ARTICLE
18 May 2016

In Re Chinacast Education Corporation Securities Litigation: Court Finds Corporate Scienter Can Be Imputed In Certain Circumstances Even Though Employee's Actions Were Adverse To The Company's Interests

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A&O Shearman

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In In re Chinacast, the CEO and founder of a for-profit educational services provider defrauded the company of over $120 million and thus devastated its finances.
United States Corporate/Commercial Law

On 23 October 2015, in In re Chinacast Education Corporation Securities Litigation, the federal appellate court based in California addressed an issue of first impression within the jurisdiction of this court: whether an employee's intent to defraud may be imputed to the corporation as a basis for the company's liability for securities fraud under Section 10(b) of the Securities Exchange Act even where the employee acted for his or her own personal benefit and against the company's interests. The court held that, even though the intent of such an employee ordinarily may not be imputed to the company, imputation is permissible where the employee acts with apparent authority and an innocent third party relies on the employee's actions.

In In re Chinacast, the CEO and founder of a for-profit educational services provider defrauded the company of over $120 million and thus devastated its finances. There was no dispute that the CEO committed securities fraud. The only issue was whether his fraudulent intent could be imputed to the company. While the actions of corporate agents ordinarily are imputed to the company, an "adverse interest exception" protects the corporation from liability for the conduct of employees who act for their own personal benefit and against the company's interests. But the court held that when the employee acts under the cloak of apparent authority from the company and an innocent third party relies on the employee's actions, an "exception to the exception" allows the employee's adverse actions to be imputed to the corporation. This rule is meant to ensure the fair allocation of risk in protecting innocent parties who rely on an agent's apparent authority and to incentivize corporations to carefully choose and monitor high-ranking corporate officials (who are the most likely employees to have such authority). In this case, the securities fraud claims were based on disclosures that the CEO made with apparent authority concerning the company's finances and innocent investors relied on these statements.

Although this was an issue of first impression within the jurisdiction of this court, the court here noted that other courts around the country have adopted the same rule. The court found it particularly significant that the employee at issue was the company's CEO and founder and that the corporation's board failed to properly oversee him. In addition, the court explained that at the pleading stage of a securities class action, whenever an employee acts with fraudulent intent under his or her apparent authority from the company and a claim for securities fraud is brought by a legitimate investor, that intent will be imputed to the company at this initial stage because all investors are presumed at this early point to have relied on the alleged misrepresentations or omissions at issue.

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