Ninth Circuit Rules that Bad Acts Can be Imputed to Corporation -Even if CEO Acted Against Company Interests

The Ninth Circuit Court of Appeals recently delivered an important decision concerning a corporation’s liability for the bad acts of its chief executive officer. While the case was brought under the federal securities laws, the Court reached its decision under common-law agency principles, making it broadly applicable. It reminds boards of directors to monitor the conduct of executive officers carefully and to take aggressive action when put on notice of bad acts.

Costa Brava Partnership III LP v. ChinaCast Education Corp. (9th Cir., Oct. 23, 2015, No. 12-57232) 2015 WL 6405680, arose from an egregious case of corporate looting. The founder and former CEO of ChinaCast had embezzled millions from the company and publicly lied about its financial state to investors. The plaintiffs, a group of ChinaCast shareholders, brought suit against the company under the U.S. Securities Exchange Act.

In 2012, the federal district court dismissed the complaint, reasoning that the CEO’s intent to defraud could not be imputed to the corporation. In analyzing ChinaCast’s liability for the acts of its CEO, the district court applied the “adverse interest exception,” a principle of agency law holding that an employee’s acts cannot be imputed to his or her employer if the employee was acting adversely to the company’s interests. On appeal, the Ninth Circuit reviewed whether the adverse interest exception was properly applied. The Court ruled that it was not.

Generally, a corporation is responsible for a corporate officer’s fraud committed within the scope of employment and apparent authority. ChinaCast did not dispute that in lying to investors its CEO had acted within the scope of his apparent authority, but cited the adverse interest exception to argue that the CEO had abandoned his employer’s interests and therefore his intent to defraud could not be imputed to the company.

In rejecting this argument, the Ninth Circuit recognized “an exception to the exception.” It concluded that an employee’s bad acts, even if plainly adverse to his employer’s interests, can be imputed to the employer “when necessary to protect the rights of a third party who dealt with the [employer] in good faith” and “relies on the agent’s apparent authority.” The policy reason stated was “fair risk-allocation, including the affordance of appropriate protections to those who transact business with corporations.” When a corporate officer commits wrongdoing, “the principal who has placed the agent in the position of trust and confidence should suffer, rather than an innocent stranger.”

The decision reinforces the importance of diligent board oversight of high-level officers. The Court noted that ChinaCast’s auditors had notified the board of material weaknesses in internal controls in 2011. Rather than acting aggressively to address those weaknesses, the board turned a blind eye and failed to take significant action. Moreover, the Court observed, a CEO is “hardly a random corporate bureaucrat or mid-level manager” but rather “the one person on whom the board undoubtedly should have kept tabs.”

If your board needs advice regarding internal controls, duties with respect to corporate governance or officer oversight, contact the experienced professionals at the Capobianco Law Offices.