The proliferation of private securities class action lawsuits remains a threat to companies whose securities are listed or traded in the United States. Securities class actions impose an extremely high cost on companies: Over the last decade, there have been more than 1,850 securities class action filings, resulting in nearly $60 billion in total settlements. These notoriously lawyer-driven filings place a significant burden on the federal bench and threaten to impede the competitiveness of the U.S. capital markets and economy.
The threat of being subject to securities class actions is among the chief deterrents to listing on an American exchange, especially in the wake of the Supreme Court’s opinion in Morrison v. National Australia Bank, 130 S. Ct. 2869 (2010). Morrison restricted the extraterritorial application of the anti-fraud provisions of the Securities and Exchange Act of 1934 (Exchange Act) primarily to securities listed on a domestic exchange, thereby providing a significant inducement to list shares outside the United States.
Additionally, private securities class actions generally fail to accomplish their primary goal of deterring corporate malfeasance because the defendants—the company’s executives and board of directors—generally are not required personally to contribute toward litigation-related costs. Rather, these costs usually are paid by the corporation or its D&O insurance carriers. To the extent the company pays, the payments, therefore, ultimately are borne by the shareholders.
Securities class actions also fall short of adequately compensating purportedly injured shareholders. Cases often settle for a fraction of investors’ losses (e.g., in 2011, the median settlement amount was 2.1 percent of the median estimated damages) and, after the lawyers have taken their fee, the recovery for the average investor is so small that many do not even file a claim for their share.
A potential solution to the securities class action problem that has received attention recently is a requirement, effectuated through a corporate bylaw provision, requiring shareholders to resolve claims through individual arbitration.
Benefits and Detriments
Arbitration is a dispute resolution method involving one or more neutral third parties, or arbitrators, whose ultimate decision is binding. Parties can agree to arbitrate on an individual—as opposed to group or class—basis, thus offering companies a distinct advantage over class actions and avoiding the well-known harms associated with such suits. In addition, arbitration, at least in theory, offers the potential for a faster and less-costly dispute resolution process than a litigation.
The discovery process may be narrowly tailored in an individual arbitration (with limited document exchange, interrogatories and depositions) and motion practice can be curtailed significantly as well. The authors’ experiences suggest, however, that to achieve the efficiency goals arbitration ideally would offer, care must be taken to craft detailed arbitration clauses placing specific limits on discovery and motion practice.
Even when it provides a more streamlined procedure, arbitration has certain drawbacks. Because of a relaxed pleading standard (e.g., there is no requirement to allege fraud with particularity as under Rule 9(b) of the Federal Rules of Civil Procedure or to meet the heightened pleading standards in the Private Securities Litigation Reform Act), it is much more difficult to obtain an early dismissal based on the pleadings. Additionally, because appellate challenges are substantially limited (to, among other things, instances where an arbitration award was procured by corruption or fraud), a corporate defendant that opts to arbitrate may be susceptible to an excessive damage award without the redress of appeal.
Arbitration as Alternative
The Federal Arbitration Act (FAA), 9 U.S.C. §1, et seq., enacted in 1925 in response to judicial hostility to enforcement of arbitration agreements, provides that agreements to arbitrate are enforceable to the same extent as other contracts and establishes a strong federal policy in favor of the resolution of disputes through arbitration. The dictates of the FAA are broad, encompassing any “contract evidencing a transaction involving commerce to settle by arbitration a controversy thereafter arising out of such contract or transaction.” (9 U.S.C. §2)
In the late 1980s, the Supreme Court expressed a strong view favoring arbitration agreements by holding that claims brought by customers against their brokers under the Exchange Act and the Securities Act of 1933 were arbitrable under pre-dispute arbitration agreements. (See Shearson/Am. Express v. McMahon, 482 U.S. 220, 238 (1987) and Rodriguez de Quijas v. Shearson/Am. Express, 490 U.S. 477, 483 (1989) (“[t]here is nothing in the record before us…to indicate that the arbitral system would not afford the plaintiff the rights to which he is entitled”).)
Notwithstanding McMahon and Rodriguez de Quijas, the policy of the Securities and Exchange Commission (SEC) has been, and continues to be, that it would be contrary to the public interest to compel investors (as opposed to customers) to arbitrate securities law violations against issuers where the agreement to arbitrate is found in the corporation’s charter or bylaws. The stated public policy rationale for this position is that the inclusion of a mandatory arbitration provision in a corporation’s governing documents does not constitute the traditional “agreement to arbitrate” that is required by the FAA. For example, whereas the agreement in the customer/broker relationship is a signed brokerage contract evincing the parties’ willingness to engage in arbitration, the “agreement to arbitrate” is theoretically less clear in the issuer/purchaser relationship where the issuer amends its bylaws to mandate arbitration and the sole indicia of the purchaser’s consent to the arbitration provision is ownership of stock. Of course, to the extent shareholder votes are required to amend a company’s bylaws, as is the case in Delaware (see Del. C. §109(a)) and elsewhere, such a rationale is arguable at best. Furthermore, investors who wish to become shareholders in a company, and thereby agree to be bound by the company’s charter and bylaws, already may face a host of significant restrictions that are not separately negotiated, such as provisions that voting power rests with management or company founders, “special meeting” provisions limiting shareholder ability to intervene in corporate matters, and “classified board” provisions that limit outsider shareholders’ ability to quickly gain control of the board.
The SEC’s legal basis for rejecting mandatory arbitration proposals has been based on the anti-waiver provision in Section 29(a) of the Exchange Act: “[a]ny condition, stipulation, or provision binding any person to waive compliance with any provision of this chapter or of any rule or regulation thereunder, or of any rule of a self-regulatory organization, shall be void.” The obvious purpose of the anti-waiver provision was to prevent negotiated deals that would undermine the protections afforded by the securities laws (e.g., parties cannot contract to opt out of the anti-fraud provisions altogether). The SEC, however, interpreted Section 29(a) to effectively mandate access to federal courts to enforce rights under the Exchange Act.
Recent Attempts to Mandate
The concept of arbitration in lieu of litigation has resurfaced recently. In late 2011, two investors submitted shareholder arbitration proposals to the boards of Pfizer Inc. and Gannett Company, Inc. that would have amended the companies’ bylaws such that shareholder claims would proceed to arbitration rather than litigation. The provisions expressly precluded class arbitration: “No controversy or claim subject to arbitration under this Article may be brought in a representative capacity on behalf of a class of stockholders or former stockholders.”
Both Pfizer and Gannett, presumably wary of the SEC’s response should the arbitration proposals succeed, sought to omit the proposals from the companies’ proxy materials (on the grounds that they would violate Section 29(a) of the Exchange Act and Delaware law) and requested “no-action” letters from the commission. The commission furnished both companies with the requested “no-action” letters, and the arbitration proposals were never put to a shareholder vote.
In January 2012, the Carlyle Group L.P., a Washington D.C. based private equity firm, included a similar provision in its registration statement in connection with an IPO. The SEC came under substantial pressure, including from prominent politicians, to block the IPO if Carlyle did not drop the arbitration proposal and eventually raised concerns with Carlyle representatives during the comment process. After several consultations with SEC staff, Carlyle withdrew the provision.
Legal Developments, Trends
In light of the SEC’s long-standing hostility to mandatory arbitration provisions, the near-future looks grim for mandated arbitration of shareholder suits. But the longer term outlook may be bright. A number of recent legal developments suggest a sea change ahead on this issue, including with respect to the ability to preclude class arbitration.
In 2010, the Supreme Court considered whether a consumer arbitration agreement that is silent on the question of class procedures could be interpreted to allow class-wide arbitration. (Stolt-Nielsen S.A. v. AnimalFeeds Int’l., 130 S.Ct. 1758 (2010).) The court determined that the parties could not be compelled to submit to class arbitration unless the agreement to do so was explicit. (Id. at 1775.) While the Stolt-Nielsen holding appeared to be straightforward, a split has developed in the circuit courts of appeal regarding the interpretation of this case. (Compare Reed v. Florida Metro. Univ., No 11-50509, 2012 WL 1759298, at *14 (5th Cir. 2012) (“arbitrators should not find implied agreements to submit to class arbitration” where the arbitration clause is silent on this topic) with Jock v. Sterling Jewelers, 646 F.3d 113 (2d. Cir. 2011) (finding, in the context of an agreement that is silent on the class question, that an arbitrator can permit class arbitration unless the parties stipulate that they had not reached agreement on the issue of class arbitration (the parties in Stolt-Nielsen so stipulated)); and Sutter v. Oxford Health Plans, 675 F.3d 215, 222-23 (3d. Cir. 2012) (same).
In April 2011, the Supreme Court upheld a commercial arbitration agreement that expressly precluded class arbitration in AT&T Mobility v. Concepcion, 131 S.Ct. 1740, finding that California precedent requiring the availability of class-wide arbitration was preempted by the FAA. (Id. at 1748.) Consistent with this holding, the Ninth and Eleventh circuits have upheld pre-dispute arbitration agreements that expressly prohibit class procedures. (See Coneff v. AT&T, 673 F.3d 1155 (9th Cir. 2012); Cruz v. Cingular Wireless, 648 F.3d 1205 (11th Cir. 2011).)
The Second Circuit, however, recently issued a conflicting opinion in In re Am. Express Merchants’ Litig., 667 F.3d 204 (2d. Cir. 2012), finding a class arbitration waiver unenforceable—even in light of Concepcion—where the plaintiffs could show that the “practical effect” of the waiver “would be to preclude their ability to bring federal antitrust claims.” (Id. at 214.) This holding has been strongly criticized as being inconsistent with Concepcion by the Ninth Circuit (see Coneff, 673 F.3d at 1159-60) and multiple Second Circuit judges who penned forceful dissents to the Second Circuit’s denial of an en banc rehearing. (See Am. Express Merchants’ Litig. No. 06-1871, 2012 WL 1918412, at **8-11.)
Several months after Concepcion, the Supreme Court decided Compucredit v. Greenwood, 132 S.Ct. 665 (2012), a consumer class action that concerned a pre-dispute arbitration agreement. At issue in Compucredit was whether the arbitration clause violated the non-waiver provision (which was very similar to Section 29(a)) and disclosure provision of the Credit Repair Organizations Act (CROA), which provides in relevant part that: “You have a right to sue a credit repair organization that violates [CROA].” (Id. at 669 [emphasis added].) The Supreme Court held that the mandatory arbitration clauses in the plaintiffs’ contracts did not violate CROA’s non-waiver provision because the statutory prescription of civil liability in court (i.e., the “right to sue”) was satisfied by arbitration. (Id. at 671.) The court concluded that “it takes a considerable stretch to regard the nonwaiver provision as a ‘congressional command’ that the FAA not apply.” (Id.)
Taken together, Stolt-Nielsen, Concepcion and Compucredit demonstrate the court’s respect for arbitration provisions and the FAA. Although these cases were decided in the context of consumer arbitration agreements, the decisions are not necessarily limited to that factual context. Indeed, Compucredit could be read to require that a “non-waiver” provision in a legislative enactment specifically articulate its intent to override the FAA in order for such a provision to preclude arbitration. (Id. at 671.) Section 29(a) contains no such express intent.
Additionally, it is not clear that the adoption of a mandatory arbitration provision would violate Delaware law (as Pfizer and Gannett claimed it would in their requests for “no-action” letters). In a recent decision, In re Revlon S’holders Litig., 990 A.2d 940 (Del. Ch. 2010), the Chancery Court found that “if boards of directors and shareholders believe that a particular forum would provide an efficient and value-promoting locus for dispute resolution, then corporations are free to respond with charter provisions selecting an exclusive forum for intra-entity disputes.” (Id. at 960 [emphasis added].) Because pre-dispute arbitration agreements are a “kind of forum-selection clause” (McMahon, 482 U.S. at 255, n.11), Revlon provides support for the idea that arbitration proposals of the type sought by Pfizer and Gannett shareholders would not be contrary to Delaware law.
In the wake of Revlon, many Delaware corporations amended their bylaws such that the Delaware Chancery Court would be the exclusive forum for shareholder suits. In early 2012, shareholders brought suits challenging the validity of these forum selection provisions. While many of the defendant corporations simply repealed the provisions (thus rendering the actions moot), FedEx Corp. and Chevron Corp. have elected to contest the lawsuits (See ICLUB Inv. P’ship v. FedEx, No. 7238 (Del. Ch. 2012); Boilermakers Local 154 Ret. Fund, et al. v. Chevron, No. 7220 (Del. Ch. 2012).) The Chancery Court’s holdings in these actions should provide useful guidance on the enforceability of forum selection and, by analogy, arbitration provisions under Delaware law.
Despite the SEC’s expressed disfavor of arbitration clauses for shareholder suits, domestic corporations should be encouraged by recent Supreme Court and Delaware Chancery Court precedent suggesting that a mandatory arbitration provision would not violate federal or Delaware law. If a challenge to an SEC rejection of an arbitration proposal were pursued and reached the Supreme Court, the outlook for the company is promising in light of the court’s now 25-year deference to and respect for arbitration clauses.
To realize the theoretical benefits of arbitration, companies that amend their bylaws to allow for arbitration of shareholder disputes should draft detailed arbitration clauses that would limit, among other things, pre-arbitration discovery (e.g., limiting the number of expert and fact depositions, custodians for electronic document discovery, and the number of interrogatories and discovery-related motions). Expert reports and depositions may be eliminated, with parties having only to disclose the expert’s opinion in summary fashion in advance of the hearing.
Additionally, arbitration clauses should identify the number of prospective arbitrators, their minimum qualifications, whether or not all arbitrators are required to be “neutral,” and the manner of their selection. Ideally, the arbitrators would be identified in advance in the provision. Given the extremely limited rights of appeal, the neutrality and aptitude of arbitrators is paramount. Ultimately, the potential benefits of arbitration can be realized only if companies and their counsel take care to sensibly craft the agreement that will set the ground rules in the event of a subsequent dispute.
Jason M. Halper, Bradley J. Bondi and Martin L. Seidel are partners in the litigation department of Cadwalader, Wickersham & Taft. William J. Foley, an associate in the firm’s litigation department, assisted with the preparation of this article.