A federal appeals court's ruling that companies can be held liable for a rogue executive's wrongdoing even if the official's actions also hurt the company gives more ammunition to plaintiff attorneys in securities litigation.

The exception to the general legal rule that companies should not be held liable for an executive's wrongdoing comes into play if innocent third parties rely on the executive's authority, the 9th U.S. Circuit Court of Appeals in San Francisco ruled last month in In re: ChinaCast Education Corp. Securities Litigation.

“The language in the opinion was awesome for plaintiffs,” said Rob Yellen, New York-based executive vice president of FINEX North America, a unit of Willis Group Holdings P.L.C.

Auditors for the Hong Kong-based educational services provider revealed “serious internal control weakness” in 2011, according to the ruling.

Soon after, founder and CEO Ron Chan Tze Ngon looted the company's coffers, including proceeds from its U.S. stock offering, and transferred $120 million of corporate assets to outside accounts, among other activities.

During this time, Mr. Chan and another executive emphasized ChinaCast was stable and financially healthy in investor communications, according to the ruling.

The ChinaCast board fired Mr. Chan in March 2012. In September of that year, shareholders sued ChinaCast, Mr. Chan and others.

A Pasadena, California, federal judge dismissed the case, holding that because Mr. Chan had acted against the company's interests, ChinaCast could not be held responsible for his actions. But a three-judge panel of the 9th Circuit unanimously overturned the lower court, saying the adverse interest exception, which holds that an executive's knowledge will not be imputed to the company if he acted contrary to its interests, “doesn't apply in every instance where there is a faithless fraudster within the corporate ranks.”

“In other words, there is an exception to the exception: The adverse interest rule collapses in the face of an innocent third party who relies on the agent's apparent authority,” the appeals court ruled, saying that was the situation in this case.

“The complaint alleges that third-party shareholders understandably relied on Chan's representations, which were made with the imprimatur of the corporation that selected him to speak on its behalf and sign (Securities and Exchange Commission) filings,” according to the ruling.

Furthermore, ChinaCast learned of internal control weaknesses in 2011, yet failed to act. “Had they done so, they may have prevented much of the decimation of ChinaCast's bottom line and share value,” the appeals court ruled.

The 9th Circuit ruling is consistent with other circuits that have ruled on the issue, said Paul F. Rugani, a partner at Orrick, Herrington & Sutcliffe L.L.P. in Seattle.

Kevin LaCroix, executive vice president of RT ProExec, a division of R-T Specialty L.L.C. in Beachwood, Ohio, said another case where this issue emerged involved Pembroke, Bermuda-based Tyco International Ltd., whose top two officials, including former Chairman and CEO L. Dennis Kozlowski, were convicted in 2005 of looting the company.

Rio de Janeiro-based Petróleo Brasileiro S.A., known as Petrobras, unsuccessfully relied on the adverse interest doctrine in arguing earlier this year that its corrupt senior executives' knowledge could not be imputed to the company, Mr. LaCroix said. A New York federal judge dismissed some of the suit's claims in July.

Mr. Yellen said nearly every directors and officers liability policy has a conduct exclusion; if it is triggered, “the entity may find itself without coverage.”

“Where does it go from here?” said Sarah Good, a partner at Pillsbury Winthrop Shaw Pittman L.L.P. in San Francisco. “Are the plaintiffs lawyers going to try to push the envelope and have this apply to management in positions other than the CEO position?”

While the 9th Circuit's ruling was fairly narrow, she expects more tests of the ruling's limits.