Federal Forum Provisions and the Internal Affairs Doctrine

Dhruv Aggarwal is a J.D. Candidate at Yale Law School; Albert H. Choi is Professor of Law at the University of Michigan Law School; and Ofer Eldar is an Associate Professor of Law and Finance at the Duke University School of Law. This post is based on their recent paper. Related research from the Program on Corporate Governance includes The Market for Corporate Law by Michal Barzuza, Lucian A. Bebchuk, and Oren Bar-Gill and Federal Corporate Law: Lessons from History by Lucian Bebchuk and Assaf Hamdani.

Should a company be allowed to dictate the forum in which its shareholders can bring suit? This has been one of the most vexing and controversial issues in corporate and securities laws in recent years. At least with respect to lawsuits based on corporate law and for corporations incorporated in Delaware, the issue seems fairly well settled by now. Since the seminal case of Boilermakers Local 154 Retirement Fund v. Chevron Corp., numerous corporations began including forum selection provisions in their charters or bylaws. A key element of the decision is that forum selection for claims under state corporate law is governed by the internal affairs doctrine. The doctrine states that only the state of incorporation has authority to regulate a corporation’s internal affairs, and these internal affairs include the forum for litigating claims under the state’s corporate laws.

Forum selection with respect to federal securities lawsuits, on the other hand, is more controversial, and an important debate has taken place over whether corporations can dictate the forum for lawsuits based on federal securities laws in their charters and bylaws. Since 2017, a growing number of firms have pushed the envelope by adopting exclusive federal forum provisions (“FFPs”) that seek to limit shareholders to bringing federal law claims under the Securities Act of 1933 in federal courts only. The 33 Act, which governs claims for material misstatements or omissions in initial public offerings, specifically commits jurisdiction over these claims to both state and federal courts. FFPs were adopted in high profile initial public offerings, such as that of Snap, Inc., with the specific goal of restricting lawsuits for material misstatements or omissions in the IPO documents to federal courts. Furthermore, as the paper shows, the rate of adoptions of the FFPs significantly accelerated following the 2018 Supreme Court decision in Cyan v. Beaver County Employees Retirement Fund, which expressly validated the plaintiffs’ right to bring 33 Act lawsuits in state courts.

But what about the validity of FFPs in charters and bylaws? The answer was given, several months later. In Sciabacucchi v. Salzberg, the Delaware Chancery Court held that a company’s charter and the bylaws cannot dictate the forum in which the shareholders may bring a federal claim. The court reasoned that a corporation’s organizational documents can only address internal corporate affairs, and that claims under federal law exceed the legal bounds of the corporation’s organizational documents. Thus, under Salzberg, the internal affairs doctrine does not encompass state law provisions that regulate rights under federal law. While Cyan made the adoption of FFPs more attractive, Salzberg took away that option.

In the midst of this back-and-forth, some important policy questions remained unanswered. Should companies be allowed to have an FFP in either their charter or bylaws? How important is an FFP for a company? Why would some companies utilize them while others do not? So far there has been no systematic investigation of how widespread or how important the FFPs are. In a recent paper, we attempt to shed some light on these important issues. Through an empirical analysis, it takes a closer look at the use of FFPs in companies’ organizational documents, and evaluates the impact of the Salzberg decision on shareholder value.

First, using hand-collected data, we document the adoption of FFPs since 2017, and analyze the characteristics of firms that adopted such provisions. FFPs were adopted mainly after the Cyan decision by firms that are undergoing IPOs and that are more likely to draw lawsuits under the 33 Act. More specifically, they more likely belong to industries, such as computer software and pharmaceuticals, which have traditionally been more vulnerable to federal securities lawsuits. In addition, they tend to raise larger proceeds in their IPOs, yet exhibit negative earnings, which suggests that their valuations are based on uncertain future growth. Nonetheless, we do not find that these firms exhibit characteristics that arguably reflect greater agency problems, such as dual-class structures. To the contrary, these IPOs tend to be backed by venture capital and private equity firms, which are typically associated with better governance structures at the IPO stage, such as more independent boards. Moreover, these firms tend to underprice their IPOs, meaning that their stock prices exhibit a larger increase on the first day of trading. This suggests that these firms are seeking to reduce the risk of litigation, and that the investors in these IPOs are less likely to suffer a loss.

Second, to assess whether FFPs matter and, if so, how much, we conduct an event study of the Salzberg decision to evaluate its impact on the value of the firms with FFPs. We find that the decision is associated with a negative stock price effect. Moreover, this effect exists even if we limit the analysis (1) to firms that belong to industries that are vulnerable to federal securities lawsuits; (2) to firms that adopt the provision in their charters (as opposed to the bylaws), thereby making it harder for shareholders to amend the provision; and (3) to firms that are less vulnerable to agency costs by excluding firms that have a dual-class stock structure.

To be sure, the negative shock around the Salzberg decision does not necessarily mean that FFPs are beneficial to shareholders. First, as is applicable to all event studies, there may be intervening events around the decision that may have contributed to the result. Second, the decline in stock prices may reflect the higher likelihood that firms will have to pay larger amounts in future settlements (or judgments) rather than the desirability of these provisions. Nonetheless, there are reasons to believe that our results do reflect, at least to some extent, investors’ overall view of the decision. As we explain in the article, the recovery amounts in these lawsuits are unlikely to exceed the negative effect associated with the decision. Moreover, this negative effect is robust even if we evaluate only firms that are less likely to pay large amounts in settlements, specifically firms that underpriced their stocks at the IPO, and firms whose stock traded at above the IPO price just before the Salzberg decision.

Taken together, our findings are consistent with a growing line of research that points to the excessive costs and distorted incentives that underlie forum shopping by plaintiffs. Thus, they suggest that there are good reasons to reconsider the merits of the Salzberg decision and validate FFPs. While we agree that the legal basis underlying Salzberg is defensible, we offer an alternative, more flexible interpretation of the internal affairs doctrine that could allow state courts to enforce FFPs in charters and bylaws. The empirical analysis lends some cautious support for the latter view. It also supports reforming the 33 Act to require the filing of claims in federal courts, consistent with its twin act, the Securities Exchange Act of 1934. Finally, while our analysis lends some support for FFPs, we do note that validating FFPs does not necessarily imply validation of more controversial provisions, particularly mandatory arbitration provisions, that can potentially deny shareholders the right to sue altogether. In sum, the article suggests that revisiting Salzberg is not only desirable from a policy perspective, but also is doctrinally feasible.

The complete paper is available here.

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