On The Case

The case against mandatory shareholder arbitration

(Reuters) - Plaintiffs lawyers and consumer advocates seem increasingly concerned that sometime soon, whether it’s through a corporate charter provision in an IPO or via a bylaw change for an already-public company, a public corporation is going to attempt to impose mandatory arbitration on its shareholders.

Anti-arbitration advocates are girding for that fight. In May, after Securities and Exchange Commission chair Jay Clayton left open the possibility that the SEC might support an IPO featuring a mandatory arbitration provision, lawyers at Public Justice, Public Citizen and the American Association for Justice teamed up with consumer stalwarts, including the Consumer Federation of America and the Consumers Union, in an advocacy group called Secure Our Savings. The entire mission of SOS is to whip up opposition to any prospective corporate scheme to force shareholders into arbitration.

“I’ve had a series of meetings with corporate defense and shareholder lawyers,” said Paul Bland of Public Justice, one the coalition’s leaders. “I’ve been saying, ‘If you think 2017 was bad for companies like Equifax and Wells Fargo, you can expect the same strong scrutiny for any company that says shareholders don’t have the right to sue.”

On Monday, SOS unveiled a new Consumer Federation report laying out the legal and public policy arguments against shareholder arbitration. I suspect you’ve heard the policy justifications for securities class actions as a necessary complement to regulatory policing of the capital markets: Class actions, among other things, give small investors a shot at recovering damages they couldn’t otherwise afford to pursue; assure accountability by ratcheting up the financial exposure for misbehaving companies; and push development of securities law liability theories. All true, in my view, but not decisive if the issue of mandatory shareholder arbitration ends up in court.

So let’s look at the key legal arguments against shareholder provisions, as outlined in the Consumer Federation’s report. The report’s most sweeping assertion – and one that the SEC has advanced on the many occasions in which it has previously opposed mandatory shareholder arbitration proposals – is that federal securities laws contain anti-waiver provisions that preclude delegation of enforcement to arbitrators. The Consumer Federation cited the U.S. Supreme Court’s 1987 ruling in Shearson/American Express v. McMahon, which upheld mandatory arbitration agreements between brokerages and their customers – but also said that the anti-waiver protections of the Securities and Exchange Act of 1934 are violated if an agreement “weakens (investors’) ability to recover.”

In the Shearson case, the consumer group said, the SEC argued that investors’ rights wouldn’t be impaired if they arbitrated claims against brokers because the agency would retain oversight of the arbitration process. But the agency has said it does not have the same oversight authority in disputes between companies and their shareholders, so, according to the Consumer Federation, the anti-waiver protections kick in.

Congress passed the key anti-fraud securities laws in 1933 and 1934, after the Federal Arbitration Act was signed into law in 1925. So the FAA, according to the Consumer Federation, does not override the laws’ anti-waiver provisions because Congress specified federal court jurisdiction for securities enforcement. As you know, the 1933 and 1934 laws did not address private securities class actions, but the Consumer Federation report argues that Congress subsequently addressed shareholder actions in the Private Securities Litigation Reform Act and the Securities Litigation Uniform Standards Act of 1998. If lawmakers wanted to allow mandatory arbitration of shareholder claims, the report said, they could have done so in those laws, but didn’t. At this point, the report said, it should be up to Congress, rather than a maverick company testing the SEC’s mettle, to change the longstanding policy that shareholder claims belong in federal court.

Moreover, according to the Consumer Federation, corporate bylaws and charters aren’t the sort of contract the FAA is generally considered to cover. “Changes to corporate bylaws or corporate organizational documents are simply not agreements subject to the protections of the FAA,” the Federation said. “Several key elements of contract are missing, including, to varying degrees, privity and consent.” (On this point, the consumer group cited a 2013 letter to the SEC from 29 securities law professors, who argued that although corporate bylaws are often compared to contracts, they “are vastly dissimilar to the kind of contractual agreements that have been enforced by courts, including the Supreme Court, under the FAA.”)

It’s true, the report acknowledged, that Delaware’s Chancery Court has blessed corporate bylaw amendments that, for instance, require shareholders to litigate breach-of-duty claims in Chancery Court instead of other state courts. The Consumer Federation report refers to the Delaware decision, Boilermakers v. Chevron only glancingly, but the Federation’s financial services counsel, Micah Hauptman, told me it’s not up to Delaware or any other state court to determine whether corporations can restrict shareholders’ rights under federal law.

Both Bland and Hauptman said that ultimately, all investors will be worse off if corporations are not accountable to shareholders in securities class actions. “Our federal securities laws have provided the U.S. capital system with the most transparent, fairest, most liquid system in history,” Hauptman said. “If you take that away, our capital markets will cease to function the same way.”

There are, of course, contrary arguments about the anti-waiver provisions of federal securities law, the primacy of the FAA in shareholder disputes and the contractual nature of corporate charters and bylaws. A good place to go for those is a 2013 Harvard Law Review paper, Stockholder Adoption of Mandatory Individual Arbitration for Stockholder Disputes, in which Harvard professor Hal Scott and Cleary Gottlieb Steen & Hamilton partner Leslie Silverman argue that Supreme Court and Delaware precedent allow corporations to adopt bylaws requiring arbitration of shareholder disputes.

We’re still in the realm of hypothetical, but Bland told me his coalition wants to be ready to respond fast regardless of how mandatory shareholder arbitration rears up. (In fact, he said, the reason that groups like the Council of Institutional Investors have not joined Secure Our Savings is because they aren’t set up to approve the sort of rapid response SOS anticipates.) “The goals of the coalition is to create a big explosion,” Bland said. “But another way to measure success would be if there are no changes to bylaws.”