Delaware Has No Ban on Public Companies Mandating Arbitration

Since the Securities and Exchange Commission removed restrictions on public companies mandating arbitration for federal securities law claims in September, only one company (incorporated in Texas) has adopted such a clause.

The potential effects of mandatory arbitration clauses for securities litigation are viewed with optimism and skepticism by different camps. However the debate may play out, these clauses can slash the legal fees of defending securities claims. By removing the specter of class actions, they also allow companies to try such claims on their merits rather than accede to extortion-level settlements negotiated in the shadow of jury trial uncertainty.

Despite these benefits for companies, the low rate of adoption has a simple explanation. According to commentators ranging from academics to SEC Chairman Paul Atkins himself, Delaware—where most public companies are incorporated—prohibits such mandatory arbitration clauses by statute.

We disagree.

The Delaware statute doesn’t bar mandatory arbitration clauses on its face.

The Delaware legislature amended Section 115 of the state’s general corporation law in July. The revised law states that stockholders, “when acting in their capacity as stockholders,” may bring claims that are not internal corporate claims in one or more forums or venues (at least one court in Delaware), if they “relate to the business of the corporation, the conduct of its affairs, or the rights or powers of the corporation or its stockholders, directors or officers.”

The text of the statute is silent with respect to arbitration clauses of any kind and doesn’t mention arbitration of federal securities claims on its face.

A textualist interpretation of Delaware law rejects any ban on mandatory arbitration clauses.

“Internal corporate claims” is defined in Section 115(b) as claims for breach of fiduciary duty or over which the law grants jurisdiction to the Delaware Court of Chancery.

Section 115(c) refers to all other claims that may be brought by stockholders. That would encompass any derivative lawsuit that asserts federal securities claims in the name of the corporation. It doesn’t include a ban on arbitration clauses for direct securities claims for two reasons.

First, direct federal securities claims, under either the Securities Act or the Exchange Act, don’t require the plaintiff to be a current stockholder. It’s common for plaintiffs to bring such claims after they already sold any stock they had in the defendant company. It would be absurd for the Delaware legislature to prohibit mandatory arbitration clauses for securities claims only to the extent that they affect current stockholders, but not former stockholders.

Second, Section 115(c)’s second invocation of “stockholders,” clarifies that the plaintiff that the subsection envisions must be acting as a stockholder. Since direct securities claims aren’t brought in one’s capacity as a stockholder, and current stock ownership isn’t a prerequisite, Section 115(c)’s limitation doesn’t apply to them.

A state legislature as experienced as Delaware’s, advised by some of the most knowledgeable securities attorneys in the nation, would know that.

Delaware law allows companies and shareholders to adopt mandatory arbitration clauses.

Opponents of arbitration clauses also ignore the fundamental tenet that each section of a statute should be construed in connection with every other section to produce a harmonious whole.

Section 122(18) permits corporations to enter contracts with one or more “current or prospective stockholders,” with an exception that the contract can’t be enforced against a corporation if it conflicts with any Delaware law. That carveout is itself subject to another carveout for Section 115.

As a result, a corporation may make a contract with stockholders that is contrary to Section 115, so even if it were somehow construed to prohibit mandatory arbitration clauses, it can be contracted away.

Banning arbitration also contravenes Delaware’s public policy favoring freedom of contract.

Decades of cases confirm that Delaware law “seeks to ensure freedom of contract and allow parties to enforce their bargains” in state court.

This principle rings all the more true with Delaware’s approach to corporate contracts, or governing documents, which freely permit corporations and their stockholders to “adopt the most appropriate terms for the organization, finance, and governance of their enterprise” in governing documents.

Delaware’s embrace of parties’ freedom of contract is, of course, part of the Contract Clause that the US Constitution and the US Supreme Court endorse. Deviating from it would violate these principles as well as setting Delaware at a competitive disadvantage relative to other states that faithfully apply this doctrine.

Finally, federalism does not permit a state ban on arbitration clauses.

The argument that Delaware would attempt to restrict arbitration through Section 115(c) runs afoul of not only its law and policy, but also to principles of federalism.

Since its seminal 2011 holding in AT&T Mobility LLC v. Concepcion, the Supreme Court repeatedly has struck down state laws that “prohibit outright the arbitration of a particular type of claim.” In the event of such a state law, “the analysis is straightforward: The conflicting rule is displaced” by the Federal Arbitration Act.

For these reasons, the forced interpretation of Section 115(c) as barring valid arbitration agreements in corporate governing documents is incorrect. We expect more Delaware-incorporated companies to adopt such arbitration clauses.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Doru Gavril is a partner and Mia Tsui is an associate in the securities litigation practice of Freshfields US.

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