,
alleging that ChinaCast, Chan, Sena, and the company’s
independent directors violated Rule 10b-5 of the Securities
Exchange Act of 1934.
The district court dismissed the complaint with prejudice
under Rule 12(b)(6).1 With respect to the claim against
ChinaCast, the court concluded that the shareholders failed to
plead scienter—a bedrock requirement of Rule 10b-5.
Although the actions of corporate agents usually are imputed
to the corporate entity, the district court noted that under the
“adverse interest exception,” courts “refus[e] to impute
scienter from the fraud of a rogue agent.” In this case, “there
is no allegation that Chan or his accomplices acted out of
anything other than their own self-interest, or that their
conduct in any way benefitted ChinaCast.” Because Chan
acted adversely to ChinaCast’s interests, the district court
concluded that Chan’s scienter or intent to defraud could not
be imputed to the corporation. The shareholders therefore
failed to allege scienter as against the corporation.
1
The shareholders only appeal their claim against ChinaCast. Chan and
Sena reside outside the United States and, according to the shareholders,
have evaded service of process. The district court dismissed the claims
against ChinaCast’s independent directors because of a lack of scienter.
The shareholders do not challenge that aspect of the ruling.
IN RE CHINACAST EDUC. CORP. SEC. LITIG. 7
ANALYSIS
Federal securities law, embodied in the Securities Act of
1933 and the Securities Exchange Act of 1934, “create[s] an
extensive scheme of civil liability,” which encompasses not
only SEC enforcement actions but a private right of action
implied by the terms of § 10(b) of the 1934 Act. Central
Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.,
511 U.S. 164, 171 (1994). These private suits serve the
“animating purpose of the Exchange Act: to insure honest
securities markets and thereby promote investor confidence.”
United States v. O’Hagan, 521 U.S. 642, 658 (1997); see also
Dura Pharm., Inc. v. Broudo, 544 U.S. 336, 345 (2005) (“The
securities statutes seek to maintain public confidence in the
marketplace. They do so by deterring fraud, in part, through
the availability of private securities fraud actions.” (internal
citation omitted)). Such suits, however, are a double-edged
sword, because they also can breed abusive litigation and
“impose substantial costs on companies and individuals
whose conduct conforms to the law.” Tellabs, Inc. v. Makor
Issues & Rights, Ltd., 551 U.S. 308, 313 (2007). To balance
these competing forces, and “[a]s a check against abusive
litigation by private parties, Congress enacted the Private
Securities Litigation Reform Act of 1995,” or PSLRA. Id.
The PSLRA, among other things, imposes “[e]xacting
pleading requirements” that require “plaintiffs to state with
particularity both the facts constituting the alleged violation,
and the facts evidencing scienter, i.e., the defendant’s
intention ‘to deceive, manipulate, or defraud.’” Id. (quoting
Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194 & n.12
(1976)). Plaintiffs must show a “strong inference” of scienter
to survive a motion to dismiss. 15 U.S.C. § 78u-4(b)(2)(A).
8 IN RE CHINACAST EDUC. CORP. SEC. LITIG.
The scienter requirement is at the center of this appeal.2
To be sure, CEO Chan possessed the requisite scienter, or
intent to defraud. ChinaCast itself describes Chan’s dealings
as a “massive scheme . . . to loot the Company of its most
valuable assets,” which wrought “catastrophic” damage.3 The
question is whether Chan’s scienter can be imputed to his
corporate employer, ChinaCast. We review de novo this
legal question that underlies the Rule 12(b)(6) dismissal. N.
Cnty. Cmty. Alliance, Inc. v. Salazar, 573 F.3d 738, 741 (9th
Cir. 2009).
Section 10(b) and Rule 10b-5 can be violated by any
“person,” natural or legal, including corporations. See
15 U.S.C. § 78c(a)(9) (defining person under the Securities
Exchange Act to include corporations); see also Cent. Bank
of Denver, N.A., 511 U.S. at 191 (“Any person or
entity…may be liable as a primary violator under 10b-5.”).
Of course a corporation “can only act through its employees
and agents” and can likewise only have scienter through
them. See Suez Equity Investors, L.P. v. Toronto-Dominion
2
“The elements of a private action under Rule 10b–5 are ‘(1) a material
misrepresentation or omission by the defendant; (2) scienter; (3) a
connection between the misrepresentation or omission and the purchase
or sale of a security; (4) reliance upon the misrepresentation or omission;
(5) economic loss; and (6) loss causation.’” Janus, 131 S. Ct. at 2301 n.3
(quoting Stoneridge Inv. Part., LLC v. Scientific-Atlanta, Inc., 552 U.S.
148, 157 (2008)).
3
Chan is a Chinese national who resides in China. In 2013, the SEC
brought civil charges against Chan in the United States District Court for
the Southern District of New York. Final judgment was entered against
Chan, barring him from the securities industry and requiring him to pay
$41.4 million in disgorgement, $6.65 million in interest, and a $750,000
civil penalty. SEC v. Chan Tze Ngon, No. 13-civ-6828 TPG, Dkt. No. 29
(S.D.N.Y. Jan. 16, 2015).
IN RE CHINACAST EDUC. CORP. SEC. LITIG. 9
Bank, 250 F.3d 87, 101 (2d Cir. 2001). Because the Securities
Exchange Act and accompanying regulations do not contain
any explicit instructions on when an employee’s acts and
intent are to be imputed as those of the company, courts have
looked to agency principles for guidance.4 See Hollinger v.
Titan Capital Corp., 914 F.2d 1564, 1577 (9th Cir. 1990) (en
banc) (noting that the Exchange Act’s explicit provision for
4
There is, of course, no federal common law of agency that governs
claims brought under state law in federal court. See O’Melveny & Myers
v. F.D.I.C., 512 U.S. 79, 83 (1994). We are called on here, however, to
decide if ChinaCast is (alleged to be) a primary violator of § 10(b). That
is we must define “the scope of conduct prohibited by § 10(b), [and thus]
the text of the statute controls our decision.” Cent. Bank of Denver, N.A.,
511 U.S. at 173. Accordingly this is a question of federal securities law,
albeit one guided by (common law) agency principles. In fact, scienter
itself, though an element of state common law fraud, is required only
because of the way the Supreme Court read § 10(b). See Ernst & Ernst,
425 U.S. at 196–97.
Similarly, in American Society of Mechanical Engineers, the Supreme
Court treated the issue we deal with here¯imputation¯as a question of
interpreting the Sherman Act with guidance from agency principles, not
a question of agency law in the state (New York) where the Society of
Mechanical Engineers was incorporated. See Am. Soc. of Mech. Eng’rs,
Inc. v. Hydrolevel Corp., 456 U.S. 556, 565–66 (1982); see also Dark v.
United States, 641 F.2d 805 (9th Cir. 1981) (interpreting federal income
tax law using agency principles); but see Belmont v. MB Inv. Partners,
Inc., 708 F.3d 470, 494 (3d Cir. 2013) (concluding imputation under the
Exchange Act is a question of state law).
We also note that there does not appear to be a substantive difference
between the general common law of agency on this question and that
applied in Delaware, where ChinaCast was incorporated and whose law
would presumably govern if state law applied. The parties have likewise
addressed their briefing to general agency law rather than that of a
particular state. We conclude that our analysis would not be any different
if state law controlled.
10 IN RE CHINACAST EDUC. CORP. SEC. LITIG.
secondary liability, §20(a), “was not intended to supplant the
application of agency principles in securities cases”) (internal
quotation omitted).
Under the rule of imputation, it is “fundamental that an
employer is liable for the torts of his employee committed
while acting in the scope of his employment.” Fields v.
Synthetic Ropes, Inc., 215 A.2d 427, 432 (Del. 1965); see
also Belmont, 708 F.3d at 494 (“[T]he imputation doctrine
recognizes that principals generally are responsible for the
acts of agents committed within the scope of their authority.”)
(internal citation omitted) (alteration in original). The rule
exists for good reason: “Imputation creates incentives for a
principal to choose agents carefully and to use care in
delegating functions to them.” Restatement (Third) of
Agency § 5.03 cmt. b (2006).
In the context of Rule 10b-5, we have adopted the general
rule of imputation and held that a corporation is responsible
for a corporate officer’s fraud committed “within the scope of
his employment” or “for a misleading statement made by an
employee or other agent who has actual or apparent
authority.” Hollinger, 914 F.2d at 1577 n.28. Other courts
follow the same principles, even after the advent of the
PSLRA and its strict focus on scienter: “The scienter of the
senior controlling officers of a corporation may be attributed
to the corporation itself to establish liability as a primary
violator of § 10(b) and Rule 10b–5 when those senior
officials were acting within the scope of their apparent
authority.” Adams v. Kinder-Morgan, Inc., 340 F.3d 1083,
1106–07 (10th Cir. 2003) (collecting cases); see also Makor
Issues & Rights Ltd. v. Tellabs Inc., 513 F.3d 702, 708 (7th
Cir. 2008) (“The doctrines of respondeat superior and
apparent authority remain applicable to suits for securities
IN RE CHINACAST EDUC. CORP. SEC. LITIG. 11
fraud.”); Snowstorm Acquisition Corp. v. Tecumseh Prod.
Co., 739 F. Supp. 2d 686, 706 (D. Del. 2010) (same with
respect to Delaware corporation).
In the face of these well-established parameters,
ChinaCast does not dispute that Chan acted within the scope
of his apparent authority. Nevertheless, the corporation
argues that the ordinary rule of imputation is inapposite
because of the common law’s so-called “adverse interest
exception.” Under that exception, a rogue agent’s actions or
knowledge are “not imputed to the principal if the agent acts
adversely to the principal in a transaction or matter, intending
to act solely for the agent’s own purposes or those of another
person.” Restatement (Third) of Agency § 5.04 (2006);
Hecksher v. Fairwinds Baptist Church, Inc., 115 A.3d 1187,
1205 (Del. 2015) (“[T]he adverse interest doctrine may
prevent a court from imputing knowledge of wrongdoing to
an employer when the employee has totally abandoned the
employer’s interests, such as by stealing from it or defrauding
it.”).
So far, so good for ChinaCast—unquestionably Chan
lined his own pockets at the expense of ChinaCast’s interests.
But herein lies the rub: ChinaCast’s formulation ignores that
the adverse interest rule doesn’t apply in every instance
where there is a faithless fraudster within the corporate ranks.
Specifically, the very same Restatement provision that sets
out the adverse interest exception also provides:
“Nevertheless, notice is imputed . . . when necessary to
protect the rights of a third party who dealt with the principal
in good faith.” Restatement (Third) of Agency § 504 (2006);
see also Jensen v. IHC Hosps., Inc., 82 P.3d 1076, 1091 n.13
(Utah 2003) (“Although typically an agent’s knowledge will
not be imputed to its principal when an agent is involved in
12 IN RE CHINACAST EDUC. CORP. SEC. LITIG.
fraud or other adverse dealings, an exception exists for
innocent third parties.”); In re Am. Int’l Grp., Inc., Consol.
Derivative Litig., 976 A.2d 872, 891 (Del. Ch. 2009) aff’d
sub. nom. Teacher’s Ret. Sys. of Louisiana v. Gen. Re Corp.,
11 A.3d 228 (Del. 2010) (even when the adverse interest
exception applies, “the corporation…[remains] responsible to
innocent third parties and the polity for any offense to
them”); cf. Restatement (Second) of Agency § 262 & cmt. a
(1958) (explaining how apparent authority protects third-
party reliance). In other words, there is 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.
The interplay between these principles has been explained
as follows:
The starting point is that all information
known by the agent, at least when received
within the scope of authority, is deemed
known by the principal. But this is not so if
the agent is acting contrary to the principal’s
interests—the so-called “adverse interest”
exception. In turn, the adverse interest
exception itself has an exception: the principal
is charged with even the faithless agent’s
knowledge when an innocent third-party relies
on representations made with apparent
authority.
Donald C. Langevoort, Agency Law Inside the Corporation:
Problems of Candor and Knowledge, 71 U. Cin. L. Rev.
1187, 1214 (2003).
IN RE CHINACAST EDUC. CORP. SEC. LITIG. 13
In short, parsing the common law in context—looking to
both the adverse interest exception and its imbedded caveats
that are essential to cabining its scope—compels the
conclusion that Chan’s scienter can be imputed to the
corporation in these circumstances. Restatement (Third) of
Agency § 5.04 cmt. b (2006) (noting that adverse interest rule
and its exceptions work together “as a whole” so that the
“doctrine reflects a balance among factors that, if pressed in
isolation to their respective extremes, would lead to divergent
outcomes”). 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.
Although a question of first impression in this circuit,
case law from other courts confirms that imputation is proper
even in the face of Chan’s double dealing. The Third Circuit
recently confronted the same issue in the case of an
investment adviser who perpetrated a Ponzi scheme, diverting
$20 million of client funds to finance his lavish lifestyle.
Belmont, 708 F.3d at 479. Defrauded clients sued the
corporate employer, MB Investment Partners, Inc., for fraud
under Rule 10b-5. Id. at 494. Just like ChinaCast, the
corporation invoked the adverse interest exception. The
Third Circuit rejected that argument and held that imputation
is appropriate when an employee acts within his actual or
apparent authority. Significantly, the court held that “a
swindler may still act with apparent authority, even if he is
acting for his own benefit.” Id. at 496 (citation omitted). The
court noted that the “underlying purpose of imputation” is
“fair risk-allocation, including the affordance of appropriate
protection to those who transact business with corporations.”
Id. Hence, when a corporate officer commits wrongdoing,
the “principal who has placed the agent in the position of trust
14 IN RE CHINACAST EDUC. CORP. SEC. LITIG.
and confidence should suffer, rather than an innocent
stranger.” Id. at 494–95 (internal citation omitted); see id. at
497.
In the same vein, in the federal antitrust context, the
Supreme Court endorsed the identical principle of imputation:
“[A] principal is liable for an agent’s fraud though the agent
acts solely to benefit himself, if the agents acts with apparent
authority.” Mech. Eng’rs, 456 U.S. at 566. According to the
Court, imputation and the corresponding threat of civil
liability give an employer greater incentive to “see to it that
[its] agents abide by the law” and “take systematic steps” to
prevent misconduct. Id. at 572–73 (internal citation omitted)
(alteration in original). Although Mechanical Engineers is an
antitrust case, its reasoning is not limited to that context. The
Supreme Court explained that the “[a]pparent authority
theory has long been the settled rule in the federal system”
and cited Gleason v. Seaboard Air Line Ry. Co., 278 U.S. 349
(1929), a railroad tort case. Mech. Eng’rs, 456 U.S. at
567–68. Significantly, the Supreme Court cited two Rule
10b-5 securities cases, among others, in noting that “[i]n a
wide variety of areas, the federal courts, like this court in
Gleason, have imposed liability upon principals for the
misdeeds of agents acting with apparent authority.” Id. at
568.
ChinaCast and the district court cite to several district
court decisions that invoke the adverse interest exception.
See In re Rent-Way Sec. Lit., 209 F. Supp. 2d 493, 522 (W.D.
Penn. 2002); In re Cendant Corp. Sec. Litig., 109 F. Supp. 2d
225, 232–34 (D. N.J. 2000). These cases are hardly
illuminating, however, because they do not address the
relationship between the adverse interest exception and third-
party reliance and apparent authority. In contrast, other
IN RE CHINACAST EDUC. CORP. SEC. LITIG. 15
district courts have invoked apparent authority to override the
adverse intent exception, including a Rule 10b-5 case
involving Dennis Kozlowski’s infamous looting of Tyco. In
re Tyco Int’l, Ltd., 2004 WL 2348315, No. MDL 02-1335-B,
02-266-B, at *6 (D. N.H. Oct. 14, 2004) (holding that the
“adverse interest exception is inapplicable when a corporate
officer or director makes a material misstatement or omission
to an innocent third party while acting with the apparent
authority of the corporation for whom he works”); see also
Puskala v. Koss Corp., 799 F. Supp. 2d 941, 944, 947 (E.D.
Wis. 2011) (holding corporation liable for its vice president’s
embezzlement of more than $30 million from the company to
purchase designer clothing, jewelry, furs, and other items
even though she “committ[ed] fraud against the company
rather than on behalf of it” because she acted with apparent
authority by signing the corporation’s SEC filings).
In the circumstances of this case, imputation also
comports with the public policy goals of both securities and
agency law—namely, fair risk allocation and ensuring close
and careful oversight of high-ranking corporate officials to
deter securities fraud. See Belmont, 703 F.3d at 494–95
(noting that the “principal who has placed the agent in the
position of trust and confidence should suffer, rather than an
innocent stranger” (internal citation omitted)); see also
Broudo, 544 U.S. at 345; State Farm Fire and Cas. Co. v.
Sevier, 537 P.2d 88, 96 (Or. 1975) (“[O]ne who selects an
agent and delegates authority to him should incur the risks of
the agent’s infidelity or want of diligence rather than innocent
third persons.”).
According to the complaint, which governs our analysis
at this early procedural stage, ChinaCast received an audit
from Deloitte in 2011 detailing “material internal control
16 IN RE CHINACAST EDUC. CORP. SEC. LITIG.
weaknesses.” Yet the corporation and its board “turned a
blind eye” and failed to take significant action or heighten
oversight. Had they done so, they may have prevented much
of the decimation of ChinaCast’s bottom line and share value.
Indeed, the $120 million in illicit withdrawals began several
months after the Deloitte report was issued. What’s more,
Chan was hardly a random corporate bureaucrat or mid-level
manager. He was ChinaCast’s founder and CEO, the one
person on whom the board undoubtedly should have kept
close tabs. See In re Fin. Mgmt., 784 F.3d 29, 31–32 (1st Cir.
1986) (noting courts have applied apparent authority rule
against corporations “particularly when the person making
the misrepresentation is an important corporate official”).
Permitting imputation under these circumstances encourages
appropriate corporate oversight.
According to the complaint, both Chan and Sena
knowingly misrepresented ChinaCast’s financial condition.
Because we conclude that their scienter can be imputed to
ChinaCast for those material misrepresentation or omissions
made within the scope of their apparent authority, the
shareholders pled sufficient allegations to support imputation
and survive the pleading requirements of the PSLRA. Of
course, whether these allegations will materialize as
admissible facts remains to be seen.
In closing, we note that at the pleading stage, a key
inquiry in § 10(b) and Rule 10b-5 cases is whether the
complaint sufficiently alleges scienter attributable to the
corporation. A threshold question is whether the pleadings
IN RE CHINACAST EDUC. CORP. SEC. LITIG. 17
support application of the adverse interest rule at all.5
Assuming a well-pled complaint, we recognize 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. The gymnastic exercise of imposing a general rule of
imputation followed by analyzing the applicability of the
exception to the exception becomes unnecessary. Of course,
as the litigation proceeds, whether the plaintiff is an innocent
third party and whether the presumption of reliance is
rebutted6 remain open questions. This approach, which takes
an appropriately narrow view of the adverse interest
exception, is consistent with the purpose of the securities laws
to deter fraud and promote confidence in the securities
markets.
The district court’s order dismissing this case with
prejudice under Rule 12(b)(6) is REVERSED.
5
In re Petrobras Sec. Litig., No. 14-CV-9662 JSR, 2015 WL 4557364,
at *12 (S.D.N.Y. July 30, 2015) (rejecting the adverse interest exception
defense because “the allegations…do not conclusively establish that the
company received no benefit from the Corrupt Executives’ actions”).
6
Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398, 2408
(2014) (reaffirming in a fraud on the market suit “the rebuttable
presumption of reliance, rather than providing direct reliance on a
misrepresentation”).