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E-MailCydney S. Posner is special counsel at Cooley LLP. This post is based on a Cooley publication by Ms. Posner.
This is the opening paragraph from Tuesday’s column by Alison Frankel, one of my favorite legal columnists/bloggers:
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…mark a new SEC policy on mandatory arbitration, they could be the beginning of the end of securities fraud class actions.
As she continues, the concept of mandatory arbitration of shareholder claims has been run up the flagpole a few times in the past. The idea took hold in the late 1980s, when SCOTUS concluded that stock brokers could enforce mandatory arbitration agreements with customers. However, in subsequent encounters, the SEC has not been particularly receptive to the idea. When a private equity fund sought to go public in 2012 with a provision in its partnership agreement requiring mandatory individual arbitration of any disputes, including disputes under the federal securities laws, Corp Fin advised that it would not accelerate effectiveness of its registration statement, and the provision was withdrawn. Then, in an interesting turn of events, binding shareholder proposals were submitted at several companies seeking to amend their bylaws to include mandatory shareholder arbitration provisions. (If this seems a bit curious, the argument submitted by the proponent was that the costs of frivolous class action litigation were ultimately borne by the shareholders, and preventing these suits would therefore benefit shareholders.) Some of these companies, attempting to excludethe proposals from their proxy statements, contended that it should be excludable under Rule 14-8(i)(2)— on the basis that implementation would cause the company to violate applicable law—because implementation would violate Section 29(a) of the Exchange Act. Section 29(a) declares void any provision “binding any person to waive compliance with any provision of this title or of any rule or regulation thereunder….” Since the bylaw prohibited claims subject to arbitration from being brought in a representative capacity, that is, in class actions, the company argued, the provision effectively waived shareholders’ abilities to bring claims under Rule 10b-5. The SEC allowed exclusion of the shareholder proposal, agreeing that there was some basis for the view that implementation of the proposed bylaw amendment would cause the company to violate the federal securities laws.
As reported, Piwowar “encouraged” companies undertaking IPOs to “come to us to ask for relief to put in mandatory arbitration into their charters.” So Piwowar’s comments appear to signal the possibility of a shift in the SEC’s position, although, as Frankel observes, it’s unclear whether new SEC Chair Jay Clayton necessarily agrees with that position. Frankel “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 at least one also indicated that federal law would likely preempt attempts at the state level to preclude adoption of provisions of this type. And, as Frankel suggests, 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.”
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Note that Piwowar’s encouragement is limited to the IPO context; whether the offer would be extended to companies that are already public is not entirely certain. In addition, to include an arbitration provision in a company’s charter would require a shareholder vote, which, for an already-public company, could be an obstacle depending on what the charter provides. Of course, companies can usually amend their bylaws without a shareholder vote, but then bylaw changes can typically be more easily undone than charter provisions.
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And what’s up with these invitations to appeal for special exceptions? In this PubCo post of July 12, I wrote about a speech by Jay Clayton in which he reminded companies about the availability of Rule 3-13 of Reg S-X. That rule permits companies to request modifications to their financial reporting obligations where they believe that the required disclosures are burdensome but not material to the total mix of information available to investors. Like Piwowar above, as noted in the post, Clayton encouraged companies to consider submitting these requests “in connection with their capital raising activities,” and stressed that the “SEC staff is placing a high priority on responding with timely guidance.” Rule 3-13 was also mentioned in the announcement extending the confidentiality provisions, which seems to imply that they really mean it. (See this PubCo post.) This latest request for requests seems to underline that these commissioners may really be willing to entertain providing relief through a series of one-offs. But it remains to be seen how much flexibility the staff will really be willing to provide.
How the markets will feel about mandatory arbitration might be a different story however. Frankel quotes Columbia law professor John Coffee, who “predicted that the combination of non-voting shares and mandatory arbitration clauses would have a price impact on companies going public.” Note, however, that the proponents of the shareholder proposals discussed above seemed to think otherwise, viewing mandatory arbitration as cost-saving and therefore shareholder favorable. In addition, as a policy matter, the article asks, without the threat of shareholder class actions, will companies still be deterred from committing securities fraud? Opinions appear to be split. Some commentators suggested in the article that, so long as big institutions don’t balk altogether at investing in companies with the charter provision, they will have sufficient interest and adequate funds to continue to pursue—and thus deter—fraudsters. However, others expressed concern for small holders, who would essentially be “left in the cold”—not that they usually reap great rewards from class actions anyway—and questioned whether, in the absence of public trials and related publicity, individual private arbitrations would adequately deter fraud.
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Interestingly, the CFPB has recently adopted a new rule that would prohibit mandatory individual arbitration provisions in agreements related to bank accounts and credit cards. However, as reported in The Hill, a group of Republican Senators has introduced a bill to repeal the rule, with several House members to follow suit. Under the Congressional Review Act, Congress can jettison agency rules adopted within the preceding 60 days by simple majority vote and a presidential signature, avoiding a Senate filibuster. You may recall that the CRA was used to repeal the SEC’s resource extraction disclosure rules. (See this PubCo post.)
