The U.S. Securities and Exchange Commission last year rejected without explanation the attempt by the The Carlyle Group L.P. to go public with a provision in its partnership agreement requiring individual arbitration instead of securities class actions.
That same year, the SEC refused to let shareholders of Pfizer Inc. and Gannett Co. Inc. advance a shareholder proposal to amend their corporate bylaws, opaquely stating in a no-action letter requested by management that the proposals might violate the securities laws, notwithstanding substantial U.S. Supreme Court precedent to the contrary.
Since then, the desire of the SEC to cater to the plaintiffs' securities class action bar, which earned $653 million in 2012, has become even less tenable due to the combined effect of three significant court decisions in June of this year.
In American Express Co. v. Italian Colors Restaurant, the Supreme Court upheld a mandatory individual arbitration clause in American Express contracts with merchants against an attempt to bring an antitrust class action. The court rejected the argument (endorsed by the dissent of Justice Elena Kagan) that the prohibition on class actions precluded the "effective vindication" of the merchant claims because of the exceptional cost of experts required to support antitrust claims brought individually instead of as a class. The court said the expense of bringing the individual claims was irrelevant since the right to pursue the remedy was still preserved, and that the court's reasoning plainly applies to securities claims, which are not exceptionally costly to bring.
Also in June, the highly respected Delaware Court of Chancery Boilermakers Local 154 Retirement Fund v. Chevron Corp. rejected a challenge to a "forum-selection" bylaw, adopted by the boards of Chevron Corp. and FedEx Corp., requiring that all shareholder derivative litigation (and other similar Delaware law-governed matters) be brought in Delaware. Chancellor Leo Strine stated that such a provision could bind past and future shareholders even though the shareholders had never had the opportunity to vote on it. Shareholders of these companies, Strine reasoned, were on notice that boards of Delaware corporations had the power to unilaterally adopt such bylaws.
The case is a decisive strike against the argument that a mandatory individual arbitration provision in bylaws cannot bind shareholders. The principle — that bylaw amendments adopted by boards, let alone shareholders, are binding on all shareholders — is the same whether arbitration or forum-selection clauses are at issue.
Finally, in a case most directly on point, a Maryland state trial court decided in Corvex Management v. Commonwealth REIT t hat a public real estate investment trust board of directors could require mandatory individual arbitration of securities claims in lieu of class actions. Interestingly, when the REIT went public in the late 1980s, the SEC (as in Carlyle) rejected a corporate-charter provision requiring arbitration but was unable to block the later board-adopted bylaw amendment in 2009. As in the Delaware decision, the court ruled that future shareholders had constructive knowledge of the arbitration bylaw and that all shareholders, through a provision in the share certificates, had agreed to be bound by the bylaws.
As these cases confirm, there is no legal bar to the adoption of a bylaw amendment requiring shareholders to bring securities law claims through individual arbitration. As a policy matter, securities class actions are simply bad for shareholders and are far less effective in deterring misconduct than regulatory enforcement actions targeted at individuals. Research of the nonprofit Committee on Capital Markets Regulation has shown that small investors recover so little in securities class actions that they do not bother to file for their money — 40 to 60 percent of settlement funds generally go unclaimed. Furthermore, institutional shareholders wind up suing themselves, since they are both existing shareholders and in the plaintiff class, and the lawyers take 25 percent. The corporation is the clear loser.
Nor does the prospect of securities class actions play a significant role in deterring bad behavior of corporate executives. Class action judgments primarily affect stockholders, not management, and corrupt managers are unlikely to be deterred by the possibility of them. Only about 9 percent of the fall in the value of stock can be attributed to the filing of a class action, as opposed to the earlier disclosure of wrongdoing. The threat of securities class actions — which often have little or no merit but can lead to sizeable settlements (a total of $3.3 billion in 2012) — is a major factor in the unattractiveness of our public capital markets. Private firms are deterred from going public. This, in turn, deprives investors in those companies of an IPO exit and ultimately affects the attractiveness of venture startups.
We urge the SEC to reconsider its silent opposition, at least to provide a forum for a public discussion of the issues. In the meantime, we urge companies to sidestep the need for SEC approval by allowing shareholder bylaw proposals to go forward without objection. Board-adopted bylaws may be easier to enact but are less attractive from a shareholder choice perspective. Nevertheless, if shareholders object to board bylaw changes, they can always sell their stock.
Hal Scott is professor at Harvard Law School and director of the Committee on Capital Markets Regulation. Leslie Silverman is a partner in Cleary Gottlieb Steen & Hamilton and a member of the CCMR.