Mandatory Securities Arbitration Under New Jersey Corporate Law

Jacob Hale Russell is Assistant Professor at Rutgers Law School. This post is based on a white paper authored by Professor Russell and signed by 25 law professors. The white paper and a full list of signatories are available here.

Under New Jersey corporate law, may a corporation adopt a mandatory arbitration provision in its bylaws that would require shareholders to bring federal securities law claims via separate individual arbitration? The issue is squarely raised by a recent shareholder proposal at Johnson & Johnson, a New Jersey corporation, that asks the board to adopt such a bylaw for “disputes between a stockholder and the Corporation and/or its directors, officers or controlling persons relating to claims under federal securities laws.”

This whitepaper explains why such a bylaw (hereafter called a “mandatory securities arbitration bylaw”) would violate the New Jersey Business Corporation Act, N.J.S.A. 14A:1-1 et seq. There are additional, compelling reasons why such a provision might be impermissible, including that it might violate the anti-waiver provisions of federal securities laws or be unenforceable under state contract law. Such arguments have been developed elsewhere and are outside the scope of this white paper.

Although bylaws may be used to modify the “corporate contract” with shareholders, that authority is not unlimited. Under New Jersey law, as in Delaware, a corporation’s bylaws may only include provisions relating to internal corporate affairs. Specifically, the statute permits bylaws to contain “any provision, not inconsistent with law or the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights or power or the rights or power of its shareholders, directors, officers or employees.” Even if mandatory securities arbitration is not otherwise “inconsistent with law,” the “relating to” clause still limits the scope of permissible topics for bylaws to those pertaining to internal affairs.

Because Securities Law is Not an “Internal” Affair, Mandatory Securities Arbitration Is Not a Proper Subject for Bylaws

Because bylaws may only include provisions “relating to” the business or affairs of the corporation, bylaws may only regulate “internal affairs claims brought by stockholders qua stockholders.” Direct litigation under federal securities laws does not raise an “internal” claim. This is clear as a matter of first principles: traditional direct securities claims, for instance under Section 11 or Rule 10b-5, concern the purchase or sale of a security. This contrasts with traditional internal matters, such as derivative litigation based on an alleged breach of the directors’ or officers’ fiduciary duties. Securities claims are not a right derived from the “corporate contract,” as this section will explain; therefore, like other claims that are external to that contract, they are not proper subjects for bylaws. This reasoning has been developed in a series of Delaware cases, beginning in Boilermakers v. Chevron and concluding most recently in Sciabacucchi v. Salzberg, a case closely on point to a potential mandatory securities arbitration bylaw.

Boilermakers held that Delaware law allowed bylaws to contain a forum selection provision that required “internal affairs” claims, such as derivative litigation, to be brought in Delaware’s courts. In so ruling, the court repeatedly noted that bylaws provisions may only govern “internal affairs,” a straightforward interpretation of the language of Delaware’s bylaws statute.

For instance, the court noted, a provision that purported to govern a shareholder’s ability to bring tort claims—e.g., an attempt to create a forum selection clause that would apply to a products liability claim brought by a shareholder who also happened to purchase a defective product from the company—would obviously be improper. As the court noted, such a bylaw “would not deal with the rights and powers of the plaintiff-stockholder as a stockholder.” The Boilermakers decision implied that a bylaw that governed securities law would not be valid because securities fraud is not an “intra-corporate matter,” but declined to rule directly on that point because the bylaws in the lawsuit clearly excluded such claims.

In Sciabacucchi, the Delaware Court of Chancery directly reached that issue, and held that securities litigation is not an “internal affair” that can be governed by the charter or bylaws. The case involved a request for a declaratory judgment against three companies that, in advance of going public, added federal forum selection provisions in their charters that specifically purported to apply to securities law claims under the ’33 Act. The court distinguished “internal affairs,” governed by Delaware corporate law, from affairs relating to corporations’ external relationships, especially rights arising out of laws of other jurisdictions. For example, a Delaware charter or bylaw clearly may not contain provisions regulating claims arising out of another state’s labor or environmental laws—indeed, even were the bylaws statute to appear to permit otherwise, Delaware would not have such authority to abrogate another sovereign’s power.

Likewise, the court noted, a securities law claim is not part of the “corporate contract.” The court squarely addressed an argument, raised by defendants in the Sciabaccuchi case, that securities law involves internal business issues, and thus were different from the hypothetical forum selection bylaw governing tort cases that the Boilermakers opinion deemed impermissible. First, the argument that securities law is “related” to business matters is not sufficient to make it an “internal affair,” as under such a loose reading, nearly any claim against a corporation would be internal. For example, the theft of a stock certificate would not be an “internal affair” simply because it involved stocks; “the fact that the stolen property consists of shares is incidental to the claim.”

Second, a typical securities lawsuit by a plaintiff against an issuer arises out of the purchase (or sale) of securities—not out of the plaintiff’s status as a shareholder or out of the corporate contract embodied in the bylaws, charter, and state corporate law. The substance of a Rule 10b-5 claim relates to a fraud made “in connection with the purchase or sale of a security,” and only a purchaser or seller may bring a claim. For a typical Rule 10b-5 claim brought by a purchaser, the fraud must have been “alive” at the time of the purchase, meaning that their claim actually arises as the result of something that happens before the plaintiff is a shareholder subject to the corporate contract. Section 11 and Section 12 claims likewise are, by their text, only available to the purchaser of a security and relate to conduct that gave rise to the purchase (e.g., a misstatement in a registration statement or prospectus, or the sale of an unregistered security). Therefore, a securities purchaser who is no longer a shareholder might still be eligible to bring a securities claim, yet not be eligible to bring a derivative claim, whose substance relates to the “internal” affairs of the corporation and whose availability derives out of the shareholder’s “continuous” relationship with the corporation.

There are other aspects of traditional securities claims that suggest their external nature. This difference is recognized in securities doctrine as well. In interpreting the requirement that a claim under Rule 10b-5 be “in connection with the purchase or sale of a security,” courts have repeatedly noted that purely internal corporate disputes are not proper subjects for securities law claims. Moreover, as “security” has a broader meaning than “stock,” and corporations may offer securities other than stock, such claims might be governed by securities law but not subject to a conventional state corporate law derivative claim. Finally, the defendants for some claims are not “internal” to the corporation, as in the list of enumerated defendants in Section 11 of the ‘33 Act, which permits plaintiffs to sue those who are officers or directors of the corporation, including underwriters and accountants who worked on the report.

New Jersey Law Produces the Same Result as Delaware

New Jersey courts have not had occasion to rule on forum selection provisions such as those contemplated by Boilermakers, nor to interpret N.J.S.A. 14A:2-9(4). But it is hard to imagine they would find differently, because the statutory regime is so similar and because New Jersey courts explicitly look to Delaware’s for corporate law interpretations.

The relevant provision of the New Jersey Act, N.J.S.A. 14A:2-9(4), was modified as of 2018 to directly track that of Delaware, 8 Del.C. §109. The legislative history confirms the intent to follow Delaware, specifically stating that the language about acceptable content for bylaws “is based upon a provision of Delaware law.” New Jersey’s bylaw provision also contains some additional language relating to forum selection, which explicitly are permitted only for disputes relating to “internal affairs.” This demonstrates that New Jersey’s legislature agrees with the reasoning of Boilermakers. Although New Jersey’s language on forum selection differs from similar text adopted by Delaware, both encode Boilermakers by explicitly permitting bylaws to adopt forum selection clauses naming the home state as the exclusive forum for litigation for internal claims. Unlike Delaware’s provision, which is shorter, New Jersey’s statute enumerates examples of the types of internal claims that may be validly subject to such a bylaw. The list does not include federal securities law or any other non-internal claim, and exclusively includes the types of “internal affairs” claims contemplated by Boilermakers, such as derivative litigation, a point repeated in the bill’s legislative history. This confirms that New Jersey law, like Delaware, envisions bylaws as being focused on internal affairs.

New Jersey courts have repeatedly noted that they will look to Delaware cases in interpreting state corporate law. The New Jersey Supreme Court has repeatedly reiterated that “in analyzing corporate law issues, we find Delaware law to be helpful.” This language is repeatedly found in New Jersey cases on corporate issues, particularly for issues of first impression. The few holdings on bylaws in New Jersey courts are also consistent with the more recent holdings by Delaware’s Court of Chancery: New Jersey Supreme Court has noted that bylaws “should be confined to matters touching the administrative policies and affairs of the corporation, the relations of members and officers with the corporation and among themselves, and like matters of internal concern.”

Excluding the Proposal under Rule 14a-8

Securities Exchange Act Rule 14a-8(i)(2) permits a company to exclude a shareholder proposal that “would, if implemented, cause the company to violate any state, federal, or foreign law to which it is subject.” Johnson & Johnson has sought to exclude the individual securities arbitration proposal on this basis, although its request centered on concerns that the proposal would violate federal securities law. This white paper has presented a second ground for excluding it. As bylaws may not include provisions that govern external affairs under N.J.S.A. 14A:2-9(4), amending bylaws to include such a provision would violate state law.

The complete white paper, including footnotes and the full list of signatories, is available here.

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