On The Case

Shareholder alert: SEC commissioner floats class-action-killing proposal

(Reuters) - This could be the start of something huge: Securities and Exchange Commissioner Michael Piwowar said in a speech Monday to the Heritage Foundation that the SEC is open to the idea of allowing companies contemplating initial public offerings to include mandatory shareholder arbitration provisions in corporate charters. If Piwowar’s statements, first reported by my Reuters colleague Sarah Lynch, mark a new SEC policy on mandatory arbitration, they could be the beginning of the end of securities fraud class actions.

That’s a big if, of course. Mandatory arbitration of shareholder claims isn’t a new idea. In fact, as law professor Barbara Black has written, it’s been kicking around since the late 1980s, when the U.S. Supreme Court ruled in Shearson v. McMahon and a successor case that securities brokerages could enforce mandatory arbitration agreements with customers. I first wrote about the prospect of companies requiring shareholders to arbitrate their claims in 2013, after the Supreme Court ruled in American Express v. Italian Colors that arbitration agreements trump plaintiffs’ power to enforce statutory rights through class actions.

Despite that precedent, the SEC has long insisted that corporations cannot impose arbitration on shareholders because mandatory arbitration provisions would violate anti-waiver clauses in federal securities laws. The agency emphatically affirmed that position in two different contexts in 2012. When the private equity fund Carlyle floated the possibility of an individual shareholder arbitration clause as part of its initial public offering in early 2012, the SEC informed the fund that it would not accelerate its registration statement. Carlyle ended up dropping the mandatory arbitration provision.

Meanwhile, shareholders advised by University of Michigan law professor Adam Pritchard proposed bylaw amendments at three companies - Google, Pfizer and Gannett - that would have required shareholders to arbitrate federal securities claims. Pfizer and Gannett, according to Pritchard, sought to exclude the mandatory arbitration proposals from a shareholder vote. Pfizer asked the SEC to bless the exclusion. In response, the SEC agreed with Pfizer that “implementation of the proposal would cause the company to violate the federal securities laws.” (Google shareholders, according to Pritchard, voted down the mandatory arbitration proposal.)

So Piwowar’s comments to the conservative Heritage Foundation, encouraging companies to “come to us to ask for relief to put in mandatory arbitration into their charters,” seems to represent a different view of the law and public policy than the SEC has previously espoused. The SEC is operating with only three commissioners at the moment: Piwowar, who is a Republican, Republican chair Jay Clayton and Democratic commissioner Kara Stein.

It’s not clear whether Clayton is aligned with Piwowar on mandatory arbitration. As Sarah N. Lynch reported Monday, Clayton did not specifically mention the provisions in a speech last week about boosting IPOs. But the SEC chair did invite companies to petition the SEC for exemptions from disclosure requirements. Piwowar, according to Lynch’s account, put mandatory arbitration provisions into the same broad category of cooperation between the SEC and companies weighing whether to go public.

“This is important for the signal it’s sending,” said professor Adam Zimmerman of Loyola Law School. “Piwowar is sending up a flare – this might be okay with us.”

I talked to six securities law professors on Tuesday about the implications of mandatory shareholder arbitration provisions. Most said a pro-arbitration Supreme Court would likely uphold the legality of such provisions. And though Jill Fisch of the University of Pennsylvania suggested that state legislators might try to act to prohibit corporations from requiring shareholders to arbitrate disputes, much as Delaware lawmakers squelched loser-pays provisions in 2015, Michigan’s Pritchard said the Federal Arbitration Act would probably pre-empt a state law disfavoring arbitration.

If the SEC allows companies going public for the first time to require shareholder arbitration, companies that are already public won’t be far behind in imposing the requirement. And that, the profs agreed, will hamper shareholder class actions in state and federal court. If businesses can avoid securities class actions, they will.

It’s true that companies have not tried to defy the SEC and test their right to impose individual arbitration on shareholders. To the contrary: When Pritchard’s clients tried to bring mandatory arbitration proposals to shareholders, Pfizer and Gannett vetoed the proposals.

But Pritchard said SEC approval would change corporations’ calculus. “No one wants to be first,” he said. “No one wants to be the test case.”

If the SEC backs mandatory arbitration provisions, the only big impediment for corporations contemplating them would be market reaction. Will big institutional investors balk at waiving their right to sue? Columbia professor John Coffee predicted that the combination of non-voting shares and mandatory arbitration clauses would have a price impact on companies going public. But Penn prof Fisch said it might be hard for pension funds to steer clear of corporations with mandatory arbitration provisions because of index fund investments. Pritchard, as a supporter of the clauses, said he believes investors will pay more for shares of companies that don’t face the cost of defending securities class actions.

Law professors are divided on the policy consequences of forcing shareholders into individual arbitration. The primary policy question is deterrence: Are companies more likely to engage in misconduct if they don’t face the risk of accountability in the public forum of a courtroom?

New York University professor Jennifer Arlen told me they are. Arbitration, she said, is a private forum. “If you take shareholder suits out of the light of day and put them in a dark closet, you lose the deterrent effect,” she said. “The very reasons why some corporations would like the ability to require shareholders to arbitrate securities fraud claims are the reasons why it would be bad public policy to allow them to do so.”

Big investors will still have the means and motive to bring claims. They can afford the upfront costs of arbitration and their losses may justify individual proceedings. Michigan’s Pritchard said the risk of those individual arbitrations is enough to deter corporate misconduct.

But even if large institutional investors bring individual arbitrations against misbehaving corporations, said Boston University professor David Webber, author of the 2015 study Shareholder Litigation Without Class Actions, small shareholders would be left in the cold. “The SEC is supposed to be about shareholder protection,” Webber said. “To the extent possible, it should not be fostering policies that harm certain investors. The SEC is supposed to level the playing field.”

Piwowar’s comments are sure to spark more of the debate I’ve just touched upon here. Securities class actions survived their last existential crisis, when the Supreme Court reconsidered fraud on the market theory in 2014. Their next one may be in the offing.