There has been renewed interest in whether the SEC should allow a U.S. company to conduct a registered initial public offering if its bylaws require shareholders to arbitrate federal securities claims. In April 2018, SEC Chair Jay Clayton said that resolving this knotty issue is not a priority for the Commission, but the Supreme Court’s May 2018 pro-arbitration decision in Epic Systems Corp. v. Lewis, 138 S. Ct. 1612 (2018), may embolden an IPO candidate to force the issue.
In Epic Systems, the Supreme Court held that the Federal Arbitration Act (FAA) requires a court to enforce an employment agreement that requires an employee to bring federal employment claims in a bilateral arbitration against the employer, and to dismiss a federal class action brought in violation of such an agreement. As the Supreme Court reaffirmed, a plaintiff faces a “stout uphill climb” to show that some other federal statute (in this case, the National Labor Relations Act) overrides the FAA and guarantees the right to litigate in court or to bring class claims in arbitration. Id. at 1264. Indeed, over the last thirty years, the Supreme Court has rejected “every” attempt to “conjure conflicts between the [FAA] and other federal statutes.” Id. at 1627 (emphasis in original).
There are genuine policy arguments on both sides of the debate over whether federal securities claims should be arbitrable. Those in favor argue that this will eliminate vexatious securities litigation and maybe even help reverse the long-term decline in IPOs. But securities litigation is not quite as vexatious as in years past. Together, the Private Securities Litigation Reform Act of 1995 (PSLRA) and Securities Litigation Uniform Standards Act of 2002 direct all class claims to federal court, where cases filed around the country can be consolidated for efficient pretrial management, and where entirely meritless claims should not survive long.
Federal Rule of Civil Procedure 23(f) permits interlocutory appellate review of class certification orders. And when a federal class action is settled, the defendant can secure class-wide peace. Not all of those features of federal court litigation are readily available in arbitration, so registrants should be careful before assuming that arbitration is preferable in every respect.
Opponents argue that shutting the courthouse doors to investors will impair the effective enforcement of the securities laws. And if only institutional or wealthy investors can afford to bring arbitrations, there may well be a danger that retail investors go unprotected. But here, too, things are not entirely one-sided. Ultimately, it is investors who bear the costs of meritless litigation. And if investors truly value the right to litigate in a federal class action, then the market should be willing to pay more for shares that include that right, thereby incentivizing registrants to keep offering them.
Moreover, allowing federal securities claims to be arbitrated would hardly stop the development of the law in its tracks, as some have suggested. To be sure, private civil securities actions have yielded many important precedents, including cases limiting the territorial reach of the securities laws, see Morrison v. Nat’l Australia Bank Ltd., 561 U.S. 247 (2010), and defining what it means to “make” a misstatement, see Janus Capital Grp., Inc. v. First Derivative Traders, 564 U.S. 135 (2011), and for fraud to be “in connection with” a securities transaction, see Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S. 71 (2006).
But civil and criminal cases brought by the SEC and Department of Justice, too, have given us important case law, including decisions that tell us what a security is, see S.E.C. v. W.J. Howey Co., 328 U.S. 293 (1946), and that describe scienter, see Aaron v. SEC, 446 U.S. 680 (1980), and the contours of insider trading, see United States v. O’Hagan, 521 U.S. 642 (1997). In any event, the Supreme Court has long endorsed the arbitrability of claims under the federal antitrust, labor, and antiracketeering laws without any concern for the impact that would have on the availability of judicial decisions to elucidate the law. It is not immediately obvious why that concern should bear any greater weight in the context of the federal securities laws.
SEC Blocks Carlyle Group IPO in 2012
The last time it confronted the issue, in 2012, the SEC effectively blocked the IPO of a U.S. company, Carlyle Group, whose governing documents required the arbitration of federal securities claims. The SEC did that by declining to exercise its authority under § 8(a) of the Securities Act of 1933, 15 U.S.C. § 77h(a), to accelerate the effective date of the registration statement. The issue was not litigated in 2012, but if it ever were, it is not at all clear that § 8(a) actually permits the SEC to block an IPO based on its dim view of arbitration (as opposed to its view as to whether the arbitration requirement is properly disclosed to investors).
And the SEC was surely wrong to suggest in 2012 that the FAA is overridden by the anti-waiver provisions in the securities laws, 15 U.S.C. §§ 77n, 78cc(a). In the context of permitting securities brokers to require their customers to arbitrate, the Supreme Court long ago held that those anti-waiver provisions only block waivers of the substantive protections of the securities laws. See Rodriguez de Quijas v. Shearson/American Express, Inc., 490 U.S. 477 (1989); Shearson/American Express, Inc. v. McMahon, 482 U.S. 220 (1987).
A registrant that is truly motivated to press the arbitration issue would seem, therefore, to have real arguments to challenge any future attempt by the SEC to block its IPO. It is not clear that any registrant would want to begin its life as a public company litigating against the SEC, nor that such a fight would attract underwriters and investors. But if the SEC were to change course and affirmatively endorse arbitration, or even if it punted on the issue by simply letting the registration statement become effective, the arbitrability issue would be ripe as soon as an investor filed a federal class action and the registrant moved to dismiss in favor of arbitration.
The Epiq Systems decision makes clear that debates about the wisdom or not of arbitrating securities claims should play little role in resolving the question. Under the FAA, all federal statutory claims are subject to arbitration unless Congress has said otherwise. Some have suggested that the PSLRA reflects a Congressional judgment that securities claims should be litigated as class actions in federal court. But to displace the FAA, Congress must speak with a good deal more “clarity” than it did in the PSLRA. See CompuCredit Corp. v. Greenwood, 565 U.S. 95, 103-04 (2012). Congress knows how to displace the FAA for particular claims, as it did when it expressly invalidated agreements that require arbitration of whistleblower claims. See 18 U.S.C. § 1514A(e)(2). And in any event, the PSLRA was intended to rein in abusive securities class actions, not to exalt them above all other forms of dispute resolution.
Opponents have also suggested that the FAA does not require enforcement of arbitration provisions set forth in a company’s bylaws because corporate bylaws do not qualify as a written “contract” to arbitrate for purposes of the FAA, see 9 U.S.C. § 2. But state law generally determines whether there is an agreement to arbitrate, see, e.g., Volt Information Services, Inc. v. Bd. of Trustees of the Leland Stanford Junior University, 489 U.S. 468, 475-76 (1989), and Delaware law, which governs the constitutional documents of many U.S. companies, treats corporate bylaws as contracts between the company and its shareholders, see Hill Int’l, Inc. v. Opportunity Partners L.P., 119 A.3d 30, 38 (Del. 2015).
One other thing is clear from the Epic Systems opinion. Even assuming the continued viability of the Chevron doctrine, the Supreme Court is likely to pay little heed to the SEC’s views on whether federal securities claims are subject to mandatory arbitration. According to the Supreme Court, an agency like the SEC has no relevant expertise to bring to bear on the question of whether the statute it administers can be reconciled with the Arbitration Act. See Epic Systems, 138 S. Ct. at 1629. And the SEC’s views are likely to command even less deference if it changes its position on that question. See id. at 1630.
Andrew Rhys Davies is a partner in the litigation practice at Allen & Overy LLP in New York. He assists clients with their U.S. litigation and regulatory problems, focusing on securities and financial services, and on cross-border matters involving jurisdictional and comity issues.