A securities fraud claim has been reinstated against ChinaCast Education Corp., a for-profit online college, based on the alleged looting of the company coffers by its CEO and founder.
The 9th U.S. Circuit Court of Appeals Friday held that the CEO’s alleged fraud could be imputed to the company for purposes of a shareholder class action because he acted with authority on behalf of the company when he allegedly mislead investors.
ChinaCast founder Ron Chan was accused of embezzling millions of dollars from his company and misleading investors in a “textbook securities fraud,” Judge Margaret McKeown wrote.
Both sides in the case agree deception occurred. The question of whether Chan’s deception can be imputed to ChinaCast, even though the company was harmed by his embezzlement, is a legal first for the 9th Circuit.
ChinaCast was founded in 1999 as an online, for-profit college that sells multimedia education content from three campuses in China. It claimed a $200 million market capitalization when listed on the NASDAQ market and its stock offering in 2008 and 2009 generated $48 million.
In 2011 outside accountants warned of weak internal financial controls, a warning that the company ignored. During the same period Chan transferred $120 million of corporate assets to outside accounts controlled by him and his allies, the court said.
Chan also allowed a company vice president to move $5.6 million in company funds to his son and pledged $37 million of company funds to secured loans unrelated to ChinaCast business.
The company removed Chan as CEO in 2012 after learning he allegedly attempted to interfere with the annual audit.
All this ruined ChinaCast, leaving it unable to afford even its legal bills, according to McKeown.
The shareholder lawsuit, filed in 2012, was dismissed against ChinaCast because the trial court concluded there was no guilty knowledge attributable to the company.
But the appeals court reversed. Imputing liability for injuries based on the acts of an employee is an important legal doctrine because it creates incentives for a corporate leader to choose people carefully and use care in delegating functions to them, McKeown said.
“Unquestionably Chan lined his own pockets at the expense of ChinaCast’s interests,” she said. Chinacast argued that Chan’s actions were adverse to the company. But here’s the rub, she said, that argument ignores that the adverse interest rule “doesn’t apply in every instance where there is a faithless fraudster within the corporate ranks.”
Although the issue is new to the 9th Circuit, a similar case arose in the Philadelphia-based 3rd Circuit. The 9th Circuit ruling mirrors the 3rd Circuit.
She also noted that Tyco International was not protected in the face of its former leader, Dennis Kozlowski’s infamous looting of Tyco.
In the Chan case, imputation of corporate responsibility also supports public policy goals of both securities and agency law, McKeown wrote.
The ruling only reinstates the securities class action fraud claim against the company and the company may still argue it was an innocent third party in Chan’s misconduct.
Case: In re ChinaCast Education Corp., No. 12-57232