Pomerantz LLP

Pomerantz Beats The “Adverse Interest” Exception Again

Attorneys: Marc C. Gorrie and Emma Gilmore
Pomerantz Monitor November/December 2015

A few months ago the Monitor reported that Pomerantz had defeated a motion to dismiss our Petrobras action, persuading the District Court to reject a defense based on the so-called “adverse interest” rule. There we persuaded the court that the company, Petrobras, a Brazilian company, could be responsible for frauds committed by its senior executives. Contrary to the company’s arguments, the court concluded that Petrobras derived some benefits from the frauds and its interests were therefore not entirely adverse to those of the individual wrongdoers.

Now we have prevailed over that defense again, this time in a case involving a Chinese company, ChinaCast. In a resounding victory for the firm and the class of investors we represent, the United States Court of Appeals for the Ninth Circuit, in a question of first impression, unanimously held that a senior corporate employee’s fraud is imputed to the corporation even when the fraud actually is completely adverse to the company’s interests. ChinaCast is a for-profit, post-secondary education and e-learning service provider that gives courses online and on three physical campuses in China. Founded in 1999, its shares traded on the NASDAQ Global Select Market, at one time boasting a market capitalization of over $200 million. In March of 2011 ChinaCast filed a Form 10-K with the Securities and Exchange Commission in which it disclosed that its out-side accounting firm, Deloitte Tohmatsu CPA, Ltd., had identified “serious control weaknesses” in its financial oversight systems.

Both sides in our case essentially agreed on the underlying facts. A massive fraud occurred at ChinaCast when its CEO and founder, Ron Chan Tze Ngon, looted the company and brought it to financial ruin. Chan improperly transferred $120 million of corporate assets to bank accounts that he and his associates controlled, allowed a vice president to transfer $5.6 million in Company funds to his son, transferred control of two colleges outside of the Company, and pledged $37 million in company funds to secure loans unrelated to ChinaCast’s business.

Afterwards, Chan and ChinaCast’s CFO Antonio Sena failed to disclose this critical information to investors. Instead, through a series of earnings calls and SEC filings, they assured the market of ChinaCast’s financial stability and sound accounting controls. When the extent of the scheme was finally uncovered in early 2012, ChinaCast’s Board of Directors removed Chan as CEO, and Sena stepped down. Several class action suits were commenced on behalf of investors in the Central District of California in September 2012, and Pomerantz was appointed Lead Counsel for the class.

The district court dismissed plaintiff’s claims on the grounds that scienter, a “bedrock requirement” of a suit brought under Section 10(b) of the Securities Exchange Act of 1934, was not adequately pled against ChinaCast. Scienter requires a plaintiff to plead facts creating a “strong inference” that the corporation acted with “intent to deceive, manipulate, or defraud.” The district court found that the actions and intentions of Chan and his accomplices, however detestable, could not be imputed to ChinaCast under the “adverse interest” rule.

The general rule in securities fraud cases is that a corporate executive’s scienter is imputed to the company, as the company can only act, and formulate intent, through its employees. Where the executive is high enough in the corporate hierarchy, such as CEO Chan was here, his knowledge is the knowledge of the company. However, the adverse interest exception precludes imputation of knowledge where the employee acts solely in his own interest, injuring the corporation. The district court held that Chan’s frauds benefited himself at the expense of the corporation, and therefore satisfied the adverse interest exception to the imputation rule.

On appeal, the Ninth Circuit reversed this ruling. Pomerantz managing partner Marc Gross persuaded the court that a longstanding exception to the adverse interest exception applied. Known as the “apparent authority” or “innocent third party” exception to the exception, this doctrine “holds where a person reasonably relies upon the apparent authority of an agent, that misconduct of the agent is therefore imputed to the corporation, in this case the CEO and the company,” even if the misconduct is detrimental to the company. Pomerantz argued that imputing knowledge when innocent third parties are involved advances public policy goals in that it is the company that has selected and delegated responsibility to its executives, the doctrine creates incentives for corporations to do so carefully and responsibly.

The Ninth Circuit agreed, holding that “the adverse interest rule collapses in the face of an innocent third party who relies on the agent’s apparent authority.” In other words, a corporation can be held liable to investors even where officer’s actions are adverse to that corporation’s interest when they rely in good faith on that officer’s representations.”

The Ninth Circuit’s opinion is significant because it adopts a bright-light rule where, on a well-pled complaint, “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.”

Managing Partner Marc Gross, who argued before the Ninth Circuit panel, stated that Pomerantz is “very pleased that the Ninth Circuit has made clear that corporations are accountable for defrauding investors, as they should be, even when the company’s own coffers have been looted by its own officers. After all, the corporation hired the officers and should be held responsible for how their misconduct impacts innocent investors."