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E-MailCydney S. Posner is special counsel at Cooley LLP. This post is based on a Cooley memorandum by Ms. Posner.
The issue of mandatory arbitration bylaws is a hot potato—and a partisan one at that (with Rs tending to favor and Ds tending to oppose). And in this no-action letter issued yesterday to Johnson & Johnson—granting relief to the company if it relied on Rule 14a-8(i)(2) (violation of law) to exclude a shareholder proposal requesting adoption of mandatory arbitration bylaws—Corp Fin successfully passed the potato off to the State of New Jersey. Crisis averted. However, the issue was so fraught that SEC Chair Jay Clayton felt the need to issue a statement supporting the staff’s hands-off position:
The issue of mandatory arbitration provisions in the bylaws of U.S. publicly-listed companies has garnered a great deal of attention. As I have previously stated, the ability of domestic, publicly-listed companies to require shareholders to arbitrate claims against them arising under the federal securities laws is a complex matter that requires careful consideration,
consideration that would be more appropriate at the Commissioner level than at the staff level. However, as Clayton has previously indicated, mandatory arbitration is not an issue that he is anxious to have the SEC wade into at this time. To be sure, if the parties really want a binding answer on the merits, he suggested, they might be well advised to seek a judicial determination.
In what again seems to be an odd role reversal, a Harvard professor and shareholder of Johnson & Johnson submitted a proposal requesting that the board adopt a mandatory arbitration bylaw applicable to “disputes between a stockholder and the Corporation and/or its directors, officers or controlling persons relating to claims under federal securities laws in connection with the purchase or sale of any securities issued by the Corporation.” The bylaw would also prohibit class actions and include a five-year sunset provision unless re-approved by the shareholders. And again, curiously, the company fought to exclude the proposal on the basis of Rule 14a-8(i)(2), that the bylaw would violate federal and state law.
More specifically, the bylaw, the company argued, would violate federal law because it would, among other things, “weaken the ability of investors in Johnson & Johnson’s securities to pursue a private right of action under Exchange Act Section 10(b) and Rule 10b-5.” In addition, the company maintained, the staff has “long taken the view that including arbitration clauses in the governing documents of U.S. public companies is contrary to public policy.” In any event, echoing Chair Clayton, the company contended that a shareholder proposal was not the best place to address this issue. In response, the proponent argued that SCOTUS has frequently held that “mandatory individual arbitration, under the auspices of the Federal Arbitration Act, does not conflict with the ability of an aggrieved party to vindicate rights provided under any federal statute absent ‘a clearly expressed congressional intention’ to the contrary.”
The company then expanded its argument, contending that the proposal, if implemented, would also violate state law, resulting in costly litigation, and submitting in support an opinion of NJ counsel. Although, interestingly, the NJ opinion staked out a position in favor of arbitration, it ultimately concluded, notwithstanding the absence of NJ case law on point, that implementation of the proposal would likely violate NJ state law on two bases. Looking to precedent from Delaware, the opinion contended, first, that NJ does not permit the company to mandate in its bylaws arbitration of federal securities law claims, and second, that the bylaw would not be binding on future shareholders who did not approve the provision. The proponent disagreed, arguing that other Delaware case law supports the concept that “an external claim can be addressed in a charter or bylaw provision if it arises out of a relationship between the corporation and its shareholders qua shareholders.” Second, the proponent maintained that, under “basic principles of corporate law,… bylaws are a contract between a company and its shareholders, the terms of which shareholders accept when they become shareholders, and which are subject to amendment.”
Into the midst of this debate the company then submitted a letter from the Attorney General of the State of New Jersey, the state’s chief legal officer, which advised the SEC the proposal was excludable under Rule 14a-8(i)(2) because
adoption of the proposed bylaw would cause Johnson & Johnson to violate applicable state law. Longstanding principles of New Jersey law limit the subject matter of corporate bylaws to matters of internal concern to the corporation. Under New Jersey law, as under Delaware law, forum-selection provisions relating to claims under the federal securities laws do not address matters of internal concern, and bylaw provisions purporting to dictate the forum for such claims—including but not limited to mandatory arbitration provisions—are void.
Moreover, the NJAG argued, recent amendments to the New Jersey code specifically addressed forum-selection bylaws, but did not authorize forum-selection bylaws relating to federal securities law claims, thus reinforcing the NJAG’s position. Among other things, the proponent urged the SEC not to give the NJAG Letter “any special weight” because the AG was just interpreting Delaware law to reach a conclusion about New Jersey law.
But to no avail. The staff gave plenty of special weight to the NJAG—in fact, the staff’s no-action relief rode entirely on the back of the NJAG:
When parties in a rule 14a-8(i)(2) matter have differing views about the application of state law, we consider authoritative views expressed by state officials….We view this submission [by the NJAG] as a legally authoritative statement that we are not in a position to question.
In addition, the staff made the point, in granting the no-action request, that it was
not expressing its own view on the correct interpretation of New Jersey law [or] whether the Proposal, if implemented, would cause the Company to violate federal law. Chairman Clayton has stated that questions regarding the federal legality or regulatory implications of mandatory arbitration provisions relating to claims arising under the federal securities laws should be addressed by the Commission in a measured and deliberative manner.
In light of the staff’s position as a dispenser of only informal views regarding the propriety of Enforcement action, not as a body opining on the legality of the proposal, Corp Fin suggested that the “[p]arties could seek a more definitive determination from a court of competent jurisdiction.”
In his contemporaneous statement, Clayton observed that this issue has previously arisen in the “hypothetical context” of whether Corp Fin would be willing to declare an IPO effective if the company had included mandatory arbitration provisions in its governing documents. At the time Clayton had “stated that, if the issue were to arise in an actual initial public offering of a domestic company, it would not be appropriate for resolution at the staff level but would rather be best addressed in a measured and deliberative manner by the Commission.” Now the issue has come up again in a different context, and Clayton agreed that the approach taken by the staff was appropriate:
Since 2012, when this issue was last presented to [Corp Fin] in the context of a shareholder proposal, federal case law regarding mandatory arbitration has continued to evolve. Further, I am not aware of any circumstances where the Commission has weighed in on the legality of mandatory shareholder arbitration in the context of federal securities law. In light of the unsettled and complex nature of this issue, as well as its importance, I agree with the approach taken by the staff to not address the legality of mandatory shareholder arbitration in the context of federal securities laws in this matter, and would expect our staff to take a similar approach if the issue were to arise again. I continue to believe that any SEC policy decision on this subject should be made by the Commission in a measured and deliberative manner.
More generally, Clayton emphasized that the non-binding, informal nature of staff views expressed as part of the no-action process “do not and cannot definitively adjudicate the merits of a company’s position with respect to the legality of a shareholder proposal. A court is a more appropriate venue to seek a binding determination of whether a shareholder proposal can be excluded.”
