Innocent Third Parties

The scienter (i.e., fraudulent intent) of an officer who makes a false or misleading statement can be imputed to the company based on the law of agency, but that rule potentially is subject to an “adverse interest exception” in cases where the officer acted purely out of self-interest and his conduct did not benefit the company.  Earlier this year, The 10b-5 Daily discussed a decision from the Northern District of California where the court, in a case involving improperly claimed expenses, applied the adverse interest exception and found that the plaintiffs had failed to adequately plead that the company acted with scienter.  Accordingly, the case was only allowed to proceed against the officer who had engaged in the bad conduct.

In a decision issued last week, however, the Ninth Circuit considered the same issue and has rejected the application of the “adverse interest exception” as a pleading matter.  In In re ChinaCast Education Corp. Sec. Litig., 2015 WL 6405680 (9th Cir. Oct. 23, 2015), there was no dispute that the company’s CEO had embezzled millions of dollars of corporate assets and made false statements to investors while his fraudulent activities were ongoing.  The district court, however, invoked the “adverse interest exception” and refused “to impute scienter [to the company] from the fraud of a rogue agent.”

On appeal, the Ninth Circuit noted that the “adverse interest exception” is itself subject to an exception.  Under the relevant common law principles, “the adverse interest rule collapses in the face of an innocent third party who relies on the agent’s apparent authority.”  As set forth in the ChinaCast complaint, “third-party shareholders understandably relied on [the CEO’s] representations, which were made with the imprimatur of the corporation that selected him to speak on its behalf and sign SEC filings.”  Moreover, the court found, “imputation [of the CEO’s scienter to the company] 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 officials to deter securities fraud.”  Accordingly, at least as a pleading matter, the court found the adverse interest exception could not be invoked and the case against the company should proceed.

Holding: Dismissal reversed.

Quote of note: “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 rebutted remain open questions.”

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